Geopolitics

Theme 1 - Returning U.S. Animal Spirits: I Want To Break Free Animal spirits are making a comeback in the U.S. The catalyst for this development is the hope that a Trump administration will alleviate the regulatory burden that has been a source of worry for corporate America (Chart I-1). Feeding this impression has been Trump's anti-regulation rhetoric. His deal-maker, take-no-prisoners persona, along with a cabinet packed with businessmen and corporate scions further solidifies this perception. However, Trump's electoral victory was only the match igniting the fuel. The conditions for a resurgence of animal spirits were already in place. Animal spirits are only a Keynesian metaphor for confidence. From late 2014 to 2016, a 16% contraction in profits weighed on business confidence. However, pre-tax profits have bottomed and are set to continue their acceleration (Chart I-2). Chart I-1Hurdle To Animal Spirits bca.fes_sr_2016_12_16_s1_c1 bca.fes_sr_2016_12_16_s1_c1 Chart I-2A Drag On CAPEX Vanishing A Drag On CAPEX Vanishing A Drag On CAPEX Vanishing Since profits have bottomed, business capex intentions have picked up steam. As Chart I-3 illustrates, this development not only tends to presage a rise in business investments, it also is a leading indicator of economic activity at large. This rise in capex intentions is not only a reflection of an ebbing contraction in profits. It also indicates that many companies are starting to worry about hitting their capacity constraints if final demand firms up. After having added to their real capital stocks at the slowest pace in decades, U.S. firms are now facing rising sales, a situation that creates a bottleneck (Chart I-4). Chart I-3CAPEX Intentions And Growth bca.fes_sr_2016_12_16_s1_c3 bca.fes_sr_2016_12_16_s1_c3 Chart I-4Improving Sales Outlook ##br##Meets Supply Constraint bca.fes_sr_2016_12_16_s1_c4 bca.fes_sr_2016_12_16_s1_c4 Moreover, the labor market is tightening. All the signs are there: at 4.6%, U.S. unemployment is in line with its long-term equilibrium; the number of individuals outside of the labor force is in line with the 1999 to 2007 period, an era where hidden labor-market slack was inexistent; and the difficulty for small businesses to find qualified labor is growing (Chart I-5). As is the case today, companies are not concerned by a lack of demand, but by the quality of labor - a combination pointing to decreasing slack - wage growth tends to accelerate. Coincidentally, this is also an environment in which companies increase their allocation to corporate investments (Chart I-6). A few factors explain why companies are more willing to invest when slack narrows and wages grow. Obviously, rising labor costs incentivize businesses to skew their production function toward capital instead of labor. Additionally, rising wages support household consumption. Capex is a form of derived demand. A stronger household sector leads to more perceived certainty regarding the robustness of the expected final demand faced by corporations. Thus, when the share of wages and salaries in the national income grows, so do investments (Chart I-7). Chart I-5The Labor Market Is Tight The Labor Market Is Tight The Labor Market Is Tight Chart I-6When Demand Is Solid And Labor Is Tight... bca.fes_sr_2016_12_16_s1_c6 bca.fes_sr_2016_12_16_s1_c6 Chart I-7Animal Spirits At Work bca.fes_sr_2016_12_16_s1_c7 bca.fes_sr_2016_12_16_s1_c7 This means that while we had already expected the consumer to be a key engine of growth next year, we expect the corporate sector to join the fray.1 To us, this combination represents the main reason to expect our Combined Capacity Utilization Gauge to move into "no slack" territory, an environment where the Fed can hike rates durably. Bottom Line: U.S. animal spirits are breaking free. Trump is the catalyst, but conditions for improving business confidence and higher capex have been in place for a period of time. Profits have troughed, capex intentions are on the rise, and capacity constraints are being hit. This will give the Fed plenty of ammo to increase rates in 2017 and 2018. Theme 2 - Monetary Divergences: Pretty Tied Up Monetary policy divergences will continue to be one of the running themes for 2017. As we have argued, the Fed is in a better position to increase interest rates. However, the European Central Bank and the Bank of Japan are firmly pressing on the gas pedal. Last week, the ECB unveiled a new leg to its asset purchase program. True, bond buying will decrease from EUR 80 billion to EUR 60 billion starting April 2017, but the program is now open-ended. Also, the ECB can now buy securities with a maturity of 1-year, as well as securities yielding less than the deposit facility rates. This gives the ECB more flexibility to increase its purchases if need be to placate any potential economic shock in the future. Most crucially, the ECB does not regard its 2019 inflation forecast of 1.7% as in line with its target. Draghi has stressed that this requires the ECB to persist in maintaining its monetary accommodation. This makes sense. While the European economy has surprised to the upside, the recent roll-over in core CPI highlights the continued deflationary forces in the euro area (Chart I-8). These deflationary forces are present because the European output gap remains wide at around 4% of potential GDP.2 While the OECD pegs the Eurozone's natural rate of unemployment at 9%, it is probably lower. Despite a 2.3-percentage-point fall in the Eurozone's unemployment to 9.8% since 2013, euro area wages continue to decelerate, in sharp contrast with the U.S. situation (Chart I-9). This portends to excess capacity in the European labor market. It also limits European household income growth, which has lagged the U.S. by 14% since 2003. (Chart I-9, bottom panel). As a result, European consumption should continue lagging the U.S. Chart I-8Europe's Deflation Problem bca.fes_sr_2016_12_16_s1_c8 bca.fes_sr_2016_12_16_s1_c8 Chart I-9Signs Of Slack In Europe Signs Of Slack In Europe Signs Of Slack In Europe Additionally, European domestic demand has been supported by a rise in the credit impulse - the change in credit flows (Chart I-10). Between 2011 and 2014, to meet the EBA stress test and Basel III criteria, European banks raised capital and limited asset growth, boosting their capital ratios from 7.1% to more than 11% today. Once this adjustment was over, European banks normalized credit flows, boosting the credit impulse. This process is behind us. To keep the credit impulse in positive territory, credit flows would have to keep on expanding, implying that the stock of credit would have to grow at an ever-accelerating pace. However, the poor performance of European bank equities suggests that credit growth will slow (Chart I-11). While this may be too pessimistic a forecast, it is now unlikely that credit growth will accelerate. As a result, the credit impulse will roll over, hurting domestic demand and keeping deflationary pressures in place. Chart I-10Credit Trends In Europe: Dark Omen Credit Trends In Europe: Dark Omen Credit Trends In Europe: Dark Omen Chart I-11Another Dark Omen Another Dark Omen Another Dark Omen This should translate into a very easy monetary policy in Europe for 2017 and most likely 2018. European rates, both at the short- and long-end of the curve will not rise as much as U.S. rates. In Japan, economic slack has dissipated and the labor market is at full employment (Chart I-12). The unemployment rate stands at 3% and the job-openings-to-applicants ratio sits at 1991 levels. What has prevented the Japanese output gap from moving into positive territory has been fiscal belt-tightening. Between 2011 and today, the Japanese cyclically-adjusted deficit has fallen from 7.5% to 4.5% of GDP, inflicting a large drag on growth. Going forward, we expect Japan's GDP to actually move above trend. Based on the IMF's forecast, fiscal austerity is behind us, suggesting that the force that has hampered growth is now being lifted. This is a conservative assessment. Abe has sounded increasingly willing to expand the government's deficit following his July upper-house election victory. Japanese military spending should be a key source of stimulus. In 2004, Japan and China both spent US$50 billion in that arena. Today, Japanese defense spending is unchanged but China's has grown to US$200 billion (Chart I-13). Therefore, Japan is ever more exposed to an increasingly assertive China in the region. Moreover, a potential rapprochement between the U.S. and Russia - a country formally still at war with Japan - also increases the need for a more self-sufficient Japanese defense strategy. Chart I-12Little Slack In Japan bca.fes_sr_2016_12_16_s1_c12 bca.fes_sr_2016_12_16_s1_c12 Chart I-13A Catch Up Is Needed bca.fes_sr_2016_12_16_s1_c13 bca.fes_sr_2016_12_16_s1_c13 Outside of the fiscal realm, there is cause for tempered optimism regarding Japan. Payroll growth remains strong despite full employment, pointing toward potentially higher wages. Also, the Business Activity Index, machinery orders, and the shipments-to-inventory ratio are all firming. Encapsulating these forces, our model forecasts further improvement in industrial production (Chart I-14). While these would point toward a monetary tightening, such is not the case in Japan. The Japanese central bank has committed to let inflation significantly overshoot before removing any accommodation. Hence, as growth improves, inflation expectations can rise, dampening real rates, depressing the yen, and further supporting growth (Chart I-15). This new BoJ policy is a game changer. Chart I-14Some Glimmer Of Hope bca.fes_sr_2016_12_16_s1_c14 bca.fes_sr_2016_12_16_s1_c14 Chart I-15The Mechanics Targeted By The BoJ The Mechanics Targeted By The BoJ The Mechanics Targeted By The BoJ Moreover, this policy becomes supercharged when global bond yields rise, a central view for BCA's U.S. Bond Strategy service in 2017.3 Due to their low beta, JGB yields tend to not rise as much as global yields in a bond selloff. With the BoJ targeting near-zero rates at the long-end of the curve, JGB yields have even less upside. Rising global bond yields result in even-wider-than-before global-Japan rate differentials, which hurts the yen. This will stimulate Japanese growth even further, additionally easing monetary policy. Bottom Line: While the U.S. is on the path toward tighter policy, the ECB and the BoJ, by design, are loosening their policy. In Europe, the economy continues to suffer from underlying deflationary forces, forcing the ECB to stand pat for now. In Japan, the BoJ has elected to let inflation overshoot significantly even as the economy strengthens. This is putting downward pressure on Japanese real rates, a de facto further easing of monetary policy. Theme 3 - China And EM Slow-Down: Livin' On A Prayer After a year of respite, in 2017, emerging markets and China will once again be a source of deflationary shocks for the global economy. EM as a whole remains in a structurally precarious position. Since 2008, EM economies have accumulated too much debt and built too much capacity (Chart I-16). Most worrying has been the pace of debt accumulation. In the past five years, debt-to-GDP has risen by 51 percentage points to 146% of GDP. The debt has been backed up with new investments, but such a quick pace of asset accumulation raises the prospects of capital misallocation. When a large economic block like EM spends more than 25% of its GDP for 13 years on investment, the likelihood that many poor investments have been made is high. EM economies show all the hallmarks that capital has been miss-allocated, threatening future debt-servicing capacity. Labor productivity growth has collapsed from 3.5% to 1.5%, despite rising capital-to-labor ratios, while return on equity has collapsed despite surging leverage ratios, a sure sign of falling return on capital (Chart I-17). Chart I-16EM Structural Handicaps EM Structural Handicaps EM Structural Handicaps Chart I-17Symptoms Of A Malaise bca.fes_sr_2016_12_16_s1_c17 bca.fes_sr_2016_12_16_s1_c17 With this backdrop in mind, what happened in 2016 is key to understanding potential 2017 developments. Excess debt and excess capacity are deflationary anchors that raise the vulnerability of EM to shocks, both positive and negative. In 2016, the shock was positive. In the second half of 2015 and early 2016, China engaged in large scale fiscal stimulus (Chart I-18). Government spending grew and US$1.2 trillion of public-private infrastructure projects were rolled out in a mere six months. This lifted Chinese imports from their funk, used up some of the EM's excess capacity, dampened EM deflationary forces, and raised EM return on capital for a period. Additionally, faced with volatile markets, Western central banks eased monetary policy. The ECB and BoJ cut rates, and the Fed backed away from its hawkish rhetoric. The resultant falls in DM real rates and the dollar boosted commodity prices, further dampening EM deflationary forces and boosting EM profitability. Capital flows into EM ensued, easing financial conditions there and brightening the economic outlook (Chart I-19). Chart I-18China Fiscal Backdrop: From Good To Bad China Fiscal Backdrop: From Good To Bad China Fiscal Backdrop: From Good To Bad Chart I-19EM Financial Conditions Are Deteriorating EM Financial Conditions Are Deteriorating EM Financial Conditions Are Deteriorating This process is moving into reverse, the positive shock is morphing into a negative one. The structural handicaps plaguing EM have only marginally improved. Precisely because the Chinese industrial sector has regained composure, the already-fading Chinese stimulus will fully move into reverse (Chart I-20). With credit appetite remaining low and interbank rates already rising as the PBoC slows liquidity injections, the Chinese economy should soon rollover. Moreover, the dollar and global real rates are on the rise. Paradoxically, the return of U.S. animal spirits could endanger the EM recovery. As Chart I-21 shows, an upturn in DM leading economic indicators presages a fall EM LEIs. This simply reflects relative liquidity and financials conditions. Chart I-20China: As Good As It Gets China: As Good As It Gets China: As Good As It Gets Chart I-21DM Hurting EM DM Hurting EM DM Hurting EM Strong advanced economies, especially the U.S., lifts DM real rates and the dollar. This process sucks liquidity away from EM and tightens their financial conditions exogenously (Chart I-22). This hurts EM risk assets, currencies, and their economies. Moreover, since trade with the U.S. and other DM economies only account for 15% and 13% of EM exports, respectively, a fall in EM currencies does little to boost growth there. The fall in EM growth to be seen in 2017 will lay bare their structural weaknesses. As a result, EM assets are likely to suffer considerable downside. EM economies will limit the rise in global inflation by exerting downward pressures on globally traded goods prices as well as many commodities. Moreover, with Europe and Japan more exposed to EM growth than the U.S. (Chart I-23), EM weaknesses would further contribute to monetary divergences between the Fed and the ECB/BoJ. Chart I-22Rising DM Rates Equal Falling EM Liquidity Rising DM Rates Equals Falling EM Liquidity Rising DM Rates Equals Falling EM Liquidity Chart I-23U.S. Is The Least Sensitive To EM Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Bottom Line: 2016 was a great year for EM plays as Chinese fiscal stimulus and easier-than-anticipated DM policy contributed to large inflows of liquidity into EM assets, supporting EM economies in the process. However, as Chinese fiscal stimulus moves into reverse and as DM rates and the dollar are set to continue rising, liquidity and financial conditions in EM will once again deteriorate. Theme 4 - Oil Vs. Metals: Good Times Bad Times From the previous three themes, a logical conclusion would be to aggressively short commodities. After all, a strong dollar, rising rates, and weak EM are a poisonous cocktail for natural resources. However, the picture is more nuanced. In the early 1980s, from 1999 to 2001, and in 2005, commodity prices did rise along with the dollar (Chart I-24). In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan's and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar. In both the 1999-to-2001 and 2005 episodes, the share of U.S. and Japanese commodity consumption had already fallen. Most crucially, in both episodes, the rise in overall commodity price indexes only reflected strong energy prices. Outside of this complex, natural resource prices were lackluster (Chart I-25). Chart I-24Commodities And ##br##The Dollar Can Rise Together Commodities And The Dollar Can Rise Together Commodities And The Dollar Can Rise Together Chart I-25When A Commodity Rally Is An Oil Rally When A Commodity Rally Is An Oil Rally When A Commodity Rally Is An Oil Rally In these two instances, oil prices were able to escape the gravitational pull of a strong dollar because of supply disruptions. In 1999, following an agreement to reduce oil production by OPEC and non-OPEC states, output fell by around 4 million barrels per day, causing the market to re-equilibrate itself. In 2005, as EM growth was already creating a supportive demand backdrop, a devastating hurricane season in the Gulf of Mexico curtailed global production by around 1 million bbl/day. Today, the situation is a hybrid of 1999 and 2005. While EM economies are in a much weaker position than in 2005, the U.S. economy is gathering strength. Hence, close to 50% of global oil consumption - U.S. and DM oil demand - will stay firm (Chart I-26). But, most vitally, the supply picture once again dominates. Not only did OPEC agree to a deal to curtail production by 1.2 million bbl/day, but Russia agreed to share the burden, cutting its own output by 300 thousand bbl/day. Shortly after this agreement was reached, Saudi Arabia threw in an olive branch by pledging to further cut its production if necessary to reduce global oil inventories. This means that the oil market will firmly be in deficit in 2017 (Chart I-26, bottom panel). Our Commodity & Energy Service, which forecasted the OPEC move, believes WTI oil prices could occasionally peak toward US$65 /bbl in 2017.4 The picture for metals is more complex. The output of iron and copper continues to grow. On the demand side of the ledger, the U.S. only contributes 4% and 8% of global demand for each metal, respectively. Thus even if Trump were able to implement a large infrastructure program in 2017 - a big if for next year - the effect on global demand would be low. Instead, what matters for metal demand is the outlook for EM in general and China in particular (Chart I-27). On this front, our negative take on China and EM is a big hurdle for metals to overcome. Chart I-26Supportive Oil Back Drop Supportive Oil Back Drop Supportive Oil Back Drop Chart I-27Metals Are About China, Not The U.S. Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Yet, all is not dark. Metal and oil prices have historically been co-integrated. In fact, during the previous episodes where oil strengthened as the dollar rallied, metals have more or less been flat. This pattern is likely to repeat itself, especially if as we expect, EM experience a growth slowdown and not an outright recession. Altogether, expectations of strong oil prices and flat metal prices suggest that any EM slowdown should be more discriminating than in 2015 and early 2016. Countries like Russia and Colombia should fare better than Brazil or Peru. This reality is also true for DM economies. Canada and Norway are likely to outperform Australia. Bottom Line: Despite a bullish view on the dollar and a negative EM outlook, overall commodity indices are likely to rise in 2017. This move will mostly reflect a rally in oil - the benchmark heavyweight - a market where supply is being voluntarily constrained. The performance of metals is likely to be much more tepid, with prices mostly moving sideways next year. Theme 5 - Dirigisme: Sympathy For The Devil In 2017, a new word will need to enter the lexicon of investors: dirigisme. This was the economic policy of France after the Second World War. Dirigisme does not disavow the key support systems of capitalism: the rule of law, private property, the sacrosanct nature of contracts, or representative governments. Instead, dirigisme is a system of free enterprise where, to a certain degree, the state directs the economy, setting broad guidelines for what is admissible from the corporate sector. Donald Trump fully fits this mold. He wants business to be conducted a certain way and will try his hardest to ensure this will be the case. What will be the path chosen by Trump? Globalization and laissez-faire capitalism have been great friends of corporate profit margins and the richest echelons of U.S. society (Chart I-28). While it has also greatly benefited the EM middle class, the biggest losers under this regime have been the middle class in advanced economies (Chart I-29). As long as U.S. consumers had access to easy credit, the pain of stagnating incomes was easily alleviated. Without easy credit the pain of globalization became more evident. Chart I-28The (Really) Rich Got Richer Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Chart I-29Globalization: No Friend To DM Middle Class Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Trump has courted the disaffected middle class. While he is likely to cut regulation, he will also put in place potentially erratic policies that may destabilize markets. The key will be for investors to appreciate his ultimate goal: to boost, even if only temporarily, the income of the American middle class. As such, his bullying of Carrier - the U.S. air-conditioner manufacturer that wanted to shift production to Mexico - is only the opening salvo. Tax policy is likely to move in this direction. A proposed tax reform that would cut tax for exporters or companies moving production back to the U.S. towards 0 - that's zero - and punish importers is already in the pipeline. The implications of such policies on U.S. employment are unclear. While U.S. businesses may repatriate production, they may do so while minimizing the labor component of their operations and maximizing the capital component in their production function. In any case, more production at home will support the domestic economy for a time period. However, the global impact is clearer. These policies are likely to be deflationary for the global economy outside the United States. A switch away from production outside of U.S. jurisdiction will raise non-U.S. output gaps. This should weigh on global wages and globally traded goods prices. Additionally, this deflationary impact will cause global monetary policy to remain easy relative to the U.S., particularly hurting the currencies of nations most exposed to global trade. Compounding this effect, nations that currently export heavily to the U.S. - which will lose competitiveness due to tax policy shifts and/or potential tariffs - are likely to let their currencies fall to regain their lost competitiveness. The currencies of Asian nations, countries that have benefited the most from globalization, are likely to get hit the hardest (Chart I-30). Chart I-30Former Winners Become Losers Under Trump's Dirigisme Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Moreover, along with a shift toward dirigisme, the U.S.'s geopolitical stance could harden further, a troubling prospect in an increasingly multipolar world. Tensions in East Asia are likely to become a recurrent theme over the next few years. Ultimately, the rise of dirigisme means two things: First, the influence of politics over markets and economic developments will continue to grow. Economics is moving closer to its ancestor: political-economy. Second, while Trump's dirigisme can be understood as a vehicle to implement his populist, pro-middle class policies, they will add an extra dose of uncertainty to the global economy. Volatility is likely to be on a structural upswing. Interestingly, the risk of rising dirigisme is more pronounced in the U.S. and the U.K. than in continental Europe. Not only are economic outcomes more evenly distributed among the general population in the euro area, recent elections in Spain or Austria have seen centrist parties beat the populists. While Italy still represents a risk on this front, the likelihood of a victory by the right-wing Thatcherite reformist Francois Fillon for the French presidential election in May is very high.Germany will remain controlled by a grand coalition after its own 2017 elections.5 Bottom Line: The U.S. economy is moving toward a more state-led model as Trump aims to redress the plight of the U.S. middle class. These policies are likely to prove deflationary for the global economy outside of the U.S. and could support the U.S. dollar over the next 12-18 months. On a longer-term basis, the legacy of this development will be to lift economic and financial market volatility. Theme 6 - Inflation: It's A Long Way To The Top Our final theme for the upcoming year is that the inflationary outcome of a Trump presidency will take time to emerge and inflation is unlikely to become a big risk in 2017. Much ink has been spilled predicting that Trump's promises to inject fiscal stimulus exactly when the economy hits full employment will be a harbinger of elevated inflation. After all, this is exactly the kind of policies put in place in the late 1960s. Back then, due to the Great Society program and the deepening U.S. involvement in the Vietnam War, President Johnson increased fiscal stimulus when the output gap was in positive territory. Inflation ensued. This parallel is misleading. True, in the long-term, Trump's fiscal stimulus and dirigisme bent could have stagflationary consequences. However, it could take a few years before the dreaded stagflation emerges. To begin with, the structure of the labor market has changed. Unionization rates have collapsed from 30% of employees in 1960 to 11% today. The accompanying fall in the weight of wages and salaries in national income demonstrates the decline in the power of labor (Chart I-31). Without this power, it is much more difficult for household income to grow as fast as it did in the 1960s and 1970s. Likewise, cost-of-living-adjustment clauses have vanished from U.S. labor contracts. Hence, the key mechanism that fed the vicious inflationary circle between wages and prices is now extinct. Additionally, today, capacity utilization - a series that remains well correlated with secular inflation trend - remains much lower than in the 1960s and 1970s (Chart I-32). This means that one of the key ingredients to generate a sharp tick up in inflation is still missing. Chart I-31Labor: From Giant To Midget Labor: From Giant To Midget Labor: From Giant To Midget Chart I-32Capacity Utilization: Not Johnson Nor Nixon bca.fes_sr_2016_12_16_s1_c32 bca.fes_sr_2016_12_16_s1_c32 Chart I-33Today's Slack Is Not Where It Once Was bca.fes_sr_2016_12_16_s1_c33 bca.fes_sr_2016_12_16_s1_c33 Also, when looking at the output gap, the 1960s and 1970s once again paint a markedly different picture versus the present. Today, we are only in the process of closing the output and unemployment gaps. In the 1960s, it took U.S. inflation until mid-1968 to hit 4%. By that time, the output gap had been positive for around 5 years, hitting 6% of GDP in 1966. Unemployment had been below its equilibrium rate since 1963, and by 1968 it was 2.5% below NAIRU (Chart I-33). Together the aforementioned factors suggest that inflation should remain quite benign in 2017. We probably still have a significant amount of time before raising the stagflationary alarm bells. Finally, the Fed currently seems relatively unwilling to stay behind the curve for a prolonged period and let inflation significantly overshoot its target. Wednesday, the Fed surprised markets by forecasting three rate hikes in 2017, resulting in a much more hawkish communique than was anticipated. Therefore, the FOMC's tolerance for a "high pressure" economy now seems much more limited than was assumed by markets not long ago. This further limits the inflationary potential of Trump's stimulus. Instead, it highlights the dollar-bullish nature of the current economic environment. Bottom Line: Trump fiscal stimulus at full employment evokes the inflationary policies of the late 1960s and early 1970s. However, back then it took years of economic overutilization before inflation reared its ugly head. Additionally, the structure of the labor market was much friendlier to inflation back then than it is today. Thus, while Trump's policy may raise inflation in the long term, it will take a prolonged period of time before such effects become evident. Instead, in 2017, inflation should remain well contained, especially as the Fed seems unwilling to remain significantly behind the curve. Investment Implications USD The U.S. dollar is in the midst of a powerful bull market. While the USD is already 10% overvalued, the greenback has historically hit its cyclical zenith when it traded with more than a 20% premium to its long-term fair value. This time should be no exception. Beyond our positive view on households, resurging animal spirits are beginning to support the economy. This combination is likely to prompt the Fed to move toward a more aggressive stance than was expected a few months ago (Chart I-34). With monetary divergences fully alive and backed up by economic fundamentals, interest-rate spreads between the U.S. and the rest of the G10 will only grow wider. Factors like a move toward dirigisme and an absence of blow-out inflation will only feed these trends. Chart I-34Market's Fed Pricing: More Upside Market's Fed Pricing: More Upside Market's Fed Pricing: More Upside Tactically, the dollar is overbought, but clearly momentum has taken over. There is so much uncertainty floating in terms of economic and policy outcomes that evaluating the fair-value path for interest rates and the dollar is an even trickier exercise than normal for investors. This lack of clarity tends to be a fertile ground for momentum trading. Investors are likely to continue to chase the Fed. This process could last until market pricing for 2017 has overshot the Fed's own prognostications. Chart I-35EUR/USD: Technical Picture EUR/USD: Technical Picture EUR/USD: Technical Picture EUR At