Geopolitics

Highlights Geopolitics will not spoil the stock rally yet; European election risks remain overstated; In China, look beyond the National Party Congress; China's reforms could re-launch in 2018 ... ... But India's reforms are gaining momentum now. Feature The global economy continues to surprise to the upside, with the latest round of global purchasing managers' indices (PMIs) confirming that the business cycle continues to accelerate (Chart 1). In the context of firming global growth, the Fed's decision to hike rates may not produce as violent of a reaction from the dollar as last year, giving way to further upside in stocks. And while investors continue to fret about valuations, U.S. stocks are expensive only relative to history, not relative to competing assets, as our colleague Lenka Martinek of the U.S. Investment Strategy service points out (Chart 2).1 Chart 1Because I'm Happy Because I'm Happy Because I'm Happy Chart 2U.S. Stocks Pricey By History, Not Peers U.S. Stocks Pricey By History, Not Peers U.S. Stocks Pricey By History, Not Peers What geopolitical news could break up the party over the next six months? Europe: As we argued three weeks ago, the European electoral calendar is unusually busy (Table 1).2 However, we have also posited in our 2017 Strategic Outlook that Europe will be a red herring this year, allowing risk assets to "climb the wall of worry."3 The first test of this thesis comes today, with the Dutch general elections taking place. The polls suggest that the Dutch electorate is not following the populist trend of the Brexit referendum and U.S. election (Chart 3), but rather in the footsteps of the little noticed Austrian presidential election in December, which saw the populist presidential candidate defeated. Dutch Euroskeptics, who have led the polling throughout the last twelve months, are bleeding support as election day approaches. Meanwhile, in France, Marine Le Pen is struggling to keep momentum going with only a month and a half to the first round. Thus far, our thesis on Europe is holding. Table 1Busy Calendar For Europe This Year China Down, India Up? China Down, India Up? Chart 3Dutch Euroskeptics Are An Overstated Threat China Down, India Up? China Down, India Up? The U.S.: Investors will finally get to put numbers to President Trump's rhetoric when the White House announces its budget on March 16. As we argued last week, President Trump is who we thought he was: an economic populist looking to shake up America's status quo. That suggests he will err on the side of greater deficits and large middle-class tax cuts. We do not think Congress will bar his way, as it has rarely restrained a Republican president from profligacy (Chart 4). We could be wrong, but it is unclear if a more fiscally responsible budget would be negative for the markets. On one hand, it may disappoint optimistic growth projections, but on the other, it would mean that the Fed would have no reason to err on the side of more rate hikes in 2017. Meanwhile, while we continue to fear protectionism's impact on the market, it is unlikely that the Trump White House will focus on trade when so many domestic priorities are looming this summer. Russia: As we argued in a Special Report with the Emerging Markets Strategy group last week, Russia may be entering a low-beta paradigm - escaping from its close embrace with oil prices - due to the combination of orthodox monetary policy, modest structural reforms, and growing confidence in its geopolitical predicament.4 This is not the time for President Putin to rattle nerves in the West. He does not want to give Europe and the U.S. a reason to cooperate. We therefore expect Russia's geopolitical risk premium to continue to decline, a boon for European risk assets (Chart 5). Chart 4Budgets: Republican Presidents##br## Get What They Want China Down, India Up? China Down, India Up? Chart 5Russia's Calm##br## Is Europe's Profit Russia's Calm Is Europe's Profit Russia's Calm Is Europe's Profit From a tactical perspective, we believe that the confluence of geopolitical forces supports our continued overweight of developed-market equities versus those of emerging markets. Within developed markets, the BCA House View is to prefer euro-area equities due to overstated geopolitical risks and favorable valuations relative to the U.S. equity market. BCA's Global Investment Strategy has pointed out that euro-area equities are one standard deviation undervalued relative to the U.S., when one applies U.S. sector weights to them (Chart 6). In addition, BCA's U.S. Bond Strategy service believes that Treasury yields have more room to rise, with growth putting upward pressure on inflation and the Fed in a rate-hike cycle. This makes sense to us given that no major geopolitical risk is materializing and considerable upside risk exists in U.S. growth due to Trump's populist policies. Chart 6European Stocks Still A Buy Relative To U.S. European Stocks Still A Buy Relative To U.S. European Stocks Still A Buy Relative To U.S. In what follows, we take a break from poring over geopolitical risks in Europe and the U.S. and focus on emerging markets. Since January, very few investors have asked us about EM politics, save for the occasional question about Brazil. However, the two Asian giants - China and India - are both a source of risk: the first a downside, left-tail risk and the second an upside, right-tail risk. China: What Comes After The Party Congress This Fall? Since 2013, we have been outspoken in our low expectations for China's structural reforms.5 This view was confirmed with a series of stimulus efforts that displaced reforms, including the local government debt swap program in 2014 and extensive fiscal and monetary easing in 2015 and especially 2016.6 The upside of weak reforms was better-than-expected growth in the short run, as stimulus took effect. Indeed, China has pulled off a remarkable economic turnaround since early last year: infrastructure and housing investment have increased, the weaker yuan has boosted exports, and the global recovery in commodity prices has helped producer prices to recover, easing deflationary pressures (Chart 7). Chart 7Deflationary Pressures Easing Deflationary Pressures Easing Deflationary Pressures Easing Chart 8Stimulus Dropped Off Stimulus Dropped Off Stimulus Dropped Off Accordingly, Chinese policymakers, who are attempting to strike a balance between stimulus and restructuring, have begun leaning against the economy's gathering momentum. Government spending has collapsed now that a 6.5% GDP growth "floor" has been established (Chart 8). A new round of property market regulatory tightening began last fall, though it has had little impact so far. Also, the People's Bank of China has begun draining some liquidity (Chart 9). Signals coming out of the "Two Sessions" over the past two weeks, namely the National People's Congress, suggest that the Chinese leadership is content with the current state of affairs. Policymakers set their growth targets for 2017 a little lower than last year's targets and a little higher than last year's actual performance (Table 2).7 It is a line so thin that it is almost imperceptible. They do not want significant change. Chart 9PBoC Draining Liquidity PBoC Draining Liquidity PBoC Draining Liquidity Table 2China's Economic Targets For 2017 China Down, India Up? China Down, India Up? This stance fits with a deeper desire to keep the economy on an even keel during a pivotal year for Chinese politics. The legislative session took place under the shadow of the Communist Party's impending 19th National Party Congress - the "midterm" meeting of the party that happens every five years and features extensive promotions, rotations, and retirements for the party leadership. This year's congress promises to be especially influential because of Xi Jinping's ascendancy and the fact that around 70% of the upper tier of leaders will be replaced. Chart 10, which we have been showing clients over the past year to dampen expectations of stimulus, reveals that the party congress is not normally an excuse to throw open the floodgates of credit and government spending. Rather, it is a reason to avoid anything that might rock the boat, whether stimulus or reform. Chart 10Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Thus while government spending has declined, it should be expected to rise again if growth slows down too much for too long. There may be a period of slowdown and market jitters before the leaders reach for the fiscal lever again, but the "Socialist Put" remains in place. Meanwhile, we are not surprised that structural reforms continue to suffer. It is not that China has eschewed all reforms but rather that its reforms have focused on centralizing power for the ruling party and alleviating some outstanding social grievances. These are positive in themselves but they do not address the key concerns of foreign investors relating to economic openness, financial stability, and the role of the state. The recent imposition of capital controls and a host of non-tariff barriers in the name of "state security" exemplify a negative trend. The delayed rollout of the property tax is also a sign of Beijing's proclivity to delay policies that may be financially risky.8 And Beijing has only tentatively attempted to cut back state-owned enterprises. Simply put, a push to overhaul any significant sector or sub-sector does not fit Beijing's priorities at the moment. However, if growth, debt, or asset prices should climb too rapidly, then we expect countermeasures to tamp them down. Even on the geopolitical front - where we have a high conviction view that tail risks to financial markets are higher than the market perceives them to be, both in China and the broader Asia Pacific - there have been some signs of the U.S. and China playing ball on a shared desire for "stability," at least for the moment.9 While we expect a negative geopolitical shock, the market will only believe it when it sees it. All of the above suggest that China will focus on "maintaining stability" this year even more than usual due to the party congress. This is clearly bullish, especially given improving U.S. and global growth. However, the mantra of "stability" and "party congress" should not prevent investors from looking beyond October or November of this year. Chart 11China Needs More##br## Credit For Same Growth China Down, India Up? China Down, India Up? Chart 12China Gets Old ##br##Before It Gets Rich China Gets Old Before It Gets Rich China Gets Old Before It Gets Rich Even assuming that China experiences no significant internal or external economic shocks from now until this fall, it is important to remember that China's growth potential is still slowing for structural reasons. Productivity is collapsing and credit dependency is rising (Chart 11). The slowdown stems from deep shifts such as the end of the debt supercycle in the U.S. (weak external demand), the tipping point in Chinese demographics (higher dependency ratio) (Chart 12), and the extremely rapid build-up in corporate debt (Chart 13). Chart 13Corporate Debt Skyrockets Corporate Debt Skyrockets Corporate Debt Skyrockets Chart 14As Good As It Gets As Good As It Gets As Good As It Gets This is what leads our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, to surmise that China is at the peak of its current economic mini-cycle. This is "as good as it gets," as he shows in Chart 14. Barring a situation in which Xi somehow fails to consolidate power at the party congress, the market impact will depend on which of two scenarios follows: First scenario: Xi achieves a dominant position in all party and state organs, yet 2018 sees a continuation of the current pattern of mini-cycles of stimulus, lackluster reform, and foreign policy aggressiveness. Xi implicitly deems the strategic cost of reform too great, as we argued he would do over the past four years, and dedicates his stint in office to the accumulation of power. Perhaps a successor will be able to use these powers to enact painful reforms in the mid-2020s; that is not Xi's immediate concern. This is short-term bullish for global and Chinese growth, long-term bearish for Chinese assets. Second scenario: Xi achieves a dominant position and uses his power to reinvigorate the country's stalled reforms. Hints of big measures emerge in the wake of the party congress in November or December, and January 2018 begins with a bang. This would necessarily mean that Xi accepts slower growth, or even that he imposes it through tighter fiscal policy, real credit control, SOE failures, and aggressive overcapacity cuts. However, Chinese productivity would begin to recover. This is short-term bearish for Chinese and global growth. However, it is the most bullish outcome for the long-term performance of Chinese assets. In China's current state - with capital controls newly reinstituted (Chart 15), Xi lauding the "central role" of SOEs in development, and Xi's administration still focused on purging the party and controlling the media - the second scenario admittedly seems far-fetched. Chart 15Are Capital Controls Working? Are Capital Controls Working? Are Capital Controls Working? Moreover, Xi seems averse to risky experiments at home that could weaken the country in the face of unprecedented strategic threats from the United States and Japan. Nevertheless, a 2018 reform push should not be dismissed out of hand. Why? Because an overbearing state, credit excesses, and weak productivity really do threaten the sustainability of the Chinese economy and hence the Communist Party's grip on power. Xi must keep them in check, as the current gestures toward tighter policy indicate. The government has overseen a massive monetary and credit expansion to protect the country from faltering external demand since 2008. As the current account surplus has declined, the country's massive savings have built up at home in the form of debt (Chart 16).10 Yet the investment avenues are restricted by the role of the state. As a result, the inefficient state-supported sector is getting propped up while the shadow financial sector grows wildly and creates murky systemic risks that are difficult to monitor and control. The PBoC has undertaken further extraordinary actions to keep financial conditions loose (Chart 17). Chart 16Savings Invested At Home Savings Invested At Home Savings Invested At Home Chart 17PBoC Lends A Helping Hand PBoC Lends A Helping Hand PBoC Lends A Helping Hand What signposts should investors watch for to see which path Xi will take after the party congress? Jockeying ahead of the party congress: The latest NPC session saw some political maneuvering. Several sixth generation leaders made appearances and spoke to media.11 Xi's supposed favorite, Chen Min'er, Party Secretary of Guizhou, distinguished himself by cutting reporters short at a press conference. Meanwhile former President Hu Jintao appeared publicly alongside his apprentice, Hu Chunhua, Party Secretary of Guangdong. Elite party gatherings in the summer, especially any retreat at Beidaihe, should be watched closely for any clues of who may be up and who down, and what general policy trajectory may be forthcoming. Xi's future: First, will Xi Jinping and Li Keqiang establish clear successors for their top two positions in 2022?12 A failure to do so will suggest that Xi intends to stay in power beyond his de facto term limit of 2022. This would mean that Xi will prioritize his own future over painful structural reforms. On the other hand, a clear commitment to a leadership transition in five years may re-focus the Xi-Li administration towards their initial commitment to economic restructuring. National Financial Work Conference: This conference is held every five years, usually connected with a major new financial reform or regulatory push, and due sometime in 2017. The government is looking into serious changes to financial regulation - including the creation of a super-ministry to house the various regulatory agencies. This, or the broader attempt to ensure adequate capitalization of banks, could be behind the delay. New central banker: Central bank governor Zhou Xiaochuan, in office since 2002, may step down this fall. He could be replaced with another technocrat to little fanfare, but his exit introduces the opportunity for shaking up the PBoC regime as a whole. Other new officials: A slew of other appointments and reshuffles will take place this year as a generation of leaders born before the Revolution retires. A new director of the state economic planner, the National Development and Reform Commission, was just named, while late last year a new finance minister took his post. These officials have yet to make their mark. Their statements should be watched closely for any shifts in economic policy emphasis. Time frames for reforms: The market is still waiting for concrete proposals and time frames for major reform initiatives, particularly opening up to foreign competition and restructuring state-owned enterprises. Overcapacity cuts have also had mixed results. We do not expect major advances on big structural reforms this year due to the party congress, but details that can be gleaned about the process and timetables could be important. Bottom Line: Watch for signs of a renewed reform drive after the nineteenth National Party Congress. Xi is not going to reverse what he has done so far. And China is not going to become a market economy on the ideal western model. But a pivot point could be in the cards next year for China to pursue some pro-efficiency reforms that it has already set out for itself in a more resolute way. Xi's decision to stay in power beyond 2022 would be bearish for reforms as it would incentivize the current "Socialist Put" model of policymaking over a genuine paradigm shift. India: What Comes After Modi's Big Win? Prime Minister Narendra Modi has won a crushing victory in India's most populous state, Uttar Pradesh, positioning himself, his Bharatiya Janata Party (BJP), and National Democratic Alliance (NDA) coalition very well for the 2019 general elections. Policymaking is going to become easier for the ruling party - though there are still serious political and economic constraints. We have been long Indian equities relative to EM equities since the "Modi wave" began with Modi's victory in the Lok Sabha or lower house in 2014.13 The end of the commodity bull market signaled an opportunity for India, which imports about a third of its energy. The decline of global trade also heralded the outperformance of domestic demand-driven economies like India. Further, Modi's sweeping victory held out the promise for a reform agenda of tighter monetary and fiscal policy that would reduce inflation and make room for private investment to grow. This would make Indian risk assets attractive, especially relative to other EMs, which were at that time either lagging at reforms or failing to undertake them entirely. Since then we have seen Modi rack up a key legislative victory - the passage of the Goods and Services Tax, in the process of implementation - and engineer a surprise "demonetization" effort late last year to increase bank deposits, bring the country's gray markets into the open, and flush out crime and corruption.14 The ruling coalition's gains in Uttar Pradesh and a few other state elections this year are a striking vindication of popular support after this highly unconventional and controversial maneuver.15 Uttar Pradesh is the most important of these elections. It was slated to be a grand testing ground for Modi well before demonetization. It is the most populous Indian state, with about 200 million people, and the third largest state economy (producing about 10% of GDP). It is the second-poorest state, with a GDP per capita of about $730, it has the highest proportion of "scheduled castes" (untouchables), and ranks around the middle of states in terms of the Hindu share of population - all challenges for the landed, pro-business, Hindu nationalist BJP (Map 1). Politically, aside from its inherent heft in population and centrality, Uttar Pradesh sends the most representatives of any state to India's upper house (31 seats), the Rajya Sabha, where Modi lacks a majority. It is thus a key source of federal power and an important state ally. Map 1Modi's Saffron Wave Takes The Indian Core China Down, India Up? China Down, India Up? Given the above, it is hugely bullish that Modi's BJP romped to a historic victory in the state election, winning 312 out of 403 seats (about 39.7% of the vote), up from 47 seats previously. His coalition rose to 324 seats total (Chart 18). The BJP now has the largest majority of any party in the state since 1980. These results were not anticipated. A close election was predicted and opinion polls had BJP winning 157 seats, short of the 202 needed for a majority. This was only slightly ahead of its closest rival, an alliance made up of the local Samajwadi Party and its national partner, the left-leaning Indian National Congress (INC). Exit polls even suggested that the Samajwadi-INC coalition had edged ahead of the BJP. The immediate takeaway is that Modi will have better luck governing Uttar Pradesh itself now that the state government is on his side. Individual states hold the key to reform in India because of the country's size and socio-economic disparities. The state will now be expected to implement Modi's policies faithfully and push approved policies forward on its own. The second takeaway is that while Uttar Pradesh will not give Modi control of India's upper house of parliament, the Rajya Sabha, it will give him a better position there. The BJP has 56 seats in the upper house (fewer than the INC's 59), and