Financial Markets

Highlights The global 6-month credit impulse is now in its longest upcycle in a decade. Given also that bond yields have had their sharpest spike in a decade, we would not bet on the upcycle lasting much longer. Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500. Underweight the IBEX versus the Eurostoxx600. Feature A few days into the New Year, two over-arching economic questions are exercising our minds. Is the relationship between sharply higher bond yields and weaker bank credit creation still valid? And is the relationship between weaker bank credit creation and decelerating economic growth still valid? Chart of the WeekCredit Impulses Heading In Different Directions We suspect the answers are yes and yes. European Investors Must Think Globally, Not Locally Europe is not an investment island. Major European stock market indexes comprise large multinational companies whose sales and profits come from across the world. The upshot is that European stock markets almost always move up and down in tandem with other major world stock markets, such as the S&P500 and Nikkei225 (Chart I-2). Mainstream bond markets might seem to be more parochial, given that they are supposedly under the influence of the local central bank. But investors buy and sell high quality bonds as a global asset class. The upshot is that European bond markets also almost always move up and down in tandem with other major developed bond markets (Chart I-3). Chart I-2Major Equity Markets Move Together Chart I-3Major Bond Markets Move Together Hence, European investors must look first and foremost at global drivers. For us, the most important such driver is the global 6-month credit impulse - which sums the 6-month (dollar) credit impulses in the euro area, the United States and China. Does the global 6-month credit impulse have any predictive power? Yes. Chart I-4 shows that it has consistently led the 6-month cycle in the global government bond yield, which is a good proxy for the global growth cycle. Admittedly, this powerful predictive relationship weakened somewhat through 2013-14 during the most aggressive and distortive phase of worldwide QE. However, in the past couple of years, as QE has waned, the global 6-month credit impulse's predictive power has strongly re-asserted itself (Chart I-5). Chart I-4The Credit Impulse Leads ##br##The Global Growth 'Mini-Cycle' Chart I-5The Credit Impulse's Predictive ##br##Power Has Re-Asserted Itself In effect, the charts illustrate that whatever the structural economic backdrop, the global economy experiences a perpetual 'mini-cycle' lasting about 15-24 months. Higher bond yields (or credit restrictions) weaken the credit impulse; the weaker impulse then depresses growth; the depressed growth lowers bond yields; lower bond yields (or credit easing) strengthen the credit impulse; the stronger impulse then boosts growth; the boosted growth lifts bond yields; and back to the beginning... Remember, the credit impulse measures the growth in the credit flow. The important point to grasp is that the impulse can weaken even if the credit flow numbers themselves seem strong. For example, if the credit flow increased from $100bn to $150bn to $190bn it might appear to be growing very healthily. But actually, the impulse would have weakened from $50bn to $40bn, creating a headwind. Where are we in the perpetual mini-cycle? Today, the euro area credit impulse is losing momentum, while the U.S. impulse is waning. Which leaves China's rising credit impulse as the only component supporting the global credit impulse (Chart of the Week). But for how much longer? To repeat, it would just take the global credit flow to decelerate for the impulse to roll over. Now consider that high-quality bond yields have had their sharpest 6-month spike in a decade. And that the current 10 month upcycle in the global credit impulse already makes it the longest in a decade. Hence, we would not bet on this mini-upcycle lasting much longer. A Few Words On Our Credit Cycle Framework Our credit cycle framework has several features which uniquely define it. First, the framework focusses on bank credit. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody's spending power has to go down. In contrast, when somebody borrows by issuing a bond, it merely reallocates spending power from one person to another person. The borrower sees his bank account and spending power go up, but the lender sees his bank account and spending power go symmetrically down. Spending will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, as already discussed, the framework focusses on the bank credit impulse - which measures the growth in the bank credit flow. This is just to compare apples with apples. Remember that GDP is itself a flow statistic. So the growth in GDP receives a contribution from the growth in the credit flow1 (and not from the flow itself). Third, the framework focusses on the 6-month bank credit impulse. We choose this periodicity because 6 months is about the time that it takes to for credit to be fully spent, thereby yielding the greatest predictive power from the credit impulse to economic activity. Fourth, the framework calculates the credit cycle using bank credit to the non-financial sector2 rather than the more commonly-quoted money supply statistics such as euro area M3. The simple reason is that not all loans generate economic activity. Bank to bank lending may stay trapped in the financial system. The money supply - which is on the liabilities side of the banks' balance sheet - would not pick up this distinction. As M3 captures all bank deposits, it would still be expanding rapidly, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending - which is on the assets side of the banks' balance sheet - and only count lending that is likely to generate economic activity (Chart I-6). This reasoning only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. But unofficial shadow lending must eventually show up in the money supply. Therefore, exceptionally for the China sub-component, our credit cycle framework does prefer to use the money supply (Chart I-7). Chart I-6Our Euro Area Credit Impulse##br## Uses Bank Lending... Chart I-7...But Our China Credit Impulse ##br##Uses Money Supply A Few Words On Our Reductionist Framework We are also strong believers in Investment Reductionism. This philosophy stems from two guiding principles: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle - which says that 80% of effects come from just 20% of causes.3 The important point is that most of the moves in most financial markets result from a very small number of over-arching macro drivers. To reiterate, Europe is not an investment island. Investment Reductionism means that much of asset allocation, sector selection, and regional and country allocation distills down to getting the global growth cycle right. The remaining charts should leave readers in no doubt. Chart I-8 shows that the global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset class selection. Chart I-9 then shows that the direction of bond yields determines sector selection: for example Banks versus Technology. Chart I-8Investment Reductionism Step 1: The Global##br## Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield ##br##Drives Sector Selection Chart I-10 and Chart I-11 then show that the sector selection of Banks versus Technology determines both the regional allocation of Eurostoxx600 versus S&P500, and the country allocation of IBEX versus Eurostoxx600. Chart I-10Step 3: Sector Selection Drives##br## Regional Allocation Chart I-11Step 4: Sector Selection Drives ##br##Country Allocation To sum up, the global 6-month credit impulse is now in its longest up-cycle in a decade, and bond yields have had their sharpest spike in a decade. Hence, we would not chase cyclicality at this juncture. Which means that on a 6-month horizon: Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500.4 Underweight the IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Equivalently, the credit impulse is the growth in the growth (second derivative) of the credit stock. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Often known as the 80-20 rule. 4 BCA Strategists differ on this position. Fractal Trading Model* This week's trade is to express a tactical short in equities via Italy's MIB. An alternative market-neutral trade is to go short Italy's MIB and symmetrically long Hong Kong's Hang Seng. * 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 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-12 Chart I-13 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

Special Report

"That as the only possible policy in our day for a conqueror to pursue is to leave the wealth of a territory in the complete possession of the individuals inhabiting that territory, it is a logical fallacy and an optical illusion in Europe to regard a nation as increasing its wealth when it increases its territory, because when a province or state is annexed, the population, who are the real and only owners of the wealth therein, are also annexed, and the conqueror gets nothing." 1 Norman Angell's "The Great Illusion" posited in the early 1910s that war would be futile for developed nations, especially given the rising importance of economic and financial ties. Nevertheless, the arms race from the late-1800s gained momentum and eventually led to the Great War, dealing a devastating blow to his arguments. The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. Not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc (Chart 1).2 The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service has shown to be a key investment theme.3 Chart 1U.S. Defense Spending Is More Than The Rest Of The World Combined While we are not arguing that WWIII will erupt in the coming years, the purpose of this Special Report is to identify the winning global equity sectors from the intensifying global arms race (Chart 2): global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the U.S. defense stocks are the only game in town, but undiscovered Chinese, and to a lesser extent Russian, defense stocks are intriguing as are Israeli defense and tech stocks (please refer to the Appendix below for ticker symbols). Chart 2Intensifying Global Arms Race Late 19th/Early 20th Century: Militarism, Globalization & Finance Back in the late-1800s, the ascendancy of Germany was challenging the hegemony of Britain, fueling a European-wide arms race. Smaller newly formed states were also on the hunt for the latest and greatest weaponry. During the Balkan Wars of 1912-13 airplanes were deployed in combat for the very first time, highlighting the importance of new technology. Behind this explosive European rearmament were a few large British companies (Vickers Sons & Maxim Ltd, Armstrong and Whitworth, and Coventry Ordnance Works). "By 1905, its capital of £7.4 million ranked Vickers sixth amongst British companies; Armstrong Whitworth, with 5.3 million pounds capital was eleventh".4 Basil Zaharoff, who acted as general representative for business abroad for Vickers,5 was reputedly one of the richest men in the world.6 Moreover, globalization was on the rise in the late 19th century, as evidenced by global imports as a percentage of GDP (Chart 3). Industrialization coupled with imperialism and the colonization of Asia and sub-Saharan Africa along with population growth and rising demand for commodities were key drivers behind the jump in 19th century globalization. Finally, all of this was made possible by cross-boarder finance. Trade finance and credit growth skyrocketed in the late-1800s and the rising interconnectedness of global financial centers was most evident in the 1907 stock market panic that originated in the U.S., but spread like wildfire to the rest of the world. Chart 3Twin Peaks Of Globalization? Chart 4Heeding The Early 1960s Parallel What About The 1960s? The idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis (Chart 4), bolstering demand once again for military contractors. The mutually assured destruction (MAD) doctrine of military strategy and national security policy declared overtly in the early-1960s by U.S. defense secretary Robert McNamara and the Space Race competition between the Cold War rivals also have striking similarities with today, as far as investment implications are concerned. Parallels With Today China's ascendency to a world power large enough to challenge the hegemony of the U.S. is a sea change.7 The rearmament of East Asia is reminiscent of late 19th and early 20th century Europe and involves Japan, Australia, South Korea, Vietnam and India. All of the Middle East, along with Turkey and Russia, are on a structural military spending spree. European NATO fringe states are also arming furiously (Chart 5), trying to thwart Russia's regional ambitions. In the U.S., despite the Budget Control Act of 2011 (sequestration), the CBO projects that defense spending will rise gradually from $586 billion in 2015 to $739 billion by 2026 (Chart 6). This is before any push for a fiscal spending thrust that both presidential candidates have proposed, which would include increased defense outlays. While as a percentage of GDP defense spending may drift sideways, in absolute terms it will likely rise, and thus boost demand for defense contractors. Chart 5Stealthy Rise In Defense Outlays Chart 6CBO Estimates New Defense Spending Highs Globalization has hit an apex recently (Chart 3).8 The world is still licking its wounds from the recent GFC, where U.S. financials stocks were so intertwined with their global peers that the crisis effectively brought down to its knees the global financial system and gave birth to unorthodox monetary policy that Central Banks are still currently deploying. Global Rearmament Beneficiaries If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global defense stocks as a structural bet will pay handsome dividends. The global push away from austerity and toward more fiscal spending should also support aggregate defense demand. Thus, there are high odds that global defense stocks are primed to deliver absolute positive returns, irrespective of where the broad global equity market drifts in the next five years. Similar to Vickers and Armstrong and Whitworth making impressive stock market strides early last century, global defense stocks should continue to be high flyers. The early-1960s U.S. aerospace & defense (A&D) stocks are the only close stock market parallel we have come across in our analysis (given data constraints) and comparing this index's available metrics of that era with today is in order. A big pushback to the U.S. Equity Strategy service's constructive view on the U.S. defense index (since the late-2015 inception) has been that the valuations of these stocks are already full, leaving no valuation cushion for any mishaps (Chart 7). True, defense stocks are on the expensive side, but not if they manage to grow into their valuations, as we expect. Relative performance was up over 100% in a span of four years in the 1960s (Chart 8), as U.S. aerospace & defense industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95% (Chart 8). A&D factories were humming, racing to fulfill orders as U.S. military expenditures were thriving (Chart 4). Chart 7Buy Global Defense Stocks Chart 8In The 1960s A&D Factories Were Humming... This demand surge translated into a jump in sector sales momentum (Chart 4), and given the industry's high operating leverage, earnings and book values soared. From trough to peak, sector EPS rose more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled (Chart 9). That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the global defense index (that is a pure play on global defense spending). For comparison consistency, we use U.S. A&D figures. Currently, U.S. A&D IP is contracting, with resource utilization running at 80%. U.S. A&D relative performance has risen a mere 30% since the Great Recession (Chart 10). Chart 9...Boosting The Allure Of ##br## A&D Stocks Chart 10If History At Least Rhymes, ##br## There Is Still Ample Upside... Likely, the advance is still in the early innings, and analysts have been very slow to upgrade their EPS estimates accentuating the apparent overvaluation. Importantly, 5-year forward relative EPS growth estimates are deep in negative territory which is very perplexing given the upward trajectory of industry demand (Chart 11). Given that we only have access to data for MSCI All-Country World aerospace & defense long-term EPS expectations the caveat is that some of the poor expectations and performance could be because of the waning aerospace delivery cycle. Unlike the deteriorating health of the broad corporate sector, profit margins are expanding and net debt-to-EBITDA is a comfortable 1.2x. Similarly, interest coverage ratio is near an all-time high of 8x (Chart 12), while the overall markets EBIT/interest expense ratio is half that. Chart 11...Especially ##br## Given Depressed Analysts' Expectations Chart 12Defense ##br## Wins Championships Global defense sector return on equity (ROE) is almost 30% and rising (Chart 13), whereas global non-financial corporate (NFC) ROE is hitting multi-year lows, with the U.S. NFC ROE plumbing all-time lows (Chart 14). Free cash flow is also growing briskly and the industry is making greenfield investments, with capex growing 9.5% year-over-year, the mirror image of the global NFC sector that is pruning capital outlays (middle and bottom panels, Chart 13). Chart 13Defense Flexing ##br## Its Muscles... Chart 14...Vs. The Atrophy In The U.S. ##br## Non-Financial Corporate Sector On the valuation front, modest overvaluation