this point in time, the euro suffers from two flaws. First, as the anti-dollar, shorting the euro is a liquid way to chase the dollar's strength. Second, monetary divergences are currently in full swing between the ECB and the Fed: the U.S. central bank just increased interest rates and upgraded its rate forecast for 2017; meanwhile, the ECB just eased policy by increasing the total size of its asset purchase program. Investors are in the process of pricing these two trends and EUR/USD has broken down as a result (Chart I-35). The recent breakdown could bring EUR/USD to parity before finding a temporary floor. That being said, a EUR/USD ultimate bottom could still trade substantially below these levels. The U.S. economy is slowly escaping secular stagnation while Europe remains mired in its embrace. The euro is likely to end up playing the role of the growth redistributor between the two. JPY The Bank of Japan has received the gift it wanted. Global bond yields and oil prices are rising. This process is supercharging the potency of its new set of policies. Higher oil prices contribute to lifting inflation expectations, and rising global rates are widening interest-rate differentials between the world and Japan. With the BoJ standing as a guarantor of low Japanese yields, real-rate differentials are surging in favor of USD/JPY. USD/JPY has broken above its 100-week moving average, historically a confirming signal that the bull market has more leg. Additionally, as Chart I-36 shows, USD/JPY is a function of global GDP growth. By virtue of its size, accelerating economic activity in the U.S. will lift average global growth, further hurting the yen. Tactically, USD/JPY is massively overbought but may still move toward 120 before taking a significant pause in its ascent. We were stopped out of our short USD/JPY position. Before re-opening this position, we would want to see a roll-over in momentum as currently, the trend is too strong to stand against. GBP While political developments remain the key immediate driver of the pound, GBP is weathering the dollar's strength better than most other currencies. This is a testament to its incredible cheapness (Chart I-37), suggesting that many negatives have been priced into sterling. Chart I-36USD/JPY: A Play On Global Growth bca.fes_sr_2016_12_16_s1_c36 bca.fes_sr_2016_12_16_s1_c36 Chart I-37Basement-Bargain Pound bca.fes_sr_2016_12_16_s1_c37 bca.fes_sr_2016_12_16_s1_c37 For the first half of 2017, the pound will be victim to the beginning of the Brexit negotiations between the EU and the U.K. The EU has an incentive to play hardball, which could weigh on the pound. In aggregate, while the short-term outlook for the pound remains clouded in much uncertainty, the pounds valuations make it an attractive long-term buy against both the USD and EUR. Chart I-38CAD: More Rates Than Oil bca.fes_sr_2016_12_16_s1_c38 bca.fes_sr_2016_12_16_s1_c38 CAD The Bank of Canada will find it very difficult to increase rates in 2017 or to communicate a rate hike for 2018. The Canadian economy remains mired with excess capacity, massive private-sector debt loads, and a disappointing export performance. This suggests that rate differentials between the U.S. and Canada will continue to point toward a higher USD/CAD (Chart I-38). On the more positive front, our upbeat view on the oil market will dampen some of the negatives affecting the Canadian dollar. Most specifically, with our less positive view on metals, shorting AUD/CAD is still a clean way to express theme 4. AUD & NZD While recent Australian employment numbers have been positive, the tight link between the Australian economy and Asia as well as metals will continue to represent hurdles for the AUD. In fact, the AUD is very affected by theme 3, theme 4, and theme 5. If a move towards dirigisme is a problem for Asia and Asian currencies, the historical link between the latter and the AUD represents a great cyclical risk for the Aussie (Chart I-39). Tactically, the outlook is also murky. A pullback in the USD would be a marginal positive for the AUD. However, if the USD does correct, we have to remember what would be the context: it would be because the recent tightening in U.S. financial conditions is hurting growth prospects, which is not a great outlook for the AUD. Thus, we prefer shorting the AUD on its crosses. We are already short AUD/CAD and tried to go long EUR/AUD. We may revisit this trade in coming weeks. Finally, we have a negative bias against AUD/NZD, reflecting New Zealand's absence of exposure to metals - the commodity group most exposed to EM liquidity conditions, as well as the outperformance of the kiwi economy relative to Australia (Chart I-40). However, on a tactical basis, AUD/NZD is beginning to form a reverse head-and-shoulder pattern supported by rising momentum. Buying this cross as a short-term, uncorrelated bet could be interesting. Chart I-39Dirigisme Is A Problem For The Aussie bca.fes_sr_2016_12_16_s1_c39 bca.fes_sr_2016_12_16_s1_c39 Chart I-40New Zealand Is Perkier Than Australia bca.fes_sr_2016_12_16_s1_c40 bca.fes_sr_2016_12_16_s1_c40 NOK & SEK The NOK is potentially the most attractive European currency right now. It is supported by solid valuations, a current account surplus of 5% of GDP and a net international investment position of nearly 200% of GDP. Moreover, Norwegian core inflation stands at 3.3%, which limits any dovish bias from the Norges Bank. Additionally, NOK is exposed to oil prices, making it a play on theme 4. We like to express our positive stance on the NOK by buying it against the EUR or the SEK. The SEK is more complex. It too is cheap and underpinned by a positive current account surplus. Moreover, the inflation weaknesses that have kept the Riksbank on a super dovish bias mostly reflected lower energy prices, a passing phenomenon. However, being a small open economy heavily geared to the global manufacturing cycle, Sweden is very exposed to a pullback from globalization, limiting the attractiveness of the krona. Moreover, the krona is extremely sensitive to the USD. CHF The SNB is keeping its unofficial floor under EUR/CHF in place. Therefore, USD/CHF will continue to be a direct mirror image of EUR/USD. On a longer-term basis, Switzerland net international investment position of 120% of GDP and its current-account surplus of 11% of GDP will continue to lift its fair value (Chart I-41). Hence, once the SNB breaks the floor and lets CHF float - an event we expect to materialize once Swiss inflation and wages move back toward 1% - the CHF could appreciate violently, especially against the euro. Chart I-41The Swiss Balance Of Payment Position Will Support CHF bca.fes_sr_2016_12_16_s1_c41 bca.fes_sr_2016_12_16_s1_c41 Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the consumer and the dollar, please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy", dated December 8, 2016, available at ces.bcaresearch.com. 5 For a more detailed discussion of dirigisme, multipolarity, and rising tensions in East Asia, please see Geopolitical Strategy Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1 bca.fes_sr_2016_12_16_s2_c1 bca.fes_sr_2016_12_16_s2_c1 Chart II-2 bca.fes_sr_2016_12_16_s2_c2 bca.fes_sr_2016_12_16_s2_c2 The Fed hiked rates to 0.75% as expected. The dollar began to rally soon after the updated dot-plot suggested a faster pace of tightening than previously expected. Data from Thursday morning displayed a strengthening labor market, with expectations consistently beaten: Initial Jobless Claims came in at 254 thousand, beating expectations of 255 thousand. Continuing Jobless Claims were recorded at 2.018 million, outperforming by 7 thousand. Additionally, the NY Empire State Manufacturing Index also outperformed expectations of 4, coming in at 9. These figures provided an additional lift to the dollar with the DXY nearing the 103 mark. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 The Euro Chart II-3 bca.fes_sr_2016_12_16_s2_c3 bca.fes_sr_2016_12_16_s2_c3 Chart II-4 bca.fes_sr_2016_12_16_s2_c4 bca.fes_sr_2016_12_16_s2_c4 The Euro Area's data releases seem to be a mixed bag. Industrial production failed to meet expectations, and even contracted 0.1% on a monthly basis. The Markit Composite PMI remained steady at 53.9, and was in line with expectations, while the Services PMI fell and underperformed expectations, whereas the Manufacturing PMI rose and beat expectations. The increase in the dollar has also forced down Euro, where it has broken the crucial support level of around 1.055, and traded as low as 1.04. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5 bca.fes_sr_2016_12_16_s2_c5 bca.fes_sr_2016_12_16_s2_c5 Chart II-6 JPY Technicals 2 JPY Technicals 2 Despite the recent collapse in the Yen, Japan continues to be plagued by strong deflationary pressures. The BoJ will have no choice but to continue to implement radical monetary measures and thus the yen will continue to fall as some of the data lacks vigor: The decline in machinery orders accelerated to 5.6% YoY, underperforming expectations. Japanese industrial production is also contracting, at a pace of 1.4%. Particularly, most measures in the Tankan Survey (for both manufacturers and non-manufacturers) also underperformed expectations. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 British Pound Chart II-7 bca.fes_sr_2016_12_16_s2_c7 bca.fes_sr_2016_12_16_s2_c7 Chart II-8 bca.fes_sr_2016_12_16_s2_c8 bca.fes_sr_2016_12_16_s2_c8 Both the BoE and the market continue to be very bearish on the U.K. economy, causing the pound to be very cheap. However, the cable has remained resilient amid the recent dollar surge, in part because U.K. data, as we have mentioned many times, keeps outperforming expectations. The recent set of data confirms this view: Retail sales ex-fuel grew by 6.6% YoY, beating expectations of 6.1% YoY growth. Average earnings (both including and excluding bonus) also outperformed. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9 bca.fes_sr_2016_12_16_s2_c9 bca.fes_sr_2016_12_16_s2_c9 Chart II-10 bca.fes_sr_2016_12_16_s2_c10 bca.fes_sr_2016_12_16_s2_c10 Australian new motor vehicle sales are still quite weak: They are contracting 0.6% on a monthly basis, albeit at a slower pace from October's 2.4%; On an annual basis, they are now contracting 1.1%. Labor market data was also released, with unemployment increasing to 5.7%. However, the change in employment was better than expected, with 39,100 new total jobs being added to the economy. The Consumer Inflation Expectation measure for December also highlighted an upbeat outlook on inflation, reading at 3.4%, up from 3.2%. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11 bca.fes_sr_2016_12_16_s2_c11 bca.fes_sr_2016_12_16_s2_c11 Chart II-12 bca.fes_sr_2016_12_16_s2_c12 bca.fes_sr_2016_12_16_s2_c12 The recent dollar rally has been very damaging for the kiwi, as it has fallen by 3% since the Fed policy decision. Recent data has also been negative: Manufacturing Sales slowed down to 2.1% in Q3 from 2.2% in Q2 (this number was also revised down from 2.8%). Additionally Business PMI slowed down slightly from 55.1 to 54.4. The NZD has also shown weakness in spite of the surge in dairy price, which now stand at their highest point since June 2014. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13 bca.fes_sr_2016_12_16_s2_c13 bca.fes_sr_2016_12_16_s2_c13 Chart II-14 bca.fes_sr_2016_12_16_s2_c14 bca.fes_sr_2016_12_16_s2_c14 The outlook for Canada's economy remains murky. Although the Financial Stability Report concluded that Canada's financial system remains mostly unchanged from six months ago, the BoC highlighted three key vulnerabilities that remain in the financial system: household debt, for which the debt-to-disposable income is approaching 170%; imbalances in the housing market, where the prices have reached just under 6 times average household income - their highest recorded level; and fragile fixed-income market liquidity. Therefore, underlying weaknesses are apparent and data is reflective of a weak economy. Pressure from a rising dollar will continue to place additional pressure on the CAD going forward. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15 bca.fes_sr_2016_12_16_s2_c15 bca.fes_sr_2016_12_16_s2_c15 Chart II-16 bca.fes_sr_2016_12_16_s2_c16 bca.fes_sr_2016_12_16_s2_c16 The SNB decided to stay put and leave rates unchanged at -0.75%. In addition, the SNB slightly decreased its forecast for inflation for the coming years. However the central bank remains optimistic on the Swiss economy, as improved sentiment in other advanced economies should help the Swiss export sector. Additionally, the labor market remains solid, with only 3.3% of unemployment. Although the franc should continue to mirror the Euro, all these factors will eventually put upward pressure on this currency. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17 bca.fes_sr_2016_12_16_s2_c17 bca.fes_sr_2016_12_16_s2_c17 Chart II-18 bca.fes_sr_2016_12_16_s2_c18 bca.fes_sr_2016_12_16_s2_c18 The Norges Bank decided to stay put and leave rates at 0.5%. In their Executive Board Assessment the Norges Bank project that rates will remain around their current level in the coming years. They also project that inflation should slowdown given a somewhat slower expected path for growth. However, worries about household debt persist: House prices rose by 11.6% YoY in November, while household debt grew by 6.3%. Additionally household credit is rising faster than household income. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19 bca.fes_sr_2016_12_16_s2_c19 bca.fes_sr_2016_12_16_s2_c19 Chart II-20 bca.fes_sr_2016_12_16_s2_c20 bca.fes_sr_2016_12_16_s2_c20 The Swedish economy has picked up a bit, as annual inflation figures came out at 1.4%, closer to the Riksbank's target. The labor market also displayed resilience as the unemployment rate dropped by 0.2% to 6.2%. Despite the upbeat data, the SEK failed to perform. With the dollar trading at new highs, USD/SEK also reached a new 13-year high, trading above 9.4 for a moment. Additionally, the SEK is trading poorly on its crosses as well, down against most of the G10 currencies. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The FOMC statement was somewhat more hawkish than expected. The Fed is on course to raise rates two to three times next year. Trump's policy views are squarely bearish for bonds, but more mixed for stocks. Investors are focusing too much on the positive aspects of Trump's agenda, while ignoring the glaringly negative ones. The 35-year bond bull market is over. Deep-seated political and economic forces will conspire to lift inflation over the coming years. For now, rising wages and prices are welcome news given that inflation remains below target in most economies. However, with productivity and labor force growth still weak around the world - and likely to stay that way - reflation will eventually morph into stagflation. Feature A Fork In The Road Charlie Wilson, the former CEO of General Motors, once famously declared that "what is good for GM is good for the country." There is little doubt that policies that boost economic growth can benefit both Wall Street and Main Street alike. On occasion, however, what is good for one may not be good for the other. Consider Donald Trump's campaign promise to curb illegal immigration and crack down on firms that move production abroad. Reduced immigration means fewer potential customers, and hence weaker sales growth. Fewer immigrant workers and less outsourcing also means higher wages for native-born workers. Bad news for Wall Street, but arguably good news for Main Street. Chart 1Diminished Labor Market Slack Boosting Wages bca.gis_wr_2016_12_16_c1 bca.gis_wr_2016_12_16_c1 The distinction between Wall Street and Main Street is critical for thinking about how various policies affect bonds and stocks. Bond prices tend to be more influenced by what happens to the broader economy (the key concern for Main Street), whereas equity prices tend to be more influenced by what happens to corporate earnings (the key concern for Wall Street). Corporate earnings have recovered much more briskly over the past eight years than the overall economy. Thus, it is no surprise that stock prices have surged while bond yields have tumbled. Things may be changing, however. A tighter U.S. labor market is pushing up wages, and this is starting to weigh on corporate profit margins (Chart 1). Meanwhile, bond yields are finally rebounding after hitting record low levels earlier this year. A Somewhat Hawkish Hike This week's FOMC statement reinforced the upward trajectory in yields. Both the median and modal "dot" in the Summary of Economic Projections shifted from two to three hikes next year. While Chair Yellen mentioned that a few participants "did incorporate some assumption about the change in fiscal policy," we suspect that many did not, reflecting the lack of clarity about the timing, composition, and magnitude of any fiscal package. As these details are fleshed out, it is probable that both growth and inflation assumptions will be revised up, helping to keep the Fed's tightening bias in place. The key question is whether U.S. growth will be strong enough next year to allow the Fed to keep raising rates. Our view is that it will. As we argued in October in "Better U.S. Economic Data Will Cause The Dollar To Strengthen,"1 a recovery in business capex, a turn in the inventory cycle, a pick-up in spending at the state and local government level, and continued solid consumption growth driven by rising real wages will all support demand in 2017. Indeed, it is likely that the Fed will find itself a bit behind the curve, allowing inflation to drift higher. The Structural Case For Higher Inflation The cyclical acceleration in U.S. and global inflation that we will see over the next few years will be buttressed by structural trends. As we first spelled out in this year's Q3 Strategy Outlook entitled "The End Of The 35-Year Bond Bull Market,"2 a number of political and economic forces will conspire to lift inflation and nominal bond yields over time. Let us start with the politics. Here, three inflationary forces stand out: The retreat from globalization; The rejection of fiscal austerity; The continued will and growing ability of central banks to push up inflation. Globalization Under Attack Globalization is an inherently deflationary force. In a globalized world, if a country experiences an idiosyncratic shock which raises domestic demand, this can be met with more imports rather than higher prices. In addition, the entry of millions of workers from once labor-rich, but capital-poor economies such as China, has depressed the wages of less-skilled workers in developed economies.3 Poorer workers tend to spend a greater share of their incomes than richer workers (Chart 2). To the extent that globalization has exacerbated income inequality, it has also reduced aggregate demand. It is too early to know to what extent Donald Trump will try to roll back globalization. So far, his cabinet appointments - perhaps with the exception of immigration hawk Jeff Sessions - are little different from what a run-of-the-mill Republican like Jeb Bush would have made. Yet, as we noted last week, it will be difficult for Trump to backtrack from his protectionist views because his white working-class base will abandon him if he does.4 As Chart 3 shows, the share of Republican voters who support free trade has plummeted from over half to only one-third. For better or for worse, the Republican Party has become a populist party. Davos Man beware. Chart 2The Rich Save, The Poor Not So Much bca.gis_wr_2016_12_16_c2 bca.gis_wr_2016_12_16_c2 Chart 3Republican Voters Are Rejecting Free Trade Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks In any case, even if populist pressures do not cause global trade to collapse over the coming years, the period of "hyperglobalization," as Arvind Subramanian has called it, is over. As we discussed three weeks ago,5 many of the things that facilitated globalization over the past 30 years were one-off developments: China cannot join the WTO more than once; tariffs in most developed countries cannot fall much more because they are already close to zero; there is nothing on the horizon that will match the breakthrough productivity gains in global shipping that stemmed from containerization; the global supply chain is already highly efficient, etc. Thus, at the margin, globalization will be less of a deflationary force than it once was. Back To Bread And Circuses After a brief burst of fiscal stimulus following the financial crisis, governments moved quickly to tighten their belts. Now, however, the pendulum is starting to swing back towards easier fiscal policy, as nervous politicians look for ways to thwart the populist backlash (Chart 4). The U.K. is a good example of this emerging trend. Prior to the Brexit vote, the Conservative government had planned to tighten fiscal policy by a further 3.3% of GDP over the remainder of this decade. This goal has been thrown out the window, with Theresa May now even hinting about the prospect of some fiscal stimulus. Elsewhere in Europe, governments continue to flout their fiscal targets. Not only has the European Commission turned a blind eye to this development, but a recent report by the Commission actually suggested that a "desirable fiscal orientation" would entail larger budget deficits next year than what member states are currently targeting (Chart 5). Chart 4The End Of Austerity Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Chart 5The European Commission Recommends Greater Fiscal Expansion Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks In Japan, Prime Minister Abe has scrapped plans to raise the sales tax next year. The supplementary budget announced in August will boost annual spending by 0.5% of GDP over the next three years. Our geopolitical team thinks that further spending measures will be introduced, especially on defense. For his part, Donald Trump has pledged massive fiscal stimulus consisting of increased infrastructure and defense expenditures, along with a whopping $6.2 trillion in tax cuts over the next 10 years even before accounting for additional interest costs. Investors shouldn't rejoice too much, however. Effective tax rates for S&P 500 companies are already well below statutory levels on account of the numerous loopholes in the tax code (Chart 6). Small businesses rather than large corporations will disproportionately benefit from Trump's tax measures. Chart 6The U.S. Effective Corporate Tax Rate Is Already Quite Low bca.gis_wr_2016_12_16_c6 bca.gis_wr_2016_12_16_c6 Moreover, it is doubtful that the maximum fiscal thrust from Trump's policies will be reached before 2018. By that time, the economy is likely to have reached full employment. As such, much of the stimulus is likely to show up in the form of higher wages rather than increased real corporate sales. More Monetary Ammo The global financial crisis set off the biggest deflation scare the world has seen since the Great Depression. Eight years later, central banks are still struggling to raise inflation. The conventional wisdom is that central banks are "out of bullets." This view, however, is much too pessimistic. Even if one excludes the use of such radical measures as helicopter money, it is still the case that traditional monetary policy becomes more effective as spare capacity is reduced. Consider the case of forward guidance. If an economy has a large output gap, a central bank's promise to keep interest rates at zero, even after full employment has been reached, may hold little sway. After all, many things can happen between now and then: A change of central bank leadership, another adverse economic shock, etc. In contrast, if the output gap is already quite small, as is the case in the U.S. today, a promise to let the economy run hot is more likely to be taken seriously. Chart 7 shows that the level of the U.S. core PCE deflator, the Fed's preferred inflation gauge, is nearly 4% lower than it would have been if inflation had remained at its 2% target since 2008. Given that the Fed has a symmetric target - meaning that inflation overshoots should be just as common as undershoots - aiming for an inflation rate above 2% over the next few years makes some sense. If inflation does move up to the 2.5%-to-3% range, the Fed might be reluctant to bring it back down since this would require slower growth and higher unemployment. In fact, a case could be made that the Fed and other central banks should simply raise their inflation targets. Both private and public debt levels are still quite elevated all over the world (Chart 8). Higher inflation would be one way to reduce the real value of those liabilities. Chart 7Inflation Has Undershot the Fed's Target Inflation Has Undershot the Fed's Target Inflation Has Undershot the Fed's Target Chart 8Elevated Debt Levels Elevated Debt Levels Elevated Debt Levels The difficulty in pushing nominal short-term rates much below zero is another reason to aim for a higher inflation rate. Back in 1999 when the FOMC first broached the idea of introducing a 2% inflation target, the Fed's simulations suggested that the zero lower bound would only be reached once every 20 years, and even on these rare occurrences, interest rates would be pinned to zero for only four quarters (Table 1). In reality, the U.S. economy has spent more than half of the time since then either at the zero bound or close to it. While we do not expect any central bank to raise their inflation targets anytime soon, long-term investors should nevertheless prepare for this possibility. Table 1The Fed Underestimated The Probability Of Rates Being Stuck At Zero Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Slow Potential Growth: Deflationary At First, Inflationary Later On The narrowing of output gaps around the world has given central banks more traction over monetary policy. However, there has been a dark side to this development - and one that also leans in the direction of higher inflation. As Chart 9 shows, spare capacity has declined in every major economy not because demand has been strong, but because supply has been weak. Chart 9AWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_12_16_c9a bca.gis_wr_2016_12_16_c9a Chart 9BWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_12_16_c9b bca.gis_wr_2016_12_16_c9b The decline in potential GDP growth reflects both slower productivity and labor force growth. As we have discussed in past reports, while cyclical factors have weighed on potential growth, structural factors also loom large.6 The former include falling birth rates, flat-lining labor participation, plateauing educational attainment, and a shift in technological innovation away from business productivity and towards consumer-centric applications such as social media. Chart 10A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Critically, slower potential GDP growth tends to be deflationary at the outset but becomes inflationary later on. Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also reduces consumption, as households react to the prospect of slower real wage gains. Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation (Chart 10). One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a period when productivity growth slowed and inflation accelerated. Likewise, a slowdown in labor force growth tends to morph from being deflationary to inflationary over time. When labor force growth slows, two things happen. First, investment demand drops. Why build new factories, office towers, and shopping malls if the number of workers and potential consumers is set to grow more slowly? Second, savings rise, as spending on children declines and a rising share of the workforce moves into its peak saving years (ages 35-to-50). The result is a large excess of savings over investment, which generates downward pressure on inflation and interest rates. As time goes by, the deflationary impact of slower labor force growth tends to recede (Chart 11). Workers who once brought home paychecks start to retire en masse and begin drawing down their accumulated wealth. Since there are few young workers available to take their place, labor shortages emerge. At the same time, health care spending and pension expenditures rise as a larger fraction of the population enters its golden years. The result is less aggregate savings and higher interest rates. Chart 11An Aging Population Eventually Pushes Up Interest Rates Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Japan provides a good example of how this transition might occur. Chart 12 shows that the household savings rate has fallen from over 14% in the early 1990s to only 2% today. Meanwhile, the ratio of job openings-to-applicants has reached a 25-year high. Amazingly, the tightening in the labor market has occurred despite anemic GDP growth and a huge surge in female employment. Prime-age female labor participation has already risen above U.S. levels (Chart 13). As participation rates stabilize, labor force growth in Japan will decline from a cyclical high of around 0.8% at present to -0.2%. That may be enough to precipitate a sharp labor shortage, leading to higher wages and an end to deflation. Chart 12Japan: Declining Household Savings ##br## Rate And A Tightening Labor Market Japan: Declining Household Savings Rate And A Tightening Labor Market Japan: Declining Household Savings Rate And A Tightening Labor Market Chart 13Japan: Female Labor Force ##br## Participation Now Exceeds The U.S. bca.gis_wr_2016_12_16_c13 bca.gis_wr_2016_12_16_c13 What will the Bank of Japan do when this fateful day arrives? The answer is probably nothing. The BoJ would welcome a virtuous circle in which rising inflation pushes down real rates, leading to a weaker yen, a stronger stock market, and even higher inflation expectations. Such a virtuous circle almost emerged in 2012 had the Japanese government not short-circuited it by tightening fiscal policy by 3% of GDP. It won't make the same mistake again. Investment Conclusions Global assets have swung wildly in the weeks following the U.S. presidential election. The selloff in bonds and the rally in the dollar make perfect sense to us - indeed, we predicted as much in our September report entitled "Three Controversial Calls: Trump Wins, And The Dollar Rallies."7 In contrast, the surge in U.S. equities seems overdone. Yes, certain elements of Trump's political agenda such as deregulation and lower corporate tax rates are good news for stocks. But other aspects such as trade protectionism and tighter immigration controls are not. Others still, such as increased government spending, are good in theory but carry sizeable side-effects, the chief of which is that the stimulus may arrive at a time when the economy no longer needs it. Some commentators have argued that the good aspects of Trump's agenda will be implemented before the bad ones, giving investors a reason to focus on the positive. We are not so sure. If Trump gives the Republican establishment everything it wants on taxes and regulations, he will lose all his remaining leverage over trade and immigration. Rather than waiting to be stabbed in the back by Paul Ryan, strategically, Trump is likely to insist that Congress implement his populist platform before he hands it the keys to the economy. Even if one ignores the political intrigue, it is still the case that global stocks have tended to suffer following major spikes in bond yields such as the one we have just experienced (Table 2). We suspect that this time will not be any different. As such, investors would be wise to adopt a more defensive tactical posture over the next few months. Table 2Stocks Tend To Suffer When Bond Yields Spike Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Chart 14Global Growth Is Accelerating Global Growth Is Accelerating Global Growth Is Accelerating Things look better over a one-to-two year cyclical horizon. Outside of the U.S., much of the global economy continues to suffer from excess spare capacity. Recent data suggesting that global growth is accelerating is welcome news in that regard (Chart 14). Not only will stronger growth boost corporate earnings, but with the ECB, BoJ, and many other central banks firmly on hold, any increase in inflation expectations will translate into lower real rates, providing an additional fillip to spending. We continue to prefer European and Japanese stocks over their U.S. counterparts, on a currency-hedged basis. Emerging markets are a tougher call. The real trade-weighted dollar probably has another 5% or so of upside from current levels. Historically, a stronger greenback has been bad news for EM equities. On a more positive note, faster global growth should give some support to commodity prices. BCA's commodity strategists remain quite bullish on crude and natural gas, a view that has been further reinforced by both Saudi Arabia and Russia's announcements to restrict oil supply beginning in January. Still, on balance, we recommend a slightly underweight position in EM equities. Looking beyond the next two years, the outlook for global risk assets is likely to darken again. We are skeptical that Trump's much lauded supply-side policies will boost productivity to any great degree. Against a backdrop of rising budget deficits and brewing populist sentiment around the world, reflation may begin to give way to stagflation. In such an environment, bond yields could rise substantially from current levels, taking stocks down with them. Enjoy it while it lasts. 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 Global Investment Strategy, "Strategy Outlook Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 8, 2016, available at gis.bcaresearch.com. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "Trade Adjustment: Worker-Level Evidence," The Quarterly Journal of Economics (2014). 4 Please see Global Investment Strategy Weekly Report, "Trump And Trade," dated December 9, 2016, available at gis.bcaresearch.com. 5 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 6 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, and Global Investment Strategy Special Report, "Slower Potential Growth: Causes And Consequences," dated May 29, 2015, available at gis.bcaresearch.com. 7 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Recommendation Allocation Quarterly - December 2016 Quarterly - December 2016 Highlights Growth was picking up before the election of President Trump. His election merely accelerates the rotation from monetary to fiscal policy. This is likely to cause yields to rise, the Fed to tighten and the dollar to strengthen further. That will be negative for bonds, commodities and emerging market assets, and equivocal for equities. Short term, markets have overshot and a correction is likely. But the 12-month picture (higher growth and inflation) suggests risk assets such as equities will outperform. Our recommendations mostly have cyclical tilts. We are overweight credit versus government bonds, underweight duration and, in equity sectors, overweight energy, industrials and IT (and healthcare for structural reasons). Among alts, we prefer real estate and private equity over hedge funds and structured products. We limit beta through overweights (in common currency terms) on U.S. equities versus Europe and emerging markets. We also have a (currency-hedged) overweight on Japanese stocks. Feature Overview A Shift To Reflation The next 12 months are likely to see stronger economic growth, particularly in the U.S., and higher inflation. That will probably lead to higher long-term interest rates, the Fed hiking two or three times in 2017, and further dollar strength. The consequences should be bad for bonds, but mixed for equities - which would benefit from a better earnings outlook, but might see multiples fall because of a higher discount rate. The election of Donald Trump merely accelerates the rotation from monetary policy to fiscal policy that had been emerging globally since the summer. Trump's fiscal plans are still somewhat vague,1 but the OECD estimates they will add 0.4 percentage points to U.S. GDP growth in 2017 and 0.8 points in 2018, and 0.1 and 0.3 points to global growth. Growth was already accelerating before the U.S. presidential election. Global leading indicators have picked up noticeably (Chart 1), and the Q3 U.S. earnings season surprised significantly on the upside, with EPS growth of 3% (versus a pre-results expectation of -2%) - the first YoY growth in 18 months (Chart 2). Chart 1Global Growth Picking Up bca.gaa_qpo_2016_12_15_c1 bca.gaa_qpo_2016_12_15_c1 Chart 2U.S. Earnings Growing Again bca.gaa_qpo_2016_12_15_c2 bca.gaa_qpo_2016_12_15_c2 The problem with the shift to fiscal, then, is that it comes at a time when slack in U.S. economy has already largely disappeared. The Congressional Budget Office estimates the output gap is now only -1.5%, which means it is likely to turn positive in 2017 (Chart 3). Unemployment, at 4.6%, is below NAIRU2 (Chart 4). Historically, the output gap turning positive has sown the seeds of the next recession a couple of years later, as the Fed tightens policy to choke off inflation. Chart 3Output Gap Will Close In 2017 bca.gaa_qpo_2016_12_15_c3 bca.gaa_qpo_2016_12_15_c3 Chart 4Will This Trigger Inflation Pressures? bca.gaa_qpo_2016_12_15_c4 bca.gaa_qpo_2016_12_15_c4 As the Fed signaled at its meeting on December 14, it is likely to raise rates two or three times more in 2017. But we don't see it getting any more hawkish than that. Janet Yellen has made it clear that she will not preempt Trump's fiscal stimulus but rather wait to see it passed by Congress. The market is probably about right in pricing in an 80% probability of two rate hikes in 2017, and a 50% probability of three. With the Atlanta Fed Wage Growth Tracker rising 3.9% YoY and commodity prices (especially energy) starting to add to headline inflation, the Fed clearly wants to head off inflation before it sets in. We do not agree with the argument that the Fed will deliberately allow a "high-pressure economy." The result is likely to be higher long-term rates. The 10-year U.S. yield has already moved a long way (up 100 BP since July), and our model suggests fair value currently is around 2.3% (Chart 5). Short term, then, a correction is quite possible (and would be accompanied by moves in other assets that have overshot since November 9). But stronger global growth and an appreciating dollar over the next 12 months could easily push fair value up to 3% or beyond. The relationship between nominal GDP growth (which is likely to be 4.5-5% in 2017, compared to 2.7% in 1H 2016) and long-term rates implies a rise to a similar level (Chart 6). Accordingly, we recommend investors to be underweight duration and prefer TIPs over nominal bonds. Chart 5U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value Chart 6Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Global equities, on a risk-adjusted basis, performed roughly in line with sovereign bonds in 2016 - producing a total return of 9.2%, compared to 3.3% for bonds (though global high yield did even better, up 15.1%). If our analysis above is correct, the return on global sovereign bonds over the next 12 months is likely to be close to zero. Chart 7Will Investors Reverse The Move##br## from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? The outlook for equities is not unclouded. Higher rates could dampen growth (note, for example, that 30-year fixed-rate mortgages in the U.S. have risen over the past two months from 3.4% to 4.2%, close to the 10-year average of 4.6%). The U.S. earnings recovery will be capped by the stronger dollar.3 And a series of Fed hikes may lower the PE multiple, already quite elevated by historical standards. Erratic behavior by President Trump and the more market-unfriendly of his policies could raise the risk premium. But we think it likely that equities will produce a decent positive return in this environment. Portfolio rebalancing should help. Since the Global Financial Crisis investors have steadily shifted allocations from equities into bonds (Chart 7). They are likely to reverse that over the coming quarters if bond yields continue to trend up. Accordingly, we moved overweight equities versus bonds in our last Monthly Portfolio Update.4 Our recommended portfolio has mostly pro-cyclical tilts: we are overweight credit versus government bonds, overweight most cyclical equity sectors, and have a preference for risk alternative assets such as real estate and private equity. But our portfolio approach is to pick the best spots for taking risk in order to make a required return. We, therefore, balance this pro-cyclicality by some lower beta stances: we prefer investment grade debt over high yield, and U.S. and Japanese equities over Europe and emerging markets. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Trump Do? Trump made several speeches in September with details of his tax plan. He promised to (1) simplify personal income tax, cutting seven brackets to three, with 12%, 25% and 33% tax rates; (2) cut the headline corporate tax rate to 15% (from 35%); and (3) levy a 10% tax on the $3 trillion of corporate retained earnings held offshore. He was less specific on infrastructure spending, but Wilbur Ross, the incoming Commerce Secretary, mentioned $550 billion, principally financed through public-private partnerships. The Tax Policy Center estimates the total cost of the tax plan at $6 trillion (with three-quarters from the business tax cut). But it is not clear how much will be offset by reduced deductions. Incoming Treasury Secretary Steven Mnuchin, for example, said that upper class taxpayers will get no absolute tax cut. TPC estimates the tax plan alone will increase federal debt to GDP by 25 percentage points over the next 10 years (Chart 8). The OECD, assuming stimulus of 0.75% of GDP in 2017 and 1.75% in 2018, estimates that this will raise U.S. GDP growth by 0.4 percentage points next year and by 0.8 points in 2018, with positive knock-on effects on the rest of the world (Chart 9). While there are questions on the timing (and how far Trump will go with trade and immigration measures), BCA's geopolitical strategists sees few constraints on getting these plans passed.5 Republications in Congress like tax cuts (and will compromise on the public spending element) and it is wrong to assume that Republican administrations reduce the fiscal deficit - historically the opposite is true (Chart 10). Chart 8Massive Increase In Debt Quarterly - December 2016 Quarterly - December 2016 Chart 9GDP Impact Of U.S. Fiscal Stimulus Quarterly - December 2016 Quarterly - December 2016 Chart 10A Lot of Stimulus, And Extra Debt bca.gaa_qpo_2016_12_15_c10 bca.gaa_qpo_2016_12_15_c10 Implications for markets? Short term positive for growth and inflation; longer-term a worry because of crowding out from the increased government debt. How Will The Strong USD Impact Global Earnings? We have a strong U.S. dollar view and also favor U.S. equities over the euro area and emerging markets. Some clients question our logic because conceptually a strong USD should benefit earnings growth in the non-U.S. markets, and therefore non-U.S. equities should outperform. Chart 11USD Impact On Global Earnings bca.gaa_qpo_2016_12_15_c11 bca.gaa_qpo_2016_12_15_c11 Currency is just one of the factors that we consider when we make country allocation decisions, and our weights are expressed in USD terms unhedged. We will hedge a currency only when we have very high conviction, such as our current Japan overweight with a yen hedge, which is based on our belief that the BOJ will pursue more unconventional policies to stimulate the economy. This is undoubtedly yen bearish but positive for Japanese stocks. As shown in Chart 11, a stronger USD has tended to weaken U.S. earnings growth (panel 1). However, what matters to country allocation is relative earnings growth. Panels 3 and 5 show that in local currency terms, earnings growth in emerging markets and the euro area did not always outpace that in the U.S. when their currencies depreciated against the USD. In fact, when their currencies appreciated, earnings growth in USD terms tended to outpace that in the U.S. (panels 2 and 4), suggesting that the translation impact plays a very important role. This is consistent with what we have found for relative equity market returns (see Global Equity section on page 13). Currency affects revenues and costs in different proportions. If both revenues and costs are in same currency, then only net profit is affected by the currency. But, since many companies manage their forex exposure, at the aggregate level the currency impact will always be "weaker than it should be". What Is The Outlook For Brexit And The Pound? The U.K. shocked the world on 24 June 2016 with its vote to leave the European Union. However, the process and terms of exit are yet to be finalized pending the Supreme Court's decision on the role of parliament in invoking Article 50 of the Lisbon Treaty. Depending on this decision, there is a spectrum of possible outcomes for the U.K./EU relationship. At the two ends of the spectrum are: 1) a hard Brexit - complete separation from the EU, in which case the pound will plunge further; 2) a soft Brexit - with a few features of the current relationship retained, in which case the pound will rally. Chart 12What's Up Brexit? What's Up Brexit? What's Up Brexit? The fall in the nominal effective exchange rate to a 200-year low (Chart 12) is a clear indication of the potential serious long-term damage. With the nation's dependence on foreign direct investment (FDI) to finance its large current account deficit (close to 6% of GDP), more populist policies and increased regulation will hurt corporate profitability, making local assets less profitable to foreigners. The pound is currently caught up in a vicious circle of more depreciation, leading to higher inflation expectations and depressed real rates, which adds further selling pressure. This is the likely path of the pound in the case of a hard Brexit. For U.K. equities, under a hard Brexit that adds downward pressure to the pound, investors should favor firms with global revenues (FTSE 100) and underweight firms exposed more to domestic business and a potential recession (FTSE 250). The opposite holds true in the case of a soft Brexit. Investors should also underweight U.K. REITs because of cyclical and structural factors that will affect commercial real estate. In the case of a hard Brexit, structural long-term impacts to the British economy include: 1) a decline in the financial sector - the EU will introduce regulations that will force euro-denominated transactions out of London; 2) a slowdown in FDI - the U.K. will cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign inflows; 3) weaker growth - with EU immigration into the U.K. expected to fall by 90,000 to 150,000 per year, estimates.6 point to a 3.4% to 5.4% drop in per capita GDP by the year 2030. What Industry Group Tilts Do You Recommend? In October 2015, we advocated that, because long-term returns for major asset classes would fall short of ingrained expectations, investors should increase alpha by diving down into the Industry Group level.7 How have these trades fared, and which would we still recommend? Long Household And Personal Products / Short Energy. We closed the trade for a profit of 12.2% in Q12016. This has proven to be quite timely as oil prices, and Energy stocks along with it, have rallied substantially since. Long Insurance / Short Banks. The early gains from this trade reversed in Q2 as long yields have risen rapidly, leading to yield curve steepening. However, our cyclical view is still intact. Relative performance is still holding its relationship with the yield curve (Chart 13). Historically, Fed tightening has almost always led to bear flattening. We expect the same in this cycle, which should lead to Insurance outperformance. Long Health Care Equipment / Short Materials. This trade generated early returns but has since underperformed as Materials bounced back sharply. Nevertheless, we remain bearish on commodities and EM-related plays, viewing this rise in Materials stocks as more of a technical bounce from oversold valuations (Chart 14). Commodities remain in a secular bear market. On health care, we maintain our structural bullish outlook given aging demographics, increased spending on health care and attractive valuations. Short Retail / Global Broad. We initiated trade in January after the Fed initiated liftoff. Consumer Discretionary stocks collapsed after, and this trade has provided a gain of 2.01%. We maintain this view as the recent hike and 2017 hikes will continue to dampen Retail performance (Chart 15). Additionally, Retail has only declined slightly while other Consumer Discretionary stocks have falling drastically, suggesting downside potential from convergence. Chart 13Flatter Yield Curve Is Bullish bca.gaa_qpo_2016_12_15_c13 bca.gaa_qpo_2016_12_15_c13 Chart 14An Oversold Bounce bca.gaa_qpo_2016_12_15_c14 bca.gaa_qpo_2016_12_15_c14 Chart 15Policy Tightening = Underperformance bca.gaa_qpo_2016_12_15_c15 bca.gaa_qpo_2016_12_15_c15 Global Economy Overview: The macro picture looks fairly healthy, with growth picking up in developed economies and China, though not in most emerging markets. The weak patch from late 2015 through the first half of 2016, with global industrial and profits recessions, appears to be over. The biggest threat to growth now is excessive dollar strength, which would slow U.S. exports and harm emerging markets. U.S.: U.S. growth was surprising on the upside (Chart 16) even before the election. Q2 real GDP growth came in at 3.2% and the Fed's Nowcasting models indicate 2.6-2.7% in Q4. After rogue weak ISMs in August, the manufacturing indicator has recovered to 53.2 and the non-manufacturing ISM to 57.2. However, growth continues to be driven mainly by consumption, with capex as yet showing few signs of recovery. A key question is whether a Trump stimulus will be enough to reignite "animal spirits" and push corporates to invest more. Euro Area: Eurozone growth has also been surprisingly robust. PMIs for manufacturing and services in November came in at 53.7 and 53.8 respectively; the manufacturing PMI has been accelerating all year. This is consistent with the ECB's forecasts for GDP growth of 1.7% for both this year and next. However, risk in the banking system could derail this growth. Credit growth, highly correlated with economic activity, has picked up to 1.8% YOY but could slow if banks turn cautious. Japan: Production data has reacted somewhat to Chinese stimulus, with IP growth positive (Chart 17) for the past three months and the Leading Economic Index inching higher since April. But the strength of the yen until recently and disappointing inflation performance (core CPI -0.4% YOY) have depressed exports and consumer sentiment. The effectiveness of the BoJ's 0% yield cap on 10-year government bonds, which has weakened the yen by 14% in two months, should trigger a mild acceleration of growth in coming quarters. Chart 16U.S. Economy Surprising ##br##On The Upside bca.gaa_qpo_2016_12_15_c16 bca.gaa_qpo_2016_12_15_c16 Chart 17Growth Picks Up In##br## Most DMs And China bca.gaa_qpo_2016_12_15_c17 bca.gaa_qpo_2016_12_15_c17 Emerging Markets: China has continued to see positive effects from its reflation of early 2016, with the manufacturing PMI close to a two-year high. The effects of the stimulus will last a few more months, but the authorities have reined back now and the currency is appreciating against its trade basket. The picture is less bright in other emerging markets, as central banks struggle with weak growth and depreciating currencies. Credit growth is slowing almost everywhere (most notably Turkey and Brazil) which threatens a further slowdown in growth in 2017. Interest rates: Inflation expectations have risen sharply in the U.S. following the election, but less so in the eurozone and Japan. They may rise further - pushing U.S. bond yields close to 3% - if the Trump administration implements a fiscal stimulus anywhere close to that hinted at. This could, in turn, push the Fed to raise rates at least twice more in 2017. The ECB has announced a reduction in its asset purchases starting in April 2017, too, but the Bank of Japan will allow inflation to overshoot before tightening. Chart 18Earnings Bottoming But##br## Valuation Stretched bca.gaa_qpo_2016_12_15_c18 bca.gaa_qpo_2016_12_15_c18 Global Equities Cautiously Optimistic: Global markets have embraced the "hoped for" pro-growth and inflationary policies from the new U.S. administration since Trump's win on November 8. In the latest GAA Monthly Update published on November 30,8 we raised our recommendation for global equities relative to bonds to overweight from neutral on a 6-12 month investment horizon. However, the call was driven more by underweighting bonds than by overweighting equities, given the elevated equity valuations and declining profit margins.(Chart 18) The hoped-for U.S. pro-growth policies would, if well implemented, be positive for earnings growth, but the "perceived" earnings boost has not yet shown up in analysts' earnings revisions (panel 3). In fact, only three sectors (Financials, Technology and Energy) currently have positive earnings revisions, because analysts had already been raising forward earnings estimates since early 2016. According to I/B/E/S data as of November 2016, about 80% of sectors are forecast to have positive 12-month forward earnings growth, while only about 20% have positive 12-month trailing earnings growth (panel 3). Within global equities, we continue to favor developed markets over emerging market on the grounds that most EMs are at an early stage of a multi-year deleveraging.9 We also favor the U.S. over the euro area (see more details on the next page). The Japan overweight (currency hedged) is an overwrite of our quant model: we believe that the BoJ will pursue increasingly unconventional monetary policy measures over the coming 12 months. The quant model (in USD and unhedged) has suggested a large underweight in Japan but has gradually reduced the underweight over the past two months. Our global sector positioning is more pro-cyclical than our more defensively-oriented country allocations. In line with our asset class call, we upgrade Financials to neutral and downgrade Utilities to underweight, and continue to overweight Energy, Technology, Industrials, and Healthcare while underweighting Telecom, Consumer Discretionary and Consumer Staples. Country Allocation: Still Favor U.S. Over Euro Area GAA's portfolio approach is to take risk where it is likely to be best rewarded. Having taken risk at the asset class level (overweight equities vs. bonds), at the global equity sector level with a pro-cyclical tilt, and at the bond class level with credit and inflation tilts, we believe it's appropriate to maintain our more defensive equity tilt at the country level by being market weight in euro area equities on an unhedged USD basis while maintaining a large overweight in the U.S. Chart 19Uninspiring profit Outlook bca.gaa_qpo_2016_12_15_c19 bca.gaa_qpo_2016_12_15_c19 It's true that the euro area PMI has been improving. Relative to the U.S., however, the euro area's cyclical improvement, driven by policy support, has lost momentum. It's hard to envision what would reverse this declining growth momentum, suggesting European earnings growth will remain at a disadvantage to the U.S. (Chart 19, panel 1) It's also true that the underperformance of eurozone equities versus the U.S. has reached an historical extreme in both local and common currency terms, and that euro equities are trading at significant discount to the U.S. But Europe has always traded at a discount, and the current discount is only slightly lower than its historical average. Our work has shown that valuation works well only when it is at extremes, which is not the case currently. Conceptually, a weak euro should boost euro area equity performance at least in local currency terms, yet empirical evidence does not strongly support such a claim: the severe underperformance since 2007 has been accompanied by a 43% drop in the euro versus the USD (Chart 19 panel 2). In fact, in USD terms, the euro area tended to outperform the U.S. when the euro was strong (panel 3), suggesting that currency translation plays a more dominant role in relative performance. Our currency house view is that the euro will depreciate further against the USD, given divergences in monetary and fiscal policy between the two regions. As such, we recommend clients to continue to favor U.S. equities versus the euro area, but not be underweight Europe given that it is technically extremely oversold. Sector Allocation: Upgrade Financials To Neutral Our sector quant model shifted global Financials to overweight in December from underweight, largely driven by the momentum factor. We agree with the direction of the quant model as the interest rate environment has changed (Chart 20, panel 1) and valuation remains very attractive (panels 2), but we are willing to upgrade the sector only to market weight due to our concern on banks in the euro area and emerging markets. Within the neutral stance in the sector, we still prefer U.S. and Japanese Financials to eurozone and emerging market ones. Despite the poor performance of the Financials sector relative to the global benchmark, U.S. and Japanese financials have consistently outperformed eurozone financials, driven by better relative earnings without any valuation expansion (panel 3). U.S. banks have largely repaired their balance sheets since the Great Recession, and the "promised" deregulation by the new U.S. administration will probably help U.S. banks. In the euro area, however, banks, especially in Italy, are still plagued with bad loans (panel 4). We will watch banking stress in the region very closely for signs of contagion (panel 5) The upgrade of financials is mainly financed by downgrading the bond proxy Utilities to underweight from neutral, in line with our asset class view underweighting fixed income. Chart 20Global Financials: Regional Divergence bca.gaa_qpo_2016_12_15_c20 bca.gaa_qpo_2016_12_15_c20 Chart 21Global Equities: No Style Bet bca.gaa_qpo_2016_12_15_c21 bca.gaa_qpo_2016_12_15_c21 Smart Beta Update: No Style Bet In a Special Report on Smart Beta published on July 8 2016,10 we showed that it is very hard to time style shifts and that an equal-weighted composite of the five most enduring factors (size, value, quality, minimum volatility and momentum) outperforms the broad market consistently on a risk-adjusted basis. Year-to-date, the composite has performed in line with the broad market, but over the past three months there have been sharp reversals in the performance of the different factors, with Min Vol, Quality and Momentum sharply underperforming Value and Size (Chart 21 panel 1). We showed that historically the Value/Growth tilt has been coincident with the Cyclical/Defensive sector tilt (panel 3). Panel 2 also demonstrates that the Min Vol strategy's relative performance can also be well explained by the Defensives/Cyclicals sector tilt. Sector composition matters. Compared to Growth, Value is now overweight Financials by 25.6%, Utilities by 13.2%, Energy by 8.3% and Materials by 2.5%, while underweight Tech by 23%, Healthcare by 12.7%, and Consumer Discretionary by 10%. REITs is in pure Growth, while Utilities and Telecom are in pure Value, and Energy has very little representation in Growth. In our global sector allocation, we favor Tech, REITs, Energy, and Healthcare, while underweight Utilities, Consumer Discretionary and Telecoms, and neutral on Financials and Materials. As such, maintaining a neutral stance on Value vs. Growth is consistent with our sector positioning. Government Bonds Maintain slight underweight duration. After 35 years, the secular bull market in government bonds is over. Even with Treasury yields skyrocketing since the Trump victory, the path of least resistance for yields is upward (Chart 22). Yields should grind higher slowly as inflation rises and growth indicators continue to improve. Bullish sentiment has dropped considerably, but there is further downside potential. Additionally, fiscal stimulus from Japan and further rate hikes from the Fed will provide considerable tailwinds. Overweight TIPS vs. Treasuries. Despite still being below the Fed's target, with headline and core CPI readings of 1.6% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 23). This continued rise is a result of cost-push inflation driven by faster wage growth. Trump's increased spending and protectionist trade policies are both inflationary. As real GDP growth should remain around 2% annualized and the labor market continues to tighten, this effect will only intensify. Valuations have become less attractive but very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Overweight JGBs. The BoJ has ramped up its commitment to exceeding 2% inflation by expanding its monetary base and locking in 10-year sovereign yields at zero percent. Additionally, the end of the structural decline in interest rates suggests global bonds will perform poorly going forward. During global bond bear markets, low-beta Japanese government debt has typically outperformed (Chart 24). This will likely hold true again as global growth improves and Japanese authorities increase fiscal stimulus while maintaining their cap on bond yields. Chart 22Maintain Slight Underweight Duration bca.gaa_qpo_2016_12_15_c22 bca.gaa_qpo_2016_12_15_c22 Chart 23Inflation Uptrend Intact bca.gaa_qpo_2016_12_15_c23 bca.gaa_qpo_2016_12_15_c23 Chart 24Overweight JGBs bca.gaa_qpo_2016_12_15_c24 bca.gaa_qpo_2016_12_15_c24 Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 25). Over the last quarter, the rate of deterioration actually slowed, with all six ratios improving slightly. Nevertheless, the trend toward weaker corporate health has been firmly established over the past eleven quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. In the absence of a recession, spread product will usually outperform. U.S. growth should accelerate in 2017, with consumer confidence being resilient, fiscal spending expected to increase, and the drag from inventories unwinding. Monetary conditions are still accommodative and the potential sell-off from the rate hike should be milder than it was in December 2015 (Chart 26). Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. However, there are two key risks to our view. The end of the structural decline in interest rates presents a substantial headwind to investment grade performance. Since 1973, median and average returns were slightly negative during months where long-term yields rose. During the blow-off in yields in the late 1970s, corporate debt performed very poorly. However, yields had reached very high levels. Secondly, valuations are unattractive, with OAS spreads at their lowest in about one and a half years (Chart 27). Chart 25Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 26Still Accommodative bca.gaa_qpo_2016_12_15_c26 bca.gaa_qpo_2016_12_15_c26 Chart 27Expensive Valuations bca.gaa_qpo_2016_12_15_c27 bca.gaa_qpo_2016_12_15_c27 Commodities Secular Perspective: Bearish We reiterate our negative long-term outlook on the commodity complex on the back of a structural downward shift in global demand led primarily by China's transition to a services-driven economy. With this slack in demand, global excess capacity has sent deflationary impulses across the globe, limiting upside in commodity prices.11 Chart 28OPEC To The Rescue bca.gaa_qpo_2016_12_15_c28 bca.gaa_qpo_2016_12_15_c28 Cyclical Perspective: Neutral A divergent outlook for energy and base metals gives us a neutral view for aggregate commodities over the cyclical horizon (Chart 28). Last month's OPEC deal supports our long-standing argument of increasing cuts in oil supply, which will support energy prices. However, metal markets suffer from excess supply. A stronger U.S. dollar will continue to be a major headwind over the coming months. Energy: OPEC's agreement to cut production by 1.2 mb/d has spurred a rally in the crude oil price, as prospects for tighter market conditions next year become the base case. However, with the likelihood that the dollar will strengthen further in coming months, oil will need more favorable fundamentals to rise substantially in price from here. Base Metals: The U.S. dollar has much greater explanatory power12 than Chinese demand in price formation for base metals. The recent rally in base metals is overdone with metals prices decoupling from the dollar; we expect a correction in the near-term driven by further dollar strength. Metal markets remain oversupplied as seen by rising iron ore and copper inventories. We remain bearish on industrial and base metals. Precious Metals: Gold, after decoupling from forward inflation expectations in H1 2016 - rising while inflation expectations were weak - has converged back in line with the long-term inflation gauge. Our expectation of higher inflation, coupled with rising geopolitical uncertainties, remain the two key positives for the gold price. However, our forecast of U.S. dollar appreciation will limit upside potential for the precious metal. Currencies Key Themes: USD: Much of the post-Trump rally in the dollar can be explained by the sharp rally in U.S. bond yields (Chart 29). We expect more upside in U.S. real rates relative to non-U.S. rates, driven by the U.S.'s narrower output gap and the stronger position of its household sector. As labor market slack continues to lessen and wage pressures rise, the Fed will be careful not to fall behind the curve; this will add upward pressure to the dollar. Chart 29Dollar Continues It's Dominance bca.gaa_qpo_2016_12_15_c29 bca.gaa_qpo_2016_12_15_c29 Euro: Since the euro area continues to have a wider output gap than the U.S., the euro will face additional downward pressure on the back of diverging monetary policy. As the slack diminishes, the ECB will respond appropriately - we believe the euro has less downside versus the dollar than does the yen. Yen: Although the Japanese economy is nearing fully employment, the Abe administration continues to talk about additional stimulus. As inflation expectations struggle to find a firm footing despite the stimulus, the BOJ is explicitly aiming to stay behind the curve. Additionally, with the BOJ pegging the 10-year government bond yield at 0% for the foreseeable future, we expect further downward pressure on the currency. EM: We expect more tumult for this group as rising real rates have been negative for EM assets in this cycle. EM spreads have widened in response to rising DM yields which has led to more restrictive local financial conditions. The recovery in commodity prices has been unable to provide any relief to EM currencies - a clear sign of continued weak fundamentals (rising debt, excess capacity and low productivity). Commodity currencies will face more downside driven by their tight correlation with EM equities (0.82) and with EM spreads. Alternatives Overweight private equity / underweight hedge funds. Global growth is fairly stable and has the potential to surprise on the upside. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a considerable boost to returns. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 30). Overweight direct real estate / underweight commodity futures. Commercial real estate (CRE) assets are in a "goldilocks" scenario: Growth is sufficient to generate sustainable tenant demand without triggering a new supply cycle. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 31). Overweight farmland & timberland / underweight structured products. The trajectory of Fed policy, the run-up in equity prices and the weak earnings backdrop have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, structured products tend to outperform during recessions, which is not our base case (Chart 32). Chart 30PE: Tied To Real Growth bca.gaa_qpo_2016_12_15_c30 bca.gaa_qpo_2016_12_15_c30 Chart 31Commodities: A Secular Bear Market bca.gaa_qpo_2016_12_15_c31 bca.gaa_qpo_2016_12_15_c31 Chart 32Structured Products Outperform In Recessions bca.gaa_qpo_2016_12_15_c32 bca.gaa_qpo_2016_12_15_c32 Risks To Our View Our main scenario is for stronger growth, higher inflation and an appreciating dollar in 2017, leading to equities outperforming bonds. Where could this go wrong? Growth stagnates. U.S. growth could fail to pick up as expected: the stronger dollar will hurt profits, which might lead to companies cutting back on hiring; higher interest rates could affect the housing market and consumer discretionary spending; companies may fail to increase capex, given their low capacity utilization ratio (Chart 33). In Europe, systemic banking problems could push down credit growth which is closely correlated to economic growth. Emerging markets might see credit events caused by the stronger dollar and weaker commodities prices. Political risks. An unconventional new U.S. President raises uncertainty. How much will Trump emphasize his more market-unfriendly policies, such as tougher immigration control, tariffs on Chinese and Mexican imports, and interference in companies' decisions on where to build plants? His more confrontational foreign policy stance risks geopolitical blow-ups. Elections in France, the Netherland and Germany in 2017 could produce populist government. The Policy Uncertainty Index currently is high and this historically has been bad for equities (Chart 34). Chart 33Maybe Companies Won't Increase Capex bca.gaa_qpo_2016_12_15_c33 bca.gaa_qpo_2016_12_15_c33 Chart 34Policy Uncertainty Is High bca.gaa_qpo_2016_12_15_c34 bca.gaa_qpo_2016_12_15_c34 Synchronized global growth. If the growth acceleration were not limited to the U.S. but were to spread, this might mean that the dollar would depreciate, particularly as it is already above fair value (Chart 35). In this environment, given their inverse correlation with the dollar (Chart 36), commodity prices and EM assets might rise, invalidating our underweight positions. Chart 35Dollar Already Above##br## Fair Value Dollar Already Above Fair Value Dollar Already Above Fair Value Chart 36How Would EM And Commodities Move##br## If USD Weakens? bca.gaa_qpo_2016_12_15_c36 bca.gaa_qpo_2016_12_15_c36 1 We discuss them in the "What Our Clients Are Asking," section of this Quarterly Portfolio Outlook. 2 Non-accelerating inflation rate of unemployment - the level of unemployment below which inflation tends to rise. 3 Please see "How Will The Strong USD Impact Global Earnings," in the What Our Clients Are Asking section of this Quarterly Portfolio Outlook. 4 Please see Global Asset Allocation, "Monthly Portfolio Update: The Meaning of Trump," dated November 30, 2016, available at gaa.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency", dated November 30, 2016, available at gps.bcaresearch.com. 6 According to National Institute of Economic Research.com. 7 Please see Global Asset Allocation Strategy Special Report, "Asset Allocation In A Low-Return World, Part IV: Industry Groups," dated October 25, 2015, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation,"Monthly Portfolio Update," dated November 30, 2016 available at gaa.bcaresearch.com 9 Please see Global Asset Allocation Special Report,"Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com 10 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. 11,12 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com Recommended Asset Allocation

Feature At no time in recent history have China's foreign reserves been under such tight scrutiny by global investors as they are now. The country's multi-trillion-dollar official reserve assets, long viewed by both Chinese officials and the global investment community as an unproductive use of resources, have suddenly became a lifeline for China's exchange rate stability. The latest numbers released last week show China's official reserves currently stand at US$3.05 trillion, a massive drawdown from the US$3.99 trillion all-time peak reached in 2014. Over the years, we have been running a series of Special Reports tracking the composition of China's foreign asset holdings.1 This year's update has become all the more relevant. The monthly headline figures on China's official reserves have been eagerly anticipated for clues of domestic capital outflows and the RMB outlook. Meanwhile, as the largest foreign holder of American government paper, changes in China's official reserves are also being scrutinized to assess any impact on U.S. interest rates. Moreover, Chinese outward direct investment (ODI), which had already accelerated strongly in the past few years, has skyrocketed this year - partially driven by expectations of further RMB depreciation. The Chinese authorities have recently tightened scrutiny on large overseas investments by domestic firms, which will likely lead to a notable slowdown in Chinese ODI in the near term.2 This week we take a closer look at the U.S. Treasury International Capital (TIC) system data and various other sources to check the evolution of China's official reserves and foreign assets. There are some important caveats. First, Chinese holdings of U.S. assets reported by the TIC are not entirely held by the People's Bank of China in its official reserves. Some assets, particularly corporate bonds and equities, may be held by Chinese institutional investors. Meanwhile, it is well known that in recent years China has been using offshore custodians in some European countries, the usual suspects being Belgium, Luxembourg and the U.K., which disguises the true situation of the country's official reserve holdings. Finally, China's large conglomerates owned by the central government also hold vast amounts of foreign assets, or "shadow reserves" that could be utilized to support the RMB if needed. Recently these state-owned giants were reportedly required by the government to repatriate some of their foreign cash sitting idle overseas to counter capital outflows. All of this suggests the resources available to the government are larger than the official reserve figures. With these caveats, this week's update reveals some important developments in the past year: Chinese foreign reserves have dropped by around US$400 billion since the end of 2015 to US$3.05 trillion, a level last seen in 2005 when the RMB was de-pegged from the dollar followed by a multi-year ascendance (Chart 1). China still holds the largest amount of foreign reserves in the world, but its global share has dropped to about 40%, down from a peak of over 50% in 2014. TIC data show Chinese holdings of U.S. assets declined by a mere US$100 billion in the past year, leading to a sharp increase in U.S. assets as a share of the country's total foreign reserves (Table 1). This could be attributable to mark-to-market "paper losses" of Chinese holdings in non-dollar denominated foreign assets, due to the broad strength of the greenback. It is also possible that China may have intentionally increased its allocations to U.S. assets due to heightened risks in other countries, particularly in Europe. Chinese holdings of Japanese government bonds also increased significantly this past year. Table 1Chinese Foreign Exchange Reserves Demystifying China's Foreign Assets Demystifying China's Foreign Assets Chinese holdings of U.S. Treasurys have dropped by about US$100 billion in recent months, but holdings of some other countries suspected as China's overseas custodians have continued to rise (Chart 2). This could mean that Chinese holdings of U.S. assets could be larger than reflected in the TIC data. Chinese outward direct investments have continued to power ahead. Previously Chinese investments were heavily concentrated in commodities sectors and resource-rich countries. This year the U.S. has turned out to be the clear winner in attracting Chinese capital. Moreover, recent investment deals have been concentrated in consumer related sectors such as tourism, entertainment and technology industries. Chart 1Chinese Foreign Reserves##br## Have Continued To Decline bca.cis_sr_2016_12_15_c1 bca.cis_sr_2016_12_15_c1 Chart 2U.S. Treasurys: How Much ##br##Does China Really Hold? bca.cis_sr_2016_12_15_c2 bca.cis_sr_2016_12_15_c2 Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Demystifying China's Foreign Assets", dated September 30, 2015, available at cis.bcaresearch.com Please see China Investment Strategy Weekly Report, “How Will China Manage The Impossible Trinity”, dated December 8, 2015, available at cis.bcaresearch.com China's official data shows that the country's total holdings of international assets have stayed flat at around US$6.2 trillion since 2014, including foreign exchange reserves, direct investment, overseas lending and holdings of bonds and equities. Official reserves have declined in recent years, but other holdings have jumped sharply. Reserves assets still account for over half of total foreign assets, but their share has continued to drop. In contrast, outward direct investment and overseas loans have gained significantly both in value terms and as a share of the country's total foreign assets. Chart 3 bca.cis_sr_2016_12_15_c3 bca.cis_sr_2016_12_15_c3 Chart 4 bca.cis_sr_2016_12_15_c4 bca.cis_sr_2016_12_15_c4 Despite the sharp decline, international investment positions by Chinese nationals, public and private combined, are still much more heavily concentrated in official reserve assets compared with other major economies. In other major creditor countries, outward direct investments and portfolio investments account for much larger shares than reserve assets. Official reserves in the U.S. are negligible. Chinese official reserves give the PBoC resources to maintain exchange rate stability, but they also lower the expected returns of the country's foreign assets. Encouraging domestic entities to acquire overseas assets directly has been a long-run policy. More recently, however, the authorities have been alarmed by the pace of Chinese nationals' overseas investment and have been taking restrictive measures. Chart 5 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Our calculations shows that Chinese total holdings of U.S. assets reached US$1.74 trillion at the end of September 2016, including Treasurys, government agency bonds, corporate bonds, stocks and non-Treasury short-term custody liabilities of U.S. banks to Chinese official institutions, based on the TIC data (Table 1, on page 2). Treasurys still account for the majority of the country's total holdings of U.S. assets, while bonds and stocks are relatively insignificant. China's holdings of U.S. assets as a share of total reserves declined between the global financial crisis and 2014, since when the trend has reversed. The share of U.S. asset holdings currently accounts for 55% of Chinese official reserves, compared with a peak of over 70% in the early 2000s and a trough of 46% in 2014. This could also be attributable to the sharp appreciation of the U.S. dollar against other majors. The U.S. dollar carries a 42% weight in the SDR (Special Drawing Rights of the International Monetary Fund), and it accounts for about 60% of total foreign reserves managed by global central banks. These could be two relevant benchmarks to gauge China's desired level of holdings of U.S. dollar-denominated assets in its official reserves. Chart 6 bca.cis_sr_2016_12_15_c6 bca.cis_sr_2016_12_15_c6 Chart 7 bca.cis_sr_2016_12_15_c7 bca.cis_sr_2016_12_15_c7 In terms of duration, the major part of Chinese holdings of U.S. assets is long-term (with maturity more than one year), mainly in the form of government and agency bonds, corporate bonds and stocks. Chinese holdings of short-term U.S. assets were minimal in recent years but picked up notably in the past few months, while longer term assets declined. During the global financial crisis in 2008/09, China massively increased its holdings of short-term U.S. assets, amid a global drive of "flight to liquidity" at the height of the crisis. Chart 8 bca.cis_sr_2016_12_15_c8 bca.cis_sr_2016_12_15_c8 Chart 9 bca.cis_sr_2016_12_15_c9 bca.cis_sr_2016_12_15_c9 In terms of risk classification, the majority of Chinese holdings of U.S. assets are risk-free assets, including Treasurys and government agency bonds. China's holdings of these assets have plateaued in recent years. As a share of China's total reserves, U.S. risk-free assets currently account for about 45%, down from about 65% in 2003. Meanwhile, its accumulation of U.S. risky assets, including stocks and corporate bonds, has increased sharply in the past year. Chart 10 bca.cis_sr_2016_12_15_c10 bca.cis_sr_2016_12_15_c10 Chart 11 bca.cis_sr_2016_12_15_c11 bca.cis_sr_2016_12_15_c11 China currently holds US$1.16 trillion of Treasurys, which account for over 80% of total Chinese holdings of U.S. risk-free assets, or 37% of total Chinese foreign reserves. Notably, Treasurys as a share of Chinese foreign reserves have been relatively stable, ranging between 30% and 40% over the past decade. This may be the comfort zone for the Chinese authorities' asset allocation to the U.S. government paper. China's holdings of U.S. government agency bonds have picked up in the past year, but are still significantly lower than at its peak prior to the U.S. subprime debacle. Its share in Chinese foreign reserves has declined to 8% from a peak of close to 30% in 2008. Chart 12 bca.cis_sr_2016_12_15_c12 bca.cis_sr_2016_12_15_c12 Chart 13 bca.cis_sr_2016_12_15_c13 bca.cis_sr_2016_12_15_c13 Almost the entire Chinese holding of Treasurys is parked in long-term paper (with duration of more than one year). China's possession of short-term Treasurys has been negligible in recent years, but picked up notably of late. It is possible that the Chinese central bank may be increasing cash holdings to deal with capital outflows. Chart 14 bca.cis_sr_2016_12_15_c14 bca.cis_sr_2016_12_15_c14 Chart 15 bca.cis_sr_2016_12_15_c15 bca.cis_sr_2016_12_15_c15 Chinese holdings of risky U.S. assets - corporate bonds and equities - account for over 10% of China's total foreign reserves, up sharply since 2008 after China established its sovereign wealth fund. China's holdings of risky assets are predominately equities, currently standing at about USD 325 billion, little changed in recent years. Its possessions of corporate bonds are very low. Chart 16 bca.cis_sr_2016_12_15_c16 bca.cis_sr_2016_12_15_c16 Chart 17 bca.cis_sr_2016_12_15_c17 bca.cis_sr_2016_12_15_c17 China remains the largest foreign creditor to the U.S. government. Chinese holdings of U.S. Treasurys account for about 11% of total outstanding U.S. government bonds, or around 20% of total foreign holdings of U.S. Treasurys, according to our calculation. About 55% of outstanding U.S. Treasurys are held by foreigners. China is also one of the largest foreign holders of U.S. of agency bonds. While its holdings only accounts for 3% of total outstanding agency bonds, they account for around 25% of the total held by foreigners. About 12% of agency and GSE-backed securities are currently held by foreigners. Chart 18 bca.cis_sr_2016_12_15_c18 bca.cis_sr_2016_12_15_c18 Chart 19 bca.cis_sr_2016_12_15_c19 bca.cis_sr_2016_12_15_c19 Chinese outward direct investments have continued to march higher in the past year, reaching yet another record high in 2015, and will likely set a new record in 2016. Total overseas direct investments amount to USD 1.4 trillion, equivalent to about half of China's official reserves. China's overseas investments have been heavily concentrated in resources-rich regions and industries. Cumulatively, the energy sector alone accounts for almost half of China's total overseas investments, followed by transportation infrastructure and base metals, which clearly underscores China's demand for commodities. China's outbound investment was originally led by state-owned enterprises. More recently, private Chinese enterprises have become more active in overseas investments and acquisitions. Chart 20 bca.cis_sr_2016_12_15_c20 bca.cis_sr_2016_12_15_c20 Chart 21 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Chart 22 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Corporate China's interest in global resource space has waned in the past year. Total investment in energy space has plateaued in recent years. There has been a dramatic increase in investment in some consumer-related sectors, particularly in tourism, entertainment and technology. These investment deals are mainly driven by private enterprises, and also reflect the changing dynamics of the Chinese economy. The U.S. received by far the largest share of Chinese investment in 2016. Total U.S.-bound Chinese investment in the first half of the year already dramatically outpaced the total amount of 2015. Chinese investments in resource rich countries, such as Australia, Canada and Brazil have been much less robust. Chinese net purchase of Japanese government bonds (JGBs) increased sharply this year. In the eight months of 2016 China's net purchases of JGBs reached $86.6 billion, more than tripling the amount during the same period last year. Chinese cumulative net purchases of JGBs since 2014 reached JPY 14.5 trillion, or USD 140 billion. This amounts to 2% of total outstanding JGBs and 4% of Chinese official reserves. Chart 23 bca.cis_sr_2016_12_15_c23 bca.cis_sr_2016_12_15_c23 Chart 24 bca.cis_sr_2016_12_15_c24 bca.cis_sr_2016_12_15_c24 Chart 25 bca.cis_sr_2016_12_15_c25 bca.cis_sr_2016_12_15_c25 Cyclical Investment Stance Equity Sector Recommendations

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

Highlights Investors are understating the risks that the Trump administration will enact protectionist trade policies. Contrary to popular belief, the economic costs to the U.S. of a protracted "trade war" would be low. The geopolitical impact, however, would be much more sizeable, as would the impact on S&P 500 profits. The near-term risks to global equities are on the downside, although firmer growth in developed economies should provide support to stocks over a 12-month horizon. Global bond yields will be higher this time next year, as will the dollar. The yen is especially vulnerable. We are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. Feature They come over here, they sell their cars, their VCRs. They knock the hell out of our companies. - Donald Trump in an interview with Oprah Winfrey discussing trade with Japan, 1988 Making Tariffs Great Again Donald Trump has flip-flopped on many issues. On trade, however, he has been perfectly consistent. As the quote above demonstrates, Trump has been advocating mercantilist policies ever since he entered the public spotlight in the 1980s. Even in the unlikely event that he wanted to pivot on this issue, he would be hard-pressed to do so. The Republican establishment and most Democrats will hate him no matter what he does. If Trump backpedals from his hardline stance on trade and immigration, he will lose a large chunk of his white, working-class base (Chart 1). One might argue that Trump would have no choice but to adopt a more conciliatory tone if the imposition of protectionist trade policies were to push the U.S. into a recession. However, contrary to widespread opinion, it is far from obvious that this would happen. While rising protectionism would have a major negative effect on many other economies, the impact on the U.S. would be modest, even if other countries were to match higher U.S. tariffs with retaliatory measures. Keep in mind that the U.S. is a relatively closed economy, with exports totaling only 12% of GDP. Exports to China and Mexico amount to 0.9% and 1.4% of GDP, respectively. And much of these exports are intermediate goods that are processed and reshipped back to the U.S. or some other third market. It would not make sense for China or Mexico to put up import barriers on these intermediate goods because this would just reduce domestic employment, without giving domestic firms much of a leg up. One should also remember that an appreciation of the dollar reduces U.S. export competitiveness in much the same way as higher tariffs placed by foreign governments on U.S.-made goods. The real trade-weighted dollar has appreciated by 20% since mid-2014 (Chart 2). While this obviously has been unpleasant for U.S. exporters, it has not pushed the economy into recession. Neither will retaliatory foreign tariffs. Chart 1Trump's Supporters Are Not ##br##Free Trade Enthusiasts Trump And Trade Trump And Trade Chart 2The Dollar Has Been ##br##Appreciating Since Mid-2014 bca.gis_wr_2016_12_09_c2 bca.gis_wr_2016_12_09_c2 Why The Consensus On Trade Is Misleading The view expressed above is far outside the consensus and clashes strongly with the large number of studies arguing that the implementation of Trump's trade agenda would have grave consequences for the U.S. economy. Let me first enumerate the ways these studies fall short on strictly economic grounds, and then discuss why they may still ring true if one takes a broader perspective. As far as the pure economics are concerned, these studies all suffer from some combination of the following deficiencies: They assume that foreign producers can fully or almost fully pass on the cost of U.S. tariffs to their customers. In reality, the evidence suggests that foreign producers will absorb about half of the increase in tariffs through lower profit margins. In other words, the imposition of a 20% tariff would only raise U.S. import prices by around 10%. Granted, retaliatory tariffs would squeeze the profit margins of U.S. exporters. However, this effect would be mitigated by the fact that the U.S. runs large bilateral trade deficits with China and Mexico (Chart 3), as well as the fact that foreign producers have less pricing power in the relatively large U.S. market than American producers have abroad. On net, this implies that higher trade barriers could actually make the U.S. better off by shifting the terms of trade in its favor. Chart 3The U.S. Runs Large Bilateral Trade Deficits With China And Mexico Trump And Trade Trump And Trade These studies treat tariffs like regular old taxes. To the extent that tariffs are taxes whose burden is partly borne by domestic consumers, their imposition has a dampening effect on activity. However, to model the impact of higher tariffs simply as a tightening of fiscal policy implicitly assumes that any tariff revenue will be used to pay down debt, rather than being used to finance tax cuts and spending increases. Given that Trump is touting a program of fiscal stimulus, that is not a sensible assumption. Moreover, unlike, say, a sales tax hike, higher tariffs divert demand towards domestically-produced goods. This tends to boost employment. These studies overstate the adverse effect of tariffs on domestic investment. More than half of global trade consists of capital equipment and intermediate goods (Chart 4). To the extent that higher tariffs raise the cost of production, this can lower investment. Moreover, trade barriers tend to increase economic inefficiencies. This can lead to slower productivity growth, causing firms to reduce capital spending. In practice, however, neither effect is particularly significant. As we discussed two weeks ago, the negative impact of trade barriers on productivity growth is generally overstated, especially for large economies like the United States.1 Chart 5 shows that productivity growth was actually faster in the three decades following the Second World War than in the hyper-globalization era that began in the early 1980s. Chart 4Intermediate And Capital Goods ##br##Make Up Over Half Of Global Trade Trump And Trade Trump And Trade Chart 5Rising Trade Has Not ##br##Boosted Productivity Growth Rising Trade Has Not Boosted Productivity Growth Rising Trade Has Not Boosted Productivity Growth While the price of capital goods does influence investment spending, for the most part, firms tend to base their investment decisions on the expected demand for their products. Since the U.S. runs a trade deficit, an equal percentage-point decline in both exports and imports would increase final demand through the familiar Y=C+I+G+X-M identity. This should lead to higher investment. Moreover, even if higher trade barriers leave final demand unaffected, there are reasons to think that investment would still rise. Think about a closed economy where most households decide all of a sudden that they prefer strawberry ice cream over vanilla ice cream. Let us assume, just for the sake of argument, that shifting production from vanilla to strawberry ice cream is very difficult and requires a lot of new investment. What do you expect would happen to overall investment in this economy? The answer is that it would likely rise, as companies scramble to build out new strawberry ice cream-making capacity. Now extend the analogy to trade. If the U.S. slaps tariffs on manufacturing imports, this will lead to a wave of new domestic investment in industries that benefit from tariff protection. This is bad news for companies that must incur the cost of relocating production back onshore, but it is good news for American workers who can now find gainful employment. The Bigger Picture Our guess is that in purely economic terms, the U.S. would not suffer much if the Trump administration were to forge ahead with its protectionist trade agenda, and could actually benefit if America's trading partners felt restrained in how they could retaliate. Yet, focusing only on the economics misses the bigger picture. Trade agreements are also about politics - they help form the geopolitical glue that holds the global community together. As we noted two weeks ago, the real reason the 1930 Smoot-Hawley Tariff Act was so disastrous was not because it contributed to the Great Depression, but because it led to a breakdown of international relations among democratic governments at a time when fascism was on the rise.2 Donald Trump's threat to pull out of trade deals and unilaterally impose tariffs on countries that he feels are engaging in unfair trade practices is likely to accelerate the shift to a multipolar geopolitical order where competing countries strive to carve out their own spheres of influence. As Chart 6 shows, such geopolitical orders have often contributed to the breakdown of globalization, and at times, have even led to military conflict. Chart 6AIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand bca.gis_wr_2016_12_09_c6a bca.gis_wr_2016_12_09_c6a Chart 6BIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand bca.gis_wr_2016_12_09_c6b bca.gis_wr_2016_12_09_c6b The fact that rising protectionism could benefit the U.S. at the expense of other countries is bound to stoke anger abroad. China, the focus of much of Trump's rhetoric, is especially vulnerable. Trump has threatened to declare the country a "currency manipulator," even though it meets only one of the three criteria for such a designation as set out by the Treasury Department.3 Other countries should not breathe a sigh of relief, however. There is a certain logic about protectionism that makes it difficult to hike tariffs on just one or two countries. For example, if the U.S. raises tariffs on China, some of the existing demand for Chinese goods will be diverted to countries such as Korea or Vietnam, rather than back to the U.S. This creates an incentive to raise tariffs on those countries as well. It is easy to see how the whole global trading system can break down under such circumstances. Investment Conclusions Donald Trump's threat of across-the-border tariffs of 35% on Mexican goods and 45% on Chinese goods will likely turn out to be a negotiating ploy. That said, some increase in trade barriers seems inevitable. These need not even be explicit barriers. Trump's success in browbeating Carrier into keeping its plant open in Indiana is an example of things to come. Corporate America does a lot of business with the government, and the subtle threat of cancelled government contracts will make any CEO take notice. Good news for Main Street perhaps, but definitely bad news for Wall Street. For now, investors are focusing on the positive elements of Trump's agenda. That may change soon. Yes, increased infrastructure spending and corporate tax cuts are both bullish for stocks. However, effective U.S. corporate tax rates are already quite low thanks to numerous loopholes. Thus, any cuts to statutory rates may not boost S&P 500 profits by as much as investors are hoping (Chart 7). And while more infrastructure investment is welcome, there simply are not enough "shovel ready" projects around. Chart 7U.S. Effective Corporate Tax Rate Is Already Quite Low U.S. Effective Corporate Tax Rate Is Already Quite Low U.S. Effective Corporate Tax Rate Is Already Quite Low Moreover, Trump's plan to finance infrastructure spending through private-public partnerships greatly narrows the universe of possible projects. The U.S. Society Of Civil Engineers estimates that most of the "infrastructure gap" consists of deferred maintenance (i.e., potholes to fix, bridges to repair).4 It is difficult to get investors interested in such work, which is why it is typically financed directly through government budgets. Meanwhile, financial conditions have tightened via a stronger dollar and higher bond yields (Chart 8). Historically, such a tightening has been bearish for stocks (Table 1). We are tactically cautious on a three-month horizon, and are positioned for this by being short the NASDAQ 100 futures. Our guess is that global equities will correct by about 5%-to-10% from current levels, setting the stage for positive returns down the road. U.S. high-yield spreads, which are near post-crisis lows, are also likely to widen (Chart 9). Chart 8U.S. Financial Conditions Have Eased U.S. Financial Conditions Have Eased U.S. Financial Conditions Have Eased Chart 9U.S. High-Yield Spreads Likely To Widen U.S. High-Yield Spreads Likely To Widen U.S. High-Yield Spreads Likely To Widen Table 1Stocks Tend To Suffer When Bond Yields Spike Trump And Trade Trump And Trade A correction in risk assets could temporarily knock down Treasury yields. Nevertheless, the long-term path for global bond yields is to the upside. The three key features of Trump's platform - fiscal stimulus, tighter immigration controls, and trade protectionism - are all inflationary. Only JGB yields are likely to stay put for the foreseeable future due to the BOJ's well-timed decision to peg the 10-year yield at zero. As bond yields elsewhere rise, the yen will come under further downward pressure. We see USD/JPY reaching 125 in 12 months' time. Chart 10Global Growth Is Accelerating Global Growth Is Accelerating Global Growth Is Accelerating A weaker yen should boost Japanese stocks, at least in local-currency terms. European equities will also benefit from a somewhat cheaper euro and firming global growth (Chart 10). Steeper yield curves are helping to boost European bank shares, despite ongoing concerns about the health of the Italian financial sector. As we have discussed in the past, systemic risks around the Italian banks are overstated.5 With that in mind, we are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. The recent rally in commodity markets and the uptick in global activity indicators are welcome developments for emerging markets. Still, it will be hard for EM equities to muster a sustainable rally as long as the dollar remains in an uptrend and protectionist sentiment is on the rise. For now, a modest underweight in EM stocks is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1,2 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 3 The U.S. Treasury is allowed to define a country as a currency manipulator if: i) it runs a large trade surplus with the U.S.; ii) it has an excessively large current account surplus with the rest of the world; and iii) it is engaging in direct foreign exchange intervention in order to weaken its currency. While the first criterion arguably holds, the other two do not, given that China's overall current account surplus currently stands at 2.4% of GDP and recent currency intervention has been designed to prevent the yuan from depreciating more than it would have otherwise. 4 Please see "Failure to Act: Closing the Infrastructure Investment Gap for America's Economic Future," American Society of Civil Engineers (2016). 5 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights ECB QE has pushed the euro area's Target2 banking imbalance to an all-time high. Thereby, QE has raised the cost of euro break-up. The ECB must dial down QE because the Target2 banking imbalance is directly related to the size of asset purchases. Core euro area sovereign bonds offer poor relative value in the government bond universe. Long Italian BTPs / short French OATs is now appropriate as a tactical position. Italian bank investors might have to suffer more pain before Brussels ultimately allows a public rescue. Feature "We've eliminated fragmentation in the euro area." Mario Draghi, speaking on October 20, 2016 Mario Draghi is wrong. QE was meant to reduce economic and financial fragmentation within the euro area. But in one important regard, it has done the exact opposite. In an un-fragmented monetary union, banking system liquidity would be spread evenly across the euro area. Unfortunately, the trillions of euros of QE liquidity created by the ECB has concentrated in four northern European countries: Germany, the Netherlands, Luxembourg and Finland (but interestingly, not France). This extreme fragmentation is captured in the euro area's Target2 banking imbalance (Box I-1), which is now at an all-time high (Chart of the Week). Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability. Target2 balances therefore show the cumulative net payment flows within the euro area. Chart of the WeekQE Has Pushed The Euro Area's Target2 Imbalance To An All-Time High ECB QE Raises The Cost Of Euro Break-Up ECB QE Raises The Cost Of Euro Break-Up To be absolutely clear, this geographical polarization of bank liquidity is not deposit flight in the strictest sense (Chart I-2). Investors are simply using the ECB's €80bn of monthly bond purchases to offload their Italian, Spanish and Portuguese bonds to the central bank, and hold the received cash in banks in perceived haven countries. Nevertheless, ECB QE has unwittingly facilitated a geographical polarization of bank liquidity more extreme than in the darkest days of 2012 (Chart I-3). Chart I-2No Funding Stresses At The Moment bca.eis_wr_2016_12_08_s1_c2 bca.eis_wr_2016_12_08_s1_c2 Chart I-3Target2 Imbalances Are The Result Of QE Target2 Imbalances Are The Result Of QE Target2 Imbalances Are The Result Of QE QE Has Exposed Euro Area Banking Fragmentation To understand how this polarization has arisen, it is necessary to grasp how Eurosystem accounting works. The following section is necessarily technical, but stick with it because it is important. The ECB delegates its QE sovereign bond purchases to the respective national central bank (NCB): the Bundesbank buys German bunds, the Bank of France buys OATs, the Bank of Italy buys BTPs, and so on. When the Bank of Italy buys a BTP from, say, an Italian investor, the investor gives up the bond, but simultaneously receives a corresponding asset - cash. If the investor then deposits this cash at an Italian bank, say Unicredit, then Unicredit would have a new liability - the investor deposit. But in line with Eurosystem accounting, Unicredit would simultaneously receive a corresponding credit at its NCB, the Bank of Italy.1 Completing the accounting circle, the Bank of Italy would now have a new liability - the Unicredit claim, but it would also have a corresponding asset - the BTP that it has just bought. Therefore, all three accounts would be in perfect balance (see Figure I-1). Figure I-1Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Unicredit ECB QE Raises The Cost Of Euro Break-Up ECB QE Raises The Cost Of Euro Break-Up Now consider what happens if the Italian investor deposits the cash not at Unicredit, but at a German bank, say Commerzbank. In this case, it would be the Bundesbank that had a new liability - the Commerzbank claim. However, the Bundesbank would not have a corresponding asset. Conversely, the Bank of Italy would have a new asset - the BTP, but without a corresponding liability. In order to balance these Eurosystem accounts, the Bundesbank would accrue a Target2 asset vis-à-vis the ECB, while the Bank of Italy would accrue an equal and opposite Target2 liability (see Figure I-2). Figure I-2Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Commerzbank ECB QE Raises The Cost Of Euro Break-Up ECB QE Raises The Cost Of Euro Break-Up Essentially, the Target2 imbalance captures the mismatch between a Bundesbank liability denominated in 'German' euros and a corresponding Bank of Italy asset denominated in 'Italian' euros. Aggregated over the whole euro area, these imbalances now amount to more than €1 trillion. Does any of this Eurosystem accounting gymnastics really matter? No, as long as the monetary union holds together and the 'German' euro equals the 'Italian' euro. But if Germany and Italy started using different currencies, then suddenly the Target2 imbalances would matter enormously. This is because the Bundesbank liability to Commerzbank would be redenominated into Deutschemarks, while the Bank of Italy asset would be redenominated into lira. Hence, the ECB might end up with much larger liabilities than assets. In which case, any shortfall would have to be borne by the ECB's shareholders - essentially, euro area member states pro-rata to GDP. The ECB Must Dial Down QE Unlike in the depths of the euro debt crisis, the current Target2 imbalances do not reflect deposit flight. Rather, they are the direct result of ECB QE. Nonetheless, the indisputable fact is that QE has increased the cost of euro break-up. And another six or more months of QE will just add to this cost. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in this year's polling victories for Brexit and President-elect Trump, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do detailed cost benefit analysis. Although the ECB is unlikely to broadcast the unintended side-effects of its policy, it must be acutely aware that the costs of QE are rising while its benefits are diminishing. Given that the Target2 imbalances are directly related to the size of asset purchases, the ECB needs to indicate its intention to dial down QE purchases. And if it does need to loosen policy again in the future, it might be better off emulating the Bank of Japan - in targeting a yield rather than an asset purchase amount. The 6-9 month investment implication is that core euro area sovereign bonds offer poor relative value in the government bond universe. And within the core euro area, perhaps French OATs offer the least relative value. OATs are priced as haven sovereign bonds, yet interestingly Target2 imbalances suggest that banking liquidity flows do not regard France as a haven in the same way as Germany (Chart I-4 and Chart I-5). Chart I-4French OATs Are Priced ##br##As Haven Bonds... bca.eis_wr_2016_12_08_s1_c4 bca.eis_wr_2016_12_08_s1_c4 Chart I-5...But Banking Liquidity Flows Do Not ##br##Regard France As A Haven bca.eis_wr_2016_12_08_s1_c5 bca.eis_wr_2016_12_08_s1_c5 Another implication is that the euro should be stable or stronger against a basket of other developed economy currencies. Indeed, expect euro/pound to lurch up in the first half of next year when the U.K. government triggers Article 50 of the Lisbon Treaty to formally begin Brexit negotiations. Only then will the EU27 reveal its own negotiating strategy, and it is highly unlikely to be a sweet deal for the U.K. Italian Referendum Result: A Postscript The financial markets have shrugged off the Italian public's resounding "no" to constitutional reform, and rightly so. The current constitution, created in the aftermath of the Second World was designed to prevent a repeat of a populist like Benito Mussolini gaining power. Irrespective of whether the next General Election is in 2017 or 2018, the no vote actually reduces political tail-risk. A tactical position that is long Italian BTPs and short French OATs is now appropriate. As we discussed last week in Italy: Asking The Wrong Question the bigger issue is how Italy will unburden its banks of its non-performing loans (NPLs). Monte de Paschi's efforts at raising equity are baby steps in the right direction. But Monte de Paschi's €23 billion of sour loans2 are just the tip of Italy' NPL iceberg, which sizes up at €320 billion in gross terms and €170 billion net of provisions. These numbers, expressed as a share of GDP, show striking parallels with peak NPLs in Spain's banking system (Chart I-6 and Chart I-7). Spain ultimately unburdened its banks with a government bailout. Italy may have to do the same. But this will require Brussels to let Italy bend the EU's new bail-in rules for troubled and failing banks. Chart I-6Spain Unburdened Its Banks ##br##With A Government Bailout... bca.eis_wr_2016_12_08_s1_c6 bca.eis_wr_2016_12_08_s1_c6 Chart I-7...Italy May Ultimately##br## Do The Same bca.eis_wr_2016_12_08_s1_c7 bca.eis_wr_2016_12_08_s1_c7 The danger for investors is that Italian bank equity and bond holders might have to suffer more pain before Brussels relents. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Unicredit and all other commercial banks use their accounts at their NCLs to make interbank payments. 2 MPS NPLs amount to €45bn in gross terms and €23bn net of provisions. Fractal Trading Model* Bucking the synchronized sell-off in global bonds, Greek sovereign bonds have actually rallied strongly in the last three months. But this rally could be near exhaustion, warranting a countertrend position. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 bca.eis_wr_2016_12_08_s1_c8 bca.eis_wr_2016_12_08_s1_c8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com 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. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields bca.eis_wr_2016_12_08_s2_c1 bca.eis_wr_2016_12_08_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_12_08_s2_c2 bca.eis_wr_2016_12_08_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_12_08_s2_c3 bca.eis_wr_2016_12_08_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_12_08_s2_c4 bca.eis_wr_2016_12_08_s2_c4 Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_12_08_s2_c5 bca.eis_wr_2016_12_08_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_08_s2_c6 bca.eis_wr_2016_12_08_s2_c6 Chart II-7Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_12_08_s2_c7 bca.eis_wr_2016_12_08_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_08_s2_c8 bca.eis_wr_2016_12_08_s2_c8

Highlights There are rising odds that Turkey will undertake military action in the Middle East. When and if this occurs, it will severely undermine already fragile investor confidence, and foreign capital inflows will evaporate. Feature As foreign capital inflows dry up, the lira will continue to plunge, pushing up borrowing costs. Yet the authorities' tolerance for higher interest rates is extremely low. The only way to gain control over interest rates and prevent them from shooting up when the currency plunges will be to impose capital controls. The imposition of capital controls would be a political decision, and hence it is impossible to forecast its form or timing with any precision. That said, investors should be mindful of growing odds of capital controls being imposed, and incorporate it into their strategic decision-making. Rising risks of capital controls entail not only closing long positions and taking capital out of the country but also closing short positions because, capital controls, if enacted, mean any capital will be stuck in liras, which will likely depreciate a lot. Turkey's "Two-Level Game" BCA's Geopolitical Strategy's main geopolitical theme since 2012 has been American hegemonic deleveraging.1 This process ushered in an era of multipolarity, a distribution of power where more than one or two countries can pursue their national interests independently. We know from history and formal modeling in political science that a multipolar context is the one most likely to produce military conflict.2 Turkey is today a perfect example of why multipolarity is volatile. Once a staunch U.S. ally and model democracy for the region, Turkey largely toed the American line for the post-World War II era. Over the past five years, however, Turkish policymakers have experienced both the risks and rewards of multipolarity. On the one hand, multipolarity means that Turkey can finally pursue its own interests in the Middle East. On the other, it means that it cannot rely on the U.S. for protection when it does so. Turkey is today the most unpredictable major power. With its foreign policy outsourced to the U.S. for so many decades, Ankara is going through a trial-and-error process of what it can and cannot do on its own. This process is fraught with political risks. Complicating the situation further, President Recep Tayyip Erdogan is playing a "two-level game" between international and domestic policy. Since the anti-government protests in 2013, Erdogan has exploited domestic and international crises to rally the people "around the flag" and increase support for his ruling Justice and Development Party (AKP) and its planned constitutional reforms. Geopolitical Risks In February 2016, BCA's Geopolitical Strategy noted that direct Turkish involvement in Iraq and Syria could be one of the five "Black Swans" of the year.3 It was clear to us that the days of the Islamic State's pseudo-Caliphate were numbered, and that both Syrian Kurds and Iraqi Kurds stood to gain the most from the terrorist group's defeat. This was unacceptable to Turkey, which therefore intervened militarily to counter Kurdish gains, and may intervene further in the near future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds, who benefit from the collapse of the Islamic State. Map I-1 shows the extent to which Kurds have expanded their control in Syria and Iraq. In Syria, Turkish forces are attempting to prevent Syrian Kurds from connecting their territory in the north of the country, which would create a Kurdish mini-state right next to the Turkish border. In Iraq, it is unclear what Turkish intentions are. Map I-1Kurdish Gains In Syria & Iraq Turkey: Military Adventurism And Capital Controls Turkey: Military Adventurism And Capital Controls Conflict with Russia and Iran: Syrian and Iraqi Kurds are staunch American allies. As such, Turkey's direct military intervention in both states will anger Washington. However, the real risk to Turkey is not from its NATO ally, but rather from Russia and Iran. Consider that in Syria, Erdogan's stated objective is to remove President Bashar al-Assad from power.4 Yet Russia and Iran are both involved militarily in the country - the latter with its regular ground troops - to keep Assad in power. True, Russia and Turkey cooled tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Turkey is a member of NATO, a collective self-defense alliance. However, the cornerstone Article 5 of the NATO Treaty specifically limits the alliance to attacks that occur in Europe or North America. As such, Turkey would have no recourse to the Treaty's self-defense clause if it were to get into a war with Russia and Iran in the Middle East.5 Furthermore, tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck (Chart I-1). Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (more on Turkey's foreign capital dependence in the sections below) (Chart I-2). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. Chart I-1Turkey's Migration Threat Is Not Credible bca.ems_sr_2016_12_07_s1_c1 bca.ems_sr_2016_12_07_s1_c1 Chart I-2Turkey Is Heavily Dependent On The EU Turkey: Military Adventurism And Capital Controls Turkey: Military Adventurism And Capital Controls The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions6 - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. First, it is not clear what state the Turkish military is in. President Erdogan has purged the military of hundreds of generals and thousands of lower level officers since the July 2016 coup d'état. Second, Turkey would be directly challenging Russia and Iran when both have prepositioned troops and air assets in the Middle East. Third, any Turkish military aggression will further distance Ankara from its Western allies. The U.S. and Europe could impose an arms embargo on Turkey, which would severely limit its ability to prosecute a long military campaign (given its reliance on NATO-compliant armament). Bottom Line: Turkey's increasing involvement in the geopolitical morass that is the Middle East is a clear and definite risk. It has no upside. So why is President Erdogan contemplating it? Domestic Political Risk President Erdogan has used geopolitical and security crises to bolster his popularity and hold on power. We therefore see Erdogan's geopolitical assertiveness as a reflection of his domestic political insecurity. This insecurity began with the mid-2013 Gezi Park protests, which came as a shock to Erdogan. We noted at the time that political volatility has been the norm for Turkey since the Second World War. The anomaly was the decade of tranquility under the AKP rule.7 The anti-government protests came amidst a slumping economy and as Erdogan was trying to enact multiple constitutional changes. The first change was to turn the presidency into a democratically elected position, which Erdogan subsequently contested and won in August 2014 (albeit with only 52% of the vote). The second change, to turn Turkey into a presidential republic and give Erdogan sweeping powers at the expense of the parliament, required a two-thirds majority in the legislature and thus a big win at the scheduled 2015 elections. From that critical moment in mid-2013, Erdogan faced multiple setbacks on the domestic front that stalled his constitutional reforms: December 2013: A corruption scandal embroiled several key members of government, including family members of ministers. June 2015: The ruling AKP failed to win a majority in parliamentary elections, with the pro-Kurdish and liberal People's Democratic Party (HDP) winning an extraordinary 80 seats. July 2015: June elections were immediately followed with renewed violence between Turkish armed forces and the Kurdistan Workers' Party (PKK), a Kurdish militant group based in Turkey. November 2015: Erdogan campaigned on a law and order platform, charging pro-Kurdish HDP with responsibility for renewed violence. The incumbent AKP won a majority, but fell short of the two-thirds needed to turn the country into a presidential republic. We expect Erdogan to call a constitutional referendum in the spring of 2017, given that his AKP, plus nationalists in parliament, have 60% of the seats needed to call for one. Polls are unreliable, but if we combine public support for AKP and nationalists in the November 2015 election as a proxy for support for a presidential republic, it suggests Erdogan will win the plebiscite. To gain support from nationalists for constitutional amendment, Erdogan will have to agree to their demands that the constitution reaffirm Turkish ethnic identity as the basis for citizenship, as well other anti-Kurdish demands. The referendum could therefore rekindle tensions between the government and Kurds, a conflict that could gain an international dimension with the Kurds in Syria and Iraq ascendant. Erdogan may continue to use geopolitical crises to rally support. Domestic politics is messy in Turkey as the country has competitive and largely free elections. If the liberal, coastal opposition were to unite with the Kurdish population behind a single candidate, Erdogan could conceivably be defeated in a future election. As such, external and internal geopolitical and security crises are useful as they give a popular boost to the president while giving the security apparatus a reason to target political opponents. Unfortunately, this dynamic is likely to increase domestic political risk and encourage Erdogan to sacrifice Turkey's political and economic institutions - including the country's adherence to the principals of the free market - for short-term political gain. It is highly unlikely that this political and geopolitical context will create an environment conducive to difficult, pro-market, choices. Instead, we expect the government to double down on populist policies that boost wages, increase liquidity in the banking system, and erode central bank independence. Bottom Line: President Erdogan is playing a "two-level game," with domestic political insecurity motivating geopolitical assertiveness. This is dangerous as the game could get out of hand. Populist policies will continue. Financial And Economic Constraints Foreign financing has been and remains a major constraint. Turkey is dependent on foreign capital flows to finance its still-large current account deficit of $32 billion, or 4% of GDP (Chart I-3). Therefore Turkish policymakers should, in theory, conduct credible monetary and fiscal policies, as well as provide an investor-friendly political and economic backdrop to attract foreign capital. Yet, in reality, the exact opposite is happening. Macro policies, and monetary policy in particular, have been completely unorthodox. On the one hand, the central bank has been intervening in the foreign exchange market, depleting its already extremely low level of foreign exchange reserves. On the other, it has been injecting liquidity into the financial system via lending to banks and other means (Chart I-4). The central bank's overnight lending to commercial banks has surged (Chart I-4, bottom panel). Chart I-3Turkey: Large Current Account Deficit = ##br##Reliance On Foreign Capital bca.ems_sr_2016_12_07_s1_c3 bca.ems_sr_2016_12_07_s1_c3 Chart I-4The Central Bank Is Injecting Enormous ##br##Liquidity Into The System bca.ems_sr_2016_12_07_s1_c4 bca.ems_sr_2016_12_07_s1_c4 In short, the Central Bank of Turkey (CBT) has been conducting "reverse sterilization" by injecting liras into circulation. It is doing so to avoid a rise in market-based interest rates, since rates typically rise when a central bank sells foreign currency and buys (i.e. withdraws) local currency from the system. In addition, the CBT cut interest rates 6 times from March to September. Remarkably, this combination of liquidity expansion and rate cuts has taken place while wages have been skyrocketing - 20% in nominal terms and 10% in real (inflation-adjusted) terms (Chart I-5). Money and credit growth have also boomed at 15-20% (Chart I-6). Wages and unit labor costs are the most critical factors in generating genuine inflation in any economy. We can very confidently state that in recent years Turkey had extremely high inflation. Chart I-5Turkish Wage Inflation Is Explosive bca.ems_sr_2016_12_07_s1_c5 bca.ems_sr_2016_12_07_s1_c5 Chart I-6Turkey: Money Supply Is Booming bca.ems_sr_2016_12_07_s1_c6 bca.ems_sr_2016_12_07_s1_c6 In a country where inflationary forces are genuine and intense and the central bank is running very loose monetary policy - i.e. well behind the curve - the currency typically depreciates a lot. Chart I-7Turkey's Net Foreign ##br##Reserves Are Running Low bca.ems_sr_2016_12_07_s1_c7 bca.ems_sr_2016_12_07_s1_c7 Hence, it is not surprising that the lira has plunged. In fact, without central bank intervention through foreign currency sales, the lira would have plunged much more. The CBT's net international reserves have dropped to a mere $20 billion from $46 billion in 2010 (Chart I-7). Net foreign exchange reserves exclude commercial banks' deposits at the central bank. The often-quoted number by the central bank of $100 billion is gross foreign exchange reserves, which includes commercial banks' foreign currency deposits at the central bank. These are liabilities of the central bank, and they do not belong to the monetary authorities. Net foreign currency reserves are currently equal to only one month of imports, and odds are that the CBT will run out of its own foreign exchange reserves very soon. In such a case, the monetary authorities could choose to use banks' foreign currency deposits to defend the lira, but the CBT would then become liable to commercial banks. Since the government owns the central bank, this would ultimately become the government's liability. Although the monetary authorities could use commercial banks' foreign exchange reserves deposited at the CBT, the act of doing so would further undermine investor confidence, and foreign capital inflows would dry up and probably turn negative. This would also remove the buffer that prevents bank runs on foreign currency deposits from occurring. Furthermore, Table I-1 illustrates the current profile of Turkey's external debt. The high level of external and foreign exchange-denominated debt, as well as elevated foreign funding requirements - $150 billion or 21% of GDP over the next 12 months - mean that debtors and the overall economy have limited tolerance for further currency depreciation. Yet the only credible way to stem the currency's plunge is to hike interest rates. That, in turn, would produce a full-blown credit downturn, pushing the economy into recession. Hiking interest rates is precisely what Turkey did many times in the past when faced with unsustainable exchange-rate levels. However, that was back when the credit-to-GDP ratio was low (Chart I-8) and policymakers were more orthodox and followed IMF prescriptions. Table I-1Turkish External Debt By Sector Turkey: Military Adventurism And Capital Controls Turkey: Military Adventurism And Capital Controls Chart I-8Turkey's Credit-To-GDP ##br##Ratio Has Risen Considerably bca.ems_sr_2016_12_07_s1_c8 bca.ems_sr_2016_12_07_s1_c8 At the moment, President Erdogan is not only bashing orthodox monetary policies and blaming foreign speculators for his country's troubles,8 but also pursuing a geopolitical strategy that contradicts that of both the U.S. and the EU, as outlined above. Overall, having no appetite for higher interest rates and a recession, the Turkish authorities will ultimately have no choice but to opt for capital controls to diminish the lira's decline. Bottom Line: To prevent currency depreciation from causing a surge in interest rates and an economic implosion, policymakers will likely end up introducing capital controls. Is The Lira Cheap? Although the nominal exchange rate has depreciated a lot, the lira is not yet very cheap. This is because wages have been skyrocketing in local currency terms, while productivity has been stagnant (Chart I-9). This means Turkey's unit labor costs have swelled (Chart I-9, bottom panel). Consequently, the lira's real effective exchange rate is not yet very cheap (Chart I-10). When expressed in euros, unit labor costs in Turkey have not declined at all, and have not yet improved compared to those of central European countries (Chart I-11). Chart I-9Turkey: Low Productivity, ##br##High Unit Labor Costs bca.ems_sr_2016_12_07_s1_c9 bca.ems_sr_2016_12_07_s1_c9 Chart I-10Lira Is Not Cheap bca.ems_sr_2016_12_07_s1_c10 bca.ems_sr_2016_12_07_s1_c10 Chart I-11Turkish Manufacturing ##br##Is Not Competitive... bca.ems_sr_2016_12_07_s1_c11 bca.ems_sr_2016_12_07_s1_c11 Consistently, Turkey has lagged central European countries in penetrating European markets. Since 2006, Turkey's market share in non-energy European imports has been mostly flat, while it has significantly increased for central European countries (Chart I-12). Even though the rising export penetration of central European countries can also be attributable to factors beyond currency competitiveness, the point remains that Turkey needs further currency depreciation to boost exports. Consistent with the fact that the lira is not yet very cheap, Turkish manufacturing is struggling (Chart I-13) and the country's current account balance, excluding oil, has been deteriorating. Chart I-12...And Is Losing EU Market Share bca.ems_sr_2016_12_07_s1_c12 bca.ems_sr_2016_12_07_s1_c12 Chart I-13Turkish Industry Needs ##br##A Much Weaker Currency bca.ems_sr_2016_12_07_s1_c13 bca.ems_sr_2016_12_07_s1_c13 Bottom Line: The lira is not very cheap. It has to depreciate more to boost Turkey's competitiveness and ameliorate the current account deficit. Investment Recommendations Chart I-14Stay Underweight Turkish ##br##Stocks Versus The EM Benchmark bca.ems_sr_2016_12_07_s1_c14 bca.ems_sr_2016_12_07_s1_c14 Over the past several years, we have been recommending shorting/underweight Turkish assets on the grounds of a dire economic and financial outlook as well as uneasy geopolitics. We have repeatedly warned that the Turkish central bank cannot defy the Impossible Trinity - trying to control the exchange rate and interest rates simultaneously when the country has an open capital account. It seems a final showdown in policymakers' fight to control both the exchange rate and interest rates is looming: the odds of some sort of capital controls being implemented are rising. Dedicated EM equity and fixed-income portfolios (both credit and local-currency bonds) should continue underweighting Turkey (Chart I-14). Absolute-return and non-dedicated EM investors should limit their investments in Turkish financial markets. BCA's Emerging Markets Strategy service's trade of shorting the TRY versus the USD remains intact. However, we recommend investors book profits as the exchange rate approaches USD/TRY 3.9. Similarly, traders should take profits on our trade of shorting 2-year bonds and bank stocks when the lira's exchange rate gets closer to USD/TRY 3.9. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Stephan Gabillard, Research Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Indonesia: Beware Of Excessive Wage Inflation In the very near term, Indonesia, like other EM countries with current account deficits and high equity valuations, is vulnerable to rising U.S. bond yields, an associated relapse in EM currencies, and a simultaneous rise in local bond yields. Heading into 2017, Indonesian financial markets will likely come under pressure from a renewed decline in commodities prices and rising domestic inflation. While the country's structural fundamentals are much better than those of Turkey, South Africa, Brazil, and Malaysia, Indonesia's financial markets are quite vulnerable due to elevated valuations and foreign investor positioning. Indonesia has been one of the darlings of EM investors over the past several years, and any selloff in EM risk assets could trigger an exodus of capital. With foreigners holding some 40% of outstanding domestic bonds, Indonesia is vulnerable to capital outflows. Furthermore, the equity market has formed a major top and a breakdown is likely (Chart II-1). High Wage Inflation Is Bearish For The Rupiah And Local Rates The inflation outlook is deteriorating in Indonesia: Wages are rising briskly across most industries (Chart II-2). Even in recession-hit sectors such as mining, wages grew by a stunning 20% between February 2015 and February 2016. Given the general rise in commodities prices this year, labor will demand even higher wage growth in 2017. Chart II-1Indonesian Equities Formed A Major Top bca.ems_sr_2016_12_07_s2_c1 bca.ems_sr_2016_12_07_s2_c1 Chart II-2Indonesia's Wage Growth Is High bca.ems_sr_2016_12_07_s2_c2 bca.ems_sr_2016_12_07_s2_c2 The central government's October 2015 minimum wage regulation - which sets minimum wage increases at the level of nominal GDP growth - is unlikely to be successful in restraining wage growth. Labor unions are extremely powerful in Indonesia, and they are currently staging numerous protests demanding minimum wage increases on the order of 25% in 2017. We therefore believe average wage growth will continue to be higher than nominal GDP growth. Odds are that wage growth will be in the double digits, while nominal GDP is currently 8.4%. Please refer to Box II-1 for more details on the issue of unions and strikes. BOX II-1 Union Protests Against Wage Indexation Labor unions across the Indonesian archipelago are highly dissatisfied with the announced 2017 minimum wage level. As a result of the government's minimum wage reforms adopted last year, pushback by unions was inevitable. The new rules will tie minimum wages to nominal GDP instead of letting it be decided at the district level by unions, businesses, and local governments. Since the unions are now at risk of losing significant influence, they are staging protests: The North Sumatran administration announced an 8.3% increase in 2017 minimum wages, but the region's labor union fiercely objected to it. The latter is now planning major protests and threatening to paralyze the industrial sector if the authorities do not comply. The region is Indonesia's fourth-most populated. Similarly, in East Java, Indonesia's second-most populous province, labor unions are not satisfied by the announced wage rise and are demanding revisions. Meanwhile, the administration in South Sulawesi raised minimum wages for 2017 by 11.1% - above the central government's assigned level - and the business community has voiced major concerns. The provincial administration has nevertheless publicly denied it has violated the central government's policy. The Confederation of Indonesian Workers Unions (KSPI) has grown dissatisfied with the announced increase in Jakarta's minimum wage (8.25%). As a result, the KSPI decided to latch on to Islamist-led protests on December 2, demanding the ousting of Jakarta's Governor "Ahok" (Basuki Tjahaja Purnama). This highlights that labor unions are willing to tap into growing religious tensions in order to make their demands more potent. This could end up being a serious issue, requiring the central government to negotiate a compromise that waters down efforts to reform minimum wages. Strong wage growth has outpaced productivity gains, and will continue to do so. While strong wage gains are good for consumption, mushrooming unit labor costs (Chart II-3) are compressing corporate profit margins and damaging Indonesia's competitiveness. Companies faced with rising wages/labor costs will have to either hike prices or squeeze margins. Both scenarios are bearish for share prices. The central bank has been extremely dovish and has, so far, disregarded rampant wage growth. Odds are that it will be late in addressing rising inflationary pressures. Typically, the exchange rate of a country where its central bank is behind the inflation curve depreciates. We expect the Indonesian rupiah to weaken significantly as Bank Indonesia (BI) will be late to raise interest rates. Although the policy rate and domestic bonds yields appear attractive when compared with the inflation rate,9 interest rates are very low compared with wage growth. We believe wages, and more specifically unit labor costs, are more genuine indicators of underlying inflation dynamics than food or energy prices - even though the latter have large weights in Indonesia's consumer price index basket. In short, interest rates are too low when compared to wage growth. Notably, over the past year or so households and businesses shifted their deposits away from foreign currency and into local currency. It seems the trend is now reversing (Chart II-4). Growing demand for U.S. dollars from residents will also weigh on the rupiah. Chart II-3Unit-Labor Costs Are Soaring bca.ems_sr_2016_12_07_s2_c3 bca.ems_sr_2016_12_07_s2_c3 Chart II-4Indonesian Residents Will Start Buying Dollars bca.ems_sr_2016_12_07_s2_c4 bca.ems_sr_2016_12_07_s2_c4 A weaker currency will push up interest rates. Higher interest rates in turn will curtail credit growth. Chart II-5 shows that the local-currency loan impulse is already rolling over and will drag economic growth lower. Indonesian commercial banks are saddled with rising non-performing loans (NPLs). Banks will be forced to increase provisioning for bad assets, leading to slower profit and loan growth. For a detailed analysis on Indonesian banks, please refer to our May 18 Weekly Report.10 Finally, narrow (M1) money growth has rolled over decisively. Historically, this has coincided with a relapse in share prices (Chart II-6). Higher interest rates will ensure a further slowdown in M1, escalating downside risks in share prices. Chart II-5Indonesia: Loan Impulse Is Turning bca.ems_sr_2016_12_07_s2_c5 bca.ems_sr_2016_12_07_s2_c5 Chart II-6M1 Money Impulse: ##br##A Worrying Signal For Stocks bca.ems_sr_2016_12_07_s2_c6 bca.ems_sr_2016_12_07_s2_c6 External Vulnerability Next year, we expect commodities prices (especially, industrial metals and coal prices) to decline due to renewed weakness in Chinese demand. This negative terms-of-trade shock will further depress the rupiah, push up interest rates, and extend the equity market selloff. Chart II-7 shows that China's imports of coal from Indonesia have surged. There has been some improvement in final demand for coal and other commodities, but supply cutbacks in China as well as financial demand (investor speculation) explain most of the exponential rise in prices. This vertical move is unsustainable, and prices will drop next year. Importantly, Chinese demand will likely weaken. China's fiscal spending and credit impulses have rolled over, warranting less industrial demand for electricity (Chart II-8). Besides, property construction will contract anew following policy tightening, high leverage among developers and hidden inventories (Chart II-8, second panel). Coal and base metals account for about 15% of Indonesia's total exports. Palm oil makes up another 9%. Given that Indonesia is running both current account and fiscal deficits (Chart II-9), lower commodities prices will weigh on the exchange rate. Chart II-7Positive Terms Of Trade##br## Boost Unsustainable bca.ems_sr_2016_12_07_s2_c7 bca.ems_sr_2016_12_07_s2_c7 Chart II-8China Growth Relapse In 2017? China Growth Relapse In 2017? China Growth Relapse In 2017? Chart II-9Indonesia's Twin Deficits bca.ems_sr_2016_12_07_s2_c9 bca.ems_sr_2016_12_07_s2_c9 Bottom Line: Indonesian share prices and domestic bonds are expensive and over-owned by EM investors. We recommend underweighting/shorting Indonesia relative to EM equity, local bond and sovereign credit benchmarks, respectively. We are also maintaining short positions in the IDR versus the U.S. dollar and the HUF. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Special Report, "Geopolitical Strategic Outlook 2012," dated January 27, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 5 A risk does exist, however, of Russia retaliating against Turkish actions in the Middle East by attacking Turkey itself. At that point, it would be a legal question whether Article 5 still applied. We are certain that Europe and the U.S. would not come to Turkey's aid, particularly if Turkey was the aggressor in Syria or Iraq. 6 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 8 President Erdogan, speaking at a Borsa Istanbul ceremony on November 23, said "We are heirs to the Ottoman Empire, which had been exploited since 1854 when it took its first external loan by banks, bankers and loan sharks. Some years tax revenues could not cover the interest payment. However, I can't consent to wasting what rightfully belongs to my people through high real interest rate." 9 This is why Indonesia scores as one of the most attractive EM local bond markets in our analysis published in last week. Please refer to our Emerging Markets Strategy Weekly Report, titled "Will The Carnage In EM Local Bonds Persist?" dated November 30, 2016; the link to the report is available on page 23. 10 Please see Emerging Markets Strategy Weekly Report, titled "EM Bonds: Unloved And Under-Owned?" dated May 18, 2016; available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights We update the long-term structural themes that we expect will be key drivers of financial market performance over the next one to five years, drawing investment conclusions from each. Debt Supercycle. The final stage of a debt supercycle is often marked by an increase in public debt, which we may now see in the U.S. Meanwhile, the eurozone and emerging markets are still at an early stage of post-debt deleveraging. Technological Disruption. The IT revolution has reached the mature phase, and behind it is a new wave of technologies including artificial intelligence and biotech. The first and last stages of tech waves are the only times where investors typically make profits. Emerging Market Deleveraging. EM assets will continue to underperform until these countries complete structural reforms and deal with the consequences of a decade of credit excesses. Multipolar Geopolitics. The end of American hegemony raises the risk of military conflicts and will make the world less globalized. End Of The Bond Bull Market. Interest rates have been in structural decline since the early 1980s. With a rotation to fiscal policy and (eventually) higher inflation, the path of least resistance for yields is upwards. Subpar Long-Run Returns. With bond yields low and equities expensive, investors will find it hard to achieve the returns they have become accustomed to over the past 30 years. Substantially more risk will be required to achieve the same level of return. Bear Market In Commodities. Weak demand growth (as China reengineers its economy), excess resource capacity, and an appreciating dollar make this a very different environment to the 2000s. Mal-Distribution Of Income. The backlash from stagnant incomes in Anglo-Saxon economies will continue. Populism is likely to cause the labor share of GDP to rise, hurting profits and lowering investment returns. Feature I. Introduction Chart 1Major Market Cycles Major Market Cycles Major Market Cycles The key views in Global Asset Allocation (GAA), as in other BCA services, center on the cyclical time-horizon, six to 12 months. This means analyzing principally where we are in the business cycle, the impact of liquidity and monetary conditions, and the current outlook for economic and earnings growth. But it is also important to understand the long-term picture: the structural trends in asset prices, debt, demographics, technology, and other "long wave" factors that have profound and protracted impacts on investment performance. Specifically, investors need to get right long-term shifts in things such as economic growth, the U.S. dollar, commodity prices, interest rates, and the relative performance of stocks and bonds (Chart 1). Such long-term themes, therefore, represent the road-map around which GAA develops its cyclical views. Ever since the service began in 2011 (and indeed in its predecessor, the BCA Premium Service), we have published a list of Major Themes, that "should be key drivers of financial market performance over the next 1-5 years." This Special Report updates and fleshes out these major themes. We have retained five of our current themes: The End of The Debt Supercycle The End of The 35-Year Global Bond Bull Market Subpar Long-Run Returns Bear Market in Commodities The Mal-Distribution of Income &Social Unrest And have added three new themes: Technological Disruption EM in A Multi-Year Deleveraging Multipolar Geopolitics In the report we describe each of these themes and draw investment conclusions from them. The descriptions are relatively brief (since most of these themes will be familiar to BCA clients), but we spend more time on analyzing the new themes and on the Debt Supercycle, which is central to our world view. We have dropped two of our earlier themes: Financial Sector Re-Regulation: Bank regulation has indeed been drastically tightened in the years since the Global Financial Crisis. As a result, banks have deleveraged significantly in most regions (Chart 2), their profitability has declined (Chart 3), and share price performance has been poor. But this phase may be over. Bank loan growth has recovered in the U.S. and the new Trump administration may both boost demand for borrowing and ease regulation. In Europe and Japan, bank stock performance will henceforth be driven more by shifts in loan demand and the shape of the yield curve than by regulation. Chart 2Banks Have Deleveraged... bca.gaa_sr_2016_12_05_c2 bca.gaa_sr_2016_12_05_c2 Chart 3... And Become Much Less Profitable bca.gaa_sr_2016_12_05_c3 bca.gaa_sr_2016_12_05_c3 Chart 4The Lowest Interest Rates Ever bca.gaa_sr_2016_12_05_c4 bca.gaa_sr_2016_12_05_c4 A Generational Shift: Our concept was that Millennials (usually defined as those who came of age after 2000 - so born between 1977 and 1994) would behave differently: they would own less (preferring to Uber and couch-surf), depend on social media, and be less focused on their careers. Arguably, this has not been the case. Like previous generations, Millennials have started to acquire possessions. In the U.S. last year, one-half of homebuyers were under 36; Millennials bought 4 million cars (making them the second largest group of purchasers behind baby-boomers). Moreover, this is a hard theme to draw investment conclusions from. Every generation is slightly different - but how concretely does this affect asset prices? One final thought. A common thread running through our themes is that there is little new under the sun. Most phenomena in economics and markets are cyclical. Many of the charts in this report show that the same environment comes round time and again, after five, 10 or 50 years. Much analysis in investment theory is based on this (think of Kontratiev waves, "the fourth turning," Dow Theory etc.) But what is fascinating about today's world is that there are trends we are experiencing for the first time in history: Zero or negative interest rates: never in history have governments, companies, and individuals been able to borrow so cheaply (Chart 4), sometimes even being paid for the privilege. Demographics: The world population has grown continuously since the Black Death in 1350. Indeed the fastest population growth on record was as recent as the 1960s (Chart 5). But growth has slowed sharply since, and is expected to be only 0.1% a year by the end of the century. As a result, we are seeing an unprecedented slowdown - and even decline - in the size of the workforce in many countries (Chart 6). Chart 5Population Growth Has Slowed Drastically bca.gaa_sr_2016_12_05_c5 bca.gaa_sr_2016_12_05_c5 Chart 6The Workforce In Some Countries Is Shrinking bca.gaa_sr_2016_12_05_c6 bca.gaa_sr_2016_12_05_c6 The impacts of these two trends will be profound - but they won't be found by looking at historical precedents. II. Debt Supercycles One of the key ways in which BCA has long looked at the world is through the concept of debt supercycles. Our founder, Hamilton Bolton, wrote in 1967 of "the possibilities inherent in an intensive study of changes in bank credit as a major cyclical and supercyclical investment tool....History shows period after period of excessive bank credit inflation. It also shows a number of periods in which bank credit deflation has been allowed to erode the whole economic and investment structure."1 Simply put, when credit in the economy expands (and these days one needs to look more broadly than at just bank credit) it tends to boost growth, raise asset prices, and underpin the effectiveness of monetary policy. At some point, the level of credit becomes unsustainable and the subsequent deleveraging causes financial conservatism as borrowers focus on repairing their balance-sheets. This makes monetary policy relatively ineffective, and has negative effects on growth and asset prices. The two biggest debt supercycles over the past 50 years were in Japan from 1970 to 1990, and in the U.S. and parts of Europe starting in the early 1980s and culminating with the Global Financial Crisis in 2007 (Chart 7). The fallout from the end of Japan's debt supercycle has been stark: since 1990, Japanese nominal GDP has grown by only 0.4% a year (compared to 6% a year over the previous 10 years) and even today the Nikkei index is 55% below its peak. In the U.S., the early 1980s' financial deregulation and the fiscal policies of the Reagan government caused both private and government debt to begin to rise as a percentage of GDP (Chart 8). From the late 1990s, monetary policy was kept too easy, which culminated in the housing bubble of 2004-7. After that bubble burst, households reduced debt (partly through defaults) and government spending rose sharply for a few years to cushion the recession. Chart 7Debt Supercycles Everywhere Debt Supercycles Everywhere Debt Supercycles Everywhere Chart 8U.S. Debt Started To Rise From 1980 bca.gaa_sr_2016_12_05_c8 bca.gaa_sr_2016_12_05_c8 Since 2009, BCA has been talking about a "post debt supercycle" in the U.S.2 The household savings rate rose (Chart 9), as consumers became cautious, preferring to save rather than spend (Chart 10). This has meant that consumption growth has been lower than wage growth, whereas the opposite was the case up to 2007. Monetary policy also became ineffective since, in such a weak growth environment, companies were not inclined to spend on capital investment despite ultra-low interest rates (Chart 11). Chart 9Household Savings Rate Has Risen Since The Crisis bca.gaa_sr_2016_12_05_c9 bca.gaa_sr_2016_12_05_c9 Chart 10Consumers Prefer To Save Than Spend Consumers Prefer To Save Than Spend Consumers Prefer To Save Than Spend Chart 11Companies Not Spending Despite Low Rates Companies Not Spending Despite Low Rates Companies Not Spending Despite Low Rates There are two competing theories to explain the sub-trend growth of the current expansion. Larry Summers' theory of secular stagnation3 describes a world in which, even with ultra-low interest rates, desired levels of saving exceed desired levels of investment, leading to chronic shortfall in demand. BCA's debt supercycle explanation is closer to that of economists such as Kenneth Rogoff, who argues that once deleveraging and borrowing headwinds subside, growth trends might rise again.4But the two theories may not be so incompatible: secular factors, such as demographics, play a role in both. The final stage of a debt supercycle is often an increase in public debt. That has certainly been the case in Japan: while the private sector has deleveraged aggressively since 1990, government debt to GDP has risen from 67% to 250% - without having much discernible effect on boosting growth. In the U.S., government debt has stabilized as a percentage of GDP over the past two years, and the baseline projection made by the Congressional Budget Office in March this year forecasts it to increase by only 10 percentage points over the next decade. But the election of President Trump might change that. His campaign promised tax cuts and infrastructure spending amounting to about USD6 Trn which, all else being equal, would increase government debt/GDP by another 30 percentage points over a decade. There are two other regions where we see the debt supercycle being an important factor over the coming years: the Eurozone and emerging markets. In Europe, some of the most indebted countries, notably the U.K. and Spain, have made progress in deleveraging since the Global Financial Crisis - although the balance-sheet repair is likely to remain a drag on the economy for a while longer. But France and Italy have hardly delevered at all, and some smaller countries such as Belgium have seen a substantial increase in private debt/GDP (Chart 12). The Eurozone remains generally a very heavily bank-dependent economy, with total bank credit almost back to a historical peak (Chart 13). Germany, by contrast, has long had an aversion to debt: private sector debt/GDP has never been above 130% and is currently only around 100%. This unwillingness to borrow and spend by the world's fourth largest economy has been a drag on European growth. Chart 12Deleveraging In Europe Has Been Patchy Deleveraging In Europe Has Been Patchy Deleveraging In Europe Has Been Patchy Chart 13Eurozone Bank Loans Have Not Declined Eurozone Bank Loans Have Not Declined Eurozone Bank Loans Have Not Declined Emerging markets delevered after the Asian crisis in 1997-8 but the wave of global liquidity created in 2009-12 