the ruling coalition has 74, out of a total of 250. The coalition needs 52 seats for a simple majority. Uttar Pradesh will deliver 10 seats at most by the 2019 general election. Modi would have to win almost every seat of the 56 non-allied seats coming open between now and 2019 in order to win the upper house by that time (Chart 19). That is unlikely, but Modi is moving in the right direction and an upper-house majority cannot be ruled out in the long run. Chart 18Modi's Big Win In Uttar Pradesh China Down, India Up? China Down, India Up? Chart 19Modi's National Position Improves China Down, India Up? China Down, India Up? Of course, Modi has already shown with the Goods and Services Tax that he can pass very difficult legislation through the upper house without controlling a majority there. This achievement last year was perhaps an even greater surprise than the victory in Uttar Pradesh, which reinforces it. Modi also has a secret weapon: in case of a national emergency, however defined, he can call a joint session of parliament, where his coalition would carry the day. This is now more likely because it is the Indian president who is responsible for calling a joint session, and Modi is now more likely to get his candidate into that position due to the win in Uttar Pradesh. President Pranab Mukherjee, who is affiliated with the INC, will step down on July 25. Though Modi does not have all the votes in the electoral college to choose the president outright, smaller parties may fall in line now that the BJP has so much national momentum.16 Controlling the presidency will also give Modi greater influence over constitutional obstacles and gradually over the legal system. Separately, in August, Modi's alliance will be able to choose the vice president as well. More broadly, the Uttar Pradesh election marks a victory for Modi's style of appealing to voter demand for greater economic development as a general priority over longstanding religious and caste grievances that frequently determine electoral outcomes in state elections. This is a hugely significant indication for India's economic structural reform and nation building. Bottom Line: Modi's victory in Uttar Pradesh is proof that for all of India's sprawling inefficiencies, its political system is capable of responding to the large public demand for economic development. Do not underestimate reform momentum now. Modi's political capital remains high. Investment Conclusions The conventional wisdom has for decades been that China is better at reforming its economy because of its authoritarian regime, whereas India democratized too early and has thus lagged at reforms. We have never agreed with this simplistic view of economic reforms. Structural reforms are always and everywhere painful. As such, they require political capital. As our "J-Curve of Structural Reforms" posits, reforms deplete political capital as the pain spreads through the economy and opposition mounts among both the elite and the common man (Chart 20). Eventually, the government is faced with a "danger zone" in which the pain of reforms lingers, the benefits remain beyond the horizon, and all political capital is exhausted. Many leaders chose to water down the reforms, or back off from them altogether, at this point. Chart 20The J-Curve Of Structural Reform China Down, India Up? China Down, India Up? On the surface, authoritarian regimes have massive political capital with which to burst through the danger zone of reform. But this assumption is not entirely correct. In China's case, the political capital for reform came after disastrous performances by the "conservative" political forces. Reformers in China were buoyed by the failures of the "Cultural Revolution" (which ended in 1976) and the 1989 Tiananmen Square protests. Each political and social crisis gave the reformers an opening - following a consolidation period - to pursue controversial economic reforms at the expense of "conservative" forces. The fruit of these reform efforts has been the growth of China's middle class. And while this middle class expects reforms in the delivery and quality of public services, it is not interested in seeing a slowdown in economic growth, no matter how temporary or healthy it may be. As such, Chinese leaders are faced with a significant hurdle to their reform preference: how to convince the public that a slowdown is needed in order to restructure the economy. We are unsure whether the upcoming party congress will make a difference. However, we can see a scenario where President Xi decides to pursue market-friendly reforms because he sees an increase in his political capital. In particular, he may feel that he has cemented his personal dominance over his intra-party rivals and that the aggressive foreign and trade policy emanating from the Trump White House gives him a foil to blame for any downturn in growth. Reform would also be a return to Xi's original agenda, and would conform to the playbook of former president Jiang Zemin, whose precedents Xi has followed in some other areas. Given Xi's modus operandi, a post-consolidation reform drive would be executed relatively effectively and would therefore present short-term risks to Chinese and hence global growth, despite the long-term improvement. Markets are definitely not expecting such a policy pivot at the moment. China bulls are content with the current reforms, while China bears see no chance of the Xi administration changing tack. While we are just beginning to see the potential for a turn in Chinese policymaking towards reforms, India is a much clearer example of a reformist administration. Modi will feel empowered by the Uttar Pradesh election, a political recapitalization of sorts. Foreign investment will likely continue cheering Modi's ongoing revolution (Chart 21). The question now is whether Modi intends to use the infusion of political capital for genuine reforms. After all, the economy is not looking up (Chart 22). Chart 21Foreign Investors Cheer On Modi Foreign Investors Cheer On Modi Foreign Investors Cheer On Modi Chart 22Indian Economy Still Weak Indian Economy Still Weak Indian Economy Still Weak The evidence is mixed. First, Modi has not maintained strictness on fiscal spending and the budget deficit is creeping back to where it was when he took over the reins (Chart 23). Rising government spending along with higher commodity prices suggest that inflation will continue making a comeback (Chart 24). Poor food production is also driving up inflation. And higher spending and inflation pose a key threat to the sustainability of the reform agenda, since rising government bond yields will crowd out private investment. Chart 23Losing Budgetary Discipline? Losing Budgetary Discipline? Losing Budgetary Discipline? Chart 24Inflation Makes A Comeback Inflation Makes A Comeback Inflation Makes A Comeback Second, the RBI will be less likely to pursue a tighter monetary policy with both political influence and weak growth pressing on it. Moreover, Indian stocks are not all that cheap. In 2014, valuations were favorable and the backdrop included cheap commodities, fiscal prudence, and Modi's electoral success. Today, India is trading at its historical mean relative to EM (Chart 25), but using the equal sector weighted P/E ratio, by which India was very cheap back in 2014, India is at a 52% premium now (Chart 26). Chart 25Indian Stocks Trading##br## At Mean Against EM Indian Stocks Trading At Mean Against EM Indian Stocks Trading At Mean Against EM Chart 26Indian Stocks Pricey##br## Versus EM Sector-Weighted Indian Stocks Pricey Versus EM Sector-Weighted Indian Stocks Pricey Versus EM Sector-Weighted We are therefore taking this opportunity to close our long India / short EM trade for a 28% gain (since May 2014). We will reassess Modi's structural reform priorities in future research and gauge whether a new entry point is warranted. We remain optimistic on India in the long run as Modi certainly has the political capital for reforms. The question is whether he plans to use it. Meanwhile, we remain skeptical about China's long-term trajectory. To become fully optimistic about Chinese risk assets in absolute terms, we need to see the Xi administration chose short-term pain for long-term gain. For the time being, China continues to repress its structural problems rather than deal with them head on, relying on minimal openness, high and rising leverage, and state-owned banks and companies. India may be lagging in its reform effort, but it has at least established market reforms as a priority. And the Modi administration has built political capital through the slow and painful democratic process. Over the long term, India's approach is more sustainable. If President Xi wastes the opportunity afforded to him by the upcoming party congress, we suspect that China will face a much higher probability of left-tail economic risks than India over the long term. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "How Expensive Are U.S. Stocks?," dated March 13, 2017, available at usis.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and "China: The Socialist Put And Rising Government Leverage" in Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA China Investment Strategy, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 8 Please see Chong Koh Ping, "No plans for NPC to discuss property tax," Straits Times, March 5, 2017, available at www.straitstimes.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. 11 China's leadership is typically referred to in terms of "generations," with Mao Zedong and his peers the first generation, Deng Xiaoping and his cohort the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth. The fifth generation was born in the early 1950s, the sixth generation was born in the early 1960s. 12 Xi may tweak retirement norms to let close allies, like Wang Qishan, the anti-graft attack dog, stay on the Politburo Standing Committee. This might also suggest that Xi himself intends to overstay his age limit in 2022. 13 Please see Geopolitical Strategy Special Report, "Long Modi, Short Jokowi," dated August 28, 2014, available at gps.bcaresearch.com, and Emerging Markets Strategy Special Report, "Long Indian / Short Indonesian Stocks," dated July 30, 2014, available at ems.bcaresearch.com. 14 Please see "India: Demonetization And Opportunities In Equities," in Emerging Markets Strategy Weekly Report, "EM: Untenable Divergences," dated December 21, 2016, available at ems.bcaresearch.com. 15 Though the mixed results also indicate persistent regional differences. Modi's coalition won seats in Uttarakhand and Manipur but lost them in Goa and Punjab. Gujarat, Modi's home state, will hold elections later this year. Himachal Pradesh will also vote this year and will be a subsequent testing ground. 16 Please see Gaurav Vivek Bhatnagar, "BJP Sweep in UP Will Impact Decision on President, Rajya Sabha Numbers," The Wire, March 12, 2017, available at https://thewire.in/116044/bjp-sweep-will-impact-decision-president/

Highlights We discuss three "battles" that will shape the investment landscape in the euro area over the remainder of the decade. Battle #1: Reflation Versus Deleveraging - Reflation will triumph over the next 12 months. For the time being, this justifies an overweight position in euro area equities. Beyond then, the outlook is likely to darken. Battle #2: Hawks Versus Doves - The doves will win. Germany will reluctantly accept an overheated economy and higher inflation. Stay short the euro. Battle #3: Globalists Versus Populists - Marine Le Pen will lose this year's election, but Europe's populist parties will finally gain the upper hand by the end of the decade. Buy gold as a long-term hedge. Feature Market Update Global equities are technically overbought in the short term, but the longer-term cyclical (12-month) trend remains to the upside. Chart 1 illustrates the "reflation trade" in a nutshell. The Citigroup global economic and inflation surprise indices have surged and now stand at their highest combined level in the 14-year history of the series. While tracking estimates for Q1 U.S. GDP growth have fallen, this is mainly because of negative contributions from government spending, net exports, and inventories. Taken together, these three factors have shaved about 1.4 percentage points off of Q1 growth according to the Atlanta Fed's GDPNow model (Chart 2). Private final domestic demand is still growing at a reasonably robust 2.6% pace, and forward-looking indicators such as the ISM indices suggest that this number could rise over the next few quarters. Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Underlying U.S. Growth Is Still Healthy Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny As such, it is not too surprising that U.S. equities have had little trouble digesting the prospect of a March Fed rate hike. The market is still pricing in less than three rate increases this calendar year. Four hikes would not be out of the question. Investors should remain positioned for a stronger dollar and higher Treasury yields. We continue to favor higher beta developed markets such as the euro area and Japan over the U.S. on a currency-hedged basis. The Battle For Europe History is often shaped by great battles. Sometimes these are of the military variety. But often they transcend physical conflict, pitting competing ideas, interests, and trends against one another. In the remainder of this week's report, we discuss three economic and political battles that will determine Europe's fortunes over the next 12 months and beyond. Battle #1: Reflation Versus Deleveraging The euro area grew faster than the U.S. in 2016, the first time this has happened since 2008. While the U.S. is likely to resume pole position in 2017, we still expect the euro area economy to expand at an above-trend pace. That should be enough to keep unemployment on a downward trajectory. The euro area economic surprise index remains in positive territory. The composite PMI rose to 56 in February - the highest level since April 2011 - with the forward-looking "new orders" component hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart 3). In addition, private-sector credit growth has sped up to the fastest pace since the 2008-09 financial crisis (Chart 4). All this is good news for the region. Investors should overweight euro area equities on a currency-hedged basis over the next 12 months. Chart 3Euro Area Growth Holding Up Well Euro Area Growth Holding Up Well Euro Area Growth Holding Up Well Chart 4Euro Area: Accelerating Private-Sector ##br##Credit Growth Euro Area: Accelerating Private-Sector Credit Growth Euro Area: Accelerating Private-Sector Credit Growth Beyond then, things look murkier. The ECB's Bank Lending Standards survey showed a modest tightening in lending standards for business loans in Q4 of 2016 (Chart 5). Private-sector debt levels also remain elevated across the region, which is likely to dampen credit demand (Chart 6). Both of these factors suggest that loan growth could begin to moderate later this year. Chart 5Slight Tightening In Lending Standards ##br##For Business Loans And Mortgages In Q4 Of 2016 Slight Tightening In Lending Standards For Business Loans And Mortgages In Q4 Of 2016 Slight Tightening In Lending Standards For Business Loans And Mortgages In Q4 Of 2016 Chart 6Still A Lot Of Debt Still A Lot Of Debt Still A Lot Of Debt If the positive impulse from rising credit growth does begin to fade, GDP growth will fall off. Whether that proves to be just another run-of-the-mill "mid-cycle slowdown" or something more nefarious will depend on the policy response. On the fiscal side, the period of extended austerity has ended. The fiscal thrust in the euro area turned positive last year, the first time this has happened since 2010. The European Commission is advising member states to loosen fiscal policy further this year, but the governments themselves are targeting a modest tightening (Chart 7). With a slew of elections slated for this year, budget overruns will be hard to avoid. Nevertheless, barring a significant economic slowdown, no major European economy is likely to launch a large fiscal stimulus program anytime soon. Thus, while fiscal policy will not be a drag on growth, it will not provide much of a tailwind either. Chart 7European Commission Recommending Greater Fiscal Expansion Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny This puts the ball back in the ECB's court. As we discuss next, monetary policy is likely to stay highly accommodative. That should help extend the cyclical recovery into 2018. Battle #2: Hawks Versus Doves Jean Claude Trichet's decision to raise rates in 2011 would have gone down as the most disastrous blunder the ECB ever made, were it not for his even more disastrous decision to raise rates in 2008. Mario Draghi has gone out of his way to avoid repeating the mistakes of his predecessor. Nevertheless, the risk is that the improving growth backdrop instills a false sense of complacency. There is no doubt that Draghi has become more confident about the economic outlook. The ECB revised up its growth and inflation projections for 2017-18 at this week's meeting and signaled that it was unlikely to extend its targeted longer-term refinancing operations, or TLTROs. The ECB is also likely to further reduce the value of its monthly asset purchases in 2018 with a view towards phasing them out completely by the end of that year. It is possible that these steps could trigger a "taper tantrum" in European government debt markets of the sort the U.S. experienced in 2013. If that were to happen, we would see it as a buying opportunity. As Draghi stressed during his press conference, wage growth is anemic. Without faster wage growth, inflationary pressures will remain muted. Granted, euro area headline inflation reached 2.0% in February. However, this was mainly the result of base effects stemming from higher food and energy prices. Our expectation is that headline inflation will fall back close to 1% by the end of the year. This is where core inflation currently stands. One should also keep in mind that the trade-weighted euro has depreciated by 8% since mid-2014 (Chart 8). To the extent that a weaker euro has put upward pressure on import prices, this has caused core inflation to be higher than it would otherwise have been. In contrast, the trade-weighted U.S. dollar has appreciated by 24% over this period. Yet, despite the diverging path between the two currencies, core inflation in the euro area remains noticeably lower than in the U.S. This is true even if one excludes housing costs from the U.S. CPI in order to make it more comparable to the European estimate of inflation. Excluding shelter, U.S. core inflation is currently 43 basis points higher than in the euro area (Chart 9). The point is that the Fed is much further along the path to monetary policy normalization than the ECB. Chart 8A Stronger Dollar Has Restrained U.S. Inflation... A Stronger Dollar Has Restrained U.S. Inflation… A Stronger Dollar Has Restrained U.S. Inflation… Chart 9...Yet Core Inflation In The U.S. ##br##Is Still Higher, Even Excluding Housing ...Yet Core Inflation In The U.S. Is Still Higher, Even Excluding Housing ...Yet Core Inflation In The U.S. Is Still Higher, Even Excluding Housing If that were all to the story, it would be enough to justify the ECB's wait-and-see approach. But there is so much more. Start with the fact that the euro area's poor demographics, high debt levels, and dysfunctional institutions all imply that the neutral rate - the interest rate consistent with full employment - is lower there than in the U.S. How does one ensure that real rates can fall to a low enough level in the event of an economic slowdown? One solution is to target a higher inflation rate. If inflation is running at 1% going into a recession, it might be impossible to bring real rates down much below -1%. But if inflation is running at 3%, real rates can fall to as low as -3%. This implies that the ECB should actually target a higher inflation rate than the Fed. Then there are the internal constraints imposed by the common currency. Countries with flexible exchange rates can adjust to adverse economic shocks by letting their currencies depreciate. That is not possible within the euro area. If one or a few countries in the region are suffering while others are not, the unlucky ones have to engineer an "internal devaluation." This requires that wages and prices in the ill-fated countries decline in relation to those in the better-performing ones. However, if inflation is already low in the latter, outright deflation may be necessary in the former, something that only a deep recession can achieve. The travails experienced by the peripheral countries over the past eight years brought home this lesson in stark and painful terms. Will Germany accept higher inflation? There is little in its recent history to suggest that it won't. Mario Draghi was not the odds-on favorite to become ECB president. That job was supposed to go to Axel Weber, the former president of the Bundesbank. Weber met with Angela Merkel on February 10, 2011. During this meeting with the chancellor, he made it clear that he did not support the ECB's emergency bond buying. Merkel balked and so the next day Weber tendered his resignation. Six months after that, ECB board member and uber-hawk Jürgen Stark quit, leaving the ECB more firmly in the control of the doves.1 Chart 10Germans Turning Radically Europhile Germans Turning Radically Europhile Germans Turning Radically Europhile Merkel's preference for a less hawkish ECB leadership wasn't solely based on altruistic feelings towards her European compatriots. Politically, Merkel knew full well that Germany would be blamed for the breakup of the euro area. Economically, German taxpayers also stood to lose a lot from a breakup. It is easy to forget now, but Germany spent 8% of GDP during the global financial crisis on bailing out its own banks. All that effort would have been for naught if German banks had been forced to write off billions of euros in loans that they had extended to peripheral Europe. Critically, the demise of the euro would have also saddled German exporters with a much more expensive Deutsche Mark, thus blowing a hole through the country's gargantuan current account surplus. The calculus has not changed much over the last six years. Germany may not welcome higher inflation, but the alternative is much worse. If anything, the polls suggest that German voters have become even more Europhile since the euro crisis ended (Chart 10). This gives Draghi even more free rein. For investors, this implies that the ECB is unlikely to raise rates for the next two years, and perhaps not until the end of the decade. As inflation expectations across the euro area drift higher, real rates will fall. This will push down the value of the euro. We expect EUR/USD to approach parity over the course of this year. Battle #3: Globalists Versus Populists First Brexit, then Trump, and now Le Pen? The spread between French and German 10-year government bond yields briefly touched 68 basis points in February, the highest level since the euro crisis (Chart 11). While the spread has edged down since then, investors remain on edge. Betting markets are currently assigning a one-in-three chance that Le Pen will become president, close to the odds that they were giving Donald Trump before his surprise victory (Chart 12). Chart 11Investors Worried About The Coming ##br##French Election Investors Worried About The Coming French Election Investors Worried About The Coming French Election Chart 12Will Le Pen Rule? Wanna Bet? Will Le Pen Rule? Wanna Bet? Will Le Pen Rule? Wanna Bet? There is little doubt that populism is in a secular "bull market." However, that doesn't mean that every populist politician is going to win every single election. For all their faults, U.S. nationwide presidential election polls were not that far off the mark. The RealClearPolitics average had Clinton up by 3.2% going into the election. She won by 2.1 points. Where the polls fell flat was at the state level. They completely underestimated Trump support in the Rust Belt states of Pennsylvania, Ohio, Michigan, and Wisconsin. That's not an issue in France, where the presidential vote is tallied at the national level. Le Pen currently trails Macron by 26 percentage points in a head-to-head contest (Chart 13). It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. The only way that Le Pen could win is if one of the two leftist candidates drops out.2 However, given the animosity between Benoit Hamon and Jean-Luc Mélenchon, that is almost inconceivable. And even if that did occur, the odds would still favor Macron slipping into the final round. As such, investors should downplay risks of a populist uprising this year. Beyond then, things are likely to get messier. At some point, Europe will face another downturn, either of its own doing or the result of an external shock. Many voters have been reluctant to vote for populist leaders out of fear that the ensuing economic turmoil could leave them out of a job. But if they have already lost their jobs, that reason goes away. Chart 14 shows the strong correlation between unemployment in various French départements, and support for Marine Le Pen's National Front. If French unemployment rises, her support is likely to increase as well. The same goes for other European countries. Chart 13Macron Leads Le Pen By A Mile Macron Leads Le Pen By A Mile Macron Leads Le Pen By A Mile Chart 14Higher Unemployment Would Benefit Le Pen Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny In addition, worries about large-scale immigration from outside Europe will continue to work to the advantage of populist leaders. Recent immigrants and their children have sometimes struggled to integrate into European society. This has manifested itself in the form of low labor participation rates, poor educational achievement, elevated involvement in criminal activity, and high welfare usage. The problem has been especially acute in European countries with very generous welfare states (Chart 15). Chart 15Many Immigrants To Europe Are Lagging Behind Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny The reaction of establishment parties to mounting concerns about immigration has been completely counterproductive. Rather than acknowledging the problems, they have sought to censor uncomfortable "hatefacts" and stage show trials of populist leaders - such as the one Marine Le Pen will likely be subjected to for her alleged crime of tweeting graphic photos of terrorist atrocities. This strategy will backfire and the result will be a wave of populist victories towards the end of the decade. With that in mind, investors should consider buying some gold as a long-term hedge. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see BCA Geopolitical Strategy, “Europe: Game Was Changed A Long Time Ago,” in a Monthly Report, “Fortuna And Policymakers,” dated October 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, “Europe – Election Update, France,” in a Weekly Report, “Donald Trump Is Who We Thought He Was,” dated March 8, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Substituting certain imports with local production will ensure that Russia's inflation rate will become less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy. This is on top of the counter-cyclical fiscal policy emerging from the new fiscal rule. Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Continue overweighting Russian stocks, ruble, local fixed-income and credit relative to their EM counterparts. A new trade: Go long the ruble and short crude oil. Feature Russian equities and the ruble have been high-beta bets on oil prices. While the positive correlation between crude prices and Russian financial markets is unlikely to change soon, the country's stock market and currency will likely become low-beta within the EM universe. Sound macro policies and some import substitutions will make inflation less sensitive to the exchange rate. As such, the central bank will not need to hike interest rates amid falling oil prices. The key point is that fiscal and monetary policies are becoming less pro-cyclical. This will reduce volatility in the real economy, which in turn will warrant a lower risk premium on Russian assets, particularly within the EM aggregates. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Both Europe and the U.S. have lost appetite for direct confrontation. And while some of the exuberance immediately following Trump's victory will wear off, the U.S. and Russia are unlikely to revisit the 2014 nadir in relations. Orthodox Macro Policies... Russia has adhered to orthodox macro policies amid a severe recession over the past two years: On the fiscal front: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart I-1). The fiscal deficit is still large at 3.8% of GDP, but it typically lags oil prices (Chart I-2). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $/bbl 40 Urals. Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel ($40 oil price times 67 USD/RUB exchange rate) and sell foreign exchange when the oil price is below that level (Chart I-3). Chart I-1Russia Has Undergone ##br##Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Chart I-2...Which Is Now Over ...Which Is Now Over ...Which Is Now Over Chart I-3Oil Price Threshold For ##br##The New Fiscal Rule Oil Price Threshold For The New Fiscal Rule Oil Price Threshold For The New Fiscal Rule The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. With respect to monetary policy, Russia's central bank has been highly prudent. Unlike many other emerging countries, the central bank has refrained from injecting liquidity into the banking system (Chart I-4) and has maintained high real interest rates (Chart I-4, bottom panel). Chart I-5 demonstrates that the central bank's domestic assets have been flat, while the same measure has surged for many other EM central banks. Although this measure does not reflect central banks' net liquidity injections, it in general validates that Russia's monetary authorities have been more conservative than their counterparts in many developing countries. This is ultimately positive for the currency. Chart I-4Russian Central Bank: ##br##Tight Monetary Stance Russian Central Bank: Tight Monetary Stance Russian Central Bank: Tight Monetary Stance Chart I-5Russian Central Bank Has Been ##br##Conservative Among Its Peers Russian Central Bank Has Been Conservative Among Its Peers Russian Central Bank Has Been Conservative Among Its Peers Furthermore, the central bank has been forcing banks to acknowledge non-performing loans (Chart I-6, top panel) and has been reducing the number of dysfunctional banks by removing their licenses (Chart I-6, bottom panel). This assures that the credit system has already gone through a cleansing process, and a gradual credit recovery will commence soon. This is also in stark contrast with many other EM banking systems, where credit-to-GDP ratios continue to rise. In brief, Russia is advanced on the path of deleveraging (Chart I-7), while many EM countries have not even begun the process. Chart I-6Russian Central Bank Has ##br##Forced Banking Restructuring Russian Central Bank Has Forced Banking Restructuring Russian Central Bank Has Forced Banking Restructuring Chart I-7Russia Is Very Advanced ##br##In Its Deleveraging Cycle Russia Is Very Advanced In Its Deleveraging Cycle Russia Is Very Advanced In Its Deleveraging Cycle Bottom Line: The new fiscal rule will reduce fluctuations in the ruble. The central bank's ongoing tight policy stance will also put a floor under the ruble. Even though we expect oil prices to drop meaningfully in the months ahead, any ruble depreciation will be moderate. ... Plus Some Imports Substitution... The dramatic currency devaluation in 2014-15 and sanctions imposed on Russia by the West have led to the substitution of some imported goods with locally produced ones. First, the most visible import substitution has occurred in the agriculture sector. Chart I-8 suggests that in agriculture import substitution has been broad-based and significant. Second, while there has been some import substitution in the industrial sector, it has been less pronounced. Demand for industrial goods and non-staples (autos and furniture, for example) has plunged significantly. Hence, local production has also collapsed, but less so than imports (Chart I-9). Chart I-8Russia: Import ##br##Substitution In Agriculture Russia: Import Substitution In Agriculture Russia: Import Substitution In Agriculture Chart I-9Some Import ##br##Substitution In Manufacturing Some Import Substitution In Manufacturing Some Import Substitution In Manufacturing As domestic demand recovers, manufacturing production of industrial goods will increase. However, it is not clear how much of this demand recovery will be met by rising imports versus domestic production. On one hand, the ruble is not expensive, and argues for more import substitution going forward - i.e. relying more on domestic production rather than imports. On the other hand, Russia is hamstrung by a lack of manufacturing productive capacity, technology and know-how in many sectors to produce competitive products. FDI by multinational companies will likely rise from extremely low levels (Chart I-10), yet it is unlikely to be sufficient to make a major difference in terms of Russia's competitiveness. Third, the ruble depreciation has helped Russia increase oil and natural gas production (Chart I-11). Chart I-10Russia: Meager Net FDI Inflows Russia: Meager Net FDI Inflows Russia: Meager Net FDI Inflows Chart I-11Russia: Oil And Natural Gas Output Is Robust Russia: Oil And Natural Gas Output Is Robust Russia: Oil And Natural Gas Output Is Robust Finally, in an attempt to lessen dependence on foreigners, Russian President Vladimir Putin has been pushing the use of domestic technology. For example, Microsoft products will be replaced by locally developed software. Bottom Line: The combination of currency depreciation and trade sanctions has led to some import substitution. ...Will Make Inflation Less Sensitive To The Currency Chart I-12Russia: Unit Labor ##br##Costs Have Collapsed Russia: Unit Labor Costs Have Collapsed Russia: Unit Labor Costs Have Collapsed The collapse of the ruble has drastically reduced labor costs in Russia's manufacturing sector (Chart I-12). A diminished share of imports in domestic consumption - import substitution - will ensure Russia's inflation rate becomes less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs instead. Tame wages and some improvement in productivity - as output recovers - will cap Russian unit labor costs and restrain inflation in the medium term. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy - i.e., hike interest rates when oil prices drop and the ruble depreciates. Less pro-cyclical monetary and fiscal policies will diminish fluctuations in the economy, and economic visibility will improve. This bodes well for the nation's financial assets. We do not mean to suggest that the central bank of Russia will immediately pursue counter-cyclical monetary policy - i.e., that it will be able to cut interest rates when oil prices fall. While this would be ideal for the national economy, it is not a practical option for now. Bottom Line: Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. The Growth Outlook The Russian economy is about to exit recession (Chart I-13, top panel), but growth recovery will be timid: Bank loans will recover after pronounced contraction over the past two years. The credit impulse - the change in bank loan growth - has already turned positive (Chart I-13, bottom panel). Retail sales volumes and auto sales have not yet recovered but manufacturing output growth is already positive (Chart I-14). Rising nominal and real wages argue for a pick-up in consumer spending (Chart I-14, bottom panel). Capital spending has collapsed both in absolute terms and relative to GDP (Chart I-15). Such an underinvested position and potential recovery in consumer spending warrant a pickup in investment outlays. The key difference between Brazil and Russia - the two economies that plunged into deep recession in the past 2-3 years - is public debt load and sustainability. Chart I-13Russia: Recovery Is At Hand Russia: Recovery Is At Hand Russia: Recovery Is At Hand Chart I-14Russia: Economic Conditions Russia: Economic Conditions Russia: Economic Conditions Chart I-15Russia: Capex Recovery Is Overdue Russia: Capex Recovery Is Overdue Russia: Capex Recovery Is Overdue The public debt-to-GDP ratio is 77% in Brazil and 16% in Russia, while fiscal deficits are 9% and 3.8% of GDP, respectively. Public debt could spiral out of control in Brazil1 in the next two years, while it is not an issue in Russia. Bottom Line: Russia is about to embark on a mild and gradual economic recovery, even if oil prices relapse. Russia Is In A Geopolitical Sweet Spot Geopolitical headwinds will continue to abate for Russia. We expect that some of the loftiest expectations of a U.S.-Russia détente will fail to materialize as the Trump Administration continues to face domestic pressures. However, the 2014 nadir in relations will not be revisited. Meanwhile, Russia will benefit from several geopolitical tailwinds: The path of least resistance for tensions between Russia and the West is down. The Trump administration is highly unlikely to increase sanctions against Russia. Congress is likely to open an investigation into allegations of Russian interference in the 2016 U.S. election, but we highly doubt that any genuine "smoking guns" linking the Kremlin to the election result will be found. As such, we expect the thaw in U.S.-Russia relations to continue, albeit haltingly and without any possibility that the two powers become allies. Washington has recently removed sanctions related to U.S. tech exports to Russia. While U.S. sanction can be easily removed by presidential decree, EU sanctions require a unanimous vote on behalf of the European council. A summary can be found bellow. Table I-1 Russia: Entering A Lower-Beta Paradigm Russia: Entering A Lower-Beta Paradigm Putin's support remains high (Chart I-16), giving him a sense of confidence that modest structural reforms and economic opening is possible without undermining his support base. Military intervention in Syria has largely been a success, from Moscow's point of view. Chart I-16Popularity Of Putin And Government Popularity Of Putin And Government Popularity Of Putin And Government None of the current candidates in the upcoming elections in Europe are overtly anti-Russia. In France, leading candidate Emmanuel Macron is mildly hawkish on Russia, but the other two candidates - Marine Le Pen and François Fillon are downright Russophile. In Germany, the historically sympathetic to Russia Socialist Democratic Party (SPD) has taken a lead against Angela Merkel's ruling party. Even if Angela Merkel retains her Chancellorship, it is likely that the Grand Coalition would have to give the SPD a greater role given their dramatic rise in polling. Despite two major diplomatic incidents between Turkey and Russia,2 relations between the two countries continue to improve. In fact, the Turkstream project - which will connect Russia with Turkey via the Black Sea - has been approved by both sides. This is a positive development for the Russian energy sector as the capacity of that pipeline is large, standing at 63 Bn cubic meters per year. In Syria, the two countries have gone from outright hostility to coordinating their military operations on the ground, a dramatic reversal. The Rosneft IPO was a success, a positive sign for foreign investments in Russia. While the issuance was conducted for budget reasons, it is a sign that Russia is willing to open itself to foreign investors. The caveat being that it will only do so selectively. Further evidence of this selective opening is the recent announcement by the head of the Finance Ministry debt department that the next Eurobond auction will be conducted privately. Past investments from western firms in Russia failed due to the fact that a large number of Western oil companies were complacent in their investment analysis and failed to do due diligence.3 Furthermore, foreign investments in Russia have often failed because it was caught in the cross fire between the Kremlin and the various oligarchs who brought in the foreign investment.4 Given that President Vladimir Putin has largely neutered oligarchs, FDI that arrives in the country will have full blessing of the government. Finally, we would expect western energy companies to be more selective in their foreign investments given the recent crash in oil prices. As BCA's Geopolitical Strategy has been warning since 2014, globalization is in a structural decline and protectionism may follow. The Trump administration has threatened to use tariffs against both geopolitical adversaries, like China, and allies, like Germany. The border adjustment tax, proposed by Republicans in Congress, is a protectionist measure that could launch a global trade war.5 Due to the fact that Russia exports commodities, we would expect Russia's export revenue stream to be unaffected compared to countries who export more elastic goods such as consumer products. Bottom Line: We expect geopolitical dynamics to play in Russia's favor going forward. These will mark a structural shift in how foreign investment is conducted in Russia and risk assets will continue re-pricing. Investment Conclusions Chart I-17Continue Overweighting Russian Stocks Continue Overweighting Russian Stocks Continue Overweighting Russian Stocks Russian stocks will outperform the EM equity benchmark in the months ahead (Chart I-17). Stay overweight. Typically, the Russian bourse has outperformed the EM index during risk-on phases and underperformed in risk-off episodes - i.e., Russia has been a high-beta market. This will likely change, and we expect Russia to outperform in a falling market. Also, maintain the long Russian stocks and ruble / short Malaysian stocks and ringgit trades. Continue overweighting Russian sovereign and corporate credit within the EM credit universe. Continue overweighing local currency bonds within EM domestic bond portfolios. A new trade: Go long the ruble and short oil. When oil prices drop, as BCA's Emerging Markets Strategy team expects to happen in the months ahead, the ruble might weaken too. However, adjusted for the carry, the aggregate long ruble/short oil position will prove profitable. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 14. 2 Turkey shot down a Russian Sukhoi Su-24 on November 24th 2015 and Andrei Karlov, the Russian ambassador to Turkey got shot dead by a Turkish police officer in Ankara on December 19th 2016. 3 The BP and TNK deal failed for obvious reasons. BP and TNK had already come in confrontation when in the mid-1990's BP had bought a 10 percent stake in Sidanco only to see TNK strip the company of its asset. Furthermore, TNK was involved in other mergers inside Russia, making extremely confusing to understand what assets it actually owned. 4 Putin's campaign to sideline Khodorkovsky and Berezovsky for example sometimes came at odds with foreign investment in Russia. 5 Please see BCA Geopolitical Strategy Special Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com.

Highlights Nothing in Trump's congressional address changes our outlook from November; Trump has reaffirmed his commitment to mercantilism; Investors should continue to favor small caps over large caps; We expect Trump to get his way on more spending, and a tax reform plan to pass by the end of the year; The Dutch election is a red herring, Le Pen's chances of winning are falling, but Italy remains a risk, especially in 2018; North Korea has evolved from a red herring into a black swan, stay short KRW/THB. Feature President Donald J. Trump delivered a reassuring speech last week. Sporting a magnanimous tone (and a new tie!) the president shocked the media by invoking a "new surge of optimism." Gone were the diatribes about "American carnage." Instead, President Trump implored Congress to work together to bring forth a major infrastructure program that would rival that of Eisenhower's interstate highway system, adopt a merit-based immigration system akin to Canada, and reform Obamacare in a way that would retain all its popular pillars. Trump concluded the speech by stating that "everything that is broken in our country can be fixed" and warning the polarized Congress that "true love for our people requires us to find common ground." After the speech, a narrative emerged in the media and financial press saying that Trump was a changed man. Should investors believe it? Not at all! There was simply nothing in the Trump speech that changes our outlook in November: that President Trump was elected on a populist platform and that he will be unconstrained on blowing out the U.S. budget and pursuing a mercantilist agenda.1 On everything else - from immigration reform to Obamacare - Trump may pursue a pragmatic set of policies. Or he may not. But what investors really care about is whether the Trump administration and Congress will: Get sweeping tax cut legislation done in 2017; Pass some infrastructure spending in 2017; Pursue protectionist policies. On all three counts, we believe that the answer is yes. Trump will get his way on both his pro-growth - anti-fiscal discipline - and mercantilist agendas. The timing is difficult to gauge, but we believe that we will see all three policy avenues aggressively pursued throughout the year and passed into law by the year's end. Trump's speech has only reinforced this view. Who Is Trump? Tax Cuts As we discussed in a recent report detailing the border adjustment tax (BAT) proposal, newly elected presidents rarely fumble on tax reform.2 Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In addition, the GOP knows that it must move fast if it wants to pass any tax cuts in 2017. President Trump is now the most unpopular president since polling began tracking the question (Chart 1). Chart 1Does President Trump Lack Political Capital? Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was However, Republican voters continue to support him at 88%. This means that the House Republicans are vulnerable both to a Democrat/Independent backlash against Trump in the midterm elections and a Trump supporter backlash in the Republican primaries. They need to pass major legislation that satisfies middle class concerns and ensure that they do not incur the wrath of the Trump voters in primary races. While it is unlikely that the Democrats could significantly eat into Republican majorities in the House of Representatives and the Senate, stranger things have happened.3 Adding fire under the GOP are two special Congressional Elections, in Georgia's sixth district and for Montana's "at large" seat, to be held in April and May respectively.4 Both were easily won in November by Republicans. A slippage by the Republicans in either would send shockwaves through Congress. There is therefore little time to waste. The Republicans know that they must strike while the iron is hot. We suspect that most representatives will abandon their demand for revenue-neutral tax reform to get any tax reform. That may mean adjusting House Speaker Paul Ryan's favorite revenue-raising proposal - the border adjustment tax (BAT) - so that it brings less revenue by exempting whole categories of imports from punitive corporate taxes. "Dynamic scoring" - an accounting method that considers the holistic impact of budget measures on revenues and thus deficits - will be used to make the "math" work and satisfy the procedural demand for budget responsibility.5 What about Obamacare? A narrative has emerged in the media that Republicans cannot work on tax reform while the issue of "repealing and replacing" the Affordable Care Act looms over their heads. We disagree. There are plenty of examples of the White House and Congress cooperating on multiple policy agendas at the same time. For example, the Obama White House used its majorities in Congress to push through a major fiscal stimulus, financial reform, and the controversial health care plan. Ronald Reagan also managed to enact comprehensive immigration and tax reform in 1986. Trump's congressional address made only one mention of government debt. But he did emphasize that his tax plan would provide "massive tax relief for the middle class." This implies that the election campaign's individual income tax proposals may have to be altered. Trump's and the GOP's plans from last year agreed that the individual income tax should be reduced from seven to three brackets, with the marginal rates at 12%, 25%, and 33%. This would have cut the top marginal rate from 39.6% to 33%, but would also have left a significant number of Americans with an increase, or no change, to their marginal tax rate.6 It is likely that this will have to change, potentially creating an even greater impact on the deficit. Bottom Line: We expect both corporate and individual tax reform by the end of 2017. We do not have clarity on how legislators will go from here to there, but we suspect that to get both passed, Republicans in Congress will err on the side of greater deficits. As such, investors should expect exemptions on many imports under the final BAT (weakening any USD spike) and likely greater middle class tax cuts than are currently priced in the market. Infrastructure Spending Trump's congressional address ended several weeks of silence from the Trump administration on infrastructure spending. Not only did Trump reference the Eisenhower interstate highway system as a model to emulate, but he also promised a considerable increase in military spending and the completion of the wall on the border with Mexico ahead of schedule. Trump referred back to the original $1 trillion price tag that he announced in the heat of the electoral campaign. This figure was revised down by Trump's transition team to a modest $550 billion, though the difference may only be due to time frame. Whatever the case, Trump is using the bigger number now. We continue to believe that GOP representatives will not obstruct Trump's spending priorities. First, "dynamic scoring" can be applied to both tax cuts and infrastructure spending to make anything look close to revenue neutral. Second, voters want infrastructure spending (Chart 2). It is in fact the only issue other than combating drug addiction that Republicans and Democrats deeply agree on (Chart 3). Chart 2Everyone Loves Infrastructure Spending Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 3Infrastructure Is Not A Partisan Issue Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Third, history is not on the side of deficit hawks. True, the national debt is higher today at $20 trillion than it has been for previous Republican administrations. However, it is not only an arithmetic fact that Republican administrations run large deficits (Chart 4), it is also a fact that they tend to get more than they ask from Congress. Chart 5 shows, with astonishing consistency, that Congress is only a check on Democratic presidents when it comes to the final size of appropriation bills, whereas Republican presidents always managed to get Congress to approve more funding than they asked for. Chart 4Fact: Republicans Run##br## Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Chart 5Budgets: Republican Presidents ##br##Get What They Want Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Bottom Line: It remains difficult to gauge the actual size or economic impact of Trump's government spending proposals. However, we expect that President Trump will get his way on more spending not only for defense, veterans, and the wall, but also for infrastructure. While the impact will be minimal in 2017, investors should see greater fiscal thrust in 2018. Mercantilism While the media focused on the magnanimous tone of Trump's speech last week, we saw little change in his commitment to mercantilism. We continue to believe that Trump is a populist protectionist and that he is serious about enacting mercantilist policies.7 Recent government appointments (Table 2) and statements from the Trump administration (Table 3) suggest that we are correct. Table 2Government Appointments That Certify That Trump Is A Protectionist Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In his speech, Trump invoked President Abraham Lincoln's words that "abandonment of the protective policy by the American Government [will] produce want and ruin among our people."8 He went on to call for "fair trade," contrasted explicitly with "free trade," and to suggest that he would support changing the U.S. corporate tax system to make U.S. exports more competitive. Trump also said on February 24, in a Reuters interview, that he thought that the border adjustment tax would boost exports and help keep jobs in the U.S.9 This should end the speculation - prompted by an early comment from Trump on the BAT - that the president and congressional GOP are irreconcilably at odds over the BAT. Table 3Protectionist Statements From The Trump Administration Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was While Trump has yet to endorse Ryan's BAT proposal officially, he does not oppose its protectionist aspects. As a reminder, the BAT is protectionist because of two key elements: The BAT would give a "rebate" on exports (implicitly or explicitly) that could be higher than the amount of tax due on foreign profits (Diagram 1). For all intents and purposes, this is a dirigiste government subsidy for export-oriented industries. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was The BAT would allow companies to write off wages and salaries as costs, just like under the current corporate income tax system. But under the value-added tax systems of the rest of the world wages are not deductible. In addition, Trump still retains a bevy of traditional tools like tariffs with which to go after potential trade rivals. As we have pointed out since November, there are few constraints on a U.S. president when imposing protectionist measures.10 Bottom Line: Donald Trump remains committed to a mercantilist agenda. Investors should expect him to live up to the hype at some point in 2017. Investment Implications If markets have been cheering Trump's pro-growth policies, in addition to improving global growth data, we suspect the stock-market party will continue. Investors can take from President Trump's March 1 speech a renewed commitment to a populist agenda that should cause government spending to increase, regulations to be cut, corporate and individual tax rates to fall, and the budget deficit to widen. Won't this pursuit of nominal GDP growth at any cost create conditions for inflation and eventually a recession? Yes, but the timing is difficult to gauge and much will depend on whether Donald Trump replaces the doves on the Fed governing board with hawks, as current conventional wisdom has it. We highly doubt that he would chose hawks, or policymakers committed to rules-based central banking, given his singular focus on reviving economic growth. But even a dovish Fed may move to raise interest rates aggressively given the slate of pro-growth policies being undertaken so late in the economic cycle. In the meantime, on a cyclical horizon, the party will continue and stocks will go higher. As we posited two weeks ago, many of our clients are cautious and tactically bearish, expecting a correction, but we cannot find a single structural bear. In this environment, where everyone expects to "buy on dips" following the correction that never seems to happen, it is hard for a correction to happen. But isn't protectionism and a trade war between the U.S. and China, or even the rest of the world, a risk to the rally? Not necessarily. First, the timing is uncertain. Second, the impact on economic growth is even more uncertain. Third, aside from any knee-jerk selloffs, protectionism will split sectors and stocks into winners and losers. Those with a greater share of revenues abroad will suffer due to potential retaliation from America's trade partners. Furthermore, much of Trump's policies will be dollar bullish - including tax cuts, greater government spending, and likely the BAT. As such, export-oriented sectors and companies will stand to suffer. We continue to believe that an overweight position in small caps will be a way to play the "Trump effect" on a strategic basis. Europe - Election Update Europe's election season is heating up, with the Dutch election just a week away and the first round of the French presidential election in just over a month. Here is a quick update on the key developments: The Netherlands According to the latest polls from the Netherlands, the Euroskeptic Party for Freedom (PVV) appears to be slipping (Chart 6). Just two months ago, the PVV was projected to capture around 35 seats, a number that has now fallen to around 25. Given that the Dutch parliament has 150 seats and that the PVV has no potential allies amongst the other 13 competitive parties, this election is largely a red herring. Should investors be worried about the Netherlands' role in European integration in the future? We don't think so. Support for the euro and the EU has not slipped in the Netherlands, at least not according to the data we have presented in these pages before.11 Instead, the PVV's support has risen due to the recent migration crisis. In fact, the number of asylum seekers has correlated almost perfectly with the PVV's support level since mid-2015 when the influx began (Chart 7). Given that the migration crisis is over (and we do not expect it to restart any time soon), we suspect that the PVV's support will moderate over the next electoral cycle. Chart 6Dutch Euroskeptics Are##br## An Overstated Threat Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 7Dutch Populists Are A##br## Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis France The French election continues to grab headlines in Europe. However, almost all the news is bad news for Marine Le Pen. First, François Bayrou, a notable centrist who captured 9.3% of the vote in the first round of the 2012 election and 18.6% in 2007, has decided not to contest the election and instead support Emmanuel Macron. Non-French media have not picked up on the significance of the endorsement. It is more important than Bayrou's 3-5% level of support in the polls suggests. While Bayrou is a centrist, he once belonged to the center-right, conservative movement and was a cabinet minister during Jacques Chirac's reign. As such, his endorsement will give Macron, a former Socialist Party minister, even more "cross-over appeal" for center-right voters in the second round against Le Pen. Chart 8Le Pen Is Facing Resistance Le Pen Is Facing Resistance Le Pen Is Facing Resistance Second, the rumored alliance between the far-left Jean-Luc Mélenchon and the left-wing candidate of the ruling Socialist Party, Benoît Hamon, has failed to materialize. Their potential alliance was one of the main concerns that many of our clients brought to us in recent meetings. Given current polling, such a marriage could have produced a singular left-wing candidacy that would have propelled either Mélenchon or Hamon into the second round. However, the alliance was always a long shot, as anyone who has followed French politics knows, given Mélenchon's staunch commitment to running on his own platform. And furthermore, arithmetically combining the polling of the two candidates makes no sense given that a singular platform would have forced compromises that would have led to serious defections by voters to other candidates. As such, the combined ticket's support level was always just a theoretical exercise. Third, the latest polls suggest that Le Pen's mini-rally has been arrested (Chart 8). She has failed to consistently break through the 40% percentile mark for the second round. Against Macron, her most likely opponent, she continues to trail by a 25-30% margin. The second-round election is on May 7, just two months away. Two months from November 8, Donald Trump trailed Hillary Clinton by just 5%. Italy Our main political concern in Europe remains Italy. Polls continue to show that Euroskeptics are gaining on the centrist parties (Chart 9). Most worryingly, Italians continue to gain confidence in life outside the EU. According to a poll that asks respondents whether they think "their country could better face the future outside of the EU," Italians are the most optimistic, next to the Brits and the historically Euroskeptic Austrians, about life outside the bloc (Chart 10). Chart 9Italian Establishment##br## Is Collapsing Italian Establishment Is Collapsing Italian Establishment Is Collapsing Chart 10AItalians Are Now The Only People In ##br##The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Chart 10BItalians Are Now The Only People In##br## The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits We therefore find the market's sanguine view on Italy to be myopic. Yes, the probability of an election in 2017 is declining. The ruling Democratic Party (PD) has set its leadership race for April 30, which rules out an election this summer, and former Prime Minister Matteo Renzi appears to have agreed to an election in February 2018.12 On a cyclical time horizon of 12 months, Italy is therefore not a major risk. However, once the election does take place, it could be source of considerable market volatility. At that point, investors would have to ask whether the election would take place under a new electoral law. If not, then the probability of a hung parliament would be considerable. Unless, that is, the Euroskeptic parties could form a coalition based solely on holding a referendum to leave the euro area. We doubt that the left-wing Five Star Movement (M5S) would be able to cooperate with the more staunchly Euroskeptic and right-wing Northern League and Brothers of Italy on this matter. Particularly since M5S has already begun to moderate on the issue of Euroskepticism. There is no point in speculating on an outcome of an election a year from now given that we are not even certain what electoral rules the contest would use. However, we do not think that investors should be sanguine because the likeliest outcome is governmental dysfunction. Chart 11SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent The one thing that may help Italy in 2018 is the outcome of the German election in September. The radically Europhile chancellor-candidate of the Social Democratic Party (SPD), Martin Schulz, has continued to do well in the polls against Angela Merkel (Chart 11). On a recent tour of highly sophisticated clients in New York we were surprised that only a handful were aware of Schulz's platform and background. Even if Schulz does not win, a renewed Grand Coalition between Merkel's Christian Democratic Union and the SPD would have to take into consideration his meteoric rise. The price for a renewed Grand Coalition could be the abandonment of Merkel's reticent leadership of the euro area. Investment Implications For now, our view that the markets will climb the wall of worry in Europe in 2017 is holding up. We suspect that investors will quickly refocus their attention on Italy once the French election is out of the way. One of the best gauges of euro area breakup risk has been the performance of French bonds versus German bonds relative to the performance of Spanish and Italian bonds versus German bonds. In our view, every time French spreads have correlated highly with Spanish and Italian spreads, the euro area faced existential threats. The shaded sections of Chart 12 largely conform to the political context in Europe over the past five years. In particular, it is interesting that French yields have decoupled from their Mediterranean peers ever since the ECB's "whatever it takes" announcement. Chart 12French Spreads Are Overstated French Spreads Are Overstated French Spreads Are Overstated Until right now, that is. We think the bond market is making a mistake. France is not a risk and euro area breakup risk over the next 12 months is essentially near zero. However, the probability of a major economy leaving the euro area over the next five years is going up. This is both because of the political situation in Italy and because Euroskeptics like Marine Le Pen could take over the mantle of the "official opposition" to the "centrist consensus" running Europe. If a country like Italy exits the euro area, would the currency union be doomed? It depends, largely on how that economy were to perform post-exit. In the ceteris paribus world of macroeconomics, a massive currency devaluation post-exit would be a clear and definitive positive. However, BCA's Geopolitical Strategy was created specifically to go beyond ceteris paribus analysis. And we doubt that the euro area exit would be undertaken by pragmatic policymakers capable of taking advantage of currency devaluation while reassuring both markets and EU member states that they would pursue orthodox economic policies. As a guide for what we think would happen to Italy, we would suggest our clients read our January 2016 report on the Greek future post euro area.13 In this think piece, we argue that Greece would not become a "land of milk and honey" after exiting, largely because the political context of exit would be turbulent and lead to populist policies that would devastate the economy. As such, we would stress that while the probability of an individual member state leaving the euro area is climbing - even one as important as Italy - it does not necessarily mean that the probability of euro area dissolution is climbing at the same rate. North Korea: No Longer A Red Herring A brief word about the Korean peninsula is in order after the four North Korean missile tests on March 6 and our report last week recommending that clients steer clear of South Korean assets.14 Simply put, the Korean peninsula is a source of real geopolitical risk right now, contrary to the status quo in which North Korea was largely a red herring. We have narrated this transition since last year,15 but it boils down to the following points: North Korea is finally "arriving" at the nuclear club: It is coming upon that horizon foreseen long ago in which it possesses the ability strike the United States with a nuclear missile, however crude. The American and Japanese defense establishments are becoming more concerned, and their public opinion can follow on command.16 Trump's policy looks to be more assertive, though that is not certain. U.S.-China relations have gone sour: The worsening of Sino-American tensions makes these two more suspicious of each other's motives and simultaneously increases economic and political pressure on both Koreas. Ironically, China is currently sanctioning both North and South Korea, the latter because it is hosting the U.S. THAAD missile defense system (Chart 13). The U.S., for its part, has been rushing THAAD, which it is just now rapidly deploying after the latest North Korean launches. North Korean internal stability is overrated: It is hard to argue that Kim Jong Un has not consolidated power impressively. But this consolidation has coincided with some loosening of internal economic control to help compensate for slower Chinese growth and worse Chinese relations. Gradual marketization threatens to undermine the regime from within, yet the standard playbook of belligerence threatens to provoke sanctions with real teeth from without, like China's proposed coal import ban for the rest of this year.17 Chart 13China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles Adding to the volatile mix, South Korea's right-of-center ruling party is collapsing, which affects the behavior of all the interested parties. The Constitutional Court is set to decide whether to uphold the president's impeachment as early as this week. Where is it all going? In the short term, markets will respond to the court case and elections. A ruling is expected immediately, but could take until June. A ruling ejecting the president would be positive for South Korean risk assets, as it would reduce the current extreme uncertainty. As to the long-term outlook, if everything were to happen according to the region's familiar patterns of rising and falling tensions, China's sanctions would force North Korea to offer de-escalation, a new left-wing government in South Korea would launch a bold new "Sunshine Policy" of engagement with the North, and the alignment of these three in favor of new diplomatic negotiations would drive Japan and the United States to give peace another chance despite their skepticism about the outcome. By 2018, a revival of something like the Six Party Talks, discontinued in 2009, would be on the horizon or even underway. The problem is that the usual cycle is less assured because of the North's improving capabilities and other factors above. Thus, until we see China verifiably enforce sanctions, North Korea step back from its provocations, and the Trump administration take a non-aggressive posture (with Japan following suit), the Korean peninsula will be at a heightened risk of producing geopolitical "black swan" events. Bottom Line: North Korea is shifting from a red herring to a potential black swan, at least until U.S.-China relations improve and lend some stability to the situation. Stay short KRW/THB. Marko Papic, Senior Vice President marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 3 For example, the 2010 "Tea Party" revolution reversed the Democrat's majority in the House with one of the most sweeping victories merely 24 months following President Obama's 2008 victory, which itself was a lot more convincing than Trump's victory over Clinton. 4 Republican Ryan Zinke won the Montana seat but left it to become Trump's Secretary of Interior; Republican Tom Price won the Georgia seat but left it to become Secretary of Health and Human Services. 5 Dynamic-scoring, also known as macroeconomic modeling, is a favorite tool of Republican legislators when passing tax cut legislation. It allows policymakers to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. The same method could be used to pass "revenue-neutral" infrastructure spending, given that it too would produce higher economic growth and thus presumably higher government revenues. 6 Several income brackets would see no substantial tax cuts under the original tax cut plan proposed by the Trump campaign. Those making $15,000-$19,000 would see their tax rate increase from 10% to 12%. Those making $52,500-101,500 would see their rate stay the same at 25%, while those making $127,500-$200,500 would see their rate rise substantively, from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 President Trump failed to mention that the U.S. was - when Lincoln made the statement in 1846 - a developing economy. Nor did he mention that Lincoln made the statements not as a president but a representative. 9 Please see Holland, Steve, Reuters, "Exclusive: Trump says Republican border tax could boost U.S. jobs," dated February 24, 2017, available at reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 12 Renzi said on February 26 that "The elections are envisaged in February 2018. Fullstop." Please see Reuters, "Decision on early Italian elections up to PM Gentiloni: Renzi," dated February 26, 2017, available at reuters.com. 13 Please see BCA Geopolitical Strategy Special Report, "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, and "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 16 Please see Mark Landler, "North Korea Nuclear Threat Cited by James Clapper, Intelligence Chief," New York Times, February 9, 2016; Siegfried S. Hecker, "The U.S. Must Talk To North Korea," New York Times, January 12, 2017, available at www.nytimes.com. See also Jeff Seldin, "N. Korea Capable of Nuclear Strike at US, Military Leader Says," Voice of America, April 7, 2015, available at www.voanews.com. In 2013, Chairman of the Joint Chiefs of Staff General Martin Dempsey said that "in the absence of concrete evidence to the contrary, we have to assume the worst case, and that's ... why we're postured as we are today," quoted in "Hagel: North Korea Near 'Red Line,'" UPI, April 10, 2013, available at www.upi.com. 17 Enforcement is as yet unclear. Please see Leo Byrne, "North Korean cargo ship moves between Chinese, DPRK coal facilities," dated March 6, 2017, available at www.nknews.org.

Highlights In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Three Controversial Calls, Five Months On Three Controversial Calls, Five Months On Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat U.S. Economic Data Are Upbeat U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Three Controversial Calls, Five Months On Three Controversial Calls, Five Months On Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Investors Still Not Entirely Convinced Japan Is Eradicating Deflation Investors Still Not Entirely Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Global Bank Shares Have Bounced Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Factors Supporting Bank Stocks Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Global Banks Are Still Fairly Cheap Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Euro Area: Improving Corporate Health Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Euro Area: Banks See Rising Loan Demand Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace This Will Not Get Le Pen Into The Elysee Palace This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Tensions are still high between the U.S. and China; China's neighbors are in the line of fire; Korea and Taiwan stand to suffer; We are bullish Thailand, Vietnam, and the Philippines; We are bearish Indonesia and Malaysia. Feature Over the past two weeks we have taken clients on a tour through Europe, where we think political and geopolitical risks are generally overstated in the short term. This provides ample room for European financial assets to outperform this year.1 This week we turn to Asia Pacific, where the situation is quite different. We see this region as the chief source of geopolitical "Black Swans," mainly due to rising U.S.-China tensions, which we have highlighted since 2012.2 While U.S. President Donald Trump and Chinese President Xi Jinping have recently reassured the world that relations will be cooperative and stable, it is far too soon to declare that the two have resolved anything substantial. While we have addressed U.S.-China relations before, it is essential to watch the rest of EM Asia, where proxy battles between the U.S. and China continue to play out.3 If the Philippines shocked the world in 2016 by pivoting away from the U.S. and toward China, South Korea is the country that will do the same in 2017. In this report, we review the opportunities and risks afforded by this regional dynamic. I. Will Trump And Xi Cool Their Heels? Fundamentally, geopolitical risk in Asia Pacific is driven by the "Thucydides Trap," a struggle between the established regional and global power (the United States), and an emerging power that seeks to rewrite the region's geopolitical order (China).4 This dynamic emerged well before President Donald Trump's election.5 Trump is an unpredictable agent thrown into a structural dynamic. His election on an avowed platform of protectionism, his comments singling out China as a U.S. threat, and his break with the U.S. foreign policy establishment all suggest that the secular rise in Sino-U.S. tensions is about to get worse.6 Yet, since taking office, Trump has sent mixed signals. On the one hand, he threatens a policy of isolationism that would see the U.S. withdraw from its global security commitments. On the other hand, he has threatened to escalate geopolitical conflicts in order to get what he wants on business and trade. Table 1Market Implications Of ##br##Trump's Options Toward China How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia As Table 1 illustrates, it is extremely important for investors which of these foreign policies Trump ultimately pursues - nationalist or isolationist - and whether he combines it with the trade protectionism (or mercantilism) that he has threatened. In the short term, the most bullish combination would be the economic status quo with a scaled-down U.S. presence. The most bearish would be mercantilism combined with nationalist foreign policy. Trump's recent interchanges with Xi were notable because for once he adhered to diplomatic protocol. He and Xi gave some initial - and we would add tentative - assurances to the world that Sino-U.S. relations will not explode in a ball of flames this year: Taiwan - Trump reaffirmed the One China Policy, i.e., that Taiwan has no claim to independence from the mainland. Trump's phone call with the Taiwanese President Tsai Ing-wen in December, and subsequent comments, had put this principle in doubt, raising the prospect of a new Cold War or actual war. North Korea - China has offered to enforce a stringent new set of economic sanctions on North Korea, namely barring coal imports for 2017. This is significant, given the short duration of China's previous punitive measures against the North and the hit that North Korean exports have already suffered from China's slowing economic growth (Chart 1). The Obama administration had begun sanctioning China as a result of its unwillingness to enforce, so with enforcement may come the Trump administration's deactivation of such threats for a time. The RMB - Trump did not accuse China of currency manipulation on "day one" of his administration as he had promised during his campaign, though he has informally called the Chinese the "grand champions" of manipulation.7 This strongly suggests that he will allow the Treasury Department's semi-annual foreign exchange review process to run its course (Diagram 1). On that time frame, the U.S. would issue a warning in the April report and then begin negotiations that legally should take a year. Of course, China does not qualify by the usual measures. Since 2015 it has been propping up its currency rather than suppressing it (Chart 2), and its current account surplus has dropped sharply from 10% to 2% of GDP over the past ten years (though still massive in absolute terms). Diagram 1Calling China A Currency Manipulator: The Process How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia The Trans-Pacific Partnership (TPP) - Trump yanked the U.S. out of the major multilateral trade initiative of the Obama administration, which was an advanced trade deal that excluded China and primarily benefited smaller Chinese competitors like Vietnam and Malaysia. Though Trump acted unilaterally - and therefore cannot have gotten any real concessions from China in exchange for killing an "anti-China" trade deal - he avoided the frictions with China that would have resulted over the coming years from implementing the deal. Chart 1Will China Cut Imports From Here? Will China Cut Imports From Here? Will China Cut Imports From Here? Chart 2The 'Grand Champions' Of Currency Manipulation The 'Grand Champions' Of Currency Manipulation The 'Grand Champions' Of Currency Manipulation In addition, the Trump administration is already embroiled in domestic politics with a number of its early actions. Thus it would not surprise us if Trump - exactly like Ronald Reagan, Bill Clinton, Barack Obama, and George W. Bush - needed to pacify relations with China despite his early tough talk. Meanwhile President Xi wants stability even more than usual this year as the Communist Party holds its "midterm" five-year National Party Congress. We will return to the party congress in an upcoming report, but for now we will simply reiterate that stability means neither excessive stimulus nor excessive reform (Chart 3). Chinese policymakers could trigger unintended consequences with their financial tightening, but that's why we think they will be exceedingly cautious.8 If Trump does not try to sabotage this politically sensitive year, China should be relatively stable. Chart 3China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress So have U.S.-China ties become bullish all of a sudden? No. At least, not yet. Consider the following: South China Sea still a powder keg - On both sides, the idea of excluding "access" to the sea is being openly discussed, if disavowed.9 While there is conceivably a path for both sides to de-escalate, it will take very tough negotiations, and we are not there yet. Trade fight hasn't even begun - Though previous presidents got sidetracked, Trump was the first to campaign aggressively on a protectionist, anti-China platform, and to put a team in place to pursue that platform.10 We think he will get tough. We also think he will endorse the House Republicans' plan of a Border Adjustment Tax - a tax on imports - which would hurt China most of all as the country with the biggest trade surplus with the U.S.11 Japan is proactive - Japan has virtually no domestic political constraints and has an incentive to play up security threats. Why? Because Prime Minister Abe wants a nationwide popular referendum on revising the constitution to legitimize the Japanese Self-Defense Forces.12 And this is not even to mention that Taiwan and the Koreas are still major risks. Structurally, we still see Sino-U.S. tensions as the chief source of geopolitical risk and "Black Swan" events this year that could rattle markets in a very big way. Bottom Line: A modus vivendi between Trump and Xi is conceivable, but the U.S. and China are not out of the woods yet. II. What About The Neighbors? Short of the formidable "left-tail" risk of direct U.S.-China conflict, China's periphery is the chief battlefield and source of risk for investors. Asian EM economies have the most to risk from the reversal of the past decade's trade globalization (Chart 4). Investors also tend to underrate the fact that they are in the thick of the geopolitical risk arising from Sino-U.S. tensions and global "multipolarity" more broadly.13 A look across the region suggests that most Asian EM economies are shifting their policy to become more accommodative with China. This should reduce their geopolitical risk in the short term, though it is too soon to sound the "all clear." We remain strategically short EM stocks relative to DM. Within the EM space, we are bullish on Thailand, less so on the Philippines and Vietnam, and neutral-to-bearish on Taiwan, South Korea, Malaysia, and Indonesia. Chart 4De-Globalization Hurts Asia Pacific Most Of All How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Koreas - Here Comes The Sunshine Policy South Korea is at the center of the U.S.-China struggle as it faces a domestic political crisis, economic pressure from China, rising North Korean nuclear and missile capabilities, and a likely clash with the new U.S. administration. First, the Constitutional Court must decide the fate of impeached President Park Geun-hye. The market has rallied since the ruling Saenuri Party turned against her in early December, paving the way for her December 9 impeachment in the assembly. However, the politics of the court makes her removal from office less likely than the market expects, especially if the court does not rule by March 13, when a second judge this year retires from the bench.14 If the impeachment falters, it will lock South Korea into greater political instability throughout the year, at least until the scheduled election on December 20. Chart 5Leftward Policy Shift In South Korea ... How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia However, it is virtually impossible for the Saenuri Party candidate, Acting President Hwang Kyo-Anh, to win the election, despite his fairly strong polling (Chart 5). His party has been discredited and split, and there are now calls for his impeachment as he defends Park from further investigation. The leading contenders are all left-of-center. They are contending in a primary election over how to redistribute wealth, crack down on the Chaebol (corporate conglomerates), engage North Korea, and improve relations with China. These policies are receiving a tailwind because Korean society has seen the economic system shocked by the end of the debt supercycle in the United States and the slowdown in China. Moreover, inequality has been rising in Korea (Chart 6). As in neighboring Taiwanese elections last year, the election is shaping up to be a backlash against the pro-trade and globalization policies of the preceding decade. Korea's share of global exports has increased, and its tech companies are profitable, but the government has engaged in conservative fiscal policies, its workers are overworked and underpaid, and its social safety net is non-existent (Chart 7). Redistribution and reforming the Chaebol could bring serious benefits over the long run, but both will negatively affect corporate profits on the margin. Internationally, improving relations with North Korea and China will mean that the new South Korean government, in H2 of this year or H1 of next, could be on a collision course with the United States and especially Japan. We expect Korea to go its own way for a time, giving the impression globally that another American ally is "pivoting to China" (after the Philippines in 2016).15 While this may seem bullish for Korea, as it did for the Philippines due to the fact that China is a growing economy, Korean exports to the U.S. and Japan are still a significant portion of its total exports (Chart 8). Korea is also constrained by the fact that China is increasingly a trade competitor, and Korea's exports to China mainly consist of goods that China wants to make itself: high-end electronic manufacturing, cars, and car parts. Thus, China will welcome greater ties as it looks for substitutes for the increasingly protectionist West in acquiring technology and expertise, but Korea's new government will see rising fears of economic "absorption" as it attempts to improve access to Chinese markets. Chart 6... As Inequality Has Risen Sharply How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Chart 7Workers Want More Largesse Workers Want More Largesse Workers Want More Largesse Chart 8Korea's Balancing Act Korea's Balancing Act Korea's Balancing Act What are the market implications? South Korea is in a decent place in the short run. Global growth, exports, and corporate earnings are improving, and stock valuations have come down, especially relative to EM. Over the long run, however, we are turning bearish. Korean labor productivity is in a downtrend (Chart 9), its population is not growing, and there is no reservoir of young people left to tap. There are three basic options for securing future growth. First, Korea could become a net investor nation like Japan (Chart 10). However, it is not yet wealthy enough to do so, and needs to build the aforementioned social safety net. Second, South Korea could reunify with the North, which would alleviate its labor force problems, though the costs of reunification would be extreme (Chart 11). Chart 9Reforms On Hold Until New Government Sits Reforms On Hold Until New Government Sits Reforms On Hold Until New Government Sits Chart 10Korea's Japanese Dream Korea's Japanese Dream Korea's Japanese Dream Chart 11Reunification Would Increase Labor Force How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Third, it could continue on its current path of trying to secure large markets like the U.S. and China, while conducting a balancing act between them as geopolitical tensions rise. The problem right now is that the first two options are not ready and the balancing act is getting too hard, too soon. The South stands to suffer from both protectionism and multipolarity, i.e., being sandwiched between resurgent Sino-U.S. and Sino-Japanese tensions. Furthermore, the Trump administration has not yet decided whether its North Korea policy will be one of engagement, aggression, or continued neglect. Yet the U.S. defense and intelligence establishment's threat assessment is reaching a level that will cause greater public concern and more demand for action. Until Trump's policy is clear, South Korea's attempts to launch a new "Sunshine Policy" toward eventual reunification will be extremely vulnerable. Over time, North Korea is likely to become more of a black swan than the red herring it has been in the past (Chart 12). Chart 12North Korean Incidents: Mostly Red Herrings North Korean Incidents: Mostly Red Herrings North Korean Incidents: Mostly Red Herrings Bottom Line: Now is ostensibly a good entry point for Korean stocks relative to EM stocks, but we remain reluctant due to the political and geopolitical factors. Also, the path of least resistance for the Korean won is down, so we recommend going long THB/KRW, discussed further below. Taiwan - "One China" Or More? Our prediction that China-Taiwan relations would deteriorate dramatically, and that Taiwan could be one of five "Black Swans" of 2016, has essentially played out.16 The two sides cut off formal contact, Trump accepted a phone call from the Taiwanese president in a sharp break with U.S.-China convention, and the Taiwanese navy accidentally fired a missile toward the mainland during a drill on the Chinese Communist Party's 95th birthday on July 1. Despite the tensions, hard data coming out of Taiwan have been strong. Its export-oriented economy is buoyed by strong global growth. Both its equities and currency are the few bright spots in the EM universe and investors have been responding positively to the strong data (Chart 13). Yet Taiwan remains highly vulnerable to geopolitical tensions, as its economy is "too open," especially to China. China has imposed discrete economic sanctions, as we expected. The number of mainland tourists to Taiwan have dropped by 50% (Chart 14). This trend will continue, hurting consumer sentiment. While Trump has backed away from his threat to break the One China Policy, a move markets view as very reassuring, he cannot unsay his words and China will not forget them. Moreover, his administration will attempt to shore up the U.S.-Taiwan alliance in traditional ways, including with new arms sales that will provoke angrier responses than in the past from Beijing (Chart 15). Chart 13Investors Do Not Fear Independence Talk Yet Investors Do Not Fear Independence Talk Yet Investors Do Not Fear Independence Talk Yet Chart 14China's Silent Sanctions China's Silent Sanctions China's Silent Sanctions Chart 15Plenty More To Come How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Crucially, Taiwan's domestic politics are not a major constraint on its actions, which heightens the risks of a cross-strait "incident." The Democratic Progressive Party (DPP) is in control at almost every level of government on the island. President Tsai Ing-wen and the DPP swept to power on a popular mandate to stall and roll back trade liberalization with China, which the public felt had gone too far under the previous Kuomintang government. Perhaps if Trump had never entered the picture, Taiwan and China would have found a new equilibrium in which Taiwan distanced itself while assuring the mainland it did not seek independence. Now, however, the odds of that solution are declining. Taipei may become overly aggressive if it believes Trump has its back, and this dynamic will ensure continuous Chinese pressures and sanctions, all negative for Taiwanese assets. Bottom Line: Despite the fact that Taiwan's economy has some bright spots (exports, capital formation), we are sticking with our "One China Policy" trade of going long Chinese equities / short Taiwanese and Hong Kong equities. BCA's China Investment Strategy agrees with this call and is shorting Taiwanese stocks relative to its mainland counterparts.17 We expect China to penalize these territories for expressing the desire for greater autonomy. We also suggest going short the Taiwanese dollar versus the Philippine peso, to be discussed further below. Thailand - The Junta's Persistence Is Bullish For most of the past fifteen years, the death of Thailand's King Bhumibol Adulyadej, which occurred on October 13 of last year, was feared as a catalyst for a total breakdown of law and order due to the deep socio-political and regional division in Thai politics that has pitted an urban royalist faction against a rural populist faction. But the 2014 coup was intended to preempt the king's death and ensure that the royalist, pro-military faction held firm control over the country during the risky succession period. The market responded positively during the coup in 2014 and upon the king's death last year (Chart 16). We recommended going long Thai stocks and THB last October, in a joint report with BCA's Emerging Markets Strategy, and both trades are in the black.18 Chart 16Thailand: Investors Cheered The Succession Crisis Thailand: Investors Cheered The Succession Crisis Thailand: Investors Cheered The Succession Crisis The junta's strategy has been to root out the leaders of the populist movement and rewrite the constitution to legitimize its ability to intervene in the future. The new monarch has cooperated with the military so far, upholding the status quo, but if at any point he favors the populists to the detriment of the military, political uncertainty will spike from its current historically low levels (Chart 17). The junta is fully in charge for the time being. It has pushed back elections to February 2018 or later, delaying the re-introduction of political instability into the Thai market. It is also surging public spending and transfers to the rural poor to ensure social stability. Historically, strong public capital investment and global exports coincide with strong Thai manufacturing output (Chart 18). Favorable domestic and external macro environments should be bullish for Thai equities, creating a near-term buying opportunity in the Thai market. Chart 17Junta Keeps A Lid On Politics... Junta Keeps A Lid On Politics... Junta Keeps A Lid On Politics... Chart 18... And Buys Friends With Public Money ... And Buys Friends With Public Money ... And Buys Friends With Public Money Thailand is distant from China's quarrels with its neighbors over the South China Sea. It was the first of the U.S. allies to hedge against President Obama's pivot and seek better relations with China instead, a strategy that has paid off. Thailand, like many regional actors, may be forced to choose between China and U.S. at some point, but for now it enjoys the best of both worlds. With a fundamentally strong macro-backdrop, including a large current account surplus of 12% of GDP, we are bullish on Thai assets relative to EM. Bottom Line: Thailand is the most attractive Asian EM economy right now from an investment-oriented geopolitical point of view. It is not too late to go long THB/KRW or long Thai stocks relative to EM. Philippines - The War On Drugs Is A Headwind The Philippines continues to display strong macro-fundamentals and market momentum in the EM universe. However, domestic political risks are significant and prevent us from returning to an overweight stance relative to EM.19 The inauguration of populist southerner Rodrigo Duterte as president of the Philippines in July of last year led the country into a bloodbath that has since claimed over 7,000 lives in a "war on drugs." Only recently has it shown any sign of abating, and it is not clear that it will. The political backlash is gradually building. Duterte's policy preferences are left-leaning and mark a partial reversal of the pro-market, reform orientation of the preceding Aquino government.20 As a result, foreign investment has dropped off from its sharp rise, though it remains elevated (Chart 19). The Philippines may also fall victim to its own success. Due to the booming economy under the Aquino presidency, bank loans and deposits have enjoyed strong growth in recent years. However, the loan-to-deposit ratio is getting overextended and the economy is showing signs of heating up with inflation creeping above 2% in 2016 (Chart 20). Populist policies and the advanced cyclical expansion may add more heat. Thus, it is becoming more likely that monetary policy will tighten as the economy moves into the advanced stage of its cyclical expansion. Duterte could create a problem if at any point he decides to interfere with the central bank or technocratic management of the economy more broadly. In terms of geopolitical risk, Duterte is engineering a pivot away from the United States toward Russia and China, aggravating relations with the former, its chief ally (Chart 21). As relations with China improve, they will bring some investment in infrastructure and a calming of the near seas. Chart 19Duterte Marked The Top Duterte Marked The Top Duterte Marked The Top Chart 20Credit Is Strong, Inflation Creeping Back Credit Is Strong, Inflation Creeping Back Credit Is Strong, Inflation Creeping Back Chart 21Duterte's 'Pivot' To Asia Duterte's 'Pivot' To Asia Duterte's 'Pivot' To Asia Ultimately, however, we view this calming as temporary, since China's assertiveness is a long-term phenomenon. We also think that the fundamental U.S.-Philippine alliance will survive any major disagreements of the Duterte era. Duterte is constrained by his weakness in the Philippine Senate and the popularity of the United States among Filipinos, which is among the highest in the world. In essence, the public is not anti-American but "anti-colonialist" - many feared that the U.S. "Pivot to Asia" of the Obama and Aquino administrations would put the Philippines into a subordinate "colonial" role highly vulnerable to Chinese aggression. Like other U.S. allies in the region, the Philippines wants to be a partner of the U.S. and not just a naval base. Thus, for now, we see the Philippines in a gray area of frictions with the U.S. yet disappointing hopes with regard to China. Until Duterte removes the headline risk to internal stability from his belligerent law and order policies - and compromises on his more anti-market economic stances - we are at best open to tactical possibilities. Bottom Line: Considering its strong macro-fundamentals, advanced cyclical expansion, and politically driven uncertainty, we are only willing to entertain short-term, tactical opportunities in the Philippines. Now is a decent entry point for equities relative to EM. Also, our colleagues at BCA's Foreign Exchange Strategy point out that the peso is currently trading at a 10% discount.21 We recommend going long the peso versus the Taiwanese dollar to capitalize on the dynamics outlined for both countries above. Indonesia - A Dream Deferred Indonesia outperformed our expectations throughout 2016.22 President Joko Widodo ("Jokowi") managed to corral his party behind him despite an internal leadership struggle. And the large bureaucratic party, Golkar, joined his coalition in parliament, creating a strong legislative majority. These were our two preconditions for a more effective government; Jokowi has also found allies within the military, as we surmised. As a result, he managed to make some progress on his tax-raising, union-restraining, and infrastructure-building initiatives. Nevertheless, the market has sniffed out the difference between a pro-reform government and the enormous difficulties of pulling off reform in Indonesia. Long-term investment has fallen even as short-term portfolio investment has rallied on the back of the EM reflation trade (Chart 22). While Jokowi reduced the size of costly domestic fuel subsidies in his first year, it was easy to do so amid the oil-price collapse in 2014. Since then, Indonesian retail gasoline prices have remained subdued, indicating that subsidies are still significant. As the global oil prices continue increasing, so will the subsidy (Chart 23), adding to the country's budget deficit. Jokowi also put forth minimum-wage reforms in 2015, introducing a formula which requires the minimum wage to be adjusted every year based on inflation and economic growth (rather than ad hoc negotiations with local unions and governments). Predictably, wages have skyrocketed since the indexing policy was implemented, which is negative for profit margins (Chart 24). Chart 22Investors Skeptical Of Jokowi's Reforms Investors Skeptical Of Jokowi's Reforms Investors Skeptical Of Jokowi's Reforms Chart 23Fuel Subsidies Still In Effect Fuel Subsidies Still In Effect Fuel Subsidies Still In Effect Chart 24No Wage Rationalization Yet No Wage Rationalization Yet No Wage Rationalization Yet Indonesia is on the outskirts of China's claims in the South China Sea and has a domestically driven economy that should suffer less than that of its neighbors in a context of de-globalization. In that sense, we are inclined to view it favorably. However, its currency is at risk from twin deficits - current account and budgetary reforms have stalled, and the credit impulse is weakening. If Jokowi's favored candidate wins the heavily contested gubernatorial run-off in Jakarta in April, it will not be very bullish, but a loss would be bearish for Jokowi's reform agenda ahead of the 2019 elections. Bottom Line: We are still short Indonesia within the EM space - its underperformance since the second half of last year can persist. Vietnam - No American Guarantee Vietnam is highly vulnerable to a geopolitical conflict with China which would impact markets. Unlike the Philippines and Thailand, it cannot count on an underlying bedrock of American defense to anchor its pivot toward China - and yet, it has the greatest historical and territorial conflicts with China of all the Southeast Asian states. Chart 25Fighting In The Teeth Of The Dragon Fighting In The Teeth Of The Dragon Fighting In The Teeth Of The Dragon Nevertheless, in the short term, geopolitical risks are abating. Relations have improved since a recent low point in 2014.23 And Vietnamese leaders, having invested heavily in the TPP as the trade pact's biggest potential beneficiaries, are trying to make amends with China now that it is canceled. Thus, we remain long Vietnamese equities relative to EM. This is mostly due to the country's strong domestic demand and export competitiveness (Chart 25), attractive environment for foreign investment, and ability to capitalize on diversification away from China. The country's reforms are not perfect, but it has at least recognized NPLs and begun privatizing some SOEs. Bottom Line: We are sticking with long Vietnamese equities versus EM, though downgrading it to a tactical trade due to our wariness of a turn for the worse in China relations or the broader trade environment. Malaysia - Going To The Pawnshop Malaysia, with Vietnam, was to be the top beneficiary of the TPP. It, too, has lost greater access to the U.S. market that the deal would have provided and must now make amends with China. The latter process has already begun, as Malaysia's government has turned to China for a $33 billion deal in exchange for energy assets and valuable land in the state of Johor. The general election of 2013 and the economic slowdown have catalyzed domestic political divisions, especially ethnic and religious ones, igniting a drastic push over the past two years to have Prime Minister Najib Razak ousted for his alleged embezzlement of funds from the state-owned 1MDB corporation. Najib chose to crack down on the opposition and ride out the storm, which he has managed so far, causing unprecedented political instability. Najib's decision to sell land to the Chinese will not sit well with much of the Malay population. Many will see it as undignified; and historically, there is much animosity toward the local Chinese. Najib already faces an intense political struggle due to the exodus of high-ranking politicians from his ruling United Malay National Organization (UMNO). Former strongman leader Mahathir Mohammad and ex-Deputy Prime Minister Muhyiddin Yassin are leading the defectors to form a new Malay party that will pose a serious challenge in the 2018 elections. Recent flirtation between the ruling UMNO and the Islamist Pan-Malaysia Islamic Party (PAS) also injected new uncertainty into the already turbulent domestic political environment. In essence, the one-party state that investors once knew (and loved) is forming new factions that will contest the upcoming elections with abandon. Chart 26Growth Slowing, Credit Drying Up Growth Slowing, Credit Drying Up Growth Slowing, Credit Drying Up This struggle over the 2018 election promises to be emphatically unfriendly to investors. And until Najib gets a new mandate, he can do very little to arrest the economic breakdown. As long as the support and continuity of Najib's policies are in question, it is difficult to take a directional view of Malaysian assets. A victorious UMNO does not mean that investors should be bullish, but it will resolve the question of "Who is in charge?" At that point, we can reassess the market attractiveness based on the higher "certainty" of the policy preferences of the country. Meanwhile the constraints to Malaysia's economy are clear from a host of weak data, from domestic trade to the property market to the current account and the currency, along with a rise in NPLs that will undermine the inadequately provisioned banks' willingness to lend (Chart 26). While palm oil and petroleum prices have recovered, which is positive for Malaysian markets, this is not enough to outweigh the negative factors. Bottom Line: We are bearish on Malaysian assets and currency. Matt Gertken, Associate Editor mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, and BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Special Report, "The Looming Conflict In The South China Sea," dated May 29, 2012, available at gis.bcaresearch.com, and BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see BCA China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 9 In the short time since Trump's and Xi's phone call, the U.S. has announced that it intends to intensify the Freedom of Navigation Operations around the rocks in the South China Sea to assert its rights of navigation and overflight. Meanwhile Chinese lawmakers have revealed that they want to pass a new maritime law by 2020 that would encourage maritime security forces to bar foreign ships from passing through Chinese "sovereign" waters if they are ill-intentioned. 10 Trump's Treasury Secretary Steve Mnuchin was only just confirmed by the Senate and could not have taken any significant action yet. His appointees, notably Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer, are China hawks. If not currency, Trump's team will rotate the negotiations to focus on China's capital controls and failure to liberalize the capital account, its lackadaisical cuts to industrial overcapacity, and the negative business environment for U.S. firms. 11 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com, and Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 12 The first nationwide evacuation drill in the event of a North Korean missile attack will take place sometime in March of this year. 13 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 14 Bringing the total number of judges from nine to seven, and thus reducing the threshold for a vote in favor of retaining Park in office from four to two, for constitutional reasons. All but one of the judges were appointed by Park or her party's predecessor. 15 For instance, if the new administration reverses the deployment of the U.S. Terminal High Altitude Area Defense (THAAD) system, it will provoke a crisis with the U.S., but if it does not, China will continue its underhanded economic sanctions on the South, and the new South Korean president's North Korean policy will be stillborn. 16 Please see BCA Geopolitical Strategy Special Reports, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Taiwan's 'Trump' Risk," dated February 2, 2017, available at cis.bcaresearch.com. 18 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW," in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, available at ems.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 For instance, he is imposing controls on the mining sector that will scare away investors, in an echo of Indonesia's mining fiasco implemented since 2013, and he is working on eliminating a "contract worker" system that enables employers to avoid the costs of full-time hiring. Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 21 Please see BCA Foreign Exchange Strategy Special Report, "Updating Our Long-Term FX Value Models," dated February 17, 2017, available at fes.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Stick To Long Modi / Short Jokowi," dated November 23, 2015, available at gps.bcaresearch.com. 23 Vietnam has moved toward better crisis management with China since the HYSY-981 incident in 2014, when a clash broke out over a mobile Chinese oil rig in the South China Sea. Significantly, the Vietnamese Communist Party's leaders removed former Prime Minister Nguyen Tan Dung, the highest-ranked China hawk and pro-market reformer on the Politburo, in the January 2016 leadership reshuffle.

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Long Expansion Comparison (I) Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) Long Expansion Comparison (II) Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat March 2017 March 2017 But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds March 2017 March 2017 Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Chart I-11Gilts To Underperform Gilts To Underperform Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights Markets are facing large tail risks - both negative and positive; Donald Trump is a "Fat-Tail" president; European politics offer both a right-tail risk - German Europhile turn ... ... And a left-tail risk - Italian election and a shock in France; Investors should turn to the options market for opportunities. Feature "Stock market hits new high with longest winning streak in decades. Great level of confidence and optimism - even before tax plan rollout!" President Donald Trump "tweet" - February 16, 2017 Global stocks continue their tear as the market shrugs off President Trump's tweets, European Black Swans, saber-rattling in the South China Sea, and fears of de-globalization. Some of the optimism is backed by economic data, but mostly by the "soft data," or survey-based indicators (Chart 1).1 Chart 1Not Much Behind The Optimism Aside From Animal Spirits Not Much Behind The Optimism Aside From Animal Spirits Not Much Behind The Optimism Aside From Animal Spirits So, why the party? It's the Animal Spirits. The bears are in retreat ... or facing deportation! We think investors are betting that the combination of the Brexit referendum and election of Donald Trump has forced policymakers to take their heads out of the sand. The market believes that policymakers have heard the angry electorate whose message is that dithering over economic policies must stop. BCA has been in this camp since last summer, when our colleague Peter Berezin penned an optimistic missive titled "The Upside To Populism."2 The hope that urgency will translate to expediency is what we think has propelled the S&P 500 to one of its best post-election performances (Chart 2). Trump's market performance is in the 83rd percentile of post-election outcomes. As promised, Trump has delivered a win. Chart 2Trump Is Winning The S&P 500 Contest Trump Is Winning The S&P 500 Contest Trump Is Winning The S&P 500 Contest The danger is that the market is extrapolating from the Trump presidency all the "right-tail" or super-positive policy outcomes without accounting for any left-tail events. Trump is a "Fat-Tails" president, an unorthodox politician that could break the gridlock and deliver positive change, but whose brand of nationalist populism may also produce paradigm-shifting crises along the way. Several indicators suggest that caution is warranted. Our U.S. Equity Strategy colleagues offer two measures of complacency, the valuation-to-volatility ratio (Chart 3) and "Complacency-Anxiety Index" (Chart 4).3 Both are stretched and suggest that the market has never been as engrossed by the right-tail narrative as today. Given our constraints-based methodology, we are concerned by how certain the market appears. It seems to believe that all the wonderful things that Trump has promised will face no constraints, while his nationalism and mercantilism will be discarded. Chart 3Market Sees Only Right Tails Market Sees Only Right Tails Market Sees Only Right Tails Chart 4Complacency Reigns Complacency Reigns Complacency Reigns First, on the domestic front, Trump faces several mounting constraints: Political capital: Trump is an unpopular president (Chart 5), at least by the standards of his peers who enjoyed a post-election "honeymoon." This could affect his relationship with the GOP-controlled Congress that hardly warmed up to him in the first place. Precedent: Congress is struggling to produce Obamacare-replacement legislation, which the GOP had six years to prepare for. This bodes poorly for the timeliness of other legislation, like tax reform. Paying for stimulus: Republicans and the White House appear to be at odds over how to pay for the coming household and corporate tax cuts. The former want to pass the controversial border adjustment tax (BAT),4 while the Trump administration may not care how tax cuts are paid for. The BAT proposal is also facing opposition from major retailers and its legality under the WTO is still in question. Infrastructure: Spending on infrastructure, which is a no-brainer and has broad public support (Chart 6), has not seen a concrete plan despite Trump's emphasis on it during his inaugural address and campaign. Chart 5Trump's Approval Ratings Dismal A Fat-Tails World A Fat-Tails World Chart 6Everyone Loves New Roads A Fat-Tails World A Fat-Tails World In addition to the domestic political agenda, investors must deal with a packed European political calendar that we elucidated in last week's report5 (Table 1) and a potential U.S.-China trade war that could spill over into military tensions in the South China Sea.6 Table 1Busy Calendar For Europe This Year A Fat-Tails World A Fat-Tails World Investors may have been lulled into complacency by the February 10 phone call between presidents Xi and Trump. During the call, Trump committed to uphold the "One China" policy that has formed the bedrock of the Beijing-Washington rapprochement since 1972. A week later, on February 16, China suspended all imports of coal from North Korea - 50% of the country's entire export haul - until the end of the year. The move was a big nod to Donald Trump, a message by Beijing that China can play the role of an indispensable partner - if not outright ally - in the region. These moves have put fears of trade protectionism, our main candidate for a catalyst of a market correction, on the backburner. Investors can certainly be disappointed by smaller-than-expected tax cuts and tepid infrastructure spending, but such policy reversals will only encourage the Fed to stay easy and thus prolong the party. In the context of a synchronized global growth recovery - with both the global (Chart 7) and U.S. (Chart 8) economies looking decent - investors will not be deterred from bullishness merely by congressional intrigue. Chart 7Global Growth Looks Solid ... Global Growth Looks Solid ... Global Growth Looks Solid ... Chart 8... And So Does U.S. Growth ... And So Does U.S. Growth ... And So Does U.S. Growth The problem for investors is that the main two risks to global markets in 2017 have no set timeline. Last week, we pointed out that the main political risk in Europe is the Italian election whose date could be in autumn, or even as late as spring 2018. Today we add the French election to the list, where Marine Le Pen is mounting a furious rally on the back of rioting in the banlieue of Aulnay-sous-Bois. Similarly, Trump's mercantilism may remain dormant as he focuses on immigration, the "dishonest media," and cabinet appointees, even though it is very real. His administration is laser-focused on correcting a major perceived ill of the U.S. economy: the current account deficit. Therefore, investors should certainly welcome the Xi-Trump phone call, but the fact that the two leaders spent valuable time reaffirming a policy set 45 years ago should not be encouraging. In fact, the Trump administration has since asked the U.S. Trade Representative's office to consider changing how it calculates the U.S. trade deficit. According to the Wall Street Journal, Trump's White House is looking to exclude "re-exports" - goods imported into the U.S. merely so they can be assembled and then exported - from the calculation of U.S. exports.7 This would naturally balloon the U.S. trade deficit and give the Trump administration greater political ammunition - particularly against Mexico - for retaliation. Given solid global growth data, extremely positive surveys, and a market narrative still focused on the "Upside of Populism," it is tempting for investors to throw caution to the wind. Every time we encounter a bear in a client meeting or conference, we ask if he or she would "buy on dips" in case a correction happened. Their answer is almost universally "yes." It is difficult to see how a correction occurs in such an environment, where nobody actually expects a bear market. Although we are throwing in the towel with our two hedges - both the S&P 500 and Eurostoxx hedges have stopped out, we continue to stress that the market has priced in none of the left-tail risks that remain. We have a Fat-Tail President in the White House and an increasingly binary resolution to the euro area saga in the making in Europe. Fat Tails In Europe Since late 2016, we have suspected that Merkel's rule is unsustainable.8 However, while most investors fretted that Merkel would be replaced by a Euroskeptic, we considered that outcome extremely unlikely (at least in the current electoral cycle). For one, the refugee crisis that befell Europe would be short-lived, and indeed it is now over (Chart 9). For another, Germans are not Euroskeptics. What is astonishing is how quickly the German political establishment has realized and sought to profit from these facts. Instead of opposing Merkel with a cautious choice, the center-left Social Democratic Party (SPD) has turned to an unabashed Europhile, former President of the European Parliament Martin Schulz. Schulz is a relative unknown in Germany and was perceived by Merkel's coterie as a lightweight. On the surface, this made sense. Schulz has no university education and worked as a bookseller before becoming a politician. However, he knows EU politics extremely well, as he has been a member of the European Parliament since 1994. He has therefore heard every Euroskeptic argument on the continent and has learned to counter it emphatically. And he seems to understand the benefits that euro area membership has bestowed upon Germany, a view he appears to share with 80% of the German public, if the latest polls are to be believed (Chart 10)! Chart 9Migrant Crisis Waning Migrant Crisis Waning Migrant Crisis Waning Chart 10Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Thus far, Schulz's campaign has focused on three main lines of attack: the traditional SPD call for greater economic redistribution, general appeal for European solidarity, and blaming Merkel for the rise of populists. To everyone's surprise - other than folks who understand how Germany works - this has been a successful approach. In just three weeks, the SPD has gone from trailing Merkel's Christian Democratic Union (CDU) by double digits to leading in the polls for the first time since 2001 (Chart 11). What should investors make of Schulz's meteoric rise? For one, nobody should get too excited, as the election is still a long seven months away. However, the SPD's resurrection suggests that the German political marketplace has been demanding a genuinely pro- euro area political alternative to the overly cautious Angela Merkel for some time. In other words, Schulz has realized that the median voter in Germany is far more Europhile than the conventional wisdom and Merkel have thought. Again... Chart 10 says it all! Unfortunately for the euro, Germany's Europhile turn may be too little too late. Italy's election is a major risk. As with the threat of American mercantilism, Italian elections are a risk that we cannot properly time. Furthermore, polls remain extremely close in Italy, suggesting that the election could go either way between the establishment and Euroskeptic parties. At this point, the best outcome may be a hung parliament. Meanwhile, the ongoing unrest in the northeast suburb of Paris, Aulnay-sous-Bois, appears to have given Marine Le Pen some wind in her sails (Chart 12). She has closed her head-to-head polling gap against Francois Fillon and Emmanuel Macron to just 12% and 20% respectively. Our net assessment is that she is not going to win, but our conviction level is declining. Her subjective probability has climbed to well over 20% at this point. Chart 11Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Chart 12Le Pen Lags By 12-20% In Second Round A Fat-Tails World A Fat-Tails World Similar rioting in 2005 launched the political career of one Nicolas Sarkozy, who, as the country's Minister of Interior, took a hard line approach to the unrest, which launched him into the presidency. The lesson from Sarkozy's rise is important for two reasons. First, unrest in France's banlieues is politically relevant. These frequent bursts of violence support the National Front (FN) narrative that the integration of migrants has failed, that the country needs full control over its borders, and that the elites in Paris are not serious about law and order. The second lesson is that centrist, establishment politicians have no problem with being tough on crime, minorities, or immigrants. Sarkozy's rhetoric in 2007 mirrored much of the FN electoral platform. There is enough time, in other words, for Macron and Fillon to do the same in 2017. This will be particularly easy for Fillon, whose immigration policies already echo those of the FN. Chart 13ECB Policy Will Stimulate Core Europe ECB Policy Will Stimulate Core Europe ECB Policy Will Stimulate Core Europe Macron, however, could be in trouble in the second round. And at the moment, he is more likely to face Le Pen in the second round than Fillon. As we pointed out in last week's missive, Macron could struggle to get right-wing voters to support him in the second round. We still do not have a historical case where right-wing voters were the ones who swung against the FN. In both the 2002 presidential election and the 2015 regional elections, it was mostly left-wing voters who swung to the center-right to keep the FN out of power. Will French conservative voters come out and support a centrist candidate like Macron who may be perceived as "soft" on crime? Time will tell. His polling appears to be holding up well against Le Pen, but her momentum is now rising. Bottom Line: Europe faces its own version of Fat Tails in 2017. On the one hand, we expect the ECB to remain easier than consensus would have it, given the mounting political risks in the periphery. We expect the ECB to ignore the broad euro area economy and focus on the interest rates that the periphery - namely Italy - needs (very low for very long time) (Chart 13). When combined with a Europhile turn in Germany and a positive fiscal thrust as the EU Commission turns against austerity, we see a Goldilocks scenario for euro area assets over the short and medium term. We are betting that this right-tail risk will ultimately prevail. On the other hand, Italian elections could knock the train off the rails at any time. Due to the announced leadership race in the ruling Democratic Party (PD), the election will most likely have to take place after the summer. Or, it may have to be put off until Q1 2018. But whenever it is announced, it will become the risk to European and global assets. For now, we continue to recommend that clients remain overweight euro area equities. However, vigilance will be needed as the market climbs the wall of worry. Investment Implications - Trading Fat Tails In A Low-Vol World What should investors do in a world that is increasingly exemplified by our Fat-Tails thesis? Current levels of the VIX suggest that the market is not pricing in a potentially higher level of volatility, which we would intuitively expect to rise in a Fat-Tail world (Chart 14). On the other hand, current low levels of volatility may merely be the calm before the storm. Investors may be "frozen" by the high probability of both left- and right-tail outcomes and thus choosing to sit on the sidelines instead of committing to any one narrative. Chart 14Volatility Extremely Low Volatility Extremely Low Volatility Extremely Low One way to think about investing in this world is to turn to the options market. The options market is unique in that it allows investors to take a view on the dispersion of the expected returns of the asset against which the option is written.9 This is because one of the critical components of a call or put option's value is the expected volatility of returns for the asset underlying the option itself. Volatility is trading-market shorthand for the annualized standard deviation of expected returns for the underlying asset. Volatility is a calculated value, whereas the other components of an option's price - i.e. the underlying asset's price, the strike price, time to expiration, and interest rates - are known inputs. Volatility, like the price of the underlying asset, is "discovered" when a trade occurs. After an option trades and its premium is known, an option-pricing model - e.g., the Black-Scholes-Merton model - can be run backwards, so to speak, to see what level of volatility solves the pricing model for the value that cleared the market. This is known as the option's implied volatility, because it is the expected standard deviation of returns implied by the price at which the option clears the market. One reason investors and traders buy and sell options is to express a view on implied volatility. Option buyers who think the market is underestimating the likelihood of sharply higher returns can express this view by buying out-of-the-money options. This can arise for any number of reasons, but they all boil down to one essential point: option buyers think there is a higher probability that returns will be higher or lower during the life of an option than what is being priced in the options market.10 Option sellers, on the other hand, are expressing the opposite view. We believe the geopolitical tail risks we have discussed in this report are not being fully reflected in the options markets most sensitive to this information, among them the gold market. Our own assessment of these risks implies much fatter tails than we currently observe in out-of-the-money gold options. For this reason, we are recommending investors consider buying $1,200/oz gold puts and $1,300/oz gold calls expiring in either June or December of this year. This is a strategic recommendation. We leave it to investors to set their own stop-loss, if they are not comfortable foregoing the full premium paid to hold these options to expiry, possibly expiring worthless. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Robert Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Downside To Full Employment," dated February 3, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 6 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?," dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 7 "Please see William Mauldin and Devlin Barrett, "Trump Administration Considers Change In Calculating U.S. Trade Deficit," Wall Street Journal, February 19, 2017, available at www.wsj.com. 8 Please see Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 9 Call options give the buyer the right to go long an underlying asset at the price at which an option contract is struck - i.e. the option's strike price. Puts give option buyers the right to go short the underlying asset at the price at which the contract is struck. While an option buyer is not required to ever exercise an option, option sellers must take the other side of the deal if the buyer chooses to exercise. Option buyers pay a premium for the put or call they purchase. 10 This probability also can be expressed in terms of price levels, which allows investors to take an explicit view of the likelihood of a particular price being realized during the life of the option being purchased. Please see Bob Ryan and Tancred Lidderdale, "Energy Price Volatility and Forecast Uncertainty," published by the U.S. Energy Information Administration (2009), for a discussion of options markets and implied volatility. "Appendix II: Derivation of the Cumulative Normal Density for Futures Prices" beginning on p. 22 shows how to transform the returns distribution into a price distribution. It is available at https://www.eia.gov/outlooks/steo/special/pdf/2009_sp_05.pdf. Geopolitical Calendar

Dear Client, In addition to our regular Weekly Report, we sent you a Special Report on Wednesday prepared by my colleague Marko Papic, BCA's chief geopolitical strategist, assessing the election landscape in Europe this year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Global growth has accelerated, corporate earnings are rebounding, and leading indicators suggest that these positive trends will persist over the remainder of the year. This supports our cyclically bullish view on global equities. Looking further out, the impulse to growth from the easing in financial conditions that began in early 2016 will fade, setting the stage for a slowdown in 2018. If growth does falter next year, easier fiscal policy could provide an offsetting tailwind. However, there continues to be a large gap between what politicians are promising and what they can realistically deliver. What is different this time is that spare capacity is much lower than it was during previous mid-cycle slowdowns. Thus, while global bond yields could eventually dip, they remain in a secular uptrend. Feature The Elusive Correction We have been arguing since last fall that stronger global growth will help fuel a variety of reflationary trades.1 This part of our view has panned out nicely. What has surprised us is just how relentlessly the market has traded that view. With the exception of a few small wobbles, the S&P 500 has basically marched higher since the morning following the U.S. presidential election. Reflecting this development, the VIX fell to near record low levels earlier this week (Chart 1). The market's failure to take a breather has sabotaged our efforts to have our cake and eat it too - to maintain an overweight stance on global equities, while also profiting from the occasional correction. In contrast to our last three tactical hedges - which generated a cumulative return of 42% - our latest hedge is now down 9%. That's a lot of red ink. Out of pure risk management considerations, we will close this trade if the loss breaches 10%. Nevertheless, most indicators continue to warn of a looming correction. In particular, our U.S. equity strategists' new "Complacency-Anxiety" index is at an all-time high, suggesting that stocks have entered a technical overshoot phase (Chart 2).2 Chart 1VIX Is Near Record Lows VIX Is Near Record Lows VIX Is Near Record Lows Chart 2Complacency Reigns Complacency Reigns Complacency Reigns Cyclical Picture Still Solid In contrast to the short-term outlook, the 12-month cyclical picture for risk assets still looks reasonably good. Measures of current activity are rebounding as animal spirits begin to kick in (Chart 3). Falling unemployment and stronger wage growth are causing households to open their wallets. Against the backdrop of decreasing spare capacity, firms are reacting to this by increasing investment spending. Capital goods orders in the G3 economies have jumped higher in recent months, and capex intention surveys are pointing to further upside (Chart 4). Chart 3Current Activity Indicators Are Rebounding Current Activity Indicators Are Rebounding Current Activity Indicators Are Rebounding Chart 4An Upswing In Capex An Upswing In Capex An Upswing In Capex Corporate earnings have also accelerated on the back of faster economic growth. Consensus estimates call for global EPS to expand by 12% in local-currency terms this year, with the S&P 500 registering 10.4% growth, the STOXX Europe 600 gaining 14.3%, Japan's TOPIX adding 12.5%, and MSCI EM leading the pack at 16%. Outside the U.S., year-to-date earnings revisions have generally been positive, particularly in Japan and EM (in the U.S., 2017 EPS estimates have ticked down a modest 0.8%). BCA's in-house earnings models are consistent with this optimistic profit picture (Chart 5). What accounts for this fortuitous turn of events? A number of reasons help explain why growth accelerated in the second half of 2016: The drag on global growth from the plunge in commodity sector investment ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7 percent off the level of U.S. GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 6). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus, helping to reflate the economy. Global growth benefited with a lag from the easing in financial conditions that began in earnest in early 2016. Government bond yields fell to record low levels in July. In addition, junk bond spreads collapsed, dropping from a peak of 7.9% in February to 4.3% by year-end (Chart 7). Higher equity prices, particularly in a number of beaten down emerging markets, also helped. Chart 5Broad-Based Acceleration In Corporate Earnings Broad-Based Acceleration In Corporate Earnings Broad-Based Acceleration In Corporate Earnings Chart 6Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 7Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen How Much Longer? Chart 8Improvement In Global ##br##Leading Economic Indicators Improvement In Global Leading Economic Indicators Improvement In Global Leading Economic Indicators The key question for investors is how long the good times will last. Right now, most leading indicators that we follow are signaling that the expansion will endure for the remainder of this year (Chart 8). As we look towards 2018, however, things get murkier. Conceptually, it is the change in financial conditions that matters for growth. While the ongoing rally in global equities and continued narrowing in credit spreads has contributed to some easing in financial conditions since the U.S. presidential election, this has been partly offset by higher government bond yields. A stronger dollar has also led to an incremental tightening in the U.S., as well as in some emerging markets with high levels of U.S. dollar-denominated debt. As such, it is likely that the positive "impulse" to economic growth from the easing in financial conditions that took place last year will begin to dissipate towards the end of this year. Fiscal Policy To The Rescue? If growth does slow next year, easier fiscal policy could provide an offsetting tailwind. The fiscal thrust for developed economies turned positive in 2016, the first year this happened since 2010 (Chart 9). However, it remains to be seen whether this trend will continue. There is little support among Republicans in Congress for a big infrastructure program. It once seemed possible that Chuck Schumer and his fellow Democrats could find common ground with President Trump on this issue, but that is looking less likely with each passing day, given the level of vitriol in Washington. Broad-based tax cuts are a certainty, but the risk is that they will be coupled with cuts to government spending. Empirically, the latter have a larger "multiplier effect" on GDP than the former. To complicate matters, the introduction of a border adjustment tax - something to which we assign 50% odds - could generate significant near-term dislocations for the global economy.3 Meanwhile, much of Trump's regulatory agenda is in limbo. A repeal of Dodd-Frank is off the table. Senate Republicans do not have the 60 votes needed to scrap it. The Volcker rule is here to stay. On the other side of the Atlantic, the European Commission has recommended a further loosening in fiscal policy this year, but member states themselves are actually targeting somewhat smaller fiscal deficits (Chart 10). As is often the case, budgetary overruns are likely, but with the Greek bailout program now back on the ropes, Germany and a number of other countries may begin to dial up the austerity rhetoric. Chart 9Will Fiscal Policy Continue To Ease? The Reflation Trade Rumbles On The Reflation Trade Rumbles On Chart 10European Commission Recommending Greater Fiscal Expansion The Reflation Trade Rumbles On The Reflation Trade Rumbles On Uncertainty over the slew of European elections slated for this year could also weigh on business sentiment. Marine Le Pen is likely to place first in the initial round of the French presidential election, but faces an uphill battle in the subsequent runoff. Nevertheless, betting markets are assigning a one-in-three chance of Le Pen becoming president - similar to the odds they were assigning to a Brexit "yes vote" and a Trump victory (Chart 11). Italy also remains a risk, as my colleague Marko Papic, BCA's chief geopolitical strategist, discussed in this week's Special Report.4 Anti-euro sentiment is now stronger there than in any other major European economy (Chart 12). Chinese fiscal policy has already tightened significantly, with the year-over-year rate of change in government spending falling from a high of 25% in November 2015 to zero at present (Chart 13). So far the Chinese economy has held up well, but there is a risk that this may change. Despite Trump's backpedaling on the "One China" question, we expect the Trump administration to declare China a currency manipulator later this year. This will pave the way for higher tariffs on a variety of Chinese goods, which could lead to retaliatory measures by China. Chart 11Brexit, Then Trump... Is Le Pen Next? Brexit, Then Trump... Is Le Pen Next? Brexit, Then Trump... Is Le Pen Next? Chart 12Italy: Anti-Euro Sentiment Is A Risk Italy: Anti-Euro Sentiment Is A Risk Italy: Anti-Euro Sentiment Is A Risk Chart 13China: Fiscal Stimulus Is Fading China: Fiscal Stimulus Is Fading China: Fiscal Stimulus Is Fading Investment Conclusions Chart 14Diminished Slack In The Global Economy Diminished Slack In The Global Economy Diminished Slack In The Global Economy Global growth continues to be strong, and is likely to stay that way for the remainder of this year. However, there is a heightened risk that the global economy will falter in 2018. We remain cyclically overweight global equities and underweight government bonds, but are not dogmatic about this view. As the discussion above suggests, plenty of things could derail the reflation trade. If evidence begins to mount that a slowdown is coming earlier than we think, we will turn more bearish on stocks. Given that equities are technically overbought at present, we would not fault anyone for taking some money off the table. If growth does slow in 2018, does this mean that bond yields will fall back towards last year's lows? We don't think so. For one thing, a major deflationary commodity bust of the sort we endured in 2014-15 is not in the cards. In addition, there is less slack in the global economy now than there was last year, or for that matter, anytime since early 2008 (Chart 14). As we discussed in our Q1 Strategy Outlook, potential GDP growth is likely to remain structurally depressed across much of the world, owing to slower productivity and labor force growth.5 Lower potential growth means that excess capacity could continue to be absorbed even if growth slows somewhat from its current well-above trend pace. In the U.S., this absorption of excess capacity is nearly complete, with most labor market indicators suggesting that the economy is approaching full employment (Chart 15). In this vein, we would heavily discount the decline in average hourly earnings in January's employment report. Chart 16 shows that this was mainly driven by an anomalous drop in compensation in the financial sector. Broader measures continue to point to brewing wage pressures (Chart 17). We expect the Fed to raise rates three times this year, one more hike than the market is now pricing in. If this happens, the dollar is likely to strengthen modestly over the remainder of the year. Chart 15U.S. Economy Approaching ##br##Full Employment U.S. Economy Approaching Full Employment U.S. Economy Approaching Full Employment Chart 16Financial Sector Dragging ##br##Down Hourly Earnings In The U.S. Financial Sector Dragging Down Hourly Earnings In The U.S. Financial Sector Dragging Down Hourly Earnings In The U.S. Chart 17U.S.: Broad Measures Pointing ##br##To Rising Wage Pressures U.S.: Broad Measures Pointing To Rising Wage Pressures U.S.: Broad Measures Pointing To Rising Wage Pressures Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 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. 2 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Bonds are universally unloved. The economic 'mini-upswing' is extended. 6-month bank credit impulses have rolled over. Europe is entering a period of high-impact political events. Equities are universally loved. If bond prices bounce back, Bank equities are losers and Real Estate equities are winners. Feature From time to time it is worth stepping out of the herd and asking: is the herd heading in the right direction? Given the seemingly universal dislike of high-quality government bonds, this week's report goes through five reasons why bonds could make a surprising comeback in the coming months.1 Chart of the WeekBrexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing Brexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing Brexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing 1. Bonds Are Universally Unloved The extent of herding in bonds is extreme on both a 65-day and 130-day basis (Chart I-2). The herd is a good metaphor for financial markets given the capacity for investor sentiment to move en masse. However, excessive herding is dangerous, because it destroys market liquidity. Chart I-2The Extent Of Herding In Bonds Is Extreme The Extent Of Herding In Bonds Is Extreme The Extent Of Herding In Bonds Is Extreme Liquidity - defined as the ability to buy or sell an investment in large volume without moving its price - requires healthy disagreement. After all, at today's price, if you sell a bond and I buy it from you, we are disagreeing about the attractiveness of the price. If many investors disagree on the attractiveness of the price, then there will be plenty of liquidity. The main reason for healthy disagreement and plentiful liquidity is that the market is usually split between short-term momentum traders and long-term value investors. If the price fluctuates downwards, the momentum trader interprets this as a strong sell-signal but the value investor sees it as an equally strong buying-opportunity. Hence, the two types of investor can trade with each other in large volume without moving the price (much). However, if the value investor flips to become a momentum trader and sells rather than buys, the price must fall until it attracts a bid from a deep value investor. If the deep value investor then also flips to become a momentum trader, the price must fall further until it attracts a bid from an even deeper value investor. And so on... As everybody in turn flips to the same view, the herd and the trend will get stronger and stronger. The tipping point comes when there is nobody left to flip and to join the herd. If a value investor then suddenly reverts to type and puts in a buy order, he will find that there are no sellers left. Liquidity has evaporated, and to replenish it might require a substantial reversal in the price. On both our 130-day and 65-day herding indicators, bonds appear vulnerable to such a reversal in the coming weeks. 2. The Economic 'Mini-Upswing' Is Extended Chart 1-3Major Economies Exhibit ##br##Very Clear 'Mini-Cycles' Major Economies Exhibit Very Clear 'Mini-Cycles' Major Economies Exhibit Very Clear 'Mini-Cycles' A typical business cycle lasts multiple years. But within this longer cycle, major economies exhibit very clear 'mini-cycles' whose upswings and downswings last 6-12 months (Chart I-3). As we demonstrated in Slowdown: How And When? 2 these mini-cycles result from the perpetual interplay between changes in bond yields, accelerations/decelerations in credit growth, and accelerations/decelerations in economic growth. The inception of the current mini-upswing coincided with last February's G20 meeting in Shanghai. At the start of 2016, global growth appeared to be stalling and financial markets were fragile. In response, a so-called 'Shanghai Accord' facilitated a synchronized stimulus in the major economies - either directly, or in the case of the U.S., a watering down of monetary tightening expectations. By spring last year, bond yields were forming a typical mini-cycle bottom. But in June, the Brexit shock sent yields sharply, but briefly, lower. Conversely, the Trump shock-victory in November accelerated the upswing in yields that was already well underway (Chart of the Week). Absent these two political shocks, 2016 produced a typical mini-upswing whose duration is now approaching 12 months - making it long in the tooth. Mini-upswings do not die of old age. But it would be highly unusual for the economy's credit-sensitive sectors not to feel a strong headwind now from the sharp upswing in bond yields. 3. 6-Month Bank Credit Impulses Have Rolled Over 6-month credit impulses have indeed rolled over in the major economies (Chart I-4 and Chart I-5), exactly as would be expected after a sustained upswing in bond yields. Chart I-46-Month Credit Impulses Have ##br##Rolled Over In Major Economies... 6-Month Credit Impulses Have Rolled Over In Major Economies... 6-Month Credit Impulses Have Rolled Over In Major Economies... Chart I-5... And ##br##Globally ... And Globally ... And Globally Now you could argue that the upswing in bond yields is simply a response to improved expectations for growth. The problem with that argument comes from the inter-temporal and geographical distribution of that potential growth pickup. U.S. fiscal stimulus and infrastructure spending is an uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Furthermore, this stimulus is unlikely to benefit Europe or other economies outside the U.S. Yet the recent rise in bond yields and weakening of credit impulses has occurred everywhere. Compared to Trump's intangible stimulus, the choke on credit-sensitive sectors is a certain headwind whose impact will be felt sooner and more universally. 4. Europe Is Entering A Period Of High-Impact Political Events The next few months will also see a sequence of potentially high-impact political events in Europe. The Netherlands and France hold elections in which disruptive populist politicians are likely to perform well, though probably not well enough to gain power. Meanwhile, Greece appears to be reneging on the terms and conditions of its latest bailout - whose next tranche of funds it needs to make a large debt repayment in July. Into this sensitive mix, add the start of the formal and potentially acrimonious divorce proceedings between the U.K. and the EU27, due to start by the end of March. To be clear, the probability of a shock outcome in any of these individual events is low. But the probability of a shock from at least one of these multiple events is not so low. If the probability of an individual shock is, let's say, 20% then the probability that the event goes smoothly is clearly 80%. Therefore, the probability that all four events go smoothly would be 0.8 to the power of 4, equal to 41%.3 Which means that the probability of at least one shock would be a significant 59%. Perhaps the probability of an individual shock in any of these four events is less than 20%. However, there are also other more nebulous sources of risk, such as the possibility of early elections in Italy, and a disruptive outcome. To reiterate, an individual risk might be low or very low. But the chance of at least one shock in the upcoming sequence of events must be close to evens. And this is the chance that high-quality government bonds will receive significant haven demand at some point in the coming months. 5. Equities Are Universally Loved High-quality government bonds are universally unloved, but mainstream equities have the opposite problem. They are universally loved. The extent of herding in equities is extreme on a 65-day basis (Chart I-6). Chart I-6The Extent Of Herding In Equities Is Extreme The Extent Of Herding In Equities Is Extreme The Extent Of Herding In Equities Is Extreme This perfect symmetry of herding behaviour suggests to us that if investors suddenly fall out of love with equities - even briefly - then unloved bonds would be the very likely beneficiaries. Pulling all of the five arguments above together, we conclude that the odds of a tactical retracement in high-quality government bond yields in the next 3-6 months are more than evens. And we would position accordingly. In this eventuality, stock market investors should note that the sector that might be most vulnerable is Bank equities (Chart I-7). Conversely, the sector that might be one of the biggest beneficiaries is Real Estate equities (Chart I-8). Chart I-7If Bond Prices Bounce Back, ##br##Bank Equities Are Losers... If Bond Prices Bounce Back, Bank Equities Are Losers... If Bond Prices Bounce Back, Bank Equities Are Losers... Chart I-8... And Real Estate ##br##Equities Are Winners ... And Real Estate Equities Are Winners ... And Real Estate Equities Are Winners Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Our analysis throughout uses the JP Morgan Global Government Bond Index as the best representation of the direction of high-quality government bonds, including those in Europe. 2 Published on February 2, 2017 and available at eis.bcaresearch.com 3 Strictly speaking, this assumes that all four events are independent - that is, the outcome of one does not influence the outcome of another. Fractal Trading Model There are no new trades this week. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 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