exists, as portrayed by the high relative price-to-cash flow and price-to-book multiples. However, the global defense stocks forward P/E ratio and EV/EBITDA multiple are on an even keel with the broad market (Chart 15), and if our thesis that a secular uptrend in defense-related demand looms proves accurate, then these stocks are not expensive, but on the contrary still represent a buying opportunity. Chart 15Mixed Signals On The Relative Valuation Front Chart 16Defense Is The Best Offense The Rise In Terrorism, Global Space Race And Cyber Security Threat The unfortunate structural increase in terrorist activity will also embolden governments around the world to step up defense spending (top panel, Chart 16).9 The latter tends to move in long cycles. U.S. defense industry revenues have already begun to outpace those of the overall S&P 500, and a prolonged upturn lies ahead, based on the message from the previous upcycle. From a cyclical perspective, the defense capital goods shipments-to-inventories ratio is outpacing the overall manufacturing sector (second panel. Chart 16), reinforcing the case for ongoing earnings outperformance. The same also holds true in Europe. Western European terrorist attacks have increased, heralding further relative gains for the euro area aerospace & defense index (bottom panel, Chart 16). Beyond the disastrous spike in terrorism, the global space race is also gaining traction, with China spearheading the charge. There is a good chance that China will attain geosynchronous orbit satellites (residing more than 20,000 miles above the earth), challenging U.S. space dominance. India's space aspirations are grand and it is slowly and stealthily rising up the ranks on the space race. Moreover, as more countries aim to have manned space missions, that translates into higher space budgets and thus firming demand for space-related expenditures (Chart 17). Chart 17Space, The Final Frontier Finally, the number of cyber-attacks is also on the rise globally. Defending against attacks is a challenge. Not only does the cyber space domain definition remain elusive, but tracking hackers down is also increasingly difficult given the vastest of the internet, lack of global uniform policing methods and physical country borders. Crudely put, it is a lot easier for a Chinese or Russian hacker to deal a blow, for example, to U.S. nuclear infrastructure rather than physically deliver an attack. All of this suggests that investment in anti-hacking and counter cyber-attack capabilities is necessary around the globe in order to thwart cyber-terrorism. Risks To Our View While there is conceivably a risk that China will abruptly halt its intense militarization and make a U turn in its long-term strategy of becoming a military superpower, we assign a very low probability to such a turn of events. The global push for more fiscal spending may not materialize, which would be a risk to our sanguine global defense spending view. As Paul Volcker and Peter Peterson recently opined in a NY Times article10 - offering a different view from the always-articulate Larry Summers - prudent and fiscally responsible spending is in order given the excessive debt-to-GDP ratio that is probing war-like levels (Chart 18). This excessive debt overhang is not only a U.S. phenomenon, but also a global one spanning both advanced and emerging economies. Chart 18Excessive Debt Is A Risk To Bullish View On Global Defense Stocks One final risk is that the world will enter a prolonged peace phase and global terrorism will get quashed, with conflicts dying down in the Middle East, Russia reining in its imperialistic ambitions and China ceasing to stir the waters in the South and East China Seas. We would also assign low odds to this optimistic "no conflict phase" scenario, but it would indeed be welcome. Investment Conclusion Factors are falling into place for a structural outperformance period in the global defense index. The early-1900s and early-1960s parallels, coupled with the trifecta of terrorism, space race and cyber security all point to upbeat demand for defense-related goods and services. Expressing this buoyant view can be done from a bottom up perspective. The Appendix below highlights all the companies in the global defense index we track from Datastream and the alternative one from Bloomberg. An investable proxy is the U.S. aerospace & defense index as the U.S. dominates global A&D indexes and aerospace outfits also sport significant defense corporate segments (please see the Appendix below for relevant tickers). There are also three fairly liquid ETFs mimicking the U.S. A&D index: ITA:US, PPA:US & XAR:US. Moreover, below are a few more speculative investment ideas. Given China's dominance of global defense spending (ex-U.S.) we are confident that Chinese A&D stocks will also be eagerly sought after and deliver alpha in the coming years (please refer to the Appendix below for a list of China plays). If one has the resilience and the stomach to invest in Russian equities given high political and currency risk, then Russian A&D stocks may be a desirable vehicle. Russia remains a massive weapons exporter with a large sphere of influence. We would not underestimate the returns in local currency of some Russian A&D stocks (the Appendix below lists some Russian A&D listed firms). Finally, Israel A&D and IT companies either listed on NASDAQ or domestically in Tel Aviv offer some great opportunities for investors that can handle riskier investments. Not only Israel's geography, but also its intense IT/military focus and entrepreneurial culture imply that a number of these companies will be long-term winners (please see the Appendix below for relevant tickers). While most of the drones, space-related, and highly specialized IT companies are private, there is a drone and an anti-hacking ETF (IFLY:US & HACK:US). On the space front, we are tracking an index that comprises a number of space-related constituents that we show in the Appendix below. Nevertheless, most of these companies are categorized under A&D. Bottom Line: We are initiating a structural overweight in the global defense index with a longer-than-usual five year secular investment horizon. The re-rating phase in this index is still in the early innings. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com Appendix Table A1BI Global Defense Primes Competitive Peers Table A2World Defense Index (DS: DEFENWD) Table A3S&P 500 Aerospace & Defense Index ##br## (S5AERO Index) Table A4China ##br## Aerospace & Defense Table A5Russia & Israel Aerospace & Defense Table A6Kensho Space Index 1 Angell, Norman (1911), The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, (3 ed.), New York and London: G.P. Putnam's & Sons. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com 3 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com 4 Angell, Warren, Kenneth (1989), Armstrongs of Elswick: Growth In Engineering And Armaments To The Merger with Vickers, London, The Macmillan Press Ltd. 5 http://www.oxforddnb.com/index/38/101038270/ 6 https://www.britannica.com/biography/Basil-Zaharoff 7 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com 8 Please see BCA Geopolitical Strategy, "The Apex Of Globalization - All Downhill From Here," in Monthly Report, "Winter Is Coming," dated November 12, 2014, available at gps.bcaresearch.com 9 Please see BCA Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gps.bcaresearch.com 10 http://www.nytimes.com/2016/10/22/opinion/ignoring-the-debt-problem.html?_r=0

Highlights Will inflation return in Europe & Japan? Can Trumponomics successfully boost U.S. economic growth? Will global market volatility remain this low? Can China avert a crisis and still be the engine of global growth? Feature With a New Year now upon us, fixed income investors are trying to determine what the next move is for global bond yields after the rapid rise at the end of 2016. While much has been made of the impact of the 2016 U.S. election result on the global bond rout, many other important factors will drive fixed income markets this year (Chart of the Week). In our first Weekly Report of the New Year, we present our list of the most important questions for global bond markets in 2017. Chart 1The Big Questions For 2017 Chart 2Taper Tantrum 2.0? Will Inflation Return In Europe & Japan? Extremely low inflation in the Euro Area and Japan over the past few years has forced both the European Central Bank (ECB) and Bank of Japan (BoJ) to pursue exceptionally accommodative monetary policies like negative interest rates and large scale quantitative easing (QE) programs - the latter acting to depress bond term premia among the major developed markets. Much of this decline in headline inflation in both regions was due to the 2014/15 collapse in oil prices and the previous strength in both the euro and yen (Chart 2), but core inflation and wage growth have also been subdued. If headline inflation were to move higher in either Europe or Japan, it could call into question the central banks' commitment to continue hyper-easy monetary stimulus programs. This could raise the threat of another "taper tantrum" in developed bond markets later in 2017. The recovery in global energy prices in 2016, combined with significant currency depreciations related to ECB/BoJ QE, have boosted the annual growth in the local currency price of oil to 72% in the Euro Area and 63% in Japan. Already, headline inflation measures have begun to move higher in response and, judging by past relationships, a move up to 2% headline inflation in both regions by year-end is possible. In Chart 3 & Chart 4, we present simulations for headline inflation in both the Euro Area and Japan assuming the only changes come from movements in oil prices, the euro and the yen. We show two scenarios where the Brent oil price rises to $65/bbl (the high end of the range expected by our commodity strategists in 2017) and $75/bbl (an extreme scenario). In both simulations, the euro and yen continue to weaken versus the U.S. dollar until mid-2017 before recovering to near current levels by year-end. Chart 3Euro Area Inflation Simulation Chart 4Japan Inflation Simulation Our simulations show that headline inflation in both the Euro Area and Japan could rise to at least the 2% level, and perhaps even higher, if oil prices continue to climb and both the yen and Euro weaken towards 125 and parity versus the U.S. dollar, respectively. Given our views on the likely path of interest rates in the U.S. - higher, as the Fed continues hiking rates - the U.S. dollar is likely to strengthen more in 2017. The oil price moves incorporated in our simulations are somewhat more bullish than our base case expectation, but not extraordinarily so. If there are any upside surprises to global growth this year, oil prices could show surprising strength given the production cutbacks occurring in many of the major oil exporting nations. Higher inflation would be welcome by both the ECB and BoJ, especially if it were accompanied by a rise in inflation expectations. Both central banks have acknowledged the role played by low realized inflation in recent years in depressing expected inflation, but the latter could move up surprisingly fast if the markets believe that either central bank will be slow to respond to the rise in realized inflation. That seems like more of a risk in Japan, where the BoJ is aiming for an overshoot of its 2% inflation target and is promising to keep the Japanese government bond (JGB) curve at current levels until that point is reached. The ECB would be much more likely to make the decision to begin tapering their bond purchases if Euro Area inflation approaches 2%. We see this as the biggest potential threat to global bond markets in 2017 - even more than the expected Fed rate hikes, which are already largely priced into the U.S. yield curve. The ECB was able to successfully kick the tapering can down the road last month by choosing to extend its QE program to the end of 2017, but a decision to defer tapering again will be much harder to make if Euro Area inflation is closer to 2%. If the ECB were to announce a taper later in 2017, this would be very damaging for the long ends of yield curves in the developed markets as bond term premia would begin to normalize - perhaps very rapidly. There is more room for adjustment for term premia in core Euro Area government bonds relative to U.S. Treasuries. An ECB taper announcement, or even just expectations of it, would mark the peak in the spread between U.S. Treasuries and German Bunds which is now at the highest levels in a quarter century. Given the busy upcoming election calendar in the Euro Area, the ECB will not want to even mention the word "taper" until later in the year. Until then, owning inflation protection in Europe, and Japan as well, is the best way to position for upside surprises in inflation in those regions. Bottom Line: Rising inflation in the Euro Area and Japan in 2017 will prompt a rethink of the hyper-easy monetary policies of both the ECB and BoJ, but only the former is likely to consider a taper of its bond purchase program this year. That decision would push global bond yields higher via wider term premia and cause Euro Area government bond markets to underperform U.S. Treasuries, but not until later in the year. Can Trumponomics Successfully Boost U.S. Economic Growth? After a long and divisive U.S. election campaign, the curtain is about to officially be raised on the Trump era on January 20. In anticipation of a more pro-growth agenda from the new president, investors have already bid up the valuations of assets sensitive to U.S. economic growth, like equities and corporate bonds, while also driving up both U.S. Treasury yields and the U.S. dollar. Chart 5Time To Spruce Up U.S. Infrastructure Markets are now discounting a fairly rosy scenario for a solid "Trump bump" to U.S. economic growth in 2017. This is to be expected, given that the president-elect won the White House on a platform full of promises to, among other things, boost government infrastructure spending, cut corporate taxes, tear down excess regulations on U.S. companies and adopt a more protectionist U.S. trade policy. In terms of a direct impact to U.S. GDP growth, there are three obvious places where the economic plan of Candidate Trump could turn into stronger growth this year for President Trump: government fixed investment, net exports and private capital expenditure. Trump's infrastructure plans have received much of the attention from those bullish on U.S. growth in 2017; unsurprising given the proposed size of the proposals ($550 billion). This stimulus would appear to be a source of low-hanging fruit to boost U.S. economic growth, as years of underinvestment has left America with an aging government infrastructure in need of an upgrade (Chart 5). Yet the boost to growth from government investment spending has historically not been large, adding between 0.25% and 0.5%, at most, over the past 40 years (bottom panel). Trump's proposed figure of $550 billion would fit right in with that experience, as it would represent 0.3% of the current $18.6 trillion U.S. economy. That assumes that all the proposed infrastructure spending occurs in a single year. Given the usual long lead times for big government infrastructure projects, and the discussions between the White House and the U.S. Congress over the scope and funding of any major government spending initiative, it is highly unlikely that the direct effect of more infrastructure spending will provide much of a boost to U.S. growth in 2017. That impact is more likely to be seen in 2018. A boost to growth from trade is also possible given Trump's fiery protectionist election rhetoric and his decision to nominate China hawks for major cabinet positions. It is unclear if Trump is willing to risk entering a trade war with China (or even Mexico) by raising import tariffs soon after taking office. It is even more uncertain if this will provide much of an immediate lift to U.S. net exports, if tariffs merely raise the cost of imports without any material substitution to domestically produced goods and services. Even if it did, trade has rarely contributed positively to real U.S. GDP growth outside of recessions since 1960. That leaves private fixed investment as the biggest potential source of new growth in the U.S. in 2017. Trump is proposing a cut in the U.S. corporate tax rate from 35% to 15%, while the Republican plan already set out by House Speaker Paul Ryan is calling for a cut to 25%. Both sides also are in favor of a lower "repatriation tax" on corporate profits held abroad, at a rate of 10-15%. So with all parts of the U.S. government in agreement, a move to cut corporate taxes appears to be a near certainty. In the past, efforts to initiate comprehensive tax reform have been not been done quickly in Washington. Our colleagues at BCA Geopolitical Strategy, however, believe that a deal between the White House and Congress could happen in the first half of 2017. The details of the other major policy initiatives that Trump wants done early in his first term - repealing and replacing Obamacare, and the infrastructure spending program - will be much harder to iron out than a tax cut on which both Trump and the Republican Congress agree. Doing the tax reform first will be the easier choice for a new president.1 Cutting corporate taxes seems like a move that should help boost U.S. private investment spending, as it would raise the after-tax return on capital. However, investment spending has already been underperforming relative to after-tax cash flows since the 2008 Financial Crisis, and the effective tax rate paid by the U.S. corporate sector is already much lower than the 35% marginal tax rate (Chart 6). Something else besides tax levels has been weighing on U.S. corporate sentiment with regards to capital spending intentions. It may be that the burden of excess government regulations, which has soared during the years of the Obama administration (bottom panel), has dampened animal spirits in the U.S. corporate sector. On that front, Trump's proposals to slash regulations - none bigger than repealing Obamacare - could help boost business confidence and fuel an upturn in capital spending. Chart 6A Regulatory Burden, Not A Tax Burden Chart 7Making Corporate America Happy Again Some rebound in capex was likely to occur, Trump or no Trump, given the recent improvement in U.S. corporate profits (Chart 7, top panel). This is especially true in the Energy sector which generated the biggest drag on U.S. corporate investment spending after the collapse in oil prices in 2014/15. Since the election, however, there has been a noticeable improvement in confidence within the "C-suite" for American companies. The Duke University/CFO Magazine measure of optimism on the U.S. economy hit the highest level in over a decade (middle panel), while the Conference Board index of CEO optimism soared to the highest level in three years, at the end of 2016. Executive confidence at those levels would be consistent with a pace of capital spending that could add up to 1 full percentage point to U.S. real GDP growth, based on past relationships - (bottom panel). For both of these surveys, executives cited a more positive outlook on future growth after the U.S. election as a major reason for the increase in optimism. In sum, the biggest potential lift to U.S. economic growth in 2017 from Trumponomics will come from business investment and not government spending or exports, and likely by enough to boost overall U.S. GDP growth to an above-trend pace that will prompt the Fed to deliver at least 2-3 rate hikes by year-end. Bottom Line: A major boost to U.S. economic growth from government investment spending and net exports is unlikely in 2017. A pickup in corporate investment, however, seems far more likely given the boost to longer-term business confidence seen after the U.S. elections, coming at a time of improving global economic growth. Will Market Volatility Stay This Low? Given all the uncertainties over the latter half of 2016, from Brexit to Trump to Italy, it is surprising how low market volatility has been. Measures of implied volatility like the VIX index for U.S. equities have remained incredibly subdued, while even the uptick in MOVE index has been relatively modest considering the year-end carnage in the Treasury market (Chart 8). The fact that global risk assets can remain so relatively well-behaved, even after a surprising U.S election result and a Fed rate hike that has boosted the U.S. dollar, is a sign that the "Fed Policy Loop" - where a more hawkish U.S. monetary stance causes an unwanted surge in the U.S. dollar and a selloff in equity and credit markets - has been broken. As we discussed in our 2017 Outlook report, the Fed Policy Loop framework would not apply in an environment where non-U.S. economic growth was improving, as is the currently the case.2 This may be the most obvious explanation for why market volatilities are low, with developed market equities hitting cyclical highs and corporate credit spreads staying at cyclical lows. In other words, volatility is low because growth is accelerating and global central banks (most notably, the Fed) are not slamming on the brakes. Chart 8The Death Of The Fed Policy Loop? Chart 9U.S. Dollar Strength Will Persist In 2017 The strength of the U.S. dollar has been a function of the widening real interest rate differential between the U.S. and the rest of the world (Chart 9), which is likely to continue this year as the Fed delivers a few more rate hikes while U.S. inflation grinds slowly higher. We do not expect the Fed to be forced to shift to a more aggressive pace of tightening than currently implied by the FOMC forecasts. On the margin, this will help keep market volatility at subdued levels. A predictable Fed slowly tightening into an improving economy is not overly problematic for financial markets. That logic would be turned upside down if non-U.S. growth were to begin to slow sharply (not our base case) or if there were some non-U.S. source of uncertainty that could make markets jittery. Last year, political surprises ended up being the biggest shock for financial markets. Given the busy upcoming election schedule in Europe (Table 1), there is concern that a similar story could play out in 2017. Table 1Europe In 2017 Will Be A Headline Risk The shock of Brexit and Trump have investors asking "where will the next populist uprising be?" France seems like the most obvious possibility, with the well-known right-wing (and anti-EU) populist Marine Le Pen running in this year's presidential election. French government debt has already priced in some modestly higher risk premium in recent months (Chart 10). Even in the bastion of stability, Germany, the rise of anti-immigration parties has some forecasting a difficult re-election campaign for Chancellor Angela Merkel later in the year. Our geopolitical strategists have long argued that there is not enough support for populist, anti-EU, anti-immigration parties in either Germany, France or the Netherlands (who also have an election this year) to win an election.3 The recent polling data strongly supports that view, with Le Pen's popularity on the decline for the past three years and with Merkel's popularity holding steady over the past year (Chart 11) - even as horrific terror incidents committed by "foreigners" have occurred on both French and German soil. Chart 10Not Worried About European Populism... Chart 11...For Good Reasons BCA's Chief Geopolitical Strategist, Marko Papic, believes that Italy remains the greatest political risk in Europe in 2017, with elections possible as early as the spring. With the Senate reforms defeated in the December referendum, the country needs to re-write its already complicated electoral laws. This will likely take time, pushing the potential election date to late spring or early summer. If an early election is not called, a new vote must be held by the expiry of the government's mandate in May 2018. Chart 12Italy Is The Biggest Political Risk In Europ Chart 13A Managed Renminbi Depreciation Given the lower support for the euro in Italy than the rest of the Euro Area (Chart 12), and given the strong showing in the polls for the anti-establishment, anti-EU Five Star Movement led by Beppe Grillo, an early Italian election could be the biggest potential political shock for markets in 2017. This likely will not be enough to cause a major flare-up of global market volatility, but it does suggest that investors should remain underweight Italian government debt. Bottom Line: Improving global growth will continue to support low market volatility during 2017, even with the Fed remaining in a tightening cycle. European political risk should not be a Brexit/Trump-type source of concern for investors outside of Italy. Can China Avert A Crisis And Still Be The Engine Of Global Growth? This is a question that we may be asking every year for the next decade, given China's high debt levels and decelerating potential economic growth. Periodic episodes of uncertainty over Chinese currency policy are always a threat to trigger capital outflows, as has occurred over the past year and half (Chart 13). The Chinese authorities have chosen to allow currency depreciation versus the U.S. dollar to help manage the pace of that outflow, particularly during the past year when interest rate differentials have moved in a more dollar-positive direction. With over US$3 trillion in foreign exchange reserves at the government's disposal, the odds remain low that a true economic crisis can unfold in China. Additional renminbi weakness versus the U.S. dollar is likely in 2017, but the recent actions to sharply raise offshore renminbi interest rates is an indication that Chinese authorities will not tolerate a rapidly weakening currency. The incoming Trump administration is obviously an unforecastable wild card here, and China could respond to a new trade war with the U.S. by allowing a more rapid pace of currency weakness versus the dollar. Having said that - if China-U.S. relations don't boil over, then the underlying story for China will be one of improving economic growth in 2017. The underlying growth indicators in our "China Checklist" unveiled late last year (Table 2) continue to improve (Chart 14), and we continue to see China as being a positive contributor to the global economic cycle in 2017 (Donald Trump and his band of China hawks notwithstanding). This is important, as the global upturn seen in 2016 began in China early in the year. This fed through into many other countries either directly via exports to China or indirectly through an improvement in the pricing power for commodity exporters that benefitted from faster Chinese demand. Table 2The GFIS China Checklist Chart 14Chinese Growth Still Improving Bottom Line: China will likely remain a positive driver of the global economic upturn in 2017, with the biggest risk coming from increased tensions with the incoming Trump administration, not accelerating domestic capital outflows. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency", dated November 20th 2016, available at gps.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "How To Think About Global Bond Investing In 2017", dated December 20th 2016, available at gfis.bcarsearch.com 3 Please see BCA Geopolitical Strategy Strategic Outlook 2017, "5 Themes For 2017", dated December 2016, available at gps.bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Upside Risks & Uncertainty The evidence of economic acceleration continues to pile up and we maintain our view that bond yields will be higher than current forwards by the end of 2017. In the near-term, however, the bond market has been too quick to discount a more positive growth outlook, especially considering still-elevated levels of economic policy uncertainty. Our cautious optimism is echoed by the readings from our global PMI models and also by the Fed. The minutes from December's FOMC meeting revealed that more participants saw upside risks to growth and inflation than saw downside risks, but also that this improved economic forecast was judged to be more uncertain than any Fed forecast since 2013 (Chart 1). We remain bond bears on a 12-month horizon, but advocate a benchmark duration stance in the near term. A period of flat bond yields is the most likely outcome until elevated uncertainty levels revert to a more normal range (see the global economic policy uncertainty index). Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 82 basis points in December and by 478 basis points in 2016. The index option-adjusted spread tightened 6 bps on the month and 42 bps on the year. At 122 bps, the spread is currently well below its historical average (134 bps). Corporate spreads have tightened substantially since last February despite elevated gross leverage (Chart 2).1 As we pointed out in our end-of-year Special Report titled "Seven Fixed Income Themes For 2017",2 it is very rare for spreads to tighten when leverage is in an uptrend. While a rebound in profit growth will likely cause the uptrend in leverage to abate this year, spreads have already moved to discount a significant reversal. Although valuations are by no means attractive, accelerating economic growth and still-accommodative Fed policy will keep spreads at tight levels during the first half of this year. This sweet spot will persist at least until TIPS breakeven inflation rates return to pre-crisis levels, which would likely presage a hawkish shift in Fed policy. Energy sector debt returned 12.5% in excess of duration-equivalent Treasuries in 2016, compared to excess returns of under 5% for the overall corporate index. Despite this large outperformance, energy credits still appear attractive according to our model (Table 3), and should continue to outperform into the New Year. Table 3ACorporate Sector Relative Valuation##br## And Recommended Allocation* Table 3BCorporate Sector##br## Risk Vs. Reward* High-Yield: Underweight Chart 3High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 188 basis points in December and by 1539 basis points in 2016. The index option-adjusted spread narrowed 46 bps on the month and 251 bps on the year. At 383 bps, it is currently 137 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default backdrop, we are actively looking to upgrade our allocation to high-yield debt. However, valuations do not present a sufficiently compelling opportunity at the moment. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is below 150 bps (Chart 3). This is close to one standard deviation below the long-run average. Historically, we have found that a default-adjusted spread between 100 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of close to zero. With the spread in this range, a 90% confidence interval would place 12-month excess returns between -3% and +4%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in December, but underperformed by 11 bps in 2016. The conventional 30-year MBS yield rose 5 bps in December, completely driven by a 5 bps increase in the rate component. The compensation for prepayment risk (option cost) and option-adjusted spread were both flat on the month. In 2016, the conventional 30-year MBS yield rose 6 bps. This was driven by a 12 bps increase in the rate component that was partially offset by a 9 bps decline in the option-adjusted spread. The option cost increased 3 bps on the year. Our underweight in MBS is predicated upon very low option-adjusted spreads, relative both to history and other comparable spread product (Chart 4). Historically, the option-adjusted spread is correlated with net MBS issuance and eventually we expect rising net issuance to lead the option-adjusted spread wider. Importantly, purchase applications have remained firm in the face of higher mortgage rates even though refinancings have collapsed (bottom panel). Another tail risk for the MBS market is the possibility that the Fed ceases the reinvestment of its mortgage portfolio. While we do not expect this to occur in 2017, with two rate hikes now in the bank the fed funds rate is approaching levels where the Fed might begin to consider it. A new Fed Chair in early 2018 might also be more inclined to wind down the balance sheet. Government Related: Overweight Chart 5Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 27 basis points in December. Foreign Agency and Sovereign bonds outperformed by 84 bps and 83 bps respectively, while Local Authorities outperformed by 22 bps. Domestic Agency bonds and Supranationals were a drag on performance during the month, underperforming the Treasury benchmark by 10 bps and 7 bps respectively. The government-related index outperformed the duration-equivalent Treasury benchmark by 150 bps in 2016. The best performing sub-sectors for the year were Sovereigns (outperformed by 322 bps), Local Authorities (outperformed by 286 bps) and Foreign Agencies (outperformed by 258 bps). Domestic Agency bonds outperformed Treasuries by 38 bps, while Supranationals underperformed by 11 bps. Foreign Agency bonds and Local Authority bonds continue to appear attractive relative to U.S. corporate credit, after adjusting for credit rating and duration. We recommend focusing our government related allocation in these two sectors. In contrast, Sovereigns and Supranationals both appear expensive relative to U.S. corporate credit, and we recommend avoiding these sectors. Spreads on Domestic Agency debt have room to tighten in the near-term (Chart 5). Spreads widened to the top of their recent range last month on rumors that the new government could seek to speed up the process of GSE reform. We view these concerns as premature. This week we also remove our recommendation to favor callable agencies over bullets. Bullets have tended to outperform when the 2/5 Treasury slope steepens (bottom panel). We expect the 2/5 curve to be biased steeper in the first half of this year. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 134 basis points in December, but underperformed the index by 103 basis points in 2016 (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 8% in December, but increased 13% during 2016. At present the average M/T ratio is 98%, only slightly below its post-crisis average (Chart 6). Although M/T ratios moved higher last year, trends in issuance and fund flows suggest they are still too low. As we noted in our year-end Special Report,4 our tactical model of the M/T yield ratio - based on issuance, fund flows, ratings changes and economic policy uncertainty - pegs current fair value for the average M/T yield ratio at 112%. Further, as was also highlighted in our year-end report, the municipal credit cycle is likely to take a turn for the worse in late 2017, with muni downgrades starting to outpace upgrades. This analysis is based on indicators of state & local government budget health that tend to follow our indicators of corporate sector health with a two year lag. Just last month Moody's downgraded $1.6 billion worth of the City of Dallas' general obligation debt from Aa3 to A1. The downgrade was justified based on the city's poorly funded public safety pension plan. Attention will increasingly turn to underfunded public pensions when state & local government budget health starts to deteriorate later this year. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher and flattened in December. The 2/10 slope flattened by 1 basis point on the month and the 5/30 slope flattened 6 bps. For 2016 as a whole, the Treasury curve bear-steepened out to the 10-year maturity. The 2/10 slope steepened 4 bps and the 5/30 slope flattened 12 bps. In our year-end Special Report,5 we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen in the first half of 2017. This steepening will be driven by continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. A steepening curve environment will cause bullet trades to outperform barbells. On top of that, the 5-year bullet is currently extremely cheap on the curve (Chart 7). For these reasons we recommended entering a long 5-year bullet, short 2/10 barbell trade on December 20. This trade has already returned 8 bps since initiation, even though the 2/10 slope has flattened 10 bps during this period. A resumption of curve steepening will cause our long 5-year bullet, short 2/10 barbell trade to perform even better in the months ahead. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in December, and by 331 bps in 2016. The 10-year TIPS breakeven rate increased by 1 bp in December and by 41 bps in 2016. At present it sits at 1.96%, still well below the 2.4% to 2.5% range that is consistent with the Fed's 2% inflation target. As we explained in our year-end Special Report,6 the Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly back away from a hawkish policy stance should breakevens fall. But while breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. It is difficult for the Fed to drive long-dated inflation expectations higher while it is in the midst of a tightening cycle. For this reason, trends in actual inflation will be a more important determinant of TIPS breakevens than in the past. And while there are indications that the uptrend in realized inflation will persist, notably recent accelerations in wage growth and survey measures of prices paid (Chart 8). There is currently no indication that core and trimmed mean inflation are breaking out to the upside (bottom panel). We remain overweight TIPS relative to nominal Treasuries on the expectation that long-dated breakevens reach the 2.4% to 2.5% range in the second half of 2017, and that core PCE inflation reaches the Fed's 2% target by the end of the year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 17 basis points in December but outperformed the Treasury benchmark by 94 bps in 2016. Aaa-rated ABS underperformed Treasuries by 21 bps in December but outperformed by 75 bps in 2016, while non-Aaa ABS outperformed the benchmark by 13 bps in December and by 257 bps in 2016. The index option-adjusted spread for Aaa-rated ABS widened by 11 bps in December, but tightened by 10 bps in 2016. Further, the spread differential between Aaa-rated auto ABS and Aaa-rated credit card ABS narrowed substantially in 2016. The option-adjusted spread for Aaa-rated auto loan ABS has tightened by 20 bps since the end of 2015, while the option-adjusted spread for Aaa-rated credit card ABS has tightened by 10 bps. We have previously noted that, after adjusting for spread volatility, Aaa-rated auto loan ABS no longer offer an attractive opportunity relative to Aaa-rated credit cards (Chart 9). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, given the low spread differential and divergences in collateral credit quality (bottom panel). As was noted in the Appendix to our year-end Special Report,7 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except for Baa-rated corporates and Caa-rated high-yield in 2016. With spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. Non-Agency CMBS: Underweight Agency CMBS: Overweight Chart 10CMBS Market Overview Agency CMBS underperformed the duration-equivalent Treasury index by 40 basis points in December, but outperformed by 117 bps in 2016. The index option-adjusted spread for Agency CMBS widened 10 bps in December but tightened 6 bps in 2016. Agency CMBS still offer 50 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (51 bps) and greater than what is offered by conventional 30-year MBS (26 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in December, but outperformed by 313 bps in 2016. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps in December but tightened 48 bps in 2016. It has recently moved well below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Treasury Valuation Chart 11Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.31% (Chart 11). Our 3-factor version of the model, which also incorporates the global economic policy uncertainty index, places fair value at 2.02%. The lower fair value is the result of a large spike in the global economic policy uncertainty index in November that barely reversed in December (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. However, unusually high uncertainty is one reason we are reluctant to adopt a below benchmark duration stance for the time being even though we expect yields to be higher in 12 months. At the time of publication the 10-year Treasury yield was 2.37% For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). With the MCI having just reached this estimate of equilibrium, the shaded region in Chart 13 shows the expected path of the federal funds rate assuming that the MCI remains at its equilibrium level. The upper-end of the shaded region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the shaded region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios As can be seen in Chart 13, both the market and Fed are discounting a move in the MCI above its equilibrium level. This would be consistent with behavior witnessed in past cycles when the MCI broke above its equilibrium level several years before the next recession. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights The economy is near full employment, but betting on significant inflation is premature. Market-based inflation expectations have risen substantially in recent weeks but these moves are not corroborated by survey measures of inflation expectations. Consumer inflation expectations are very well anchored due to ongoing deflation in many frequently purchased goods and services. We are on high alert for a near-term equity pullback, with Chinese liquidity tightening as a potential catalyst. Feature Chart 1Market-Based Inflation ##br##Expectations Breaking Out After years of focusing on deflation, the possibility of inflation has made a comeback on investors' radars. The shift makes sense, given that the labor market is now operating near full employment. The December payroll report showed that payrolls increased by 156,000, slightly lower than the 3-month average of 165,000. But, average hourly earnings increased by 0.4%, suggesting that slightly weaker employment growth is not due to sluggish demand, and reflects a smaller available pool of workers. However, as we explain below, the potential for a major inflation surge is low in 2017 and is premature as an investment theme. We are on high alert for a near-term pullback to the equity bull market, given that valuation and sentiment are stretched. But as we outline, the threat to the equity market is less likely to be domestic inflation than an external event, such as the fallout from tightening liquidity in China (similar to what occurred in mid-2015 and early 2016). In the past few weeks, one-year inflation expectations have moved to their highest level since mid-2014, when oil prices were above $110/bbl. Long-run inflation expectations have also spiked since the U.S. election (Chart 1). The extent to which this trend is judged sustainable, and provides an accurate forecast for general inflation, has important investment implications. Our view is that, although TIPS could move a bit higher, the market move should not be interpreted as a harbinger for a broad-based inflation acceleration. Policymakers consider a range of inflation expectations measures, but in recent years, market-based measures have garnered a lot of attention. The 5-year/5-year forward TIPS breakeven rate in particular is often viewed as the market's assessment of whether the Fed can successfully achieve its inflation target. According to the Minutes of the December FOMC meeting, the recent rise in market-based inflation expectations was discussed at length. On this basis, the rise in TIPS is important as it could have a significant role in setting monetary policy. Beyond that, we have argued for some time that a major challenge for firms this cycle will be to raise selling prices, i.e. a lack of pricing power will restrain profit margins and, ultimately, earnings growth. If the recent pick-up in market-based inflation expectations heralds a more robust rise in actual inflation, then profits could positively surprise this year. The Rise In TIPS Is Partially Energy-Driven... Since 2010, there has been a strong correlation between oil prices and TIPS (Chart 2). The correlation has somewhat confounded policymakers.1 In theory, any oil price shock, even if it is considered to be permanent, should not exert any lasting impact on long-dated forward measures of inflation expectations. The reason is that as long as the Fed is committed to its 2% inflation target, then the market should expect that monetary policy will prevent a one-time shock to oil prices from having any permanent effect on the overall inflation rate. This is why, in theory, the 5-year/5-year forward TIPS breakeven rate is a good indicator for policymakers. Chart 2Oil Prices And Breakevens As our fixed income team explained in a report last year,2 the main reason for the tight correlation between TIPS and oil prices stems from the market perception that monetary policy has been constrained. Prior to the financial crisis, oil prices rose from below $40 in 2003 to $140 in 2008. During that time, long-dated breakevens remained stable. One possible explanation for this lack of correlation is that the Fed tightened policy during this period, offsetting the inflationary impact from higher oil prices. But in 2015-2016, when oil prices fell from above $100 to below $40, breakevens plunged alongside. If the market perceives monetary policy to be constrained by the zero lower bound, then it could be the case that the cost of inflation compensation is highly sensitive to falling oil prices because the market perceives that the Fed has no ability to offset the deflationary shock. In other words, the 5-year/5-year TIPS breakeven rate has fallen because the zero lower bound is challenging the credibility of the Fed's inflation target. Our U.S. fixed income team forecasted that breakevens will head higher once oil prices move up and that the correlation between oil prices and breakevens will eventually weaken as the fed funds rate moves further away from the zero lower bound. The bottom line is that TIPS are most likely being unduly affected by energy price movements. ..And Only Thinly Corroborated By Alternative Inflation Indicators Despite our bias that the recent moves in market-based inflation expectations are exaggerated, TIPS are not the only gauge sending a more inflationary signal. This week's ISM manufacturing and non-manufacturing surveys both reported an uptick in prices paid (Chart 3). According to the manufacturing survey, 18 out of 21 recorded inputs were up in price over the past month. However, the bulk of these are commodities that have gone up in price alongside other financial market prices, and it is not clear the extent that the price rise is physical demand-driven, or financial demand-driven. In the non-manufacturing survey, the price rise was not quite as broad-based, but is nonetheless suggestive of upward price pressure. The NFIB small business survey also hinted at higher prices, although much more modestly than the ISM surveys (Chart 3). The Atlanta Fed's Business Inflation Expectations Survey has not broken out of the range that has held since 2011. There was no change in inflation expectations from the most recent survey of professional forecasters. Meanwhile, as we noted last week, consumers are not at all worried about inflation. In fact, according to the Conference Board survey, consumer inflation expectations are at a new cyclical low! At least part of the reason that consumers do not expect more inflation is likely due to their experience with frequently-purchased items. Table 1 shows inflation rates for selected high-frequency spending items, which account for about 30% of the total CPI basket. The table makes it easy to understand why perceptions about inflation are low: almost half of the items in the table are in deflation and only two are above the Fed's target of 2%. It may not matter that a good or service accounts for a small share of spending: if its price is going up/down at a steady pace, then there will be an impact on perceptions about inflation. Currently, very low or negative rates of inflation among frequently purchased items are likely pulling down consumers' perceptions of broad-based inflation. In this sense, one could argue that inflation expectations are very well-anchored. Chart 3Survey-Based Inflation ##br##Expectations More Mixed Table 1Inflation Rates For Selected ##br## High-Frequency Spending Items Actual Inflation Will Stay Subdued In 2017... Chart 4Only Mild Uptrend Likely In 2017 For many years, we have deconstructed core CPI and core PCE into their three major components to better understand and forecast the trend in consumer price inflation (Chart 4). Performing this exercise today continues to give a fairly benign forecast for inflation. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017. Core goods inflation (25% of core CPI) will also remain very low and possibly stay in deflationary territory. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 4, panel 3), and so will stay depressed as long as the bull market in the dollar remains intact. Wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 4, bottom panel). This component, which accounts for 25% of core CPI, is the most likely source of inflation pressure now that wages are beginning to rise. But as we wrote in a Special Report on November 28, 2016, any wage inflation and pass-through is likely to be very gradual based on several structural headwinds at play this cycle. All in all, core PCE may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next six - twelve months. ...And Don't Blame Government Spending For Higher Inflation When It Does Come One missing ingredient from the above analysis is the likelihood that the political environment will become inflationary. This subject has been thoroughly covered by the financial press. Our own view has been that upcoming policies may not turn out to be particularly inflationary, at least not this year. For example, Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions in 2017. As for proposed personal tax cuts, the impact is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that many companies are already flush with cash and effective tax rates are well below statutory levels. Our benign view about the impact of government spending on inflation is shared by researchers at the St Louis Federal Reserve. In a recent paper,3 researchers looked at periods when the central bank was not working to offset the potentially inflationary effects of fiscal policy, e.g. between 1959 and 1979, when the Fed followed a policy in which it accommodated increases in inflation. They found almost no effect of government spending on inflation. For example, a 10 percent increase in government spending during that period led to an 8 basis point decline in inflation. Note that this period covers years of when the economy was operating at full employment and below. As the researchers point out, this does not imply that countercyclical government spending is ineffective at boosting output, but it simply demonstrates that empirical evidence of inflation related to government spending is thin. The bottom line is that we view the likelihood of significant inflation pressure as low in 2017. The implication is that under this scenario, the Fed can afford to adjust their "dots" gradually, diminishing the risk for stocks and bonds of an aggressive adjustment to the policy backdrop. Equity Correction: Will China Be A Contributing Factor? Chart 5Is China Liquidity Tightening##br## A Repeat Threat To U.S. Equities? Over the past few weeks, we have argued that the odds of a meaningful equity correction are running high, given the aggressive rise in bond yields and exaggerated move in sentiment relative to only minor upside surprises in economic and earnings growth. We are still on high alert for this outcome and believe that one possible trigger is tighter liquidity conditions in China, which are aimed at supporting the renminbi. Indeed, just like the start of 2016, the Chinese renminbi is kicking off 2017 on a weak note. Chinese policymakers are again tightening rules to limit capital outflows: earlier this week, they adjusted the FX basket used to set the CNY's official daily fix. The new FX basket will include 24 currencies (up from 13). Consequently, the weight of the U.S. dollar drops from 26.4% to 22.4%. This will make it easier for the authorities to target a relatively stable renminbi versus the basket even as USD/CNY pushes higher. These attempts to support the renminbi is leading to tighter liquidity conditions and higher interbank interest rates. In Hong Kong, 3-month CNH Hibor has spiked to 10%. In the past, a combination of a weaker renminbi and rising interbank rates has spelled trouble for U.S. and global equities (Chart 5). There is no guarantee that history will repeat itself and one big difference with the sharp market sell-offs in mid-2015 and early 2016 is that the Chinese economy is not as weak as it was then. The PMIs released this week were generally firm. Overall, we are positive on equities and negative on bonds on a 12-month horizon but still see the risk of a correction to the Trump trade as elevated. Thus, investors should continue to stick close to benchmark tactically, looking to implement positions after a pullback in stock prices. Like in 2015 and early 2016, China could provide the trigger to that pullback if the authorities give up on capital controls and allow a sharp depreciation of the RMB. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard-N… 2 Please see U.S. Bond Strategy Weekly Report "A Tale Of Two Rallies", dated March 29, 2016, available at usbs.bcaresearch.com 3 https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-…

Highlights Portfolio Strategy A battle between tighter monetary conditions and the anticipation of fiscal largesse will be a dominant market theme this year. Our high-conviction equity allocation calls do not require making a major directional global economic bet, or second guessing the Fed's desire to continue tightening. The bulk of our calls could currently be considered contrarian, based on recent market momentum and sub-surface relative valuation swings. Recent Changes S&P Insurance Index - Downgrade to high-conviction underweight. Nasdaq Biotech Index - Downgrade to high-conviction underweight. Feature Stocks have already paid for a significant acceleration in earnings and economic growth this year and beyond. Fourth quarter earnings season will be the first real test of investor expectations since the post-election market surge. While recent data have been encouraging, forward corporate profit guidance is unlikely to be robust in the face of the U.S. dollar juggernaut. Currently, the hope is that fiscal stimulus will offset tighter monetary settings, ultimately delivering a higher plane of economic activity. The major risks are that the economy loses momentum before fiscal spending cranks up, and/or that profits diverge from a more resilient economic performance than liquidity conditions forecast. Indeed, fiscal stimulus isn't slated to accelerate until next year (Chart 1), while the impact of anti-growth market moves is far more imminent. Our Reflation Gauge has plunged, heralding economic disappointment (Chart 1). With the economy near full employment, Fed hawkishness could persist even in the face of any initial evidence of economic cooling. Under these conditions, the gap between nominal GDP and 10-year Treasury yields could turn negative in the first half of the year (Chart 2), which would be a major warning sign for stocks. Chart 1Fiscal Stimulus Is Still A Long Way Off Chart 2Warning Signal As a result, while the market has recently been focused almost solely on return, our emphasis at this juncture is on minimizing risk. That is consistent with the historic market performance during Fed tightening cycles. Going back to the early-1970s and using the last seven Fed interest rate hiking periods, it is evident that non-cyclical sector relative performance benefits immensely on both a 12 and 24 month horizon from the onset of Fed tightening (Charts 3 and 4). Cyclical sectors typically lag the broad market, while financials generally market perform1. Chart 312-Month Performance After Fed Hikes Chart 424-Month Performance After Fed Hikes Some of the other major macro forces that are likely to influence the broad market and sectoral trends are: Ongoing strength in the U.S. dollar and its drag on top-line growth: loose fiscal policy and tight monetary policy is a classic recipe for currency strength. Tack on high and rising interest rate differentials due to policy divergences with the rest of the world (Chart 5), and exchange rate strength is likely to persist in the absence of a major domestic economic downturn. A tough-talking Fed. Wage growth is accelerating and broadening out, and will sharpen the Fed's focus on inflation expectations. With dollar strength constraining revenue growth potential, strong wage gains are profit margin sapping (Chart 2). A divergence between economic growth and profit performance, i.e. stronger growth is unlikely to feed into equal growth in corporate sector earnings given the squeeze on profit margins from a recovery in labor's ability to garner a larger share of aggregate income. Disappointment and/or uncertainty as to the timing and rollout of the much anticipated fiscal spending programs and unfunded tax cuts. Favoring domestic vs. global exposure will remain a key theme. Emerging markets (EM) have not validated the sharp jump in the global vs. domestic stocks, nor cyclical vs. defensives (Chart 6). Chart 5Greenback Is A Drag##br## On S&P 500 Top Line Growth Chart 6Mind##br## The Gap EM stocks are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. The surging U.S. dollar is a growth impediment for many developing countries with large foreign liabilities to service. The U.S. PMI is gaining vs. the Chinese and euro area PMI (Chart 7, second panel), heralding a rebound in cyclical share price momentum. World export growth remains anemic and will remain so based on EM currency trends (Chart 7). When compared with the reacceleration in U.S. retail sales, the outlook for domestically-sourced profits is even brighter. The other key sectoral theme is to favor areas geared to the consumer rather than the corporate sector. Consumer income statements and balance sheets are far healthier than those of the corporate sector (Chart 8). As a result, they are in a more propitious position to spend and expand. Chart 7Domestics Will Rise To The Occasion Chart 8Consumers Trump The Corporate Sector We expect all of these forces to truncate rally attempts in 2017. The market is already stretching far enough technically to flag risk of a potentially sizeable correction in the first quarter, i.e. greater than 10%, particularly given the significant tightening in monetary conditions and overheating bullish sentiment that have developed. In other words, it is not an environment to chase the post-election winners, nor turn bearish on the losers that have been eschewed. Against this backdrop, we are introducing our top ten high-conviction calls for 2017. As always, these calls are fundamentally-based and we expect them to have longevity and/or meaningful relative return potential, rather than just reflect recent momentum trends. We recognize the difficulty of trading in and out of positions on a short-term basis. Energy Services - Overweight Chart 9Playable Rally The energy sector scores well in relative performance terms when the Fed is hiking interest rates2, supporting a high-conviction overweight in the energy services group. OPEC's agreement to curtail production should hasten supply/demand rebalancing that was already slated to occur via non-OPEC production declines through 2017. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies reduced capital expenditures by 40% over the same period. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to restore capital availability to the sector. With easier access to capital, producers, especially shale, will be able to accelerate drilling programs in a stable commodity price environment. The three factors traditionally required to sustain a playable rally are now in place. The rig count has troughed. The growth in OECD oil inventories has crested. The latter is consistent with a gradual rise in the number of active drilling rigs. Finally, global oil production growth is falling steadily. Pricing power is likely to be slow to recover this cycle given the scope of previous capacity excesses, but even a move to neutral would remove a major drag and reduce the associated share price risk premium (Chart 9). Consumer Staples - Overweight 2016 delivered a number of company specific body blows to the consumer staples sector, most notably concerns about the pharmacy benefit manger pricing model, which undermined the retail drug store group. Thereafter, the sector was shunned on a macro level following the election, as it was used as a source of capital to fund aggressive purchases in more cyclical sectors. This has set the stage for a contrarian buying opportunity in a high quality, defensive sector with one of the best track records during Fed tightening cycles3. The sector is now closing in on an undervalued extreme, in relative terms, having already reached such a reading in technical terms (Chart 10). Our Cyclical Macro Indicator is climbing, supported by the persistent rise in consumers' preference for saving. The latter heralds an increase in outlays at non-cyclical retailers relative to sales at more discretionary stores. Importantly, consumer staples exports have reaccelerated, despite the strong U.S. dollar, pointing to a further acceleration in sector sales growth, and by extension, free cash flow. The strong U.S. dollar is a major boon, from an historical perspective, given that it typically creates increased global economic and market volatility. The latter is starting to pick up (Chart 10). A strong currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and heralds a relative performance rebound (Chart 11). Chart 10Contrarian Buy Chart 11China To The Rescue? Home Improvement Retail - Overweight Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. Household formation is reaccelerating, as full employment is boosting consumer confidence, and clocking at a higher speed than housing starts. The implication is that pent-up housing demand will be unleashed. In fact, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. Remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Building supply store construction growth has plumbed to the lowest level since the history of the data. Historically, capacity restraint has represented a boost to home improvement retail (HIR) profit margins and has been inversely correlated with industry sales growth. Stable housing data and improving operating industry metrics entice us to put the compellingly valued S&P HIR on our high-conviction buy list for 2017 (Chart 12). Chart 12Benefiting From Enticing##br## Long-Term Housing Prospects Chart 13Healthy Consumer Is A Boon##br## To Consumer Finance Stocks Consumer Finance - Overweight We are focusing our early-cyclical exposure on overweighting the still bruised S&P consumer finance index. This group is levered to the rising interest rate environment and debt-financed consumer spending. The selloff in the 10-year Treasury bond has been closely correlated with relative performance gains and the current message is to expect additional firming in the latter (Chart 13, top panel). Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led (Chart 13, bottom panel). On the consumer front, consumer finances are healthy, the job market is vibrant and consumer income expectations are on the rise. In addition, house prices have vaulted to fresh all-time highs and are still expanding on a y/y basis. The positive wealth effect provides motivation for consumers to run down savings rates (Chart 13, second & third panels). Health Care Equipment - Overweight Health care equipment (HCE) stocks have been de-rated alongside the broad health care index, trading at a mere market multiple and below the historical mean, representing a buy opportunity. Revenue growth has been climbing at a double digit clip (Chart 14, third panel) and the surging industry shipments-to-inventories ratio is signaling that still depressed relative sales growth expectations will surprise to the upside (Chart 14, top panel). Synchronized global growth is also encouraging for U.S. medical equipment exports, despite the U.S. dollar's recent appreciation. The ageing population in the developed markets along with pent up demand for health care services in the emerging markets where a number of countries are developing public safety nets, bode well for HCE long-term demand prospects. The bottom panel of Chart 14 shows that the global PMI has been an excellent leading indicator of HCE exports and the current message is positive. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity (Chart 14, second panel). Chart 14HCE Stocks Are Cheap Given##br## Improving Final Demand Outlook Chart 15More Than##br## Meets The Eye REITs - Overweight REITs have traded as if the back up in global bond yields will persist indefinitely, and that the level of interest rates is the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin. The RDI is also positively correlated with commercial property prices, implying more new highs ahead. That will support higher net asset values. While increased supply is a potential sore spot, particularly in the residential space, multifamily housing starts have rolled over relative to the total, suggesting that new apartment builds are diminishing. As discussed in previous research reports, contrary to popular perception, relative performance is also depressed from a structural perspective. REIT relative performance is trading well below its long-term trend, a starting point which has historically overwhelmed any negative pressure from a Fed tightening cycle (Chart 15). Tech Hardware Storage & Peripherals - Underweight The S&P technology hardware storage & peripherals (THSP) sector is a disinflationary play (10-year treasury yield change shown inverted, second panel, Chart 16) and benefits when prices are deflating, not when there are whiffs of inflation4. The tech sector has the highest foreign sales/EPS exposure among the top 11 sectors, and the persistent rise in the greenback is weighing on export prospects for the THSP sub-index (Chart 16, third panel), and by extension top and bottom line growth. Computer and electronic products new order growth has fallen sharply recently, warning that THSP sales growth will remain downbeat. Industry investment is also probing multi-year lows (not shown). Asian inventory destocking is ongoing, which will pressure selling prices, but the end of this liquidation phase would be a signal that the worst will soon be over. Technical conditions are bearish. A pennant formation signals that a breakdown looms. Chart 16Tech Stocks Hate Reflation Chart 17Shy Away, Don't Be Brave Biotech - Underweight The Nasdaq biotech index is following the BCA Mania Index, which includes previous burst bubbles in a broad array of asset classes. The top panel of Chart 17 shows that if history at least rhymes, biotech bubble deflation is slated to continue. Only 45 stocks in the NASDAQ biotech index have positive 12-month forward earnings estimates, comprising 27% of the 164 companies in the index according to Bloomberg. There is still a lot of air to be taken out of the biotech bubble. Historically, interest rates and relative performance have been inversely correlated. The back up in bond yields and Fed tightening represent a draining in liquidity conditions which bodes ill for higher beta and more speculative investments. The biotech derating has been earnings driven and a sustained multiple compression period looms, especially given the sector's poor sales prospects (Chart 17, bottom panel) Worrisomely, not only have biotech stocks fallen despite Trump's win, but recent speculative zeal (buoyant equity sentiment and resurging margin debt, not shown) has also failed to reinvigorate biotech equities. The NASDAQ biotech index is a sell (ETF ticker: IBB:US). Industrials - Underweight The industrials sector was added to our high-conviction underweight list late last year so the turn in calendar does not require a change in outlook. The sector has discounted massive domestic fiscal stimulus and disregarded the competitive drag on earnings from the U.S. dollar, trading as if a profit boom is imminent. Recent traction in surveys of industrial activity is a plus, but is more a reflection of an improvement in corporate sentiment and is unlikely to translate into imminent industrials sector profit improvement. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure or private sector investment spending. Commodity prices and EM drag when the dollar is strong. Chronic surplus EM industrial capacity remains a source of deflationary pressure for their currencies, economies and U.S. industrial companies. U.S. dollar strength warns of renewed pricing power pressure (Chart 18). Non-tech industrial capacity is growing faster than output, and capital goods imports prices are contracting (Chart 18). Tack on the relentless surge in the U.S. dollar, and a new deflationary wave appears inevitable. Relative forward earnings momentum is already negative, and is likely to remain so given the barriers to a top-line recovery, and a soaring domestic wage bill. The sector is not priced for lackluster earnings. Chart 18Fade The Bounce Chart 19Advance Is Precarious Insurance - Underweight Insurance stocks have benefited from the upward shift in the yield curve and the re-pricing of the overall financials sector, but the advance is precarious. Previously robust insurance pricing power has cracked. The CPI for household insurance is barely growing. The latter is typically correlated with auto premiums, underscoring that they may also slip (Chart 19). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios and incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and less pricing power. Insurance companies have added massively to cost structures in recent years (Chart 19), while the rest of the financials sector was shedding labor costs. Relative valuations have enjoyed a step-function upshift, but the path of least resistance will be lower for as long as relative consumer spending on insurance products retreats on the back of pricing pressure (Chart 19). 2016 Review... Last year's high-conviction calls were hot out of the gate, and generally had very strong gains until the late-summer/early-fall, but were hijacked by the post-election surge in a few sectors. As a result of the end of year fireworks, our high conviction calls trailed the market by just under 2% for the year ending 2016. Had we had the foresight to predict a Trump win and a massive market rally, we could have closed our positions in early November for comfortably positive gains. In total, our average booked gains in the year were 3% in excess of the broad market since the positions were initiated. We are also closing our pair trades, and will re-introduce a number of new trades in the near future. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see the U.S. Equity Strategy Special Report titled: "Sector Performance And Fed Tightening Cycles: An Historical Roadmap", available at uses.bcaresearch.com. 2 Ibid 3 Ibid 4 Please see the U.S. Equity Strategy Special Report titled: "Equity Sector Winners And Losers When Inflation Climbs", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights The U.S. growth outlook has improved but markets already reflect this reality. The U.S. dollar is losing momentum despite healthy economic releases, highlighting the risk of a pullback. EUR and JPY should be the prime beneficiaries of a dollar correction as commodity currencies are exposed to brewing Chinese risks. Short CAD/NOK and AUD/JPY. Happy New Year! Feature A defensive posturing seems increasingly appropriate for currency investors in the coming months. While we continue to expect U.S. growth to strengthen toward 3% this year, asset prices have already discounted a very positive economic outcome. As Chart I-1 illustrates, the ratio of metal to bond prices (adjusted for relative return volatilities) tends to be a good leading indicator of U.S. growth. However, this indicator clearly shows that investors are already positioned for solid growth. Chart I-1The Economic Outlook Has Improved, But Markets Are Aware Moreover, bond prices have uniformly discounted good news. Both our composite sentiment indicator and the bonds' fractal dimension - a measure of groupthink - highlight that investors are collectively positioned for a bearish Treasury outcome (Chart I-2). This raises the risk that even a good growth number out of the U.S. will disappoint investors. Lofty expectations are not confined to bonds and metals, however. DXY and the broad trade-weighted dollar are also displaying some groupthink, another troubling sign for dollar bulls like us (Chart I-3), who find our side of the ledger increasingly crowded. Chart I-2Buying Bonds Is A Contrarian Play Chart I-3Dollar Could Pull Back What does this all mean? In our 2017 outlook, we mentioned that while the risk of a dollar correction was rising, the dollar's momentum was too strong to fight at this point in time.1 Moreover, historically, January tends to be a strong month for the dollar (Chart I-4). A window of opportunity to get short may be opening up. For one, the dollar has been losing momentum in the past few weeks, shown by the divergence that is emerging between prices and momentum (Chart I-5). Additionally, net speculative positions on the dollar are near record highs but, more importantly, are not making new highs (Chart I-6). Chart I-4The Greenback Likes The New Year Chart I-5Dollar Momentum Is Weakening Chart I-6Long Dollar: A Crowded Trade Interestingly, the Swedish krona, the currency with the most negative beta to the dollar is now showing surprising signs of strength (Chart I-7). This is particularly remarkable as this week the Riksbank announced it would pursue currency-market interventions if it judges that a strong currency threatens its inflation target. Hence, if the krona's underperformance was a harbinger of dollar strength this past fall, the SEK's current resilience may foreshadow a correction in the greenback. In terms of the dollar's reaction to recent economic data, the greenback has been unable to rally on strong fundamentals this week. Instead, the dollar softened despite healthy readings from the ISM manufacturing survey, with the headline measure rising to 54.7 and the new orders component surging to 60.2. Relatively hawkish FOMC minutes couldn't even support DXY. In fact, European PMIs seem to have overshadowed U.S. economic data. The European Manufacturing PMI is at a six year high (Chart I-8). Even the French consumer is feeling perky, with the consumer confidence hitting a nine year high. Chart I-7SEK Upside Equals USD Downside Chart I-8Good Numbers In Europe The absence of U.S. dollar strength in response to strong economic news at a time of seasonal strength for the USD raises the risk of a dollar correction in the coming weeks. We expect the yen and the euro to be the prime beneficiaries of such moves. Commodity currencies, on the other hand, might be unable to take advantage of any dollar weakness. Too much good news have been priced in. Commodities have been lifted by the perception of stronger growth in the U.S., but also by the common refrain among investors that the Chinese authorities will continue to reflate the economy in the run up to the Communist Party Congress this autumn. We worry that China is likely to be a source of negative shock. Investors are increasingly likely to see their hopes of stimulus dashed, particularly since the Chinese economy does not look like it needs much stimulus right now. The Keqiang index - a comprehensive measure of industrial activity - is at post-2010 highs and real estate markets have become very frothy (Chart I-9). Moreover, the recent surge in bitcoin prices - despite a strong dollar - suggests that capital outflows out of China are intensifying despite tightening capital account restrictions (Chart I-10). Indeed, bitcoin prices started their recent ascent as talks of capital controls in China grew in late 2015. The result has been higher interest rates and a tightening of Chinese financial conditions. This also gives the authorities an impetus to let the RMB fall - representing another deflationary shock for EM economies and commodity producers. Chart I-9China Doesn't Need Reflation Chart I-10Symptoms Of Chinese Outflows In this environment, oil prices are likely to fare better than metal prices, one of the key themes we highlighted in our 2017 outlook, which should benefit our short AUD/CAD trade. In addition, we are reopening our short CAD/NOK position. CAD/NOK is trading 15% over its fair value (Chart I-11), and would benefit in the event of a USD correction. Moreover, the Canadian surprise index, which had surged relative to that of Norway has now rolled over, pointing toward weaknesses for this cross (Chart I-12). Chart I-11CAD/NOK Is Overvalued ##br##CAD/NOK Is Expensive Chart I-12Economic Momentum ##br##Moving Against CAD/NOK Another opportunity seems to be emerging in the yen. Speculators are massively short the yen and our yen capitulation index continues to hover near 22-year lows (Chart I-13). From current levels, the yen could easily move toward 110, especially if our view on the dollar and Chinese policy risks is correct. That being said, the more than 1% fall in USD/JPY yesterday suggests that investors may want a more attractive entry point. Investors should also consider shorting AUD/JPY. Not only is this cross very sensitive to movements in the yen, but it also provides a direct way to capitalize through the currency market on falling metal prices and rebounding bond prices (Chart I-14). Moreover, AUD is very sensitive to Chinese economic conditions, and tightening Chinese liquidity along with a falling RMB would do great damage to the Aussie. Chart I-13JPY Has ##br##Upside Chart I-14Short AUD/JPY Equal ##br##Short Metals / Long Bonds Bottom Line: Financial markets have priced in a lot of good news in a short amount of time. Investors are now vulnerable to a pullback in risk assets and a rebound in bond prices. This process is likely to support the European currencies and the yen against the dollar, but hurt commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The minutes from the December 14 FOMC meeting highlighted that Trump's fiscal proposal still lacks clarity, but the Fed's hawkish shift remains in place despite the tightening conditions brought about by a rising dollar. Anxiety about future growth may have resurfaced from this realization, prompting dollar bulls to close some of their bets: the DXY plunged 1.7% in just two days. Alongside this, Treasurys have rallied 1.7% and the 10-year yield has dropped 8 bps. Data from the U.S. in the past few months has been consistently positive, with this week also showing an uptick in Manufacturing PMI to 54.7 from 53.2, and prices paid increasing by 11 points to 65.5. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro Area ended the year on an up note, as manufacturing, service and composite PMIs all outperformed consensus and preceding figures for most of the major euro countries. The resulting effect was a pickup in CPI, as headline inflation for the Euro Area came in at 1.1% YoY, and core at 0.9%. The labor market continues to make steady progress as Germany recorded a decrease in unemployed people by 17,000, and Spain, a decrease of 86,800. It is too early to tell whether this data will affect the ECB's next monetary policy stance. However, what is evident is that EUR/USD is more likely to move on U.S. economic surprises than anything else. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 On December 20th the BoJ left rates unchanged and maintained its yield curve control program that keeps 10-year rates near 0%. In its statement, the bank admitted that it expects a moderate expansion on 2017 as Japan continues to recover. We are sympathetic to this view. With the yen and Japanese real rates falling, the economy should be able to get out of its deflationary trap. Indeed, recent data shows that things might be turning for Japan: Both Services and Manufacturing PMI increased last month and are now at 52.3 and 52.4 respectively. Retail trade growth came at 1.7% YoY, beating expectations. We maintain that the yen should see more downside on a cyclical basis, given that the BoJ will maintain their yield curve control program until inflation overshoots their 2% target. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The pound has remained relatively unchanged against the dollar since the start of the year. The decision by the Supreme Court will be a key event to watch as it will determine whether the U.K. parliament has authority in determining how Britain exits from the European Union. Aside from political risks, The British Economy has remained resilient despite the uncertainty unleashed by last year's referendum. Recent data confirms this: Markit Manufacturing PMI came in at 56.1 versus expectations of 53. Surprisingly, Markit Services PMI reached 56.2, marking the biggest expansion of the service sector in a year. Despite much fear about the effects that the fear of Brexit would have on property prices, house prices continue to rise at a healthy 4.5% pace, beating expectations. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has enjoyed a recent rally on the back of the greenback's decline. Additionally, the Australian services sector has improved considerably with the AiG Performance of Services Index recording a 6.6 point increase in November to 57.7. Although this may have contributed to the AUD bump, it is important to not look too much into this data as the Australian economy looks questionable - something we have discussed on several occasions. Australia's mining sector, China and emerging market uncertainty, a bearish outlook for commodity currencies and a USD bull market are all factors which will put downward pressure on AUD in the future. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi reached its lowest level since June right before the New Year, dipping slightly below 0.69. Indeed some recent developments have proved negative for the NZD: Dairy prices have slowed down after their meteoric growth in the last half of 2016. GDP growth came at 3.5%, below expectations of 3.7%. Nevertheless structural forces appear to favor the Kiwi economy. First, permanent long-term migration in Auckland is at a 24-year high. Although, in the short term this should contain inflation as the supply of workers increases, in the long term the additional demand should boost the economy. Moreover, household credit growth continues to be healthy at almost 10% without being excessive, as it still is well below pre-2008 levels. These factors should boost the kiwi economy and provide long-term support for the NZD, at least compared to the AUD. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian dollar failed to appreciate against the dollar alongside rising oil prices after the Fed's December 14 monetary policy decision. For a moment, the Canadian dollar seemed to be more a function of the dollar than of oil. However, this decoupling is historically unprecedented and USD/CAD will soon revert back to its negative association with oil prices, especially due to the likely subdued movements in the dollar in the near future. A longer term outlook for CAD entails moderate downside. A dollar bull market will keep a lid on oil prices and be bullish for USD/CAD. Shorter-term momentum points to some strength in the CAD, with the MACD line surpassing the signal line and the 14-day RSI approaching oversold levels. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 USD/CHF should continue to mirror the behavior of the euro against the U.S. Dollar. While it is true that the euro area had strong data at the end of the year, continued dollar strength should cap any rally in the euro. Thus, USD/CHF should remain relatively unchanged. On the other hand, EUR/CHF is currently at 1.07, a level at which the SNB is very likely to intervene if it drifts any lower. The SNB has been very explicit that they will not tolerate any further currency appreciation, until deflationary pressures have started to dissipate. Given that inflation finished 2016 with a yearly growth of 0%, the SNB will not stop intervening any time soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 In a recent speech, Norges Bank Governor Oystein Olsen asserted that the economy has turned the corner, projecting real GDP growth of 1.5% in 2017 and above 2% in 2018 and 2019. He also pointed to the solid growth experienced by the non-oil sector. Wage growth, after falling for the past 8 years, also appears to have bottomed at around 2% and is now picking up. More importantly, leverage in the economy is very high and continues to grow, with debt as a percent of disposable income projected to reach close to 250% by the end of 2018. All of these factors could fortify already present inflationary pressures in the Norwegian economy. This will push the Norges Bank off its dovish bias, and consequently, thrust the NOK higher, particularly against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Riksbank's monetary policy meeting on Wednesday concluded with an unexpected outcome -the board considered the option to be able to immediately intervene on the market if necessary. It is clear that Swedish officials are making an adamant attempt in achieving their inflation target, clearing out any obstructions that may slow down inflation. It must be highlighted however that Governor Martin Flodén is reticent on this policy in the current situation, suggesting that intervention risk is not looming for the time being. Nevertheless, it is important to note that this instrument has been added to their toolkit. This decision most likely stems from the 4.5% decline in EUR/SEK since November 8 of last year. Since Europe represents 82% of Sweden's imports, a risk of importing deflation exists. We believe a level of around 9.000 to 9.1000 for EUR/SEK seems like a potential intervention trigger. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Overall Strategy: The global economy is entering a reflationary sweet spot that will last for the next two years. Investors should overweight equities, maintain slightly below benchmark exposure to government bonds, and underweight cash over a 12-month horizon. Fixed Income: Global bond yields will rise only modestly over the next two years, reflecting an abundance of spare capacity in many parts of the world. A major bond bear market will begin towards the end of the decade, as stagflationary forces gather steam. Equities: Investors should underweight the U.S. for the time being, while overweighting Europe and Japan in currency-hedged terms. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate another 6% from current levels. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is approaching a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks later this year. Feature I. Key Theme: A Reflationary Window The global economy is entering a reflationary sweet spot where deflationary forces are in retreat but fears of excess inflation have yet to surface. Activity data are surprising to the upside and leading economic indicators have turned higher (Chart 1). Falling unemployment in most major economies is boosting confidence, fueling a virtuous cycle of rising spending and even further declines in joblessness. Manufacturing activity is bouncing back after a protracted inventory destocking cycle (Chart 2). In addition, the stabilization in commodity prices has given some relief to emerging markets, while fueling a modest rebound in resource sector capital spending. Meanwhile, easier fiscal policy is providing a welcome tailwind to growth. The aggregate fiscal thrust for advanced economies turned positive in 2016 - the first time this has happened in six years. We expect this trend to persist for the foreseeable future. Reflecting these developments, market-based measures of inflation expectations have risen, offsetting the increase in nominal interest rates. In fact, real rates in the euro area and Japan have actually declined across most of the yield curve since the U.S. presidential election (Chart 3). This should translate into higher household and business spending in the months ahead. Chart 1Global Growth Is Accelerating Chart 2Inventory Destocking Was A Drag On Growth Chart 3Falling Real Rates In The Euro Area And Japan Supply Matters Yet, there has been a dark side to this reflationary trend, and one that could sow the seeds for stagflation as the decade wears on. Simply put, much of the reduction in spare capacity over the past eight years has occurred not because of much faster demand growth, but because of continued slow supply growth. Chart 4 shows that output gaps in the main developed economies would still be enormous today if potential GDP had grown at the rate the IMF forecasted back in 2008. Chart 4AWeak Supply Growth Has Narrowed Output Gaps Chart 4BWeak Supply Growth Has Narrowed Output Gaps Unfortunately, we do not expect this state of affairs to change much over the coming years. The decline in birth rates that began in the 1960s has caused working-age populations to grow more slowly in almost all developed and emerging economies (Chart 5). In some countries such as the U.S., the downward pressure on labor force growth has been exacerbated by a structural decline in participation rates, especially among the less educated (Chart 6). Chart 5Slowing Workforce Growth Chart 6U.S.: The Less Educated Are Shunning The Labor Force Productivity growth has also fallen (Chart 7). Part of this phenomenon is cyclical in nature, reflecting the impact of several years of weak corporate investment in new plant and equipment. However, much of it is structural. As Fed economist John Fernald has shown, the slowdown in productivity growth since 2004 has been concentrated in sectors that benefited the most from the adoption of new information technologies in the late 1990s (Chart 8).1 Recent technological innovations have focused more on consumers than on businesses. This has resulted in slower productivity growth. Chart 7Slowing Productivity Growth Around The World Chart 8The Productivity Slowdown Has Been ##br##Greatest In Sectors That Benefited The Most From The I.T. Revolution To make matters worse, human capital accumulation has decelerated both in the U.S. and elsewhere, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the rate it did in the 1990s (Chart 9). Educational achievement, as measured by standardized test scores, has also peaked, and is now falling in many countries (Chart 10). Chart 9The Contribution To Growth ##br##From Rising Human Capital Is Falling Chart 10Math Skills Around The World From Deflation To Inflation To reiterate what we have discussed at length in the past, the slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on.2 Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation (Chart 11). One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a period during which productivity growth slowed and inflation accelerated. Likewise, a slowdown in labor force growth tends to morph from being deflationary to inflationary over time. When labor force growth slows, two things happen. First, investment demand drops. Why build new factories, office towers, and shopping malls if the number of workers and potential consumers is set to grow more slowly? Second, savings rise, as spending on children declines and a rising share of the workforce moves into its peak saving years (ages 35-to-50). The result is a large excess of savings over investment, which generates downward pressure on inflation and interest rates. As time goes by, the deflationary impact of slower labor force growth tends to recede (Chart 12). Workers who once brought home paychecks start to retire en masse and begin drawing down their accumulated wealth. Since there are few young workers available to take their place, labor shortages emerge. At the same time, health care spending and pension expenditures rise as a larger fraction of the population enters its golden years. The result is less aggregate savings and higher interest rates. Chart 11A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Chart 12An Aging Population Eventually Pushes Up Interest Rates Is Debt Deflationary Or Inflationary? The answer is both. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Moreover, once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. Acting on that incentive also becomes easier as the output gap evaporates. Consider the case of forward guidance. If an economy has a large output gap, a central bank's promise to maintain interest rates at ultra-low levels, even after full employment has been reached, may hold little sway. After all, many things can happen between now and then: A change of central bank leadership, an adverse economic shock, etc. In contrast, if the output gap is already close to zero, a promise to let the economy run hot is more likely to be taken seriously. The U.S. Economy: Still In A Reflationary Sweet Spot The stagflationary demons described above will eventually come back to haunt the U.S., but for now and probably for the next two years, the economy will remain in a reflationary sweet spot. After a weak start to 2016, growth has bounced back. Real GDP grew by 3.5% in Q3. The Atlanta Fed's GDPNow model points to still-healthy growth of 2.9% in Q4. We expect growth to stay robust in 2017, as improving confidence and a stabilization in energy-sector investment lift overall business capex, homebuilding picks up after contracting in both Q2 and Q3 of 2016, and rising wages push up real incomes and personal consumption. Above-trend growth will continue to erode spare capacity. The headline unemployment rate has fallen to 4.6%, close to most estimates of NAIRU. Broader measures of unemployment, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 13). Consistent with this observation, the job openings rate in the JOLT survey, the share of households reporting that jobs are "plentiful" versus "hard to get" in the Conference Board's Consumer Confidence survey, and the share of small businesses reporting difficulty in finding suitably qualified workers in the NFIB survey are all at or above 2007 levels (Chart 14). In contrast to most measures of labor market slack, industrial utilization still remains quite low by historic standards (Chart 15). In fact, the Congressional Budget Office's "capacity utilization-based" estimate of the output gap stands at around 3% of GDP, whereas its "unemployment-based" estimate is close to zero. Chart 13U.S. Labor Market: Not Much Slack Left Chart 14Most U.S. Labor Market Measures ##br## Are Back To Pre-Recession Levels Chart 15U.S.: Industrial Capacity Utilization Remains Low A strong dollar, as well as the ongoing decline of the U.S. manufacturing base, partly explain the low level of industrial utilization. However, another important reason bears noting: Years of depressed real wage growth has made labor scarce compared with capital. The free market solution to this problem is higher wages for workers. Good news for Main Street; but perhaps not so good news for Wall Street. Stagflation Is Coming, Just Not Yet While inflation will creep higher in 2017, a major spike is unlikely over the next two years. There are two main reasons for this. First, if the economy does run into severe capacity constraints, the Fed will have to step up the pace of rate hikes. Higher interest rates will push up the value of the dollar, curbing growth and inflation. Second, the historic evidence suggests that it takes a while for an overheated economy to generate meaningfully higher inflation. Consider how inflation evolved during the 1960s. U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 due to rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 16). The relationship between economic slack and inflation is depicted by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 17). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Chart 16It Can Take A While For Inflation To Rise In Response To An Overheated Economy Chart 17The Phillips Curve Has Flattened The adoption of inflation targeting, coupled with more transparent Fed communication, has helped anchor inflation expectations. This has flattened the Phillips curve. A flatter Phillips curve implies a lower "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. Going forward, the temptation to exploit the flatness of the Phillips curve may be too great to resist. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that she is at least willing to entertain the idea. Interest rates are still fairly low and a few more hikes are unlikely to cause much distress among corporate and household borrowers. As rates continue to climb, however, this may change, making it difficult for the Fed to further tighten monetary policy. This is especially the case if potential real GDP growth remains lackluster, as this would make it harder for borrowers to generate enough income to service their debts. Trump's budget-busting fiscal deficits may also put some pressure on the Fed to eschew raising rates too much in an effort to hold down interest costs. Even if such political pressures do not materialize, the challenges posed by the zero bound constraint on nominal interest rates could still justify efforts to raise the Fed's 2% inflation target. After all, if inflation were higher, this would give the Federal Reserve the ability to push down real rates further into negative territory in the event of an economic downturn. Admittedly, such a step is unlikely to be taken anytime soon. Nevertheless, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF; San Francisco Fed President John Williams; and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. The bottom line is that inflation is likely to move up slowly over the next two years, but could begin to accelerate more sharply towards the end of the decade. Japan: The End Of Deflation? Like the U.S., Japan has also entered a reflationary window. Retail sales surprised on the upside in November, rising 1.7%, against market expectations of 0.8%. Industrial production and exports continue to rebound, a trend that should persist thanks to the yen's recent depreciation (Chart 18). Stronger economic growth is causing the labor market to heat up. The Bank of Japan estimates that the "labor input gap" is now positive, meaning that the economy has run out of surplus workers (Chart 19). Reflecting this, the ratio of job openings-to-applicants has reached a 25-year high (Chart 20). Chart 18Japan: Some Positive Economic News Chart 19Japan: Labor Market Slack Has Evaporated, But Industrial Capacity Utilization Has Fallen Chart 20Japan: Sign Of Tightening Labor Market Wage growth so far has been tepid, but that should change over the next two years. The labor force expanded by 0.9% year-over-year in November - the latest month for which data are available - largely due to the continued influx of women into the labor force. Chart 21 shows that the employment-to-population ratio for Japanese prime-age women now exceeds that of the U.S. by three percentage points. As Japanese female labor participation stabilizes, overall labor force growth will turn negative, pushing up wages in the process. Chart 21Japan: Female Labor Force ##br##Participation Now Exceeds The U.S. In contrast to the Fed, the BoJ is unlikely to tighten monetary policy in response to higher inflation. As a consequence, real yields will continue to fall as inflation expectations rise further. This will lead to higher net exports via a weaker yen, as well as increased spending on interest-rate sensitive goods such as consumer durables and business equipment. Indeed, a virtuous circle could develop where an overheated labor market pushes down real rates, causing aggregate demand and inflation to rise, leading to even lower real rates. If this occurs, growth could accelerate sharply, avoiding the need for more radical measures such as "helicopter money." In short, Japan may be on the verge of escaping its deflationary trap. This is something that could have happened shortly after Prime Minister Abe assumed office, but was short-circuited by the government's lamentable decision to tighten fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. Europe: Fine... For Now The European economy grew at an above-trend pace in 2016. Real GDP in the EU is estimated to have expanded by 1.9%, compared to 1.6% in the U.S. The euro area is estimated to have grown by 1.7% - the first time that growth in the common currency bloc exceeded the U.S. since the Great Recession. Euro area growth should remain reasonably strong in 2017, as telegraphed by a number of leading economic indicators (Chart 22). Fiscal austerity has been shelved in favor of modest stimulus. The European Commission is now even advising member countries to loosen fiscal policy more than they themselves are targeting (Chart 23). Chart 22Euro Area Growth Will Remain On Solid Footing In 2017 Chart 23The European Commission Recommends Greater Fiscal Expansion Ongoing efforts to strengthen the euro area's banking system will also help. As we noted in the "Italian Bank Job," the costs of cleaning up the Italian banking system are modest compared with the size of the Italian economy.3 The failure to have done it earlier represents a massive "own goal" by the Italian and EU authorities. As banking stresses recede, the gap in economic performance between northern and southern Europe should narrow. The overall stance of monetary policy will facilitate this trend. If the ECB keeps interest rates near zero for the foreseeable future, as it almost certainly will, Germany's economy will overheat. Chart 24 shows that the German unemployment rate has fallen to a 25-year low, while wage growth is now running at twice the rate as elsewhere in the euro area. Chart 24German Labor Market Going Strong An overheated German economy will help the periphery in two important ways: First, higher wage inflation in Germany will give a competitive advantage to Club Med producers seeking to sell their goods in the euro area's biggest economy. Second, faster wage growth and stronger domestic demand in Germany will erode the country's gargantuan current account surplus of nearly 9% of GDP. This will put downward pressure on the euro, giving the periphery a further competitive boost. Of course, all this rests on the assumption that Germany accepts an overheated economy. One could objectively argue that it is in Germany's political best interest to do so, as this may be the only means by which to hold the euro area together. One could also argue that rebalancing German growth towards domestic demand, and away from its historic reliance on exports, would be in the country's long-term best interest. One might also contend that German banks would accept a few more years of low rates if this helped lower nonperforming loans across the euro area, while also paving the way for the eventual abandonment of ZIRP and NIRP. Chart 25Italy Lags Peers On Euro Support Whatever the merits of these arguments, they clash with Germany's historical antipathy towards inflation. This means that political risk could escalate over the coming years. Against the backdrop of growing anti-establishment sentiment - fueled in no small measure by the EU's deer-in-the-headlights response to the migration crisis - Europe's populist parties will continue to make gains at the polls. Timing is important, however. With unemployment trending lower, our hunch is that any truly disruptive populist shock may have to wait until the next recession, which is likely still a few years away. BCA's Geopolitical Strategy team holds a strong conviction view that Marine Le Pen, the leader of the eurosceptic National Front, will be defeated in the second round of the presidential election in May. They also think that Angela Merkel will cling to power, partly because Germany still lacks an effective anti-establishment opposition party. Italy is more of a concern, given that support for the common currency among Italians has been falling and is now lower than virtually anywhere else in the euro area (Chart 25). Nevertheless, our geopolitical strategists assign very low odds to Italy following Britain's example and voting to leave the EU. Indeed, it is still not even clear that the U.K. will actually follow through and exit the EU. Brussels is likely to play hardball with the U.K. during the negotiations slated to begin in March. EU officials are keen to send a clear warning to other EU members who may be tempted to leave the club. It is still quite possible that another referendum will be held in one or two years concerning the terms of the negotiated agreement that would govern Britain's future relationship with the EU. Given how close the first referendum was, there is a reasonable chance that U.K. voters will choose EU membership over a bad deal. In that case, Brussels will back off from its threat that triggering Article 50 would irrevocably lead to the U.K.'s expulsion from the EU. China: Still In Need Of A Spender-Of-Last Resort Investor angst about China rose to a fever pitch early last year, but has since faded into the background. The main reason for this is that the deflationary forces which once threatened to precipitate a hard landing for the economy have abated. Growth has picked up and producer price inflation has risen from -5.3% in early 2016 to 3.3% in November (Chart 26). As our China strategists have argued, the end of PPI deflation is a major positive development for the Chinese corporate sector, as it improves its pricing power while reducing its real cost of funding (Chart 27). Real bank lending rates deflated by the PPI rose to near-record highs early last year, but have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This has bestowed dramatic relief on some highly-levered, asset-heavy industries. These industries were the biggest casualties of the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bode well for banks. Chart 26China: Improving Growth Momentum Chart 27China: Real Interest Rates Dropping ##br## Thanks To Easing Deflation Unfortunately, the reflationary forces in China are masking deep underlying problems. Structural reform has been patchy at best; credit continues to expand much faster than GDP; and speculation in the real estate sector is rampant (Chart 28). Meanwhile, capital continues to flow out of the country, taking the PBOC's foreign exchange reserves down from a high of $4 trillion in June 2014 to $3.1 trillion at present. There are no easy solutions to these problems. Tightening monetary policy could help fend off capital flight, but this would hurt growth and potentially plunge the economy back into deflation. This week's spike in interbank rates is evidence of just how sensitive the economy has become to any withdrawal of monetary accommodation (Chart 29). Chart 28China: Credit Continues Expanding And The##br## Real Estate Sector Is Getting Frothy Chart 29China: Yet Another Spike In Interbank Rates As we controversially argued in "China Needs More Debt," China's underlying problem is a chronic excess of savings.4 This has kept aggregate demand below the level commensurate with the economy's productive capacity. In the past, China was able to export some of those excess savings abroad via a large current account surplus, which peaked at 10% of GDP in 2007 (Chart 30). However, China is now too large to export its way out of its problems. It was one thing for China to run a current account surplus of 10% of GDP when its economy represented 6% of global GDP. It is quite another to do so when the economy represents 15% of global GDP, as it does now. This is especially the case when other economies are also keen to have cheap currencies. Faced with this reality, the government has been trying to buttress aggregate demand by funneling a huge amount of credit towards state-owned companies, which have then used these funds to finance all sorts of investment projects. The problem is that China no longer needs as much new capacity as it once did. As trend GDP growth has slowed, the level of investment necessary to maintain a constant capital-to-output ratio has fallen by about 10% of GDP over the past decade.5 China's aging population will eventually lead to a drop in savings. Government plans to strengthen the social safety net should also help this transition along by reducing household precautionary savings. However, these are long-term developments. Over the next couple of years, China will have little choice but to let credit grow at a rapid pace. The good news is that China has ample domestic savings to continue financing credit expansion. The ratio of bank loans-to-deposits remains near all-time lows (Chart 31). The government also has plenty of fiscal resources to safeguard the banks from losses on nonperforming loans extended to local governments and state-owned enterprises. Chart 30China Used To Rely On Large ##br##Current Account Surplus To Export Excess Savings Chart 31China: Banks Have Ample Deposit Coverage All that may not be enough, however. Given the risks to financial stability from excessive investment by state-owned enterprises, the government may have little choice but to cajole households into spending more by suppressing bank deposit rates while purposely engineering higher inflation. The resulting decline in real rates will reduce the incentive to save while helping to inflate away the mountain of debt that has already been accumulated. II. Financial Markets Equities Chart 32Investors Are Optimistic Deflation is bad for equities, as is stagflation. But between deflation and stagflation there is reflation - and that is good for stocks. This reflationary window should remain open for the next two years. As such, we expect global equities to be higher in 12 months than they are today. However, the risks for stocks are tilted to the downside over both a shorter-term horizon of less than two months and a longer-term horizon exceeding two years. The near-term outlook is complicated by the fact that global equities are overbought, and hence vulnerable to a selloff. Chart 32 shows that bullish sentiment is stretched to the upside. Expectations of long-term U.S. earnings growth have also jumped to over 12%, something that strikes us as rather fanciful. Renewed rumblings in China could also spook the markets for a while. We expect global equities to correct 5%-to-10% from current levels, setting the stage for a more durable recovery. Once that recovery begins, higher-beta developed markets such as Japan and Europe should outperform the U.S. As my colleague, Mark McClellan, has shown, Europe and Japan are considerably cheaper than the U.S., even after adjusting for sector skews and structural valuation differences.6 The relative stance of monetary policy also favors Europe and Japan. Neither the ECB nor the BoJ is likely to hike rates anytime soon. This means that rising inflation expectations in these two economies will push down real rates, weakening their currencies in the process. Emerging markets are a tougher call. The combination of a strengthening dollar, growing protectionist sentiment in the developed world, and high debt levels are all bad news for emerging markets. EM equity valuations are also not especially cheap by historic standards (Chart 33). Nevertheless, a reflationary environment has typically been positive for EM equities. The tight correlation between EM and global cyclical stocks has broken down over the past three months (Chart 34). We suspect the relationship will reassert itself again over the course of 2017, giving EM stocks a bit of a boost. Chart 33EM Stocks Are Not Particularly Cheap Chart 34EM Stocks Are Lagging On balance, EM equities are likely in a bottoming phase where returns over the next 12 months will be positive but not spectacular. BCA's favored markets are Korea, Taiwan, China, India, Thailand, and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil, and Peru. Turning to global equity sectors, a bias towards cyclical names is appropriate in an environment of rising global growth. Longer term, our equity sector specialists like health care and technology names. The outlook for financial stocks remains a key area of debate within BCA. Most of my colleagues would still avoid banks. I am more partial to the sector. As I argued in September in "Three Controversial Calls: Global Banks Finally Outperform," steeper yield curves will boost net interest margins over the next few years while rising demand for credit will support top-line growth (Chart 35). On a price-to-earnings basis, global banks are quite cheap, despite being much better capitalized than they were in the past (Chart 36). Chart 35AHigher Yields Will Benefit Banks Chart 35BHigher Yields Will Benefit Banks Lastly, in terms of size exposure, we prefer small caps over large caps. Small capitalization stocks tend to do better in reflationary environments (Chart 37). The ongoing retreat from globalization will also benefit smaller domestically-focused firms at the expense of those with large global footprints. In the U.S. specifically, small caps face a potential additional benefit. If the new Trump administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Chart 36Global Banks Are Cheap ##br##And Better Capitalized Since The Crisis Chart 37Reflationary Backdrop ##br##Favors Small Caps Outperformance Fixed Income And Credit Back in March 2015, we predicted that the 10-year Treasury yield would fall to 1.5% even if the U.S. economy avoided a recession.7 The call was notably out of consensus at the time, but proved to be correct: The 10-year yield reached a record closing low of 1.37% on July 5th. As luck would have it, on that very same day, we sent out a note entitled "The End Of The 35-Year Bond Bull Market," advising clients to position for higher bond yields. Global bonds have sold off sharply since then, with the selloff intensifying after the U.S. presidential election. As discussed above, inflation in the U.S. and elsewhere will be slow to rise over the next two years. Hence, global bond yields are unlikely to move significantly higher from current levels. Indeed, the near-term path for yields is to the downside if our expectation of a global equity correction proves true. However, once the stagflationary forces described in this report begin to gather steam towards the end of the decade, bond yields could spike higher, imposing significant pain on fixed-income and equity investors alike. Regionally, we favor Japanese and euro area bonds relative to their U.S. counterparts over a 12-month horizon. Inflation in both Japan and the euro area remains well below target, suggesting that neither the BoJ nor the ECB will tighten monetary policy anytime soon. In contrast, the Fed is likely to raise rates three times in 2017, one more hike than the market is currently pricing in. In addition, we would underweight U.K. gilts. While U.K. growth will decelerate next year as uncertainty over the Brexit negotiations takes its toll, a weaker pound and some fiscal loosening will keep the economy from flying off the rails. In this light, the market's expectations that U.K. rates will rise to only 0.66% at end-2019 seems too pessimistic. Elsewhere in the developed world, our global fixed-income strategists are neutral on Canada and New Zealand bonds, but are underweight Australia. A modest underweight to EM government bonds is also warranted. Turning to credit, a reflationary backdrop is positive for spread product insofar as it will keep defaults in check, while also propping up the appetite for riskier assets. That said, U.S. high-yield credit is now quite expensive based on our fundamental models (Chart 38). Private-sector leverage remains at elevated levels and our Corporate Health Monitor is still in deteriorating territory (Chart 39). Rising government yields could also prompt yield-hungry investors to move some of their money back into sovereign debt. On balance, U.S. corporate spreads are likely to narrow slightly this year, but corporate credit will still underperform equities. Regionally, we see more upside in European credit, given the ECB's continued bond-buying program and greater scope for corporate profit margins to rise across the region. Chart 38U.S. High-Yield Valuations Chart 39U.S. Corporate Health Keeps Deteriorating Currencies And Commodities BCA's Global Investment Strategy service has been bullish on the dollar since October 2014, a view that has generated a gain of nearly 17% for our long DXY trade recommendation. We reiterated this position last October in a note entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen,"8 where we predicted that the dollar would rally a further 10%. Since that report was published, the real trade-weighted dollar has gained 4%, implying another 6% of upside from current levels. Chart 40Real Rate Differentials Are Driving Up The Dollar Both economic and political forces have conspired to keep the dollar well bid. The resurgent U.S. economy has pushed up real rate expectations in the U.S. relative to its trading partners. Chart 40 shows the amazingly strong correlation between the trade-weighted dollar and real interest rate differentials. Rate differentials should widen further over the coming months as investors price in more Fed rate hikes, and rising inflation expectations abroad push down real rates in economies such as Japan and the euro area. As we predicted in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Wins And The Dollar Rallies," Donald Trump's triumph on November 8th has given the greenback an additional boost. Progress in implementing any of Trump's three signature policy proposals - fiscal stimulus, trade protectionism, and immigration restrictions - will cause the U.S. output gap to narrow more quickly than it otherwise would, forcing the Fed to pick up the pace of rate hikes. Chart 41The Pound Is A Bargain The adoption of a "destination-based tax system" would further strengthen the dollar. Under the existing corporate tax structure, taxes are assessed on corporate profits regardless of where they are derived. In contrast, under a destination-based system, taxes would be assessed only on the difference between domestic sales and domestic costs. In practice, this means that imports would be subject to taxes, while exports would receive a tax rebate. In the simplest economic models, the imposition of a destination-based tax has no effect on domestic economic activity, inflation, or the distribution of corporate profits across the various sectors of the economy. This is because the dollar is assumed to appreciate by precisely enough to keep net exports unchanged. For that to happen, however, the requisite change in the currency needs to be quite large. For example, if the Trump administration succeeds in bringing down effective corporate tax rates to 20%, the required appreciation would be 1/(1-tax rate)=25%. Under current law, the required appreciation would be over 30%! In reality, the dollar probably would not adjust that quickly, implying that the transition period to a destination-based tax system would disproportionately benefit exporters at the expense of importers. Partly for this reason, the proposal will probably be heavily watered down if it is ever passed. Nevertheless, overall U.S. policy will continue to be biased towards a stronger dollar. Looking at the various dollar crosses, we still see more downside for the yen. The BoJ's policy of pegging the 10-year nominal yield will result in ever-lower real yields as Japanese inflation expectations rise. The euro should also continue to drift lower, most likely reaching parity against the dollar later this year. The pound could dip further if an impasse is reached during Brexit negotiations, as is likely at some point this year. That said, sterling is now very cheap, which limits the downside for the currency (Chart 41). Chart 42The Dollar Has Weighed On Gold The Chinese yuan will continue to grind lower, in line with most other EM currencies. As we discussed in March 2015 in a report entitled "A Weaker RMB Ahead," China's excess savings problem necessitates a weaker currency. The real trade-weighted RMB has fallen by 7% since that report was written, but a bottom for the currency remains elusive.9 As noted above, the Chinese government may have no choice but to boost household spending by suppressing deposit rates while working to engineer higher inflation. Negative real borrowing rates will keep capital flowing out of the country, putting downward pressure on the yuan. The overall direction of the Canadian and Aussie dollars will be dictated by the path of commodity prices. A reflationary environment tends to be bullish for commodities. Nevertheless, an uncertain macro outlook in China muddies the waters. We prefer oil over metals, given that the former is more geared towards growth in developed economies while the latter is heavily dependent on Chinese demand. This also makes the Canadian dollar a more attractive currency than the Aussie dollar. Lastly, a few words on gold: The combination of political uncertainty, rising inflation expectations, and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar. The strengthening of the dollar clearly was a factor undermining gold prices in the second half of 2016 (Chart 42). On balance, we would maintain a modest position in gold for the time being, but would look to increase exposure later this year as the dollar peaks. Peter Berezin Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 John G. Fernald, "Productivity and Potential Output Before, During, and After the Great Recession," Federal Reserve Bank of San Francisco, Working Paper 2014-15, (June 2014), and John G. Fernald, "The Pre-Great Recession Slowdown in U.S. Productivity Growth," (November 16, 2015). 2 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com 4 Please see Global Investment Strategy Weekly Report, "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. 5 Back in 2007, trend growth was around 10%. Consistent with the empirical literature, let us assume that an appropriate capital-to-GDP ratio is 250% and that the capital stock depreciates at 5% a year. With a trend growth of 10%, China needs 2.5*10%=25% of GDP in new investment before depreciation to keep its capital-to-GDP ratio constant, and an additional 2.5*5%=12.5% of GDP in investment to cover depreciation, for a grand total of 37.5% of GDP in required investment. With a trend GDP growth rate of 6%, however, the required investment-to-GDP ratio would only be 2.5*6%+2.5*5%=27.5%. 6 Please see The Bank Credit Analyst Monthly Reports Section 2, "Are Eurozone Stocks Really That Cheap?" dated June 30, 2016, and "Japanese Equities: Good Value Or Value Trap?" dated November 24, 2016, available at bca.bcaresearch.com. 7 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "A Weaker RMB Ahead," dated March 06, 2015, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades