Europe

Recommended Allocation Highlights We are late cycle. Strong growth could turn in 2018 from a positive for risk assets into a negative. More risk-averse investors may thus want to turn cautious. But the last year of a bull run can be profitable, and we don't expect a recession until late 2019. For now, therefore, our recommendations remain pro-risk and pro-cyclical. We may turn more defensive in 2H 2018 if the Fed tightens above equilibrium. We expect inflation to pick up in 2018, which will lead the Fed to hike maybe four times. This will push long rates to 3%, and strengthen the U.S. dollar. Equities should outperform bonds in this environment. We prefer euro zone and Japanese equities over U.S., and remain underweight EM. Late-cycle sectors such as Financials and Industrials, should do well. We also favor corporate bonds and private equity. Feature Overview Fin de cycle Global economic growth in 2017 was robust for the first time since the Global Financial Crisis (Chart 1). Forecasts for 2018 put growth slightly lower, but are likely to be revised up. However, as the year rolls on, the strong economic momentum may turn from being a positive for risk assets into a negative. U.S. output is now above potential, according to IMF estimates. As Chart 2 shows, historically recessions - and consequently equity bear markets - have usually come within a year or two of the output gap turning positive. With the economy operating above capacity, inflation pressures force the Fed to tighten monetary policy, which eventually causes a slowdown. Chart 1Growth Finally On A Firm Footing Global Growth Has Accelerated Chart 2Recessions Follow Output Gap Closing That is exactly how BCA sees the next couple of years panning out, leading to a recession perhaps in the second half of 2019. U.S. inflation was soft in 2017, but underlying inflation pressures are picking up, with core CPI inflation having bottomed, and small companies saying they are raising prices (Chart 3). Add to that wage pressures (with unemployment heading below 4% in 2018), tax cuts (which might boost growth by 0.2-0.3% points in their first year) and a higher oil price (we expect Brent to average $67 a barrel during the year), and core PCE inflation is likely to rise to 2%, in line with the Fed's expectations. This means the market is too sanguine about the risk of monetary tightening in the U.S. It has priced in less than two rates hikes in 2018, compared to the Fed's three dots, and almost nothing after that (Chart 4). If inflation picks up as we expect, four rate hikes in 2018 could be on the cards. Chart 3Inflation Pressures Picking Up Chart 4Market Still Underpricing Fed Hikes The consequences of this are that bond yields are likely to rise. Despite a significant market repricing since September of Fed behavior, long-term rates have not risen much, leading to a flattening yield curve (Chart 5). The market has essentially priced in that inflation will not rebound and that, consequently, the Fed will be making a policy mistake by hiking further. If, therefore, we are correct that inflation does reach 2%, the yield curve would be likely to steepen over the next six months, with the 10-year U.S. Treasury yield reaching 3% by mid-year. Other developed economies, however, have less urgency to tighten monetary policy and we, therefore, see the U.S. dollar appreciating. The only other major economy with a positive output gap currently is Germany (Chart 6). However, the ECB will continue to set policy for the weaker members of the euro area, and output gaps in France (-1.8% of GDP), Italy (-1.6%) and Spain (-0.7%) remain significantly negative. In the absence of inflation pressures, the ECB won't raise rates until late 2019. Japan, too, continues to struggle to bring inflation up the BOJ's 2% target and the Yield Curve Control policy will therefore stay in place, meaning that a rise in global rates will weaken the yen. Chart 5Is Fed Making A Policy Mistake? Chart 6Still A Lot Of Negative Output Gaps This sort of late-cycle environment is a tricky one for investors. The catalysts for strong performance in equities that we foresaw a few months ago - U.S. tax cuts and upside surprises in earnings - have now largely played out. Global earnings will probably rise next year by around 10-12%, in line with analysts' forecasts. With multiples likely to slip a little as the Fed tightens, high single-digit performance is the best that investors should expect from equities. The macro environment which we expect, would be more negative for bonds than positive for equities. That argues for the stock-to-bond ratio to continue to rise until closer to the next recession (Chart 7). And, for now, none of the recession indicators we have been consistently monitoring over the past months is flashing a warning signal (Chart 8). Chart 7Stock-To-Bond Ratio Likely To Rise Further Chart 8Recession Warning Signals Still Not Flashing More risk-averse investors might chose to reduce their exposure to risk assets now, given how close we are to the end of the cycle. But this would be at the risk of leaving some money on the table, since the last year of a bull run can often be the most profitable (remember 1999?). We, therefore, maintain our recommendation for pro-cyclical and pro-risk tilts: overweight equities versus bonds, overweight credit, overweight higher-beta equity markets and sectors, and a preference towards riskier alternative assets. We may move towards a more defensive stance in mid to late 2018, when we see clearer signs that the Fed has tightened above equilibrium or that the risk of recession is rising. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Be The Impact Of The U.S. Tax Cuts? It is not a done deal, but it still seems likely (notwithstanding the Democratic victory in Alabama) that the U.S. House and Senate will agree a joint tax bill to pass before the end of the year. Since the two current bills have only minor differences, it is possible to make some estimates of the macro and sector impacts of the tax reform. The Joint Committee on Taxation estimates that the cuts will reduce government revenue by $1.4 trillion over 10 years - or $1 trillion (5% of GDP) once positive effects on growth are accounted for. The Treasury argues that tax reform (plus deregulation and infrastructure development) will push GDP growth to 2.9% and therefore government revenues will increase by $300 billion. BCA's estimate is that GDP growth will be boosted by 0.2-0.3% in 2018 and 2019.1 For businesses, the key tax changes are: 1) a reduction in the headline corporate rate from 35% to 21%; 2) immediate expensing of capital investment; 3) a limit to deduction of interest expenses to 30% of taxable income; 4) a move to a territorial tax system from a worldwide one, with a 10% tax on repatriation of past profits held overseas; 5) curbs for some deductions, such as R&D, domestic production and tax-loss carry-forwards. Corporate tax cuts will give a one-off boost to earnings, since the effective tax rate is currently over 25% (Chart 9, panel 1), with telecoms, utilities and industrials likely to be the biggest beneficiaries. This is not fully priced into stocks, since companies with high tax rates have seen their stock prices rise only moderately (Chart 9, panel 2). BCA's sector strategists expect that capex will especially be boosted: they estimate that the one-year depreciation increases net present value by 14% (Table 1).2 This should be positive for the Industrials sector (supplying the capital goods) and for Financials (which will see increased demand for loans). We are overweight both. Chart 9Tax Cuts Should Boost Earnings Table 1 Is Bitcoin A Bubble, And What Happens When It Bursts? The recent surge in prices (Chart 10) of virtual currencies has pushed Bitcoin and aggregate cryptocurrency market cap to $275 billion and $500 billion respectively. The recent violent run-up certainly bears a close resemblance to classic bubbles, but the impact of a sharp correction should be minimal on the real economy and traditional capital markets. As mentioned above, the market cap of cryptocurrencies has reached $500 billion. Globally, there is about $6 trillion in currency3 outstanding, so the value of virtual currencies is now 8% that of traditional fiat currency. Additionally, an estimated 1000 people own about 40% of the world's total bitcoin, for an average of about $105 million per person. At the moment, the macro impact has been constrained by the fact that most people are buying bitcoins as a store of value (Chart 11) or vehicle for speculation, rather than as a medium of exchange. However, when the public begins to regard them as legitimate substitutes for traditional fiat currencies, their impact will be felt on the real economy. Chart 10A Classic Bubble Chart 11Bitcoin Trading Volume By Top Three Currencies That would raise the issue of regulation. The U.S. government generates close to $70 billion per year as "seigniorage revenue." Governments across the world have no intention of losing this revenue, and would most likely introduce their own competitors to bitcoin. Until then, the biggest potential impact of these private currencies might be to spur inflation in the fiat currencies in which their prices are measured. That would be bad for government bonds, but potentially good for stocks. A further risk - and a similarity with the real estate bubble of 2007 - is the use of leverage. The news of a Tokyo-based exchange (BitFyler) offering up to 15x leverage for the purchase of bitcoins has spooked investors. However, the U.S. housing market is valued at $29.6 trillion, almost 60 times that of cryptocurrencies. Finally, the 19th century free banking era in the U.S., which at one point saw 8000 different currencies in circulation, experienced multiple banking crises. A world with myriad private currencies all competing with one another would be similarly unstable. Why Did The U.S. Dollar Weaken In 2017, And Where Will It Go In 2018? Chart 12Positioning And Relative Rates Supportive For USD We were wrong to be bullish on U.S. dollar at the start of 2017. We think the dollar weakness during most of the year can be attributed to the fact that investors were massively long the dollar at the end of 2016 (Chart 12, panel 2), which made the market particularly vulnerable to surprises. Several surprises did come: inflation softened in the U.S. but strengthened in the euro area. There were also positive geopolitical surprises in Europe - for example the victory of Emmanuel Macron in the French presidential election - while the failure to repeal Obamacare in the U.S. raised investors' concerns on the administration's ability to undertake fiscal stimulus. As a result, the U.S. dollar depreciated against euro despite widening interest rate differentials (Chart 12 panel 4) in 2017. Chart 13late Cycle Outperformance Since investors are now aggressively short the dollar, the hurdle for the greenback to deliver positive surprises is much lower than a year ago. Since the Senate passed the Republican tax bill in early December, we have already seen some recovery in the dollar (Chart 12, panel 1). As the labor market continues to firm, with GDP running above potential, U.S. inflation should finally start to pick up in 2018, which will allow the Fed to hike rates, possibly as many as four times during the year. This will contrast with the macro situation overseas: Japan and Europe are likely to continue loose monetary policy to maintain the momentum in their economies. All this should be supportive of the dollar. Are Convertible Bonds Attractive Over The Next 12 Months? With valuations for traditional assets expensive and investors' thirst for yield continuing, the market is in need of alternative sources of return. Convertible bonds offer a hybrid credit/equity exposure, giving investors the option to participate in rising equity markets but with less risk. An allocation to convertibles could prove attractive for the following reasons: Convertible bonds typically outperform high-yield debt in the late stages of bull markets, because of their relatively lower exposure to credit spreads. Junk spreads have a history of starting to widen before equity bear markets begin. Fifty percent of the convertibles index comprises issuance from small-cap and mid-cap firms. Although equity valuations are expensive, prices should continue to rise as long as inflation stays low. Additionally, our U.S. Investment Strategy service thinks that small-cap equities will outperform large caps in the coming months, partly because the likely cuts in U.S. corporate taxes will disproportionately benefit smaller companies. Convertible bonds do appear somewhat cheap relative to equities (Chart 13, panel 3) but, on balance, there is not a strong valuation case for the asset class. Equities appear fairly valued relative to junk bonds, and convertibles are trading at an elevated investment premium. However, valuation is not likely to be a significant headwind to the typical late-cycle outperformance of convertibles versus high yield. biggest near-term risk for convertibles relative to high yield stems from the technology sector, which makes up 35% of the convertibles index. Technology convertible bonds have strongly outperformed their high-yield counterparts in recent months (Chart 13, panel 4), and are possibly due for a period of underperformance. We recommend investors stay cautious on technology convertibles. Other Than U.S. Tips, What Other Inflation-Linked Bonds Do You Like? Our research shows that inflation-linked bonds (ILBs) are a good inflation hedge in a rising inflationary environment.4 With our house view of rising inflation in 2018, we have been overweight U.S. Tips over nominal Treasury bonds as the U.S. is the most liquid market for inflation-linked bonds, with a market cap of over US$ 1.2 trillion. Outside the U.S., we favor ILBs in Japan and Australia, while we suggest investors to avoid ILBs in the U.K. and Germany (even though the U.K. linkers' market is the second largest after the U.S.), for the following two key reasons: First, even though inflation is below target in Japan, Australia and the euro area, while above target in the U.K., in all of these markets, inflation has bottomed, as shown in Chart 14. Second, our breakeven fair-value models, which are based on trade-weighted currencies, the Brent oil price in local currencies, and stock-to-bond total-return ratios, indicate that ILBs are undervalued in Japan and Australia, while overvalued in the U.K. and Germany, as shown in Chart 15. Chart 14Inflation Dynamics Chart 15Where to Buy Inflation? The shorter duration (in real terms) of ILBs are an added bonus which fits well with our overall underweight duration positioning in the government bond universe. Global Economy Overview: Growth in developed economies remains strong and there is little in the data to suggest it will slow. This is likely to push up inflation and interest rates, especially in the U.S., over the next six to 12 months. Prospects for emerging markets, however, are less encouraging given that China is likely to slow moderately as it pushes ahead with reforms. U.S.: U.S. growth momentum remains very strong. GDP growth in the past two quarters has come in over 3%, and NowCasts for Q4 point to 2.9-3.9%. The Citigroup Economic Surprise Index (Chart 16, panel 1) has surged since June, and the Manufacturing ISM is at 53.9 and the Non-Manufacturing at 57.4 (panel 2). The worst that can be said is that momentum will be unable to continue at this rate but, with business confidence high, wage growth likely to pick up in 2018, and some positive impacts from tax cuts, no significant slowdown is in sight. Euro Area: Given its stronger cyclicality and ties to the global trade cycle, euro zone growth has surprised on the upside even more strongly than in the U.S. The Manufacturing PMI reached 60.6 in December (its highest level since 2000), and GDP growth in Q3 accelerated to 2.6% QoQ annualized. The euro's strength in 2017 seems to have done little to dent growth, and even weaker members of the euro zone such as Italy have seen improving GDP growth (1.7% in Q3). With the ECB reining back monetary easing only slightly, and banking problems shelved for now, growth should remain resilient in early 2018. Japan: Retail sales saw some weakness in October (-0.2% YoY), probably because of bad weather, but elsewhere data looks robust. Q3 GDP came in at 1.3% QoQ annualized and export growth remains strong at 14% YoY. There are even some signs of life in the domestic economy, with wages finally picking up a little (+0.9% YoY), driven by labor shortages among part-time workers, and consumer confidence at a four-year high. Inflation has been slow to rise, but at least core core inflation (the Bank of Japan's favorite measure) is now in positive territory at +0.2%. Emerging Markets: Chinese credit and monetary series, historically good lead indicators for the real economy, continue to decline (M2 growth in October of 8.8% was the lowest since data started in 1996). But, for now, economic growth has held up, with the Manufacturing and Non-Manufacturing PMIs both stably above 50 (Chart 17, panel 3). Key will be how much the government's moves to deleverage the financial system and implement structural reform in 2018 will slow growth. Elsewhere in emerging markets, economic growth remains sluggish, with GDP growth in Brazil barely rebounding to 1.4% YoY, Russia to 1.8%, and India slowing to 6.3% (down from over 9% in early 2016). Chart 16Growth Momentum Very Strong Chart 17Will China And EM Slow in 2018? Interest rates: We expect U.S. inflation to pick up in 2018, as the lagged effects of 2017's stronger growth and the weak dollar start to come through, amid higher oil prices and rising wages. We, along with the Fed, expect core PCE inflation to rise to 2% during the year. This means the Fed is likely to raise rates four times, compared to market expectations of twice. Consequently, we see the 10-year Treasury yield over 3% by mid-year. In the euro zone, the still-large output gap means inflation is less likely to surprise on the upside, allowing the ECB to keep negative rates until well into 2019. The Bank of Japan is unlikely to alter its Yield Curve Control, given the signal this would send to the market when inflation expectations are still well below its 2% target (Chart 17, panel 4). Chart 18Equities: Priced for Perfection Global Equities Still Cautiously Optimistic: Our pro-cyclical equity positioning in 2017 worked very well in terms of country allocation (overweight euro zone and Japan in the DM universe) and global sector allocation (favoring cyclicals vs defensives). The two calls that did not pan out were underweight EM equities vs. DM equities, which was partially offset by our positive stance on China within the EM universe, and the overweight of Energy, which was the worst performing sector of the year. The stellar equity performance in 2017 was largely driven by strong earnings growth. Margins improved in both DM and EM; earnings grew in all sectors, and analysts remained upbeat (Chart 18). Another important contributor to 2017 performance was the extraordinary performance of the Tech sector, especially in China: globally, tech returned 41.9%, outperforming the MSCI all country index by 18.9%. GAA's philosophy is to take risk where it is mostly likely be rewarded. In July, we took profits in our Tech overweight and used the funds to upgrade Financials to overweight from neutral. Then in October we started to reduce tracking risk by scaling down our active country bets, closing our overweight in the U.S. to reduce the underweight in EM. BCA's house view is for synchronized global growth to continue in 2018, but a possible recession in late 2019. We are a little concerned that equity markets are priced for perfection, given that our earnings model indicates a deceleration in the coming months mostly due to a base effect. As such, our combination of "close to shore" country allocation and "pro-cyclical" sector allocation is appropriate for the next 9-12 months. Country Allocation: Still Favor DM Over EM Chart 19China: From Tailwind to Headwind for EM ? Our longstanding call of underweight EM vs. DM since December 2013 was gradually reduced in scale, first in March 2016 (to -5 percentage points from -9) and then in October 2017 (further to -2 points). Going forward, investors should continue to maintain this slight underweight position in EM vs. DM. First, our positive stance on China proved to be timely as shown in Chart 19, panel 4, with China outperforming EM by 54.1% since March 2016, and by 18.8% in 2017. Back then our positive stance on China was supported by attractive valuations (bottom panel) and our view that Chinese politics would be supportive for global growth in the run up to the 19th Party Congress. Now BCA's Geopolitical Strategists think that "China politics are shifting from a tailwind to a headwind for global growth and EM assets".5 In addition, Chinese equities are no longer valued at a discount to the EM average (bottom panel). Second, BCA's currency view is for continued strength in the USD, especially against emerging market currencies. This does not bode well for EM/DM performance in US dollar terms (Chart 19, panel 1). Third, EM money growth leads profit growth by about three months (Chart 19, panel 2). The rolling over in money growth indicates that the currently strong earnings growth may lose steam going forward, while relative valuation is in the fair-value zone (Chart 19, panel 3). Sector Allocation: Stay Overweight Energy Our pro-cyclical sector positioning has worked well in aggregate as the market-cap-weighted cyclical index significantly outperformed the defensive index in 2017. This positioning is also in line with BCA's house view of synchronized global growth and higher inflation expectations, which translates into two major sector themes: capex recovery and rising interest rates. (Please see detailed sector positioning on page 24.) Within the cyclical space, however, the Energy sector did not perform as expected in 2017 (Chart 20). It returned only 3.4%, underperforming the global aggregate by 19.6%. For the next 9-12 months, we recommend investors to stay overweight this underdog of 2017. Chart 20Energy Stocks Lagging Oil Price First, the energy sector is a major beneficiary from a capex recovery. There are already signs of a recovery in basic resources investment in the U.S.6 Second, the energy sector's relative return lagged oil price performance in 2017. Given the generally close correlation between earnings and the oil price, and between analyst earnings revisions and OECD oil inventory growth, earnings in the sector should outpace the broad market. Third, based on price-to-cash earnings, the energy sector is still trading at about a 30% discount to the broad market, and offers a much higher dividend yield (about 1.2 points higher) than the broad market. Even though these discounts are in line with historical averages, they are still supportive of an overweight. Government Bonds Maintain Slight Underweight Duration. One important theme for 2018 will be a resumption of the cyclical uptrend in inflation.7 The implications are that both nominal bond yields and break-even inflation rates will be higher in 2018. We have been underweight duration in government bonds since July 2016. Now with the U.S. 10-year Treasury yield at 2.35%, much lower than its fair value of 2.81%, there is considerable upside risk for global bond yields from current low levels. Investors should continue to underweight duration in global government bonds Maintain Overweight Tips Vs. Treasuries. The base-case forecast from our U.S. bond strategists is that the Tips breakeven rate will rise to 2.4-2.5% as U.S. core PCE reaches the Fed's 2% target, probably sometime in the middle of 2018. Compared to the current level of 1.87%, 10-yr Tips would have upside of 33-38 bps, an important source of return in the low-return fixed-income space (Chart 21, bottom panel). In terms of relative value, Tips are now slightly cheaper than nominal bonds, also supportive of the overweight stance. Underweight Canadian Government Bonds. BCA's Global Fixed Income Strategy has taken profits in their short Canada vs. U.S. and U.K. tactical position, as the market has become too aggressive in pricing in more rate hikes in Canada. Strategically, however, the underweight of Canada (Chart 22) in a hedged global portfolio is still appropriate because: 1) the output gap has closed in Canada, according to Bank of Canada estimates, and so any additional growth will translate into higher inflation; and 2) the rising CAD will not deter the BoC from more rate hikes if the oil prices remain strong. Chart 21U.S. Bond Yields Have Further To Rise Chart 22Strategic Underweight Canadian Bonds Corporate Bonds Our overweights through most of 2017 on spread product worked well: U.S. investment grade (IG) bonds returned around 290 bps over Treasuries in the year to end-November, and high-yield bonds almost 600 bps. Returns over the next 12 months are unlikely to be as attractive. Spreads (Chart 24) are now close to historic lows: the U.S. IG bond spread, at 90 bps, is only about 30 bps above its all-time record. High-yield valuations look a little more attractive: based on our model of probable defaults over the next 12 months, the default-adjusted spread over U.S. Treasuries is likely to be around 240 bps (Chart 25). In both cases, however, investors should expect little further spread contraction, meaning that credit is now no more than a carry trade. However, in an environment where rates remain fairly low and investors continue to stretch for yield, that pick-up will remain attractive in the absence of a significant turn-down in the economic cycle. The key to watch is the shape of the yield curve. An inverted yield curve in history has been an excellent indictor of the end of the credit cycle. We expect the yield curve to steepen somewhat in H1 2018, before flattening again and then inverting late in the year. Spread product is likely, therefore, to produce decent returns until that point. Thereafter, however, the deterioration of U.S. corporate health over the past three years (Chart 23) could mean a sharp sell-off in corporate bonds. This might be exacerbated by the recent popularity of open-ended mutual funds and ETFs: a small widening of spreads could be magnified by a panicked sell-off in such funds. Chart 23Rising Leverage May Worsen Sell-Off Chart 24Credit Spreads Close To Record Lows Chart 25But Default - Adjusted, Junk Still Looks Attractive Commodities Energy: Bullish Energy prices performed strongly in H2 2017, and we expect bullish sentiment to continue. OPEC 2.0 is likely to maintain production discipline, and will maintain its promised 1.8mm b/d production cuts through the end of 2018. Our estimates for global demand growth are higher than those of other forecasters. This, along with potential unplanned production outages in Iraq, Libya and Venezuela (together accounting for 7.4mm b/d of production at present), drives our above-consensus price forecast of $67 a barrel for Brent crude during 2018. Industrial Metals: Neutral Since China accounts for more than 50% of world base-metal consumption, prices will continue to be highly dependent on developments there. (Chart 26, panel 4). Since the government is trying to accelerate environmental and supply-side reforms, domestic production capacity for base metals will shrink, which will be a positive for global metals prices. However, a focus on deleveraging in the financial sector and restructuring certain industries could slow Chinese GDP growth, reducing base-metal demand. Precious Metals: Neutral Gold has risen by 12% in 2017, supported by an uncertain geopolitical environment coupled with low interest rates. We believe that geopolitical uncertainties will persist and may even intensify, and that inflation may rise in the U.S., which would be positives for gold (Chart 26, panel 3). Based on BCA's view that stock market could be at risk from the middle of 2018,8 a moderate gold holding is warranted as a safe-haven asset. However, rising interest rate and a potentially stronger U.S. dollar are likely to limit the upside for gold. Currencies USD: The currency is down over 6% on a trade-weighted basis over the past 12 months (Chart 27). Looking into 2018, the USD is likely to perform well in the first half. U.S. inflation should gather steam in the first two to three quarters, and the Fed will be able at least to follow its dot plot - something interest rate markets are not ready for. As investors remain short the USD, upside risk to U.S. interest rates should result in a higher dollar. Chart 26Bullish Oil, Neutral Metals Chart 27Dollar Likely To Appreciate EM/JPY: Carry trades are a key mechanism for redistributing global liquidity, and they have recently begun to lose steam. A crucial reason for this has been the policy tightening in China which has been the key driver of growth in EM economies. Additionally, Japanese flows have been chasing momentum into EM assets. Further tightening in EM could reverse the flows and initiate a flight to safety, favoring the yen relative to EM currencies. CHF: The currency continues to trade at a 5% premium to its PPP fair value against the euro. However, after considering Switzerland's net international investment position at 130% of GDP, the trade-weighted CHF trades in line with fair value. The CHF will continue to behave as a risk-off currency, and so long as global volatility remains well contained, EUR/CHF will experience appreciating pressure. GBP: Sterling continues to look cheap, trading at an 18% discount to PPP against the USD. However, Brexit remains a key problem. If future immigration is limited, the U.K. will see lower trend growth relative to its neighbors, forcing its equilibrium real neutral rate downward. Consequently, it will be more difficult to finance the current account deficit of 5% of GDP. Until negotiations with the EU come closer to completion, the pound will continue to offer limited reward and plenty of volatility. Alternatives Chart 28Favor Private Equity and Farmland Alternative assets under management (AUM) have reached a record $7.7 trillion in 2017. Lower fees and a broader range of investment types have helped attract more capital. Private equity remains the most popular choice,9 driven by its strong performance and transparency. Many investors have also shifted part of their allocations toward potentially higher-return private debt programs. Return Enhancers: Favor Private Equity Vs. Hedge Funds In 2017 so far, private equity has returned 12.1%, whereas hedge funds have managed only a 5.9% return (Chart 28). We expect private-equity fund-raising to continue into 2018, but with a larger focus on niche strategies with more favorable valuations. Additionally, deploying capital gradually not only provides for vintage-year diversification, but also creates opportunities for investors to benefit from potential market corrections. We continue to favor private equity over hedge funds outside of recessions. During a recession, we recommend investors take shelter in hedge funds with a macro mandate. Inflation Hedges: Favor Direct Real Estate Vs. Commodity Futures In 2017 to date, direct real estate has returned 5.1%, whereas commodity futures are down over 3.7%. Direct real estate as an asset class continues to provide valuable diversification, lower volatility, steady yields and an illiquidity premium. However, a slowdown in U.S. commercial real estate (CRE) has made us more cautious on the overall asset class. With regards to the commodity complex, the long-term transition of the global economy to a more renewables-focused energy base will continue the structural decline in commodity demand. We continue to stress the structural and long-term nature of our negative recommendation on commodities. Volatility Dampeners: Favor Farmland & Timberland Vs. Structured Products In 2017 to date, farmland and timberland have returned 3.2% and 2.1% respectively, whereas structured products are up 3.7%. Farmland continues to outperform timberland. The slow U.S. housing recovery has added downward pressure to timberland returns. Investors can reduce the volatility of a traditional multi-asset portfolio with inclusion of farm and timber assets. For structured products, low spreads in an environment of tightening commercial real estate lending standards and falling CRE loan demand, warrant an underweight. Risks To Our View We think upside and downside risks to our central scenario for 2018 - slowing but robust economic growth, and continuing moderate outperformance of risk assets - are roughly evenly balanced. On the negative side, perhaps the biggest risk is China, where the slowdown already suggested in the monetary data (Chart 29) could be exacerbated if the government pushes ahead aggressively with structural reforms. Geopolitical risks, which the market over-emphasized in 2017, seem under-estimated now.10 U.S. trade policy, Italian elections, and North Korea all have potential to derail markets. Also, when the U.S. yield curve is as flat as it is currently, small risks can be blown up into big sell-offs. This is particularly so given over-stretched valuations for almost all asset classes. Chart 29China Monetary Conditions Suggest A Slowdown Table 2How Will Trump Try To Influence The Fed? The most likely positive surprise could come from a dovish Fed. New Fed chair Jay Powell is something of an unknown quantity, and the White House could use the three remaining Fed vacancies to push the Fed to keep rates low, so as not to offset the positive effect of the tax cuts. Without these new appointees, the Fed would have a slightly more hawkish bias in 2018 (Table 2). The intellectual argument for hiking only slowly would be, as Janet Yellen said last month: "It can be quite dangerous to allow inflation to drift down and not to achieve over time a central bank's inflation target." The Fed has missed its 2% target for five years. It is possible to imagine a situation where the Fed increasingly makes excuses to keep monetary policy easy (encouraged, for example, by a short-lived sell-off in markets or a slowdown in China) and this causes a late-cycle blow-out, similar to 1999. 1 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017 available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Insight Report, "Tax Cuts Are Here - Sector Implications," dated December 12, 2017, available at uses.bcaresearch.com. 3 CBNK Survey: Monetary Base, Currency in Circulation. Source: IMF - International Financial Statistics. 4 Please see Global Investment Strategy Special Report, "Two Virtuous Dollar Circles," dated October 28, 2016, available at gis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 6 Please see U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 7 Please see The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com. 8 Please see The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 9 Source: BNY Mellon - The Race For Assets; Alternative Investments Surge Ahead. 10 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. GAA Asset Allocation

Highlights Overweighting Eurostoxx50 versus S&P500 is just a sector play - you must believe that banks are going to outperform technology. It is categorically not a relative economic growth or relative valuation play. The best expression of euro area economic outperformance - as we believe is likely - is not through mainstream equity indexes. It is through the euro. Could Spain in 2014-17 be Italy in 2018-21? If so, the cleanest play is through Italian bonds: long Italian BTPs versus French OATs. Play the lottery for free: when the price gap between the second and first month VIX future is greater than that between the first month and VIX spot - as it is now - it signals a potentially free lottery ticket. Feature Don't Play The Euro Area Economy Through The Stock Market The fallacy of division is a logical fallacy. It occurs when somebody falsely infers that what is true for the whole is also true for the parts that make up the whole. For example, somebody might see that their computer screen appears purple, and infer that the pixels that make up the screen are also purple. In fact, pixels are never purple. They are either red or blue. The fallacy of division is that the property of the whole - purpleness - does not translate to the property of the parts - redness or blueness. Chart of the WeekEuro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology The fallacy of division also affects investors. Since global equities are a play on the global economy, some investors infer that major equity indexes such as the Eurostoxx50 are relative plays on their regional economies. In fact, this is a fallacy of division: the property of the equity market as a global aggregate does not translate to the relative property of an equity market as a regional or national part. Through the past three years, the euro area economy has comfortably outperformed the U.S. economy1 (Chart I-2). Yet the Eurostoxx50 has substantially underperformed the S&P500 (Chart I-3). Why? Because the Eurostoxx50 has a major 14% weighting to banks and a minor 7% weighting to technology. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 24% weighting to technology. Chart I-2The Euro Area Economy ##br##Has Outperformed... Chart I-3...But The Eurostoxx50 ##br##Has Underperformed Hence, for the Eurostoxx50 the distinguishing property is 'bank'; for the S&P500 it is 'technology'. And as banks have underperformed technology, the Eurostoxx50 has underperformed the S&P500. This large difference in sector exposure also means that a head-to-head comparison of equity market valuation is misleading. The euro area, trading on a forward price to earnings (PE) multiple of 15, appears considerably cheaper than the U.S., trading on a forward PE of 19. But this head-to-head difference just reflects the forward PEs of banks at 11 and technology at 19. As banks will likely generate less long-term growth than technology, banks are rightfully cheaper than technology and the Eurostoxx50 is rightfully cheaper than the S&P500. Some people suggest sector-adjusting stock market valuations to allow for the sector biases. The problem is that this suggestion cannot avoid the inescapable end-result. The bank-heavy Eurostoxx50 versus the tech-heavy S&P500 relative performance will still depend on banks versus technology (Chart of the Week). Remarkably, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. This means that relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,2 or vice-versa (Chart I-4). Chart I-4Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Everything else is largely irrelevant. Hence, the counterintuitive conclusion is that overweight Eurostoxx50 versus S&P500 is actually a sector play. You must hold the view that banks are going to outperform technology. At the moment, we are agnostic on this view. The best expression of euro area economic outperformance - as we believe is likely - is not through mainstream equity indexes. It is through bond yield spread compression and through exchange rates. Our preferred expression is structurally long EUR/USD. Could Spain In 2014-17 Be Italy In 2018-21? In 2013, Spain seemed to be on its knees. The economy had slumped by almost 10%, unemployment stood at 27%, and the stock of bank loans which were non-performing exceeded 13%. Doomsayers abounded. Standard and Poor's downgraded Spain's sovereign credit rating to BBB-, one notch above junk, and esteemed Wall Street strategists predicted the unemployment rate would remain above 25% for the rest of the decade. But the esteemed strategists were completely wrong. Through 2014-17, Spanish real GDP per head has grown by almost 15% (Chart I-5) - making it one of the top performing developed economies; unemployment has plunged by 10% (Chart I-6); and non-performing loans have declined sharply. What suddenly transformed Spain from zero to hero? The answer is that Spain recapitalised its banks. Chart I-5Through 2014-17 Spanish Real GDP ##br##Per Head Is Up Almost 15%... Chart I-6...And Unemployment##br## Is Down 10% After a financial crisis, the golden rule of recovery is to repair the banking system as soon as possible. In the aftermath of housing-related banking crises in 2008, the U.S. and U.K. quickly recapitalised their damaged banking systems; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as soon as the banks' aggressive deleveraging ended. Which brings us to Italy. Many people claim that Italy's long-standing economic underperformance is due to deep-seated structural problems. We do not dispute that such problems exist, but they cannot be the main cause of the economic underperformance. After all, through 1999-2007, Italian real GDP per head performed more or less in line with the U.S., Canada and France (Chart I-7), even without a private sector credit boom which the other economies had. Italy's underperformance really started after the 2008 financial crisis. And the most plausible explanation is that its dysfunctional banking system has been left broken for so long. Italy has procrastinated because its government is more indebted than other sovereigns and its banking problems have not caused an outright crisis - yet. But now policymakers in Rome, Brussels and Frankfurt realise that a hamstrung economy carries risks of a populist backlash against the European project. Finally, Italian banks' equity capital is rising, their solvency is improving and the share of non-performing loans appears to have peaked at the same level as in Spain in 2013 (Chart I-8). Chart I-7Through 1999-2007 Italy Performed In##br## Line With Other Major Economies Chart I-8Spanish NPLs Peaked In 2013, ##br##Italian NPLs Are Peaking Now So could Spain in 2014-17 be Italy in 2018-21? Once again, doomsayers abound and the counterintuitive thought could pay off. The cleanest way to play this is through Italian bonds: long Italian BTPs versus French OATs. Play The Lottery For Free As everybody knows, playing the lottery is not a good investment strategy. Most of the time your Lotto ticket brings zero reward, though occasionally you do win a prize. In fact, the U.K. National Lottery has said that the expected win per £1 played averages £0.47. Meaning the long-term return on this strategy is -53%. In the financial markets, the equivalent of a Lotto ticket is to buy volatility. In practice, this means buying a future on a volatility index such as the VIX. The problem is that the VIX futures curve usually slopes upwards. So if the curve doesn't change, a future bought above the spot price loses value when it expires at the spot price (Chart I-9). The upshot is that most of the time, the future 'rolls down the curve', and you lose money, though occasionally when volatility spikes you win. But counterintuitively, sometimes you can play the lottery for free. Look at the VIX futures curve: when the price gap between the second and first month is greater than that between the first month and spot - as it is now (Chart I-10) - it signals a potentially free lottery ticket. Chart I-9VIX Futures "Roll Down The Curve" Chart I-10Spotting A Free Lottery Ticket Under these circumstances, the strategy is to go long the first month future and short the second month future. If the futures curve stays broadly as it is - and both futures contracts roll down the curve - the loss on the first month long position will be made up by the gain on the second month short position. Effectively, the combined position becomes costless. Yet this potentially costless position is still playing the lottery. Because if volatility does spike, the volatility futures curve tends to invert sharply (go into backwardation). Hence, the gain on the first month long position substantially outweighs the loss on the second month short position. Now might be a good time to play the lottery for free. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 On a real GDP per capita basis. 2 Listed as Alphabet. Fractal Trading Model* Silver's 65-day fractal dimension is at a level which has previously indicated four tradeable trend reversals. Go long silver with a profit target / stop-loss of 4.5% In other trades, we are pleased to report that short basic materials versus market and short copper / long tin both hit their respective profit targets. This leaves us with six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Overweight Selected Companies Dear Client, This week I am away visiting clients in Australia, so we are sending you this report written by my colleague Oleg Babanov (Emerging Market Equity Sector Strategy). Oleg identifies select companies in Austria as excellent conduits to emerging market growth whilst maintaining high standards of corporate governance. Oleg also has a list of top stocks in Poland, Russia and Turkey. Please contact us if you would like to see those additional picks. Dhaval Joshi Highlights We are recommending an overweight position in select Austrian companies on a long-term (one year-plus) time horizon. Austrian-listed companies traditionally have high exposure to Central and Eastern Europe (CEE) and other Emerging Markets (EM), while offering superior corporate governance standards, which secures a premium to EM peers. At the same time, geographically diversified revenues stemming from developed and emerging markets support less-volatile earnings growth and outperformance over the long-term. Table 1Single-Stock Statistics On Select Austrian Companies* Austrian Companies - EM Focused... Companies in Austria have traditionally been active in both Western Europe, with a main focus in Austria and Germany, as well as in the CEE region, providing investors with a unique access to both kind of markets. Sectors with high exposure include financials, with around 56% in emerging markets, consumer discretionary, with 46%, and materials with 45%. Furthermore, in terms of company count, pretty much every listed company in the materials as well as the real estate sector has exposure to emerging markets (Chart I-1A, Chart I-1B, Chart I-1C, Chart I-1D, Chart I-1E, Chart I-1F). Chart I-1AGeographical Revenue Breakdown Austria: ##br##Consumer Discretionary Chart I-1BGeographical Revenue Breakdown Austria: ##br##Financials Chart I-1CGeographical Revenue Breakdown Austria:##br## IT Chart I-1DGeographical Revenue Breakdown Austria:##br## Materials Chart I-1EGeographical Revenue Breakdown Austria: ##br##Real Estate Chat I-1FGeographical Revenue Breakdown Austria:##br## Utilities ...And With High Corporate Governance Standards The Austrian ATX equity index has significantly outperformed the MSCI EM index on both a long-term (+21% over five years and +27% over three years) and short-term time horizon (+12%) (Chart I-2A & Chart 1-2B). Chart I-2AFive-Year Performance: ##br##Austrian ATX Index Vs. MXEF Index Chart I-2BYTD Performance:##br## Austrian ATX Index Vs. MXEF Index We believe part of this outperformance is warranted by better corporate governance standards of Austrian companies, which score highly compared to their emerging market peers on all metrics, with the exception of environmental disclosure (Chart I-3A, Chart I-3B, Chart I-3C, Chart I-3D).1 Effectively such companies are offering investors access to emerging markets with less corporate risk, and better management and disclosure standards. Chart I-3AESG Disclosure Comparison Chart I-3BSocial Disclosure Comparison Chart I-3CEnvironment Disclosure Comparison Chart I-3DGovernance Disclosure Comparison Based on the findings above, we have created a portfolio of six companies from the consumer discretionary, financials, real estate and industrials sectors, combining exposure to emerging markets with a high ESG score and sound operational and financial performance (Table I-2). Table I-2Select Overweight Companies And ##br##12-Month Beta Vs. MSCI EM Sector Specifics Price performance over the past five years has been strong, with our overweight basket outperforming the broad MSCI EM index by 53% (Chart I-4). Valuations between Austrian banks and companies from other sectors are diverging. While non-bank companies are trading at a 16% premium to EM peers on a P/E basis, Austrian banks are trading at a 14% discount to the EM Banks Index on a price-to-book comparison (Chart I-5). Chart I-4Select Austrian Companies Outperforming##br## MSCI EM Index Chart I-5Valuations Are Diverging##br## Depending On Sector Nevertheless, Austrian companies display better bottom-line growth dynamics, helped by recovering performance on an operational level, translating into slightly higher profitability (Chart I-6A, Chart I-6B, Chart I-6C). Chart I-6AA Recovery In Operating Margins Of ##br##Austrian Companies In Late 2015... Chart I-6B...Has Helped EPS Growth To Outstrip EM ##br##Companies Since The End Of 2015... Chart I-6C...While Profitability Is Close ##br##To The EM Average Chart I-7ACash Flow Generation Is Subdued##br## Among Austrian Companies... Furthermore, despite negative cash flow generation for the select basket, Austrian companies have comfortable debt levels, and are paying out higher dividends than EM companies (Chart I-7A, Chart I-7B, Chart I-7C). Chart I-7B...With Debt Levels Close To The EM Average... Chart I-7C...And Dividend Yields Higher Than EM Peers The Overweight Basket Erste Group Bank (EBS AV) Erste Group Bank (EBS AV) (Chart I-8). Chart I-8Performance Since October 2016: ##br##Erste Group Bank vs. MSCI EM Erste Group Bank (EBS AV) reported better-than-expected third-quarter 2017 financial results on November 3. Net interest income stabilized, ticking up 1% year over year, mainly driven by the integration of Citigroup's consumer banking business in Hungary. Net interest margin was still under pressure, down 4 basis points year over year to 2.39%. Net fee and commission income expanded by 4%, supported by fee income, but was offset by trading income deterioration. Operating expenses grew by 3% year over year due to regulatory and IT project costs. With the decrease in provisions offsetting declining operating results, the bottom line rose by 8% year over year. Asset quality showed improvement, with the NPL ratio shrinking by a significant 111 basis points year over year to 4.3%. The company's tier-1 ratio grew by 2 basis points year over year to 13.4%. The market is estimating a 0.2% EPS CAGR over the next four years. We believe operating expenses should grow at a slower pace in the coming quarters, positively affected by decelerating regulatory and IT project investments. At the same time, we expect net interest income to continue to expand, driven by strong macro performance in the CEE region and countercyclical measures by the corresponding central banks. Raiffeisen Bank (RBI AV) Raiffeisen Bank (RBI AV) (Chart I-9). Chart I-9Performance Since October 2016:##br## Raiffeisen Bank vs. MSCI EM Raiffeisen Bank International (RBI AV) reported remarkable third-quarter 2017 financial results on November 14, solidly beating market expectations. Net interest income advanced by 4% year over year, with net interest margin up 4 basis points to 2.47%. Net fee and commission income climbed by 8% year over year, boosted by the bank's payment transfer business but offset by sluggish trading income as well as a one-off litigation cost in Slovakia. However, pre-provisional profit surged by 35% thanks to disciplined cost management. As a result, net income soared 46% year over year, substantially beating market expectations. Asset quality improvement was another positive. The NPL ratio came in at 6.7%, down 200 basis points year over year, aided by slower NPL formation and write-offs. The tier-1 capital ratio expanded by 100 basis points year over year to 13.4%. The market is estimating an 18% EPS CAGR over the next four years. We welcome the bank's digital transformation strategy in Romania. We believe the new version of the banking platform to be launched in 2018 will better support customers' needs and optimize the bank's transaction business. Andritz AG (ANDR AV) Andritz AG (ANDR AV) (Chart I-10). Chart I-10Performance Since October 2016:##br## Andritz vs. MSCI EM Andritz AG (ANDR AV) reported weak third-quarter 2017 financial results on November 3. Revenue contracted by 8% year over year, weaker across all business segments, especially in pulp and paper (-13%). This was reflected by a shrinkage in overall order intakes, down 9% year over year. In terms of geographic exposure, Andritz continues its sales expansion in Europe (+6%) and China (+25%). EBITDA fell 9% year over year, mainly dragged down by the materials business, despite this being moderately compensated by the separation business segment. EBITDA margin was also disappointing across the board, down 20 basis points year over year to 7.2%, except for the hydro segment (+154%). As a result, the bottom line declined by 20% year over year, missing market expectations. Andritz is trading at a forward P/E of 16.5x, while the market is estimating a 4.7% EPS CAGR over the next four years. Despite lower-than-expected third-quarter earnings, we remain bullish on the company, given its strong track record of business growth in difficult environments. Earlier this month, the company won a contract from SaskPower to refurbish a hydroelectric power station in Canada, with a total contract value of more than US$104 million. CA Immobilien Anlagen (CAI AV) CA Immobilien Anlagen (CAI AV) (Chart I-11). Chart I-11Performance Since October 2016: ##br##CA Immobilien Anlagen vs. MSCI EM CA Immobilien Anlagen AG (CAI AV) reported better-than-expected third-quarter 2017 financial results on November 22. Revenue increased by 5.6% year over year, helped by a 10% increase in rental income, as occupancy rates increased in all three major regions (Germany, Austria and CEE). On the operating side, expenses fell by 5% year over year, while income jumped by 21.4% year over year, pushing operating margin higher to 45.8% from 39.8% for the same period last year. The EBITDA grew 11% year over year. As a result of strong top line performance and a further decline in costs, bottom line expanded by 25% year over year on adjusted basis. CA Immo is trading at a forward P/E of 19.5x, while the market is estimating a 6% EPS CAGR over the next three years. Among some of the highlights of this quarter was the successful reduction in financing cost (-22% compared to the first quarter 2017). The new property additions in Budapest and Prague have already positively contributed to the results, and focus is now shifting to the future pipeline, which is heavily tilted towards Germany (in terms of projects). We expect the positive earnings momentum to continue in 2018. UBM Development (UBS AV) UBM Development (UBS AV) (Chart I-12). Chart I-12Performance Since October 2016:##br## UBM Development vs. MSCI EM UBM Development reported better-than-expected third quarter 2017 financial results on November 28. Quarterly revenue fell by 66.5% year over year, but nine-month output volume stood 18% higher, while operating expenses contracted by 66.7% year over year, helped by lower material costs. Nevertheless, operating income decreased by 70% compared to the same period last year, while operating margin finished 70 basis points lower at 7.9%. Pretax income was helped by a one off gain from affiliates, as a result, net profit climbed 10% compared to last year, and 24% for the first three quarters. On adjusted basis bottom line finished the quarter in negative territory. UBM Development is currently trading at a forward P/E of 10x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. The company came close to reaching its debt reduction target of EUR 550 million, despite EUR 164 million of investments in the first half of the year. Improvements on the balance sheet should provide the company with cheaper financing in 2018. Furthermore, sales are on track, with another EUR 120 million of cash sales secured after the third quarter reporting period, bringing UBM close to its full achieving its full-year guidance. DO & CO (DOC AV) DO & CO (DOC AV) (Chart I-13). Chart I-13Performance Since October 2016: ##br##DO & CO vs. MSCI EM DO & CO (DOC AV) announced first-half year financial results on November 16. Revenues dropped by 10% year over year, primarily dragged down by the international event catering segment. EBITDA contracted accordingly, down 13% year over year. However, EBITDA margin remained stable in the international event catering as well as the restaurants and lounges segments. The bottom line came in shy of expectations, shrinking by 18% year over year. We believe the inclusion of a new customer - Juventus soccer club - will boost the margin further in the second-half of the year. DO & CO is trading at a forward P/E of 17.5x, while the market is estimating a 7.2% EPS CAGR over the next four years. The company is fairly valued compared to its five-year average, but trades at up to a 30% discount to its international peers. We believe that DO & CO should be able to crystalize the effects of a strong 2018 pipeline, with new clients in the airline segment (e.g. Lufthansa, and Air China) and the opening of new locations in Los Angeles and Paris (and expansions in London and New York). On a longer-term perspective, the positive outcome on possible construction of a third airport in Turkey would also boost performance. How To Trade? The EMES team recommends gaining exposure to this theme through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Erste Group Bank (EBS AV); Raiffeisen Bank (RBI AV); Andritz AG (ANDR AV); CA Immobilien Anlagen (CAI AV); UBM Development (UBS AV); DO & CO (DOC AV). ETFs: iShares Austria Capped ETF (EWO US) provides exposure to all described companies. Funds: Pioneer Funds Austria (VIENTPF AV); 3 Banken Osterrrech-Fonds (3BKOESI AV); Raiffeisen-Oesterreich-Aktien (OSTAKTT AV). Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case On a macro level, we see the main risks stemming from possible asset-purchase tapering by the European Central Bank, which could slow GDP growth in Eastern Europe as well as trigger FX weakness and a slowdown in property markets. Taking into account that exposure to this region is high, such a scenario would most likely cause earnings headwinds for the selected companies, especially in the banking sector. Separately, some of the companies have high exposure to Russia and Turkey. Both countries are prone to geopolitical turbulence, as seen in the past, which in turn can negatively affect economic development and negatively affect companies. Company specific risks include higher rates of projects under construction in the real estate sector, with risks of delays and higher input costs inflating budgets. For Andritz, we see the main risk in the slowdown of capex in the European auto segment (which it seems already happened in the second quarter), and the possible need for additional restructuring in the auto division. We also see some regulatory risk for the banking segment from adverse regulations, such as the bank tax introduction already seen in Hungary, or possible increases in bank taxes in Austria. Oleg Babanov, Associate Vice President obabanov@bcaresearch.co.uk Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com 1 BCA Estimates and Bloomberg Data

Highlights Geopolitical risks were overstated in 2017, but have now become understated; If Donald Trump becomes an early "lame duck" president, he will seek relevance abroad; This could mean a protectionist White House, or increased geopolitical tensions with Iran and North Korea; North Korean internal stability could come into question as economic sanctions begin to bite; Political risks in the U.K. and Italy could rise with markets overly complacent on both; Emerging markets, particularly Brazil and Mexico, will see renewed political risk. Feature Buoyant global growth, political stability in Europe, and steady policymakers' hands in China have fueled risk assets in 2017. As the year draws to a close, investors also have tax cuts in the U.S. to celebrate. Our high conviction view that tax cuts would happen - and that they would be fiscally profligate - is near the finish line.1 In making this call, we ignored the failure to repeal Obamacare, the "wisdom" of old "D.C. hands," and direct intelligence from a source inside the White House circle who swore tax reform would be revenue neutral. Throughout the year, BCA's Geopolitical Strategy remained confident that the GOP would ignore its fiscal conservative credentials and focus on the midterm elections.2 That election is increasingly looking like a bloodbath-in-the-making for the Republican Party (Chart 1). What of the latest opinion polls showing that the tax cuts are unpopular with half of all Americans? The polls also show that a solid one-third of all Americans remain in support of the Republican plan (Chart 2). We suspect - as do Republican strategists - that those are the Republicans who vote in midterm elections. Given the atrociously low turnout in midterm elections - just 36.4% of Americans voted in 2014 - Republicans need their base to turn out in November. The tax cuts are not about the wider American public but the Republican base. Chart 1Midterm Election: A Bloodbath? Chart 2Republican Base Supports Tax Cuts As we close the book on 2017, we look with trepidation towards 2018. Our main theme for next year is that the combination of economic stimulus from the tax cuts in the U.S. and structural reforms in China will create a U.S.-dollar-bullish policy mix that will combine into a headwind for global risk assets, particularly emerging market equities.3 However, in this report, we focus on some of the more exotic risks that investors may have to deal with. In particular we focus on five potential "black swans" - low probability, high market-impact events - that are neither on the market's radar nor the media's. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months. Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk. Geopolitical: We must be able to identify the risk scenario through the lens of our geopolitical methodology. Genuinely unpredictable events - such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe - do not make the cut. Black Swan 1: Lame Duck Trump "Lame duck" presidents - leaders whose popularity late in their term has sunk so low that they can no longer affect policy - are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.4 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents seek relevance abroad. Chart 3The Day After The Midterms, Trump's Overall Popularity Will Matter More Than That Among Republicans President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains healthy, his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 3). Based on these poll numbers, his party is likely to underperform in the upcoming midterm election (Chart 4). A Democrat-led House of Representatives would have the votes to begin impeachment, which we would then consider likely in 2019. As we have argued in our "impeachment handbook," the market impact of such a crisis would ultimately depend on market fundamentals and the global context, not political intrigue.5 Chart 4Trump Is Becoming A Liability For The GOP President Trump's political capital ahead of the midterm elections is based on his ability to influence Republican legislators. Despite low overall poll numbers, President Trump can use the threat of endorsing primary challengers against conservative peers in Congress to move his agenda in the legislature. He has effectively done this with tax cuts. However, the day after the midterm elections, President Trump's own numbers will matter for the GOP. Given that President Trump will be on the ballot in the 2020 general election, his low approval numbers with non-Republican voters will hang like an albatross around the party's neck. This is a serious issue, particularly given that 22 of the 33 Senators up for reelection in 2020 will be Republican.6 Robust economic growth and a roaring stock market have not boosted Trump's popularity so far. At the same time, a strong economy ready to translate into higher wages is about to be "pump-primed" by stimulative tax cuts (Chart 5). We would expect the result to be a stronger dollar, which should keep the U.S. trade deficit widening well into Trump's second year in office. At some point, this will become a sore political point, given Trump's protectionist rhetoric and his administration's focus on the trade balance as a key measure of U.S. power. Chart 5Wage Pressures Are Building What kind of adventures would we expect to see President Trump embark on in 2018? There are three prime candidates: China-U.S. trade war: The Trump administration started off with threats against China and then proceeded to negotiations. However, neither the North Korean situation nor the trade deficit has seen substantial improvement, and a lame duck Trump administration would be more likely to resort to serious punitive actions. Even improvements on the Korean peninsula would not necessarily prevent Washington from getting tougher on Beijing over trade, as the Trump administration will be driven by domestic politics. Investors should carefully watch whether the World Trade Organization deems China a "market economy," which could trigger a U.S. backlash, and whether the various investigations by U.S. Trade Representative Robert Lighthizer and Commerce Secretary Wilbur Ross result in anti-dumping and countervailing duties being imposed more frequently on specific Chinese exports. Thus far, the empirical evidence suggests that the Trump administration has picked up the pace of protectionist rulings (Chart 6). Notably, the Trump administration claims that the Comprehensive Economic Dialogue has "stalled," and it is reviving deeper, structural demands on Chinese policymakers.7 Iran Jingoism: Rumors that Secretary of State Rex Tillerson may be replaced by CIA Director Mike Pompeo - who would be replaced at the CIA by Senator Tom Cotton - can only mean one thing: the White House has Iran in its sights. Both Pompeo and Cotton are hawks on Iran. The administration may be preparing to shift its focus from North Korea, where American allies in the region are urging caution, to the Middle East, where American allies in the region are urging aggression. Investors should watch whether Tillerson is removed and especially how Congress reacts to President Trump's decision on October 15 to decertify the Iran nuclear agreement (also called the Joint Comprehensive Plan of Action or JCPOA). The Republican-controlled Congress has until December 15 to reimpose sanctions on Iran that were suspended as part of the deal, with merely a simple majority needed in both chambers. However, President Trump will also have an opportunity, as early as January, to end waivers on a slew of sanctions that were not covered under the JCPOA. North Korea: It would be natural to slot North Korea as first on our list of potential foreign policy adventures for President Trump. However, it does not really fit our qualification of a black swan. North Korea is not "out of sight." Additionally, President Trump has already broken with the tradition of previous administrations by upping the pressure on Pyongyang. In fact, a North Korean black swan would be if President Trump succeeded in breaking the regime in Pyongyang. To that scenario we turn next. Chart 6Trump: Game Changer In U.S. Trade Policy? Bottom Line: Geopolitics has not affected the markets in 2017, with risk assets reaching record highs and the VIX reaching record lows (Chart 7). This was our view throughout the year and we called for investors to "buy in May and have a nice day" as a result of our analysis.8 We do not see this as likely in 2018. The Trump administration has no credible legislative agenda after tax cuts. We expect Congress to stall as we enter the summer primary season and for the GOP to lose the House to the Democrats. President Trump is an astute political analyst and will sense these developments before they happen. There is a good chance that he will attempt to sway the election and pre-empt his lame duck status with an aggressive foreign policy. Chart 72017 Goldilocks: S&P 500 Up, VIX Down Investment implications are twofold. First, we continue to recommend an equally weighted basket of Swiss 10-year bonds and gold as a portfolio hedge.9 Second, risk premium for oil prices should rise in 2018. Not only is the supply-demand balance favorable for oil prices, but geopolitical risks are likely to rise as well. Black Swan 2: A Coup In Pyongyang Our colleague Peter Berezin, BCA's Chief Global Strategist, has suggested that a coup d'état against Supreme Leader Kim Jong-un could be a black swan trigger that spooks the markets.10 While Peter used the scenario as a tongue-in-cheek way to weave Kim into a narrative that tells of a late 2019 recession, we have long raised North Korean domestic politics as the true Korean black swan.11 Here we entertain Peter's idea for three reasons.12 First, China has upped the economic pressure on Pyongyang. Under Kim Jong-un, the North Korean state has attempted some limited economic "opening up," namely to China. But the attempt to finalize the nuclear deterrent has delayed an already precarious process. There has now been a $617 million drop in Chinese imports from the country since the beginning of the year (Chart 8), with coal imports particularly affected (Chart 9). China has also pulled back on tourism. Meanwhile, North Korea's imports of Chinese goods have risen, which suggests that the country's current account balance may be widening. At some point, if these trends continue, Pyongyang will run out of foreign currency with which to purchase Chinese and Russian imports. Chart 8China Is Turning The Screws On Pyongyang... Chart 9...Particularly On Coal Imports Second, Pyongyang is well aware of pressures against the regime. The assassination of Kim Jong-nam - the older half-brother of Kim Jong-un - in February of this year sent a message to the world, but especially to China, which kept Kim Jong-nam around as an alternative to the current Kim. That Pyongyang went to the extreme lengths of poisoning Kim Jong-nam with VX nerve agent in a foreign airport suggests that Kim Jong-un is still worried about threats to his rule.13 If Beijing's economic sanctions continue to tighten in 2018, the military could conceivably see the Supreme Leader's aggressive foreign policy as a risk to regime survival. Third, Pyongyang could miscalculate and create a crisis from which it cannot deescalate. A provocation that disrupts international infrastructure and commerce or kills civilians from the U.S. or Japan could trigger a downward spiral. For instance, an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.14 We could see the U.S. following the script from Operation Praying Mantis in the Persian Gulf in 1988 - the largest surface engagement by the U.S. Navy since the Second World War. In that incident, the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines. Such a conflict is not our baseline case, but we assign much higher probability to it than an all-out war on the Korean Peninsula. How would Pyongyang react to the sinking of its submarines? Our best case is that the regime would do nothing. The leadership in Pyongyang is massively constrained by its quantifiable military inferiority. True, North Korea has around 6 million military personnel - about 25% of the total population is under arms - but unfortunately for Pyongyang, this large army is arrayed against one of the most sophisticated defenses ever constructed by man: the Demilitarized Zone (DMZ). To support its ground forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15s and F-16s, plus American forces that would vary in size depending on how many aircraft carriers were deployed in the vicinity. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would quickly find themselves fighting a losing battle. Which is why they may never initiate one. If Kim Jong-un insists on retaliation, the military could remove and replace him with, for instance, his 30-year old sister, who has recently risen in party ranks, or his 36-year old brother Kim Jong-chul, who is apparently not entirely uninvolved in the regime despite living an unassuming life in Pyongyang. What would a regime change mean for the markets? It depends on whether it is successful or not. An unsuccessful coup could lead to a massive purge and likely a total break in Pyongyang's relations with the outside world, including China. This would seriously destabilize North Korea's decision-making. The global community would have to begin contemplating a total war on the Korean peninsula. Alternatively, a successful coup could lead to temporary volatility, yet long-term stability. The military regime in the North may even be open to reunification over the long term, depending on how U.S.-China relations evolve. Bottom Line: China does not want to cripple North Korea or throw a coup. But it is cooperating with sanctions and could therefore trigger one by mistake. At least two regimes have collapsed in the past when facing the pincer movement of economic sanctions and American military pressure - South Africa's apartheid regime in 1991 and Slobodan Miloševic's Yugoslavia in 1999. Kim Jong-un could face a similar fate, particularly if China applies excessive economic pressure. Black Swan 3: Prime Minister Jeremy Corbyn There is no election scheduled in the U.K. for 2018, but if one were to be held the ruling Tories would be in trouble (Chart 10). In fact, the combined anti-Brexit forces are currently in a solid lead over the pro-Brexit parties, Conservatives and the U.K. Independence Party (UKIP) (Chart 11). Chart 10Labour Is In The Lead... Chart 11...As Are Anti-Brexit Forces Writ-Large What could trigger such an election? Ultimately, the final exit deal may prompt a new election. More immediately, the ongoing negotiations over the status of the Irish border would be a prime candidate. As our colleague Dhaval Joshi, head of BCA's European Investment Strategy noted recently, Prime Minister Theresa May's government is propped up by the Northern Irish Unionists to whom May has promised that there will be no hard border between Northern Ireland and the Republic of Ireland. This will likely create a crisis as the EU negotiations may inadvertently threaten the Good Friday peace agreement. The Northern Ireland Unionists will not tolerate the border moving to the Irish Sea. This would effectively take Northern Ireland into the EU customs union and single market, and out of the U.K.'s domestic trading zone. It would also embolden Scotland's push for single market access. In essence, the Tory government may collapse because of differences within the U.K.'s "three kingdoms" before it even has the chance to collapse over differences with the EU.15 The market may cheer a Labour-Scottish National Party (SNP) coalition government, a potential winner of an early election, as it would mean that a new referendum on the U.K. leaving the EU could be held. The latest polls suggest that "Bremorse" (remorse for Brexit) has set in, as a clear majority in the U.K. thinks that Brexit was a bad idea (Chart 12). However, we suspect that it would take Prime Minister Jeremy Corbyn several months, if not over a year, before he called such a referendum. First, Corbyn is on record supporting a soft Brexit, not a new referendum, and he has only just begun to adjust this position. Second, a soft Brexit is far more difficult to achieve than the hard Brexit of Prime Minister Theresa May since it requires the U.K. to subvert its sovereignty in significant ways (i.e., accepting EU regulation) in order to access the EU Common Market. Third, the most politically palatable way to re-do the referendum is to put a U.K.-EU deal up to the people to decide, which means that Corbyn first has to spend a long time negotiating that deal. Chart 12Bremorse Sets In The market may be disappointed to find out that PM Corbyn is not willing or able to put the question of the U.K.'s EU exit up to a vote right away. Instead, the market would have to deal with Corbyn's economic policies, which are markedly left-wing. Corbyn harkens back to the 110 Propositions pour la France of French President François Mitterrand, if not exactly to the ghastly 1970s of the U.K.'s own history. A brief sample platter of Labour's proposals under Corbyn includes: Increasing the U.K. corporate tax rate to 26% from 20%; Increasing the minimum wage; Forcing companies not to out-source operations; Nationalizing public infrastructure companies. How should investors play a Corbyn victory? We think that the U.K. pound would likely rally on a higher probability of reversing Brexit. However, this "no Brexit" rally would quickly dissipate as PM Corbyn reiterated his promise to fulfill the democratic desire of the population to exit the EU. While Corbyn's negotiating team set to work on getting a better Brexit deal out of Brussels, the market would quickly turn its attention to the reality that Corbyn is not kidding about socialism.16 The result would be a selloff in the pound. Bottom Line: BCA's Foreign Exchange Strategy has pointed out that the pound remains well below its fair value (Chart 13). However, as BCA's chief FX strategist Mathieu Savary points out, the valuation technicals may be misleading as the currency has entered a new economic, trade, and political paradigm. A Corbyn premiership is not clearly positive for Brexit, while opening up a completely different question: is the U.K. also exiting the free-market, laissez-faire paradigm that it has helped lead since May 1979? Black Swan 4: Italy Is A Black Swan Hiding In Plain Sight The spread between Italian and German 10-year government bonds has narrowed 72 basis points since April, suggesting that investors have grown comfortable with the risks associated with the Italian election due by May (Chart 14). There are three reasons why we agree with the market: Chart 13Pound Valuation Reflects Post-Brexit Paradigm Chart 14Investors Not Worried About Italy New electoral rules passed in October make it highly likely that a center-right alliance will take shape between the Forza Italia of former Prime Minister Silvio Berlusconi and the mildly Eurosketpic Lega Nord. These two could form a government alone, or in a grand coalition with the center-left Democratic Party (PD) (Chart 15). Both Lega Nord and the anti-establishment Five Star Movement (M5S) have moved to the center on the questions of European integration and membership in the currency union; The European migration crisis is over and its supposedly constant impact on Italy is waning (Chart 16). Meanwhile, Italy's economy is on the mend, with its banking sector finally following the Spanish trajectory with a drop in non-performing loans (Chart 17). Chart 15Italy Set For A Hung Parliament Chart 16Migration Crisis Is Over (Yes, Even In Italy) Chart 17Italian Recovery Is Just Starting That said, we continue to warn clients that the underlying support for the common currency is lagging in Italy. The support level is just above 55%, despite a strong rally in the rest of the Euro Area (Chart 18). Similarly, over 40% of Italians appear confident in the country's future outside of the EU (Chart 19). Chart 18Italians Stand Out For Distrust Of Euro Chart 19Italians Not Enthusiastic About EU Our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a Euroskeptic one. How could we be wrong? Easy: one of the three reasons why we agree with the market could shift. For example, M5S could alter its pledge to remain in the Euro Area and surprisingly win on a Euroskeptic platform. Why would the party do something like that? Because it makes sense! Polls are already showing that M5S's recent moderation on the euro is not paying political dividends, with its support sharply sliding since the summer. With power quickly slipping out of reach for the party, why wouldn't they put a down-payment on the next election by trusting the underlying trend in opinion polling and investing in a Euroskeptic platform that might pay political dividends in the future? If we think that this strategy makes sense based on the data, then the M5S leadership might as well. Chart 20Can MIB Keep Outperforming? Another scenario is a major terror attack perpetrated by recent migrants from North Africa. Italy has been spared from radical Islamic terror. As such, the country may not be as desensitized to it as other European nations. A strong showing by Lega Nord and the far-right Fratelli d'Italia could force Forza Italia to move to the right as well. On our travels, we have noticed that few investors want to talk about Italy. There is wide acknowledgement of the structural trends pointing to a rise of Euroskepticism in the country, but also an appearance of consensus that this is a problem for a later date. We agree with this consensus, but our conviction is low. Bottom Line: Italian election risk is completely unappreciated by the markets. The country's equity market is one of the best performing this year (Chart 20), while government bonds are pricing in no political risk as the election approaches. We believe that shorting both would present a good hedging opportunity. Black Swan 5: Bloodbath In Latin America Our last black swan risk is not really a black swan to us but a forecast we believe will happen. As we outlined last month, we fear that Chinese policy-induced credit contraction will be negative for emerging markets, as BCA's Emerging Markets Strategy data asserts (Chart 21). BCA's Foreign Exchange Strategy has pointed out in its latest missive that its "Carry Canary Indicator" - performance of EM/JPY crosses - is signaling that a sharp deceleration in global growth is coming in Q1 2018 (Chart 22).17 Latin America (especially Chile, Peru, and Brazil) is the region most exposed to the combination of a slowing China and a China-induced drop in commodity prices. Chart 21When China Sneezes, EM Gets The Flu Chart 22Ominous Signal From EM/JPY From a political perspective, this is most negative for Brazil and Mexico. Both countries hold elections in 2018, with the Mexican election further complicated by the ongoing NAFTA renegotiations. We believe that the future of NAFTA hangs in the balance, with a high probability that the Trump administration will decide to abrogate the deal.18 Currently, anti-market political forces are in the lead in both countries. In Brazil, no pro-market candidate is leading in the polls (Chart 23). In fact, anti-market options have a 48% lead on the centrists. Granted, there are ten months until the election, but we are skeptical that the Brazilian population will change its mind and support reformers. If the "median voter" in Brazil supported reforms, the current Temer administration would have passed them already. In Mexico, anti-establishment candidate Andrés Manuel López Obrador (also known as AMLO) is leading in the polls (Chart 24), as is his new party Morena (Chart 25). If Morena wins the most seats in the Mexican Congress, it will be more difficult for the opposition parties to combine to counter it.19 Chart 23There Is No Pro-Market Option In Brazil Chart 24AMLO Is In The Lead ... Chart 25...As Is Morena In 2017, we argued that politics were not a tailwind for EM asset performance. Instead, investors chased yield in the favorable economic context of Chinese economic stimulus, low developed market yields, and a weak U.S. dollar. In reality, politics was just as dire in much of EM as it was in prior years of asset underperformance, but the surge of global liquidity in 2018 masked the problems. We do not think the EM rally is sustainable in 2018. As the global economic and market context shifts, investors will start paying attention. Suddenly, political problems will enter into focus. Here we argue that Brazil and Mexico are likely to be the main targets of portfolio outflows, but a strong case could be made for South Africa and Turkey as well.20 Bottom Line: Political risk in Latin America will return. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, and "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 4 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014. 5 Please see BCA Geopolitical Strategy, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Particularly vulnerable, in our view, will be Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), and Thom Tillis (R, North Carolina). 7 U.S. Treasury Under Secretary for International Affairs David Malpass recently claimed that high-level talks had "stalled" and re-emphasized the U.S.'s structural complaints: "We are concerned that China's economic liberalization seems to have slowed or reversed, with the role of the state increasing ... State-owned enterprises have not faced hard budget constraints and China's industrial policy has become more and more problematic for foreign firms. Huge export credits are flowing in non-economic ways that distort markets." The growing presence of Communist Party cells within corporations is another important structural concern that puts the administration at loggerheads with China's leaders. Please see Andrew Mayeda and Saleha Mohsin, "US Rebukes China For Backing Off Market Embrace," Bloomberg, November 30, 2017, available at www.bloomberg.com. 8 Please see BCA Geopolitical Strategy, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy, "A Timeline For The Next Five Years: Part II," dated December 1, 2017, available at gis.bcaresearch.com. 11 Please see "North Korea: From Overstated To Understated" in BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. A notable coup attempt occurred in 1995-96 in North Hamgyong; something like a coup attempt may have occurred in 2013; and defectors from North Korea have reported various stories of plots and conspiracies against the regime. 12 After all, Peter predicted that Donald Trump would be a serious candidate for the U.S. presidency back in September 2015! 13 Still worried, that is, even after Kim Jong-un's supposed "consolidation of power" in 2013-14 when he executed his influential and China-aligned uncle, Jang Song Thaek, and purged the latter's faction. There were reports of rogue military operations at that time. With low troop morale reported by North Korean defectors, the possibility of insubordination cannot be ruled out. 14 A North Korean submarine sank the South Korean corvette Cheonan in 2010, and North Korean artillery shelled two islands killing South Korean civilians later that year, but these attacks were still within the norm of North Korean provocations. The two countries are still technically at war and have contested maritime as well as land borders. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 16 To help investors get ready for a Corbyn premiership, we thought his appearance on President Nicolás Maduro's weekly radio show would be a good place to start: https://www.youtube.com/watch?v=7eL8_wtS-0I 17 Please see BCA Foreign Exchange Strategy, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Global Investment Strategy, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy, "South Africa: Crisis Of Expectations," dated June 28, 2017, and "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Special Report

Highlights Geopolitical risks were overstated in 2017, but have now become understated; If Donald Trump becomes an early "lame duck" president, he will seek relevance abroad; This could mean a protectionist White House, or increased geopolitical tensions with Iran and North Korea; North Korean internal stability could come into question as economic sanctions begin to bite; Political risks in the U.K. and Italy could rise with markets overly complacent on both; Emerging markets, particularly Brazil and Mexico, will see renewed political risk. Feature Buoyant global growth, political stability in Europe, and steady policymakers' hands in China have fueled risk assets in 2017. As the year draws to a close, investors also have tax cuts in the U.S. to celebrate. Our high conviction view that tax cuts would happen - and that they would be fiscally profligate - is near the finish line.1 In making this call, we ignored the failure to repeal Obamacare, the "wisdom" of old "D.C. hands," and direct intelligence from a source inside the White House circle who swore tax reform would be revenue neutral. Throughout the year, BCA's Geopolitical Strategy remained confident that the GOP would ignore its fiscal conservative credentials and focus on the midterm elections.2 That election is increasingly looking like a bloodbath-in-the-making for the Republican Party (Chart 1). What of the latest opinion polls showing that the tax cuts are unpopular with half of all Americans? The polls also show that a solid one-third of all Americans remain in support of the Republican plan (Chart 2). We suspect - as do Republican strategists - that those are the Republicans who vote in midterm elections. Given the atrociously low turnout in midterm elections - just 36.4% of Americans voted in 2014 - Republicans need their base to turn out in November. The tax cuts are not about the wider American public but the Republican base. Chart 1Midterm Election: A Bloodbath? Chart 2Republican Base Supports Tax Cuts As we close the book on 2017, we look with trepidation towards 2018. Our main theme for next year is that the combination of economic stimulus from the tax cuts in the U.S. and structural reforms in China will create a U.S.-dollar-bullish policy mix that will combine into a headwind for global risk assets, particularly emerging market equities.3 However, in this report, we focus on some of the more exotic risks that investors may have to deal with. In particular we focus on five potential "black swans" - low probability, high market-impact events - that are neither on the market's radar nor the media's. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months. Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk. Geopolitical: We must be able to identify the risk scenario through the lens of our geopolitical methodology. Genuinely unpredictable events - such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe - do not make the cut. Black Swan 1: Lame Duck Trump "Lame duck" presidents - leaders whose popularity late in their term has sunk so low that they can no longer affect policy - are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.4 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents seek relevance abroad. Chart 3The Day After The Midterms, Trump's Overall Popularity Will Matter More Than That Among Republicans President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains healthy, his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 3). Based on these poll numbers, his party is likely to underperform in the upcoming midterm election (Chart 4). A Democrat-led House of Representatives would have the votes to begin impeachment, which we would then consider likely in 2019. As we have argued in our "impeachment handbook," the market impact of such a crisis would ultimately depend on market fundamentals and the global context, not political intrigue.5 Chart 4Trump Is Becoming A Liability For The GOP President Trump's political capital ahead of the midterm elections is based on his ability to influence Republican legislators. Despite low overall poll numbers, President Trump can use the threat of endorsing primary challengers against conservative peers in Congress to move his agenda in the legislature. He has effectively done this with tax cuts. However, the day after the midterm elections, President Trump's own numbers will matter for the GOP. Given that President Trump will be on the ballot in the 2020 general election, his low approval numbers with non-Republican voters will hang like an albatross around the party's neck. This is a serious issue, particularly given that 22 of the 33 Senators up for reelection in 2020 will be Republican.6 Robust economic growth and a roaring stock market have not boosted Trump's popularity so far. At the same time, a strong economy ready to translate into higher wages is about to be "pump-primed" by stimulative tax cuts (Chart 5). We would expect the result to be a stronger dollar, which should keep the U.S. trade deficit widening well into Trump's second year in office. At some point, this will become a sore political point, given Trump's protectionist rhetoric and his administration's focus on the trade balance as a key measure of U.S. power. Chart 5Wage Pressures Are Building What kind of adventures would we expect to see President Trump embark on in 2018? There are three prime candidates: China-U.S. trade war: The Trump administration started off with threats against China and then proceeded to negotiations. However, neither the North Korean situation nor the trade deficit has seen substantial improvement, and a lame duck Trump administration would be more likely to resort to serious punitive actions. Even improvements on the Korean peninsula would not necessarily prevent Washington from getting tougher on Beijing over trade, as the Trump administration will be driven by domestic politics. Investors should carefully watch whether the World Trade Organization deems China a "market economy," which could trigger a U.S. backlash, and whether the various investigations by U.S. Trade Representative Robert Lighthizer and Commerce Secretary Wilbur Ross result in anti-dumping and countervailing duties being imposed more frequently on specific Chinese exports. Thus far, the empirical evidence suggests that the Trump administration has picked up the pace of protectionist rulings (Chart 6). Notably, the Trump administration claims that the Comprehensive Economic Dialogue has "stalled," and it is reviving deeper, structural demands on Chinese policymakers.7 Iran Jingoism: Rumors that Secretary of State Rex Tillerson may be replaced by CIA Director Mike Pompeo - who would be replaced at the CIA by Senator Tom Cotton - can only mean one thing: the White House has Iran in its sights. Both Pompeo and Cotton are hawks on Iran. The administration may be preparing to shift its focus from North Korea, where American allies in the region are urging caution, to the Middle East, where American allies in the region are urging aggression. Investors should watch whether Tillerson is removed and especially how Congress reacts to President Trump's decision on October 15 to decertify the Iran nuclear agreement (also called the Joint Comprehensive Plan of Action or JCPOA). The Republican-controlled Congress has until December 15 to reimpose sanctions on Iran that were suspended as part of the deal, with merely a simple majority needed in both chambers. However, President Trump will also have an opportunity, as early as January, to end waivers on a slew of sanctions that were not covered under the JCPOA. North Korea: It would be natural to slot North Korea as first on our list of potential foreign policy adventures for President Trump. However, it does not really fit our qualification of a black swan. North Korea is not "out of sight." Additionally, President Trump has already broken with the tradition of previous administrations by upping the pressure on Pyongyang. In fact, a North Korean black swan would be if President Trump succeeded in breaking the regime in Pyongyang. To that scenario we turn next. Chart 6Trump: Game Changer In U.S. Trade Policy? Bottom Line: Geopolitics has not affected the markets in 2017, with risk assets reaching record highs and the VIX reaching record lows (Chart 7). This was our view throughout the year and we called for investors to "buy in May and have a nice day" as a result of our analysis.8 We do not see this as likely in 2018. The Trump administration has no credible legislative agenda after tax cuts. We expect Congress to stall as we enter the summer primary season and for the GOP to lose the House to the Democrats. President Trump is an astute political analyst and will sense these developments before they happen. There is a good chance that he will attempt to sway the election and pre-empt his lame duck status with an aggressive foreign policy. Chart 72017 Goldilocks: S&P 500 Up, VIX Down Investment implications are twofold. First, we continue to recommend an equally weighted basket of Swiss 10-year bonds and gold as a portfolio hedge.9 Second, risk premium for oil prices should rise in 2018. Not only is the supply-demand balance favorable for oil prices, but geopolitical risks are likely to rise as well. Black Swan 2: A Coup In Pyongyang Our colleague Peter Berezin, BCA's Chief Global Strategist, has suggested that a coup d'état against Supreme Leader Kim Jong-un could be a black swan trigger that spooks the markets.10 While Peter used the scenario as a tongue-in-cheek way to weave Kim into a narrative that tells of a late 2019 recession, we have long raised North Korean domestic politics as the true Korean black swan.11 Here we entertain Peter's idea for three reasons.12 First, China has upped the economic pressure on Pyongyang. Under Kim Jong-un, the North Korean state has attempted some limited economic "opening up," namely to China. But the attempt to finalize the nuclear deterrent has delayed an already precarious process. There has now been a $617 million drop in Chinese imports from the country since the beginning of the year (Chart 8), with coal imports particularly affected (Chart 9). China has also pulled back on tourism. Meanwhile, North Korea's imports of Chinese goods have risen, which suggests that the country's current account balance may be widening. At some point, if these trends continue, Pyongyang will run out of foreign currency with which to purchase Chinese and Russian imports. Chart 8China Is Turning The Screws On Pyongyang... Chart 9...Particularly On Coal Imports Second, Pyongyang is well aware of pressures against the regime. The assassination of Kim Jong-nam - the older half-brother of Kim Jong-un - in February of this year sent a message to the world, but especially to China, which kept Kim Jong-nam around as an alternative to the current Kim. That Pyongyang went to the extreme lengths of poisoning Kim Jong-nam with VX nerve agent in a foreign airport suggests that Kim Jong-un is still worried about threats to his rule.13 If Beijing's economic sanctions continue to tighten in 2018, the military could conceivably see the Supreme Leader's aggressive foreign policy as a risk to regime survival. Third, Pyongyang could miscalculate and create a crisis from which it cannot deescalate. A provocation that disrupts international infrastructure and commerce or kills civilians from the U.S. or Japan could trigger a downward spiral. For instance, an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.14 We could see the U.S. following the script from Operation Praying Mantis in the Persian Gulf in 1988 - the largest surface engagement by the U.S. Navy since the Second World War. In that incident, the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines. Such a conflict is not our baseline case, but we assign much higher probability to it than an all-out war on the Korean Peninsula. How would Pyongyang react to the sinking of its submarines? Our best case is that the regime would do nothing. The leadership in Pyongyang is massively constrained by its quantifiable military inferiority. True, North Korea has around 6 million military personnel - about 25% of the total population is under arms - but unfortunately for Pyongyang, this large army is arrayed against one of the most sophisticated defenses ever constructed by man: the Demilitarized Zone (DMZ). To support its ground forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15s and F-16s, plus American forces that would vary in size depending on how many aircraft carriers were deployed in the vicinity. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would quickly find themselves fighting a losing battle. Which is why they may never initiate one. If Kim Jong-un insists on retaliation, the military could remove and replace him with, for instance, his 30-year old sister, who has recently risen in party ranks, or his 36-year old brother Kim Jong-chul, who is apparently not entirely uninvolved in the regime despite living an unassuming life in Pyongyang. What would a regime change mean for the markets? It depends on whether it is successful or not. An unsuccessful coup could lead to a massive purge and likely a total break in Pyongyang's relations with the outside world, including China. This would seriously destabilize North Korea's decision-making. The global community would have to begin contemplating a total war on the Korean peninsula. Alternatively, a successful coup could lead to temporary volatility, yet long-term stability. The military regime in the North may even be open to reunification over the long term, depending on how U.S.-China relations evolve. Bottom Line: China does not want to cripple North Korea or throw a coup. But it is cooperating with sanctions and could therefore trigger one by mistake. At least two regimes have collapsed in the past when facing the pincer movement of economic sanctions and American military pressure - South Africa's apartheid regime in 1991 and Slobodan Miloševic's Yugoslavia in 1999. Kim Jong-un could face a similar fate, particularly if China applies excessive economic pressure. Black Swan 3: Prime Minister Jeremy Corbyn There is no election scheduled in the U.K. for 2018, but if one were to be held the ruling Tories would be in trouble (Chart 10). In fact, the combined anti-Brexit forces are currently in a solid lead over the pro-Brexit parties, Conservatives and the U.K. Independence Party (UKIP) (Chart 11). Chart 10Labour Is In The Lead... Chart 11...As Are Anti-Brexit Forces Writ-Large What could trigger such an election? Ultimately, the final exit deal may prompt a new election. More immediately, the ongoing negotiations over the status of the Irish border would be a prime candidate. As our colleague Dhaval Joshi, head of BCA's European Investment Strategy noted recently, Prime Minister Theresa May's government is propped up by the Northern Irish Unionists to whom May has promised that there will be no hard border between Northern Ireland and the Republic of Ireland. This will likely create a crisis as the EU negotiations may inadvertently threaten the Good Friday peace agreement. The Northern Ireland Unionists will not tolerate the border moving to the Irish Sea. This would effectively take Northern Ireland into the EU customs union and single market, and out of the U.K.'s domestic trading zone. It would also embolden Scotland's push for single market access. In essence, the Tory government may collapse because of differences within the U.K.'s "three kingdoms" before it even has the chance to collapse over differences with the EU.15 The market may cheer a Labour-Scottish National Party (SNP) coalition government, a potential winner of an early election, as it would mean that a new referendum on the U.K. leaving the EU could be held. The latest polls suggest that "Bremorse" (remorse for Brexit) has set in, as a clear majority in the U.K. thinks that Brexit was a bad idea (Chart 12). However, we suspect that it would take Prime Minister Jeremy Corbyn several months, if not over a year, before he called such a referendum. First, Corbyn is on record supporting a soft Brexit, not a new referendum, and he has only just begun to adjust this position. Second, a soft Brexit is far more difficult to achieve than the hard Brexit of Prime Minister Theresa May since it requires the U.K. to subvert its sovereignty in significant ways (i.e., accepting EU regulation) in order to access the EU Common Market. Third, the most politically palatable way to re-do the referendum is to put a U.K.-EU deal up to the people to decide, which means that Corbyn first has to spend a long time negotiating that deal. Chart 12Bremorse Sets In The market may be disappointed to find out that PM Corbyn is not willing or able to put the question of the U.K.'s EU exit up to a vote right away. Instead, the market would have to deal with Corbyn's economic policies, which are markedly left-wing. Corbyn harkens back to the 110 Propositions pour la France of French President François Mitterrand, if not exactly to the ghastly 1970s of the U.K.'s own history. A brief sample platter of Labour's proposals under Corbyn includes: Increasing the U.K. corporate tax rate to 26% from 20%; Increasing the minimum wage; Forcing companies not to out-source operations; Nationalizing public infrastructure companies. How should investors play a Corbyn victory? We think that the U.K. pound would likely rally on a higher probability of reversing Brexit. However, this "no Brexit" rally would quickly dissipate as PM Corbyn reiterated his promise to fulfill the democratic desire of the population to exit the EU. While Corbyn's negotiating team set to work on getting a better Brexit deal out of Brussels, the market would quickly turn its attention to the reality that Corbyn is not kidding about socialism.16 The result would be a selloff in the pound. Bottom Line: BCA's Foreign Exchange Strategy has pointed out that the pound remains well below its fair value (Chart 13). However, as BCA's chief FX strategist Mathieu Savary points out, the valuation technicals may be misleading as the currency has entered a new economic, trade, and political paradigm. A Corbyn premiership is not clearly positive for Brexit, while opening up a completely different question: is the U.K. also exiting the free-market, laissez-faire paradigm that it has helped lead since May 1979? Black Swan 4: Italy Is A Black Swan Hiding In Plain Sight The spread between Italian and German 10-year government bonds has narrowed 72 basis points since April, suggesting that investors have grown comfortable with the risks associated with the Italian election due by May (Chart 14). There are three reasons why we agree with the market: Chart 13Pound Valuation Reflects Post-Brexit Paradigm Chart 14Investors Not Worried About Italy New electoral rules passed in October make it highly likely that a center-right alliance will take shape between the Forza Italia of former Prime Minister Silvio Berlusconi and the mildly Eurosketpic Lega Nord. These two could form a government alone, or in a grand coalition with the center-left Democratic Party (PD) (Chart 15). Both Lega Nord and the anti-establishment Five Star Movement (M5S) have moved to the center on the questions of European integration and membership in the currency union; The European migration crisis is over and its supposedly constant impact on Italy is waning (Chart 16). Meanwhile, Italy's economy is on the mend, with its banking sector finally following the Spanish trajectory with a drop in non-performing loans (Chart 17). Chart 15Italy Set For A Hung Parliament Chart 16Migration Crisis Is Over (Yes, Even In Italy) Chart 17Italian Recovery Is Just Starting That said, we continue to warn clients that the underlying support for the common currency is lagging in Italy. The support level is just above 55%, despite a strong rally in the rest of the Euro Area (Chart 18). Similarly, over 40% of Italians appear confident in the country's future outside of the EU (Chart 19). Chart 18Italians Stand Out For Distrust Of Euro Chart 19Italians Not Enthusiastic About EU Our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a Euroskeptic one. How could we be wrong? Easy: one of the three reasons why we agree with the market could shift. For example, M5S could alter its pledge to remain in the Euro Area and surprisingly win on a Euroskeptic platform. Why would the party do something like that? Because it makes sense! Polls are already showing that M5S's recent moderation on the euro is not paying political dividends, with its support sharply sliding since the summer. With power quickly slipping out of reach for the party, why wouldn't they put a down-payment on the next election by trusting the underlying trend in opinion polling and investing in a Euroskeptic platform that might pay political dividends in the future? If we think that this strategy makes sense based on the data, then the M5S leadership might as well. Chart 20Can MIB Keep Outperforming? Another scenario is a major terror attack perpetrated by recent migrants from North Africa. Italy has been spared from radical Islamic terror. As such, the country may not be as desensitized to it as other European nations. A strong showing by Lega Nord and the far-right Fratelli d'Italia could force Forza Italia to move to the right as well. On our travels, we have noticed that few investors want to talk about Italy. There is wide acknowledgement of the structural trends pointing to a rise of Euroskepticism in the country, but also an appearance of consensus that this is a problem for a later date. We agree with this consensus, but our conviction is low. Bottom Line: Italian election risk is completely unappreciated by the markets. The country's equity market is one of the best performing this year (Chart 20), while government bonds are pricing in no political risk as the election approaches. We believe that shorting both would present a good hedging opportunity. Black Swan 5: Bloodbath In Latin America Our last black swan risk is not really a black swan to us but a forecast we believe will happen. As we outlined last month, we fear that Chinese policy-induced credit contraction will be negative for emerging markets, as BCA's Emerging Markets Strategy data asserts (Chart 21). BCA's Foreign Exchange Strategy has pointed out in its latest missive that its "Carry Canary Indicator" - performance of EM/JPY crosses - is signaling that a sharp deceleration in global growth is coming in Q1 2018 (Chart 22).17 Latin America (especially Chile, Peru, and Brazil) is the region most exposed to the combination of a slowing China and a China-induced drop in commodity prices. Chart 21When China Sneezes, EM Gets The Flu Chart 22Ominous Signal From EM/JPY From a political perspective, this is most negative for Brazil and Mexico. Both countries hold elections in 2018, with the Mexican election further complicated by the ongoing NAFTA renegotiations. We believe that the future of NAFTA hangs in the balance, with a high probability that the Trump administration will decide to abrogate the deal.18 Currently, anti-market political forces are in the lead in both countries. In Brazil, no pro-market candidate is leading in the polls (Chart 23). In fact, anti-market options have a 48% lead on the centrists. Granted, there are ten months until the election, but we are skeptical that the Brazilian population will change its mind and support reformers. If the "median voter" in Brazil supported reforms, the current Temer administration would have passed them already. In Mexico, anti-establishment candidate Andrés Manuel López Obrador (also known as AMLO) is leading in the polls (Chart 24), as is his new party Morena (Chart 25). If Morena wins the most seats in the Mexican Congress, it will be more difficult for the opposition parties to combine to counter it.19 Chart 23There Is No Pro-Market Option In Brazil Chart 24AMLO Is In The Lead ... Chart 25...As Is Morena In 2017, we argued that politics were not a tailwind for EM asset performance. Instead, investors chased yield in the favorable economic context of Chinese economic stimulus, low developed market yields, and a weak U.S. dollar. In reality, politics was just as dire in much of EM as it was in prior years of asset underperformance, but the surge of global liquidity in 2018 masked the problems. We do not think the EM rally is sustainable in 2018. As the global economic and market context shifts, investors will start paying attention. Suddenly, political problems will enter into focus. Here we argue that Brazil and Mexico are likely to be the main targets of portfolio outflows, but a strong case could be made for South Africa and Turkey as well.20 Bottom Line: Political risk in Latin America will return. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, and "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 4 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014. 5 Please see BCA Geopolitical Strategy, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Particularly vulnerable, in our view, will be Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), and Thom Tillis (R, North Carolina). 7 U.S. Treasury Under Secretary for International Affairs David Malpass recently claimed that high-level talks had "stalled" and re-emphasized the U.S.'s structural complaints: "We are concerned that China's economic liberalization seems to have slowed or reversed, with the role of the state increasing ... State-owned enterprises have not faced hard budget constraints and China's industrial policy has become more and more problematic for foreign firms. Huge export credits are flowing in non-economic ways that distort markets." The growing presence of Communist Party cells within corporations is another important structural concern that puts the administration at loggerheads with China's leaders. Please see Andrew Mayeda and Saleha Mohsin, "US Rebukes China For Backing Off Market Embrace," Bloomberg, November 30, 2017, available at www.bloomberg.com. 8 Please see BCA Geopolitical Strategy, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy, "A Timeline For The Next Five Years: Part II," dated December 1, 2017, available at gis.bcaresearch.com. 11 Please see "North Korea: From Overstated To Understated" in BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. A notable coup attempt occurred in 1995-96 in North Hamgyong; something like a coup attempt may have occurred in 2013; and defectors from North Korea have reported various stories of plots and conspiracies against the regime. 12 After all, Peter predicted that Donald Trump would be a serious candidate for the U.S. presidency back in September 2015! 13 Still worried, that is, even after Kim Jong-un's supposed "consolidation of power" in 2013-14 when he executed his influential and China-aligned uncle, Jang Song Thaek, and purged the latter's faction. There were reports of rogue military operations at that time. With low troop morale reported by North Korean defectors, the possibility of insubordination cannot be ruled out. 14 A North Korean submarine sank the South Korean corvette Cheonan in 2010, and North Korean artillery shelled two islands killing South Korean civilians later that year, but these attacks were still within the norm of North Korean provocations. The two countries are still technically at war and have contested maritime as well as land borders. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 16 To help investors get ready for a Corbyn premiership, we thought his appearance on President Nicolás Maduro's weekly radio show would be a good place to start: https://www.youtube.com/watch?v=7eL8_wtS-0I 17 Please see BCA Foreign Exchange Strategy, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Global Investment Strategy, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy, "South Africa: Crisis Of Expectations," dated June 28, 2017, and "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. The most dovish central banks will be forced to turn less dovish: The ECB and BoJ will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. Feature BCA's annual Outlook report, outlining the main investment themes that will drive global asset markets in 2018, was sent to all clients in late November.1 In this Weekly Report, we drill down into the specific implications of those themes for global bond markets over the next year. In a follow-up report to be published in two weeks, we will discuss how to piece together those implications into an effective fixed income portfolio for 2018. A More Bearish Backdrop For Bonds, Led First By The U.S., Then By Europe The first major takeaway for bond investors from the BCA Outlook is that the current bullish global backdrop of easy monetary policy, solid growth and low inflation is going to change in the coming year. A robust global economy with broadening inflation pressures will force the major central banks to continue incrementally moving away from extraordinarily accommodative monetary policy settings. This will set up an eventual collision between policy and the markets, the latter of which have benefitted so much from the support of the former during the current bull run for risk assets. The changing monetary backdrop will essentially split 2018 into two halves. The current pro-risk backdrop will be maintained in the first half of the year, with continued above-potential global growth and higher realized inflation in the major developed economies at a time when monetary policy is still too accommodative (Chart 1). This will put upward pressure on global bond yields. There is potential for a significant move higher, as real yields now are too low relative to robust global growth and market-based inflation expectations remain well below central bank inflation targets (Chart 2). Chart 1Central Banks Are##BR##Lagging The Cycle Chart 2Both Global Real Yields AND Inflation##BR##Expectations Are Too Low The trend of rising bond yields will be most acute in the U.S., at least in the first half of 2018. The economy is already operating above potential (Chart 3), and this is before factoring in any impact from the tax cut plan currently being finalized in the U.S. Congress. This fiscal stimulus risks overheating the U.S. economy and will likely encourage the Fed to hike interest rates in 2018 by at least as much as it is currently projecting (75bps after the almost certain rate hike later this month). A faster growth trajectory, combined with a rebound in realized inflation after the 2017 slump, will restore investors' belief that U.S. inflation can move back to the Fed's 2% target. The latter can boost the inflation expectations component of the benchmark 10-year U.S. Treasury yield by as much as 60bps next year. The Fed will feel more emboldened to continue delivering rate hikes if inflation expectations are closer to the central bank's target, thus providing an additional boost to Treasury yields. We project that the 10-year Treasury yield can rise up into the 2.9-3% range, well above the current market forwards. The pressure on global bond yields will not only come from the U.S., according to the BCA Outlook. The booming European economy, freed from the years of fiscal austerity after the Euro Debt Crisis and supported by hyper-easy monetary policy from the European Central Bank (ECB), will continue to grow at an above-trend pace in 2018. Japan is enjoying a very powerful cyclical move (by its own modest post-bubble standards) that should continue given very easy monetary policy, robust profit growth and a historically tight labor market. While China is expected to slow on the back of tighter monetary policy and less fiscal stimulus, growth is still expected to be above 6% in 2018. For all of these economies, inflation is expected to rise alongside growth (to varying degrees) given tight labor markets and diminished levels of global spare capacity. Higher oil prices will also boost global inflation and raise the inflation expectations component of global bond yields, given BCA's above-consensus view on oil prices in 2018 (Chart 4). This will also put bear-steepening pressure on many developed market government bond yield curves as inflation expectations increase, particularly with so many countries operating without much economic slack. This argues for being long inflation protection (i.e. inflation-linked bonds vs. nominals or CPI swaps) in 2018, particularly in the U.S., Euro Area and Japan where inflation expectations are well below central bank targets. Chart 3The Global Output Gap Is Closed Chart 4Rising Oil Will Boost Inflation Expectations The BCA Outlook noted that government bond valuations are poor in most countries, with inflation-adjusted (real) yields well below long-run historical averages (Chart 5). We see higher inflation expectations translating directly into higher global bond yields next year, with little room for real yields to decline as an offset. Chart 5Valuation Ranking Of Developed Bond Markets The latter half of 2018 will see increased worries about future U.S. growth after the Fed has delivered a few more rate hikes and U.S. monetary policy potentially shifts into restrictive territory. At the same time, the strength in global growth and, especially, inflation will cast doubts on the need for continued aggressive bond buying by the ECB and the Bank of Japan (BoJ). Unlike last year, the ECB will be unable to wiggle its way out of the politically difficult decision to begin tapering its asset purchases when the latest program ends in September. Even the BoJ may be forced to alter its current "yield curve control" strategy by raising the target on longer-term JGB yields in response to pressures from better domestic growth and rising global bond yields. Thus, the pressures for higher bond yields will rotate away from the U.S. in the latter half of 2018 towards Europe and possibly Japan. Other developed economy central banks, like the Bank of England (BoE), the Bank of Canada (BoC), the Reserve Bank of Australia (RBA) and the Swedish Riksbank will also be faced with decisions on dialing back monetary accommodation in 2018. Although we anticipate that only the BoC and the Riksbank could credibly deliver on monetary tightening given robust growth and, in the case of Sweden, rapidly rising inflation. Which leads to the second major takeaway from the BCA 2018 Outlook ..... Growth & Policy Divergences Will Create Cross-Market Bond Investment Opportunities The BCA Outlook noted that growth expectations for 2018 still look too cautious in many countries. For example, the IMF is forecasting growth in the developed economies will slow from 2.2% to 2% next year, led by decelerations in the Euro Area, Japan, the U.K., Canada and Sweden (Table 1). At the same time, growth in the emerging economies is optimistically projected to accelerate to a 4.9% pace in 2018, even as China's economy cools to 6.5%. Inflation is expected to modestly increase across most of the world, but remain below central bank targets in many countries. So upside growth surprises, particularly in the U.S. and Europe, will continue to be a major investment theme in 2018. Table 1IMF Global Growth & Inflation Forecasts For 2018 Are Too Pessimistic The growth trends, however, may be more divergent than seen in 2017. This leads to potential cross-market bond trading opportunities by playing relative central bank expectations. The OECD's leading economic indicators are accelerating in the U.S., Europe and Japan; potentially peaking at a very high level in Canada; and outright slowing in the U.K. and Australia (Chart 6). When looking at our central bank discounters, which measure the amount of interest rate changes that are currently priced into money market curves, there are some notable discrepancies with the leading indicators (Chart 7). Chart 6More Divergent##BR##Growth... Chart 7...Will Lead To More Divergent##BR##Monetary Policies The market is now pricing in multiple rate hikes in 2018 from the Fed and BoC, modest increases from the BoE and RBA, and no move from the ECB and BoJ. Given the trends in the leading indicators, rate hikes from the Fed and the BoC are likely, while the BoE and RBA will be hard pressed to raise rates at all next year. Thus, U.S. Treasuries and Canadian government bonds are likely to underperform in 2018, while U.K. Gilts and Australian government bonds can be relative outperformers against a backdrop of rising global bond yields. The outlook for the ECB and BoJ, and the implications for bond yields in Europe and Japan, are a special case that represents the third major takeaway from the BCA Outlook ... The Most Dovish Central Banks Will Be Forced To Turn Less Dovish Chart 8ECB Will Fully Taper By The End Of 2018 The BCA Outlook noted that growth in both the Euro Area and Japan has done very well versus the U.S. over the past four years, essentially matching U.S. growth on a per capital basis (i.e. adjusting for faster population growth in the U.S.). In the Euro Area, an end to the painful fiscal austerity after the 2011-13 sovereign debt crisis was a big driver of the economic strength. The BCA Outlook noted that the drag from tighter fiscal policy during the crisis years was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There has been little fiscal tightening in the following three years, which allowed growth in those economies to catch up rapidly. Add in extremely easy financial conditions - low borrowing rates, a cheap euro, and booming European equity and credit markets - and it is no surprise that the Euro Area economy has enjoyed robust growth over the past couple of years. Looking ahead to 2018, the outlook for Euro Area growth still looks very positive. The OECD leading indicator is rising steadily (Chart 8, top panel). The stock of non-performing loans that has clogged up banking systems in the Peripheral European economies is being whittled down - even in Italy where efforts to fix the many problems of its banks are starting to bear fruit (second panel). At the same time, there will be continued upward pressure on Euro Area inflation in 2018. This will mostly come from higher headline inflation related to higher oil prices (third panel), but also from a grind higher in core inflation and wage growth with the Euro Area unemployment rate already at the OECD's estimate of full employment (bottom panel). The Euro Area economy is likely to expand at an above-potential pace over 2% in the first half of 2018, while headline inflation is set to accelerate back towards the ECB's 2% target. This means that the ECB will have to go through another long conversation with the markets about the future of the asset purchase program. Only the outcome will be different than in 2017 as the economic and inflation arguments for continuing with ECB bond buying will be much harder to justify - especially to the hard money core of the ECB led by Germany. Already, the reduced pace of ECB bond buying set for next year, with the monthly purchases cut in half to €30bn/month, implies a significant slowing of Euro Area monetary liquidity (Chart 9). This will put upward pressure on German Bund yields, but with the move being more concentrated in the latter half of the year as the talk of a true ECB taper, perhaps as soon as the end of 2018, builds. Thus, we see Euro Area government debt being an outperformer in the first half of 2018 and an underperformer in the second half. A move in the benchmark 10-year German Bund yield to the 0.8-1.0% range by year-end is a reasonable target. This would reflect the rise in global bond yields that we expect (i.e. the 10-year U.S. Treasury pushing close to 3%), more normalization in Euro Area inflation expectations and the market pulling forward the timing of future ECB rate hikes. Our base case is still that the ECB will not hike policy interest rates until late 2019, however, which will limit the upside for Euro Area yields next year to some degree. In Japan, the BoJ will continue with its current yield curve targeting regime, aiming to cap 10-year JGBs yields through its bond purchases. This is the most effective way to try and boost Japanese inflation through a weaker yen (Chart 10). The BoJ hopes that this will then lead to rising wage growth as workers demand more pay in response to higher realized inflation. Only if there is a pickup in core/wage inflation in Japan can the BoJ have any chance of reaching its 2% inflation target. Chart 9ECB Tapering Will Put European Yields##BR##Under Upward Pressure Chart 10BoJ Will Keep Rates Low To Boost Inflation##BR##Through A Weaker Yen The current BoJ yield target is around 0% on the 10-year JGB. There has been talk of late from some BoJ officials that the yield target could be raised in response to the strengthening Japanese economy. This is likely just talk to placate BoJ board members who were against the yield curve targeting regime in the first place (it was a very close 5-4 vote to implement the new policy framework in September 2016). Yet the BoJ could conceivable raise the yield target by a modest amount in the context of a bigger move higher in global bond yields. According to a simple econometric model of the 10-year JGB yield unveiled by the BoJ in 2016, a 10bp move higher in the 10-year U.S. Treasury yield would raise the fair value of the JGB yield by 2.7bps (Table 2).2 That model currently shows that JGB yields are about 8bps above fair value (around 0%) at the moment. If the 10yr U.S. Treasury yield were to rise to 3%, however, the current level of the JGB yield would be 7bps too low, which would represent the limit of "overvaluation" on this model since 2013 (Chart 11). Under such a scenario, the BoJ raising the yield target to 0.2%, for example, would not be an unusual response - and it would still be consistent with keeping yield differentials wide enough to generate a weaker yen. Table 2Bank Of Japan 10-Year##BR##JGB Yield Model Chart 11BoJ Could Face Pressure To Raise##BR##The Yield Target If UST Yields Rise In any event, the boost to global monetary liquidity from the asset purchases of the ECB and BoJ will fade next year as both central banks will buy a smaller number of bonds than in 2017. Which brings us to the final main takeaway from the 2018 BCA Outlook .... The Low Market Volatility Backdrop Will End Through Higher Bond Volatility The Outlook noted that the conditions underpinning the growth and liquidity driven bull markets for risk assets will start to turn more negative by mid-2018. Tightening financial conditions, especially as the Fed delivers more rate hikes, will eventually start to weigh on global growth expectations. There is even a very real possibility that the Fed will engineer a U.S. recession in 2019 through tighter monetary policy. At the same time, the Fed will be in the process of its balance sheet runoff, while the ECB and BoJ will be buying smaller amounts of bonds. As we have noted many times this year in Global Fixed Income Strategy reports, a slower growth rate of central bank balance sheets will weigh on the performance of risk assets in 2018 (Chart 12). Add in the risk of growth expectations starting to deteriorate in response to tighter monetary policy in the U.S. (and in China, as well), and markets may become increasingly more volatile later next year - starting with more volatile government bond yields (Chart 13). Chart 12Central Bank Liquidity Tailwind To##BR##Risk Assets Will Fade In 2018 Chart 13The Low Market Vol Backdrop Will End##BR##Through Rising Bond Vol A higher volatility backdrop raises the risk for so many global fixed income markets that have benefitted from investors stretching for yield in order to try and achieve adequate returns. In Chart 14, we show the historical range of yields for global government bonds and spread product (using the benchmark indices for each country or sector) dating back to 2000. The gray dots in the chart represent the current yield for each fixed income category and shows how yields are at historic lows in all markets. Chart 14Historical Range Of Bond Yields For Various Fixed Income Markets, 2000-2017 In Chart 15, we present the historic range of volatility-adjusted yields (the same yields from the previous chart, divided by the trailing 12-month realized index total return volatility of each sector). In this chart, the gray dots again represent the current readings. The blue squares show how volatility-adjusted yields would look if the median volatility of each asset class since 2000 was used in the denominator instead of the latest low level of volatility. Chart 15Historical Range Of VOLATILITY-ADJUSTED Bond Yields##BR##For Various Fixed Income Markets, 2000-2017 As can be seen in the chart, many of the sectors that currently have reasonably attractive volatility-adjusted yields, like U.S. Investment Grade, U.S. High-Yield, and hard-currency Emerging Market debt, will look much less compelling if volatility were to increase to more "normal" levels. The market response will be typical in such a higher volatility environment, as yields would increase to compensate for the greater volatility of returns. The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. In terms of the investment strategy implications, we end this report with a quote taken directly from the 2018 BCA Outlook: "Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018." Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see the December 2017 edition of The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course", available at bca.bcaresearch.com and gfis.bcaresearch.com. 2 The model can be found in this report: https://www.boj.or.jp/en/announcements/release_2016/rel160930d.pdf The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights EM/JPY carry trades represent an important "canary in the coal mine" for the global economy that investors need to monitor very closely. They are currently sitting at a key resistance. A breakout above these levels would suggest that global growth will only strengthen, a move down would point to a deceleration in EM and global industrial activity. If EM/JPY carry trades indeed suffer, the key reasons are likely to be the combined onslaught of Chinese policy tightening and DM removal of monetary accommodation. While still not a base case, this breakdown would affect commodity currencies, the AUD in particular, most severely. Scandies would also suffer but the JPY and CHF would be much stronger than we currently anticipate. The ECB is unlikely to match the Fed next year, thus rate differentials will move against EUR/USD. GBP is still stuck in its post-Brexit range. It is likely to weaken anew toward its lower bound once the upper bound is hit during the coming weeks. Feature Chart I-1EM/JPY Carry Trades: ##br##A Canary To Monitor A "canary in the coal mine" for the global economy, EM / JPY crosses, have hit what has been their ceiling for the past ten years, and have begun to roll over (Chart I-1). We believe that carry trades are a key component to global liquidity that historically provide important signals for global industrial activity and EM assets. The weakness in EM/JPY carry trades is in the early innings, but further deterioration would raise dark flags heading into 2018. On the other hand, if EM/JPY carry trades manage to break out of their historical ceiling, the likelihood that the global industrial cycle accelerates further and EM assets strengthen will only grow. Therefore, EM/JPY carry trades need to be both monitored and understood. In this report, we examine one of the two key dynamics affecting these EM carry trade returns: Chinese policy and EM growth dynamics. In another report later this month, we will examine the other key factor: changes in DM monetary policy. Why Do Carry Trades Matter? In a carry trade, funds are borrowed from nations where they are plentiful and cheap - countries like Japan, with high current account surpluses, plenty of foreign assets and low interest rates. Then, these funds are lent to countries experiencing savings shortfalls, but where prospective returns are perceived to be high. These countries tend to have higher growth, current account deficits and higher interest rates. Through this activity, the funding currencies depreciate, and the high-carry currencies appreciate. Chart I-2After Carry Trades Lose Momentum, ##br##Global IP Weakens This transfer of funds supports global economic activity, as it facilitates a more efficient allocation of capital: Carry trades distribute liquidity to the faster-growing corners of the global economy where investment opportunities are plentiful. In the process, this liquidity further supports economic activity, profit growth and asset returns in those attractive markets. A virtuous loop ensues: As asset and currency returns in the high-carry nations remain elevated, further liquidity finds its way into these economies, which supports additional economic and profit growth. All that said, the virtuous loop can quickly mutate into a vicious downward spiral. If returns in the economies that need the borrowed foreign liquidity disappoint, liquidity can quickly find its way out of these nations. This outflow of funds not only hurts the exchange rate of the high-returns economies, it creates a dearth of liquidity in their domestic markets, which hurts domestic asset returns, profits and growth. This invites further outflows, further currency depreciation, and further economic pain. As Chart I-2 illustrates, when EM carry currencies outperform the yen, this tends to support global industrial activity. However, when EM carry currencies weaken relative to the yen, this tends to lead to a sharp deceleration in global growth by an average of three months. What is surprising is the reliability of the signals, especially when picking episodes of decelerating growth. We posit that this relationship works because of three factors. On one hand, EM are where most of the global capex happens (Chart I-3). Capital goods are the key driver of both global industrial production and global trade. Moreover, EM excluding China still needs foreign capital, as they are expected to run a combined current account deficit of US$300 billion in 2018. Thus, industrial activity is greatly influenced by the cost of financing of EM economies. On the other hand, Japan is still the greatest creditor nation in the world, with a net international investment position (NIIP) of US$3 trillion (Chart I-4). Chart I-3EM Are Where Capex Happens Chart I-4Japan Is The World's Biggest Creditor As a result of these dynamics, when EM currencies underperform the yen, it is a symptom that a key source of liquidity is leaving EM economies, and that global industrial activity is set to suffer. Chart I-5EMU PMIs Follow The EM/JPY Carry Trade Unsurprisingly, the performance of EM currencies vis-à-vis the yen also tends to lead dynamics for euro area industrial growth. As Chart I-5 illustrates, the euro area manufacturing PMI is a function of the performance of this supercharged carry trade. The European economy and its manufacturing sector in particular are very exposed to the EM business cycle. This relationship is a confirmation of the validity of the link between EM carry trades and global growth. Bottom Line: EM/JPY carry trades provide a reliable leading signal on global industrial activity. It is because carry trades are a key mechanism of redistributing global liquidity - taking savings from countries where they are oversupplied, and bringing them to countries where they are needed. EM countries are where the marginal capex in the global economy takes place today. Hence, a deterioration in carry trades' returns signals a deterioration of liquidity conditions in the economies that matter most for the global industrial cycle. It is noteworthy that EM/JPY carry trades have recently begun to lose steam. What Lies behind the Weakness in EM/JPY carry Trades? Chinese Policy! What could explains the recent slowdown in EM carry trades? The yen does not seem to be the culprit, as USD/JPY continues to follow the path charted by U.S 10-year yields this year. Instead, we posit that the source of the weakness is Chinese dynamics, the other key driver of EM returns beyond global liquidity conditions. Chinese policymakers have been curtailing their support to the domestic economy this year. Fiscal spending had decelerated massively, and Chinese monetary conditions have been on a tightening path since the end of 2016 (Chart I-6). Moreover, the administrative and regulatory tightening of the shadow banking system is also beginning to leave its mark. Small financial institutions have not been borrowing as aggressively as in recent years. Historically, this leads to a slowdown in the Chinese credit impulse (Chart I-6, bottom panel). Chart I-6Key Risk To Chinese Credit Growth Chinese##br## Policy Has Been Tightened Chart I-7The Chinese Economy Depends On Policy##br## Because Excess Savings Are Deflationary This is especially important as China is very reliant on policy support. As Chart I-7 shows, fiscal spending and credit creation contributed nearly twice as much to Chinese GDP as exports. This is because the Chinese economy's private savings exceed investments by 5% of GDP. If government spending or the lending machine slows, these excess savings are not used, creating deficient demand which imparts a deep deflationary influence on China and the global economy. We are already seeing early signs that the removal of stimulus is beginning to bite. The diffusion index of Chinese house prices, a key leading indicator of prices themselves, has fallen below the 50% line. Since Chinese real estate construction tends to lag prices, a slowdown in this sector is likely to emerge (Chart 8). Additionally, the slowdown in the leading economic indicator also highlights the risks to China's industrial activity as measured by the Keqiang Index (Chart I-8, bottom panel). The implications for EM are straightforward. EM economies outside of China have exhibited little domestic momentum, with poor credit growth of 5.5% and retail sales growth of 1.1%. Thus, a slowdown in Chinese monetary conditions could do what it historically does: lead to a slowdown in EM industrial production that will reverberate throughout the world (Chart I-9). Chart I-8Policy Is ##br##Biting Chart I-9EM Economies Don't Respond ##br##Well When China Tightens Bottom Line: The crucial factor that could explain why our favorite canary in the coal mine has begun to lose momentum is most likely to be tightening Chinese policy. China is dependent on policy actions to allocate its vast amount of savings. The tightening that began this year is already causing some symptoms to pop up in the Chinese economy. Since China has been the key driver of growth in other EM economies, these dynamics could begin to weigh on EM returns. EM/JPY carry trades will be the canary in the coal mine to judge whether or not these risks begin to weigh on global growth. Other Considerations And Some Implications Positioning considerations could exacerbate the negative impulse emanating from Chinese policy. To begin with, investors are not positioned for this. Not only are risk reversals in EM currencies still pricing in a very benign outcome, short interest in popular EM bond plays remain very low. Thus, the risk of a sharp repositioning in EM plays is high; in fact, it is much higher than for much-maligned assets like the supposedly over-loved S&P 500 (Chart I-10). Japanese investors have been heavily investing outside of their country, and since 2016, EM markets have been the recipients of these portfolio flows. But as Chart I-11 shows, these Japanese flows seem to have been chasing momentum into EM. Thus, if EM assets begin to suffer from a tightening of policy in China, the Japanese flows could reverse, causing a drying out of liquidity conditions in EM and exacerbating the pain already induced by China. Chart I-10Investors Are Oblivious ##br##To EM Risks Chart I-11Japanese Investors Are ##br##Chasing EM Momentum DM monetary policy and inflation dynamics also can play a key role. Carry trades have historically been a play on low volatility in capital markets. An environment of improving growth, low inflation surprises, and easy monetary policy has been key to support this low-volatility state. However, BCA believes that U.S. inflation is set to surprise to the upside, which will contribute to a tighter Federal Reserve. The European Central Bank will begin tapering its asset purchases and the Bank of Japan has ramped up its hawkishness despite the absence of inflation in Japan. This is likely to contribute to an increase in volatility that should prove especially harmful for carry trades in the FX space. This should tighten global liquidity conditions, especially in emerging markets. We will explore this angle in more detail in an upcoming report. Chart I-12EM/JPY Carry Informs EUR/USD In terms of investment implications, if EM carry trades were to break down in the near future, this would represent a major risk to the views espoused in the BCA Outlook and the investment recommendations associated with it. Most obviously, it would have an immediate negative impact on commodity currencies, since it would point to tightening liquidity and financial conditions in EM economies that will impact global industrial activity. The expensive AUD would be the currency most likely to suffer in this environment. The Scandinavian currencies would also suffer against the euro. Scandinavian economies have been highly levered to EM growth, and historically the SEK and the NOK have been greatly affected by EM spreads and commodity prices.1 The dovish bend of the Norges Bank and the Riksbank would only strengthen these negative impulses. EUR/USD would also likely suffer. As we argued two weeks ago, in the past 12 months, the euro has not behaved as a risk-off currency. In fact, quite the contrary, the euro has rallied alongside traditional EM plays, as the euro area has benefited from the positive economic impulse emanating from EM economies.2 Moreover, historically, EUR/USD has weakened when EM/JPY canaries have depreciated (Chart I-12). Finally, the yen would obviously enjoy such an unwinding of carry trades. We are currently negative the yen on U.S. bond yield dynamics. However, an underperformance of carry trades would prompt much short covering in the JPY as well as repatriation flows into Japan. If the EM canaries weaken further. We will be forced to change our stance on the JPY. Bottom Line: Investors are not positioned for any meaningful weakness in EM/JPY carries, and Japanese flows could move in reverse in a heartbeat. DM policy too is becoming a risk for these carry plays. China's tightening is thus coming at a terrible time for these carry trades. If canaries were to weaken, the AUD would bear the brunt of the pain among G10 currencies. The NOK and the SEK would also underperform a euro that would be falling against the USD. The yen would likely be able to rally in this environment. EUR/USD: Focus On The Western Shores Of The Atlantic Last week, data from Europe once again confirmed that growth in the euro area is stellar. Meanwhile, rate expectations declined in the U.S. as the Fed minutes displayed an FOMC increasingly concerned with the conundrum of a very tight labor market and weak inflation. EUR/USD rallied by 1%. But what really drove the rally in EUR/USD this year? It first and foremost reflected a massive repricing in relative rate expectations between the euro area and the U.S. However, most of this repricing was caused by a decline in the U.S. terminal rate, not an upward adjustment in the European policy end-point (Chart I-13). Chart I-13EUR/USD: All About Falling ##br##U.S. Terminal Rates Chart I-14Most Major Euro Area Economies Experienced##br## Little Inflationary Pressures In 2017 U.S terminal rates have fallen because the market doesn't believe the Fed's interest rate forecast, as core PCE has collapsed by nearly 45 basis points despite a U.S. economy at full employment. Meanwhile, long-term rate expectations in the euro area have remained flat because core inflation did not move much in the major euro area economies (Chart I-14). Going forward, the U.S. terminal rate is likely to move higher against that of the euro area. U.S. inflation is set to accelerate versus the euro area as financial conditions in Europe have tightened massively versus the U.S. since early 2016, a factor we have highlighted in the past.3 The strength in the U.S. economy is also considerable, and would argue that since the U.S. is more advanced in the business cycle than the euro area, this strength is more likely to generate inflationary pressures in the U.S. than in the euro area (Chart I-15). Moreover, U.S. tax cuts are looking increasingly likely in 2018, which will only add fuel to the U.S. fire. We continue to expect the Fed to follow its "dots," generating a policy outcome well in excess of what is currently priced into the OIS curve. If our base-case scenario for the Fed unfolds, for interest rate differentials to stay constant, the EONIA rate would need to be at 1% by the end of 2020 (Chart I-16). In our view, this is highly unlikely, and we expect rate differentials to move in favor of the USD. Chart I-15Europe Is Strong, ##br##But So Is The U.S. Chart I-16Fed Funds Rate Scenarios ECB Rates Will Have To ##br##Rise Much More To Match What The Fed Will Deliver An EONIA rate of 1% by the end of 2020 will not only defy what the ECB is currently forecasting, it will also be the highest rates since Trichet committed his infamous 2011 policy mistake of hiking rates. In order for European rates to be that high by that date, global growth will have to still be stellar. If this is the case, U.S. rates are likely to be even higher than what the Fed dots are currently implying. This means that based on our expectations for global growth, U.S. inflation and European inflation, the most likely path for rate differentials is that they widen in favor of the U.S. as the Fed still is in a better position to increase rates than the ECB. This expected widening in spreads between the U.S. and the euro area will favor a move in EUR/USD toward 1.10 by the middle of 2018. An adverse move in EM liquidity conditions only adds credence to these dynamics as it will affect European growth more than it will affect U.S. growth. Moreover, safe-haven flows associated with EM weakness would only add to global demand for the USD. Bottom Line: EUR/USD rallied in line with changes in relative terminal rates in 2018. However, this did not reflect an upgrade to the expected terminal rate in the euro area; it mostly reflected a downgrade to the U.S. terminal rate. We do anticipate this downgrade in the expected U.S. terminal rate to reverse course, especially when compared to the euro area. U.S. growth will accelerate further and U.S. inflation will outpace that of the euro area. In an environment where the Fed hikes in line with its "dots," the EONIA rate will not be able to follow, which will put downward pressure on EUR/USD. GBP/USD: Divorce-Bill Rally? This week, the U.K. agreed that its share of liabilities to the EU is around EUR100 billion, which would mean a net payment of around EUR50 billion. The GBP rallied massively in response to this news as markets interpreted this as a sign that negotiations on future trade relationships would start. The pound is very cheap on a PPP basis, and is likely to generate attractive returns on a long-term time horizon. However, Brexit is far from being over. Nagging questions regarding the Irish border remain, and the EU clearly has the upper hand in the negotiations. Moreover, Brexit would hurt both British trade and British potential growth. While abandoning Brexit down the road would help the GBP, this would happen around much political turmoil and result in a likely Corbyn government. When we compare all these positives and negatives, at the current juncture, it is highly unlikely that GBP/USD and EUR/GBP will escape their post-June 2016 trading range. In the short term, EUR/GBP is likely to hit 0.84, and cable, 1.37. We would use moves to such levels to sell the pound on a tactical basis. A move below the post Brexit lows is also highly unlikely as long as the stalemate continues. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Euro: Risk On Or Risk Off?", dated November 17, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Best Of Possible Worlds?", dated October 6, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was positive this week: Annualized GDP growth came in at 3.3%, above the expected 3.2%; The PCE price deflator grew at a 1.6% annual rate, above the expected 1.5%, while the core PCE deflator stayed in line with expectations at 1.4%; Initial jobless claims were lower than expected at 238,000; However, the dollar was only up against the CAD and the NZD, while down against all other G10 currencies as the nomination of Marvin Goodfriend as a member of the FOMC was interpreted as a potential dovish move by the markets. The U.S. 10-year yield was up 4 basis points on higher inflation expectations. U.S. growth is now beginning to outperform Germany's 3.2% annualized GDP growth which should help translate into higher inflation relative to the euro area next year, which will shift upside risk in the favor of the dollar. Report Links: The Xs And The Currency Market - November 24, 2017 It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: German CPI was strong, with the headline measure growing at 1.8%, and the harmonized index also at 1.8%; German retail sales contracted at an annual rate of 1.4%; The number of unemployed people in Germany declined by 18,000 yet the unemployment rate stayed flat at 5.6%; European unemployment decreased to 8.8% from 8.9%; Euro area inflation increased by less than expected at 1.5% on an annual basis. Despite this mixed data, the euro was up 0.6% against the dollar on Thursday. Certain European metrics such as Industrial Confidence are also at all-time highs, levels at which a reversal is increasingly likely. Robust U.S. growth and higher inflation could serve as an indicator that the tide is about to turn in the favor of the greenback as the Fed resumes its hiking cycle. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Nikkei Manufacturing PMI outperformed expectations, coming in at 53.8. Meanwhile, large retailers sales growth also outperformed expectations, coming at -0.7%. Nevertheless, this was a decline from last month's 1.9% expansion. Industrial production growth surprised to the downside, coming in at 5.9%. Finally housing starts also underperformed expectations, coming in at -4.8% and declining even more from last month's -2.9% reading. On Sunday, the BoJ unexpectedly shifted to a less dovish stance, as they hinted that their yield curve control program might be watered down next year. This change in rhetoric could limit the JPY's downside. In fact, the risk growing risk that EM carry trades could begin to crack down even raises the probability that a yen rally unfolds. In this environment trades like short AUD/JPY and short NZD/JPY would benefit greatly. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative Consumer credit underperformed expectations, coming in at 1.451 billion pounds, and declining from the previous month's number. Moreover, mortgage approvals also underperformed expectations, coming in at 64,575. This number was also decline from last month's reading. GBP/USD has appreciated by almost 1% this week, as the United Kingdom and the European Union seem to have agreed that the cost to the U.K. for leaving the EU will be 50 billion euro. Overall, it is unclear whether this breakthrough in the negotiations will be positive or negative for the pound, as many details are yet to be defined. We continue to be negative on cable on the short term, as we expect rate differentials to favor the U.S. over the U.K. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data for Australia was mixed: Private sector credit grew at a 5.3% annual pace, albeit slower than the previous 5.4% figure; Building permits increased sharply by 18.4% annually; Private capital expenditure grew in line with expectations at 1%; Chinese Manufacturing PMI was strong, coming in at 51.8 - stronger than the previous 51.6 and the expected 51.4; Stronger Chinese data buoyed the AUD, however, the Aussie is still weighed down by low wages and a dovish RBA stance. The recent outperformance of the yen versus high carry currencies could be foreshadowing a growth-negative event, especially as Chinese authorities are tightening policy. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday, the RBNZ announced that they will ease mortgage lending restrictions, as it expects policies by the new government to dampen the housing market. After January 1st, banks will be allowed to provide more low-deposit home loans to owner occupiers. Moreover the down payment required to obtain a mortgage will also decline. This announcement by the RBNZ goes in line with our view that the new populist government, will curb immigration, and thus curb pressures in the kiwi economy. Overall we remain bearish on the NZD against the U.S. dollar and against the yen, as we expect global growth to slow down momentarily by the end of the year, as China continues to tighten monetary policy. However, we remain bearish on AUD/NZD as the AUD would suffer more than the NZD in this environment. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was decent: Industrial product prices are growing at a 1% monthly pace, higher than the expected 0.5% pace; Raw materials Index increased by 3.8% in October, higher than the previous 0.2% contraction, pointing to higher inflation; The current account deficit grew to CAD -19.53 bn, better than the expected CAD -19.50 bn. However, the CAD has displayed some weakness recently following Governor Poloz's comments about financial stability within the economy. These fragilities mostly involve household debt and the housing market, which continue to be carefully monitored by the BoC. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Gross domestic Product growth outperformed expectations, coming in at 1.2%. This measure also increased form a growth rate of 0.5% the previous quarter. Moreover, the KOF leading indicator also surprised to the upside, coming in at 110.3. Industrial production yearly growth also continued to increase, coming in at 5.5% However real retail sales growth underperformed expectations substantially, contracting at a 3% pace, after a 0.5% growth in September. EUR/CHF has appreciated by nearly 0.8% this week. Overall we continue to believe that Swiss inflation is still too weak for the SNB to stop intervening in the franc. We will continue to monitor the Swiss economy and global economy for inflationary pressures, to get an idea when the SNB might shift its monetary stance. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover Norway's credit indicator also underperformed coming in at 5.7%. USD/NOK has rallied by roughly 2% this week, as the NOK has experienced a dramatic sell off across the board. This sell off has been caused by the decline in oil prices that we have experienced this week. This is partly because positioning in oil seems to be over stretched, thus a tactical correction in oil prices is expected. Overall, regardless of the outlook for oil prices, we continue to be bullish on USD/NOK, as this cross will mostly trade on rate differentials between Norway and the U.S. rather than on oil prices. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden was disappointing: Retail sales growth slowed to 0.1% monthly and 2.6% annually, compared to the expected 0.2% and 3.4% rates, respectively; The trade balance went into negative territory, coming in at SEK -3.1 bn, compared to the previous SEK 3.2 bn; Annual GDP growth in Q3 was only 2.9% compared to the expected 3.5%. The Q2 data point was also revised downwards from 4% to 2.7%. While quarterly growth was in line with expectations at 0.8%, it still weakened from the previous quarterly growth of 1.2% - which was also revised down from 1.7%. The Riksbank will take these data points into account in their next meeting in two weeks and is likely to stay dovish especially as Stefan Ingves has been re-appointed as governor, adding downward pressure on the krona against the dollar. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Watching The Warning Signals Recommended Allocation Two of the three indicators we have focused on all year as reliable signals of recession (and, therefore, of the timing for reducing exposure to risk assets) have wobbled in the past month. But, for now, we are not too concerned about this, and continue to argue that the current bull market has maybe another year to run, until a possible 2019 recession starts to get priced in. Global growth indicators are showing no signs of slowdown, with the Global Manufacturing PMI at 53.5, and 26 of the 29 markets for which Markit runs its survey returning a PMI above 50 - close to the highest percentage on record (Chart 1). However, the flattening yield curve in the U.S. has raised concerns: the gap between the yield on two-year and 10-year Treasuries has fallen to less than 60 bps (Chart 2). But a flattening yield curve is not unusual when the Fed is tightening policy, and historically the curve has needed to invert before it became a recession signal. Also of concern was a jump in early November in high-yield spreads, which have also been a good lead indicator for recession (Chart 3). The rise was caused by poor earnings from lowly-rated telecoms companies, which triggered a sell-off in junk bond ETFs. But the rise in spreads remains insignificant, and has mostly reversed since. Chart 1Global Growth Looks Fine... Chart 2But Should We Worry About The Yield Curve... Chart 3...And Rising Credit Spreads? BCA's macro view, as laid out in detail in our recent 2018 Outlook,1 is that the strong growth that has been a positive for risk assets this year will slowly become a negative next year as it is increasingly accompanied by rising inflation. Two-thirds of countries globally now have unemployment below the NAIRU (Chart 4). In the U.S., employment has reached a level at which the Philips Curve has historically been "kinky", associated with an acceleration in wage growth (Chart 5). Upside surprises in inflation will mean that the Fed will hike three or four times next year (compared to the market's expectation of only 1½ hikes), 10-year bond yields will rise to above 3%, and the dollar will appreciate. Chart 4Unemployment Is Below Nairu In Most Places Chart 5The 'Kinky' U.S. Philips Curve What are the implications of this scenario for portfolio construction? We continue to recommend an overweight on risk assets on the 12-month time horizon, as we would expect equities to outperform bonds until Fed policy tightens above the neutral level (which is still about five rate hikes away, as long as core PCE inflation picks up to 2%, as we expect - Chart 6). However, the risks to this scenario are rising. The Fed could stubbornly push ahead with rate hikes even if inflation remains subdued. Chinese growth could slow if the authorities misjudge the timing of structural reforms. Our geopolitical strategists argue that, while investors overestimated political risks at the start of 2017, now they are underestimating the risks (North Korea, NAFTA renegotiation, China trade issues, Italian elections).2 With valuations stretched, small shocks could trigger a disproportionate negative market reaction. More risk-averse investors, therefore, might choose to reduce exposure now, at the risk of leaving some money on the table. Equities: If global equities have further upside, as we believe, higher beta markets such as the euro zone (average beta to global equities over the past 20 years: 1.2) and Japan (beta: 0.9) are likely to continue to outperform. Both have central banks that remain accommodative, our models suggest further upside for earnings growth into next year (Chart 7), and valuations are less stretched than in the U.S. While EM equities are also high beta, we think they are likely to lag next year: higher U.S. interest rates, a stronger U.S. dollar, potential slowdown in China, and sluggish domestic demand in most major emerging economies all represent significant headwinds. Chart 6How Long Until Rates Above Neutral? Chart 7Euro and Japan Earnings Have Upside Fixed Income: A combination of higher inflation and a more aggressive Fed is not a positive environment for government bonds. We expect the yield curve to steepen over the next six months, as the market prices in higher inflation and fiscal deficits (after the U.S. tax cut), but to resume flattening mid next year, as the Fed pushes ahead with rates hikes, and worries about the risk of a policy error emerge. For now, we remain underweight duration, and prefer inflation-linked over nominal bonds. For spread product, while valuations are stretched, we see some attractiveness. As long as the global expansion continues, U.S. investment grade bonds should see a carry pickup over Treasuries of around 100 bps, and high-yield bonds one of around 250 bps (adjusting for likely defaults) - even if we don't assume further spread contraction. In a world of continuing low rates, that remains alluring. Currencies will continue to be driven by relative monetary policy. While we see the Fed tightening more than the market expects, the ECB will not raise rates until late 2019, since underlying inflationary pressures in the euro zone are much weaker. This is largely in line with what the futures market is pricing in. Interest rate differentials (and an unwind of the current large speculative long-euro positions) should cause some weakness of the euro versus the dollar. We expect the Bank of Japan to stick to its 0% target for 10-year JGBs, which means that the yen will also weaken, to below 120 to the dollar, if U.S. interest rates rise in line with our forecasts (Chart 8). Emerging market currencies have already fallen by 1.3% since early September as U.S. rates rose, and amid signs of economic weakness in some emerging economies. We expect this to continue. Chart 8Yen Is Driven By U.S. Rates Chart 9China Is What Matter For Metals Commodities: Our energy strategists recently raised their target for Brent and WTI crude to an average over the next two years of $65 and $63 respectively, with risk of upside surprises in the event of geopolitical disruptions (Venezuela, Kurdistan etc.). They see the OPEC agreement being extended possibly to December 2018, and argue that backwardation of the oil curve (futures prices lower than spot) and rising extraction costs will delay the response of shale oil producers to the higher price. The outlook for industrial commodities depends, as always, on China, which now comprises greater demand for base metals than the rest of the world put together (Chart 9). The risk of a slowdown in Chinese infrastructure spending next year makes us wary on metals such as iron ore, and markets such as Australia and Brazil. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "2018 Outlook - Policy And The Markets On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated 22 November 2017, available at gps.bcaresearch.com GAA Asset Allocation

Dear Client, In this report, we image a hypothetical timeline of key economic and financial events spanning the next five years. The events described in the report correspond with our view that the global economy will continue to expand into the second half of 2019, before succumbing to a recession and a decade of stagflation in the 2020s. This warrants an overweight position in risk assets for the next 6-to-12 months, but a much more cautious stance thereafter. Charts 1-4 provide a visual representation of how we see the main asset classes evolving over the coming years. Best regards, Peter Berezin, Chief Global Strategist Feature I. The Blow-Off Phase December 4, 2017: U.S. stocks fall by 1.7% on reports that Mitch McConnell does not have enough votes to get the tax bill through the Senate. A sell-off in high-yield markets and a tightening of financial conditions in China aggravate the situation. December 13, 2017: The Fed hikes rates by 25 basis points, taking the Fed funds target range to 1.25%-to-1.5%. December 14, 2017: Global equities continue to weaken. The S&P 500 suffers its first 5% correction since June 2016. December 15, 2017: The correction ends on news that the Senate will consider a revised bill which trims the size of corporate tax cuts and uses the savings to finance a temporary reduction in payroll taxes. President Trump and House leaders promise to go along with the proposal. The PBoC also injects fresh liquidity into the Chinese financial system. December 29, 2017: Global equities rally into year-end. The S&P 500 hits 2571 on December 29, placing it just shy of its November high. The dollar also strengthens, with EUR/USD closing at 1.162. The 10-year Treasury yield finishes the year at 2.42%. January 10, 2018: The global cyclical bull market in stocks continues. European and Japanese indices power higher. Both the NASDAQ and the S&P 500 hit fresh record highs. EM stocks move up but lag their DM peers, weighed down by a stronger dollar. January 12, 2018: U.S. retail sales surprise on the upside. Department store stocks, having been written off for dead just a few months earlier, end up rising by an average of 40% between November 2017 and the end of January. February 14, 2018: The euro area economy continues to grow at an above-trend pace. Nevertheless, inflation stays muted due to high levels of spare capacity across most of the region and the lagged effects of a stronger euro. The 2-year OIS spread between the U.S. and the euro area widens to a multi-year high. February 26, 2018: China's construction sector cools a notch, but industrial activity remains robust, spurred on by a cheap currency, strong global growth, and rising producer prices. Chinese H-shares rise 13% year-to-date, beating out most other EM equity indices. March 14, 2018: The U.S., Canada, and Mexico reach a last-minute deal to preserve NAFTA. The Canadian dollar and Mexican peso breathe a sigh of relief. March 16, 2018: In a surprise decision, Donald Trump nominates Kevin Hassett as Fed vice-chair. Trump cites the "tremendous job" Hassett did in selling the GOP's tax cuts. A number of Fed appointments follow. Most of the picks turn out to be more hawkish than investors had expected. This gives the greenback further support. March 18, 2018: Pro-EU parties do better than anticipated in the Italian elections. Italian bond spreads compress versus the rest of Europe. March 21, 2018: The Fed raises rates again, bringing the fed funds target range up to 1.50%-to-1.75%. April 8, 2018: Bank of Japan governor Kuroda is granted another term in office. He pledges to remain single-mindedly focused on eradicating deflation. April 11, 2018: Chinese core CPI inflation reaches 2.9%. Producer price inflation stays elevated at 6%. A major market theme in 2018 turns out to be how China went from being a source of global deflationary pressures to a source of inflationary ones. April 30, 2018: U.S. core PCE inflation jumps 0.3% in March, reaching 1.7% on a year-over-year basis. Goods and service inflation both pick up, while the base effects from lower cell phone data charges in the prior year drop out of the calculations. May 17, 2018: Oil prices continue to rise on the back of ongoing discipline from OPEC and Russia, smaller-than-expected shale output growth, and production disruptions in Libya, Iraq, Nigeria, and Venezuela. June 13, 2018: Strong U.S. growth in the first half of the year, a larger-than-projected decline in the unemployment rate, and higher inflation keep the Fed in tightening mode. The FOMC hikes rates again. June 25, 2018: Global capital spending accelerates further. Global industrial stocks go on to have a banner year. June 27, 2018: Wage growth in the U.S. accelerates to a cycle high. Donald Trump takes credit, stating that "this wouldn't have happened" without him or his tax cuts. July 31, 2018: The Japanese labor market tightens further. The unemployment rate falls to 2.6%, 1.2 percentage points below 2007 levels, while the ratio of job vacancies-to-applicants moves further above its early-1990s bubble high. A number of high-profile companies announce plans to raise wages. August 2, 2018: A brief summer sell-off sees global equities dip temporarily, but strong global earnings growth keeps the cyclical bull market in stocks intact. August 28, 2018: The London housing market continues to weaken, with home prices falling by 9% from their peak. The rest of the U.K. economy remains fairly resilient, however. EUR/GBP closes at 0.87. August 31, 2018: The Greek bailout program ends and a new one begins. Greece's economy continues to recover, but Tsipras fails to obtain debt relief from creditors. September 7, 2018: The U.S. unemployment rate falls to a 49-year low of 3.7%, nearly a full percentage below the Fed's estimate of NAIRU. September 26, 2018: The Fed raises rates again. By now, the market has gone from pricing in only two hikes for 2018 at the start of the year to pricing in almost four. September 27, 2018: Profit growth in the U.S. moderates somewhat as higher wage costs take a bite out of earnings. Nevertheless, stock market sentiment remains buoyant. Retail participation, which had been dormant for years, takes off. CNBC sees a surge in viewers. Micro cap stocks go wild. October 7, 2018: The outcome of Brazil's elections shows little appetite for major structural reforms. Economic populism lives on. October 31, 2018: Realized inflation and inflation expectations continue grinding higher in Japan, triggering market speculation that the BoJ will abandon its yield-curve targeting policy. The resulting rally in the yen is short-lived, however. At its monetary policy meeting, the Bank of Japan indicates that it has no near-term plans to modify its existing strategy. November 6, 2018: The Democrats narrowly regain control of the House but fail to recapture the Senate. Investors shrug off the results, figuring correctly that a Republican Senate will keep Trump's corporate tax cuts in place and that Democrats will agree to extend the expiring payroll tax cut and other tax measures that benefit the middle class. December 7, 2018: The U.S. unemployment rate falls to 3.5%. Donald Trump tweets "You're welcome, America". December 19, 2018: The Fed raises rates for the fourth time that year - one more hike than it had signaled in its December 2017 "dot plot" - taking the fed funds target range to 2.25%-2.5%. December 31, 2018: The MSCI All-Country Index finishes up 12% for the year (in local-currency terms), led by the euro area and Japan. U.S. stocks gain 8%. EM equities manage to rise 6%. Small caps edge out large caps, value stocks beat growth stocks, and cyclical stocks outperform defensives. December 31, 2018: The 10-year U.S. Treasury yield finishes the year at 3.05%. German bund yields reach 0.82%, U.K. gilt yields rise to 1.7%, Canadian yields hit 2.3%, and Australian yields back up to 3%. Japanese 10-year yields remain broadly flat, but the 20-year yield moves up 40 basis points to nearly 1%. Credit spreads finish the year close to where they started, providing a modest carry pick-up over high-quality government bonds. December 31, 2018: The DXY index rises 4% to 98. EUR/USD closes at 1.11, USD/JPY at 123, GBP/USD at 1.31, and AUD/USD at 0.76. The Canadian dollar manages to edge up against the greenback on the year, with CAD/USD finishing at 0.81. The Chinese yuan also strengthens to 6.4 versus the dollar. December 31, 2018: Brent and WTI spot prices finish the year at $65 and $63, respectively. Copper and metal prices are broadly flat for the year, having faced the dueling forces of a stronger dollar (a negative) and above-trend global growth (a positive). Gold sinks to $1,226. II. The Clouds Darken February 22, 2019: The global economy starts to decelerate. The slowdown is led by China, where the government's crackdown on shadow banking activities begins to take a bigger toll on growth. Most measures of U.S. economic activity also soften somewhat in the first two months of the year. Investors take heart in the hope that the economy will achieve a soft landing, allowing the Fed to moderate the pace of rate hikes. February 27, 2019: In an otherwise mundane day, the S&P 500 edges up 0.3% to 2832. Little do investors know that this marks the cyclical peak in the U.S. stock market. March 13, 2019: Hopes that the Fed can take its foot off the brake are dashed when the Bureau of Labor Statistics reveals that inflation rose by more than expected in February. U.S. core CPI inflation increases to 2.9% while the core PCE deflator accelerates to 2.4%. Market chatter turns from whether the Fed can slow the pace of rate hikes to whether it needs to start hiking more rapidly than once-per-quarter. The S&P falls 2.1% on the day. March 20, 2019: The Fed lifts the funds rate target range to 2.5%-to-2.75% and signals a readiness to keep hiking rates. The 10-year Treasury yield rises to 3.3%. EUR/USD sinks to 1.08. The first quarter of 2019 marks a watershed of sorts. In 2018, the Fed raised rates because of stronger growth; in 2019, it kept raising them because of brewing inflation. As it turned out, risk assets were able to tolerate the former, but not the latter. March 29, 2019: The U.K. does not leave the EU two years after Britain invoked Article 50 of the Lisbon Treaty. The EU votes to prolong negotiations given growing political support within Britain for the country to remain part of the European bloc. April 5, 2019: The S&P 500 sinks further and is now 10% below its February high, returning close to where it was at the start of 2018. The increasingly sour mood on Wall Street does not appear to be hurting Main Street very much, however. The U.S. unemployment rate edges down further to 3.4%. Euro area growth remains resilient. May 31, 2019: The Brazilian government announces that the fiscal deficit will come in larger than originally expected. USD/BRL slips to 3.45. June 4, 2019: Jens Weidmann, who had gone out of his way to soften his hawkish rhetoric over the preceding months, is chosen to succeed Mario Draghi, whose term expires in October. Nevertheless, the euro still strengthens on the news. June 6, 2019: Markets temporarily regain their composure. The S&P 500 gets back to within 4% of its all-time high. The reprieve does not last long, however. June 12, 2019: The Fed hikes rates, taking the fed funds target range to 2.75%-to-3%. The FOMC cites inflation as its primary concern. July 8, 2019: Global risk assets weaken anew as a fiscal crisis grips Brazil. Turkey, South Africa, and a number of other emerging markets show increasing signs of fragility. August 20, 2019: Korean exports, a leading indicator of the global business cycle, decelerate once again. Global PMIs sag, as do most measures of business confidence. September 25, 2019: Despite a slowing U.S. economy, the Fed hikes rates again, bringing the fed funds target range to 3%-to-3.25%. The FOMC justifies the decision based on the fact that the unemployment rate is below NAIRU, core inflation is above the Fed's 2% target, and real rates are less than 1%. To assuage markets, Jay Powell suggests that the Fed could keep rates on hold in December. This turns out to be more prescient than he realizes. It will be another three years before the Fed raises rates again. By then, Powell is no longer the Fed chair. September 30, 2019: Commodity prices tumble, further adding to the pressure facing emerging markets. The U.S. yield curve inverts for the first time during this business cycle. The dollar, which previously strengthened due to a hawkish Fed, now starts strengthening on flight-to-safety flows back into the U.S. The yen appreciates even more than the greenback. October 15, 2019: The bottom falls out of the Canadian housing market. Home sales dry up and prices begin to sink. The Canadian dollar, which peaked back in February at 83 cents, falls to 74 cents against the U.S. dollar. October 19, 2019: A failed North Korean launch lands a missile 80 kilometres from Japanese shores. Prime Minister Abe pledges swift retaliation. October 21, 2019: The negative feedback loop between a rising dollar, falling commodity prices, and EM stress intensifies. Sentiment towards emerging markets deteriorates dramatically. Rumours begin to swirl that Brazil will miss a debt payment. October 23, 2019: Trump tweets "Dopey Rocketman thinks he is so smart, but we know where all his hideouts are. Sweet dreams!" October 24, 2019: News reports are abuzz about a massive buildup of troops on the North Korean side of the border. Panic grips Seoul. Asian bourses sell-off, taking global stock markets down with them. III. The Reckoning October 25, 2019: All hell breaks loose. North Korea's state broadcaster announces that Kim Jong-un has been "incapacitated". It later turns out that the tubby tyrant was killed by a group of military officers. Having not slept for days, Kim had become increasingly erratic and paranoid. Convinced that he was surrounded by spies and that Trump had deployed a secret weapon to read his mind, he ordered the execution of many people in his inner circle. Fearing for their lives, his henchmen decided to strike first. October 31, 2019: North Korea's new military rulers signal a desire for closer relations with China and a less belligerent posture towards the South. Over the coming decades, historians will debate whether Trump's tactics were a reckless gambit that luckily paid off, or the work of a master strategist playing 3D chess while everyone else was playing backgammon. Trump himself wastes no time in taking credit for ousting the Kim dynasty. November 4, 2019: The relief investors feel from the ebbing of tensions in the Korean Peninsula does not last long. The turmoil in emerging markets intensifies. A series of high-profile defaults rock the Chinese corporate debt market. Copper and iron ore prices nosedive. Brent swoons to $39/bbl. November 5, 2019: The head of Brazil's central bank resigns after the government pressures it to increase its holdings of government bonds in an effort to ward off an imminent default. The Brazilian real falls to nearly 6 against the dollar. Other EM currencies plunge. The Turkish lira is particularly badly hurt. December 6, 2019: The pain on Wall Street finally spreads to Main Street. U.S. payrolls rise by only 19,000 in November. Subsequent revisions ultimately show a drop of 45,000 for that month. The NBER will eventually go on to declare November as the start of the recession. December 11, 2019: Having raised rates just three months earlier, the FOMC cuts rates by 25 basis points and signals that it is willing to keep easing if economic conditions deteriorate further. December 16, 2019: Markets initially cheer the prospect of lower rates, but the euphoria is quickly forgotten. Credit spreads soar as investors price in an increasingly bleak economic outlook. Commercial real estate prices fall. Banks further tighten lending standards. IV. A Global Recession December 19, 2019: The recession spreads around the world. The ECB ditches plans to raise rates. The U.K., Sweden, Norway, Canada, Australia, and New Zealand all cut rates. In the emerging world, Korea, Taiwan, and Poland reduce interest rates, but a number of other countries - most notably, Turkey, South Africa, and Malaysia raise rates in a desperate bid to prop up their currencies so as to keep the local-currency value of their foreign-currency obligations from spiraling out of control. December 31, 2019: The S&P 500 closes at 2194, down 21% for the year. Most other bourses fare even worse. The U.S. dollar, which peaked against the euro at $1.02 just six weeks earlier, finishes at $1.07. The 10-year Treasury yield closes at 2.37%, down 68 basis points on the year. The 10-year German bund yield falls back to 0.5%. January 11, 2020: In a surprise twist, WikiLeaks reveals that the CIA has found no credible evidence that Russia had any material influence over the 2016 elections, but that Putin has been trying to cultivate the impression that it did. The document disparagingly notes that "Putin has relished the U.S. media's characterization of him as a master political manipulator with global reach, when in fact he is just the ruler of an impoverished, demographically depleted, militarily overextended country." The Mueller probe fizzles out. January 27, 2020: Voting in the Democratic primaries begins. Kamala Harris, Elizabeth Warren, and Sherrod Brown lead a crowded field of hopefuls. Bernie Sanders and Joe Biden choose not to run. Brown enjoys the biggest lead against Trump in head-to-head polls, but his support among primary voters is weighed down by his status as a cisgendered white male. January 28, 2020: On the other side of the Atlantic, the U.K. holds another referendum - this one to ratify the separation agreement reached with the EU. The terms of the agreement are widely regarded as being highly unfavorable to the U.K. Prime Minister Corbyn, having formed a coalition government with the Liberal Democrats and the SNP following elections in late 2018, makes it clear that a rejection of the deal is tantamount to a vote to stay in the EU. With the British economy in the doldrums, 53% of voters reject the deal. The U.K. remains in the EU. EUR/GBP falls to 0.84. January 29, 2020: The Fed cuts rates by another 25 basis points. Hiking rates once per quarter was good enough when unemployment was falling. However, now that the economy is on the rocks, the Fed reverts to a more aggressive loosening cycle, cutting rates once per meeting. Even so, a growing chorus of voices both inside and outside the Fed argue that it is not doing enough. February 17, 2020: Kamala Harris and Elizabeth Warren pull out ahead in the Democratic primaries. Similar to the Clinton/Sanders duel in 2016, Warren polls best among younger, whiter voters, while Harris leads among minorities and establishment Democrats. March 10, 2020: Donald Trump, seeing his poll numbers tank after the post-Korea bump, unilaterally raises trade barriers across a wide variety of industries. Foreign producers retaliate, leading to a contraction in global trade. April 26, 2020: Warren's relentless characterization of Harris as a shill for moneyed interests pays off. The Massachusetts senator secures the Democratic nomination. Hollywood celebrities line up to support Warren. Taylor Swift's silence on the matter is deafening, leading to a further increase in her album sales. June 5, 2020: The U.S. unemployment rate surges to 5.1%. Corporate America sees a wave of business closings, with the retail sector being particularly badly hit. July 21, 2020: The bellwether German IFO index falls to a multi-year low. Germany's manufacturing sector feels the pinch from the collapse in demand for capital equipment, especially from emerging markets. Merkel's popularity plummets after it is revealed that she tried to suppress data that more than half of asylum seekers classified as children were actually adults. Support for the Alternative for Deutschland Party, which by this time has greatly moderated its anti-EU rhetoric, rises sharply. August 17, 2020: The trade-weighted yen continues to strengthen, pushing Japan deeper into recession. In response, the Japanese government announces a major new stimulus package. In the clearest attempt yet to link fiscal with monetary policy, the authorities pledge to start issuing consumption vouchers to households, the value of which will be incrementally increased until long-term inflation expectations rise to the Bank of Japan's 2% target. The policy proves to be a smashing success. September 9, 2020: The U.S. presidential campaign ends up being even more divisive than the one in 2016. Unlike four years earlier, equities rally at any glimmer of hope that Trump will win. However, with unemployment rising, such moments prove few and far between. September 22, 2020: Senator Warren states on the campaign trail that she will not renominate Jay Powell in 2022 for a second term as Fed chair if she is elected president. Lael Brainard's name is floated as a likely replacement. V. The Return Of Stagflation October 13, 2020: Green shoots appear in the U.S. economy, marking the end of the recession. The unemployment rate rises for another two months, peaking at 6.8% in December. Other economies also begin to turn the corner. November 3, 2020: The tentative improvement in U.S. economic data happens too late to bail out Trump. Elizabeth Warren wins the presidential election. Warren loses Ohio but picks up Pennsylvania, Michigan, and Wisconsin. An influx of Democratic voters from Puerto Rico puts her over the top in Florida. The Democrats take back control of the Senate. November 4, 2020: The S&P 500 barely moves the day after the election, having already priced in the outcome months earlier. Still, at 2085, the index is 26% below its February 2019 peak. December 2, 2020: President-elect Warren pledges to introduce a major spending package after she is inaugurated. She brushes off concerns from some economists that fiscal stimulus is coming too late, noting that the unemployment rate is more than three points higher than it was one year earlier. Stocks rally on the news. January 27, 2021: The FOMC votes to keep rates on hold at 1%. Lael Brainard dissents, arguing that further monetary stimulus is necessary. March 19, 2021: The Chinese government shifts more bad loans from commercial banks into specially-designed state-owned asset management companies. The banks generally receive well above-market prices for their loans. Chinese bank shares move higher. April 2, 2021: Congress proposes to significantly raise taxes on higher-income earners and corporations with more than 500 employees and use the proceeds to fund an expansion of the Affordable Care Act. It also promises to introduces a "Tobin tax" on financial transactions. The post-election stock market rally fades. June 8, 2021: In a seminal speech, Lael Brainard argues that current inflation measures fail to adequately correct for technological improvements and other methodological issues. She suggests that this leads to an overstatement of the true level of inflation. The implication, she concludes, is that an inflation target of 2.5%-to-3% would be consistent with the Fed's existing mandate. September 24, 2021: Many Trump-era deregulation measures are rolled back. Anti-trust efforts are also ramped up. Despite an improving economy, the S&P 500 sinks to 2031, marking a five-year low. November 17, 2021: A wave of panic selling grips Wall Street. The S&P 500 crashes to 1969, down 31% from its February 2019 peak. As is often the case, this marks the bottom of the equity bear market. The subsequent recovery, however, proves to be tepid and prone to numerous setbacks. January 31, 2022: Thanks to ample fiscal stimulus, inflation in Japan rebounds from its recession lows. Aggregate income growth slows as more Japanese workers exit the labor force, but spending holds up as health care expenditures continue to climb. Japan's current account moves into a structural deficit position. February 16, 2022: Lael Brainard succeeds Jay Powell as Fed chair. The decision by Republicans in 2013 to reduce the number of senators necessary to approve appointments to the Fed board from 60 to 51 ensures smooth sailing for Brainard during congressional hearings and the confirmation of a slew of highly dovish candidates over the subsequent two years. April 6, 2022: China belatedly introduces modest financial incentives to encourage couples to have more children. The public jokingly dubs this as the new "at least one child policy". It ends up having little effect. Future Chinese scholars will end up describing China's failure to arrest the decline in its population as its greatest geopolitical blunder. July 20, 2022: The U.S. becomes the latest country to introduce strict restrictions on the use of bitcoin. Although the U.S. government never says so, fears that bitcoin and other cryptocurrencies will eat into the $75 billion in seigniorage revenue that the Treasury earns every year underpins the decision. The price of bitcoin falls to $550, down 95% from its all-time high. September 29, 2022: Japan officially abandons its yield-curve targeting regime. The 30-year yield rises to 2.5%. Faced with onerous long-term debt-servicing costs and stagnant tax revenues, the government starts refinancing much more of its debt through short-term borrowings. The Bank of Japan obliges, keeping short-term rates near zero. The combination of negative short-term real rates and higher inflation allows Japan to reduce its debt-to-GDP ratio over time. This proves to be the modus operandi for Japan and many other fiscally-challenged governments over the coming decades. October 18, 2022: Productivity growth in most developed economies continues to disappoint. For the first time in modern history, the flow of new workers entering the labor force are no better skilled or educated than the ones leaving. With potential GDP growing at a lackluster pace, output gaps disappear, setting in motion the acceleration in inflation over the remainder of the decade. The U.S. 10-year Treasury yield rises to 4%. It will be over 6% by the middle of the decade. November 22, 2022: The price of gold surpasses its previous high of $1895/oz. The 2020s turn out to be an excellent decade for bullion. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Chart 1Market Outlook: Equities Chart 2Market Outlook: Bonds Chart 3Market Outlook: Currencies Chart 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Idea 2: Long EUR/USD Idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Feature Question 1: Where Is The Worrying Imbalance? Last week, in the Quantum Theory Of Finance,1 we pointed out that when bond yields reach ultra-low levels, the payoff profile from bonds becomes highly asymmetric. When yields approach a lower bound, they cannot fall much further but they can rise a lot. Meaning that bond prices have very limited potential for gains, but have great potential for sudden and deep losses. Chart of the WeekThe Norway Versus Euro Area Bond Yield Spread Is Too Wide The unattractive asymmetric payoff profile - known as negative skew - applies to both nominal and real returns. This is because negative skew is concerned about deep nominal losses over a relatively short period. In which case, a deep nominal loss will be a deep real loss too.2 As equity returns always possess negative skew we can say that at ultra-low bond yields, bond risk becomes equity-like. Given this risk equalization, equities no longer justify a risk premium over bonds. And the lower prospective return required from equities means that today's equity valuations and prices become a lot richer. But the new delicate balance of valuations is conditional on bond yields remaining ultra-low. This is because the unattractive negative skew on a 10-year bond's returns disappears when its yield moves up into the 'high 2s' (Chart I-2). At this point, risk is no longer equalized and the equity risk premium must fully re-emerge - requiring today's equity market valuation and price to drop, perhaps substantially. However, the ensuing fight to havens would then once again pull bond yields back down from the 'high 2s'. It follows that the rise in expected interest rates is self-limiting. Any policy interest rate expectation already in the 'high 2s' - such as the Eurodollar December 2022 contract - cannot sustainably rise much further, whereas those that are still some way below - such as the Euribor December 2022 contract - can (Chart I-3). Which leads to our first investment idea. Chart I-2Bonds Become Much More ##br##Risky At Ultra-Low Yields Chart I-3The Euro Area/U.S. Interest Rate Expectation ##br##Spread Is Too Wide Investment idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Question 2: Which Is The Safest Currency To Hold? Chart I-4Euro/Dollar Just Tracks ##br##The Bond Yield Spread To reiterate, at ultra-low bond yields, bond returns offer a highly unattractive payoff profile. Put simply, you can quickly lose a lot more money - in both nominal and real terms - than you can make! Now observe that the payoff profile for a foreign exchange rate just tracks the bond yield spread (Chart I-4). This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive payoff profile called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, the direction of policy rate expectations cannot go significantly lower. Conversely, policy rate expectations for the Federal Reserve (for 2022) are not far from our upper bound of the 'high 2s'. So these expectations cannot go significantly higher without threatening a risk-asset selloff. On this basis, EUR/USD has more scope to gap up than to gap down. Investment idea 2: Long EUR/USD But be aware that investment ideas 1 and 2 are highly correlated with each other! Question 3: Where Are We In The Global Growth Mini-Cycle? Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May we can infer that it is likely to end in early 2018. So one surprise in 2018 could be that global growth slows in the first half rather than in the second half - contrary to what the consensus is expecting. That said, half-cycle lengths do have some degree of variation: the current upswing might be a few months longer or shorter than the average. So how can we avoid positioning too early or too late for the next turn? The answer is to focus on investments that have already fully priced the current upswing, so that timing becomes less of an issue. On this basis, we propose that the rally in industrial metals and Basic Materials equities is already extended. Our technical indicator which captures herding and groupthink correctly identified the trough at the end of 2015, the mini-peak at the end of 2016, and is now signalling that the latest rally is likely to fade (Chart I-5 and Chart I-6). Chart I-5Metals Have Fully Priced ##br##The Mini-Upswing... Chart I-6...And The Metal Rally Is Reaching##br## Its Technical Limit Investment idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Question 4: Will Inflation Lift Off? The ECB's continued indulgence with ultra-loose monetary policy would make you think that the euro area is on the edge of a deflationary abyss. In fact, inflation has been running comfortably within a 0-2% band for almost two years. Will inflation edge closer to the ECB's 2% point target? Given our view on the growth mini-cycle, not immediately. In the first half of 2018, inflation may even edge lower within the 0-2% band, but this global dynamic will affect inflation in all jurisdictions, not just in the euro area. There is nothing wrong with inflation running comfortably within a 0-2% band. Now that we know that nominal interest rates can go slightly negative, a 0-2% inflation band even permits negative real interest rates. The big mistake is to aim for an arbitrary point target, like 2%. This is because inflation is a non-linear phenomenon, and a defining characteristic of a non-linear phenomenon is that it cannot hit an arbitrary point target.3 It is our high conviction expectation that the major central banks will eventually change their point targets for inflation into target bands such as 0-2% or 1-3%. But afraid to lose credibility, they will not change tack abruptly. In the meantime, we notice that the Norges Bank is undershooting its 2.5% inflation target by considerably more than the ECB is undershooting its 2% target (Chart I-7). Yet the yield spread between Norwegian and euro area bonds has not caught up with this reality (Chart of the Week). Chart I-7The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB Investment idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Question 5: Will Political Risk Re-emerge? Political events have had a hand in three of the sharpest recent moves in financial markets. The vote for Brexit catalysed a 15% decline in the pound; the vote for Trump triggered an 80 bps spike in the 10-year T-bond yield, and the vote for Macron unleashed a 10% rally in the euro. Political change disrupts markets if it dislocates the long-term expectations embedded in economic agents and financial prices. The vote for Brexit changed expectations about the U.K.'s long-term trading relationships; the election of Trump changed expectations about fiscal stimulus, the tax structure, and protectionism (perhaps unrealistically); and the election of Macron exorcised the potential chaos of a Le Pen presidency. Chart I-8The U.K. Versus Ireland Bond ##br##Yield Spread Is Too Wide In contrast, the recent (disputed) vote for independence in Catalonia, and the breakdown of coalition discussions in Germany barely moved the markets - because neither event changed expectations of long-term economic outcomes. As investors, this is the test we should apply to all political events. In 2018, the evolution of Brexit has the potential to move markets. This is because hard Brexiters and the EU27 are on a collision course. Specifically, the issue of the Irish border is insoluble. It is Brexit's Gordian knot. Theresa May has promised the hard Brexiters that the U.K. will leave the EU customs union and single market. She has also promised the Northern Ireland Unionists - who are propping up May's minority government - that there will be no hard border between Northern Ireland and the Republic of Ireland or the rest of the U.K. But these promises are irreconcilable. The Republic of Ireland will veto a border that threatens the Good Friday peace agreement; the Northern Ireland Unionists will not tolerate the border moving to the Irish Sea, which would effectively take Northern Ireland into the EU customs union and single market; and the EU27 will block a Hong Kong type 'free port' status for Northern Ireland - as this would remove the integrity of harmonized standards across the EU. Eventually, the impenetrable Irish border problem is likely to be the roadblock to a hard Brexit. But first there needs to be a collision. And the collision could move markets. With the yield spread between U.K. 10-year gilts and Irish 10-year bonds near a 2-year wide (Chart I-8), this leads us to our fifth investment idea. Investment idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Quantum Theory Of Finance' November 23 2017 available at eis.bcaresearch.com. 2 For example if the nominal return over 3 months was a very painful -10%, and inflation was running at -10% per annum, the real return over 3 months would be a still very painful -7.5%. 3 Please see the European Investment Strategy Weekly Report 'Three Mantras For Investors' August 17 2017 available at eis.bcaresearch.com. Fractal Trading Model* Ahead of the OPEC meeting on November 30, the WTI crude oil price is vulnerable to any disappointment - because its rally is technically very extended. This week's trade recommendation is to expect a retracement of 7.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations