Global

Highlights Global Growth: If global demand follows the recent improvements seen in economic sentiment, growth will surprise positively relatively to expectations in 2017. With global inflation also likely to continue drifting higher over the course of the year, the medium-term bearish implications for bonds are clear. Duration Technicals: Government bond markets remain technically stretched, as the bearish positioning from late 2016 is still intact. Combined with price momentum measures that have barely corrected from oversold extremes, yields are not quite ready to resume their ascent. It is too soon to reduce portfolio duration exposure to position for the higher yields that we expect this year. Canada: The Canadian economy has shown clear signs of improvement of late. This trend can continue in the first half of 2017, thus we are closing our short Canadian corporates/long Canadian provincial debt trade and entering a new position - shorting Canadian 10-year government bonds versus 10-year U.S. Treasuries. Feature Chart of the Week Post-Truth: relating to or denoting circumstances in which objective facts are less influential in shaping public opinion than appeals to emotion and personal belief. - Oxford Dictionary Oxford voted that term, "post-truth", as the 2016 international word of the year. That is not a surprise, as the two dominant news stories of the past twelve months, Brexit and Trump, represented triumphs of hot emotional arguments over cold hard facts. Pessimists may argue that what we are currently seeing in the U.S. is a "post-truth" economic upturn, where confidence is soaring in expectation of the potential positive impact from Donald Trump's proposed pro-business agenda, but without a corresponding boost in actual growth. Financial markets appear to have already discounted a more rapid pace of growth, as evidenced by the surge in government bond yields in November/December and sharp outperformance of economically-sensitive asset classes like equities and high-yield (Chart of the Week). We do expect growth to deliver some upside surprises in 2017, putting additional upward pressure on government bond yields and downward pressure on credit spreads. In the meantime, however, markets need to consolidate the recent moves while the hard economic data catches up to booming sentiment. This leads us to maintain a cautious tactical investment stance, both towards duration exposure and credit allocations, while looking for more attractive levels to position for the improving global growth dynamic in 2017 by re-establishing below-benchmark duration positions and increasing corporate bond exposure. Real Growth Or Fake News? In our previous Weekly Report, we discussed how improving U.S. business confidence within the corporate sector could lead to a revival of capital spending after three years of decline.1 Not all of this is attributable to the "Trump effect", though. Global leading economic indicators were already starting to tick upward even before the U.S. election, while actual data in the major economies was surprising to the upside. This suggests that some pickup in global growth is likely in the next few quarters which would put additional upward pressure on the real component of government bond yields (Chart 2). Growth forecasts remain subdued, however, even with the recent bump in sentiment. The Bloomberg consensus expectation for real global GDP growth in 2017 is 3.2%. The International Monetary Fund is slightly more optimistic, projecting growth of 3.4% in 2017 but with only 2.3% growth in the U.S. (this is an updated forecast released yesterday, so after the U.S. election). Central bank growth forecasts at the country level are also relatively downbeat; for example, the Fed is expecting U.S. growth of only 2.1% in 2017 while the European Central Bank (ECB) is projecting Euro Area growth of 1.7%. Given the relatively high level of uncertainty over the potential effects of the incoming Trump administration's economic agenda, it is no surprise that professional forecasters are being cautious as they wait for the details to unfold. Yet while improving sentiment among consumers and businesses does not guarantee a faster pace of economic growth in the absence of rising household incomes and healthier corporate profits. However, greater confidence (i.e. "animal spirits") is often a prerequisite before a cyclical upturn can blossom, turning "post-truth" sentiment into a true recovery. Looking at the data among the major economic regions shows that, if the confidence indicators are to be believed, then global growth could deliver some upside surprises this year: United States: Consumer confidence is soaring, with the Conference Board measure reaching an 8-year high at the end of 2016. The December reading for U.S. National Federation of Independent Business (NFIB) survey released last week showed a similar spike in confidence among U.S. small businesses, with capital expenditures, hiring plans and overall optimism returning to levels not seen since before the Great Recession (Chart 3). This is a similar move to the strong confidence data for corporate CEOs that we presented in last week's report. Chart 2A Cyclical Upturn In Growth & Yields Chart 3U.S. Economic Confidence Improving Euro Area: Euro Area sentiment measures, such as the European Commission confidence surveys or the widely-followed German IFO and ZEW indices, hooked upward at the end of 2016 (Chart 4). Both household and business confidence improved, underscoring how the current cyclical upturn in the Euro Area is broad-based. Japan: While Japan should not be expected to be a major contributor to overall global growth given its well-known structural economic impediments (contracting population, weak productivity, high government debt, etc), the most recent data does show a slight uptick in consumer confidence, business confidence and the Japan leading economic indicator (Chart 5). Chart 4A Solid Uptick In Euro Area Confidence Chart 5Japanese Sentiment Inching Higher Chart 6Upside Risks For Chinese Growth? China: Both consumer and business confidence have improved alongside the cyclical Chinese recovery seen in 2016, but this has not been enough to boost consensus forecasts for Chinese growth this year. Importantly, this creates the possibility of an upside growth surprise as both the OECD leading indicator for China and the proprietary GDP growth model from our colleagues at BCA China Investment Strategy are calling for faster growth in 2017 (Chart 6).2 A potential increase in trade or even military tensions between China and the U.S. is a potential risk to this sunny scenario but, given what we know now about the underlying economy, China looks poised to deliver another year of solid growth. The data does show that the improvement in economic sentiment goes beyond what is happening in the U.S. Some of that could be the spillover effect from greater optimism on the Trump-fueled U.S. economy to the rest of the world. The synchronized uptick in global leading economic indicators, however, suggests that there is more going on than a simple post-election hope that Trump can deliver faster U.S. growth. A genuine synchronized global upturn is underway, which is not "fake news" (which we expect will be the Oxford word of the year in 2017!) Bottom Line: If global demand follows the improvements seen in economic sentiment, growth will surprise positively relative to expectations. With global inflation also likely to continue drifting higher over the course of 2017, the bearish implications for bonds are clear. Bond Market Technicals Have Not Moved Much Normally, such a growing body of evidence pointing to improving global economic sentiment would be a bearish development for bond prices. Fixed income markets have already moved very rapidly, however, to discount a more optimistic outlook for growth. The rise in yields over the final two months of 2016 has left the major sovereign bond markets in a highly stretched position. This was one of the reasons we shifted our recommended duration stance from below-benchmark to neutral in early December.3 Looking at technical indicators such as the deviation of 10-year government bond yields from their 200-day moving averages, or momentum measures such as the 26-week total return for the sovereign bond indices, show that bonds remain deeply oversold in the main "G-4" markets: the U.S. (Chart 7), Germany (Chart 8), the U.K. (Chart 9) and Japan (Chart 10). Chart 7UST Technicals: Stretched Chart 8German Bund Technicals: Stretched Chart 9U.K. Gilt Technicals: Stretched Chart 10JGB Technicals: Stretched In the case of U.S. Treasuries, indicators of market positioning suggest that most traders have not unwound their bearish bets. The Commitment of Traders report shows that speculators currently have the largest net short position in Treasury futures in the history of the data. Meanwhile, the Market Vane index of Treasury sentiment has bounced slightly off the recent lows, but remains at generally downbeat levels (Chart 11) - and still above the levels that heralded prior peaks in yields in 2010, 2013 & 2015. Only the JPMorgan duration survey has shown a closing of net short positions for the more "active" trader base, but not for the overall set of bond investors. We will continue to monitor these positioning and momentum indicators in the weeks ahead to assess when the oversold market conditions have unwound enough to justify a shift back to a below-benchmark duration stance. For now, keep portfolio duration exposure at benchmark. Bottom Line: Government bond markets remain technically stretched, as the bearish positioning from late 2016 is still intact. Combined with price momentum measures that have barely corrected from oversold extremes, yields are not quite ready to resume their ascent. It is too soon to reduce portfolio duration exposure to position for the higher yields that we expect this year. Encouraging Signs From Canada Last October, this publication laid out a sobering view on the Canadian economy.4 Softening exports were a concern, especially in the non-commodity related sectors and even with a weaker Canadian dollar. Growth in corporate capital spending growth was still contracting, constrained by tight lending conditions. Moreover, household consumption appeared at risk, given the depressed labor force participation rate and low wage increases. This view led us to adopt: a neutral stance - but with a positive bias - on Canadian bonds versus global hedged benchmarks; a slightly more dovish view then the consensus on the next monetary policy move by the Bank of Canada (BoC), not discarding the possibility of a rate cut in 2017 and; a short position on Canadian corporates versus Canadian provincial government debt. Since then, however, the Canadian economic cycle has taken a positive turn. The euphoria surrounding Trump's economic plan for Canada's largest trading partner has definitely prompted some of the improvements. The enthusiasm towards possible pro-business American economic policies seems to have seeped into Canadian business owners' mindset as well (Chart 12). Chart 11UST Positioning Still Very Short Chart 12Trump Is Also Influencing Canada's Mood But there is more to it than that. First, employment data have firmed up. The net change in Canadian employment has been positive in each of the last five months, increasing on average by a robust 47.5k. The previously declining labor force participation rate has stabilized, posting a 65.8% reading in December versus the July low of 65.3%. Plus, more jobs have been created in the private sector versus the public sector and in more stable "regular" employment rather than self-employment (Chart 13). Second, the business sector's mood has brightened. According to the BoC's Winter Business Outlook Survey, sales expectations, investment plans and employment intentions are all recovering.5 More striking, firms' pricing power has jumped higher; prices of products and services sold are expected to increase substantially in the next twelve months (Chart 14, top panel). Better pricing power should help Canadian corporate profits, going forward. Chart 13Employment Firming up Chart 14A Business Cycle Reversal? Chart 15Exports Perking Up This, combined with better credit conditions, could potentially turn the Canadian economic cycle around. Real capital expenditure has been the big missing ingredient to a healthy economic expansion in the last few years. This is about to change as the BoC's Senior Loan Officer survey shows that Canadian bank lending conditions re-entered "easing" territory in Q4 2016 (Chart 14, bottom panel).6 Looser credit conditions usually lead to faster loan growth and stronger investment spending. Third, better sentiment globally, and especially in the U.S., has lifted demand for Canadian products, with growth for both commodity and non-commodity-related exports showing improvement in the last quarter of 2016. While higher commodity prices have certainly boosted commodity-related exports, improving U.S. consumer confidence suggests that Canadian goods exports numbers will perk up in the coming months (Chart 15). Fourth, Canadian housing prices could still grind higher for a while longer and a broad retrenchment in the construction sector might be avoided again in 2017. Granted, the backdrop remains quite risky given high prices and soaring household debt levels. According to the BoC, about 15% of high loan-to-income mortgages issued in 2016 would have been ineligible under the new regulatory framework for allowable mortgage lending.7 Hence, the construction sector will face some headwinds going forward as some new mortgage loans will be harder to come by, on the margin. However, it is not a given either that housing affordability (or lack thereof) has reached peak levels yet (Chart 16).8 Lately, the housing market has held up relatively well, despite the regulatory tightening measures put in place to reduce the systemic risks from overvalued Canadian real estate. New house prices grew at a 3% year-over-year rate in December - the fastest pace in four years - while housing starts have averaged 198k in the last twelve months, surpassing the levels seen during the previous three years. In sum, the Canadian economy has performed better than we previously expected. As such, we remain open to the idea that it could continue in that vein over at least the first half of 2017. That said, our optimism remains guarded. The health of the Canadian non-financial, non-energy corporate sector has been deteriorating over the last two years, limiting the potential for the kind of revival of animal spirits that we are seeing in the U.S. Plus, the cyclical data for Alberta - Canada's fourth most important province - remains moribund. A more robust expansion in that province would be necessary to solidify our conviction level towards the strength of the overall economy. Chart 16Not That Unaffordable Chart 17No Inflation On The Horizon Canada remains fragile; consumer indebtedness levels are elevated by international standards. Accordingly, this economy remains a hiccup away from disappointing in the event of an external shock. A global equity market correction, softer oil prices, a reversal in the latest Chinese reflationary push, a Trump geopolitical blunder and/or a move toward more trade protectionism in the U.S. (especially concerning NAFTA9) could negatively impact Canada at any moment - and in a much bigger fashion compared to most other developed economies. As such, the BoC will be prudent and probably stay on hold in 2017. Inflationary pressures are simply not strong enough to justify turning hawkish. Unemployment at 6.9% remains close to half a percentage point away from full employment levels.10 Our Canadian weekly earnings diffusion index is pointing to lower wage pressures, as well (Chart 17). The 30% probability of a rate hike by year-end currently discounted in the OIS market could easily be priced out if inflation remains subdued. Nonetheless, we have to acknowledge the improving backdrop in our portfolio recommendations: we are choosing to close our trade, shorting Canadian corporates versus Canadian provincial debt, at a loss of -53bps. The defensive characteristics of that trade, which also incurs negative carry, now appear less appealing, especially considering the global "risk on" environment currently in place. For now, we are maintaining our neutral stance on Canadian bonds in our global model portfolio, with Canada unlikely to see the same degree of upside inflation pressures that we expect in the other developed economies. However, we are opening a tactical trade, shorting Canadian government bonds versus U.S. Treasuries at the 10-year maturity. From a historical stand point, Canadian yields are very low compared to the U.S., offering an interesting entry point. In addition, the Canada-U.S. employment ratio and the price ratio of Brent oil to lumber - which have been broadly correlated to the Canada-U.S. spread over the years - are both hooking up, pointing to a wider Canada-U.S. spread and representing an interesting macro signal (Chart 18). U.S. inflation prospects add to this trade's attractiveness. Our colleagues at BCA U.S. Investment Strategy recently made a compelling case for U.S. inflation not being a major threat in 2017 after assessing the prospects for the main components of U.S. core PCE inflation (shelter, core goods and core services).11 Core PCE should converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot beyond that is not the base case (Chart 19). That could allow Canadian bonds yields to catch up to higher U.S. yields, especially if the oversold conditions in the U.S. Treasury market described earlier persist. Chart 18Go Short Canadian Bonds Versus U.S. Treasuries Chart 19Only A Mild Uptrend Is Likely In 2017 Bottom Line: The Canadian economy has shown clear signs of improvement of late. This trend can continue in the first half of 2017, thus we are closing our short Canadian corporates/long Canadian provincial debt trade and entering a new position - shorting Canadian 10-year government bonds versus 10-year U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "4 Big Questions For Bond Markets In 2017", dated January 10, 2017, available at gfis.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, available at cis.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Vigilantes Take A Break For The Holidays", dated December 6, 2016, available at gfis.bcaresearch.com 4 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Bear Phase Continues", dated October 11, 2016, available at gfis.bcaresearch.com 5 http://www.bankofcanada.ca/2017/01/bos-winter-2016-17/ 6 http://www.bankofcanada.ca/wp-content/uploads/2017/01/slos-winter2016.pdf 7 http://www.bankofcanada.ca/2016/12/fsr-december-2016/ 8 A description of the Bank of Canada Housing Affordability Index can be found at http://credit.bankofcanada.ca/financialindicators/hai 9 NAFTA (the North American Free Trade Agreement) is a treaty between Canada, the United States, and Mexico aimed at removing trade barriers and encouraging economic activity. 10 NAIRU stands at 6.5% 11 Please see BCA U.S. Investment Strategy Weekly Report, "Inflation In 2017: An Idle Threat", dated January 9, 2017, available at usis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

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

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

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

Special Report

Future Development In Emerging Markets And What Sectors To Look Out For1 The global population is peaking. For Emerging Markets this means significant changes in economic development models. Commodity super-cycles are coming to an end and technological development will become more disruptive for the "old economy". Global growth will be driven by emerging and frontier markets and the accelerated speed of development will ensure leaps in technology and changes in the demographic structure of the workforce in countries that are catching up. The human population in different historic periods totalled roughly the same number, ten billion people. Periods of historic and economic development are becoming shorter. Until recently demographic growth was assumed to be exponential, but in reality it follows a hyperbolic curve, very slow in the beginning and rising faster as it approaches infinity. Growth cannot continue to infinity and models explaining tail events of the growth trajectory are of particular interest. Signs of a slowdown are apparent as humankind is approaching a global population of ten billion. The global growth model is shifting from a quantitative to a qualitative approach, with information and speed of information exchange becoming the determining factors for development. "The sciences do not try to explain, they hardly even try to interpret, they mainly make models. By a model is meant a mathematical construct which, with the addition of certain verbal interpretations, describes observed phenomena. The justification of such a mathematical construct is solely and precisely that it is expected to work - that is correctly to describe phenomena from a reasonably wide area. Furthermore, it must satisfy certain aesthetic criteria - that is, in relation to how much it describes, it must be rather simple". John von Neumann The purpose of describing the model framework in this paper is first of all to provide investors with a glimpse into our long-term investment philosophy and the way we try to think about future developments. We like the framework described below, because of the good fit to reality that it has shown. Considering that the initial parts of the theory were developed in the 1980s, the model accurately predicted many events we are witnessing now. Furthermore, we hope to achieve a certain degree of predictability of future events, and lay out scenarios for how these events might affect investors. This might stimulate modelling and the thought-process. We are not advising changes in investment policy based on this, but rather invite the reader to a dialog about scenario analysis. In the end, as with every theory or model, everybody is entitled to their own views and, in this academic spirit, we welcome ideas of how to develop the framework further and apply it to different areas. Modelling Of Demographic Growth "The main difference of a human being to an animal is the desire for knowledge and the capacity to reason". Aristotle The most cited theory on demographic growth was formulated by English cleric and scholar Thomas Malthus in 1798.2 The theory later became known as the Malthusian growth model and argued that the world population is growing exponentially: P (t) = P0e rt Where P0 is the initial population size, r is the population growth rate and t is time. In essence the theory suggests that the rate of population growth increases with the number of people living on the planet, while the main constraint for growth is the scarcity of resources (Chart 1). With time it has become obvious that the human population is not evolving according to the rules applicable to all other animal species, and that the Malthusian growth model does not describe the growth trajectory correctly (Chart 2). For example, humankind represents the only exception to the inverse relationship rule between the body mass of an animal species and its population size (lower body mass equals larger population).3 Chart 1Malthusian Growth Model ##br## For The World Population Chart 2Malthusian Growth Model Vs. ##br## Actual Population Growth In 1960, von Forester, Mora and Amiot, and later Hoerner in 1975,4 demonstrated that population growth is much better described by a hyperbolic growth function5 - very slow in the early stages and exploding as we approach the present day (Charts 3A & 3B). In other words the growth-momentum relationship is not dependant on the number of people, but rather on the number of interactions between those people (the so-called "second order reaction" in physics or chemistry). Chart 3AHyperbolic Growth Function Vs. Malthusian Growth Model ##br## And Real Population Growth Chart 3BExamples Of Linear, Exponential ##br## And Hyperbolic Growth Further research tried to connect the population growth model to the economic growth function and understand where the trajectory of population growth is going.6 For example, Nielsen7 (2015) makes the assumption that the world population is going through a demographic transition process (the third in the world's history) from the latest hyperbolic trajectory to a yet unknown trend. One interesting theory was developed by Russian physicist and demographer Sergey Kapitsa (1928 - 2012). Sergey Kapitsa was the son of Nobel laureate physicist and Cambridge professor Petr Kapitsa. Being a physicist himself, Kapitsa applied physical principles to explain population growth in the perspective of the whole planet, and concentrated on the changing phases of growth at the tails of the hyperbolic curve. "Only Contradiciton Stimulates The Development Of Science. It Should Be Embraced, Not Hidden Under The Rug". Sergey Kapitsa In his work to explain population growth, Kapitsa applied methods developed in physics to describe systems with many particles and degrees of freedom.8 Kapitsa saw an advantage in the complexity of the world population, as it would allow a statistical approach to the solution of the problem, averaging out all temporary processes. Kapitsa found several constraints in the simple hyperbolic growth model, occurring at the tail ends of the trajectory. The hyperbolic model would assume that at the beginning of time, approximately 10 people would have inhabited the planet and would have lived for a billion years. At the same time, approaching 2025 our population is due to double each year. To solve these tail problems, Kapitsa introduced a so-called "cut-off growth rate", to tackle growth in the very early stages of humankind, and a "cut-off time" constant. This led to the population growth formula: dN/dt = N 2/K 2 Chart 4World Population Growth This states that "growth depends on the total number of people in the world N, and is a function - the square - of the number of people, as an expression of the network complexity of the global population".9 Furthermore, the "growth rate is limited, that is to say by the internal nature of the growth process, not by the lack of external resources" (Chart 4). The easy way to understand the population growth relationship is to think about it the following way - if each BCA client would write an investment advice letter to all the other BCA clients, the total number of letters written would be equal the square of the number of clients. Kapitsa also formulated three periods in the development of humankind: "Epoch A", which began 4.4 million years ago and lasted 2.8 million years. This period was characterized by linear growth of the population. "Epoch B", which included the Palaeolithic, Neolithic periods and up to recent history and lasted 1.6 million years, and growth was hyperbolic (1, 2, 3 on the chart). "Epoch C", which according to Kapitsa's calculations, started in approximately 1965, when the global population reached 3.5 billion people (4 and 5 on the chart) and population growth started to slow globally (Chart 5). Chart 5World Population Growth Rate Is Falling The model was found to be a good connecting medium between a pure mathematical approach to demographics and observations made by palaeontologists, anthropologists and historians. The main conclusions made by Kapitsa are the following: Historical periods are becoming shorter over time. The Palaeolithic period lasted over 2 million years, the Neolithic period lasted "just" 5,000-8,000 years, while the Middle Ages spanned only about 500 years. Time is passing faster, the more complex the global system of interaction becomes. Or, in other words, the larger the world population becomes. Over each historic period, approximately the same number of people have lived on the planet, in the range of 9 to 12 billion. In later papers Kapitsa singles out 10 billion as the exact number (this depends on input parameters in the formula). World population will reach the 10 billion mark before 2060. Growth is determined by social and technological changes and is driven by the number of social and economic interactions within the global system. On a historical timescale, each cycle is 2.5 - 3 times shorter than the previous one, driving the overall growth in population. Information is the controlling factor of growth. Kapitsa equates his population growth model to the economic production function and explains the non-linearity of the function by "information interaction, which is multiplicative and irreversible, and is the dominant feature of the system, determining or rather moderating its growth". Food or other resources are not a constraint factor, as through the whole of history, humankind never actually encountered any constraints in resources which would derail population growth from its hyperbolic trajectory. Humankind is now in a period of demographic transition, where the beginning is the point of most rapid increase of the growth rate (around 1965) and the end is the point of most rapid decrease. On a historic scale this transition is happening in an extremely short period - 1/50,000 of total historical time - while one in ten people who ever lived will experience this period. The rate of transition in this last period is approximately 90 years, which is just a touch longer than the life expectancy in developed countries. Furthermore, changes in the developing world are happening twice as fast as in the developed. And the reason for that is the increase in speed with which we, as human beings, exchange information. Demographic Transition And Implications For The Economy If the demographic transition period is estimated correctly and the population growth trajectory will level off, as the population stabilizes at around 10 billion, the world will face two scenarios. Either we are approaching a zero-growth reality, or development will shift from the usual "quantitative" growth model of the economy (agriculturally and later industrially driven), to a qualitative approach, where the generation and exchange of information will be paramount. This fits very well with the current reality, where we can see both scenarios happening simultaneously. While growth is approaching zero in the developed world, the move to an information-driven society is pronounced in emerging and developed markets alike. The transition period is characterized by a decrease in death rates among the population, followed by a fall in birth rates. At the same time, a surge in wealth levels and standard of living occurs, followed by longer life expectancy as a result (Charts 6A & 6B). These processes are accompanied by urbanization and a shift of the workforce from production sectors to services. Chart 6AGlobal Population ##br## Is Getting Older Chart 6BAge Dependency Ratio ##br## (Old Population % Of Working Population) While this transition has taken decades, and sometimes centuries, in the old world, emerging markets are catching up much faster and the gap in development, estimated by the model, might be not more than 50 years (Chart 7). In fact, we already can observe that the later the transition started, the faster the catch-up period. Kapitsa argues that this narrowing is "due to the nonlinear interaction between countries", or in other words, the increased speed of information transfer. What implications will this have for the global economy and emerging market economies in particular? Chart 7Population Transition, As Described By The Model, ##br## In Different Countries Chart 8Global Economic Growth ##br## Driven By EM And FM Global growth will be driven by emerging and frontier markets for the next decades. Developed countries are already at the final stage of development, where growth will oscillate around zero (Chart 8). The implications of demographics for developed world growth have been studied in a recent paper by the Federal Reserve,10 and so we will not go into too much detail. Investors should be aware that, according to the trajectory suggested by the model, the catch-up period and, hence, the period of high growth, will be shorter for emerging and frontier markets than experienced in the developed world. It is fair to assume that by the time frontier countries move into the "emerging" classification, their period of high growth might be limited to several years to a decade. The model suggests that the period of high GDP growth rates is coming to an end and that investors should be prepared for lower growth for longer. World economy will move to a qualitative focus. Kapitsa argues that humankind will not face any resource constraints, as it never has in the past. Resource constraints are overcome by migration and new technology, while the real issue is in the equal distribution of resources (including wealth and knowledge). As a result, in the coming decades the industrial sector might repeat the destiny of the agricultural sector, as seen in the U.S. and other developed economies (Chart 9). Currently only 2.5 - 3% of the world population are working in the agricultural sector, and this is sufficient to produce food for the world. It can be argued that with the further development of technology, such as 3D printing, the problem of industrial overcapacity will become even more prominent and countries with an industrial focus will face a difficult transition period. China is currently one of the EM countries undergoing such a transition, and we can see how the overcapacity created by the "old economy" is weighing on the performance of the overall economy (Chart 10). Chart 9U.S.: Move Of Working Population ##br## From Agriculture And Manufacturing To Services Chart 10Decline Of The No more commodity super-cycles? This might not be exactly true, but investors need to change the way they look at commodities and resource companies (and materials sector overall) (Chart 11). Long-term projections of supply and demand should resemble or incorporate the population growth function, which will have implications for capital expenditure. We have already seen a shift to acquire more technology rather than focus on the resource base (fields, mines etc.) (Chart 12). Chart 11Commodity Super-Cycles Coming To An End? Chart 12Capex Expenditures In The Oil Sector Are Falling The trend is towards cost-saving technology, rather than betting on higher prices and production volume. From the model's perspective, no resources will ever become scarce enough to drive prices sky high for a long period. It is rather a question of getting the timing right and finding a relative long-term dislocation between supply and demand, rather than playing fundamental "peak" stories. Chart 13South African Mining Vs. ##br## U.S. Shale Oil, ##br## A Striking Difference A good example of a winner in the commodity sector is U.S. shale oil: even after two years of low oil prices many companies are ready to restart production and compete on the market within a short period of time. On the other hand, the once mighty mining sector in South Africa is only a shadow of its former self, since most companies have been chasing quantity (mine expansion) and forgot about quality (extraction methods) (Chart 13). The shift of the workforce from the "old economy" to services. This process is nearly complete in the developed world, while still in full swing in the emerging markets. With an ever-aging population even in emerging markets, social spending will have to increase and new sectors - such as education, healthcare, information technology and leisure - will come into investors' focus. Information Technology. The driver of all progress. Kapitsa suggests that information cannot be treated as a commodity, due to its irreversible nature once shared with other participants. Nevertheless, in the way in which the model determines future progress, there will be surely an ever-growing industry built around information protection. It is also interesting to note that the confusion arising between generations of parents and their children is probably the effect of the ever-growing speed of information generation and exchange, where significant technological shifts are happening within the lifetime of one generation and the old generation finds it hard to keep up. The main outcomes of the appearance of an information-centric society will be the following: Disruption to old industries. We see this all over the place: the oil industry being threatened by renewables, brick-and-mortar retailers by online stores, and the banking industry might be the next victim (Chart 14). If banks fail to adopt blockchain technology into their business model, they might be excluded as an unnecessary middle man. Chart 14Change In The S&P Index Composition 1990 - 2016 Leaps in development stages in countries. Assuming historical periods are getting shorter and information exchange is intensifying, we might see more leaps in development stages in emerging, but especially in frontier, markets. This will become a central part of any research: to identify which countries might be "jumping" one or several stages in their development, and what those stages/industries/products might be. Chart 15Computer Companies Vs. Smartphone Producers In the past 10 years we witnessed several such precedents. One was China skipping the PC stage completely, with the appearance of the broadly affordable smartphone. At the end of the 1990s, tech research would have suggested investing in PC makers, extrapolating growth numbers to the Chinese population. How has this worked out (Chart 15)? Another good example is the banking industry in Africa. Apart from South Africa, which has a rich banking tradition, more and more countries in the region see growing numbers of users in the online banking space. People use their phones for every day banking needs. Many banks do not even have a brick-and-mortar presence. Maybe that is why we see so many established institutions struggling in this part of the world (Charts 16A & 16B). Chart 16AMobile Money Use By Region Chart 16BNumber Of Mobile Money Services In Sub-Saharan Africa Education. The population growth model says that information will be the main growth driver in the future and, as a consequence, education will be the most important process in human life. Education will take up more time and effort than in any other period of human history (Chart 17). Already now, education can last as long as 20 to 30 years. Compare that to the learning period of any animal. In many jobs, we are required to learn for the better part of our working life and take tests, write exams and attend seminars to keep up-to-date with progress in our industry. Healthcare. Probably the most obvious outcome because, as the older generation requires more treatment and care, the whole social system will need to be adjusted. Many countries will be unable to bear this burden financially, and the private sector will have to step in. This is what we have seen in China since 2015 (Chart 18). Chart 17Tuition Fees In The U.S. Are A Large Part Of Inflation Chart 18Healthcare As Proportion Of GDP Leisure and entertainment. Maybe not as large or obvious, but it's one of the industries that will benefit. The younger generation has already made a shift from material values, such as luxury brands, to assigning higher values to experiences and creating memories (Chart 19). The appearance of "experience day" offerings (such as driving a super-car or jumping out of an airplane), shifting shopping patterns, or the growing number of travellers even in emerging markets confirms this view. One of the questions that remains is: will government turn out to be the largest employer and provider of services, as for example in the UK (largely because of the National Health Service), or will the private sector take over a large part in this role? Chart 19China Spending On Luxury Goods ##br## Growing More Slowly Than On Travel Chart 20Still Calling Your ##br## Broker? Financial markets: future in the algorithms? It is fair to assume that financial markets will move in the direction of total automation, and will probably be "ruled" by algorithms focusing on short-term strategies (Chart 20). Robo-advisors and passive strategies will decrease commission income and force managers to rethink their investment strategies. On the other hand, people tend to save more as they get older (Chart 21). This pattern reverses, once retirement age is hit (think about medical bills etc.). Consequently, we might see lower demand for savings products once the wave of baby boomers hits retirement, which is bad news for insurance companies and for the bond market. Chart 21Consumption And Income In Perspective Geopolitics - no more large-scale conflicts, but lots of migration? Chart 22Worldwide Battle-related Deaths On The Decline Kapitsa also touched on some controversial topics in his papers - the probability of a global war and a migration crisis (keep in mind there was no migration crisis at the time the theory was developed). Kapitsa argued that, on a global scale, factors such as migration or wars do not really matter for the outcome of the model, creating only statistical "noise". But he also drew some interesting conclusions, arguing that large wars, as we saw them in the 20th century, are unlikely to happen anymore. Because of the restriction on "human resources", states will not be able to conscript and sustain large armies, as it was the case in the past, and conflicts will arise only on a local scale (Chart 22). Chart 23Population In The Baltic States Reducing Dramatically Conflicts are most likely to arise in areas of the world experiencing a spike in their population growth trajectory. This period of time is characterized by the highest instability in the "system". This means that inequality in the distribution of resources is peaking together with the population growth rate, which causes social unrest. Such inequalities in resource distribution are evened out over time together with the levelling-off of the population, or more rapidly through war or migration. On the topic of migration, Kapitsa noted that in general migration flows are driven by the search for resources, but have reduced substantially over time. Some 2,000 years ago or earlier, whole nations moved, but nowadays migration flows barely exceed 0.1% of global population. From Kapitsa's point of view, migration should be nothing to worry about. In the framework of a complex physical system, as long as migration does not come from another planet, it is unlikely to cause any harm. In Europe we might be witnessing the first countries in history with drastically shrinking populations, due to the policy of freedom of movement, and people migrating in search of resources (better work and life prospects) (Chart 23). Furthermore, the older generation will probably become more influential in terms of casting votes and deciding future development of countries or whole continents. This year's two black swan events (Brexit and the outcome of the U.S. election) were essentially driven by the older generation, and the divide in opinion may become even more pronounced in future (Chart 24). Chart 24Election Results Determined By Older Generations Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk 1 Based on the work of Sergey Kapitsa (1928 - 2012) 2 Malthus T.R. 1978. An Essay on the Principle of Population. Oxford World's Classics reprint. 3 Brody, S. Bioenergetics and Growth (Reinhold, New York, 1945) Moen, A. N. Wildlife Ecology: an Analytical Approach (Freeman, San Francisco, 1973) Van Valen, L. Evol. Theory 4, 33-44 (1978). 4 Hoerner, von S. Journal of British Interplanetary Society 28 691 (1975) 5 U.S. Census Bureau (2016). International Data Base. http://www.census.gov/ipc/www/idb/worldpopinfo.php. von Foerster, H., Mora, P., & Amiot, L. (1960). Doomsday: Friday, 13 November, A.D. 2026. Science, 132, 255-296. 6 Maddison, A. (2001). The World Economy: A Millennial Perspective. Paris: OECD. Maddison, A. (2010). Historical Statistics of the World Economy: 1-2008 AD. http://www.ggdc.net/maddison/Historical Statistics/horizontal-file_02-2010.xls. 7 Nielsen, R. W. (2015). Hyperbolic Growth of the World Population in the Past 12,000 Years. http://arxiv.org/ftp/arxiv/papers/1510/1510.00992.pdf 8 From here onwards both papers are quoted extensively: S. P. Kapitsa (1996). The Phenomenological Theory of World Population Growth. Russian Academy of Sciences 9 S.P. Kapitsa (2000). Global Population Growth and Social Economics. Russian Academy of Sciences 10 Gagnon, Etienne, Benjamin K. Johannsen, and David Lopez-Salido (2016). "Understanding the New Normal: The Role of Demographics," Finance and Economics Discussion Series 2016-080. Washington: Board of Governors of the Federal Reserve System, http://dx.doi.org/10.17016/FEDS.2016.08

Highlights The tactical environment is dynamic, chaotic and unpredictable. ...Chaos also brings opportunity. We must recognize and exploit opportunities when chance presents them. Look for recurring patterns to exploit.1 Feature Highlights Strategically, major commodity markets are balanced with the exception of ags, where we remain underweight on the back of record grain harvests and high stock-to-use ratios. Otherwise, broad exposure to the asset class is warranted. However, within the larger investment context, we believe tactical positioning once again will produce higher returns than strategic index exposure to commodities. Chart of the WeekTactical Positioning ##br##Rewarded In Oil Markets Supply-driven price volatility and erratic monetary policy presented commodity markets strategic and tactical opportunities in 2016, particularly in oil, where our recommendations returned an average of 95% (Chart of the Week). We remain overweight oil, expecting continued opportunities from volatile markets. Going forward, the contribution of demand-side risk to price volatility will increase. This will be evident in iron ore, steel and base metals, where the opacity of China's fiscal and monetary policy - especially re heavily indebted state-owned enterprises (SOEs) and the banks that support them - in the lead-up to the Communist Party's Congress abounds. Continued adjustments by the U.S. Fed to random-walking data will again contribute to volatility, particularly in oil and gold markets. A stronger dollar resulting from continued Fed tightening will hit U.S. ag exports, and benefit competitors such as Argentina and the EU. However, uncertainty re the Trump administration's fiscal and trade policies could keep the Fed looser for longer, particularly if border-adjusted taxation favoring exports over imports is realized. Geopolitics - particularly vis-à-vis U.S. and China trade and military policy - will become more important if America tilts toward dirigisme, i.e., actively managing its economy by adjusting taxation and policy to support favored industries. Governments typically allocate resources inefficiently, which distorts fundamentals. If border-adjusted taxation becomes law in the U.S. we will look to get long volatility across commodity markets: Such legislation likely would rally the USD, which would lower global demand for commodities generally and lift supply by lowering local costs. This would run smack into higher U.S. inflation arising from the increasing cost of imported goods. This is a recipe for heightened uncertainty and price volatility. Russia lurks in the background: U.S. sanctions in the wake of alleged interference in American presidential elections, and Russia's response, will keep oil markets on edge. 2017 Weightings Energy: Overweight. The OPEC-Russia co-operation pact to limit production could evolve into a durable modus operandi for managing oil supply. Markets will judge the pact effective if tanker chartering out of the Persian Gulf falls, and global inventories draw by mid- to end-February. Base Metals: Neutral. Bulks and base metals prices will remain rangebound, until greater clarity on China's fiscal and monetary policy emerges. Fiscal stimulus in the U.S. will have a marginal effect on demand toward year-end. Precious Metals: Neutral. Gold will remain sensitive to shifts in U.S. fiscal and monetary policy expectations. The possibility of border-adjusted taxes in the U.S. will hang like the proverbial Sword of Damocles over the gold market. Should it pass, the Fed could be forced to keep interest rates lower for longer to offset the massive tightening in financial conditions such a tax would impose. Ags/Softs: Underweight. We see limited downside for grains, despite record harvests. We favor wheat and rice over corn and beans. A stronger USD will be bearish for grain exports. Feature Commodities as an asset class remain attractive. However, constantly changing information flows affecting these markets compel us once again to favor tactical positioning over a broad strategic exposure to the asset class. Fundamentals - supply, demand, inventories - and financial variables remain in a state of flux. In the oil market, the durability of the OPEC-Russia co-operation pact to reduce oil production will be tested, following a year-end surge in global production. Markets will closely follow shipping activity - particularly out of the Persian Gulf - and global oil inventory levels for signs the production cuts engineered late last year by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC producers, led by Russia, are taking hold. Uncertainty regarding the incoming Trump administration's tax and trade policies - and responses from states targeted by such policies (e.g., China and Mexico) - will keep decisions affecting supply and demand fluid. The incoming Trump administration's trade policies could alter global oil flows: e.g., a re-working of NAFTA that reduces U.S. refined-product exports to Latin America would result in lower demand for crude at American refineries, and present an opening to Chinese refiners. In addition, as mentioned above, legislation authorizing border-adjusted taxes favoring exports and penalizing imports likely will be taken up this year in the U.S. Congress. If we did see tax policy favouring U.S. exports over imports, we believe it would prompt a USD rally via reducing America's current account deficit. This would, all else equal, send commodity prices sharply lower, as EM commodity demand will contract, owing to higher USD prices for commodities, and production ex U.S. will increase, due to lower local costs. That said, border-adjusted taxation in the U.S. also would increase the price of imports, and lift realized and expected inflation. How this plays out is highly uncertain at present. A border-adjusted tax bill likely will be taken up in the current session. If it passes, it would have major implications for pricing relationships globally - chiefly WTI vs. Brent, and Brent vs. Dubai crudes, along with product differentials that drive shipping economics. If such a bill looks like it will pass, we expect a sharp increase in commodity-price volatility globally. If the odds do favor such a tax regime shift, we would look to get long WTI and short Brent further out the curve, expecting higher U.S. exports and lower imports. In addition, we would look to get long gold volatility - buying puts and calls - as policy uncertainty effects resolve themselves. Heightened Uncertainty Means Tactical Positioning Once Again Trumps Passive Commodities Allocation The primacy of tactical positioning was demonstrated in 2016 in the oil market, when strategic positions quickly became tactical, either because they were stopped out or reached their P&L targets quicker than expected. Supply destruction dominated price formation last year, following OPEC's decision to abandon its strategy to support prices via production management in November 2014. This destruction occurred mostly in non-Gulf OPEC, which was down 7.0% yoy in 2016 (Chart 2), and non-OPEC producers, particularly the U.S. shale-oil fields, where yoy production was down 12.0% by year-end 2016 (Chart 3). Chart 2Low Prices Crushed Non-Gulf Production... Chart 3...And U.S. Production Even in states where production increased - chiefly KSA and Russia (Chart 4) - domestic finances crumbled, leaving them in dire straits. By our estimates, between July 2014, just prior to its decision to launch OPEC's market-share war, and December 2016, KSA had burned through $220 billion of it foreign reserves, equivalent to 30% of its central-bank holdings. Russia had drawn down its official reserves by $77 billion over the same period, or 16% of its holdings; its burn rate was reduced by allowing its currency to depreciate, which lowered the local cost of producing oil and boosted profitability of exports priced in USD. This was the background that forced OPEC, led by KSA, and non-OPEC, led by Russia, to negotiate the year-end pact that resulted in an agreement to cut production by up to 1.8 mm b/d. The stated volumes to be cut are comprised of 1.2 mm from OPEC, 300k b/d from Russia, and another 300 from other non-OPEC producers. The goal of this agreement is to reduce global oil inventories to more normal levels (Chart 5). Chart 4KSA, Russia Production Ramp ##br##Exacerbated Price Weakness Chart 5KSA-Russia Production Pact Aimed ##br##At Lowering Inventories Throughout 2016, as the supply-destruction drama was unfolding, numerous opportunities opened up to investors to fade market overshoots, brought about by over-reactions to fast-moving news flows. Unrestrained output by OPEC and non-OPEC producers strained oil-storage facilities early in the year, taking markets to the brink of breaking down entirely. Unexpected shifts in U.S. monetary policy - driven by random-walking data - also contributed to oil price volatility and opened numerous trading opportunities. Markets essentially ignored the cumulating right-tail price risks last year, following the supply destruction wrought by OPEC's declaration of a market-share war, and Russian overtures to OPEC seeking a production-allocation dialogue, which were very much in evidence in January 2016. The continual OPEC-Russia dialogue, which appeared to be bearing fruit in Doha before it was scuppered by KSA at the last minute in April, was the underlying geopolitical driver last year, and kept the odds of a production deal elevated. Based on our modeling, the supply surge following OPEC's decision made getting long contingent upside price exposure extremely compelling, particularly as it imperiled the finances of all oil producers - rich and poor, but mostly the poorer states like Venezuela and Nigeria. Our reasoning was lower prices would accelerate rebalancing of global markets and raise the odds of a major supply disruption at one of these failing states.2 Our modeling consistently indicated global oil markets would rebalance in 2016H2.3 Ultimately, this is how things played out, aided in no small measure by mid-year wildfires in Canada, which temporarily removed move than 1mm b/d from global markets, and sabotage of pipelines and loading facilities in Nigeria. Even with that, markets remained under pressure as Canadian barrels returned, and foreign reserves in KSA and Russia were rapidly depleted. These fundamentals, along with constantly changing Fed guidance, provided numerous opportunities to exploit recurring patterns thrown up by chance, as is evident in the returns on recommendations we made - averaging 95.1% last year - that naturally followed from our analysis (Table 1). Our favored exposure was getting long contingent exposure (i.e., options), using deferred call spreads in WTI and Brent, given our assessment the odds of higher prices exceeded the market's. Later in the year, following the OPEC-Russia pact, we got long a front-to-back crude oil spread (Dec/17 WTI vs. Dec/18 WTI) expecting the goal of the deal - reducing global inventories - stood a good chance of being realized. We got lucky putting the trade on as the market was correcting, but just ahead of the statement by KSA's oil minister that the Kingdom would do "whatever it takes" to make the deal work. This transformed a strategic position - one we expected to hold for months - into a one-week exposure that returned 493% (Table 1). Table 1Energy Trades Closed In 2016 In order to obtain a more detailed assessment of our energy portfolio's performance, we built an information ratio (IR) to evaluate how our energy recommendations performed compared to a selected benchmark, the S&P GS Commodity Index (GSCI). Essentially, our IR is used to assess whether an active portfolio has outperformed the selected benchmark in a consistent manner during the period of analysis, given the risk it incurred. To that end, our ratio looks at the average excess return of the active portfolio against the benchmark. This average excess return is then divided by its standard deviation (also referred to as the tracking error volatility) in order to get a risk-adjusted metric to evaluate whether the risk we took were compensated by the returns we generated. Our IR thus is calculated as: Formula The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: high returns in the portfolio, low returns in the benchmark, or low tracking error volatility. Hence, this measure helps analyzing the notion of risk-reward tradeoff; it tells us whether or not the risk assumed in our trades was compensated by larger returns. In our case, to get the risk-adjusted returns of the energy portfolio, we selected the GSCI as a benchmark, as it is heavily skewed towards Energy commodities (around 60% of its composition). We believe this is a plausible benchmark alternative to our energy trade recommendations for an investor, whose choice is passive index exposure with a significant energy weighting. Our portfolio's average return in 2016 was 95%, while the GSCI return was 11%. The tracking error volatility was 56%.4 Using these inputs, we calculated the IR of our recommendations was 1.47. This is an excellent risk-adjusted return, and indicates the high volatility of our returns was more than compensated for by consistent positive excess returns our recommendations generated relative to passive GSCI exposure, which also can be used as a benchmark for energy-heavy commodity index exposure (i.e., "commodity beta"). Remain Overweight Oil We expect the combination of production cuts and natural declines will remove enough production from the market this year to restore global oil stocks to five-year average levels toward the end of 2017Q2 or early Q3 (Chart 5), even with cheating by OPEC and non-OPEC producers capable of increasing production. As a result, in 2017, we expect the OPEC-Russia deal to result in inventory draws of ~ 10% by 2017Q3. On the demand side, we continue to expect global growth of ~ 1.3 to 1.5mm b/d. Given these expectations, we expect U.S. benchmark WTI crude prices to average $55/bbl, up $5 from our 2016 forecast, on the back of the end-year OPEC-Russia pact. We are moving the bottom of the range in which we expect WTI prices to trade most of the time to $45/bbl and keeping the upside at $65/bbl. Markets already are pricing in a normalization of global inventories by year end (Chart 6 and Chart 7). We will look for opportunities to re-establish our long front-to-back positions, expecting the backwardation further out the curve will steepen. Chart 6Backwardation Steepening Near Term... Chart 7...And Further Out the Curve Further out the curve - i.e., mid-2018 and beyond - our conviction is lower: The massive capex cuts seen in the industry for projects expected between 2015 - 2020 will place an enormous burden on shale producers and conventional oil producers, chiefly Gulf Arab producers and Russia. It will be difficult to offset natural decline-curve losses - which will increase as U.S. shales account for a larger share of global supply - and meet increasing demand. As we've often noted, any indication U.S. shales or conventional supplies (Gulf states and Russian production) will not be able to move quickly enough to meet growing demand and replace natural declines could spike prices further out the curve. We expect U.S. oil exports to increase this year, which means the international benchmark, Brent crude oil, will increasingly price to move WTI into global markets. We expect U.S. WTI exports to increase from an average ~ 500k b/d, which should keep the price differential roughly around +$1.50/bbl differential (Brent over) for 2017. If we see border-adjusted taxation laws take effect, we would look to get long WTI vs. short Brent, and long U.S. products (e.g., U.S. Gulf gasoline and distillate exposure) vs. short Brent exposure. Remain Neutral Bulks, Base Metals Over in the bulks and base metals markets, a full-fledged iron-ore market-share war at the beginning of last year threatened to take prices to $30/ton. Then, seemingly out of the blue, an unexpected pivot by Chinese policymakers toward stimulating the "old economy" caught many bulks and base-metals traders and analysts - ourselves included - flat-footed. Powerful rallies in iron ore, steel and base metals early in the year on Chinese exchanges were dismissed as irrational exuberance on the part of retail investors. But, at the end of the day, these market participants were responsible for well-informed price signals that fully reflected low inventories and surging demand.5 The -0.5% average return in our bulks and base metals recommendations last year attests to how difficult we found these markets to read and anticipate (Table 2). Table 2Base Metals Trades Closed In 2016 As always, the evolution of China's economy will, as always, be critical to these markets, given that country's outsized role in iron ore, steel and base metals. We are broadly neutral the complex, and, with the exception of the nickel market, see supply and demand relatively balanced to slightly oversupplied globally and in China. Production globally and in China is growing yoy, while consumption shows signs of slowing. (Chart 8 and Chart 9). Chart 8World Base Metals Consumption Slowing,##br## Relative to Production... Chart 9...As Is ##br##China's Uncertainty re the direction of China's fiscal and monetary policy - chiefly, whether policymakers will, once again, resort to stimulating the "old economy" - will keep us broadly neutral bulks and base metals until we get further clarity on the direction of policy. We expect the monetary and fiscal stimulus that massively boosted China's housing market this year will wind down, bringing an end to the run-up in iron ore, steel and base metals prices. Odds favor "reflationary" policies to continue going into the Communist Party Congress next fall, but we do not expect anything along the lines of the surge in policy stimulus seen earlier this year: Unwinding and controlling property-market excesses and high debt levels will limit policymakers' desire to turbo-charge the housing market again, limiting the boost such policies provide. The fate of border-adjusted taxation in the U.S. Congress is critically important to bulk and base-metals markets, since it would encourage exports and discourage imports (along with raising their prices). Tax policy favouring U.S. exports over imports likely would prompt a USD rally, which would send commodity prices generally sharply lower. It would boost U.S. steel production and base metals exports, while raising the cost of imports. A border-adjusted tax bill likely will be taken up in the current session of Congress. We are downgrading our tactically bullish view on iron ore to neutral. Strategically, we retain a bearish bias, as rising iron ore supply may overwhelm the market again in 2017H2. We remain tactically neutral and strategically bearish steel. Low steel inventories and production disruptions caused by China's recently launched environmental inspection program likely will continue to support steel prices in the near term. However, persistently high steel output and falling demand from the Chinese property sector will eventually knock down prices in 2017H2. Manufacturing will play a larger role in copper markets, and will drive the demand side this year. However, if we see a stronger USD - either as a result of Fed policy or U.S. fiscal policy - price appreciation will be limited. We remain neutral copper, expecting a concerted effort to slow the housing boom in China. Reflationary policies will still support real demand for copper, but will reduce demand from new construction. The supply deficit in nickel will widen on the back of rising stainless steel demand and falling nickel ore supply in 2017, which will support prices. We expect nickel will outperform zinc over a one-year time horizon. For zinc, we remain tactically neutral and strategically bearish. We expect zinc supply to rise considerably in response to current high prices. Aluminum supply - for the moment - will lag demand globally, which keeps us tactically bullish and strategically neutral. Supply shortages will likely persist ex-China over the next three to six months. Stay Neutral Precious Metals Precious metals, gold in particular, staged an impressive rally on the back of unexpected easing by the U.S. Fed in response to weaker-than-expected sub-1% GDP growth in 1Q16 GDP. Markets had been pricing in as many as four interest-rate hikes earlier in the year into short-term expectations, which were quickly dashed. Markets lowered their expectations for multiple rate hikes last year, which weakened the USD and U.S. real rates, setting the stage for the gold rally. Nonetheless, gold proved a difficult commodity to trade last year, as our results indicate - the average return on our precious metals recommendations amounted to a paltry -0.65% (Table 3). For the near term - i.e., until greater clarity on Fed policy and the incoming Trump administration's fiscal policy direction becomes clear - we remain neutral precious metals, and will avoid taking any further exposure other than perhaps getting long gold volatility - i.e., buying puts and calls in the gold market - if the odds of border-adjusted taxation legislation passing increase. Such legislation likely would rally the USD, which would lower global demand and increase supply ex U.S. at the margin for commodities generally, oil and base metals in particular. This would be deflationary, given the high correlations between oil and base metals consumption and U.S. inflation (Chart 10).6 However, such a taxation scheme also would raise U.S. inflation by increasing the cost of imported goods, sending the U.S. core PCE, the Fed's preferred inflation gauge, higher. The global disinflationary impulse from a stronger USD would run headlong into higher U.S. inflation, which would be a recipe for heightened uncertainty and price volatility. Table 3Precious Metals Trades ##br##Closed In 2016 Chart 10Risk of Deflation Will Rise If Border-Adjusted ##br##Taxes Prove Deflationary This will complicate U.S. monetary policy. We believe the Fed also will be waiting on such direction, and that interest-rate policy will, therefore, remain pretty much be on hold, keeping precious metals - gold, in particular - rangebound. For the moment, the possibility of border-adjusted taxes in the U.S. will hang like the proverbial Sword of Damocles over the gold market. We are taking profits on the tactical long gold position we opened December 15, 2016, as of today's close. Remain Underweight AGS Lastly, Ag markets provided us no joy, as the El Nino wreaked havoc on our recommendations. Our average -1.0% return for the year amply demonstrates the difficulty of trading markets so heavily influenced by weather (Table 4). Going into 2017, we believe there is a limited downside for grains. The downtrend since August 2012 like forms a bottom this year, if, as we are modeling, we see a return to normal weather conditions. That said, the principal upside risk remains unfavorable weather in major grain-producing countries, which could send badly battered grain prices surging as they did in 2016H1. Among grains, we favor wheat and rice over corn and soybeans. Global soybean acreage is likely to expand as the crop provides higher returns than other grains. South American corn output will continue rising on favorable policies and weak currencies, adding further pressure to already-high U.S. corn inventories, in particular, and global inventories globally (Chart 11). Table 4AGS Trades Closed In 2016 Chart 11Global Grain Inventories Remain High Softs - cotton and sugar - likely will underperform grains in 2017, reversing their outperformance this year. We are tactically bearish cotton, as U.S. cotton acreage is likely to increase next spring. Strategically, we are neutral cotton. For the global sugar market, barring extremely unfavorable weather, we are tactically and strategically bearish. This year's extreme rally in prices may result in a small supply surplus in 2017. Our Ag strategies will continue to focus on relative-value investments. Robert P. Ryan, Senior Vice President Commodities & Energy Strategy rryan@bcaresearch.com Hugo Belanger, Research Assistant hugob@bcaresearch.com 1 Please see "Tactics Cliff Notes; A Synopsis of MCDP 1-3 Tactics," published by the United States Marine Corps, Marine Corps Warfighting Lab, Marine Corps Combat Development Command, Quantico, Virginia. 10 May 1998 (pp. 2, 3. sf). 2 In our January 7, 2016, publication we noted investors were ignoring growing upside price risk and suggested they get long a Dec/16 $50/$55 WTI call spread to gain exposure to higher volatility. We also recommended remaining long Dec/16 and Dec/17 WTI vs. Brent following passage of legislation to allow U.S. crude exports. We ultimately took profits on these recommendations of 172% on the call spread in June, and 97% on the Dec/16 WTI vs. Brent spread in June, and 88% on the Dec/17 WTI vs. Brent spread in July, respectively (Table 1). Please see "Oil Market Ignores Right-Tail Saudi Risks" in the January 7, 2016, issue of BCA Research's Commodity & Energy Strategy, which is available at ces.bcaresearch.com. 3 In our January 21, 2016, Commodity & Energy Strategy article entitled "Global Oil Sell-off Will Accelerate Rebalancing," we noted, "We expect oil markets to rebalance by late 2016Q3 or early Q4. We remain long Dec/16 $50 calls vs. $55 calls, in anticipation of rebalancing and as a hedge against geopolitical risk." 4 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 203 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking error volatility. 5 Please see "Dead-Cat Bounces Notwithstanding, Iron Ore Will Trade Lower" in the January 21, 2016 issue of BCA Research's Commodity & Energy Strategy, and "Fade The Copper Rally" in the February 25, 2016 issue. Both are available at ces.bcaresearch.com. 6 In earlier research, we've shown U.S. core PCE inflation is highly correlated with EM oil and base metals demand. Please see "2017 Commodity Outlook: Precious Metals" published December 15, 2016. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 30, 2016. The model has boosted its overweight in the Euro Area, especially in Italy, Spain and Netherland, financed mainly by a slight reduction in the large overweight in the U.S. Japan's underweight is back to the largest again, followed by the U.K. (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the non-U.S. model (Level 2) outperformed its benchmark by 206 bps in December, thanks to the overweight in Euro Area. The large overweight in the U.S. caused the Level 1 model to underperform by 27 bps. Overall, the GAA model outperformed its MSCI World benchmark by 15 bps in December. Since Inception, the GAA model outperformed its benchmark by 26 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of December 30, 2016. Table 3AllocationsTable 4Performance Since Going Live Chart 4Overall Model Performance The momentum component has shifted Info Tech from overweight to underweight. The valuation component indicated that Consumer Staples is no longer expensive. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In December, the model underperformed global equities and the S&P in USD and local-currency terms. For January, the model increased its allocation to stocks and reduced its allocation to bonds (Chart 1). Within the equity portfolio, the weighting to euro area stocks was increased. The model boosted its allocation to Canadian and Swedish bonds at the expense of other European markets. The risk index for stocks deteriorated in December, as did the bond risk index. Feature Performance In December, the recommended balanced portfolio gained 2.1% in local-currency terms and 0.8% in U.S. dollar terms (Chart 2). This compares with a gain of 2.9% for the global equity benchmark and a 3.4% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide other suggestions on currency risk exposure from time to time. The continued bonds selloff was a drag on the model's performance in December. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and trimmed its bond weighting from 47% to 43% (Table 1). The model boosted its equity allocation to Spain by 3 points, Germany by 2 points, Italy by 1 point, Japan by 1 point and France by 1 point. Meanwhile, weightings were reduced in Sweden by 3 points and New Zealand by 1 point. In the fixed-income space, the allocation to Canadian paper was boosted by 5 points, Sweden by 3 points, New Zealand by 2 points. The allocation to Italian bonds was reduced by 6 points, France by 4 points, U.K. by 3 points, and U.S. Treasurys by 1 point. Table 1Model Weights (As Of December 22, 2016) Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar's attempt at consolidating its gains was cut short by the hawkish Fed. As a result, our Dollar Capitulation Index is back to levels that indicate the rally in the broad trade-weighted dollar could pause. However, unless the new administration pours cold water on expectations of a major fiscal boost, monetary policy divergence will underpin the dollar bull market (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities improved slightly reflecting a better reading from the momentum indicator. However, this asset class remains excluded from the portfolio (Chart 4). The risk index for global equities remains at the highest level in over two years. Despite this, our model slightly increased its allocation in equities following four consecutive months of reductions (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The deterioration in the value and liquidity indicators for U.S. stocks was offset by some improvement in the momentum reading. As a result, the risk index for U.S. stocks was flat in December (Chart 6). The risk index for euro area equities increased in December and is now at neutral levels. However, even after the latest increase, the risk index for euro area stocks is noticeably lower than the U.S. measure (Chart 7). Positive growth momentum and a weaker currency could provide support for the euro area equities. Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk The model slightly increased its allocation to German equities despite the deterioration in the risk index (Chart 8). Unlike most of the equity risk indexes in the model's universe, the one for Emerging Asian stocks improved in December. The model kept its allocation to this asset unchanged (Chart 9). Chart 8German Stock Market And Risk Chart 9Emerging Asian Stock Market And Risk The risk index for bonds deteriorated in December, but remains at a historically low-risk level reflecting oversold readings from the momentum indicator. The model has trimmed its allocation to bonds a touch (Chart 10). The risk index for U.S. Treasurys was little changed in December. Despite its very low risk reading, the model is adding allocation to bond markets that feature more oversold conditions. (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk Canadian bonds remain massively oversold based on our momentum measure, and the overall risk index is at extremely low-risk levels. The model boosted its allocation to this asset (Chart 12). With oversold conditions unwinding and the cyclical indicator moving in a more bond-negative direction, the overall risk index for Italian bonds has shifted back to neutral levels. The model has excluded this asset class from its allocation (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13Italian Bond Yields and Risk U.K. bonds remain deeply in low-risk territory, despite a small deterioration in its risk index. The oversold reading in the momentum measure is completely overshadowing the negative signal from the cyclical indicator. Allocation to gilts remains one of the highest in the bond universe, even after the model trimmed its exposure to this market (Chart 14). The risk index for Swedish bonds fell once again in December reflecting improved readings in all of its components. Extremely oversold conditions dominate the overall risk index and suggest that a pullback in yields is overdue. The model boosted its allocation to Swedish paper. (Chart 15). Chart 14U.K. Bond Yields And Risk Chart 15Swedish Bond Yields And Risk Currency Technicals The 13-week momentum measure indicates that the dollar's ascent could face near-term resistance. However, the continued recovery in the 40-week rate of change measure suggests that the dollar bull market has more upside. The latest round of central bank meetings reinforces the monetary divergence between the Fed on one side, and the ECB and BoJ on the other (Chart 16). With the prospect of the Bank of Canada staying put, while its southern peer gradually raises rates, the rate differential should exert downward pressure on the CAD/USD. Technically, the breakdown of the longer-term rate-of-change measure is pointing in that direction. In addition, the short-term rate of change metric is not stretched. However, the risk to this view is that the headwinds for the loonie arising from monetary policy divergences can be mitigated by higher oil prices (Chart 17). With the BoJ pegging nominal JGB yields, the differential in real rates is supportive of a stronger USD/JPY. This cyclical outlook for the yen is being confirmed by the 40-week rate of change measure. That said, the 13-week momentum measure is at levels that have signaled a pause in the yen weakening trend in both 2013 and 2015 (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Canadian Dollar Chart 18Yen Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Dear Client, This is our last report of the year. We will be back the first week of January with our 2017 Strategy Outlook. On behalf of BCA's Global Investment Strategy team, I would like to take this moment to wish you and your loved ones a Merry Christmas, Happy Holidays, and all the best for the coming year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The global economy has entered a reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. Emerging markets should also gain from a more reflationary environment. However, a rising dollar and elevated debt levels will take the bloom off the rose. Chronically low productivity and labor force growth will make it difficult for central banks to contain inflation once it does begin to accelerate. Global bond yields will rise only modestly next year, but could begin to surge as the decade wears on. Feature Stagflation Is Coming, But Not Yet Bill Gates once noted that "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." This observation applies just as well to the risk of stagflation as it does to technology. For the next few years, the likelihood of a disorderly rise in inflation is extremely low. Beyond then, however, the risk is that inflation surprises to the upside, perhaps significantly so. Three factors will prevent global inflation from rising too rapidly over the next two-to-three years: The global economy still suffers from a fair amount of spare capacity; While spare capacity is likely to decline further, it will do so only gradually; Even when all remaining spare capacity is exhausted, the knock-on effect to inflation will initially be quite small. Spare Capacity Lingers Chart 1 shows that the global output gap has declined from its high in 2009, but is still larger than it has been at any time since the early 1990s. This can be seen in low industrial capacity utilization rates in some countries (Chart 2), as well as in the high levels of joblessness and involuntary part-time employment (Charts 3 and 4). Chart 1Mind The (Output) Gap Chart 2Global Capacity Utilization Remains Low Chart 3AJoblessness Still Elevated In Europe Chart 3BJoblessness Still Elevated In Europe Chart 4AHigher Incidence Of Involuntary ##br##Part-Time Employment Chart 4BHigher Incidence Of Involuntary ##br##Part-Time Employment Granted, the U.S. is much closer to full employment than most other economies. However, high levels of spare capacity abroad will still exert downward pressure on U.S. inflation. The reason for this was first laid out by Robert Mundell and Marcus Fleming in the early 1970s. The Mundell-Fleming model, as it is now called, posits that a country's interest rate will rise in response to stronger growth, thereby pushing up the value of its currency. Indeed, Mundell and Fleming showed that easier fiscal policy would not benefit a small open economy at all in a world of perfect capital mobility and flexible exchange rates because any gains from the stimulus would be entirely offset by a deterioration in the trade balance. Chart 5Real Rate Differentials ##br##Are Driving Up The Dollar While the Mundell-Fleming model is a gross oversimplification of how the global economy actually functions, it is still highly relevant for understanding today's macro environment. The real broad trade-weighted dollar has appreciated by 21% since mid-2014, largely due to the widening of interest rate differentials between the U.S. and its trading partners (Chart 5). We estimate that the stronger dollar has reduced the level of U.S. real GDP by 1% so far, and will reduce it by another 0.5% stemming from the lagged effects from the recent dollar rally. The buoyant greenback will keep a lid on U.S. inflation both directly, in the form of lower import prices and indirectly, in the form of slower employment growth. The analysis above leads to three important investment implications. First, it implies that the dollar will remain well bid as long as the Fed remains the only major central bank in hiking mode. We have been long the DXY since October 2014 - a trade that has gained 18.6%. We think there is another 5% of upside from current levels. Second, a stronger dollar will help redistribute growth to Europe and Japan, two economies that desperately need it. We are bullish on European and Japanese stocks and bearish on the euro and the yen. Third, Treasury yields will be hard-pressed to rise substantially from current levels until spare capacity outside the U.S. is extinguished. Only once other central banks start raising rates will the Fed be able to hike rates in a sustainable manner. Until then, any Fed tightening beyond what the market is currently expecting will put upward pressure on the dollar, reducing the need for further hikes. A Gradual Recovery Table 1Global Growth Will Improve Next Year Global growth should pick up next year in line with the IMF's most recent projections (Table 1). Alongside stronger growth in Japan and continued above-trend growth in Europe, the U.S. economy will benefit from robust consumer spending on the back of rising real wages. In addition, residential investment should rise, as foreshadowed by the jump in homebuilder confidence in December. Tighter credit spreads, deregulation, and a modest recovery in energy sector investment should also boost business capex. Despite this welcome reflationary backdrop, a number of factors will hold back growth. Most prominently, debt levels are still high around the world (Chart 6). In fact, emerging market debt continues to rise more quickly than GDP. Even in the optimistic scenario where the ratio of EM debt-to-GDP merely stabilizes, this would still entail a negative credit impulse (Chart 7). Chart 6Global Debt Levels Are Still High Chart 7Negative EM Credit Impulse Looming Meanwhile, monetary policy continues to be constrained by the zero bound in a number of developed economies. Many EM central banks will also be reluctant to cut interest rates due to fears that this could precipitate a disorderly plunge in their currencies. And while fiscal policy around the world will no longer be restrictive, a major burst of government stimulus is not in the cards. Donald Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. As we have noted before, most of America's infrastructure needs consist of basic maintenance. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions. There is also a significant risk that Congressional Republicans will try to sneak through cuts to Social Security and Medicare, much to the annoyance of many of Trump's voters. As for Trump's proposed personal tax cuts, while they are hefty in size, their bang for the buck is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Indeed, it is possible that cutting the estate tax would actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that companies are already flush with cash and effective tax rates are well below statutory levels. The bottom line is that global growth is likely to rise in 2017, but not by enough to cause inflation to surge. A Flat Phillips Curve ... For Now Chart 8The Phillips Curve Has Flattened It might take a few more years for most of the developed world to claw its way back to something approximating full employment, but with any luck, it will get there. What happens to inflation then? The answer is probably not much. The relationship between economic slack and inflation is encapsulated by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 8). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Economists have proposed a variety of reasons for why the Phillips curve may have flattened out over time. Globalization is often cited as one factor, but the empirical evidence for this view is rather shaky.1 True, free trade and capital mobility have helped keep inflation in check by diverting excess domestic demand into higher net imports via the Mundell-Fleming channel discussed above. However, this only implies that globalization may prevent economies from sliding too far along the Phillips curve. It says nothing about the slope of the curve itself. A fall in unionization rates and a decline in the use of inflation-indexed wage contracts are also often cited as reasons for why the correlation between inflation and economic slack has diminished. Here again, the evidence is rather mixed. While the U.S. has experienced a pronounced decline in unionization rates, Canada has not (Chart 9). Nevertheless, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-index contracts in the 1970s appears mainly to have been a response to rising inflation, rather than a cause of it (Chart 10). The one point on which most economists agree is that long-term inflation expectations are much more stable now than they used to be, which has reduced the volatility of actual inflation. Central banks deserve some of the credit for this. The adoption of inflation targeting, coupled with more transparent communication policies, has helped anchor inflation expectations. A more sober assessment of economic conditions has also been a plus. Back in the 1970s, the Fed continuously overstated the degree of economic slack (Chart 11). This led it to keep interest rates too low for too long, thereby sowing the seeds for much higher inflation later on. Chart 9Inflation Fell In Canada, ##br##Despite A High Unionization Rate Chart 10When High Inflation ##br##Entailed Inflation-Indexed Contracts Chart 11The Fed Continuously Overstated ##br##The Magnitude Of Economic Slack Shifting Sands For Inflation The Fed has vowed not to make the same mistake again, but the temptation to exploit the flatness of the Phillips curve may be too great to resist. A flattish Phillips curve implies a low "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that it is at least willing to entertain the idea. The 25-year period of falling inflation that began in the early 1980s had a dark side. As Hyman Minsky first noted, economic stability can beget instability: The so-called "Great Moderation" that policymakers were patting themselves on the back for before the financial crisis created a fertile milieu for rising debt levels. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. The challenges posed by the zero-bound constraint could also justify efforts to raise inflation targets. After all, if inflation were higher, this would give central banks the ability to push down real rates further into negative territory in the event of an economic downturn. Such a step is unlikely to be taken anytime soon. That said, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF, San Francisco Fed President John Williams, and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. In any event, as we discussed in great detail last week, underlying economic trends - ranging from the retreat from globalization to the slowdown in potential GDP growth - are all pushing the global economy in a more inflationary direction.2 This suggests that inflation could move appreciably higher towards the end of this decade. Investment Conclusions Chart 12Near-Term Inflation Risk Is Low Inflation is unlikely to rise significantly over the next few years. Indeed, the sharp appreciation in the dollar since the election will put downward pressure on U.S. inflation in the coming months. This view is supported by the Federal Reserve Bank of St. Louis Price Pressure gauge, which shows that there is less than an 8% chance that inflation will rise above 2.5% over the next 12 months (Chart 12). And even when the economy has reached full employment and the effects of a stronger dollar have washed through the system, inflation will be slow to increase. Consider how inflation evolved during the 1960s. As my colleague Mathieu Savary has pointed out, U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 on the back of rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 13).3 The lesson is that it often takes a number of years for an overheated economy to generate meaningful inflation. This suggests that the global economy is entering a "goldilocks" reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. This is obviously good news for global risk assets, and underpins our cyclically constructive view on global equities. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. In fact, both economies have seen a decline in real yields since the U.S. elections, as rising inflation expectations have outpaced the increase in nominal yields (Chart 14). Emerging markets should also gain from a more reflationary environment, but a rising dollar and elevated debt levels will take the bloom off the rose. Chart 13It Can Take A While For Inflation ##br##To Rise In Response To An Overheated Economy Chart 14Europe And Japan: Rising Inflation ##br##Expectations Suppressing Real Yields While we have a positive cyclical (3-to-24 month) view on risk assets, we have significant concerns about both the near-term and longer-term outlooks. From a short-term tactical perspective, developed market equities - especially U.S. equities - are highly vulnerable to a correction. This is reflected in our sentiment indices, which have moved firmly into overbought territory (Chart 15). It can also be seen in the weak historic performance of global stocks following sharp spikes in bond yields (Table 2). Chart 15U.S. Equity Sentiment Is Stretched Table 2Stocks Tend To Suffer When Bond Yields Spike Over a longer-term horizon, the risks to global equities are also to the downside. Once inflation is on a firm upward trajectory, central banks may find it more difficult to arrest the trend. Against the backdrop of weak productivity and labor force growth, memories of stagflation may reappear. As Chart 16 shows, stagflation in the 1970s was devastating for equities, and this time may not be any different. The bottom line is that investors should lease the bull market in stocks, rather than own it. Chart 16Stagflation Was Devastating For Stocks From The Vault: Two "Big Picture" Holiday Reports Lastly, for those who would like to take their minds off the nitty-gritty of the financial world for the next two weeks and focus more on transcendent issues, let me recommend two special reports. The first, entitled A Smarter World is based on a speech I delivered at the 2014 BCA New York Investment Conference. I argue that genetic changes in the human population sowed the seeds for the Industrial Revolution. This development then unleashed a virtuous cycle where rising living standards led to better health and educational outcomes, generating even further gains in living standards. Many countries now appear to be at the end of this cycle, but new technologies could one day generate huge gains in IQs, sending humanity down a path towards immortality. Of course, before we get there, we have to contend with all sorts of existential pitfalls. With that in mind, the second report, Doomsday Risk, examines what is literally a life-and-death issue: the likelihood of human extinction. Drawing on insights from biology, history, cosmology, and probability theory, our analysis yields a number of surprising investment implications. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Eddie Gerba and Corrado Macchiarelli, "Is Globalization Reducing The Ability Of Central Banks To Control Inflation?" European Parliament, Policy Department A: Economic and Scientific Policy, Brussels, Belgium (2015); Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, "Some Simple Tests Of The Globalization And Inflation Hypothesis," International Finance Vol. 13, no. 3 (2010): pp. 343-375; and Laurence M. Ball, "Has Globalization Changed Inflation?" NBER Working Paper No. 12687 (2006). 2 Please see Global Investment Strategy Weekly Report, "Main Street Bonds, Wall Street Stocks," dated December 16, 2016, available at gis.bcaresearch.com. 3 Please see Foreign Exchange Strategy, "Outlook: 2017's Greatest Hits," dated December 16, 2016, available at fes.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Feature Dear Client, For the last publication of 2016, we have opted to do something a little different. 2016 was a year were political shocks took pre-eminence. Whether we are talking Brexit, Trump, Italian referendum, Japanese upper-house elections, or Rousseff's impeachment; it often felt like economics took the back seat to political events. While this kind of regime shift toward more politically-driven markets can feel jarring, it is not new. In the late 1970s and early 1980s, a similar event occurred. Populations in Western democracies - the U.S. and the U.K. in particular - exhausted by a decade of elevated inflation, created one of these shifts by putting Thatcher and Reagan in power. With the benefit of insight, we know how the story ended: with great economic successes in both the U.K. and the U.S. However, when Thatcher and Reagan actually took power, it was far from obvious that Western economies were about to leave stagflation and begin a low inflation boom. Today, we do not know how the Trump experiment will end. It is a similarly radical shift that politician wants to implement. Trump and his team want to beat deflation, especially wage deflation for the middle class. This is easier said than done. While we cannot claim to know how a Trump presidency will unfold, BCA has tried to provide some clarity among the noise by focusing on the implications and risks created by the various policies proposed, as well as the threat to the actual implementation of the policies. To finish the year, we would like to provide our client with some perspective. We are sending you the "Mr X" BCA Outlook published in December 1980, when Reagan was the President-elect. What is striking is that then as today, BCA was trying to make a balanced assessment of the potential for positive or disastrous changes that were about to affect the U.S. and global economy. The worries were very pronounced but ultimately proved to be unfounded. We are not saying that worries regarding Trump's proposed policies are unwarranted, but it is important to remember that investors need to remain very nimble when such shifts are emerging. Ultimately, the final direction and effect of the shifts Trump wants to implement will take years to materialize. Looking at historical reactions to similar political sea-changes is a comforting way to put things into perspective. After all, according to Zhou Enlai, it is still too early to judge the effect of the French Revolution.1 Have a great holiday period and a happy and prosperous new year. Best regards, Mathieu Savary, Vice President