flowed into EMs, triggering excessively high credit growth. Private-sector EM debt has reached an average of 140% of GDP (Chart 14), and a higher percentage of global GDP than was U.S. debt at the peak of the housing bubble in 2006. Although the debt buildup is most extreme in China, where private-sector debt/GDP has risen by 70 percentage points over the past seven years, the same phenomenon is apparent in many other emerging markets, notably Brazil, Turkey, Russia and Malaysia (Chart 15). Chart 14The EM Debt Supercycle May Be Ending The EM Debt Supercycle May Be Ending The EM Debt Supercycle May Be Ending Chart 15And It's Not Just About China And It's Not Just About China And It's Not Just About China BCA's Emerging Markets Strategy has argued for a while that this is unsustainable and that a period of deleveraging will cause growth to slow in many emerging markets and that the strains from the excessive lending, such as rising NPL ratios, will become apparent.5 The deleveraging has already started to happen, with loan growth in Brazil, Malaysia and Turkey - but not yet China - slowing sharply (Charts 16 & 17). Chart 16EM Bank Lending Now Slowing... EM Bank Lending Now Slowing... EM Bank Lending Now Slowing... Chart 17...Almost Everywhere ... Almost Everywhere ... Almost Everywhere We draw a number of conclusions for long-term asset allocation from this analysis. The post debt supercycle is likely to remain a drag on global growth, and therefore on returns from risk assets, for some years to come. But the U.S. is likely to be less affected than the eurozone since the household sector there has already substantially deleveraged and the Trump administration is more likely to use government spending to fill the gap. Emerging markets will underperform for some years to come as they too go through a period of deleveraging. III. Disruptive Technology Technological change is a key driving force of economies and markets. As Joseph Schumpeter said, capitalism is a "process of industrial mutation...that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." Nikolai Kondratiev described 45-60 year waves that were triggered by "the irruption of a technological revolution and the absorption of its effects." Understanding where we are in the technological cycle, then, is very important for investors wanting to catch deep trends. But it is particularly hard at the moment because, at the same time as the world is still seeing ramifications coming through from personal computing (which began as long ago as 1971, with Intel's announcement of the first microprocessor) and from the internet (which started as Arpanet in 1969), there is a new wave of revolutionary technologies still mainly on the drawing-board, including robotics, artificial intelligence, and genetic engineering. The best framework for thinking about technological cycles is provided by economist Carlota Perez.6 She describes five "surges of development" starting with the Industrial Revolution, which she dates from the opening of Arkwright's cotton spinning mill in Cromford in 1771 (Table 1). Her key argument is that these revolutionary technologies have powerful and long drawn-out effects on the financial, social, institutional, and organizational framework and therefore tend to move through a similar pattern of four phases (Chart 18) lasting around 50 years in all. The fifth wave, Information Technology, for example, started in its installation phase with development of the microprocessor, PCs, and mobile phones in the 1970s and 1980s, reached frenzy in the 1990s, hit a turning-point (which often triggers a stock market crash) in 2000-2, before reaching the deployment phase in the 2000s, and may now be at maturity (growth in computers and smart phones is slowing). Table 1The Five Historic Technology ##br##'Surges Of Development' Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 18The Four Stages Of Technology Waves Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes But Perez wrote her book in 2002, and we could now be close to the beginning of the sixth wave. Think about the situation 30 years ago, in 1986. It would not have been hard to extrapolate how technology might develop over the coming years since some people already used PCs, mobile phones, and the internet but, as William Gibson said at the time, "the future is already, here - it's just not very evenly distributed." Today there are still a few further developments to come in these fifth-wave technologies (we've listed some in Table 2). But there is a whole further set of technologies (self-driving cars, graphene, distributed energy generation) which almost nobody uses now, but which could become important. Many of these build on the developments of the fifth wave (ubiquitous connectivity, cheap and powerful computing) in the same way that previous revolutions grew from their predecessors (cars wouldn't have been possible without steel, for example). Table 2Fifth And Sixth Wave Technologies Still To Come Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The implications of these new technologies are hard to predict, and many have undoubtedly been over-hyped. As Bill Gates said: "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." So how should investors deal with this? The macro implications are enormous. Every new wave of technologies has a large impact on employment, as jobs in dying industries disappear. U.S. farm workers, for example, fell from over half of the labor force in 1880 to only 12% by 1950 (Chart 19). But perhaps more relevant - given that self-driving vehicles may replace taxi, truck, and delivery drivers - is that the number of horses in the U.S. fell from 26 million to 4 million over the 50 years starting in 1915 (Chart 20). These jobs, of course, were replaced by new opportunities in manufacturing or services. And the number of drivers in the U.S. is only 3.8 million currently, or less than 3% of the workforce. Nonetheless, in the maturity phase of the technology wave (where we are now for the IT revolution), Perez points out, there is often popular unrest as "workers organize and demand...the benefits that have been promised and not delivered." Chart 19Farm Workers Were Disrupted ##br##In The Late 19th Century Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 20...And So ##br##Were Horses Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Investing in new technologies is naturally appealing to investors, but often tricky to get right. Alastair Nairn7 identifies five similar phases for investing in technology but concludes that investors can usually make money only in the first stage, when initial skepticism reigns, and in the final stage, when the technology has matured and the surviving handful of leading players can now make good profit. Analysis by economists at the Atlanta Fed showed (Table 3) that, of the 24 U.S. PC manufacturers listed on the U.S. stock market between 1983 and 2006, only 10 made a positive return for shareholders.8 Of these, only five beat the overall index. The picture is similar for other technology waves, except perhaps for the nascent auto industry when 12 of 23 listed manufacturers outperformed the index in 1912-1928. Table 3Investments In New Technology Companies Rarely Beat The Market Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Nairn also argues that it is easier to spot losers than winners: "The winners take many years to emerge and...it is well-nigh impossible to identify them early. ...Conversely, the losers tend to be more obvious, and more obvious at an early stage." Think back to the early days of the internet. Investors would have struggled to pick the eventual winners (Apple, Amazon, Google - but many might have guessed Yahoo or even Pets.com) but should have understood that the media, travel, retailing, and film-camera industries would all be disrupted. Chart 21IT And Healthcare Sectors ##br##Are Likely To Continue To Outperform IT And Healthcare Sectors Are Likely To Continue To Outperform IT And Healthcare Sectors Are Likely To Continue To Outperform So how should investors apply these conclusions? If we are in the mature phase of the Fifth Wave and the skepticism phase of the Sixth, this is a time when investors can benefit from tilts towards sectors where technological changes are taking place, most notably IT and Healthcare, which are likely to continue to outperform over the long run (Chart 21). Exposure to what our colleague Peter Berezin calls BRAIN stocks - biotech, robotics, artificial intelligence, nanotech - makes sense.9 This can be captured through venture capital funds. Potential losers might include energy companies and utilities, as improvements in solar energy lead to more distributed power. Even oil company BP reckons that renewables will provide 16% of power generation in 2035 - and 35% in the EU - up from 4% today, with the cost of solar power expected to fall by 40% over the time. Other sectors that could be disrupted include automakers, which could be challenged by developments in electric vehicles, and financial institutions, whose business model could be under threat from peer-to-peer lending, robo-advisers and other developments in fintech. IV. Emerging Markets In A Multi-Year Deleveraging BCA has recommended a structural underweight on emerging market (EM) equities relative to developed markets (DM) since 2010.10 This call worked well until the end of last year. So far this year, however, EM equities have outperformed DM by 5%, despite their sharp selloff (Chart 22) after the U.S. election. Our view is that emerging markets remain structurally challenged and that their long-run underperformance is likely to continue. We view the outperformance this year as simply a counter-trend move driven largely by two factors: a) the extreme relative undervaluation of EM vs. DM at the beginning of the year; and b) unconventional quantitative easing from the ECB and BoJ, and massive back-door liquidity injections (Chart 23) by EM central banks, such as in China and Turkey. Chart 22Counter-Trend Rally Largley Driven By... bca.gaa_sr_2016_12_05_c22 bca.gaa_sr_2016_12_05_c22 Chart 23QE / Massive Liquidity Injection By PBoC bca.gaa_sr_2016_12_05_c23 bca.gaa_sr_2016_12_05_c23 After the bounce, however, EM equities are no longer especially cheap relative to their DM counterparts, with the relative forward PE ratio now at its five-year average. Going forward, the poor profit outlook - due to persistent structural problems in the EM economies - will continue to weigh on the relative performance of EM assets. We maintain our structural underweight call on EM equities in a global portfolio. First, the factors that drove the massive outperformance of emerging markets in 2002-2010 have disappeared: the once-in-a-generation debt-fueled consumption binge in DM, and the investment-fueled double-digit growth in China which triggered a bull market in commodities (Chart 24). But EM countries did not take full advantage of these exogenous forces to reform their economies: to foster domestic demand, and optimize resource allocation and industrial structure. When China slowed and U.S. consumers went through a much-needed deleveraging after the Great Recession, exports to DM slowed and even contracted, and commodities prices declined sharply. As a result, the export-driven economic model of EM countries has broken down. The structural drivers of economic growth in the EM, both productivity and capital efficiency (Chart 25), have been in a downtrend, while debt (Chart 26) has continued to soar. Chart 24Regime Has Shifted bca.gaa_sr_2016_12_05_c24 bca.gaa_sr_2016_12_05_c24 Chart 25Structural Drivers Have Weakened bca.gaa_sr_2016_12_05_c25 bca.gaa_sr_2016_12_05_c25 Chart 26Debt Has Soared Debt Has Soared Debt Has Soared Structural problems require structural solutions. These solutions vary by country, but in general require less state intervention in the economy, flexible labor markets, and better incentive structures to encourage innovation and entrepreneurship. But structural reforms are a painful process and take strong political will to implement. A case in point is China, which delayed its announced supply-side reforms and reverted to monetary and fiscal stimulus when growth slowed. Second, history shows that no credit boom can last forever. Chart 27 shows private non-financial credit-to-GDP ratios in major developed economies. They have experienced periods of deleveraging of various magnitudes and durations, even though these nations have deep and sophisticated banking, credit, and financial markets, and some have plenty of domestic savings. Similar patterns have been observed in EM economies, although their deleveraging episodes have tended to be more frequent and of larger magnitude (Chart 28). Chart 27No Credit Boom Lasts ##br##Forever In DM Economies No Credit Boom Lasts Forever In DM Economies No Credit Boom Lasts Forever In DM Economies Chart 28Asian Economies: Many Interruptions During Structural Leveraging Process bca.gaa_sr_2016_12_05_c28 bca.gaa_sr_2016_12_05_c28 The main reason for these boom-bust credit cycles is the burden of debt servicing. As the private credit-to-GDP ratio rises, if interest rates are held constant, a larger share of income needs to be allocated to paying interest. At some point, debt service eats too much into debtors' incomes, causing debtors to default and creditors to reduce credit provision. This causes the economy to slow, followed by a painful but necessary restructuring to work off the excess leverage before a new cycle can start. We see no reason see why EM countries, China in particular, can sustain their current high and rising leverage levels. Deleveraging is inevitable. Third, this deleveraging in EM is at a very early stage, since credit in most EM countries continues to grow faster than nominal GDP (Chart 29). After years of booming corporate and household debt, a period of consolidation is inevitable. Hence, credit growth is set to slow to at least the level of nominal GDP growth. The credit impulse - the change in the rate of credit growth - is a key factor influencing GDP and profit growth. Chart 30 shows that if credit growth converges to nominal GDP growth within the next 12-24 months, the credit impulse will turn negative, ensuring a slowdown in the EM economies and a further contraction in corporate earnings, thus putting downside pressure on asset prices. Chart 29A Break In LEveraging Cycle Is Overdue bca.gaa_sr_2016_12_05_c29 bca.gaa_sr_2016_12_05_c29 Chart 30Negative Credit Impulse Bodes Ill For Profit And Equities Prices Negative Credit Impulse Bodes Ill For Profit And Equities Prices Negative Credit Impulse Bodes Ill For Profit And Equities Prices Chart 31Dismal Return on Equity Dismal Return on Equity Dismal Return on Equity Bottom Line: EM economies are at a very early stage of a multi-year deleveraging to work off credit excesses. Despite their year-to-date outperformance, we expect EM equities will continue to underperform their DM counterparts over the long run until their return on equity (Chart 31) improves significantly. V. Geopolitical Multipolarity Since the end of the Cold War, geopolitics has mostly remained in the background for investors. This is because the collapse of the Soviet Union ushered in an era of American hegemony that lasted for roughly two decades. During this period, the global concentration of economic, trade, and military power increased as the U.S. became the only true superpower (Chart 32). The world entered a period of "hegemonic stability," an era during which regional powers dared not pursue an independent foreign policy for fear of U.S. retaliation and during which the "Washington consensus" of laissez-faire capitalism and free trade was adopted by policymakers in both developed and emerging markets. Chart 32The End Of American Hegemony bca.gaa_sr_2016_12_05_c32 bca.gaa_sr_2016_12_05_c32 A central thesis of BCA's Geopolitical Strategy is that the world has entered a multipolar phase.11 Multipolarity implies that the number of states powerful enough to pursue an independent and globally-relevant foreign policy is greater than one (unipolarity) or two (bipolarity). Today, multipolarity is the product of America's decaying unipolar moment. The U.S. remains, by far, the most powerful country in the absolute sense, but it is experiencing a relative decline as regional powers become more capable on both the economic and geopolitical fronts (Chart 33). Multipolarity is not a popular theme with investors. It augurs uncertainty, rising risk premia, and unanticipated "Black Swan" events. In addition, some of our clients take issue with the thesis that the U.S. is in "decline." Although we can measure hard power and illustrate the relative decline of the U.S. empirically, perhaps the greatest evidence of global multipolarity are recent events that were unimaginable just five or ten years ago: Russia's annexation of Crimea; China's military expansion in South China Sea; Turkey's disregard for U.S. interests in Syria; U.S.-Iran détente (with little evidence that Tehran has actually curbed its nuclear capabilities); Dramatic withdrawal of U.S. troops in the Middle East. The point of a multipolar world is not that Russia, China, Turkey, Iran, and other powers seek to challenge America's global reach, but rather that each is more than capable of pursuing an independent foreign policy within their own spheres of influence. As the number of "veto players" in the global "Great Game" increases, however, equilibrium becomes more difficult to achieve. Uncertainty rises and conflicts emerge where none were expected. So what does multipolarity mean for investors? First, we know from formal modeling in political science, and from history, that a multipolar world is unstable and more likely to produce military conflict (Chart 34).12 There are three reasons: Chart 33U.S. Experiencing Relative Decline U.S. Experiencing Relative Decline U.S. Experiencing Relative Decline Chart 34Geopolitical Risk Is The Outcome Of Global Multipolarity bca.gaa_sr_2016_12_05_c34 bca.gaa_sr_2016_12_05_c34 During periods of multipolarity, more states can effectively pursue foreign policies that lead to war, thus creating more potential "conflict dyads" in the parlance of International Relations theory. In fact, evidence shows that this has already happened (and continues to happen), with the number of international or internationalized conflicts rising since 2010 dramatically (Chart 35). Power imbalances between states are more likely if there are more states that matter geopolitically. And power imbalances invite conflict as they are more likely to produce a situation in which one country's rising capabilities threaten another. During the Cold War, it didn't matter that Iran was more powerful than Saudi Arabia because the U.S. was present in the Middle East and willing to balance against Tehran. In a multipolar world, the weaker states are on their own. The probability of miscalculation rises due to the number of relevant states making geopolitical decisions simultaneously. For example, last year's shooting down of a Russian jet by the Turkish air force over Syria is an example of an incident that is mathematically more likely in a multipolar world. During the Cold War, the chances that Turkey would independently make the decision to shoot down a Soviet jet was far smaller as its foreign policy was closely aligned with that of its NATO ally the U.S. Chart 35Multipolarity Increases ##br##The Frequency Of Conflict Multipolarity Increases The Frequency Of Conflict Multipolarity Increases The Frequency Of Conflict There are a number of derivatives from the multipolarity thesis that will be relevant for investors. For example, despite Brexit, a multipolar world will support European integration.13 With geopolitical uncertainty rising in Europe's neighborhood - particularly in the Middle East and with Russia reasserting itself - Europe's core countries will not follow down the "exit" path that the U.K. pursued. On the other hand, the geopolitical disequilibrium in East Asia is deepening, with China's pursuit of a sphere of influence in the South and East China Seas likely to continue to raise tensions in the region. But the overarching concern for investors should be how multipolarity impacts the global economy. Global macroeconomic imbalances - such as the current combination of insufficient demand and excessive capacity - can be overcome either by unilateral policy from the hegemon or through coordination among the major economic and political powers. A multipolar world, however, lacks such coordination. Globalization is therefore at risk from multipolarity.14 Not only are regional powers pursuing spheres of influence, which is by definition incompatible with a globalized world, but the world lacks the hegemon that normally provides the expensive, and hard to come by, global public goods: namely economic coordination and geopolitical stability. History teaches us that the ebb and flow of trade globalization has been closely associated in the past with the shifting global balance of power (Chart 36). Trade globalization collapsed right around 1880, when the rise of a unified Germany and the ascendant U.S. undermined the century-old Pax Britannica. This trend ushered in a rise of competitive tariffs as the laggards of industrialization attempted to catch up with the established powers. Trade globalization recovered and began to grown again in the early twentieth century and immediately after the First World War, but both attempts were aborted by the lack of a clear hegemon willing to undertake the coordinating role necessary for globalization to take root and persevere. Chart 36Back To The 1930's? bca.gaa_sr_2016_12_05_c36 bca.gaa_sr_2016_12_05_c36 The lack of a clear hegemon and the diffusion of geopolitical power amongst multiple states can act as a headwind to global coordination. In the late nineteenth and early twentieth century, the U.K. was too weak to enforce global rules and norms, and the surging U.S. was unwilling to do so. Today, the U.S. is (relatively) too weak and unwilling to do the job of a hegemon, while China is understandably unwilling to coordinate its economic policy with a strategic rival. The investment implications of multipolarity center on three broad themes: Apex globalization: Going forward, the world is going to be less, not more, globalized. This will favor domestic over global sectors and consumer-oriented economies over the export-oriented ones. Globalization is also a major deflationary force, which would suggest that, on the margin, a world that is less globalized should be more inflationary. DM over EM: Multipolarity is more likely to produce a number of conflicts, some of which lay dormant throughout the Cold War and subsequent era of American hegemony. These conflicts tend to be in emerging or frontier markets. Safe Havens: With the frequency of geopolitical conflict on the rise, safe haven assets like the U.S. Treasurys, U.S. dollar, gold, and Swiss and Japanese government bonds, should continue to hold an important place in investors' asset allocation. VI. End Of The 35-Year Global Bond Bull Market Since the early 1980s, interest rates have been in a structural decline on the back of falling inflation expectations. Thirty-five years later, the global bond bull market has reached its end (Chart 37). Importantly, this is not to suggest that a secular bear market in bonds is beginning. The global economy is still suffering from significant spare capacity and markets usually go through a volatile bottoming process before a new secular trend is established. Nevertheless, the path of least resistance for yields is upwards. Chart 37Long-Term Yields Have Bottomed Long-Term Yields Have Bottomed Long-Term Yields Have Bottomed The most significant shift regarding sovereign yields is the global transition from monetary to fiscal stimulus. Over the next few years, central bank asset purchases will be negligible at best, with normalization in central bank balance sheets being far more likely, albeit at a muted pace. From the fiscal perspective, the rotation has already occurred in several regions, with the liberal government in Canada promising to increase infrastructure spending, Japanese Prime Minister Shinzo Abe postponing next year's planned VAT tax hike, and incoming U.S. President Donald Trump expected to ramp up fiscal spending. Sovereign bond yields have been weighed down by the rise in inequality. IMF studies found that this increase in inequality has had substantial negative effects on real GDP growth and therefore the real component. Populism is growing, as evidenced by the surprising outcome of the Brexit vote, the rise of anti-establishment parties in Europe, and the highly polarizing candidates in the U.S. elections. However, as populism continues to mount, policymakers will be further pressured to take on additional reflationary measures, inevitably leading to higher inflation. Anemic productivity growth has dampened aggregate demand and applied downward pressure to bond yields. Initially, weak productivity gains are deflationary as they reduce the incentive for firms to invest and consumers to reduce their spending. The longer term effect however, is that the supply side catches up, causing the economy to overheat and inflation to rise (Chart 38). This was the case in low productivity economies in Africa and Latin America. Chart 38A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Nevertheless, not all factors are pointing to higher yields. Demographic trends have been unfavorable, as working age population growth in the major countries has decelerated sharply since 2007. Conditions will likely worsen, with the UN forecasting growth to reach zero in the latter half of the next decade. The effect is further compression in the real component of bond yields as slower labor force growth reduces the incentive for firms to build new factories, shopping malls and office towers. Overall, while the global economy has been plagued by deflation, these signs suggest that the tide is finally turning. Higher consumer prices will not only lead to an increase in the inflation expectations component, but also the inflation risk premium, which compensates investors over the inflation outlook. As the majority of the rise in bond yields will come via the inflation component and not the real component, we advocate a long-term allocation to TIPS. VII. Subpar Long-Run Returns Asset prices have surged following the global financial crisis and have reached fairly expensive valuations. While this not to say that a bear market is imminent, it certainly makes financial assets more vulnerable to correction and it does suggest that long-term return prospects are bleak. Lower future returns will shift the efficient frontier inward, requiring substantially more risk to achieve the same level of returns. Investors will find it far more difficult to achieve returns they have become accustomed to over the past 30 years. Sovereign Bonds: After 35 years, the structural decline in interest rates is at an end. While we do not expect an outright bond bear market, the path of least resistance for yields is up (Chart 39). Across all major countries and regions, starting long-term real yields have been an excellent predictor for future five-year returns. Given that yields are at multi-century lows, and even negative in some regions, future returns will be meager. Investors should reduce their long-term allocation to sovereign debt. Chart 39Yields: The Path Of Least Resistance Is Up Yields: The Path Of Least Resistance Is Up Yields: The Path Of Least Resistance Is Up Corporate Bonds: Corporate debt is also priced expensively relative to its long-term history. The credit cycle is in its late stages, and while accommodative monetary policy will extend this phase, defaults will eventually grind higher and low starting yields will limit long-term returns. Investment grade real returns can be mostly explained by their starting real yields. In fact, real yields have been an even better predictor for investment grade returns than they have for sovereigns. Investment grade spreads are less important as they have historically been stable, and defaults are fairly rare in this space. For high yield, while starting real yields are important, spreads and defaults are also crucial determinants for performance. All valuation metrics suggest that both future investment grade and high-yield returns will fall far short of investors' ingrained expectations (Chart 40). Equities: The relationship between cyclically-adjusted price-to-earnings ratios (CAPEs) and real returns is well established, as a simple regression generates a high r-squared (Chart 41). Current valuations are expensive, suggesting low to mid single digit returns. However, there is reason to believe that this scenario is overly optimistic. First, global equities have benefitted from the structural decline in interest rates. Going forward however, the end of the bond bull market removes a substantial tailwind. Secondly, the Debt Supercycle, in which each cycle begins with more indebtedness than the one that preceded it, is played out in the developed world. The implication is that household credit demand will be weak and businesses are less likely to spend on capex, thereby dampening economic growth. Chart 40Low Starting Yields = Low Future Returns bca.gaa_sr_2016_12_05_c40 bca.gaa_sr_2016_12_05_c40 Chart 41Shiller P/E Suggests Below-Average Long-Run Equity Returns Shiller P/E Suggests Below-Average Long-Run Equity Returns Shiller P/E Suggests Below-Average Long-Run Equity Returns In order for investors to reach their return targets, we recommend several options. The end of the structural decline in interest rates does not bode well for sovereign bond returns. Instead, allocators should increase their structural exposure to equities. Investors should also focus more on bottom-up analysis and differentiating at lower levels, i.e. industry groups (GICS level 2). Finally, we advocate a long-term allocation to alternative assets. Alternatives provide downside protection through volatility reduction and substantial return enhancement potential given their active management and an illiquidity premium. VIII. Structural Bull Market In Resources Is Over Commodities experienced an unusually strong bull market in the 2000s, driven by very supportive global economic and financial conditions (Chart 42): 1) the U.S. dollar spent the decade in decline; 2) investment in mining capacity was depressed following the bear market of the 1990s; 3) rapid industrialization and double-digit growth in China. The bull market of 2000s lasted longer than its predecessors and was driven more by demand growth than by supply shortages. Commodities have never been a long-term buy. While there have been cyclical bull markets, the commodity complex in real terms has been in a structural downtrend for the past two centuries (Chart 43). This is despite a 20-fold increase in real GDP, a sign that rapid economic growth and weaker commodity prices can go hand in hand. The simple reason is that humans constantly find ways to extract commodities from the ground more cheaply and use them more efficiently. The current cyclical downturn is likely to continue for some years. Demand: A number cyclical and structural factors (Chart 44) will weigh on marginal demand for commodities in the long run: Chart 42Very SUpportive Backdrop In The 1990s bca.gaa_sr_2016_12_05_c42 bca.gaa_sr_2016_12_05_c42 Chart 43Not A Good Long-Term Investment Not A Good Long-Term Investment Not A Good Long-Term Investment Chart 44Shaky Demand Outlook bca.gaa_sr_2016_12_05_c44 bca.gaa_sr_2016_12_05_c44 Anemic Global Growth: Despite rising incomes, per capita consumption of base metals has been flat in most developed nations. With growth in the working age population slowing to 0.7% in 2010 - 2050, down from 1.7% in 1970 - 2010, the long-term outlook for consumer demand is poor. China: China consumes more zinc, aluminium and copper than the U.S., Japan, and Europe combined. It comprises more than 40% of global base metal demand, while it has only a 15% share of global GDP. With China's plans to transition into a consumer-driven services economy, this magnitude of incremental demand is highly unlikely in the future. Alternatives & Technological Advancements: Improved energy efficiency, the transition to renewable sources, and growth in electric-hybrid vehicles will weigh on demand for traditional sources of energy. A large-scale push towards nuclear energy, led by China's plans for 80GW of installed capacity by 2020, will pose a serious threat to marginal demand. Supply: Coordinated production cuts are a thing of the past. Underutilization (Chart 45) and market share-wars by countries that need to finance rising fiscal deficits have changed supply dynamics: Excess Capacity: Following the Global Financial Crisis, completion of projects which had been previously committed to, led to enormous capacity expansion when global growth was struggling. Both mining and oil & gas extraction capacity have reached new highs led by the U.S. This will continue to put downward pressure on both metals and energy prices until excess capacity has been removed. Proven Reserves: Known reserves of most metals have risen over the past decade and reached new highs: for example, in the case of copper, nearly three tons have been added to reserves for every ton consumed. In the crude oil market, technological progress has led to discovery of unconventional deposits, the best-known being Canadian oil sands, which by some estimates contain more than twice Saudi Arabia's crude oil reserves. Price Elasticity: The shale revolution brought with it leaner drilling operations which have a much shorter supply response time. The key to the price of crude is how quickly U.S. shale oil producers respond once the oil price rises above their current average cash cost of $50. This will limit the upside potential to crude oil for the next few years. U.S. Dollar & Real Rates: The dollar (Chart 46) has much more explanatory power for commodity prices than Chinese demand does. Given monetary policy and growth divergence between the U.S. and the rest of the world, the U.S. dollar will continue to appreciate. When real rates are low, the opportunity cost of keeping resources in the ground is also low. As growth starts to stabilize, rising real rates will add downward pressure on prices. Chart 45Relentless Supply Response bca.gaa_sr_2016_12_05_c45 bca.gaa_sr_2016_12_05_c45 Chart 46U.S. Dollar Vs Chinese Growth bca.gaa_sr_2016_12_05_c46 bca.gaa_sr_2016_12_05_c46 We remain structurally bearish on the overall commodity complex, but expect short-lived divergences within the group. As more nations agree on production cuts in oil, we expect energy markets to outperform metals. Precious metals will continue to stage mini-rallies on the back of heightened equity market volatility. Agricultural commodities will continue to bear the brunt of poor global demographics. IX. Mal-Distribution Of Income And Social Unrest The decision by the U.K. in June's referendum to leave the EU and Donald Trump's victory in the U.S. presidential election suggest a high degree of dissatisfaction with the status quo in Anglo-Saxon economies. This is hardly surprising given the stagnation of median wages in developed economies since the early 1980s, especially among the less educated (Chart 47), and growing inequality. The middle class (defined as those with disposable income between 25% below and 25% above the median) in the U.S. has fallen to 27% of the population from 33% in the early 1980s, and in the U.K. to 33% from 40% (Chart 48). Note that the decline in the middle class is much less prominent in continental Europe and Canada. Chart 47Wages For Less Educated Have Stagnated bca.gaa_sr_2016_12_05_c47 bca.gaa_sr_2016_12_05_c47 Chart 48Middle Class Has Shrunk In U.S. And U.K. But Not In Continental Europe Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The Gini coefficient in the U.S. has risen to as high a level as during the 1920s (Chart 49). Branko Milanovic, the leading academic working on global inequality, explains the reasons are follows: "The forces that pushed U.S. inequality up in the roaring twenties were, in many ways, similar to the forces that pushed it up in the 1990s: downward pressure on wages (from immigration and/or increased trade), capital-based technological change (Taylorism and the Internet), monopolization of the economy (Standard Oil and large banks), suppression or decreasing attractiveness of trade unions, and a shift toward plutocracy in government."15 Chart 49U.S. Inequality Back To 1920's Level Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The backlash has begun. BCA's Geopolitical Strategy service has described how the median voter in the Anglo-Saxon world is shifting to the left.16 Around the world governments are abandoning austerity and moving to fiscal stimulus and spending to improve infrastructure. Many, for example, are raising the minimum wage. In the U.K., it is due to go up from GBP7.20 to 60% of the median wage (about GBP9.35) by 2020, and in California from $10 to $15 by 2022. The 40 years of a falling labor share of GDP and rising capital share have started to reverse in the U.S. over the past two or three years (Chart 50). These shifts also threaten growth of global trade. Trump opposes the Trans-Pacific Partnership (TPP) trade agreement and says he will renegotiate or scrap the North America Free Trade Agreement (NAFTA). Global trade, after continuous growth as a percentage of GDP since World War Two, has slowed since the Great Recession (Chart 51). The WTO reports an increase in trade-restrictive measures and a fall in trade-facilitating measures over the past 12 months (Chart 52). Chart 50Fall In Labor Share ##br##Of GDP Starting To Reverse Fall In Labor Share Of GDP Starting To Reverse Fall In Labor Share Of GDP Starting To Reverse Chart 51Trade Globalization* bca.gaa_sr_2016_12_05_c51 bca.gaa_sr_2016_12_05_c51 Chart 52Trade Measures Are Getting ##br##Increasingly Restrictive Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 53Populism Could Cause ##br##Profit Margins To Mean Revert Populism Could Cause Profit Margins To Mean Revert Populism Could Cause Profit Margins To Mean Revert These trends have significant implications for investors. The shift to populist politics is likely to be inflationary, as governments increasingly fall back on stimulative fiscal policy. A faster rise in wages will hurt corporate profit margins which, in the U.S., are likely to mean-revert from their current near-record highs (Chart 53). The popular discontent (and the growing unreliability of opinion polls) will make election results more unpredictable, as witnessed in the Brexit vote and the U.S. presidential election. A further pullback in global trade will hurt exporting sectors and export-dependent countries. All these factors lead to the conclusion that returns from investment assets over coming years are likely to be lower, and volatility higher, than has been the case over the past 40 years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com 1 Money And Investment Profits, A. Hamilton Bolton, Dow-Jones-Irwin Inc, 1967, pp74, 304. 2 For our most recent detailed analysis of this, please see BCA Special Report, "The End Of The Debt Supercycle, An Update," dated May 11, 2016, available at reports.bcaresearch.com 3 Please see, for example, Summers' article in Foreign Affairs, "The Age of Secular Stagnation," dated February 15, 2016. 4 Please see, for example, Rogoff's article, "Debt Supercycle, not secular stagnation," Centre for Economic Policy Research, dated April 22, 2015. 5 Please see, for example, Emerging Markets Strategy Special Report, "Gauging EM/China Credit Impulses," dated August 31, 2016, available at ems.bcaresearch.com 6 Please see, for example, her book Technological Revolutions and Financial Capital, published in 2002. 7 Please see Alasdair Nairn, "Engines That Move Markets," Wiley, dated January 4, 2002. 8 Measured either over the whole period, or between the dates that they were listed during the period. 9 Please see The Bank Credit Analyst, "Human Intelligence And Economic Growth," March 2013, available at bca.bcaresearch.com. 10 Please see Emerging Markets Strategy Weekly Report, "EM Equities: Downgrade To Underweight," dated April 20, 2010, available at ems.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "Stay The Course: EM Risk - DM Reward," dated January 23, 2014, available at gps.bcaresearch.com. 12 Please see Mearsheimer, John "The Tragedy Of Great Power Politics," New York: W.W. Norton & Company (2001). 13 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-Exit?," dated July 13, 2016, available at gps.bcaresearch.com, and BCA The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014. 15 Please see Branco Milanovic, "Global Inequality: A New Approach for the Age of Globalization," Harvard University Press, 2016. 16 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com.

Highlights Trump is adding stimulus and potential rigidities to the U.S. economy as the labor market slack vanishes. This evocates the 1970s and stagflation. This risk could resonate among investors as there are enough similarities with the late 1960s / early 1970s. But as well, crucial differences greatly reduce the likelihood of such a scenario. Ultimately, the Fed holds the key. If the Fed stays behind the curve for too long, inflation will emerge. Our bet is that the Fed will not fall behind the curve significantly. On a cyclical basis, the dollar will remain strong and the yen will underperform massively. Feature On November 11 we argued that the first round effect of a Trump victory would be to boost an already improving U.S. economy, giving the Fed more reason to increase interest rates faster than was priced in by markets.1 However, we did conclude our economic assessment of Trump by highlighting the potential for a dangerous outcome: "In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day." What will be the nature of this payback? Goosing up the economy as the U.S. approaches full employment evokes the inflationary policies of the late 1960s and early 1970s. Back then, the Vietnam War caused the Federal government deficit to increase while economic slack was limited. Stagflation ensued. While this parallel is appealing, it is also too simplistic. Trump's policies will be inflationary, but, key structural factors will prevent the fiery inflationary inferno that engulfed the 1970s. Policymakers will need to be careful, however, because while stagflation and the 1970s are only distant risks today, a Pandora's box is being opened. The Similarities The first similarity between the late 1960s / early 1970s is that Trump promises to inject stimulus exactly as the economy hits full employment. When President Johnson increased the U.S.'s involvement in Vietnam, the U.S. output gap was already closed. The result of this fiscal stimulus was to create excess demand. This excess demand not only put upward pressure on wages and prices, but also caused the U.S. current account deficit to balloon. Trump wants to cut taxes by US$6.2 trillion, as expected by the Tax Policy Institute. Before November 8, the labor market had already tightened and wage growth was already accelerating (Chart 1). Stimulating in this context could unleash potent inflationary forces. The second similarity to Vietnam-era stagflation is that Trump's fiscal stimulus will materialize as monetary policy remains easy. By 1969, U.S. real short rates were already hovering near 0%, and were negative for three years between 1974 and 1977 (Chart 2). Today, we are also experiencing deeply negative real rates. However, back then these easy monetary conditions were being felt at the tail end of a multi-decade boom. Today, they reflect the aftermath of a financial crisis that has greatly increased the demand for precautionary savings and depressed the private sector's appetite for credit. Chart 1Tightening Labor Market Tightening Labor Market Tightening Labor Market Chart 2Similarity: Low Real Rates Similarity: Low Real Rates Similarity: Low Real Rates The third parallel comes from the liquidity on bank balance sheets. Today, as was the case in the late 1960s and early 1970s, banks are flush with liquid assets (Chart 3). Thus, banks have the fuel to aggressively lend and create money. Outside of banking crises, the willingness of banks to lend is often closely correlated with the demand for loans.2 Both respond to the same economic shocks, whether positive or negative. After the 1970 recession, the Fed eased aggressively, and business investment rebounded quickly. Today, Trump's fiscal reflation could revive animal spirits in a similar fashion. In both instances, banks have the wherewithal to support growing capex and loan demand. Another troubling resemblance is the illiquid state of household balance sheets. Today, household liquidity represents as small a share of disposable income as it did in 1970 (Chart 4). In fact, compared to total liabilities, household liquidity remains in the lower end of the historical distribution. Why does this matter? Chart 3Similarity: Bank Liquidity Similarity: Bank Liquidity Similarity: Bank Liquidity Chart 4Similarity: Household Illiquidity Similarity: Household Illiquidity Similarity: Household Illiquidity Under this set of circumstances, households will have a higher political tolerance for inflation. Except for the rich, the average household has little to lose from inflation, especially if the rise in prices emanates from an over-stimulated labor market. Inflation does decrease the real value of household liquid assets, but it does the same thing to their much larger debt burdens. The large increase over the past 30 years in U.S. income inequality only reinforces these dynamics (Chart 5). Chart 5Growing Inequalities Trump: No Nixon Redux Trump: No Nixon Redux The last parallel is the potential for a return to pre-Reagan economic rigidities. Trump has talked about imposing tariffs on global exporters in order "to make America great again." He also mentioned limiting immigration in the U.S. Neither of these promises are clear, and like the fiscal stimulus, they could be greatly dialed back compared to the campaign-trail promises. What would be the impact of such a move away from globalization? Our Global Investment Strategy service argues that the growth impact would be limited. Academic models show that since 1990, only 5% of the increase in global GDP growth can be attributed to deeper trade linkages.3 However, the integration of China in the global supply chain and the expansion of the American labor force through immigration has depressed wages for less skilled U.S. workers. Yet, the emergence of new markets outside of the G10 has boosted profits for U.S. multinationals. This has accentuated income inequality. Meanwhile, the marginal propensity to save of rich households is around 60%, while that of the middle class and the poor sits much closer to zero. Thus, the change in the U.S. income distribution has depressed U.S. consumption by 3% since 1980 (Chart 6). This has created a strong deflationary impact on in the economy. Chart 6Unequal Income Depresses Consumption bca.fes_sr_2016_12_02_c6 bca.fes_sr_2016_12_02_c6 Therefore, if Trump does implement a protectionist and anti-immigration agenda, it would likely put upward pressure on prices by causing both a small inward shift in U.S. aggregate supply as well as from the increase in demand resulting from higher middle class wages (and therefore consumption). Bottom Line: Today, like in the late 1960s / early 1970s, five conditions are present to lift inflation: Trump is set to stimulate the economy as it is hitting full employment; Monetary policy is extremely accommodative; Banks have plenty of liquidity to fuel any resurgence in excess demand; household balance sheet make them politically friendly to inflationary dynamics; And by moving away from globalization and immigration, Trump may add further fuel to any inflationary developments The Differences While there are troubling parallels between Trump and the 1970s, key differences could prove to be just as important if not even more so than the similarities. The first difference between now and then is the structure of the labor market. Unionization rates have collapsed from 30% of employees in 1960 to 11% today. The accompanying fall in the weight of wages and salaries in national income demonstrates the decline in the power of labor (Chart 7). Without this power, it is much more difficult for household income to grow as fast as it did in the 1960s and 1970s. In conjunction, cost-of-living-adjustment clauses have vanished from U.S. labor contracts (Chart 8). Hence, the key mechanism that fed the vicious inflationary circle between wages and prices is now extinct. Chart 7Difference: Labor Has Lost Its Power Difference: Labor Has Lost Its Power Difference: Labor Has Lost Its Power Chart 8With No Bargaining Power, Concessions To Labor Ceased... Trump: No Nixon Redux Trump: No Nixon Redux Second, the broad capacity utilization picture could not be more different than in the 1970s. In 1970, the U.S was at the tail end of a decade of strong cyclical spending, which was powered by consumer durable-goods purchases, not by capex and capacity growth (Chart 9). In fact, the stock of fixed assets as a percent of GDP is much higher today than it was back then, pointing to excess capacity in the system, at least relative to the 1970s (Chart 10). Chart 9Difference: Cyclical Spending Difference: Cyclical Spending Difference: Cyclical Spending Chart 10Difference: Capital Stock Difference: Capital Stock Difference: Capital Stock Corroborating this image, capacity utilization remains quite low by historical standards. Interestingly, this series continues to hold good explanatory power for inflation (Chart 11). While a Trump stimulus would cause this measure to perk up, and for deflationary risk to vanish, we are nowhere near levels associated with a major inflation outbreak. Chart 11Difference: Capacity Utilization Difference: Capacity Utilization Difference: Capacity Utilization Even when we look at capacity in the labor market, the picture is once again markedly different. Today, unemployment is only beginning to flirt with its equilibrium after nearly nine years of deep labor market slack. In contrast, by the late 1960s, the unemployment gap had been negative for seven years. It barely moved into positive territory during the 1970 recession and only surged higher after 1974 (Chart 12). This was a very inflationary labor market. Mirroring the U.S., global capacity utilization is depressed and the rest of the world remains a deflationary anchor (Chart 13). In the late 1960s and early 1970s, non-U.S. inflation was just as high as U.S. inflation, as global capacity was tight and global money growth was strong. Today, heavy capex in EM means that despite a sharp slowdown in DM investment after 2000, global capex has remained at 25% or so of global GDP - a very high level compared to history - for 7 out of the last 10 years. Chart 12Difference: Labor Market Difference: Labor Market Difference: Labor Market Chart 13Global Capacity Utilization Is Low Global Capacity Utilization Is Low Global Capacity Utilization Is Low Third, in the 1960s and 1970s, animal spirits were running wild. Despite growing government deficits and rising borrowing costs, the crowding out of the private sector never materialized (Chart 14). This was a testament to the optimistic belief of the era, a belief fed by the resilience of the economy since 1950, as well as by the implicit support created by decades of Keynesian policies. Today, fiscal stimulus and rising consumer spending could resurrect animal spirits. However, this would be a nascent phenomenon, not a multi-decade one, implying a very different set of expectations for investors, consumers, and business than in the late 1960s / early 70s. Fourth, the monetary picture is very different. Today, both the money multiplier and money velocity are extremely depressed, a sign that monetary constipation still defines our age. In the 1960s and 1970s, money velocity and the money multiplier were both elevated or experiencing sharp upturns (Chart 15). This is why low real rates of that era did translate into accelerated economic activity and inflation, unlike the uninspiring effects of low rates or QE programs today. Chart 14Raging Animal Spirits Raging Animal Spirits Raging Animal Spirits Chart 15Difference: Monetary Backdrop Difference: Monetary Backdrop Difference: Monetary Backdrop Finally and most crucially, the rising inflation of the late 1960s only mutated into genuine stagflation after the economy was hit by a massive supply shock: the 1973 oil embargo. In the wake of the Yom Kippur War, OPEC tripled the price of oil - the commodity powering the modern economic machine. Global capacity utilization was already tight, but this shock created a massive inward shift in global aggregate supply, ratcheting aggregate price levels higher while hurting aggregate output (Chart 16). But the true coup de grace only emerged when fiscal and monetary authorities massively eased policy in response to this shock: The U.S. federal deficit skyrocketed from 2.3% of GDP in 1974 to 8% in 1975 and short rates fell from 8.9% in 1974 to 4.9% in 1976. This boosted aggregate demand back to its original level, but with sharply more elevated price levels (Chart 16). Chart 16Mechanics Of A Supply Shock Trump: No Nixon Redux Trump: No Nixon Redux Today, we have seen oil prices collapse by 56% since 2014 in response to a positive supply shock, and global capacity utilization is low. Thus, while fiscal stimulus could push aggregate price levels upward as it lifts aggregate demand, the effect on inflation should prove much more muted than when such policies are implemented in the face of a supply shock. Bottom Line: Important similarities exist between the potential effect of Trump's suggested policies and the economic environment of the late 1960s / early 1970s. However, five structural and cyclical differences suggest that Trump is not bound to recreate stagflation: The de-unionization of the labor force has removed its pricing power, capacity utilization is now infinitely more benign than back then, animal spirits are only recovering today while they were running wild in the late 1960s / early 1970s, the monetary environment backdrop is also much less inflationary, and finally, we are not experiencing the kind of supply shock and mistaken policy response that hit the world in the wake of the 1973 oil embargo. Question Marks Key to the outlook is the Fed itself. Trump's policies will put upward pressure on prices. However, the Fed continues to avoid committing to a tighter policy path beyond this December. The Fed has good reasons to do so: Trump has offered the world no clarity regarding his actual plans while in office. With little labor market slack, any stimulus is inflationary; how inflationary will be a function of the details. So should be the Fed's response. For inflation to truly emerge in the system, the Fed will need to keep policy easy even as Trump's plans become clearer. In the 1970s, a too-easy Fed spurred excess demand that lifted inflation and inflation expectations. Moreover, if the Fed had not cut rates as aggressively as it did in 1974 - a policy that boosted demand but that did nothing to compensate for the shortfall in aggregate supply - the inflationary shock from the oil embargo should have proven much more transitory. The Fed's recent talk of a "high-pressure" economy evokes a repeat of the 1970s mistake. However, there is no guarantee that this error will be repeated. For one, the references to a "high-pressure" economy predated the Trump victory. Second, fiscal stimulus is what the Fed has wanted for a long time. Trump is giving the FOMC the cover they have needed to do what they have tried to do since 2014: increase rates. Finally, inflation expectations are beginning to move upward. This is what the Fed needs to push interest rates higher. Moreover, this is happening as long-term inflation expectations begin decoupling from oil prices (Chart 17). This is important as it suggests that the economy is gaining traction and that markets are starting to anticipate a lift off from the zero lower bound. Thus, while we think a lagging Fed is a risk, it is not currently our base-case scenario. The second question mark is the dollar. One of the key factors that prompted the dis-anchoring of inflation and inflation expectations in the early 1970s was the suspension of the dollar's convertibility to gold in August 1971. This unleashed a period of weakness for the greenback that culminated in a 30% devaluation by 1980 (Chart 18). Moreover, a weak dollar fueled the commodity bull market. Chart 17The Fed Must Enjoy This The Fed Must Enjoy This The Fed Must Enjoy This Chart 18The Dollar Added To Inflation The Dollar Added To Inflation The Dollar Added To Inflation Today, the dollar is strong and expensive, creating a deflationary anchor in the U.S. economy. Our expectations that the Fed will not fall behind the curve once the nature of the Trump stimulus becomes clearer would re-inforce this trend. However, a failure by the Fed to tighten monetary policy appropriately, leaving the U.S. central bank behind the curve, would have a negative impact on the dollar. Not only would it put downward pressure on real rate differentials between the U.S. and the rest of the world, but it would also depress the PPP fair value of the dollar by increasing domestic inflation. Bottom Line: The two key swing factors are the Fed's policy response and the dollar. In the late 1960s / early 1970s, the Fed kept policy too easy. Not only did this greatly fan the underlying inflationary dynamics that were already present in the economy, but it also created a very negative environment for the dollar, prompting the end of the dollar peg in August 1971. This further lifted inflation in the economy. The Endgame And Investment Conclusion Given all these conflicting forces, how will this experiment end? Pure stagflation with late 1970s-style inflation is out of the picture. However, inflation of 4% to 5% is very possible, but it could take time to show up in the data. In the 1960s, it took U.S. inflation until mid-1968 to hit 4%. By that time, the output gap had been positive for around 5 years, hitting 6% of GDP in 1966 (Chart 19). Unemployment had been below its equilibrium rate since 1963, and by 1968 was 2.5% below NAIRU. Chart 19No Slack In The 1960s No Slack In The 1960s No Slack In The 1960s This suggests that unless the Fed falls significantly behind the curve, even 4% inflation may take a long time to emerge this cycle. However, inflationary risks will grow considerably after the next recession. We do not know when this recession will happen, but we know what the result will be: more policy easing. It took until the 1970 recession and the associated policy boost to genuinely dis-anchor inflation expectations in the U.S. Today, an easing in policy and an associated fall in the dollar are likely to be the key criteria to generate real inflation risk in the U.S. As for currency implications, the lack of an inflationary outburst along with a responsible Fed will continue to support the dollar and hurt precious metals. In terms of exchange rates, USD/JPY should perform particularly well. The Japanese economy is near full employment and the Abe administration also is talking about additional stimulus. Yet, while the Fed will not stay behind the curve for long, the BoJ is explicitly aiming at staying behind the curve. This is a recipe for a higher dollar/yen on a 12-18 months basis. The euro is likely to continue to weaken as there remains more slack in the euro area than the U.S. However, this slack is diminishing and the ECB would respond to its disappearance, which implies that EUR/USD has less downside than the yen on a 12-18 months basis. Commodities are unlikely to repeat their amazing performance seen in the 1970s. Thus, commodity currencies should continue to suffer from dollar strength. The pound will be dominated by its own set of dynamics. While the probability of a soft Brexit has been growing ever since the High Court's ruling was issued, the appeal decision still needs to be made. Moreover, headline risk remains very elevated. Thus while valuation argues in favor of GBP, buying GBP today is a high-risk gamble. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 William F. Bassett, Mary Beth Chosak, John C. Driscoll, and Egon Zakrajsek, "Changes In Bank Lending Standards And The Macroeconomy," Journal of Monetary Economics 62 (2014): pp. 23-40. 3 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization", dated November 25, 2016, available at gis.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades