Corporate Bonds

Mr. X is a long-time BCA client who visits our offices towards the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: What a year it has been. The Brexit vote in the U.K. and the U.S. election result took me completely by surprise and have added to an already uncertain economic environment. A year ago, you adopted the theme of "Stuck In A Rut" to describe the economic and financial market environment and that turned out to be quite appropriate. Consistent with that rut, many issues concerning me for some time have yet to be resolved. Global economic growth has stayed mediocre, debt levels remain elevated almost everywhere, the outlook for China continues to be shrouded in fog, and stimulative monetary policies are still distorting markets. And now we face political shifts that will have major economic and financial effects. Some big changes are underway and I fear that we are more likely to head in a negative rather than positive direction. Therefore, I am very interested to learn how you see things developing. You have recommended a cautious investment stance during the past year and I was happy to go along with that given all my concerns about the economic and policy environment. While stocks have done rather better than I expected, it has all been based on flimsy foundations in my opinion. I have never been comfortable buying an asset just because prices are being supported by excessively easy money policies. The question now is whether looming changes in the policy and economic environment and in global politics will fuel further gains in risk assets or whether a significant setback is in prospect. I hope our discussion will give some clarity on this but, before talking about the future, let's quickly review what you predicted a year ago. BCA: It has indeed been a momentous year and we do seem to be at important turning points in many areas. For example, changing attitudes toward free trade and fiscal policy do have important implications for economic growth and interest rates. And this is being reinforced by cyclical economic trends as labor markets tighten in the U.S. However, it is too soon to know the extent to which political and policy uncertainties will diminish in the U.S. and Europe. You seek clarity on the investment outlook, but that will remain as challenging an objective as ever. You asked to start with a review of last year's predictions and this is always a moment of some trepidation. A year ago, our key conclusions were as follows: The current global economic malaise of slow growth and deflationary pressures reflects more than just a temporary hangover from the 2007-09 balance sheet recession. Powerful structural forces are at work, the effects of which will linger for a long time. These include an ongoing overhang of debt, the peak in globalization, adverse demographics in most major economies, monetary policy exhaustion, and low financial asset returns. Investor expectations have yet to adjust to the fact that sub-par growth and low inflation are likely to persist for many years. The Debt Supercycle is over, but weak nominal GDP growth has made it virtually impossible to reduce debt burdens. Nonetheless, a debt crisis in the advanced economies is not in prospect any time soon because low interest rates are keeping a lid on debt servicing costs. Perhaps high inflation and debt monetization will be the end-point, but that is many years away and would be preceded by a deflationary downturn. Despite ongoing exciting technological advances, the IT boom has lost its edge in terms of boosting economic growth. Even if productivity is understated, the corollary is that inflation is overstated, suggesting that central bankers will continue to face a policy dilemma. The Fed will raise interest rates by less than implied by their current projections. And the European Central Bank and Bank of Japan may expand their QE programs. Yet, monetary policy has become ineffective in boosting growth. Fiscal policy needs to play a bigger role, but it will require another recession to force a shift in political attitudes toward more stimulus. The U.S. economy will remain stuck in sub-2.5% growth in 2016, with risks to the downside. The euro zone's performance has improved recently, but 2016 growth will fall short of the IMF's 1.9% forecast. Japan's growth will continue to disappoint as it will in most other developed economies. China will continue to avoid a hard landing but growth will likely average below 6% in 2016 and beyond. Other emerging economies face a difficult environment of weak commodity prices, declining global trade. Those with excessive foreign-currency debt face additional pressures with weak exchange rates preventing an easing in monetary policy. Bonds offer poor long-term returns from current yields, but sovereign bonds in the major developed countries offer a hedge against downside macro risks and we recommend benchmark weightings. The fundamental backdrop to corporate and EM bonds remain bearish and spreads have not yet reached a level that discounts all of the risks. A buying opportunity in high-yield securities could emerge in the coming year but, for the moment, stay underweight spread product. We have turned more cautious on equities given a deterioration in the earnings outlook and in some technical indicators. No more than benchmark weighting is warranted and we would not argue against a modest underweight. The typical warning signs of a bear market are not in place but risks have risen. The U.S. equity market is expected to underperform that of Europe and Japan. Continue to stay away from emerging equities and commodity-oriented bourses. We continue to favor a defensive sector stance, favoring consumer staples and health care over cyclical sectors such as materials, energy and industrials. The bear market in commodities is not over. The sharp drop in oil prices will eventually restore balance to that market by undermining non-OPEC production and supporting demand, but this could take until the third quarter of 2016. The oil price is expected to average around $50 a barrel for the 2016-2018 period. The strong dollar and deflationary environment create a headwind for gold, offsetting the benefits of negative real interest rates. But modest positions are a hedge against a spike in risk aversion. The dollar is likely to gain further against emerging and commodity-oriented currencies. But the upside against the euro and the yen will be limited given the potential for disappointments about the U.S. economy. As was the case a year ago, geopolitical risks are concentrated in the emerging world. Meanwhile, the new world order of multipolarity and an increased incidence of military conflicts is not yet priced into markets. We do not expect the U.S. elections to have any major adverse impact on financial markets. On the economic front, we suggested that economic risks would stay tilted to the downside and this turned out to be correct with global growth, once again, falling short of expectations. A year ago, the IMF forecast global growth of 3.6% in 2016 and this has since been downgraded to 3.1%, the weakest number since the recovery began (Table 1). The U.S. economy fell particularly short of expectations (1.6% versus 2.8%). The downgrading of growth forecasts continued a pattern that has been in place since the end of the 2007-09 downturn (Chart 1). We cannot recall any other time when economic forecasts have been so wrong for such an extended period. The two big disappointments regarding growth have been the lackluster performance of global trade and the ongoing reluctance of businesses to expand capital spending. Not surprisingly, inflation remained low, as we expected. Table 1IMF Economic Forecasts Chart 1Persistent Growth Downgrades Given the disappointing economic performance, we were correct in predicting that the Federal Reserve would not raise interest rates by as much as their earlier forecasts implied. When we met last year, the Fed had just raised the funds rate from 0.25% to 0.5% and the median expectation of FOMC members was that it would reach 1.4% by end-2016 and 2.4% by end-2017. As we now know, the Fed is now targeting a funds rate of 0.5% to 0.75% and median FOMC projections are for 1.4% by end-2017 (Chart 2). Meanwhile, as we expected, both the ECB and Bank of Japan expanded their quantitative easing programs in an attempt to stimulate growth. Chart 2Changes In the Fed's Expectations Our concerns about the poor prospects for emerging economies were validated. The median 2016 growth rate for 152 emerging economies tracked by the IMF was only 3.1%, a notch below the 2015 pace and, barring 2009, the weakest number since the late 1990s Asia crisis. The official Chinese data overstate growth, but there was no hard landing, as many commentators continued to predict. Turning to the markets, there was considerable volatility during the year (Table 2). For example, U.S. bond yields fell sharply during the first half then rebounded strongly towards the end of the year, leaving them modestly higher over the 12 months. Yields in Europe and Japan followed a similar pattern - falling in the first half and then rebounding, but the level continued to be held down by central bank purchases. Japanese bonds outperformed in common currency terms and we had not expected that to occur, although there was a huge difference between the first and second halves of the year, with the yen unwinding its earlier strength in the closing months of the year. Table 2Market Performance Our caution toward spread product - corporate and EM bonds - turned out to have been unjustified. Despite worsening fundamentals, most notably rising leverage, the search for yield remained a powerful force keeping spreads down and delivering solid returns for these securities. Spreads are back to very low levels, warning that further gains will be hard to achieve. Equity markets made moderate net gains over the course of the year, but it was a roller coaster journey. A nasty early-year downturn was followed by a rebound, an extended trading range and a late-year rally. While the all-country index delivered a total return of around 8% for the year in common currency terms, almost one-third of that was accounted for by the dividend yield. The price index rose by less than 6% in common currency and 7% in local currency. However, our recommendation to overweight Europe and Japan did not pan out. Once again, the U.S. was an outperformer with the financially-heavy European index weighed down by ongoing concerns about banks, and Japan held back by its lackluster economic performance. Oil prices moved much as we expected, with Brent averaging around $45 over the year. At this time in 2015, prices were below $40, but we argued that a gradual rebalancing would bring prices back into a $45-$60 range in the second half of 2016. We did not expect much of a rise in the gold price and it increased less than 7% over the year. However, we did not try to dissuade you from owning some gold given your long-standing attraction to the asset, subject to keeping the allocation to 5% or less of your portfolio. Industrial commodity prices have been much stronger than we predicted, benefiting from a weak dollar in the first half of the year and continued buoyant demand from China. Finally, the dollar moved up as we had predicted, with the gains concentrated in the second half of the year. The yen's first-half strength was a surprise, but this was largely unwound in the second half as U.S. bond yields climbed. Mr. X: Notably absent has been any mention of the two political shocks of 2016. BCA: We did tell you that the U.K. referendum on Brexit was the key risk facing Europe in 2016 and that the polls were too close to have a strong view. Yet, we did not anticipate that the vote to leave the EU would pass. And when you pushed us a year ago to pick a winner for the U.S. election we wrongly went with Clinton. Our Global Strategist, Peter Berezin, was on record predicting a Trump victory as long ago as September 2015. But it seemed such an outrageous idea that our consensus view stuck to the safer option of Clinton. Interestingly, during our discussion at the end of 2014, we did note that a retreat from globalization was one of the risks in the outlook and we re-emphasized that point last year, pointing to rising populist pressures. However, we underestimated the ability of Brexit campaigners and Donald Trump to capitalize on the anger of disaffected voters. Trade and immigration policies are not the only areas where policy appears to be at a turning point. For example, fiscal conservatism is giving way to stimulus in the U.S. and several other countries, inflation and interest rates are headed higher, at least temporarily, and 2017-2018 should finally arrest the multi-year spectacle of downgrades to global growth projections. Yet, markets have a tendency to overreact and that currently seems to be the case when it comes to discounting prospective changes in the economic environment for the coming year. Turning Points And Regime Shifts: How Much Will Really Change? Mr. X: The U.S. election result and Brexit vote obviously were seismic events with potentially major policy implications. But there seem to be more questions than answers in terms of how policies actually will evolve over the next few years and the extent to which they will be good or bad for growth. The markets are assuming that economic growth will get a big boost from changes in fiscal policy. Do you agree with that view? Chart 3Fiscal Austerity Ended In 2015 BCA: We need to begin by putting things into perspective. Fiscal austerity came to an end pretty much everywhere a couple of years ago. Data from the IMF show that the peak years for fiscal austerity in the advanced economies were 2011-2013, and the budget cutbacks in those years did not even fully offset the massive stimulus that occurred during the downturn in 2008-10. Since 2013, the fiscal drag on GDP has gradually diminished and policy shifts are estimated to have added to GDP in the U.S., euro area and Japan in 2016 (Chart 3). Nonetheless, with economic growth falling short of expectations and easy money losing its effectiveness, there have been widespread calls for fiscal policy to do more. President-elect Trump has made major tax cuts and increased spending an important part of his policy platform, so the issue is the extent to which he follows through on his plans. Inevitably, there are some challenges: The plan to boost U.S. infrastructure spending is welcome, but the intention seems to be to emphasize private/public partnerships rather than federally-funded projects. Setting up such agreements could take time. Meanwhile, although there is great scope to improve the infrastructure, it is far less clear that a number of "shovel-ready" projects are simply waiting for finance. The bottom line is that increased infrastructure spending is more a story for 2018 and beyond, rather than 2017. And the same also is true for defense, where it may take time to put new programs in place. Turning to the proposed tax cuts, history shows there can be a huge difference between election promises and what eventually is legislated. According to the Tax Policy Center, Trump's plans would add more than $6 trillion to outstanding federal debt over the next decade and more than $20 trillion over 20 years. And that excludes the impact of higher interest costs on the debt. Even if one were to take an optimistic view of a revenue boost from faster economic growth, there would still be a large increase in federal deficits and thus debt levels and this could be problematic for many Republicans. It seems inevitable that the tax plans will be watered down. An additional issue is the distributional impact of the proposed tax cuts. Eliminating the estate tax and proposed changes to marginal rates would disproportionally help the rich. Estimates show the lowest and second lowest quintile earners would receive a tax cut of less than 1% of income, compared to 6.5% for the top 1%. Given that the marginal propensity to consume is much higher for those with low incomes, this would dilute the economic impact. Moreover, there is again the issue of timing - the usual bargaining process means that tax changes will impact growth more in 2018 than 2017. Mr. X: You did not mention the plan to cut the corporate tax rate from 35% to 15%. Surely that will be very good for growth? BCA: According to the OECD, the U.S. has a marginal corporate tax rate of 38.9% (including state and local corporate taxes), making it by far the highest in the industrialized world. The median rate for 34 other OECD economies is 24.6%. However, the actual rate that U.S. companies pay after all the various deductions is not so high. According to national accounts data, the effective tax rate for domestic non-financial companies averaged 25% in the four quarters ended 2016 Q2. Data from the IRS show an average rate of around 21% for all corporations. And for those companies with significant overseas operations, the rate is lower. There certainly is a good case for lowering the marginal rate and simplifying the system by removing deductions and closing loopholes. But special interests always make such reforms a tough battle. Even so, there is widespread support to reduce corporate taxes so some moves are inevitable and this should be good for profits and, hopefully, capital spending. The bottom line is that you should not expect a major direct boost to growth in 2017 from changes in U.S. fiscal policy. The impact will be greater in 2018, perhaps adding between 0.5% and 1% to growth. However, don't forget that there could be an offset from any moves to erect trade barriers. Mr. X: What about fiscal developments in other countries? Chart 4Japan Is A Fiscal Nightmare BCA: The Japanese government has boosted government spending again, but the IMF estimates that fiscal changes added only 0.3% to GDP in 2016, with an even smaller impact expected for 2017. And a renewed tightening is assumed to occur in 2018 as postponed efforts to reign in the deficit take hold. Of course, a sales tax hike could be delayed yet again if the economy continues to disappoint. But, with an overall budget deficit of 5% of GDP and gross government debt of more than 250% of GDP, Japan's room for additional stimulus is limited (Chart 4). Although the Bank of Japan owns around 40% of outstanding government debt, the authorities cannot openly admit that this will be written off. While more fiscal moves are possible in Japan, it is doubtful they would significantly alter the growth picture. The euro area peripheral countries have moved past the drastic fiscal austerity that was imposed on them a few years ago. Nevertheless, there is not much room for maneuver with regard to adopting an overtly reflationary stance. It is one thing to turn a blind eye to the fiscal constraints of the EU's Growth and Stability Pact and quite another to move aggressively in the opposite direction. Most of the region's economies have government debt-to-GDP ratios far above the 60% required under the Maastricht Treaty. In sum, a move to fiscal stimulus is not in the cards for the euro area. The U.K. is set to adopt more reflationary policies following the Brexit vote, but this would at most offset private sector retrenchment. In conclusion, looming shifts in fiscal policy will be positive for global growth in the next couple of years, but are unlikely to be game changers. Of course, fiscal policy is not the only thing that might change - especially in the U.S. There also are hopes that an easing in regulatory burdens will be very positive for growth. Mr. X: I am glad you raised that point. I have many business contacts in the U.S. who complain bitterly about regulatory overload and they are desperate for some relief. BCA: There certainly is a need for action on this front as regulatory burdens have increased dramatically in the U.S. in recent years. The monthly survey of small businesses carried out by the National Federation of Independent Business shows that rising health care costs, excessive regulation and income taxes are regarded as the top three problems. According to the Heritage Foundation, new regulations from the Obama administration have added more than $100 billion annually to costs for businesses and individuals since 2009. While the U.S. has a good score in the World Bank's Ease of Doing Business Index (8th best out of 190 countries), it is ranked 51st in the component that measures how easy it is to start a business, which puts it behind countries such as Jamaica, Mongolia and Albania. So we can hope that the new administration will act to improve that situation. We can be confident that there will be major reductions in regulations relating to energy and the environment. Other areas may be more challenging. It did not take long for Trump to back away from his pledge to repeal the Affordable Care Act (ACA) in its entirety. Returning to the previous status quo will not be politically acceptable and devising an alternative plan is no small task. The end result still will be a major modification of the ACA and this should ease health care costs for small businesses. With regard to the financial sector, it is no surprise that the pendulum swung massively toward increased regulation given the pre-crisis credit excesses. The economic and financial downturn of 2008-09 left a legacy of strong populist resentment of Wall Street and the banks, so a return to the previous laissez-faire model is not in the cards. At one stage, Trump indicated that he was in favor of replacing Dodd-Frank with a Glass-Steagall system, requiring commercial banks to divest themselves of their securities' businesses. The large banks would employ legions of lobbyists to prevent a new Glass-Steagall Act. The end result will be some watering down of the Dodd-Frank regulatory requirements, but again, a return to the pre-crisis status quo is not in the cards. The Retreat From Globalization Mr. X: You have challenged the consensus view that fiscal stimulus will deliver a meaningful boost to the global economy over the coming year. Having downplayed the main reason to be more positive about near-term growth, let's turn to global trade, the issue that causes most nervousness about the outlook. The Brexit vote in the U.K. was at least partly a vote against globalization and we are all familiar with Trump's threat to dramatically raise tariffs on imports from China and Mexico. What are the odds of an all-out trade war? BCA: At the risk of sounding complacent, we would give low odds to this. Again, there will be a large difference between campaign promises and actual outcomes. Let's start with China where the U.S. trade deficit ran at a $370 billion annual rate in the first nine months of 2016, up from around $230 billion a decade before (Chart 5). China now accounts for half of the total U.S. trade deficit compared to a 25% share a decade ago. On the face of it, the U.S. looks to have a good bargaining position, but the relationship is not one-sided. China has been a major financer of U.S. deficits and is the third largest importer of U.S. goods, after Canada and Mexico. Meanwhile, U.S. consumers have benefited enormously from the relative cheapness of imported Chinese goods. As for the threat to label China as a currency manipulator, it is interesting to note that its real effective exchange rate has increased by almost 20% since the mid-2000s, and since then, the country's current account surplus as a share of GDP has fallen from almost 10% to around 2.5% (Chart 6). The renminbi has fallen by around 10% against the dollar since mid-2015, but that has been due to the latter currency's broad-based rally, not Chinese manipulation. The fact that China's foreign-exchange reserves have declined in the past couple of years indicates that the country has intervened to hold its currency up, not push it down. Chart 5China-U.S. Trade: ##br##A Symbiotic Relationship? Chart 6China Has Not Manipulated ##br##Its Currency Downward Of course, facts may not be the guiding factor when it comes to U.S. trade policy, and we can expect some tough talk from the U.S. This could well involve the imposition of some tariffs and perhaps some concessions from China in the form of increased imports from the U.S. Overall, we are hopeful that rational behavior will prevail and that an all-out trade war will not occur. Mr. X: I also would like to believe that, but nothing in the U.S. election process made me think that rationality is guaranteed. BCA: Of course it is not guaranteed, and we will have to monitor the situation carefully. We should also talk about Mexico - the other main target of Trump's attacks. The U.S. trade deficit with Mexico accounts for less than 10% of the total U.S. deficit and has changed little in the past decade. More than 80% of the U.S. trade deficit with Mexico is related to vehicles and Trump clearly will put pressure on U.S. companies to move production back over the border. Within a week of the election, Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. And Trump subsequently browbeat Carrier Corporation into cancelling some job transfers across the border. If other companies follow suit, it could forestall major changes to NAFTA. Ironically, the Mexican peso has plunged by 10% against the dollar since the election, boosting the competitiveness of Mexico and offsetting some of the impact of any tariff increase. Not all the news on global trade is bad. After seven years of negotiation, the EU and Canada agreed a free trade deal. This has bolstered the U.K.'s hopes that it can arrange new trade deals after it leaves the EU. However, this will not be easy given the sheer number of bi-country deals that will be required. The time it took to negotiate the EU-Canada deal should be a salutary warning given that there was no particular animosity toward Canada within the EU. That will not be the case when it comes to negotiations with the U.K. Mr. X: Let's try and pull all this together. You have downplayed the risk of an all-out trade war and I hope that you are right. But do you expect trade developments to be a drag on economic activity, perhaps offsetting any positive impact from fiscal stimulus? Chart 7Only Modest Growth In World Trade BCA: You might think that trade is a zero-sum game for the global economy because one country's exports simply are another's imports. But expanding trade does confer net benefits to growth in terms of allowing a more efficient use of resources and boosting related activities such as transportation and wholesaling. Thus, the rapid expansion in trade after the fall of the Berlin Wall was very good for the global economy. Trade ceased to be a net contributor to world growth several years ago, highlighted by the fact that global export volumes have been growing at a slower pace than GDP (Chart 7). This has not been due to trade barriers but is more a reflection of China's shift away from less import-intensive growth. A return to import-intensive growth in China is not likely, and technological innovations such as 3-D printing could further undermine trade. If we also add the chances of some increase in protectionist barriers then it is reasonable to assume that trends in global trade are more likely to hinder growth than boost it over the coming couple of years. It really is too soon to make hard and fast predictions about this topic as we need to see exactly what actions the new U.S. administration will take. Nevertheless, we lean toward the optimistic side, and assume the economic impact of fiscal reflation will exceed any drag from trade restrictions. Again, this is a more of a story for 2018 than 2017. What we can say with some confidence is that the previous laissez-faire approach to globalization is no longer politically acceptable. Policymakers are being forced to respond to voter perceptions that the costs of free trade outweigh the benefits and that points to a more interventionist approach. This can take the form of overt protectionism or attempts to influence corporate behavior along the lines of president-elect Trump's exhortations to U.S. companies. Mr. X: What about the issue of immigration? Both the Brexit vote and the U.S. election result partly reflected voter rebellion against unrestrained immigration. And we know that nationalist sentiments also are rising in a number of other European countries. How big a problem is this? Chart 8Immigration's Rising Contribution ##br##To U.S. Population Growth BCA: In normal circumstances, immigration represents a win-win situation for all parties. The vast majority of immigrants are prepared to work hard to improve their economic position and in many cases take jobs that residents are not willing to accept. This all works well in a fast-growing economy, but difficulties arise when growth is weak: competition for jobs increases, especially among the unskilled, and the result is downward pressure on wages. The irony is that the U.S. and U.K. labor markets have tightened to the point where wage growth is accelerating. However, this all happened too late to affect the opinions of those who voted for tighter controls over immigration. There is an even more important issue from a big-picture perspective. As you know, an economy's potential growth rate comes from two sources: the growth in the labor force and productivity. According to the Census Bureau, U.S. population growth will average 0.8% a year over the next decade, slowing to 0.6% a year over the subsequent ten years. But more than half of this growth is assumed to come from net migration. Excluding net migration, population growth is predicted to slow to a mere 0.1% a year by the end of the 2030s (Chart 8). Thus, major curbs on immigration would directly lower potential GDP by a significant amount. In Europe, the demographic situation is even more precarious because birth rates are far below replacement levels. Europe desperately needs immigration to achieve even modest population increases. However, the migrant crisis is causing a backlash against cross-border population flows, again with negative implications for long-run economic growth. Even ignoring humanitarian considerations, major curbs on immigration would not be a good idea. Labor shortages would quickly become apparent in a number of industries. Some may welcome the resulting rise in wages, but the resulting pressure on inflation also would have adverse effects. So this is another area of policy that we will have to keep a close eye on. Chart 9A Mixed U.S. Inflation Picture Inflation And Interest Rates Mr. X: I am glad that you mentioned inflation. There are good reasons to think that an important inflection point in inflation has been reached. And bond investors seem to agree, judging by the recent spike in yields. If true, this would indeed represent a significant regime shift because falling inflation and bond yields have been such a dominant trend for several decades. Do you agree that the era of disinflation is over, along with the secular bull market in bonds? BCA: Inflation and bond yields in the U.S. have passed a cyclical turning point, but this does not mean that a sustained major uptrend is imminent. Let's start with inflation. A good portion of the rise in the underlying U.S. inflation rate has been due to a rise in housing rental costs, and, more recently, a spike in medical care costs. Neither of these trends should last: changes to the ACA should arrest the rising cost of medical care while increased housing construction will cap the rise in rent inflation. The rental vacancy rate looks to be stabilizing while rent inflation is rolling over. Meanwhile, the inflation rate for core goods has held at a low level and likely will be pushed lower as a result of the dollar's ascent (Chart 9). Of course, this all assumes that we do not end up with sharply higher import tariffs and a trade war. The main reason to expect a further near-term rise in underlying U.S. inflation is the tightening labor market and resulting firming in wage growth. With the economy likely to grow above a 2% pace in 2017, the labor market should continue to tighten, pushing wage inflation higher. So the core PCE inflation rate has a good chance of hitting the Federal Reserve's 2% target before the year is out. And bond investors have responded accordingly, with one-year inflation expectations moving to their highest level since mid-2014, when oil prices were above $110 a barrel (Chart 10). Long-run inflation expectations also have spiked since the U.S. election, perhaps reflecting the risk of higher import tariffs and the risks of political interference with the Fed. When it comes to other developed economies, with the exception of the U.K., there is less reason to expect underlying inflation to accelerate much over the next year. Sluggish growth in the euro area and Japan will continue to keep a lid on corporate pricing power and the markets seem to agree, judging by the still-modest level of one-year and long-run inflation expectations (Chart 11). The U.K. will see some pickup in inflation in response to the sharp drop in sterling and this shows up in a marked rise in market expectations. Chart 10U.S. Inflation Expectations Have Spiked Chart 11Inflation Expectations In Europe And Japan Turning back to the U.S., a key question regarding the longer-term inflation outlook is whether the supply side of the economy improves. If the new administration succeeds in boosting demand but there is no corresponding expansion in the supply capacity of the economy, then the result will be higher inflation. That will lead to continued monetary tightening and, as in past cycles, an eventual recession. But, if businesses respond to a demand boost with a marked increase in capital spending then the result hopefully would be faster productivity growth and a much more muted inflation response. Thus, it will be critical to monitor trends in business confidence and capital spending for signs that animal spirits are returning. Mr. X: So you don't think the Fed will be tempted to run a "hot" economy with inflation above the 2% target? BCA: That might have been a possibility if there was no prospect of fiscal stimulus, leaving all the economic risks on the downside. With easier fiscal policy on the horizon, the Fed can stick to a more orthodox policy approach. In other words, if the economy strengthens to the point where inflation appears to be headed sustainably above 2%, then the Fed will respond by raising rates. Unlike the situation a year ago, we do not have a strong disagreement with the Fed's rate hike expectations for the next couple of years. Nothing would please the Fed more than to return to a familiar world where the economy is behaving in a normal cyclical fashion, allowing a move away from unusually low interest rates. At the same time, the Fed believes, as we do, that the equilibrium real interest rate is far below historical levels and may be close to zero. Thus, interest rates may not need to rise that much to cool down the economy and ease inflationary pressures. This is especially true if the dollar continued to rise along with Fed tightening. Another potentially important issue is that the composition of the Federal Reserve Board could change dramatically in the next few years. There currently are two unfilled seats on the Board and it is very likely that both Janet Yellen and Stanley Fischer will leave in 2018 when their respective terms as Chair and Vice-Chair end (February 3 for Yellen and June 12 for Fischer). That means the incoming administration will be able to appoint four new Board members, and possibly more if other incumbents step down. Judging by the views of Trump's current economic advisers, he seems likely to choose people with a conservative approach to monetary policy. In sum, we do not rule out a rise in U.S. inflation to as much as 3%, but it would be a very short-lived blip. Steady Fed tightening would cap the rise, even at the cost of a renewed recession. Indeed, a recession would be quite likely because central banks typically overshoot on the side of restraint when trying to counter a late-cycle rise in inflation. Mr. X: I am more bearish than you on the inflation outlook. Central banks have been running what I regard as irresponsible policies for the past few years and we now also face some irresponsible fiscal policies in the U.S. That looks like a horrendously inflationary mix to me although I suppose inflation pressures would ease in the next recession. We can return to that possibility later when we discuss the economy in more detail. Where do you see U.S. short rates peaking in the current cycle and what does this mean for your view on long-term interest rates? To repeat my earlier question: is the secular bond bull market over? BCA: During the past 30 years, the fed funds rate tended to peak close to the level of nominal GDP growth (Chart 12). That would imply a fed funds rate of over 5% in the current cycle, assuming peak real GDP growth of around 3% and 2-3% inflation. However, that ignores the fact that debt burdens are higher than in the past and structural headwinds to growth are greater. Thus, the peak funds rate is likely to be well below 5%, perhaps not much above 3%. Chart 12The Fed Funds Rate And The Economic Cycle With regard to your question about the secular bull market in bonds, we believe it has ended, but the bottoming process likely will be protracted. We obviously are in the midst of a cyclical uptrend in U.S. yields that could last a couple of years. The combination of a modestly stronger economy, easier fiscal stance and monetary tightening are all consistent with rising bond yields. Although yields moved a lot in the second half of 2016, the level is still not especially high, so there is further upside. It would not be a surprise to see the 10-year Treasury yield reach 3% by this time next year. However, there could be a last-gasp renewed decline in yields at some point in the next few years. If the U.S. economy heads back into recession with the fed funds rate peaking at say 3.5%, then it is quite possible that long-term bond yields would revisit their 2016 lows - around 1.4% on the 10-year Treasury. There are no signs of recession at the moment, but a lot can change in the next three years. In any event, you should not be overly concerned with the secular outlook at this point. The cyclical outlook for yields is bearish and there should be plenty of advance notice if it is appropriate to switch direction. Update On The Debt Supercycle Mr. X: I would like to return to the issue of the Debt Supercycle - one of my favorite topics. You know that I have long regarded excessive debt levels as the biggest threat to economic and financial stability and nothing has occurred to ease my concerns. In the past, you noted that financial repression - keeping interest rates at very low levels - would be the policy response if faster economic growth could not achieve a reduction in debt burdens. But the recent rise in bond yields warns that governments cannot always control interest rate moves. Few people seem to worry anymore about high debt levels and I find that to be another reason for concern. BCA: You are correct that there has been very little progress in reducing debt burdens around the world. As we have noted in the past, it is extremely difficult for governments and the private sector to lower debt when economic activity and thus incomes are growing slowly. Debt-to-GDP ratios are at or close to all-time highs in virtually every region, even though debt growth itself has slowed (Chart 13A, Chart 13B). Chart 13ADebt Growth Slows, ##br##But Levels Remain High Chart 13BDebt Growth Slows, ##br##But Levels Remain High As a reminder, our End-of-Debt Supercycle thesis never meant that debt-to-GDP ratios would quickly decline. It reflected our belief that lenders and private sector borrowers had ended their love affair with debt and that we could no longer assume that strong credit growth would be a force boosting economic activity. And our view has not altered, even though government borrowing may show some acceleration. Chart 14The Credit Channel Is Impaired The failure of exceptionally low interest rates to trigger a vigorous rebound in private sector credit demand is consistent with our view. In the post-Debt Supercycle world, monetary policy has lost effectiveness because the credit channel - the key pillar of the monetary transmission process - is blocked. The drop in money multipliers and in the velocity of circulation is a stark reminder of the weakened money-credit-growth linkage (Chart 14). You always want to know what the end-point of higher debt levels will be, and we always give you a hedged answer. Nothing has changed on that front! A period of higher inflation may help bring down debt ratios for a while, but not to levels that would ease your concerns. This means that financial repression will be the fallback plan should markets rebel against debt levels. For the moment, there is still no problem because interest rates are still low and this is keeping debt-servicing costs at very low levels. If interest rates are rising simply because economic activity is strengthening, then that is not a serious concern. The danger time would be if rates were to rise while growth and inflation were weak. At that point, central banks would move aggressively to reduce market pressures with massive asset purchases. The ultimate end-point for dealing with excessive debt probably will be significantly higher inflation. But that is some time away. Central banks would not likely embrace a major sustained rise in inflation before we first suffered another serious deflationary downturn. At that point, attitudes toward inflation could change dramatically and a new generation of central bankers would probably be in charge with a very different view of the relative economic risks of inflation and deflation. However, it is premature to worry about a major sustained inflation rise if we must first go through a deflationary downturn. Mr. X: Perhaps you are right, but I won't stop worrying about debt. The buildup in debt was decades in the making and I am convinced that the consequences will extend beyond a few years of subdued economic growth. And central bank efforts to dampen the economic symptoms with unusually low interest rates have just created another set of problems in the form of distorted asset prices and an associated misallocation of capital. BCA: We agree that there may be a very unhappy ending to the debt excesses, but timing is everything. It has been wrong to bet against central banks during the past seven years and that will continue to be the case for a while longer. We will do our best to give you plenty of warning when we see signs that things are changing for the worse. Mr. X: I will hold you to that. Meanwhile, you talked earlier about the possibility of another recession in the U.S. Let's use that as a starting point to talk about the economic outlook in more detail. It seems strange to talk about the possibility of a recession in the U.S. when interest rates are still so low and we are about to get more fiscal stimulus. The Economic Outlook BCA: We do not expect a recession in the next year or two, absent some new major negative shock. But by the time we get to 2019, the recovery will be ten years old and normal late-cycle pressures should be increasingly apparent. The labor market already is quite tight, with wages growing at their fastest pace in eight years, according to the Atlanta Fed's wage tracker (Chart 15). Historically, most recessions were triggered by tight monetary policy with a flat or inverted yield curve being a reliable indicator (Chart 16). Obviously, that is extremely hard to achieve when short-term rates are at extremely low levels. However, if the Fed raises the funds rate to around 3% by the end of 2019, as it currently predicts, then it will be quite possible to again have a flat or inverted curve during that year. Chart 15U.S. Wage Growth In A Clear Uptrend Chart 16No Sign Of A U.S. Recession The recent environment of modest growth has kept inflation low and forced the Fed to maintain a highly accommodative stance. As spare capacity is absorbed, the Fed will be forced to tighten, raising the odds of a policy overshoot. And this is all without taking account of the potential threat of a trade war. Mr. X: I have never believed that the business cycle has been abolished so it would not surprise me at all to have a U.S. recession in the next few years, but the timing is critical to getting the markets right. What will determine the timing of the next economic downturn? BCA: As we mentioned earlier, the key to stretching out the cycle will be improving the supply side of the economy, thereby suppressing the cyclical pressures on inflation. That means getting productivity growth up which, in turn will depend on a combination of increased capital spending, global competition and technological innovations. Chart 17Companies Still ##br##Cautious Re: Capital Spending Thus far, there is no indication that U.S. companies are increasing their investment plans: the trend in capital goods orders remains very lackluster (Chart 17). Nonetheless, we have yet to see post-election data. The optimistic view is that the prospect of lower corporate taxes, reduced regulation and a repatriation of overseas earnings will all combine to revive the corporate sector's animal spirits and thus their willingness to invest. Only time will tell. The key point is that it is too soon for you to worry about a recession in the U.S. and for the next year or two, there is a good chance that near-term economic forecasts will be revised up rather than down. That will mark an important reversal of the experience of the past seven years when the economy persistently fell short of expectations. Mr. X: It would be indeed be a welcome change to have some positive rather than negative surprises on the economic front, but I remain somewhat skeptical. I suppose I can see some reasons to be more optimistic about the U.S., but the picture in most other countries seems as bleak as ever. The outlook for the U.K. has worsened following the Brexit vote, the euro area and Japan cannot seem to break out of a low-growth trap and China continues to skirt the edge of a precipice. BCA: The global economy still has lots of problems, and we are a long way from boom-like conditions. The IMF predicts that 2017 growth in the euro area and China will be below the 2016 level, and forecasts for the U.K. have been revised down sharply since the Brexit vote. On a more positive note, the firming in commodity prices should help some previously hard-hit emerging economies. Overall global growth may not pick up much over the coming year, but it would be a significant change for the better if we finally stop the cycle of endless forecast downgrades. Mr. X: Let's talk a bit more about the U.K. I know that it is too early to make strong predictions about the implications of Brexit, but where do you stand in terms of how damaging it will be? I am not convinced it will be that bad because I sympathize with the view that EU bureaucracy is a big drag on growth, and exiting the EU may force the U.K. government to pursue supply-side policies that ultimately will be very good for growth. BCA: The Brexit vote does not spell disaster for the U.K., but adds to downside risks at a time when the global economy is far from buoyant. The EU is not likely to cut a sweet deal for the U.K. To prevent copycat departures, the EU will demonstrate that exit comes with a clear cost. Perhaps, the U.K. can renegotiate new trade deals that do not leave it significantly worse off. But this will take time and, in the interlude, many businesses will put their plans on hold until new arrangements are made. Meanwhile, the financial sector - a big engine of growth in the past - could be adversely affected by a move of business away from London. Chart 18The U.K. Has A Twin Deficit Problem Of course, the government will not simply stand on the sidelines, and it has already announced increased infrastructure spending that will fill some of the hole created by weaker business capital spending. And the post-vote drop in sterling has provided a boost to U.K. competitiveness. Nevertheless, it seems inevitable that there will be a hit to growth over the next couple of years. The optimistic view is that the U.K. will use the opportunity of its EU departure to launch a raft of supply-side reforms and tax cuts with the aim of creating a much more dynamic economy that will be very attractive to overseas investors. Some have made the comparison with Singapore. This seems a bit of a stretch. In contrast to the pre-vote rhetoric, EU membership did not turn the U.K. into a highly-regulated economy. For example, the U.K. already is in 7th place out of 190 countries in the World Bank's Ease Doing Business Index and one of the least regulated developed economies according to the OECD. Thus, the scope to boost growth by sweeping away regulations probably is limited. At the same time, the U.K.'s ability to engage in major fiscal stimulus via tax cuts or increased spending is limited by the country's large balance-of-payments deficit and the poor state of its government finances (Chart 18). Overall, the U.K. should be able to avoid a major downturn in the next couple of years, but we don't disagree with the OECD's latest forecasts that growth will slow to round 1% in 2017 and 2018 after 2% in 2016. And that implies the risks of one or two quarters of negative growth within that period. Mr. X: I am not a fan of the EU so am inclined to think that the U.K. will do better than the consensus believes. But, I am less confident about the rest of Europe. Euro area banks are in a mess, weighed down by inadequate capital, a poor return on assets, an overhang of bad loans in Italy and elsewhere, and little prospect of much revival in credit demand. At the same time, the political situation looks fragile with voters just as disenchanted with the establishment status quo as were the ones in the U.K. and U.S. Against this background, I can't see why any companies would want to increase their capital spending in the region. Chart 19Euro Area Optimism Improves BCA: We agree that euro area growth is unlikely to accelerate much from here. The structural problems of poor demographics, a weak banking system and constrained fiscal policy represent major headwinds for growth. And the political uncertainties related to elections in a number of countries in the coming year give consumers and companies good reason to stay cautious. Yet, we should note that the latest data show a modest improvement in the business climate index, breaking slightly above the past year's trading range (Chart 19). There are some positive developments to consider. The nomination of François Fillon as the conservative candidate in France's Presidential election to be held on April 2017 is very significant. We expect him to beat Marine Le Pen and this means France will have a leader who believes in free markets and deregulation - a marked change from previous statist policies. This truly could represent a major regime shift for that country. Meanwhile, the ECB has confirmed that it will continue its QE program through 2017, albeit at a slightly reduced pace. This has costs in terms of market distortions, but will help put a floor under growth. Mr. X: You noted the fragile state of the region's banks. How do you see that playing out? BCA: Euro area banks have more than €1 trillion of non-performing loans (NPLs) and have provisioned for only about half of that amount. Nevertheless, most countries' banking sectors have enough equity capital to adequately absorb losses from these un-provisioned NPLs. On the other hand, the high level of NPLs is a protracted drag on profitability and thereby increases the banks' cost of capital. The shortage of capital constrains new lending. The biggest concern is Italy, which we estimate needs to recapitalize its banks by close to €100 billion. Complicating matters is that the EU rules on state aid for banks changed at the start of 2016. Now, a government bailout can happen only after a first-loss 'bail-in' of the bank's equity and bond holders. So if an undercapitalized bank cannot raise the necessary funds privately in the markets, there is a danger that its investors could suffer heavy losses before the government is allowed to step in. But once investors have been bailed-in, the authorities will do "whatever it takes" to prevent banking problems turning into a systemic crisis that threaten to push the economy into another recession. Mr. X: I would now like to shift our attention to Asia, most notably Japan and China. Starting with Japan, that economy seems to perfectly describe the world of secular stagnation. Despite two decades of short-term interest rates near zero and major fiscal stimulus, real growth has struggled to get above 1% and deflation rather than inflation has been the norm. Prime Minister Shinzo Abe has made a big deal about his "three arrow" approach to getting the economy going again, but I don't see much evidence that it is working. Is there any prospect of breaking out of secular stagnation? BCA: Probably not. A big part of Japan's problem is demographics - an unfortunate combination of a declining labor force and a rapidly aging population. While this means that per capita GDP growth looks a lot better than the headline figures, it is not a growth-friendly situation. Twenty years ago there were 4.6 people of working age for everyone above 64. This has since dropped to 2.2 and within another 20 years it will be down to 1.6. That falling ratio of taxpayers to pensioners and major consumers of health care is horrendous for government finances. And an aging population typically is not a dynamic one which shows up in Japan's poor productivity performance relative to that of the U.S. (Chart 20). Of course, Japan can "solve" its public finances problem by having the Bank of Japan cancel its large holdings of JGBs. Yet that does nothing to deal with the underlying demographics issue and ongoing large budget deficits. Japan desperately needs a combination of increased immigration and major supply-side reforms, but we do not hold out much prospect of either changing by enough to dramatically alter the long-run growth picture. Mr. X: I will not disagree with you as I have not been positive about Japan for a long time. We should now turn to China. It is very suspicious that the economy continues to hum along at a 6% to 7% pace, despite all the excesses and imbalances that have developed. I really don't trust the data. We talked about China at our mid-2016 meeting and, if I remember correctly, you described China as like a tightrope walker, wobbling from time to time, but never quite falling off. Yet it would only take a gust of wind for that to change. I liked that description so my question is: are wind gusts likely to strengthen over the coming year? BCA: You are right to be suspicious of the official Chinese data, but it seems that the economy is expanding by at least a 5% pace. However, it continues to be propped up by unhealthy and unsustainable growth in credit. The increase in China's debt-to-GDP ratio over the past few years dwarves that during the ultimately disastrous credit booms of Japan in the 1980s and the U.S. in the 2000s (Chart 21). The debt increase has been matched by an even larger rise in assets, but the problem is that asset values can drop, while the value of the debt does not. Chart 20Japan's Structural Headwinds Chart 21China's Remarkable Credit Boom The government would like to rein in credit growth, but it fears the potential for a major economic slowdown, so it is trapped. The fact that the banking system is largely under state control does provide some comfort because it will be easy for the government to recapitalize the banks should problems occur. This means that a U.S.-style credit freeze is unlikely to develop. Of course, the dark side of that is that credit excesses never really get unwound. You asked whether wind gusts will increase, threating to blow the economy off its tightrope. One potential gust that we already talked about is the potential for trade fights with the new U.S. administration. As we mentioned earlier, we are hopeful that nothing serious will occur, but all we can do is carefully monitor the situation. Trends in China's real estate sector represent a good bellwether for the overall economic situation. The massive reflation of 2008-09 unleashed a powerful real estate boom, accompanied by major speculative excesses. The authorities eventually leaned against this with a tightening in lending standards and the sector cooled off. Policy then eased again in 2015/16 as worries about an excessive economic slowdown developed, unleashing yet another real estate revival. The stop-go environment has continued with policy now throttling back to try and cool things off again. It is not a sensible way to run an economy and we need to keep a close watch on the real estate sector as a leading indicator of any renewed policy shifts. Over time, the Chinese economy should gradually become less dependent on construction and other credit-intensive activities. However, in the near-term, there is no escaping the fact that the economy will remain unbalanced, creating challenges for policymakers and a fragile environment for the country's currency and asset markets. Fortunately, the authorities have enough room to maneuver that a hard landing remains unlikely over the next year or two. There are fewer grounds for optimism about the long-run unless the government can move away from its stop-go policy and pursue more supply-side reforms. Mr. X: What about other emerging economies? Are there any developments particularly worth noting? BCA: Emerging economies in general will not return to the rapid growth conditions of the first half of the 2000s. Slower growth in China has dampened export opportunities for other EM countries and global capital will no longer pour into these economies in its previous, indiscriminate way. Nevertheless, the growth outlook is stabilizing and 2017 should be a modestly better year than 2016 for most countries. Chart 22India Has A Long Way To Go The rebound in oil and other commodity prices has clearly been positive for Russia, Brazil and other resource-dependent countries. Commodity prices will struggle to rise further from current elevated levels but average 2017 prices should exceed those of 2016. On the negative side, a firm dollar and trade uncertainty will represent a headwind for capital flows to the EM universe. The bottom line is that the growth deceleration in emerging economies has run its course but a major new boom is not in prospect. The Indian economy grew by around 7½% in 2016, making it, by far, the star EM performer. Growth will take a hit from the government's recent decision to withdraw high-denomination bank notes from circulation - a move designed to combat corruption. Fortunately, the impact should be relatively short-lived and growth should return to the 7% area during the coming year. Still, India has a long way to go to catch up with China. In 1990, India's economy was almost 90% as big as China's in PPP terms, but 20 years later, it was only 40% as large. Even though India is expected to keep growing faster than China, its relative size will only climb to 45% within the next five years, according to the IMF (Chart 22). Mr. X: Let me try and summarize your economic views before we move on to talk about the markets. The growth benefit from fiscal stimulus in the U.S. is more a story for 2018 than 2017. Nevertheless, a modest improvement in global growth is likely over the coming year, following several years of economic disappointments. The key risks relate to increased trade protectionism and increased inflation in the U.S. if the rise in demand is not matched by an increase in the economy's supply-side capacity. In that event, tighter monetary policy could trigger a recession in 2019. You do not expect any major changes in the underlying economic picture for Europe, Japan or China, although political shifts in Europe represent another downside risk. BCA: That captures our views quite well. Going back to our broad theme of regime shifts, it is important to re-emphasize that shifting attitudes toward fiscal policy and trade in the U.S. raise a red flag over the longer-term inflation outlook. And this of course feeds into the outlook for interest rates. Bond Market Prospects Mr. X: That is the perfect segue for us to shift the discussion to the investment outlook, starting with bonds. You already noted that you believe the secular bull market in bonds has ended, albeit with a drawn-out bottoming process. Given my concerns about the long-run inflation outlook, I am happy to agree with that view. Yet, yields have risen a lot recently and I am wondering if this represents a short-term buying opportunity. BCA: The late-2016 sell-off in bonds was violent and yields rose too far, too fast. So we recently shifted our tactical bond recommendation from underweight (short duration) to neutral. But obviously that is not the same as telling you to buy. The underlying story for bonds - especially in the U.S. - is bearish. The prospect of fiscal stimulus, rising short rates and a pickup in inflation suggests that U.S. yields will be higher over the next 12 months. Although yields may decline somewhat in the very near-term, we doubt the move will be significant enough or last long enough to warrant an overweight position. The outlook is not quite so bad in the euro zone given the ECB's ongoing bond purchases and a continued benign inflation outlook. But, even there, the market will remain highly correlated with trends in U.S. Treasurys so yields are more likely to rise than fall over the coming year. The story is different in Japan given the central bank's new policy of pegging the 10-year yield at zero. That will be a static market for some time. Although global yields may have bottomed from a secular perspective, the upturn will be gradual in the years ahead. A post-Debt Supercycle environment implies that private sector credit growth will remain subdued, and during 2018, the market may start to attach growing odds of a U.S. recession within a year or two. A more powerful bear trend in bonds awaits the more significant upturn in inflation that likely will follow the next economic downturn. Chart 23Treasurys Are High Yielders Mr. X: I am somewhat surprised at how much the spread between U.S. and euro area bonds has widened - it is now at the highest level since the late 1980s. Obviously, a positive spread makes sense given the relative stance of monetary policy and economic outlook. Yet, it is quite amazing how investors have benefited from both higher yields in the U.S. and a stronger dollar. If the dollar stays firm in 2017, will the spread remain at current high levels? BCA: Most of the increased spread during the past year can be attributed to a widening gap in inflation expectations, although the spread in real yields also spiked after the U.S. election, reflecting the prospects for fiscal stimulus (Chart 23). While the spread is indeed at historical highs, the backdrop of a massive divergence in relative monetary and fiscal policies is not going to change any time soon. We are not expecting the spread to narrow over the next year. You might think that Japanese bonds would be a good place to hide from a global bond bear market given BoJ's policy to cap the 10-year yield at zero percent. Indeed, JGBs with a maturity of 10-years or less are likely to outperform Treasurys and bunds in local currency terms over the coming year. However, this means locking in a negative yield unless you are willing to move to the ultra-long end of the curve, where there is no BoJ support. Moreover, there is more upside for bond prices in the U.S. and Eurozone in the event of a counter-trend global bond rally, simply because there is not much room for JGB yields to decline. Mr. X: O.K., I get the message loud and clear - government bonds will remain an unattractive investment. As I need to own some bonds, should I focus on spread product? I know that value looks poor, but that was the case at the beginning of 2016 and, as you showed earlier, returns ended up being surprisingly good. Will corporate bonds remain a good investment in 2017, despite the value problem? BCA: This a tricky question to answer. On the one hand, you are right that value is not great. Corporate spreads are low in the U.S. at a time when balance sheet fundamentals have deteriorated, according to our Corporate Health Monitor (Chart 24). After adjusting the U.S. high-yield index for expected defaults, option-adjusted spreads are about 165 basis points. In the past, excess returns (i.e. returns relative to Treasurys) typically were barely positive when spreads were at this level. Valuation is also less than compelling for U.S. investment-grade bonds. One risk is that a significant amount of corporate bonds are held by "weak hands," such as retail investors who are not accustomed to seeing losses in their fixed-income portfolios. At some point, this could trigger some panic selling into illiquid markets, resulting in a sharp yield spike. On a more positive note, the search for yield that propped up the market in 2016 could remain a powerful force in 2017. The pressure to stretch for yield was intense in part because the supply of government bonds in the major markets available to the private sector shrank by around $547 billion in 2016 because so much was purchased by central banks and foreign official institutions (Chart 25). The stock will likely contract by another $754 billion in 2017, forcing investors to continue shifting into riskier assets such as corporate bonds. Chart 24U.S. Corporate Health Has Deteriorated Chart 25Government Bonds In Short Supply Weighing the poor valuation and deteriorating credit quality trend against the ongoing pressure to search for yield, we recommend no more than a benchmark weighting in U.S. corporate investment-grade bonds and a modestly underweight position in high-yield. There are better relative opportunities in euro area corporates, where credit quality is improving and the ECB's asset purchase program is providing a nice tailwind. We are slightly overweight in both investment-grade and high-yield euro area corporates. Finally, we should mention emerging market bonds, although we do not have much good to say. The prospect of further declines in EM currencies versus the dollar is a major problem for these securities. There is a big risk that global dollar funding will dry up as the dollar moves higher along with U.S. bond yields, creating problems for EM economies running current account and fiscal deficits. You should stay clear of EM bonds. Mr. X: None of this is helping me much with my bond investments. Can you point to anything that will give me positive returns? Chart 26Real Yields Remain Exceptionally Low BCA: Not in the fixed-income market. Your concerns about inflation might lead you to think that inflation-indexed bonds are a good place to be, but prices in that market have already adjusted. Moreover, the case for expecting higher inflation rests a lot on the assumption that economic growth is going to strengthen and that should imply a rise in real yields, which obviously is bad for inflation-indexed bonds. Real yields currently are still very low by historical standards (Chart 26). A world of stagflation - weak real growth and rising inflation - would be a good environment for these securities, but such conditions are not likely in the next couple of years. Mr. X: After what you have told me, I suppose I will concentrate my fixed-income holdings in short-term Treasurys. But I do worry more than you about stagflation so will hold on to my inflation-indexed bonds. At the same time, I do understand that bonds will represent a hedge against downside risks rather than providing positive returns. So let's talk about the stock market as a more attractive place to invest. Equity Market Outlook Mr. X: I like to invest in equities when the market offers good value, there is too much pessimism about earnings and investor sentiment is gloomy. That is not the picture at the moment in the case of the U.S. market. I must confess that the recent rally has taken me by surprise, but it looks to me like a major overshoot. As we discussed earlier, the new U.S. administration's fiscal platform should be good for 2018 economic growth but the U.S. equity market is not cheap and it seems to me that there is more euphoria than caution about the outlook. So I fear that the big surprise will be that the market does much worse than generally expected. BCA: Obviously, the current market environment is nothing like the situation that exists after a big sell-off. You are correct that valuations are not very appealing and there is too much optimism about the outlook for earnings and thus future returns. Analysts' expectations of long-run earnings growth for the S&P 500 universe have risen to 12%, which is at the high end of its range over the past decade (Chart 27). And, as you suggested, surveys show an elevated level of optimism on the part of investors and traders. The outlook for earnings is the most critical issue when it comes to the long-run outlook for stocks. Low interest rates provide an important base of support, but as we noted earlier, rates are more likely to rise than fall over the next couple of years, possibly reaching a level that precipitates a recession in 2019. Investors are excited about the prospect that U.S. earnings will benefit from both faster economic growth and a drop in corporate tax rates. We don't disagree that those trends would be positive, but there is another important issue to consider. One of the defining characteristics of the past several years has been the extraordinary performance of profit margins which have averaged record levels, despite the weak economic recovery (Chart 28). The roots of this rise lay in the fact that businesses rather than employees were able to capture most of the benefits of rising productivity. This showed up in the growing gap between real employee compensation and productivity. As a result, the owners of capital benefited, while the labor share of income - previously a very mean-reverting series - dropped to extremely low levels. The causes of this divergence are complex but include the impact of globalization, technology and a more competitive labor market. Chart 27Too Much Optimism On Wall Street? Chart 28Profit Margins: Another Regme Shift Underway? With the U.S. unemployment back close to full-employment levels, the tide is now turning in favor of labor. The labor share of income is rising and this trend likely will continue as the economy strengthens. And any moves by the incoming administration to erect barriers to trade and/or immigration would underpin the trend. The implication is that profit margins are more likely to compress than expand in the coming years, suggesting that analysts are far too optimistic about earnings. Long-term growth will be closer to 5% than 12%. The turnaround in the corporate income shares going to labor versus capital represents another important element of our theme of regime changes. None of this means that the stock market faces an imminent plunge. Poor value and over-optimism about earnings raises a red flag over long-term return prospects, but says little about near-term moves. As we all know, market overshoots can move to much greater extremes and last for much longer than one can rationally predict. And the fact remains that the conditions for an overshoot could well persist for another 12 months or even longer. Optimism about the economic benefits of the new administration's policies should last for a while as proposals for tax cuts and increased fiscal spending get debated. Meanwhile, although the Fed plans to raise rates again over the next year, the level of interest rates will remain low by historical standards, sustaining the incentive to put money into stocks rather than interest-bearing assets. Mr. X: So are you telling me to buy U.S. stocks right now? BCA: No we are not. The stock market is vulnerable to a near-term setback following recent strong gains, so this is not a great time to increase exposure. However, we do expect prices to be higher in a year's time, so you could use setbacks as a buying opportunity. Of course, this is with the caveat that long-run returns are likely to be poor from current levels and we have the worry about a bear market some time in 2018 if recession risks are building. Playing market overshoots can be very profitable, but it is critical to remember that the fundamental foundations are weak and you need to be highly sensitive to signs that conditions are deteriorating. Mr. X: I am very well aware of the opportunities and risks of playing market overshoots. I completely underestimated the extent of the tech-driven overshoot in the second half of the 1990s and remained on the sidelines while the NASDAQ soared by 130% between end-1998 and March 2000. But my caution was validated when the market subsequently collapsed and it was not until 2006 that the market finally broke above its end-1998 level. I accept that the U.S. market is not in a crazy 1990s-style bubble, but I am inclined to focus on markets where the fundamentals are more supportive. BCA: The U.S. market is only modestly overvalued, based on an average of different measures. It is expensive based on both trailing and forward earnings and relative to book value, but cheap compared to interest rates and bond yields. A composite valuation index based on five components suggests that the S&P 500 currently is only modestly above its 60-year average (Chart 29). Valuation is not an impediment to further significant gains in U.S. equities over the coming year although it is more attractive in other markets. Chart 29The U.S. Market Is Modestly Expensive If we use the cyclically-adjusted price-earnings ratio for non-financial stocks as our metric, then Japan and a number of European markets are trading at valuations below their historical averages (Chart 30). The picture for Japan is muddied by the fact that the historical average is biased upwards by the extreme valuations that existed during the bubble years and in the aftermath when earnings were exceptionally weak. Nonetheless, even on a price-to-book basis, Japan is trading far below non-bubble historical averages (Chart 31). Chart 30Valuation Ranking Of Developed Equity Markets Chart 31Japan Looks Like A Cheap Market With regard to Europe, the good value is found in the euro area periphery, rather than in the core countries of Germany, France and the Netherlands. In fact, these core countries are trading more expensively than the U.S., relative to their own history. As you know, valuation is not the only consideration when it comes to investing. Nonetheless, the direction of monetary policy also would support a better outlook for Japan and the euro area given that the Fed is raising rates while the ECB and BoJ are still implementing QE policies. Exchange rate moves complicate things a bit because further gains in the dollar would neutralize some of the relative outperformance when expressed in common currency. Even so, we would expect the euro area and Japan to outperform the U.S. over the next 12 months. The one important qualification is that we assume no new major political shocks come from Europe. A resurgence of political uncertainty in the euro area would poses the greatest threat to the peripheral countries, which partly explains why they are trading at more attractive valuations than the core. Mr. X: There seem to be political risks everywhere these days. It is a very long time since I could buy stocks when they offered great value and I felt very confident about the economic and political outlook. I agree that value looks better outside the U.S., but I do worry about political instability in the euro area and Brexit in the U.K. I know Japan looks cheap, but that has been a difficult and disappointing market for a long time and, as we already discussed, the structural outlook for the economy is very troubling. Turning to the emerging markets, you have not backed away from your bearish stance. The long-run underperformance of emerging markets relative to the U.S. and other developed bourses has been quite staggering and I am glad that I have followed your advice. Are you expecting to shift your negative stance any time soon? BCA: The global underperformance of EM has lasted for six years and may be close to ending. But the experience of the previous cycle of underperformance suggests we could have a drawn-out bottoming process rather than a quick rebound (Chart 32). Emerging equities look like decent value on the simple basis of relative price-earnings ratios (PER), but the comparison continues to be flattered by the valuations of just two sectors - materials and financials. Valuations are less compelling if you look at relative PERs on the basis of equally-weighted sectors (Chart 33). Chart 32A Long Period Of EM Underperformance Chart 33EM Fundamentals Still Poor More importantly, the cyclical and structural issues undermining EM equities have yet to be resolved. The deleveraging cycle is still at an early stage, the return on equity remains extremely low, and earnings revisions are still negative. The failure of the past year's rebound in non-oil commodity prices to be matched by strong gains in EM equities highlights the drag from more fundamental forces. In sum, we expect EM equities to underperform DM markets for a while longer. If you want to have some EM exposure then our favored markets are Korea, Taiwan, China, India, Thailand and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil and Peru. Mr. X: None of this makes very keen to invest in any equity market. However, even in poor markets, there usually are some areas that perform well. Do you have any strong sector views? Chart 34Cyclical Stocks Have Overshot BCA: Our near-term sector views reflect the expectation of a pullback in the broad equity market. The abrupt jump in the price of global cyclicals (industrials, materials & energy) versus defensives (health care, consumer staples & telecom services) has been driven solely by external forces - i.e. the sell-off in the bond market, rather than a shift in underlying profit drivers. For instance, emerging markets and the global cyclicals/defensives price ratio have tended to move hand-in-hand. The former is pro-cyclical, and outperforms when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the cyclical/defensive price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debts. Meanwhile, the growth impetus required to support profit outperformance for deep cyclicals may be elusive. As a result, we expect re-convergence to occur via a rebound in defensive relative to cyclical sectors (Chart 34). On a longer-term basis, one likely long-lasting effect of the retreat from globalization is that "small is beautiful." Companies with large global footprints will suffer relative to domestically focused firms. One way to position for this change is to emphasize small caps at the expense of large caps, a strategy applicable in almost every region. Small caps are traditionally domestically geared irrespective of their domicile. In the U.S. specifically, small caps face a potential additional benefit. If the new administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Moreover, small companies would benefit most from any cuts in regulations. When it comes to specifics, our overweight sectors in the U.S. are consumer discretionary, telecoms, consumer staples and health care. We would underweight industrials, technology and materials. For Europe, we also like health care and would overweight German real estate. We would stay away from European banks even though they are trading at historically cheap levels. Commodities And Currencies Mr. X: A year ago, you predicted that oil prices would average $50/bbl over the 2016-18 period. As that is where prices have now settled, do you still stick with that prediction? Chart 35Oil Market Trends BCA: We have moved our forecast up to an average of $55/bbl following the recent 1.8 million b/d production cuts agreed between OPEC, led by Saudi Arabia, and non-OPEC, led by Russia. The economic pain from the drop in prices finally forced Saudi Arabia to blink and abandon its previous strategy of maintaining output despite falling prices. Of course, OPEC has a very spotty record of sticking with its plans and we expect that we will end up with a more modest 1.1 to 1.2 million b/d in actual output reductions. Yet, given global demand growth of around 1.3 million b/d and weakness in other non-OPEC output, these cuts will be enough to require a drawdown in inventories from current record levels. Even with the lower level of cuts that we expect, OECD oil inventories could drop by around 300 million barrels by late 2017, enough to bring down stocks roughly to their five-year average level (Chart 35). That is the stated goal of Saudi Arabia and the odds are good that the level of compliance to the cuts will be better than the market expects. Mr. X: How does shale production factor into your analysis? What are the odds that a resurgence of U.S. shale production will undermine your price forecast? BCA: We expect U.S. shale-oil production to bottom in the first quarter of 2017, followed by a production increase of around 200,000 b/d in the second half. However, that will not be enough to drive prices back down. The bigger risk to oil prices over the next year or two is for a rise, not a decline given the industry's massive cutbacks in capital spending. More than $1 trillion of planned capex has been cut for the next several years, which translates into more than seven million b/d of oil-equivalent (oil and natural gas) production that will not be developed. And increased shale production cannot fully offset that. In addition to meeting demand growth, new production also must offset natural decline rates, which amount to 8% to 10% of production annually. Replacing these losses becomes more difficult as shale-oil output increases, given its very high decline rates. Shale technology appears to be gaining traction in Russia, which could end up significantly boosting production but capex cuts will constrain the global supply outlook until after 2018. Mr. X: Non-oil commodity prices have shown surprising strength recently, with copper surging almost 30% in the space of a few weeks. Is that just Chinese speculation, or is something more fundamental at work? You have had a cautious long-term view of commodities on the grounds that changing technology and reduced Chinese demand would keep a lid on prices. Do you see any reason to change that view? BCA: Developments in China remain critical for non-oil commodity prices. China's reflationary policies significantly boosted real estate and infrastructure spending and that was the main driver of the rally in metals prices in 2016. As we discussed earlier, China has eased back on reflation and that will take the edge off the commodity price boom. Indeed, given the speed and magnitude of the price increases in copper and other metals, it would not be surprising to see some near-term retrenchment. For the year as a whole, we expect a trading range for non-oil commodities. Longer-run, we would not bet against the long-term downtrend in real commodity prices and it really is a story about technology (Chart 36). Real estate booms notwithstanding, economies are shifting away from commodity-sensitive activities. Human capital is becoming more important relative to physical capital and price rises for resources encourages both conservation and the development of cheaper alternatives. In the post-WWII period, the pattern seems to have been for 10-year bull markets (1972 to 1982 and 2002 to 2012) and 20-year bear markets (1952 to 1972 and 1982 to 2002). The current bear phase is only six years old so it would be early to call an end to the downtrend from a long-term perspective. Chart 36The Long-Term Trend In Real Commodity Prices Is Down Mr. X: You know that I can't leave without asking you about gold. I continue to believe that bullion provides a good hedge at a time of extreme monetary policies, political uncertainty and, now, the prospect of fiscal reflation. Can you see bullion at least matching its past year's performance over the coming 12 months? Chart 37A Strong Dollar Hurts Bullion BCA: It is still a gold-friendly environment. The combination of political uncertainty, rising inflation expectations and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar: the strengthening of the dollar clearly was a factor undermining the gold price in the second half of 2016 (Chart 37). Nevertheless, a modest position in gold - no more than 5% of your portfolio - will give you some protection in what is likely to remain a very unsettled geopolitical environment. Mr. X: You mentioned the dollar so let me now delve into your currency views in more detail. The dollar has been appreciating for a few years and it seems quite a consensus view to be bullish on the currency. I know the U.S. economy is growing faster than most other developed economies but it surprises me that markets are ignoring the negatives: an ongoing large trade deficit, a looming rise in the fiscal deficit and uncertainty about the policies of the incoming administration. BCA: It is true that if you just looked at the U.S. economic and financial situation in isolation, you would not be very bullish on the currency. As you noted, the current account remains in large deficit, an increased federal deficit seems inevitable given the new administration's policy platform, and the level of short-rates is very low, despite the Fed's recent move. However, currencies are all about relative positions, and, despite its problems, the U.S. looks in better shape than other countries. The optimism toward the dollar is a near-term concern and suggests that the currency is ripe for a pullback. However, it will not require a major sell-off to unwind current overbought conditions. The main reasons to stay positive on the dollar on a cyclical basis are the relative stance of monetary policy and the potential for positive U.S. economic surprises relative to other countries. Ironically, if the administration follows up on its threat to impose trade barriers, that also would be positive for the currency, at least for a while. Longer-run it would be dollar bearish, because the U.S. probably would lose competiveness via higher inflation. The dollar is enjoying its third major upcycle since the era of floating rates began in the early 1970s (Chart 38). There are similarities in all three cases. Policy divergences and thus real interest-rate differentials were in the dollar's favor and there was general optimism about the U.S. economy relative to its competitors. In the first half of the 1980s, the optimism reflected President Reagan's pro-growth supply-side platform, in the second half of the 1990s it was the tech bubble, and this time it is the poor state of other economies that makes the U.S. look relatively attractive. Chart 38The Dollar Bull Market In Perspective The bull market in the first half of the 1980s was the strongest of the three but was cut short by the 1985 Plaza Accord when the leading industrial economies agreed to coordinated intervention to push the dollar back down in order to forestall a U.S. protectionist response to its soaring trade deficit. The second upturn ended when the tech bubble burst. There is no prospect of intervention to end the current cycle and policy divergences will widen not narrow over the next year. Thus, the dollar should continue to appreciate over the next 12 months, perhaps by around 5% on a trade-weighted basis. The fiscal policies being promoted by the Trump team promise to widen the U.S. trade deficit but that will not stand in the way of a dollar ascent. The problems will occur if, as we discussed earlier, an overheating economy in 2018 and a resulting Fed response trigger a recession in 2019. At that point, the dollar probably would plunge. But it is far too soon to worry about that possibility. Mr. X: I was very surprised with the yen's strength in the first half of 2016 given Japan's hyper-easy policy stance. What was driving that? Also, I would be interested in your views on sterling and commodity and emerging currencies. BCA: The yen often acts as a safe-haven at times of great economic and political uncertainty and that worked in the yen's favor for much of the year. However, it lost ground when U.S. bond yields headed higher. Also, the U.S. election result did not help because Japan would be a big loser if the U.S. imposed trade restrictions. The policy settings in Japan are indeed negative for the yen and while the currency is oversold in the very short run, we expect the structural bear market to persist in 2017 (Chart 39). Sterling's trade-weighted index fell to an all-time low after the Brexit vote so it does offer good value by historical standards. However, with so much uncertainty about how Brexit negotiations will proceed, we remain cautious on the currency. The economy has performed quite well since the vote, but it is far too soon to judge the long-term consequences of EU departure. And the prospect of increased government spending when the country already has a large trade deficit and high public debt poses an additional risk. Turning to the commodity currencies, the rebound in oil and metals prices has stabilized the Canadian and Australian dollars (Chart 40). With resource prices not expected to make much further headway over the next year, these currencies likely will be range bound, albeit with risks to the downside, especially versus the U.S. dollar. Chart 39More Downside In The Yen Chart 40Commodity Currencies Have Stabilized Finally, we remain bearish on emerging currencies given relatively poor economic fundamentals. And this is particularly true for those countries with chronically high inflation and/or large current account deficits, largely outside of Asia. Mr. X: What about the Chinese currency? The renminbi has dropped by 13% against the dollar over the past three years and president-elect Trump has threatened to label China as a currency manipulator. You already noted that the Chinese authorities have intervened to prop the currency up, but this does not seem to be working. Chart 41Renminbi Weakness BCA: The trend in the USD/RMB rate exaggerates the weakness of the Chinese currency. On a trade-weighted basis, the currency has depreciated more modestly over the past year, and the recent trend has been up, in both real and nominal terms (Chart 41). In other words, a good part of the currency's move has reflected across-the-board strength in the dollar. The Chinese authorities are sensitive to U.S. pressures and have taken some measures to contain private capital outflows. The next step would be to raise interest rates but this would be a last resort. With the dollar expected to rise further in 2017, the RMB will drift lower, but policy interventions should limit the decline and we doubt the U.S. will follow through with its threat to label China as a manipulator. Geopolitics Mr. X: Last, but certainly not least, we must talk about geopolitics. In addition to the new political order in the U.S. we have a very unstable political situation in Europe, most notably in Italy. We cannot rule out an anti-euro party taking power in Italy which would presumably trigger massive volatility in the markets. With elections also due in France, Germany and the Netherlands, 2017 will be a crucial year for determining the future of the single currency and the EU. What is your take on the outlook? Chart 42Europeans Still Support The EU BCA: Europe's electoral calendar is indeed ominously packed with four of the euro area's five largest economies likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As BCA's Geopolitical Strategy has argued since 2011, global multipolarity increases the logic for European integration. Crises such as Russian assertiveness, Islamic terrorism, and the migration wave are easier to deal with when countries act together rather than individually. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro or the EU (Chart 42). Despite all of its problems, the single currency should hold together, at least over the next five years. Take the recent Spanish and Austrian elections. 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 more-establishment candidate for president, Alexander Van der Bellen, won the election despite fears to the contrary. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. We expect more of the same in the three crucial elections in the Netherlands, France, and Germany. Mr. X: What about Italy? BCA: The country certainly has its problems: it has lagged badly in implementing structural reforms and support for the euro is low compared to the euro area average. Yet, if elections were held today, polls show that the ruling Democratic Party would gain a narrow victory. There are three key points to consider regarding Italy: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum. 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 voters' choices. Benefits of EU membership for Italy are considerable, especially as it allows the country to integrate its unproductive, poor, and expensive southern regions. Outside the EU, the Mezzogiorno is Rome's problem, and it is a big one. The larger question is whether other euro area countries will be content for Italy to remain mired in its fragile and troubling status quo. We think the answer is yes, given that Italy is the definition of "too-big-to-fail." Mr. X: During the past few years you have emphasized the importance of the shift from a unipolar to multipolar world, reflecting the growing power of China, renewed Russian activism and a decline in U.S. influence. How does the policy platform of the incoming Trump administration affect your view of the outlook? It seems as if the U.S. may end up antagonizing China at the same time as it tries to improve relations with Russia. How would that play out? Chart 43Asia Sells, America Rules BCA: The media is overemphasizing the role of president-elect Trump in Sino-American relations. Tensions have been building between the two countries for several years. The two countries have fundamental, structural, problems and Trump has just catalyzed what, in our mind, has been an inevitable conflict. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were instrumental: 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 43). For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its umbrella. Japan's economic model and large trade surpluses led it into a confrontation with the U.S. in the 1980s. President Ronald Reagan's economic team forced Japan to reform, but the result ultimately was a financial crisis as the artificial supports of its economic model fell away. Many investors have long 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 hinders U.S. access to its vast consumer market. There is a critical difference between the "Japan bashing" of the 1980s and the increasingly potent "China bashing" of today. In the 1980s, the U.S. had already achieved strategic supremacy over Japan as a result of WWII, but 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 U.S. to preserve its security. Far from it - China has no greater security threat than the U.S. 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. That means that when the Trump administration tries to "get tough" on long-standing American demands, these demands will not be taken as well-intentioned or trustworthy. Sino-American rivalry will be the chief geopolitical risk to investors in 2017. Mr. X: Are there any other geopolitical issues that might affect financial markets during the coming year? BCA: Investors are underestimating the risks that the defeat of the Islamic State Caliphate in the Middle East will pose. While the obvious consequence is a spread of terrorism as militants return home, the bigger question is what happens to the regional disequilibrium. In particular, we fear that Turkey will become embroiled in a conflict in both Syria and Iraq, potentially in a proxy war with Iran and Russia. The defeat of 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. The Turkish foray into the Middle East poses the chief risk of a shooting war that could impact global markets 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. Conclusions Mr. X: I think we should end our discussions here before you make me more depressed. A year ago, I was very troubled about the economic and financial outlook, and you did not say very much at that time to ease my concerns. And I feel in a similar situation again this year. I do not believe we are at the edge of a major economic or financial crisis, so that is not the issue. The problem for me is that policymakers continue to distort things with excessively easy monetary policies. And now we face fiscal expansion in the U.S., even though the economy is approaching full employment and wages are picking up. Meanwhile, nobody seems worried about debt anymore despite debt-to-GDP ratios that are at all-time highs throughout the world. And if that was not enough, we face the most uncertain political environment that I can remember, both in the U.S. and Europe. It would not be so bad if markets were cheap to compensate for the various risks and uncertainties that we face. But, as we discussed, that is not the case. So I am left with the same dilemma as last year: where to invest when most assets are fully valued. I am sure that you are right when you say that stock prices are well placed to overshoot over the coming year, but that is not a game I like to play. So I am inclined to stay with a cautious investment stance for a while longer, hoping for a better entry point into equities and other risk assets. BCA: We understand your caution, but you risk missing out on some decent gains in equities over the coming year if you remain on the sidelines. The equity market is due for a near-term pullback, but we would use that as a buying opportunity. Markets are not expensive everywhere and the policy backdrop will remain supportive of risk assets. And although we talked about an overshoot, there is plenty of upside before we need to be concerned that valuations have become a major constraint. We are certainly not trying to persuade you to throw caution to the wind. We have not changed our view that long-term returns from financial assets will be a pale shadow of their historical performance. The past 33 years have delivered compound returns of 10.3% a year from a balanced portfolio and we cannot find any comparable period in history that comes even close (Table 3). As we discussed at length in the past, these excellent returns reflected a powerful combination of several largely interrelated forces: falling inflation and interest rates, rising profit margins, a starting point of cheap valuations and strong credit growth. None of these conditions exist now: inflation and interest rates are headed up, profit margins are likely to compress, valuations are not cheap, and in a post-Debt Supercycle world, the days of rapid credit growth are over. Thus, that same balanced portfolio is likely to deliver compound returns of only 4% over the coming decade. Table 3The Past Is Not A Guide To The Future The bottom line is that the economic and policy regime that delivered exceptional markets is shifting. The end of the Debt Supercycle a few years ago represented one element of regime shift and now we face several other elements such as the end of the era of falling inflation and interest rates, a rebalancing of the income shares going to labor and capital, and politically, in attitudes and thus policies regarding globalization. A world of modest returns is one where it is very important to get the right country and sector allocation, and ideally, catch shorter-term market swings. Of course, that is much more challenging than simply enjoying a rising tide that lifts all boats. As the year progresses, we will update you with our latest thinking on market trends and investment ideas. Mr. X: I am sure we are about to have a very interesting year and I will rely on your research to highlight investment opportunities and to keep me out of trouble. Once again, many thanks for spending the time to take me through your views and let's end with a summary of your main views. BCA: That will be our pleasure. The key points are as follows: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end-point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time-lags in implementing policy mean that the fiscal plans of president-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. They key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely to avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given president-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors December 20, 2016

Special Report

Highlights Theme 1: Secular Stagnation Vs. Trumponomics. A larger deficit will cause Treasury yields to rise in 2017 and, for at least a while, it will appear as though secular stagnation has been conquered. Theme 2: A Cyclical Sweet Spot. Better growth and an accommodative Fed will create a sweet spot for risk assets in the first half of 2017. The Treasury curve will bear-steepen early in the year and transition to a bear-flattening only when long-dated TIPS breakevens reach the 2.4% to 2.5% range. Theme 3: Global Risks Shift From Bond-Bullish To Bond-Bearish. The trade-off between accelerating global growth and a stronger dollar will dictate the pace of next year's rise in Treasury yields. Be on the lookout for bond-bearish surprises from the ECB and BoJ in late 2017. Theme 4: Lingering Policy Uncertainty. Frequent spikes in the Global Economic Policy Uncertainty index are likely next year, probably warranting a policy risk premium in asset prices. The composition of the FOMC is another tail risk that bears monitoring. Theme 5: A Pause In The Default Cycle. Recovery in the energy sector will cause the uptrend in the default rate to reverse in 2017, but poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Theme 6: The Muni Credit Cycle Starts To Turn. The municipal credit cycle will take a turn for the worse in 2017, and muni downgrades could start to outpace upgrades later in the year. Theme 7: A Rare Opportunity In Leveraged Loans. The rare combination of rising LIBOR and elevated defaults will cause leveraged loans to outperform fixed-rate junk bonds in 2017. Feature In this Special Report, the last U.S. Bond Strategy report of the year, we present seven major investment themes that will drive U.S. fixed income market performance in 2017. Our regular publication schedule will resume on January 10 with the publication of our Portfolio Allocation Summary for January 2017. Theme 1: Secular Stagnation Vs. Trumponomics With 2016 almost in the books, it is clear that Treasury returns will likely be close to zero for the year. The total return from the Bloomberg Barclays U.S. Aggregate index will be only marginally better, in the neighborhood of 1% to 2% (see the Appendix at the end of this report for a detailed summary of U.S. fixed income returns in 2016). But these disappointing returns don't tell the whole story. Up until November 8, the Bloomberg Barclays Treasury and Aggregate indexes had returned 4% and 5% year-to-date, respectively (Chart 1). It was only then that the surprise election of Donald Trump caused investors to question many of the assumptions that had driven yields lower during the past several years. As of today, there is not much daylight between the market's expected path of the federal funds rate and the FOMC's own projections (Chart 2). This means that for below-benchmark duration positions to perform well going forward it is no longer sufficient to call for a convergence between the market's rate expectations and the Fed's dots, as we had been doing since July.1 For Treasury yields to rise going forward we must exit the regime of secular stagnation - one that has been characterized by serial downward revisions to the Fed's interest rate forecasts - and enter a new regime where improving global growth and Trumponomics lead to a series of faster-than-expected rate hikes and upward revisions to the Fed's dots. Chart 1Bond Market Returns In 2016 Chart 2Market Almost In Line With Fed What Is Secular Stagnation? For the purposes of the bond market we define secular stagnation based on the observation that in each cycle since 1980 it has required lower real interest rates to achieve the Fed's inflation target (Chart 3). The logical conclusion to be drawn is that the equilibrium real interest rate - the one that is consistent with steady inflation - must be in a secular downtrend. A paper published last year by the Bank of England (BoE),2 and discussed in detail by our own Bank Credit Analyst last February,3 identifies the drivers of this long-run decline in the equilibrium real rate and ranks them in order of importance. Chart 3This Is What Secular Stagnation Looks Like One key finding from the BoE's research is that expectations for lower trend growth account for only 100 bps of the 450 bps decline in global real yields since the mid-1980s. Increases in desired savings and decreases in desired investment for a given level of global growth account for the bulk of the decline (300 bps), while 50 bps of the decline remains unexplained (Table 1). Table 1The Drivers Of Secular Stagnation The most important factors identified in the paper include: Demographics: A lower dependency ratio (the non-working age population relative to the working age population) is associated with an increased desire to save. Inequality: The bulk of income gains during the past 35 years have accrued to the richest tiers of the population, the group that is most inclined to save rather than spend. EM Savings Glut: Since the 1990s many emerging market countries have increased foreign exchange reserves to guard against capital outflows, representing an extra source of demand for safe assets. Falling Capital Goods Prices: The relative price of capital goods has fallen about 30% since the 1980s. This means that less savings are required to undertake the same amount of investment. Less Public Investment: The reluctance of governments to pursue large-scale public investment projects has contributed an additional 20 bps of downside to global real yields. Spread Between Cost of Capital & Risk Free Rate: The expected cost of capital (measured using bank credit spreads, corporate bond spreads and the equity risk premium) has not fallen as much as the risk free rate during the past 30 years. This has made investment less sensitive to changes in the risk-free rate. Is Trumponomics The Solution? Can a Donald Trump presidency actually change any of these long-run factors? It is conceivable that fiscal policies focused on spurring capital investment could enhance the outlook for productivity growth and reverse some of the decline in potential GDP growth expectations. However, lower potential GDP growth expectations have also been driven by slower labor force growth, a trend that fiscal policy is powerless to address. On the plus side, the dependency ratio is likely to bottom in the coming years and the increased infrastructure investment that Trump has promised would certainly put upward pressure on rates. It is also possible that the watering-down of certain regulations might bring the cost of capital more in-line with the risk free rate. However, these potentially positive trends need to be weighed against increasingly isolationist trade and immigration policies that will hamper potential GDP growth, as well as proposed tax cuts that disproportionately target the highest income tiers. The latter will only exacerbate the impact of inequality on real yields. What's The Verdict? With so much uncertainty surrounding fiscal policy it is premature to declare the death of secular stagnation. However, secular stagnation will not be the dominant bond market theme in 2017. Amidst all the uncertainty, one thing that seems likely is that a Trump presidency will result in materially higher deficits next year and consequently more Treasury issuance. Chart 4Big Government Only A##br## Problem For Opposition With one party now in complete control of the Congress it is certain that government spending will increase next year. As our geopolitical strategists have repeatedly pointed out,4 lawmakers are only opposed to higher spending when they are not in power. Survey results show that this is also true of voters (Chart 4). Further, Moody's has estimated a range of outcomes for the federal deficit in 2017 based on how much of Trump's stated campaign agenda is implemented. These estimates range from 4.1% of GDP at the low end to 6% of GDP at the high end. This compares to 3.8% of GDP that was expected under current law.5 The greater supply of Treasury securities next year will offset some of the increased demand stemming from the excess of desired savings relative to investment. This will cause Treasury yields to move higher in 2017 and, for at least a while, it will appear as though the forces of secular stagnation have been conquered. Bottom Line: While Trumponomics will rule in 2017, the forces of secular stagnation are simply dormant and are likely to flare-up again in 2018 and beyond. Theme 2: A Cyclical Sweet Spot In the first half of 2017 the combination of improving economic growth and accommodative monetary policy will create a "sweet spot" for risk assets. The positive environment for risk assets will only end when Fed policy becomes overly restrictive. We expect that restrictive Fed policy will not be an issue until near the end of 2017. Above-Trend Growth Chart 5Contributions To GDP Growth Even prior to the election, U.S. economic growth appeared poised to accelerate in 2017. The main reason being that some of the factors that restrained growth in 2016 are shifting from headwinds to tailwinds (Chart 5). Consumer spending should continue to be a solid contributor to growth next year, just as in 2016. Surveys of consumer sentiment suggest we should even expect a modest acceleration (Chart 5, panel 1). Residential investment actually contributed negatively to real GDP in Q2 and Q3 of 2016 even though leading indicators remained firm. This drag is bound to reverse (Chart 5, panel 2). Government spending contributed almost nothing to growth in 2016 but is poised to accelerate next year based on trends in public sector employment. This does not even take into account the potential for more stimulative fiscal policy in 2017 (Chart 5, panel 3). Inventories were a large negative contributor to growth this year. History suggests that large inventory drawdowns tend to mean-revert fairly quickly (Chart 5, panel 4). Net exports exerted less of a drag on growth in 2016 than 2015 due to moderation in the pace of exchange rate appreciation. With the dollar still in a bull market, net exports will not be a significant driver of growth in 2017 (Chart 5, bottom panel). Nonresidential investment was also a large drag on growth in 2016 and should return to being a small positive contributor next year. First, most of the drag was related to lower capital spending from the energy sector (Chart 6). Now that oil prices have rebounded this drag will abate. Second, surveys of new orders have remained supportive (Chart 7, panel 1) and industrial production growth has rebounded off its lows (Chart 7, panel 2). The rebound in industrial production growth is also likely related to the recovery in energy prices. Chart 6Contribution To Nonresidential Fixed Investment Spending Chart 7Will Capex Return In 2017? The end of the drag from energy alone will be enough to make nonresidential investment a positive contributor to growth next year. The wildcard is that the easier regulatory backdrop under President Trump could unleash the animal spirits of the corporate sector and lead to even larger gains. While this outcome is obviously highly uncertain, there is some evidence that business optimism has already increased. The NFIB small business optimism index shot higher in November (Chart 7, bottom panel) and what's more, the NFIB's Chief Economist Bill Dunkelberg noted that "the November index was basically unchanged from October's reading up to the point of the election and then rose dramatically after the results of the election were known." Accommodative Monetary Policy Even with an improving growth outlook we expect the Fed will be slow to react with a faster pace of rate hikes, opting instead to nurture the recovery in inflation and inflation expectations until they are more firmly anchored around its target. With core PCE inflation still running at 1.7% - below the Fed's 2% target - and the 5-year/5-year TIPS breakeven inflation rate currently at 1.86% - well below the level of 2.4% to 2.5% consistent with the Fed's inflation target - there is no rush for the Fed to send a message that it will move aggressively to snuff out incipient inflationary pressures (Chart 8). Instead, the Fed will continue to send the message that there is no need to be aggressive given the downside risks, and will continue to be sensitive to any negative market response to more restrictive monetary policy. In other words, the "Fed put" is still in place. If risk assets start to sell off due to perceptions of overly restrictive monetary policy, the Fed will be quick to adopt a more dovish posture. The Fed will react in this manner at least until long-dated TIPS breakevens are firmly anchored in the range of 2.4% to 2.5%. It is only at that point that the Fed will be less concerned about negative market reactions to Fed tightening and more concerned with battling inflation. Further, it will take at least until the second half of next year for long-dated TIPS breakevens to return to target. This is because they will be held back by the slow uptrend in actual core inflation. The sensitivity of long-dated TIPS breakevens to core inflation has increased since the financial crisis (Chart 9). We posit that this is due to the zero-lower-bound on the fed funds rate. Prior to the financial crisis, with the fed funds rate well above zero, in the event of a deflationary shock investors would reasonably expect the Fed to offset that shock by easing policy. As such, the deflationary shock had a limited impact on long-dated breakevens. But when the fed funds rate is constrained at the zero-bound, there is reason to question whether the Fed can respond to a deflationary shock as in the past. Given the proximity of the fed funds rate to zero, realized inflation will be a much stronger determinant of long-dated breakevens in the current cycle. Chart 8Inflation Still Needs To Rise Chart 9Recovery In Breakevens Will Moderate Inflation Will Move Higher, But Only Slowly Inflation will continue to march higher in 2017, driven by a tight labor market and upward pressure on wage growth. With the unemployment rate already at 4.6% even modest employment gains can lead to exponential increases in wage growth (Chart 10). However, the pass-through from wage growth to overall price inflation is likely to be muted. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017 (Chart 11, panel 1). Core goods inflation (25% of core CPI) will also remain very low. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 11, panel 2), and so will stay depressed as long as the bull market in the dollar remains intact. Chart 10Wage Growth & Unemployment Chart 11Core Inflation By Component Historically, wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 11, bottom panel). This component, which accounts for 25% of core CPI, is where we expect the marginal change in inflation will come from. We expect that the current uptrend in core inflation will remain intact next year, but core PCE will not converge with the Fed's 2% target until late-2017. Investment Implications The combination of better economic growth and accommodative Fed policy is a fertile environment for risk assets, and we expect spread product will perform well in the first half of next year. At the moment, however, we advocate only a neutral allocation to investment grade corporate bonds and an underweight allocation to high-yield based on poor valuation (see Theme 5). Given the positive economic back-drop we will be quick to increase exposure if spreads widen in the near term. Long-dated TIPS breakevens will also continue to widen until they reach the 2.4% to 2.5% range that is consistent with the Fed's inflation target. As such, we remain overweight TIPS relative to nominal Treasury yields, even though the uptrend in breakevens is likely to moderate in the months ahead. We will likely downgrade TIPS in 2017, once long-dated breakevens reach our target in the second half of the year. The cyclical sweet spot of better growth and an easy Fed also means that the Treasury curve is likely to bear-steepen in the New Year. Historically, excluding periods when the Fed is cutting rates, the 2/10 Treasury curve tends to steepen when TIPS breakevens rise and flatten when they fall (Chart 12). Further, after last week's Fed meeting the 5-year bullet now looks very cheap on the curve (Chart 13). Chart 12Wider Breakevens Correlated With A Steeper Yield Curve Chart 13The 5-year Bullet Is Cheap On The Curve We expect Treasury curve steepening to persist next year until TIPS breakevens normalize near our target. At that point the bear-steepening curve environment will shift to a bear-flattening one. Investors should buy the 5-year bullet and sell a duration-matched 2/10 barbell to profit from curve steepening in the first half of next year and to take advantage of the cheapness of the 5-year bullet. Bottom Line: The combination of better economic growth and an accommodative Fed will create a sweet spot for risk assets in the first half of 2017. The Treasury curve will bear-steepen and TIPS breakevens will continue to rise. Curve bear-steepening will transition to bear-flattening once long-dated TIPS breakevens level-off in the 2.4% to 2.5% range. Theme 3: Global Risks Shift From Bond-Bullish To Bond-Bearish Alongside secular stagnation, the most important theme driving U.S. bond markets during the past several years has been the divergence in growth between the U.S. and the rest of the world. We have repeatedly pointed out that these global growth divergences have led to upward pressure on the dollar, and that a strong dollar necessarily limits the amount of monetary tightening that can be achieved through higher interest rates. The strong dollar thus serves as a cap on long-dated Treasury yields. This theme will remain very much intact for most of 2017, but will probably be less potent than in prior years. Our Global LEI diffusion index - a measure of global growth divergences - has moved firmly into positive territory. This makes it unlikely that we will see another dollar appreciation of the scale witnessed in 2014/15 (Chart 14). The fact that the U.S. is still leading the way in terms of growth means the bull market in the dollar will stay in place, but the appreciation will be less potent going forward. Still, from the perspective of Treasury yields, it will be important to monitor the trade-off between accelerating global growth on the one hand and a stronger dollar on the other. One tool we have devised to help guide us in this respect is our 2-factor Global PMI model (Chart 15). This is a model of the 10-year Treasury yield based on global PMI and bullish sentiment toward the U.S. dollar. A stronger global PMI puts upward pressure on the 10-year Treasury yield while, for a given level of global growth, an increase in bullish sentiment toward the dollar pressures the 10-year yield lower. Chart 14Global Growth Divergences ##br##Less Pronounced Chart 152-Factor Global ##br##PMI Model At present, this model tells us that fair value for the 10-year Treasury yield is 2.26%, well below current levels. This is one reason we tactically shifted to a benchmark duration stance on December 6 even though we expect yields to rise next year. Going forward we will continue to use this model to assess whether increasing global growth or a stronger dollar is dominating in terms of the impact on Treasury yields. Chart 16A Bond Bearish Surprise? Through the mechanism described above, the rest of the world will continue to be a bond-bullish force with respect to U.S. Treasury yields for most of 2017. However, near the end of 2017 it is possible that either the Eurozone or Japan could start to exert upward pressure on U.S. Treasury yields. This could occur if it seems likely that either economic bloc is poised to reach its inflation target and the market starts to discount an end to their extremely accommodative monetary policies. We have highlighted the risks of such events in prior reports, in the context of our Tantrum Theory of Global Bond Yields.6 The unemployment rate in the Eurozone is declining rapidly, but has historically needed to break below 9% before core inflation starts to rise (Chart 16, panels 1 & 2). If the current pace of above-trend growth in Europe is sustained throughout 2017 then higher inflation and the end of the European Central Bank's (ECB) asset purchases could become a risk to global bond markets late next year. However, even minor setbacks in growth would be enough to push this risk out to 2018. In Japan, although inflation is still well below the Bank of Japan's (BoJ) target, yen weakness suggests it should begin to rise (Chart 16, bottom panel). While the BoJ has promised to wait until inflation is above target before abandoning its yield curve peg, it is possible that near the end of next year, if inflation is much higher, the market will start to discount the eventual end of the BoJ's policy and cause global bonds to sell off. For now we would characterize these bond-bearish surprises from the BoJ and/or ECB as tail risks for the global bond market that could flare in late 2017. Bottom Line: The trade-off between accelerating global growth and a stronger dollar will dictate the pace of next year's rise in Treasury yields. Be on the lookout for bond-bearish surprises from the ECB and BoJ in late 2017. Theme 4: Lingering Policy Uncertainty With fiscal policy having the potential to drastically alter the economic landscape and yet with so much still unknown about what will occur, lingering policy uncertainty will undoubtedly be a major theme for fixed income markets in 2017. Historically, the Global Economic Policy Uncertainty index created by Baker, Bloom and Davis7 has been a reliable gauge of these risks and has also tracked asset prices surprisingly well (Chart 17). Recently, the uncertainty index has spiked and asset prices have not responded in kind. This is likely a signal that the spike in uncertainty will quickly reverse, but it could be a signal that asset prices are overly complacent. At the very least the spike in uncertainty highlights the fact that bond markets have been very quick to discount the potentially positive impacts of a Trump presidency, but are at risk if these policies are not delivered. This lack of a "policy risk premium" in fixed income markets is driven home by the reading from our 3-factor Global PMI model (Chart 18). This model adds the Global Economic Policy Uncertainty index to the 2-factor Global PMI model mentioned in the previous section, increasing the explanatory power of the model in the process. At present, the 3-factor model gives a fair value reading of 1.82% for the 10-year Treasury yield. Chart 17Economic Policy Uncertainty & Bond Markets Chart 183-Factor Global PMI Model While the most recent spike in policy uncertainty may reverse before asset prices respond, the volatile nature of the incoming administration means that more frequent spikes of the uncertainty index are likely in 2017. At some point asset prices will probably react. There is another political risk in 2017 that carries extra importance for bond markets. In 2017 President Trump will appoint two new Fed Governors. Also, there is a good chance that Janet Yellen and Stanley Fischer will not be re-appointed as Chair and Vice-Chair respectively when their terms expire in early 2018. Given the pedigrees of Trump's economic advisors, we would expect the newly appointed Governors in 2017 to have hawkish policy leanings. While this will not significantly alter Fed decision making in 2017, since the core members of the Committee will still be in place, there is a risk that the market will anticipate that one of the newly appointed Governors will be Janet Yellen's eventual replacement. If that Governor is hawkish, then there is a risk that the market will start to discount a much more hawkish Fed reaction function as early as next year. This could potentially speed up the transition from a bear-steepening curve environment to a bear-flattening environment, putting spread product at risk earlier than we currently anticipate. The MBS market would also be at risk in this scenario, since any incoming hawkish Fed Governor would be very likely to favor an unwind of the Fed's balance sheet at a much quicker pace than is currently anticipated. We already recommend an underweight allocation to MBS due to low spread levels and a continued recovery in the housing market that will keep net issuance trending higher. A change of leadership at the Fed represents an additional tail risk. Although we think it is premature to say for certain that Chair Yellen and Vice-Chair Fischer won't be re-appointed in 2018, the key risk for next year is that the market anticipates that they will be replaced. Bottom Line: Frequent spikes in the Global Economic Policy Uncertainty index are likely next year, probably warranting a policy risk premium in asset prices. The composition of the FOMC is another tail risk that bears monitoring. Theme 5: A Pause In The Default Cycle The uptrend in the trailing 12-month speculative grade default rate will reverse in 2017, falling from its current 5.6% back closer to 4%. But this will only be a temporary reprieve and the uptrend will resume in 2018 and beyond. Increases in job cut announcements, contractions in corporate profits and tightening C&I lending standards all tend to coincide with a rising default rate (Chart 19). All three of these factors signaled rising defaults last year, but have since rolled over. We have often drawn a comparison between the current default cycle and the default cycles of the mid-1980s and mid-1990s, and this comparison is still apt. Chart 19The Current Default Cycle Is A Hybrid Of the Mid-1980s and Late-1990s Distress in the energy sector caused a contraction in corporate profits and rising defaults in 1986. But then a sharp easing of Fed policy and a recovery in oil prices caused the uptrend in defaults to reverse. Corporate profit contraction, increasing job cut announcements and tighter lending standards also caused the default rate to trend higher in 1998. This time, however, Fed policy remained restrictive (Chart 19, bottom panel) and banks had no incentive to ease lending standards amidst a back-drop of rising corporate leverage. The default rate continued to trend higher in the late 1990s, and did not peak until the next recession. While the energy price shock and subsequent recovery make the current cycle similar to the 1980s episode, the fact that the Fed is more inclined to hike than cut rates brings to mind the late 1990s. This leads us to believe that the recovery in energy prices will cause the default rate to fall next year. This, along with better economic growth and a relatively accommodative Fed, will keep downward pressure on credit spreads throughout most of 2017. However at some point, likely after TIPS breakevens have recovered to pre-crisis levels, the Fed's tone will turn decidedly more hawkish. This will lead to renewed tightening in lending standards, a resumption of the uptrend in defaults and wider corporate spreads. Despite our optimism about the macro outlook for 2017 we cannot forget that corporate balance sheet health continues to deteriorate (Chart 20). Our Corporate Health Monitor has been in 'deteriorating health' territory since 2013, and although corporate spreads have tightened since February they have yet to regain their 2014 lows. Additionally, net leverage for the nonfinancial corporate sector - defined as outstanding debt less cash on hand as a percent of EBITDA - is still trending higher (Chart 20, bottom panel). The only other period since 1973 when corporate spreads narrowed as net leverage increased was following the oil price crash and default spike of 1986. In that period spreads remained under downward pressure for approximately two years but never regained their prior lows. Spreads also benefitted from Fed rate cuts and a weakening dollar during that timeframe. In our view, the best way to play the corporate bond market in the current cycle is to maintain a cautious long-term bias but to look for attractive opportunities to initiate overweight positions. At the moment, we are actively looking to upgrade our allocation to corporate bonds but need a more attractive entry point first. At 405 bps, the average spread on the Bloomberg Barclays High-Yield index is only 65 bps above the average level observed in the 2004 to 2006 period when our Corporate Health Monitor was deep in 'improving health' territory. Not surprisingly, the spread appears even lower after adjusting for expected default losses (Chart 21). Chart 20Corporate Balance Sheets Continue To Add Leverage Chart 21Corporate Bond Valuation The default-adjusted high-yield spread is our preferred valuation measure for high-yield and investment grade corporate bonds alike. As is shown in Charts 22 and 23, the current default-adjusted spread of 162 bps is consistent with negative excess returns for both investment grade and high-yield bonds, on average, over a 12-month investment horizon. Chart 2212-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Chart 2312-Month Excess Investment Grade Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) However, this average negative excess return is heavily influenced by a few periods when excess returns were deeply negative. A more detailed examination, shown in Tables 2 & 3, reveals that when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns for high-yield have been positive 65% of the time. Investment grade excess returns have been positive only 35% of the time with spreads at current levels, but have been positive 55% of the time when the default-adjusted spread is between 100 bps and 150 bps. Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Table 312-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Given our optimistic assessment of the macro back-drop, we conclude that excess returns for both investment grade and high-yield corporate bonds are likely to be positive, but very low, during the next 12 months. But we will continue to look for opportunities to upgrade our allocation to spread product from more attractive levels. Bottom Line: The improving macro back-drop means that the default rate will move lower in 2017. However, the poor state of corporate balance sheets means that the default rate will likely resume its uptrend in 2018, once Fed policy turns decidedly more hawkish. Theme 6: The Muni Credit Cycle Starts To Turn Back in October, we published a Special Report 8 wherein we observed that Municipal / Treasury (M/T) yield ratios tend to fluctuate in long-run cycles determined by ratings downgrades and net borrowing at the state & local government level. That is, there exists a municipal bond credit cycle much in the same way that there exists a corporate credit cycle. Additionally, we introduced a Municipal Health Monitor - a composite indicator of the health of state & local government finances - to help us assess the stage of the municipal credit cycle and observed that it has tended to follow our Corporate Health Monitor with a lag of approximately two years (Chart 24). Chart 24The Municipal Credit Cycle Lags The Corporate Cycle This analysis leads us to believe that our Municipal Health Monitor will move into 'deteriorating health' territory at some point during 2017 and that municipal bond downgrades could start to outpace upgrades late next year. As such, we adopt a cautious stance with respect to the municipal bond market, not least of which because of the potentially negative impact on the market from a Donald Trump presidency. Lower tax rates next year will certainly undermine the tax advantage of municipal debt, while the potential for increased infrastructure spending could lead to a sizeable increase in municipal bond supply. Historically, most public investment has been financed at the state & local government level, and while Trump's current infrastructure plan relies entirely on incentives for private sector investment, these details could change before any plan is implemented. By far the largest risk to the municipal bond market would be if the municipal tax exemption is done away with entirely in the context of broader tax reform, but this now appears unlikely. Even in the absence of a federal government initiative we would not rule out increased state & local government investment next year. State & local government finances have made substantial progress since the crisis and many states are now in a position where they may start to loosen the purse strings (Chart 25). This poses an upside risk to muni supply in 2017. Of course, we have already seen large fund outflows in response to Trump's election victory. ICI data show that net outflows from municipal bond funds have totaled $14.86 billion since the end of October, and while M/T yield ratios have risen, they remain near the middle of their post-crisis trading ranges (Chart 26). Chart 25Healthy Enough To Invest Chart 26Municipal / Treasury Yield Ratios We will continue to look for opportunities to upgrade municipal bonds when the reading from our tactical Muni model turns more positive (Chart 27). This model- based on policy uncertainty, issuance, fund flows and ratings migration - shows that M/T yield ratios are not yet attractive. This is true even if we assume that last month's spike in policy uncertainty is completely reversed. This model has a strong track record of predicting Muni excess returns since 2010 (Table 4). Chart 27Tactical Muni Model Table 4Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 Bottom Line: The municipal credit cycle will take a turn for the worse in 2017, and muni downgrades could start to outpace upgrades later in the year. Remain underweight for now, but look for near-term tactical buying opportunities in municipal bonds. Theme 7: A Rare Opportunity In Leveraged Loans Chart 28Leveraged Loans Will Outperform In 2017 Our final theme for 2017 relates to the potential for floating rate leveraged loans to outperform fixed rate high-yield bonds. Historically, these periods of outperformance have been few and far between. There have only been two periods since 1991 when loans have outperformed bonds for any length of time (Chart 28). However, we believe that the conditions are in place for loans to outperform fixed-rate junk in 2017. There are two factors that can potentially cause leveraged loans to outperform fixed-rate junk. The first is rising LIBOR, which causes loan coupon payments to reset higher. While there is some concern that LIBOR floors prevent loans from benefitting from higher LIBOR, most loans have LIBOR floors of 75 bps or 100 bps. With 3-month LIBOR already at 99 bps, LIBOR floors will not be a constraint for much longer. The second factor that could cause loans to outperform bonds is an elevated default rate. Since loans are higher-up in the capital structure than bonds, they benefit from higher recovery rates. This matters more in terms of relative performance when the default rate is high. It is highly unusual for elevated defaults and rising LIBOR to coincide. This is because the Fed is typically cutting rates when the default rate is rising. However, next year, much like in the late 1990s, both conditions are likely to be in place. Bottom Line: The rare combination of rising LIBOR and elevated defaults will cause leveraged loans to outperform fixed-rate junk bonds in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com 2 Lukasz Rachel & Thomas D. Smith, "Secular Drivers of the Global Real Interest Rate (Staff Working Paper No. 571)", Bank of England, December 2015. 3 Please see Bank Credit Analyst Special Report, "Secular Stagnation And The Medium-Term Outlook For Bonds", dated February 25, 2016, available at bca.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 Mark Zandi, Chris Lafakis, Dan White and Adam Ozimek, "The Macroeconomic Consequences of Mr. Trump's Economic Policies", Moody's Analytics, June 2016. 6 Please U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 7 For further details on the construction of this index please see www.policyuncertainty.com 8 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Appendix: U.S. Bond Market 2016 Risk/Return Summary Chart A-1U.S. Bond Returns In Historical Context Chart A-22016 Total Returns Versus Volatility Chart A-32016 Vol-Adjusted Total Returns Chart A-42016 Excess Returns Versus Volatility Chart A-52016 Vol-Adjusted Excess Returns Chart A-62016 Corporate Sector Excess Returns Versus Duration-Times-Spread Chart A-7The Performance Of Our Corporate Sector Model In 2016

Highlights Dear Clients, Please note that this will be our final Weekly Report for the year. We will resume our regular publishing schedule on January 3, 2017. The U.S. Investment Strategy team wishes you a restful holiday season and a prosperous New Year. Chart 1Trump + Yellen Recent bond market moves are soft echoes of the 1994 bond bear market, when investors suddenly began to price in a much less benign outlook for the Fed. There are mitigating factors that mean the current bond selloff will not be as violent. But the normalization of policy rates is no longer a challenge for the distant future. This process was always going to be fraught with risk, given the unprecedented amount of accommodation (conventional and unconventional) employed after the Great Recession. Even a mild version of 1994 could undermine equity returns. Indeed, the risk is that investors have pulled forward profit growth expectations due to anticipated fiscal stimulus (that may disappoint) at a time when domestic monetary conditions are tightening. Feature It was no surprise that the FOMC raised the Fed funds rate by 25bps at last week's meeting. But investors were caught off-guard by the move higher in the Fed's "dot" forecast. Instead of two more hikes next year, the Fed now expects to raise rates three times. Moreover, the Fed inched up its estimate of the terminal interest rate to 3.0% from 2.875%. These revisions to the path of interest rates did not occur with any material changes to the Fed's economic projections. During the post-meeting press conference, Fed Chair Janet Yellen downplayed the "dot" revisions, by noting that the median projections moved due to changes by only some Fed participants. But despite Yellen's soothing remarks, the financial markets did not interpret the revisions to be minor. The dollar strengthened by nearly 2%, and 10-year bond yields spiked by 20bps (Chart 1). These market moves are soft echoes of the 1994 bond bear market - when investors suddenly began to price in a much less benign outlook for the Fed. Investors will note that in that cycle, the Fed's extended on hold period in 1993 had lulled bond investors into a false sense of complacency; investors were almost completely caught off-guard when tightening began in early February 1994 (Chart 2 and Chart 3). At the end of 1993, the market projected that the 3-month rate, the 10-year and the 30-year yield would be 4.3%, 6.2% and 6.5%, respectively, by the end of 1994. The actual yields at the end of 1994 turned out to be more than 130 basis points higher at 5.6%, 7.8% and 7.85%. From the trough in yields in September 1993 to the peak in November 1994, the Treasury index lost 5%. High-grade spread product, such as Agencies, MBS and investment-grade corporate bonds also suffered losses. The S&P 500 fell by about 9% in early 1994. Economic improvement was the main factor for the re-pricing of the Fed funds rate in 1994 (Chart 4). In the first half of the year, the unemployment rate declined 0.5% (from 6.6% to 6.1%) and monthly average payrolls were above 320,000! As the economy gained self-feeding momentum, the Fed steadily hiked interest rates, causing Treasuries and spread product to buckle. In fact, inflation did not go up but bond yields kept rising and the U.S. economy remained robust. The Mexican financial crisis in late 1994/early 1995, directly stemming from Fed tightening, marked the end of the Treasury bear and Fed restraint. Chart 21993 Complacency, 1994 Panic Chart 3Bond Market Is Still Behind Chart 41994 Economic Acceleration Fueled The Bond Bear All of this bears some resemblance to current conditions, albeit the level of growth today is much lower. Like early 1994, the economy now appears on the cusp of full employment (Chart 5). Most forecasters (including BCA) expect that growth will shift to an above-trend pace for at least a few quarters. And indeed, the debate has already shifted from deflation to the potential for inflation. To be sure, as we wrote last week, it takes a long time to change a prevailing mindset about inflation or deflation and it is unlikely that the Fed will find itself in a position to aggressively tighten against an inflation breakout over the next twelve months. But if GDP growth bucks the pattern of recent years in which first quarter growth disappointed expectations, then bond investors could begin to look for the exits more fervently. What is different this cycle than in 1994? For one thing, the Fed's communication strategy has drastically changed. Since 2012, the Fed has been publishing the "dot plot," a set of FOMC projections for inflation, GDP and the projected policy path. These projections serve as forward guidance about policy intent and in theory, should help smooth out any changes in market participants' expectations about the Fed's policy path and reduce the likelihood of overshoots in expectations. In addition, it seems likely that bonds are now more concentrated in "strong hands." One of the major concerns in 1994 was that retail investors, i.e. the household sector, piled into bonds at precisely the wrong time: throughout the 1980s, bond returns only marginally trailed that of equities and with far less volatility, lulling retail investors into believe bonds couldn't lose them money. Today, according to the BIS,2 around 40% of U.S. Treasuries are owned by the Federal Reserve and the foreign official sector. In addition, the BIS also posits that it is possible that pension funds (the third largest holders of Treasuries) and insurance companies may even benefit from rising rates in the medium term, as a normalized yield environment would allow them to more easily meet promised returns. This composition of ownership, in particular the Fed and foreign official investors - who are non-profit seeking entities, will not be forced to sell into a bear market. Chart 5On The Cusp Of Full Employment True, corporate bonds are now more heavily concentrated in the hands of private investors who seek yield and total return. The prospective price volatility of these securities may be much higher than an entire generation of fixed income investors' experience has taught them to expect. Finally, the U.S. dollar traded sideways from 1990-1993, and fell throughout 1994, which is very different from today. Currently, the policy feedback loop limits the degree to which the Fed can ultimately raise interest rates. This loop has been in place since last year: each hawkish move from the Fed has been met by a sharp upward adjustment in the trade-weighted dollar and a selloff in equities and credit spreads. Tighter-than-expected financial conditions have then forced the Fed to lower its outlook for future economic growth and adopt a more dovish policy stance. A more dovish Fed then caused financial conditions to ease and the dollar to fall, and this easing eventually emboldened Fed policymakers to move in a more hawkish direction. The loop then repeats. The reason this loop has been in place is because U.S. monetary policy is so far in advance of other central banks. Overall, there are mitigating factors that suggest that the current bond selloff will not be as violent as 1994. But the normalization of policy rates is no longer a challenge for the distant future. As expectations of economic growth improve, a re-pricing of Fed interest rate hike expectations will persist. This process was always going to be fraught with risk, given the unprecedented amount of accommodation (conventional and unconventional) employed after the Great Recession. We expect that bond selloffs over the next year will happen in fits and starts, as the feedback loop from the bond market and dollar to policy decisions repeats. The move in Treasury yields since mid-November has proceeded too quickly relative to the improvement in economic fundamentals and will pause in the near term to prevent financial conditions from exerting an excessive drag on growth. However, we believe short duration positions will make money on a 2-3 year horizon. How Will Equities Cope? Apart from the 1994 episode, there have been three other major Fed tightening cycles since 1985 (Chart 6). In each case, the 10-year Treasury suffered an almost 10% or more annual loss, either following or just before short-term rates began their ascent. Investors underestimated the pace and extent of rate hikes every time and equity prices also faltered, at least temporarily. This was the case even when the Fed telegraphed a modest and steady 25 basis point-per-meeting pace of rate hikes from 2003 to 2006. The point is that even a mild version of 1994 could undermine equity returns. Indeed, the risk is that investors have pulled forward profit growth expectations due to anticipated fiscal stimulus (that may disappoint) at a time when domestic monetary conditions are tightening. Earnings-per-share growth is significantly lower today than in 1993, and the gap between trailing earnings growth and 12-month forward expectations is wide. This suggests that there is a greater risk of earnings disappointment than was the case in the early 1990s. Meanwhile, valuation is poor (Chart 6, bottom panel). Still, we concede that sentiment and technical indicators continue to favor near-term equity gains (Chart 7). Neither our technical nor our intermediate indicator is signalling danger (although both have rolled over). Only our monetary indicator is flashing a warning. The risk is that the longer the uptrend in stocks continues without interruption, the greater the payback will be should economic performance disappoint. Chart 6Fed Re-Entry Is Historically Tough Chart 7An Expensive And Risky Rally Animal Spirits Revival? In our view, the most notable development for the U.S. economy in recent weeks has been the impressive swing in confidence since the election in November. If sustained, the rise in confidence could propel growth to an above-trend pace as "animal spirits" are unleashed. We take this possibility seriously, since depressed confidence in the outlook was an important force capping the upside in growth earlier in the recovery. Nonetheless, this is not our base case, since we continue to believe that it is perilous to focus solely on the positive aspects of Trump's political agenda, while ignoring the more negative ones. This phenomenon seems to be borne out in the NFIB survey data. Although still low relative to past recoveries, optimism among small business owners improved drastically last month, according to the NFIB survey (Chart 8). The improvement was broad-based, showing gain in sales expectations, expansion plans and hiring intentions. But as the NFIB's chief economist pointed out, this surge in optimism is mainly due to businesses reacting favorably to Trump's platform of tax cuts and less regulation. In any case, the recent improvement in consumer confidence has not noticeably translated to improved consumer spending yet. Nominal retail sales eked out a tiny 0.1% m/m gain in November and the October data were revised lower. As we highlighted in a previous report, massive price discounting continues to be a factor pushing down nominal spending. Indeed, despite the potential for an upturn in inflation on the back of unconfirmed Trump policies, the current pricing environment remains tough. Core CPI rose only 0.2% in November, and the annual growth rate - at 2.1% - is lower than at the start of the year. Our diffusion index is below 50, meaning that more sub-components of the CPI are decelerating than accelerating (Chart 9). Chart 8Optimism Returning Chart 9Consumers Are Confident, Will They Spend? The overall message is that economic data continue to display a "two steps forward, one step backward" pattern. We expect growth momentum to gradually build and the economy can grow above trend next year. However, even once the output gap closes, it can take a long time for inflation pressures to build and for inflation expectations to move higher. Ultimately, this dynamic means that the Fed will have the scope to proceed slowly. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 This week's report is greatly inspired by our Special Report, "Reincarnation And Bond Vigilantes," February 5, 2013. 2 "A Paradigm Shift In Markets?," Bank For International Settlements (BIS), December 11, 2016 http://www.bis.org/publ/qtrpdf/r_qt1612a.htm Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral and in line with our benchmark portfolio recommendation for equities. The technical component retained its "buy" signal, with some improvements in the momentum and breadth & trend indicators. The monetary component, though less bullish for equities as it continued to weaken somewhat, is still in favorable territory for equities. However, on the cyclical front, the earnings-driven component continues to warrant caution as real operating earnings are at a significant distance from positive economic expectations. Earnings momentum has also further deteriorated, based on an earnings diffusion index which compares nominal earnings growth relative to four economic and monetary variables such as oil prices (WTI), ISM Inventories, 10-year Treasury yields and 3-month T-bill rates. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model. However the "buy signals" of the cyclical and technical components of the bond model have weakened, nearing critical levels which would surrender the preference for Treasuries in the near term. Chart 10Portfolio Total Returns Chart 11Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.

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

Special Report

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

Highlights Duration: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. Corporate Bonds: The macro back-drop is turning marginally more positive for corporate spreads. C&I lending standards are no longer tightening and bank stocks have rallied significantly. Corporate Bonds: Spreads are too tight at the moment, even for an improving economic environment. Remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now. We are actively looking to add exposure to corporate credit from more attractive levels. Feature There is no question that the U.S. economy is on a firm footing heading into the New Year. Third quarter real GDP growth came in at a robust 3.2%, and the Atlanta and New York Fed tracking models currently forecast fourth quarter growth of 2.6% and 2.7%, respectively. This represents a marked acceleration from the average growth rate of 1.1% witnessed during the first two quarters of 2016. Forward-looking survey data are also pointing in the right direction. The ISM non-manufacturing survey reached 57.2 in November, its highest level since October 2015, while the expectations component of the University of Michigan Consumer Sentiment survey reached 88.9 in December, its highest level since January 2015 (Chart 1). The question for bond investors is how much of this good news is already reflected in Treasury yields. Higher Treasury yields and a stronger dollar have already led to a material tightening in some broad indexes of financial conditions, enough to exert a meaningful drag on U.S. growth (Chart 2). In fact, according to the Fed's FRB/US model, the recent interest rate and dollar moves could be expected to shave 1% from GDP over the next eight quarters. Chart 1Economic Tailwinds Chart 2Financial Conditions Must Ease The natural conclusion is that while some upside in Treasury yields is justified by an improving economic outlook, the bond selloff has proceeded too quickly and must pause in the near-term to prevent financial conditions from exerting an excessive drag on growth. Sentiment and positioning indicators also confirm that the uptrend in yields appears stretched (Chart 2, bottom two panels). As such, last week we tactically shifted our recommended portfolio duration allocation from 'below benchmark' to 'at benchmark'.1 We expect Treasury yields will grind higher next year, reaching a range of 2.8% to 3% by the end of 2017, but the selloff will proceed more gradually, in line with the acceleration in economic growth. A More Uncertain World The premise that the bond selloff has proceeded too quickly is confirmed by our Global PMI models of the 10-year Treasury yield. We track two versions of our Global PMI model. One is a 2-factor model based only on the Global PMI index and a survey of bullish sentiment toward the U.S. dollar. The intuition behind this model is that improving global growth contributes to a higher fair value Treasury yield. However, for a given level of global growth, increasingly bullish dollar sentiment applies downward pressure to yields. This is because a stronger dollar represents a tightening of monetary conditions, so that all else equal, a stronger dollar means we should expect fewer Fed rate hikes. The current fair value reading from this 2-factor model is 2.26%, meaning that the 10-year Treasury yield at 2.49% appears somewhat cheap (Chart 3). The second version of our Global PMI model is a 3-factor model which adds the Global Economic Policy Uncertainty Index (EPUI) as a third independent variable. All else equal, an increase in uncertainty about the economic outlook should depress the term premium in long-dated Treasury yields. The data appear to back-up this assertion, as the EPUI is negatively correlated with the 10-year Treasury yield over time. With the addition of the EPUI, our 3-factor model explains 84% of the variation in the 10-year Treasury yield since 2010, compared to 80% from our 2-factor model. The EPUI spiked last month, and as such, this version of the model suggests that fair value for the 10-year Treasury yield is only 1.82% (Chart 4). Chart 32-Factor Global PMI Model Chart 43-Factor Global PMI Model There are probably good reasons to overlook last month's spike in policy uncertainty. For one, the EPUI, created by Baker, Bloom and Davis,2 is largely constructed from algorithms that scan newspaper articles for keywords. They do not attempt to distinguish between economic news with bond-bearish or bond-bullish implications. Second, we have found that large spikes in uncertainty that do not coincide with deterioration in economic growth tend to mean-revert fairly quickly. This past summer's Brexit vote being a prime example. As a counterpoint, however, the negative correlation between the EPUI and the 10-year Treasury yield is quite robust (Chart 5), and historically, incidents of spiking policy uncertainty and rising Treasury yields have been few and far between. Since 1991, there have been 42 instances when the monthly increase in the EPUI exceeded one standard deviation. In those 42 months, the 10-year Treasury yield increased only 36% of the time, with last month's 53 basis point rise being by far the largest on record. We tend to view the reading from the 2-factor model as the more reasonable assessment of fair value in the current environment. But the spike in policy uncertainty does underscore why we should view the recent bond selloff skeptically. The recent selloff has, to a large extent, been predicated upon promises of fiscal stimulus that have yet to be delivered, from a President-elect who has shown himself to be highly unpredictable. In this environment, near-term caution is clearly warranted. Of course, this week the market's focus will at least temporarily turn away from fiscal policy and toward the Fed. We expect that the Fed will announce a 25 basis point increase in the fed funds rate tomorrow, but also that participants' interest rate projections will not change meaningfully. The FOMC will likely be much slower to react to promises of fiscal stimulus than the market. With the Fed's projected near-term path for interest rates already mostly discounted by the market (Chart 6), we could see a "dovish hike" from the Fed tomorrow coinciding with the near-term top in Treasury yields. Chart 5Economic Policy Uncertainty & Treasury Yields Chart 6A "Dovish Hike" Is In The Price Bottom Line: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. A More Favorable Environment For Credit We frequently point to three main indicators that we use to assess the current stage of the credit cycle: Our Corporate Health Monitor (CHM) Monetary conditions relative to equilibrium C&I bank lending standards In a report3 published earlier this year we found that the performance of bank stocks relative to the overall market is another useful indicator (Chart 7). While the credit cycle is still very much in its late stages, recently, our indicators have been sending marginally more positive signals. The CHM remains deep in 'deteriorating health' territory and non-financial corporate balance sheets continue to lever-up aggressively. However, the indicator did inch slightly closer to 'improving health' territory in the third quarter due to an improvement in all six of its components (Chart 8). Make no mistake, trends in corporate balance sheet leverage are not supportive for corporate spreads. In fact, as we will explore in a future report, the recent divergence between rising leverage and tightening spreads is nearly unprecedented during the past 40 years. But at the margin, recent trends are less worrisome. Chart 7Credit Cycle Indicators Chart 8Corporate Health Monitor Components Box1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Second, although monetary conditions appear very close to our estimate of equilibrium, the recent steepening of the yield curve suggests that the market is revising its estimate of monetary equilibrium higher, leading to a de-facto easing of monetary conditions. In the long-run, with the Fed in the midst of a hiking cycle, this sort of easing is unlikely to persist. But, as we argued in a recent report,4 the bear steepening curve environment could continue in the first half of next year as the Fed is slow to respond to an improving economy. Third, C&I bank lending standards have fallen back to unchanged after having tightened for four consecutive quarters. This likely reflects less stress in the energy sector now that oil prices have rebounded. Fourth, bank stocks have rallied strongly alongside the steepening yield curve. To the extent that higher bank stock prices reflect lower future commercial loan delinquencies, then this trend should be viewed positively from the perspective of credit investors. To test the idea that bank stock performance might help us trade the corporate bond market, we take a look at the past six credit cycles, going back to 1975 (Chart 9). The bottom panel of Chart 9 shows the percent drawdown in relative bank equity performance from its peak during the most recent credit cycle. We define credit cycles as the periods between when the CHM crosses into 'improving health' territory. For example, we define the most recent credit cycle as beginning when the CHM fell into 'improving health' territory in 2002 and ending when it fell into 'improving health' territory in 2009. Shaded regions in Chart 9 show periods when the CHM is in 'deteriorating health' territory. Chart 9Bank Equity Drawdown & Corporate Bond Performance If we construct a trading strategy using the CHM alone, we can get fairly good results. We find that investment grade corporate bonds underperform duration-equivalent Treasury securities in 3 out of 6 instances, over a 12-month investment horizon, following the time when the CHM first crosses into deteriorating health territory, for an average excess return of -1.2% (Table 1). Table 1Corporate Bond Trading Rules: 12-Month Investment Horizon However, we find that this result can be improved if we also incorporate bank stock price performance. If we were to only reduce corporate bond exposure when the CHM was in deteriorating health territory and after the drawdown in bank equities exceeded 20%, then the position is still profitable in 3 out of 6 instances, but for a more negative average return of -1.9%. Further, if we were to wait for the drawdown in bank equities to surpass 30%, then the hit rate on our position improves to 3 out of 5 and the average return falls to -4.6%. We find similar results if we use a 6-month investment horizon (Table 2). In the current cycle, the drawdown in bank stocks breached 25% in February but has since reversed course, and it has not yet reached the 30% threshold. Our analysis suggests that corporate bond underperformance tends to persist for some time even after the drawdown in bank stocks exceeds 30%. Table 2Corporate Bond Trading Rules: 6-Month Investment Horizon Chart 10Corporate Spreads Are Too Low Bottom Line: The macro back-drop is turning marginally more positive for corporate spreads. We remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now, due to poor starting valuation (Chart 10). But we are looking for an opportunity to upgrade from more attractive spread levels in the next couple of months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Too Far Too Fast, But The Bond Bear Is Still Intact", dated December 6, 2016, available at usbs.bcaresearch.com 2 For further details on the construction of this index please see www.policyuncertainty.com 3 Please see U.S. Bond Strategy Weekly Report, "Lighten Up On Duration", dated February 16, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1More Upside From Inflation We moved to below benchmark duration on July 19, when the 10-year Treasury yield was 1.56%. As of last Friday's close, the 10-year Treasury yield was 2.4% and above the fair value reading from our global PMI model. While our economic outlook still justifies higher Treasury yields on a 12-month horizon, the selloff in bonds has moved too far, too quickly. We recommend tactically shifting to a benchmark duration stance. Longer run, the upside in Treasury yields will be concentrated in the inflation component. The cost of 10-year inflation compensation can rise another 49 bps before it is consistent with the Fed's target. But that adjustment will proceed gradually next year, alongside a shallow uptrend in realized inflation (Chart 1). Higher inflation compensation can occasionally be offset by lower real yields, but this only occurs when the increase in inflation compensation results from an easing of Fed policy, as in 2011-2012. With the Fed in the midst of a hiking cycle, the downside in real yields is limited. We would not be surprised to see the 10-year Treasury yield re-visit the 2%-2.2% range during the next month or two. At that point we would re-initiate a below benchmark duration stance, on the view that the 10-year yield will reach 2.80%-3% by the end of 2017. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in November. The index option-adjusted spread tightened 3 bps on the month and, at 129 bps, it is now slightly below its historical average (134 bps). Spread per unit of gross leverage1 for the nonfinancial corporate sector is slightly above its historical average (Chart 2). But unusually, spreads have been tightening this year despite sharply rising gross leverage. Since 1973, there has only been one other period when spreads tightened despite rising gross leverage. That was in 1986-88 when, similar to today, spreads were tightening from extremely oversold levels. Much like today, elevated spreads in 1986 resulted from distress in the energy sector that dissipated as oil prices recovered. This caused corporate spreads to widen dramatically and then tighten, while in the background gross leverage persistently climbed higher. The current recovery in oil prices could lead to further corporate spread tightening early next year. Indeed, energy sector credits still appear cheap on our model and we continue to recommend overweighting those sectors. This month we also upgrade Paper from neutral to overweight (Table 3). Table 3Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* However, corporate credit fundamentals are deteriorating rapidly and spreads will be at risk when the Fed adopts a more hawkish policy stance, possibly as early as the second half of next year.2 High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 128 basis points in November. The index option-adjusted spread tightened 23 bps on the month and, at 450 bps, it is 71 bps below its historical average. A model based on lagged spreads and default losses explains more than 50% of the variation in 12-month excess junk returns. This model currently forecasts excess junk returns of close to zero during the next 12 months (Chart 3), a forecast that is based on our expectation of a modest improvement in default losses (bottom panel). In a recent report,3 we examined the relationship between default-adjusted spreads and excess junk returns in more detail. We showed that a model based purely on ex-ante estimates of default losses explains around 34% of the variation in excess junk returns. We also showed that, historically, negative excess returns to junk bonds are only likely if the ex-ante default-adjusted spread is below 100 bps. Our current ex-ante default-adjusted spread is 201 bps. Historically, when the ex-ante default-adjusted spread is between 200 bps and 250 bps, junk earns positive excess returns 81% of the time. However, junk earns positive excess returns only 65% of the time if the spread is between 150 bps and 200 bps. Although our economic outlook for next year is fairly optimistic, high-yield valuations are stretched and we expect to get a better entry point from which to upgrade the sector during the next couple of months. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in November. Other than municipal bonds, MBS has been the worst performing fixed income sector relative to Treasuries, earning year-to-date excess returns of -17 bps. The conventional 30-year MBS yield rose 53 bps in November, driven by a 59 bps increase in the rate component. The compensation for prepayment risk (option cost) declined 10 bps, while the option-adjusted spread widened by 4 bps. Prior to the election, we had been tactically overweight MBS on the view that higher Treasury yields would lead to a lower option cost, benefitting MBS in the near term. Now that Treasury yields have moved substantially higher, our focus returns to the extremely depressed levels of MBS option-adjusted spreads (Chart 4). Extremely low option-adjusted spreads coupled with a housing market that should continue to recover - leading to steadily increasing net supply (bottom panel) - make for a poor risk/reward trade-off in MBS relative to other fixed income sectors. Against this back-drop, MBS are only worth a tactical trade if you have high conviction that Treasury yields are about to rise and option costs about to tighten. We do not expect the Fed to cease the reinvestment of its MBS purchases in 2017. But, if Janet Yellen is replaced as Fed Chair in early 2018, then it is possible that the new Fed will seek to end its involvement in the MBS market. This is a tail risk for MBS in 2018. Government Related: Overweight Chart 5Government Related Market Overview The government-related index underperformed the duration-equivalent Treasury index by 19 basis points in November (Chart 5). Domestic Agency bonds and Local Authority bonds outperformed the Treasury index by 2 bps and 61 bps, respectively. Sovereign debt underperformed by 122 bps, Foreign Agency debt underperformed by 54 bps and Supranationals underperformed by 6 bps. More than half of the underperformance in the Foreign Agency sector came from Mexico's state oil company, Pemex, in the aftermath of Donald Trump's election win. Losses in the Sovereign debt sector were similarly concentrated in Mexican issues. Strength in oil prices should permit Foreign Agency debt to outperform going forward, while the strong U.S. dollar will remain a drag on Sovereign debt. Local Authority and Foreign Agency debt both continue to offer attractive spreads relative to U.S. investment grade corporate bonds, after adjusting for duration and credit rating. In contrast, Supranationals and Sovereigns both appear expensive. We continue to recommend an underweight allocation to Sovereign debt within an otherwise overweight allocation to the government related sector. Bullet Agency issues outperformed callable Agency bonds in November, despite the large increase in Treasury yields (bottom panel). We expect this trend will soon reverse, and remain overweight callable versus bullet Agencies. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration equivalent Treasury index by 83 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio rose from 99% to 107% in November, and is now above its post-crisis average (Chart 6). We downgraded municipal bonds to underweight on November 15,4 following Donald Trump's election victory. Lower tax rates under the new administration will undermine the tax advantage in municipal bonds, leading to outflows and higher M/T yield ratios. ICI data show that outflows have already begun. Net outflows from Muni funds have exceeded $7 billion in the four weeks since the end of October (panel 4). There are also longer-run concerns related to supply and state & local government credit quality. Depending on how it is structured, increased infrastructure spending next year could lead to a large increase in municipal bond supply. Also, state & local government downgrades are likely to increase later next year, following the lead of the corporate sector. Both of these issues are discussed in more detail in a recent Special Report.5 In October, the SEC finalized new liquidity management standards for open-ended investment funds. Funds must now determine a minimum percentage of net assets that must be invested in highly liquid securities, and no more than 15% of assets can be invested in securities deemed illiquid. At the margin, the new rule could limit funds' appetites for municipal bonds. Treasury Curve: Laddered Chart 7Treasury Yield Curve Overview November's bond rout was concentrated in the belly (5-10 years) of the Treasury curve. The 2/10 Treasury slope steepened 28 basis points on the month, while the 5/30 slope flattened by 8 bps. We believe that the yield curve has room to steepen further in 2017, based largely on the expectation that the Fed will maintain an accommodative stance of monetary policy at least until TIPS breakeven inflation rates are at levels more consistent with the Fed's 2% inflation target (Chart 7). In our view, this level is between 2.4% and 2.5% for long-dated TIPS breakevens. However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. Although we view a "dovish hike", i.e. an increase in the fed funds rate with no upward revision to the Fed's interest rate forecasts, as the most likely outcome. If we are wrong, an upward revision to the Fed's forecasts would cause the curve to bear-flatten on the day. At present, the market expects 55 bps of rate hikes during the next 12 months (panel 1). If expectations remain at these levels until after next week's FOMC meeting they will be consistent with the Fed's median forecast, assuming there are no upward revisions. Also, as we pointed out on the front page of this report, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 148 bps in November. The 10-year breakeven rate increased 21 bps on the month, and currently sits at 1.91%. The 5-year, 5-year forward TIPS breakeven inflation rate has risen to 2.06% from its early 2016 trough of 1.41%. However, it still has room to rise before it returns to levels that are consistent with the Fed's 2% target for PCE inflation (Chart 8). As economic growth improves next year the Fed will be keen to allow TIPS breakevens to rise toward its target, and will be slow to shift to a less accommodative policy stance. As such, we maintain our recommendation to overweight TIPS relative to nominal Treasuries, with a target of 2.4% to 2.5% for the 5-year, 5-year forward TIPS breakeven rate. While breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. With the Fed in the midst of a tightening cycle, it will be difficult for the Fed to lead inflation expectations sharply higher as in past cycles. Trends in realized inflation will be more important for long-dated breakevens this time around. Core and trimmed mean PCE inflation continue to grind slowly higher, a trend that is supported by the PCE diffusion index (panel 4). Assuming the current trend remains in place, core PCE inflation should finally reach the Fed's 2% target before the end of next year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in November, bringing year-to-date excess returns up to +111 bps. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps on the month, while non-Aaa issues outperformed by 5 bps. Credit card ABS outperformed by 14 bps, while auto ABS outperformed by 7 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps in November and, at 43 bps, it is well below its average pre-crisis level. Last month we observed that after adjusting for trailing 6-month spread volatility, Aaa-rated auto loan ABS no longer offer a compelling spread pick-up relative to Aaa-rated credit card ABS. We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 9 days of average spread widening for Aaa-rated credit card ABS to underperform (Chart 9). This spread cushion is not sufficient to compensate for the fact that credit card quality metrics are in much better shape than those for auto loans. The auto loan net loss rate has entered a clear uptrend, while credit card charge-offs are still near all-time lows (bottom panel). CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in November, bringing year-to-date excess returns up to +269 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 16 bps in November, and has now fallen below its average pre-crisis level (Chart 10). Rising delinquency rates and tightening lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Further adding to our caution is that more than 6000 commercial real estate loans backing public conduit CMBS deals are set to mature in 2017. This is almost 5x the number that matured last year, according to data from Trepp. Agency CMBS outperformed the duration-equivalent Treasury index by 52 basis points in November, bringing year-to-date excess returns up to +158 bps. Agency CMBS still offer 45 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (43 bps) and greater than what is offered by conventional 30-year MBS (22 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our 3-factor Global PMI model (which includes global PMI, dollar sentiment and global policy uncertainty) places fair value for the 10-year Treasury yield at 1.82%. However, the low reading mostly reflects a large spike in global policy uncertainty in November. Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor Global PMI model (which includes only global PMI and dollar bullish sentiment) as more representative of 10-year Treasury yield fair value at the moment. The fair value reading from our 2-factor model is currently 2.26% (Chart 11). At the time of publication the 10-year Treasury yield was 2.4%. For further details on our Global PMI model please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Secular Stagnation Vs. Trumponomics", dated November 15, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Duration: The odds of further bond bearish catalysts emerging during the next 6-12 months are still quite elevated. Maintain below benchmark duration. Global Bond Strategy: The most likely candidates for another bond bearish catalyst would be an announcement of substantial fiscal stimulus from Japan and/or a hawkish policy shift from the Fed. Investors should remain overweight core Europe, underweight U.S. Treasuries and neutral on JGBs. U.S. High-Yield: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal. Feature In a U.S. Bond Strategy Special Report1 published in August we observed that, since the financial crisis, material increases in global bond yields have all been associated with a policy catalyst (Chart 1). We identified three such catalysts: the Fed's 2010 announcement of QE2, the Fed signaling its willingness to slow the pace of asset purchases in 2013, and the European Central Bank's (ECB) announcement of its own QE program in 2015. Now we can add the election of Donald Trump as a fourth catalyst that has spurred a tantrum in global bond markets. Chart 1The Four Post-Crisis Bond Tantrums The common factor that links all of these catalysts is that each causes the market to quickly re-assess its expectations about the future pace of monetary tightening. Interestingly, this re-assessment can be caused by either the announcement of a program that is perceived to be extremely stimulative or the announcement that monetary stimulus will be scaled back. Examples of the former include both the Fed's and ECB's QE announcements as well as the recent U.S. election. An example of the latter would be the 2013 taper tantrum. As in August, the goal of this report is to perform a quick survey of the major global economies in order to assess the likelihood that another bond-bearish catalyst emerges during the next 6-12 months. While we find it difficult to see a catalyst of the same scale as those shown in Chart 1, we assign high odds to the possibility that the announcement of fiscal easing in Japan will add to the bearish pressure on global bonds. We also assign high odds to the possibility that upside inflation surprises in the U.S. cause the Fed to adopt a more hawkish forward guidance, further increasing the bearish pressure on global bonds. We assign low odds to the possibility that ECB policy will contribute to the global bond selloff. U.S. Chart 2Fed Wants Breakevens To Head Higher The recent "Trump Tantrum" has sent yields sharply higher, and expectations priced into the U.S. bond market are now not far from the Fed's median rate hike expectations, especially at the short-end of the curve (Chart 2). In the U.S., the next most likely catalyst for sharply higher global bond yields would be the Fed signaling that it will adopt a quicker pace of rate hikes. Specifically, the Fed would need to cease revising its funds rate forecasts lower - which has been the pattern for the last few years - and start revising them higher. While the market was quick to price-in the likelihood of greater fiscal stimulus and rising deficits under the incoming government, the Fed will take a more cautious approach. In fact, with inflation still below target (Chart 2, bottom panel) and market-based measures of inflation compensation still depressed, the Fed will be in no rush to signal a more hawkish policy stance. We expect the Fed will follow through with an expected rate increase in December, but that the median expectation will continue to call for only two more hikes in 2017. The Fed is only likely to shift toward a more hawkish policy stance once inflation expectations are more firmly anchored around levels consistent with the Fed's inflation target. This corresponds to a range of 2.4% to 2.5% on the 5-year, 5-year forward TIPS breakeven inflation rate (Chart 2, second panel). Assuming that U.S. economic growth continues to accelerate into next year, as we expect, then the 5y5y TIPS breakeven rate could reach this target sometime in the middle of 2017. At that point, a more hawkish Fed policy becomes more likely. In the meantime, while the "Trump Tantrum" is likely to take a pause in the near-term (next 1-2 months), it may not have run its course just yet. If U.S. growth is strong in 2017 and the Trump administration appears to be making progress implementing its more stimulative policies, then the Treasury curve will likely resume its bear-steepening trend in the first half of next year.2 Euro Area Chart 3Strong Growth, But Plenty Of Slack According to the OECD and others, including the European Commission and ECB, trend GDP growth in the Eurozone is below 1%. In fact, most estimates center around 0.7%. This means that as long as GDP growth is maintained above these levels we should expect the labor market to continue to tighten. At least for now, the data suggest that growth is likely to remain well above trend. Led by gains in both the services and manufacturing indexes, the euro area's composite PMI jumped from 53.3 to 54.1 in November. The composite PMI has a good track record of leading European GDP growth (Chart 3), and the current reading is consistent with GDP growth of 2%. Despite strong growth, the ECB's policy stance is likely to remain accommodative for quite some time and is unlikely to spur a global bond tantrum within our 6-12 month investment horizon. The fact that core inflation remains below 1% (Chart 3, panel 3) tells us that the output gap in the euro area is still very wide. It will take a prolonged period of strong growth for the output gap to close and for inflationary pressures to mount. In prior cycles inflation has not begun to accelerate until the unemployment rate was below 9% (shaded regions in Chart 3). An announcement from the ECB that it will cease its asset purchase program because the economy has made adequate progress toward its economic and inflation goals would likely spur a large rise in global bond yields. However, this is unlikely to occur until the unemployment rate is below 9% and inflation is in an uptrend. As we argued in a recent Global Fixed Income Strategy report,3 the ECB will be able to alter the rules regarding the quantity of bonds available for purchase as is necessary to keep the program in place. Japan The Bank of Japan (BoJ) recently switched to a policy framework that involves targeting a level of yields as opposed to a quantity of purchases. In our view, this sends a pretty strong signal that monetary policy is close to being exhausted and that fiscal policy must take up the baton of Abenomics. While the timing and amount of any additional fiscal spending is not clear, it is probably necessary if policymakers are serious about reaching their 2% inflation goal. Chart 4Policy Action Required In Japan At present, the Japanese Diet is currently deliberating the third revision to the second supplementary budget and government officials have signaled that there will be more coordination between monetary and fiscal policy in the future. The government is also debating ways to boost household income, including raising government wages, lifting the minimum wage and providing tax incentives for the private sector to be more generous on the wage front. While any fiscal measures would not spur an increase in nominal JGB yields (because the BoJ will retain the cap), they would spur an increase in inflation expectations and a decline in real yields (Chart 4). We also think that the reflationary impulse would be felt by bond markets in the rest of the world, and that large enough fiscal stimulus from Japan would pressure global bond yields higher even though JGBs remain capped. Admittedly, the cap on nominal JGB yields would limit the contagion from Japanese fiscal stimulus to the rest of the global bond market. As would the impact of a depreciating yen relative to the euro and U.S. dollar. However, we also suspect that the shift toward greater fiscal stimulus in both the U.S. and Japan would cause investors to revise their global growth expectations higher, and that this impact would dominate in terms of the impact on global bond yields. Investment Conclusions The odds of further bond bearish catalysts emerging during the next 6-12 months remain quite elevated. The most likely candidates would be an announcement of substantial fiscal stimulus in Japan and/or a hawkish policy shift from the Fed. The ECB is unlikely to contribute to the bearish pressure on global bonds during the next 6-12 months. As such, we continue to recommend a below benchmark duration stance on a 6-12 month horizon. In global bond portfolios, investors should remain overweight core Europe, underweight U.S. Treasuries and neutral JGBs. Valuation & Expected Returns In U.S. High-Yield A commonly used tool for assessing value in the high-yield bond market is a default-adjusted spread. That is, we formulate an expectation for default losses during our investment horizon and compare it to the spread that is currently on offer. If the current spread is elevated compared to our expectation for default losses then the default-adjusted spread is high and we would see good value in high-yield bonds relative to equivalent-duration Treasuries. This week we examine two different formulations of a default-adjusted spread for the U.S. high-yield market and test how well each corresponds to excess junk returns. The first measure we look at is a true ex-ante measure. It relies only on data that are available in real time, and can therefore be used as part of a trading strategy. Specifically, our ex-ante default-adjusted spread is calculated as the average option-adjusted spread from the Bloomberg Barclays U.S. High-Yield index less an expectation of default losses for the subsequent 12 month period. Expected default losses are calculated by taking the Moody's baseline forecast for the U.S. speculative grade default rate during the next 12 months and multiplying it by 1 minus our forecast of the recovery rate for this same period. We forecast the recovery rate based on its historical relationship with the default rate. The second measure we examine is an ex-post default-adjusted spread. In this case we look at the average spread of the index less actual default losses that are realized during the subsequent 12 months. As such, this measure can only be calculated after the fact. Comparing the ex-ante and ex-post measures, we see that both tend to reside within a range of 200 to 300 basis points. However, the ex-post measure periodically shows a negative value while the ex-ante measure is more often above 300 bps (Chart 5). This tells us that when forecasting default losses it is more common to underestimate default losses, rather than overestimate them. Chart 5Distribution of Default-Adjusted Spreads Over Time The next thing we look at is how closely each measure aligns with high-yield excess returns (Charts 6 & 7). Our ex-ante measure explains 34% of the variation in high-yield excess returns since 2002 (when our sample begins). Predictably, the ex-post measure, which removes the error surrounding the default loss forecast, explains a greater proportion of the variation in excess junk returns (53%). Our sample period is also longer for the ex-post measure, beginning in 1995. Chart 612-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Chart 712-Month Excess High-Yield Returns Vs. ##br##Ex-Post Default-Adjusted Spread (1995 - Present) The current average option-adjusted spread for the High-Yield index is 459 bps. If we incorporate the Moody's baseline forecast for the default rate during the next 12 months (4.1%) and our forecast for the recovery rate (39%), then we calculate an ex-ante default-adjusted spread of 210 bps. Using the relationship in Chart 6, this translates into an expected 12-month excess return of -26 bps. If we assume there is no error in our forecast then we can use the relationship in Chart 7. In that case, our expected 12-month excess return would be +55 bps. Of course, that exercise imposes a linear relationship between excess returns and the default-adjusted spread and doesn't consider that there is considerable variation in actual excess returns around this trendline. For that reason, in Charts 8 & 9 we split both our default-adjusted spread measures into intervals of 50 basis points. For each interval we display the average 12-month excess return along with a 90% confidence interval for where those returns are likely to fall. Chart 812-Month High-Yield Excess Returns & 90% Confidence Intervals: ##br##Ex-Ante Default-Adjusted Spread Chart 912-Month High-Yield Excess Returns & 90% Confidence Intervals:##br## Ex-Post Default-Adjusted Spread Specifically, the blue dots in Charts 8 & 9 show the 12-month excess return that is earned on average when the default-adjusted spread falls into a particular interval. The top and bottom edges of the vertical lines correspond to the upper and lower limits of the 90% confidence interval. More statistics related to the 12-month excess returns that have been observed when the default-adjusted spread falls into a specific interval can be found in the Appendix to this report. The main message from these charts is that a default-adjusted spread below 100 bps is a powerful sell signal, while a default-adjusted spread above 350 bps is a powerful buy signal. Between those two thresholds the signal is less clear. Bottom Line: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal, but is consistent with small positive excess returns. Our inclination is to remain cautious on U.S. high-yield for the time being, but to look for opportunities to upgrade from more attractive valuations. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com Appendix Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Treasury Yields: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017 that will cause the Treasury curve to bear-steepen. Spread Product: Poor valuations and a probable Fed rate hike next month keep us cautious on spread product in the near term. But the environment for credit markets will turn more positive in the first half of 2017. Leveraged Loans: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Feature Several Fed speakers last week, including Fed Chair Janet Yellen, affirmed the case for a December rate hike, and the market has taken full notice of that message. We calculate that the market-implied odds of a rate hike next month rose to 84% as of the close of business on Friday.1 But just as critical for the path of Treasury yields is that the Fed will be taking a "wait and see" approach when it comes to the prospect of increased fiscal stimulus under the Donald Trump administration. Right now there is so much uncertainty about what the Congress will pass or not pass, what the president will propose. As a baseline, assuming a continuation of current fiscal policy has probably as good a chance as any other forecast that we are going to make up. Minneapolis Fed President Neel Kashkari2 This leads us to believe that the Fed will lift rates next month, but will also not revise its fed funds rate forecasts (dots) higher. We also expect that the Fed will be slow to respond to any pick-up in growth expectations as we head into 2017. This sets up a two-phase outlook for Treasury yields. During the next month, the uptrend in yields will meet resistance as both the market and Fed turn a more skeptical eye toward Trump's fiscal promises. But if growth picks up in early 2017, as we expect, and the Fed maintains its dovish bias, then we could enter a sweet spot where the Treasury curve resumes its bear-steepening and risk assets rally. Near-Term Pull-Back Two factors make us think it is likely that Treasury yields will at least level-off, and perhaps decline a bit, during the next month. First, market pricing has already mostly converged with the Fed's rate expectations, especially at the short-end of the curve (Chart 1). Our sense is that the Fed's dots provide a reasonable valuation anchor for yields in the absence of more concrete evidence that growth is accelerating. Second, technical measures and positioning data suggest that the rapid rise in yields is due for a pause. The fractal dimension for long-maturity Treasuries, a measure of groupthink developed by our Chief European Strategist Dhaval Joshi rests at 1.25, a level at which a trend reversal - even if only a temporary one - tends to emerge (Chart 2).3 Additionally, our composite sentiment indicator, based on the 13-week rate of change in prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a near-term reversal (Chart 3). Chart 1The Market & Dots Converge Chart 2Treasuries Face Technical Resistance Chart 3Bond Sentiment At A Bearish Extreme Cyclical Sweet Spot Once the December FOMC meeting has passed, we expect investor attention will turn toward U.S. economic growth, which should accelerate as we head into 2017 (Chart 4). Chart 4U.S. Growth: Poised To Accelerate Consumer confidence has been resilient at high levels, which supports continued strong consumer spending (Chart 4, panel 1). According to trends in public sector employment, government spending is poised to increase, even in the absence of new fiscal stimulus (Chart 4, panel 2). Inventories were an unusually large drag on growth in 2016. This drag will continue to unwind (Chart 4, panel 3). Survey measures suggest that non-residential investment will reverse its downtrend (Chart 4, panel 4). The supply of new residential housing remains tight, which will support increased construction even in the face of higher rates (Chart 4, bottom panel). On top of this, we can potentially tack on any newly enacted fiscal stimulus once Trump takes office in January. Our political strategists expect that the Trump administration will not face meaningful opposition from the Republican-controlled Congress, and will be able to enact - in relatively short order - a more stimulative fiscal policy in the form of lower taxes and increased spending for infrastructure and defense.4 A quicker pace of Fed tightening would be a powerful offset to this rosy growth outlook. In fact, Chair Yellen alluded to the notion that a large fiscal impulse would probably be counteracted by tighter monetary policy in her Congressional testimony last week: "The economy is operating relatively close to full employment at this point, so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state."5 In essence, with the economy close to full employment it is more likely that a sufficiently large growth impulse will result in rising inflation, which the Fed will lean against. However, we believe this is a story for the second half of 2017. At least initially, the Fed will be in no rush to deviate from the dovish bias embedded in its current forecasts. Market-based measures of inflation compensation have increased strongly in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart 5). The 5-year, 5-year forward TIPS breakeven inflation rate is currently 2.06%, and needs to rise another 34bps before it is consistent with its average pre-crisis level. The Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. This opens a window in the first half of 2017 when improving economic growth will be met with still-accommodative monetary policy. In this environment we would expect the Treasury curve to bear-steepen and spread product to outperform. All else equal, we are likely to shift our recommended portfolio allocation in that direction (initiate curve steepeners, increase allocation to spread product) once the near-term risk of a Fed rate hike is behind us. The major risk to the view that a cyclical sweet spot opens up in the first half of 2017 is that any improvement in growth might be quickly cut-off by overly restrictive financial conditions, specifically in the form of a much stronger dollar (Chart 6). The pace of dollar appreciation has increased since the election and overall indexes of financial conditions have tightened, but so far the tightening has not been as sharp as that which occurred around the time of last year's Fed rate hike. We anticipate that this time around, due to the improved trajectory of growth outside of the U.S., tightening of overall financial conditions will not be as severe. A second related risk is that the recent surge in bond yields will harm cyclical sectors of the economy such as housing and consumer spending on durable goods (Chart 7). This is undoubtedly true, but it is important to recall that this process is self-limiting. If yields rise too far, then growth will decelerate and yields will reverse course. Then lower yields will cause growth to re-accelerate, leading to higher yields. As long as the Fed is perceived to be "behind the curve" on inflation then the underlying trend will be one of improving growth and a bear-steepening of the Treasury curve. Chart 5Breakevens Still Too Low Chart 6A Strong Dollar Is The #1 Risk Chart 7Higher Yields Also A Drag On Growth Bottom Line: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017. This will cause the Treasury curve to bear-steepen and will be positive for spread product. Leveraged Loans: Still A Buy We recommended that investors favor leveraged loans over fixed-rate junk bonds on July 19.6 In large part, this recommendation was predicated on a high conviction view that Treasury yields were poised to increase, thus benefitting floating rate loans over fixed rate bonds. Since July 19, the S&P/LSTA Leveraged Loan 100 index has returned +196bps, compared to +176bps of total return from the Bloomberg Barclays High-Yield bond index, and flows into the largest leveraged loan ETF (BKLN) have outpaced flows into the largest junk bond ETF (HYG) since August (Chart 8). Historically, there are two reasons that leveraged loans might be expected to outperform fixed rate junk bonds (Chart 9). The first is that 3-month LIBOR is rising, causing loan coupons to reset higher. The second is that the default rate is elevated. Loans tend to benefit relative to bonds when the default rate is elevated because their senior position in the capital structure means they earn a higher recovery rate (Chart 10). Chart 8Loan Performance Is Lagging Fund Flows Chart 9Leveraged Loans Will Outperform Chart 10Loans Benefit From Higher Recoveries Taking a closer look at Chart 9 we can see that the above two factors have only led to two periods of sustained leveraged loan outperformance since 1991 (denoted by shaded regions). In 1994, loans outperformed bonds because the pace of Fed tightening surprised markets to the upside and 3-month LIBOR moved sharply higher. In this instance higher coupons were sufficient for loans to outperform even though corporate defaults were low. Loans also outperformed bonds between 1997 and 2002. In this case it was a prolonged uptrend in corporate defaults that drove the outperformance. Loans benefitted from higher LIBOR in the early stages of this period, but then the Fed began cutting rates in 2001. Loans did not outperform bonds during the 2004-2006 rate hike cycle, as defaults were very low and the rate hikes were well telegraphed - meaning that asset prices already reflected the up-move in 3-month LIBOR before it occurred. Likewise, loans did not outperform bonds during the 2008 default episode because the Fed was cutting rates sharply and, unlike in the 1990s, the spike and reversal in the default rate occurred over a relatively short period of time. The good news for loans is that the current environment very much resembles the early part of the 1997-2002 period insofar as the Fed is in the early stages of a rate hike cycle - so 3-month LIBOR can be expected to move higher - and corporate defaults have already started to increase. So far loans have only benefitted marginally from the rise in 3-month LIBOR because most have LIBOR floors. This means that the loan's coupon is only reset higher once 3-month LIBOR is increased above the stated floor. Bloomberg calculates that $221 billion of outstanding leveraged loans have LIBOR floors of 75bps and $690 billion of outstanding loans have LIBOR floors of 100bps. With 3-month LIBOR at 91bps currently, it will only take one more Fed rate hike before the floors on most loans are breached. Bottom Line: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: Stay Away We detailed our longer-term outlook for municipal bonds in a recent Special Report,7 and then downgraded our muni allocation to underweight (2 out of 5) following Trump's surprise election win. Our expectation is that the combination of lower tax rates and increased infrastructure spending will be toxic for municipal debt. That analysis, however, focused on investment grade municipal debt. This week we investigate the relative value in high-yield municipal bonds relative to high-yield corporates. The starting point of our analysis is an examination of the spread differential between high-yield munis and high-yield corporates (Chart 11). The second panel of Chart 11 shows that, compared to history, munis offer a sizeable spread advantage over similarly-rated corporate debt. However, this comparison does not adjust for differences in duration and convexity between the two indexes. In the bottom panel of Chart 11 we show the residual from a model where the spread differential between high-yield munis and high-yield corporates has been regressed against differences in duration and convexity. We see that high-yield munis look even more attractive after making these adjustments. These simple adjustments reveal that high-yield munis are attractive relative to high-yield corporates, but they do not consider the impact of a macro environment that is about to turn extremely negative for municipal debt. To control for this we created an augmented model of the spread differential between high-yield munis and corporates, adjusting for duration, convexity, the effective personal tax rate, relative ratings migration and several other factors (Chart 12). Chart 11High-Yield Muni Valuation I Chart 12High-Yield Muni Valuation II High-yield munis still appear quite attractive based on this model, but if we assume that the effective personal income tax rate reverts even to 2011 levels, then the a good chunk of the spread advantage vanishes (Chart 12, panel 2). This is an extremely conservative assumption. In reality, we expect the effective personal tax rate will fall much below 2011 levels under the new administration. Bottom Line: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculation differs somewhat from the widely reported probability that is available on Bloomberg terminals. The reason is that the Bloomberg calculation assumes a baseline fed funds rate of 37.5 bps (the midpoint of the Fed's current target range), while we use the current effective fed funds rate which has recently been stable at 41 bps. 2 http://www.bloomberg.com/news/articles/2016-11-16/fed-s-kashkari-says-election-hasn-t-changed-economic-outlook-yet 3 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 4 Please see BCA Special Report, "U.S. Elections: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 5 https://www.c-span.org/organization/?63944 6 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Chart 9Americans Like Voting, Just Not These Candidates 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.