Trade

Highlights Investors continue to overstate the constraints the Trump administration faces; Tax reform will happen, likely much sooner than the markets appreciate; Infrastructure spending will be modest, but will also face no constraints; Trump's de-globalization agenda - on both immigration and trade - faces few, if any, constraints; Book gains on long S&P 500 / short gold, long Japanese equities, long USD/JPY, and close long European versus global equities for a small loss. Maintain a long SMEs / short MNCs strategic outlook as a play on de-globalization. Feature "It used to be cars were made in Flint, and you couldn't drink the water in Mexico. Now, the cars are made in Mexico and you can't drink the water in Flint." - President-Elect Donald J. Trump, Flint, Michigan, September 14, 2016 Regular readers of BCA's Geopolitical Strategy know that our methodology emphasizes policymakers' constraints over their preferences. We abide by the simple maxim that preferences are optional and subject to constraints, while constraints are neither optional nor subject to preferences. President-elect Donald J. Trump is not unique. In the long term, his preferences will be cajoled and imprisoned by his constraints. However, investors may be overstating the impact of constraints in the short term. This is because Trump is a transformational - rather than merely transactional - leader whose election is a product of the yearning for significant change by the U.S. electorate.1 The key difference between the two leadership styles is that transformational leaders seek change by influencing and motivating their followers to break with convention. They make an appeal on normative and ideological grounds. Meanwhile, transactional leaders seek to maintain the status quo by satisfying their followers' basic needs. The latter use sticks and carrots, the former inspire. In the long term, even transformational leaders like Trump will be whipsawed by their material and constitutional constraints into the narrow tunnel of available options. But as we discuss in this Special Report, President-elect Trump will have a lot more room to maneuver than investors may think. That will be good for some assets, bad for others. Trump's Blue-Collar Base To understand the priorities of the Trump administration - as well his lack of political constraints - investors need to respect Trump's shock victory on November 8. Trump won the election because he was able to extend his "White Hype" strategy to the Midwest states of Ohio, Michigan, Wisconsin, and Pennsylvania (and came close to winning Minnesota) (Map 1).2 Map 1Electoral College Vote, Nov. 29, 2016 Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency To extend the Republican voting base into these traditionally "blue" states, Trump appealed to white blue-collar workers, many of whom voted for President Obama in 2012. Though he squeaked by with narrow vote-margins, he was not expected to be competitive in these states at all: Hillary Clinton did not visit Wisconsin once during her campaign (Chart 1). Trade was a chief concern of these disenchanted "Rust Belt" voters. Exit polls show that they agreed with Trump's message that globalization and neoliberal trade policies have sapped the U.S. of jobs, wages, and job security (Chart 2). Chart 1Hillary Failed To##br## Ride Obama's Coattails Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 2Trump's Winning Constituency##br## Angry About Trade Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Infrastructure, and government spending more broadly, were also major concerns - Trump's election was effectively an "anti-austerity" vote. Throughout the campaign Trump showed himself to be indifferent to budget deficits and debt, at least relative to the GOP leadership of the past six years. Instead he shattered GOP orthodoxy by promising to avoid any cuts to entitlement spending and contravened the party's fiscal hawks by promising to spend $1 trillion (later $550 billion) on infrastructure, e.g. the "bad drinking water" problem referred to in the quote at the start of this report. By contrast, Trump paid less attention to tax reform. Yes, he promised to slash taxes, even after reducing the scope of his extravagant September 2015 tax cut proposal. But no, this was not the focus of his campaign and did not get him elected. Instead, it is an area of common ground between himself and the GOP, and it has been the party's main pursuit in recent years. No one knows what Trump is going to do when he takes office. His statements are famously all over the place and he often positions himself at the opposite sides of a policy issue at the same time, prompting us to label him America's first "Quantum Politician."3 His cabinet is only beginning to take shape. Therefore, his main agenda and priorities - traditionally outlined in the upcoming Inaugural Address on January 20 - remain inchoate at best. Nevertheless, trade protections and better infrastructure were core demands of Trump's blue-collar electoral coalition and we expect him to follow through with actions, not least because he needs these states for upcoming elections in 2018 and 2020. Bottom Line: Trump's personal policy preferences are shrouded in mystery. However, investors should assume that he will take the preferences of the Midwest blue-collar voters seriously. They delivered him the presidency. Tax Reform The main reason for the market's exuberance since the election - aside from a "relief rally" given that the sky has not fallen4 - has been the prospect of substantial tax cuts. With Republicans holding all levels of government - and Democrats unable to filibuster tax reform in the Senate due to the "reconciliation procedure"5 - investors are rightly optimistic that the U.S. will finally see significant reforms. We review the plan, investigate its constraints, and assess the impact below. The Plan Trump is asking for much bigger tax cuts than the Republican Party's major alternative, House Speaker Paul Ryan's "A Better Way" plan.6 Trump would slash the corporate tax rate to 15% for all businesses, with flow-through businesses (80% of all U.S. businesses) eligible to pay the 15% rate instead of being taxed under the individual income tax rate (as currently).7 The GOP, by contrast, would set the corporate rate at 20% and the flow-through business rate at 25%. Trump and the GOP agree that the individual income tax should be reduced from seven to three brackets, with the marginal rates at 12%, 25%, and 33%. This would cut the top marginal rate from 39.6% to 33%, but would also leave a significant number of Americans with an increase, or no change, to their marginal tax rate.8 Where Trump and the GOP differ is on how to handle deductions, the flow-through businesses, child tax credits, and other issues - with Trump generally more inclined toward government largesse. Another element of tax reform is the proposed repatriation tax on overseas corporate earnings. An estimated $2.6-$3 trillion is stashed "abroad" (often only in a legal sense), which enables companies to defer paying the corporate tax rate due upon repatriation. Trump is following in the footsteps of President Obama and presidential candidate Hillary Clinton in attempting to collect these taxes - with the Republicans also broadly on board.9 Overall, Trump's plan would cut taxes and tax revenues much more aggressively than the GOP plan. Trump would see $1.3 trillion more in personal tax cuts and $1.7 trillion more in corporate taxes than the GOP plan over the coming decade (Chart 3). The country's debt-GDP ratio would grow by 25%, well above the GOP's 10-12% increase (Chart 4). Chart 3Trump Would Outdo##br## The GOP On Tax Cuts Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 4Trump Would Outdo##br## The GOP On Debt Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency The Constraints We see no significant political or constitutional constraints facing the GOP and Trump. If we had to pick, we would assume that the ultimate deal will look a lot more like the GOP plan. The two sides will be able to hammer out a compromise for the following reasons: Given the reconciliation rules in the Senate, the Democrats cannot filibuster tax-cutting legislation. Both the Reagan and Bush administrations passed tax cuts in their first year in office - Reagan signed them into law in August, Bush in June. Trump, like Bush, has the advantage of GOP control of both houses of Congress. He and his party would have to fumble the ball very badly to fail on comprehensive tax reform in 2017. Republicans have been demanding tax reform since 2010 and have several "off-the-shelf" plans to draw from, including Ryan's plan. Staffers know the issues. Trump has also already reduced his original ambitions to meet them halfway. Since Trump's campaign did not focus on tax reform, he can afford to let the GOP take the lead on it - he will still get credit for the resulting deal and will expect GOP support on infrastructure, immigration, and trade in turn. The first constraint that does exist is complexity. Comprehensive tax reform has not occurred since 1986, under Reagan, because it is fiendishly tricky. This means the timing could be delayed - perhaps as late as the third quarter of 2017, despite the eagerness of both Congress and the White House for reform. The second constraint is one of priorities. Trump and the GOP have a busy agenda for the first half of 2017, with taxes, Obamacare, and Trump's infrastructure plan. Rumors suggest that Congress will use its first reconciliation bill to repeal Obamacare. But since they do not know what will replace the current law yet, it would make more sense to reverse the order and do tax reform first. This will be easier, again, because tax reform has been a major issue for Republicans for a decade. Third is the problem of permanence. Assuming the Republicans use reconciliation to pass their tax reform, they will not be allowed to increase the federal budget deficit beyond the ten-year time frame of the budget resolution. They will have to include a "sunset" clause on the tax cuts, as occurred with the Bush tax cuts in 2001, leaving them vulnerable to expiration under the next administration.10 The Impact What will a sweeping tax reform plan mean? Headline U.S. corporate taxes are higher than every other country in the OECD, so the U.S. corporate sector will ostensibly gain competitiveness (Chart 5). This factor, combined with repatriation and threats of protectionism against outsourcing multi-national corporates (MNCs), should lift corporate investment in the U.S. Chart 5U.S. Companies Will Get Competitive Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Reducing loopholes would broaden the corporate tax base, the key value of the reform from the perspective of revenues and the country's economic structure. Multinational corporations already pay a lower effective tax rate than the official 35% corporate rate, so the impact will depend on their current effective rate as well as the new rate. Trump's plan would only increase effective taxes for firms in the utilities sector, while the GOP plan could increase effective taxes for firms in finance, electronics, transportation, and leasing. In both cases, companies in construction, retail, agriculture, refining, and non-durable manufacturing stand to benefit the most (Chart 6). Chart 6Tax Cuts Benefit Some Sectors More Than Others Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency A key question is how flow-through businesses are treated: whether they get Trump's 15% or the GOP's 25%. In the latter case they would see a tax hike (from an average rate of 19%) and thereafter be punished relative to more capital-heavy "C" corporations. Trump is a "populist" insofar as his plan would support flow-through businesses. Bottom Line: The quickest and biggest impact of Trump's fiscal policies on GDP growth will come from his tax cuts. With the Republicans long preparing for tax reform, and fully controlling Congress, tax reform is all but a done deal - and probably by Q3 2017 at latest. The outstanding question is whether Trump's infrastructure spending will be included in tax reform and thus compound the positive fiscal impact in 2017, or be pushed off into 2018. Fiscal Spending Trump's proposed $550 billion in new infrastructure investment is as nebulous as many of his other promises. However, as outlined above, we believe that Trump's victory partly depended on this issue and investors should not ignore Trump's commitment to it. Constraints are overstated. The Plan Trump's first clear infrastructure proposal came from two of his special advisers, Wilbur Ross and Peter Navarro.11 They propose government tax credits for private entities who invest in infrastructure projects. They argue that $1 trillion in new infrastructure investment - the same number cited on Trump's campaign website as the country's estimated needs over the next decade - would require $167 billion in equity investment, which could then be leveraged. To raise these sums, they propose the government offer a tax credit equal to 82% of the equity amount. They contend that the plan would be deficit-neutral because payments for the government tax credit would be matched with tax revenues from the labor involved in construction and the corporate profits flowing from the projects, charged at Trump's 15% corporate rate. The other component of the Ross-Navarro plan consists in combining infrastructure financing with the tax repatriation plan - a common proposal in Washington. Companies that are repatriating their earnings at the lower 10% rate could thus invest in infrastructure projects and use the 82% tax credit on that investment to cover the cost of their repatriation taxes. If the Trump administration sticks with this proposal, it will require the GOP to include the infrastructure plan in the tax reform bill. Or, given the bipartisan support for both a new repatriation tax and building infrastructure, Trump could turn to the Democrats for a separate bill covering these two policies. However, the specifics of the Ross-Navarro plan can be chucked out the window at will. They were designed to win the election, not to bind the administration's hands. Already, Trump has reversed his stance on the possibility of a state-run infrastructure bank (one of Clinton's proposals) as a way of financing new projects. What matters is that Trump and his top advisors are enthralled by the idea of a populist or "big government"-style conservatism that takes advantage of historically low interest rates - the post-financial crisis "Keynesian" moment - to stimulate the economy and improve U.S. productivity in the long run.12 Trump's emphasis on this issue in his November 8 victory speech says it all. Thus Trump's infrastructure ambitions are likely to be prioritized and will certainly not be abandoned. Unless Trump drastically alters his handling of the issue on January 20 - which we consider highly unlikely - it should be considered a top priority. The Constraints What are the constraints? President Obama's stimulus plan passed in February 2009, immediately after taking office, but that was in the midst of a financial crisis. Now conditions are different. Infrastructure is popular, but the timing with the economic cycle is not perfect, and the fiscal hawks in the GOP will try to water down Trump's proposals. Our clients are particularly concerned that the Tea Party-linked Republicans in Congress will be a major political hurdle. We disagree. On the issue of funding, what is important for legislative passage is not whether the plan ends up being "deficit neutral" as promised, but whether it can be marketed as such. Key Republicans like Kevin Brady, chair of the House Ways and Means Committee, have already admitted that some of the revenues from repatriated earnings will go toward infrastructure. Public-private partnerships will give Republicans a way of presenting the project as deficit-friendly. And it is true that interest rates are low for borrowers (at least for now), including state and local authorities - which account for the clear majority of infrastructure spending in the U.S. Political constraints are few. Public support for infrastructure is a no-brainer, opinion polls show that the public wants better infrastructure (Chart 7). It is also one of the least polarizing issues of all the issues in a recent Pew survey (Chart 8). Chart 7The 'Right' Kind Of ##br##Government Spending: Infrastructure Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 8Infrastructure Is Not##br## A Partisan Issue Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Moreover, there is no reason to believe that modern Republican presidents are particularly fiscally austere - Nixon, Reagan, and the Bushes were not (Chart 9). And Republican voters are not so fearful of big government when their party is at the helm as when they are in opposition (Chart 10). Election results show that voters consistently approve of about 70% of local transportation funding initiatives, which means they vote in favor of higher taxes to receive better infrastructure (Chart 11). Chart 9Fact: Republicans Run Bigger Budget Deficits bca.gps_sr_2016_11_30_c9 bca.gps_sr_2016_11_30_c9 Chart 10No Ruling Party Fears Big Government bca.gps_sr_2016_11_30_c10 bca.gps_sr_2016_11_30_c10 What about the Tea Party? It is true that fiscal conservatives in the GOP are skeptical of Trump's infrastructure ambitions. The Tea Party and Freedom Caucus make up about 60 combined votes. However, Trump's combination of Eisenhower big-spending Republicanism and populism won the election and has therefore written austerity's obituary. Furthermore, voters identifying with the Tea Party voted for Trump in the Republican primaries, according to exit polls (Chart 12). Hesitancy to support Trump on ideological grounds even caused the former Chairman of the Tea Party Caucus, Tim Huelskamp (R-KS), to lose his primary election to a more Trump-friendly challenger. Given that all members of the House of Representatives must run for re-election in 2018 - with campaigning starting in merely 18 months - they will dare not oppose Trump for fear of being Huelskamped themselves. Chart 11The 'Right' Kind Of Tax Hike: Paying For Roads Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 12Trump Won The Tea Party Vote Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency The political winds against austerity were shifting even before Trump. In January 2015, the GOP-controlled Congress approved of "dynamic scoring," an accounting method that considers the holistic impact of budget measures - spending and/or tax cuts - on revenue and thus deficits.13 The GOP has also recently come close to readmitting "earmarks," legislative tags that direct funding to special interests in representatives' home districts. Earmarks were done away with in 2011, but they have crept back in different guises (Chart 13). Republican members of Congress can hear the gravy train and are scrambling to ensure they get on board. They want to be able to ride the new wave of spending all the way back to re-election in their home districts. Chart 13Pork-Barrel Prohibition Is Ending Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Finally, if Congress takes up an infrastructure-repatriation tax bill separately from the more partisan tax cuts, Trump may be able to offset any holdout fiscal hawks with support from Democrats. In late 2015, Democrats and Republicans voted together on the first highway funding bill in ten years, with large margins in both houses, easily overwhelming dissent from the Tea Party and Freedom Caucus. Vulnerable Democrats in the now "Trump Blue" states of Michigan, Wisconsin, Pennsylvania, and Ohio will be particularly interested in crossing the aisle on any infrastructure spending legislation. The Impact What will be the size and impact of Trump's infrastructure spending? Currently his transition team says he will oversee $550 billion in new investments, albeit offering no details or timeframe. This would be 72% of Obama's 2009 five-year stimulus at a time when there is little or no output or unemployment gap. In other words, the plan is pro-cyclical stimulus that will likely end up generating "too much" growth at a time when inflation expectations are already rising and the output gap is closing. The downside could be a rate-hike induced recession in 12-18 months. In terms of its impact on debt levels, infrastructure spending is less of a concern. The federal share of that $550 billion - i.e. the size of the tax credit for private participants - is going to be much smaller. During the campaign Trump implied $1 trillion in new investments over ten years, but the federal tax credit would have been a "deficit neutral" $137 billion. Applying the same ratio, back of envelope, Trump now aims for a $75 billion tax credit for the $550 billion worth of projects. But there will also likely be other components to the plan, such as federal support for state and local debt-financed infrastructure. Thus the headline size of Trump's infrastructure plan is far bigger than the federal commitment. Still, investors should appreciate that despite its modest size, the plan marks a break from the austerity-focused past. Bottom Line: Trump's election signals an anti-austerity turn in U.S. politics from which the fiscal hawks in the GOP cannot hide. Trump will ultimately receive congressional support on infrastructure spending, possibly bipartisan, and this "Return of G" will mark an important inflection point in U.S. economic policy.14 Immigration Globalization is, broadly defined, the free movement of goods, services, capital, and people. Trump began his campaign in June 2015 with a blistering speech opposing illegal immigration. His anti-immigrant rhetoric ratcheted up from that point, but while the media focused on the alleged xenophobia of his comments, Trump's message was consistently focused on the economic downside of an "open borders" policy. Since the election, Trump's rhetoric on immigration has dramatically softened. The Plan There are two components of Trump's immigration plan as far as we can tell: deportation and border enforcement. On the first, Trump's primary goal is to terminate Obama's "two illegal executive amnesties," i.e. Deferred Action for Childhood Arrivals (DACA) and Deferred Action for Parents of Americans (DAPA).15 This means he opposes two programs that are already frozen. In addition, he has pledged to deport 2-3 million undocumented immigrants, emphasizing criminals and drug offenders. This is comparable to Obama's 2.5 million deportations from 2009-15, the highest clip on record. We expect Trump to accelerate the pace of deportations, but it is by no means clear that he will do so, or do so dramatically. There is as yet no clear plan to deal with high-skilled immigrants, especially those arriving on H-1B non-immigrant visas authorizing temporary employment. Trump has made conflicting statements regarding the H-1B program, saying he wanted to keep attracting highly skilled workers to the U.S. but also criticizing the program specifically during a debate. Trump's pick for the attorney general, Alabama Senator Jeff Sessions, is a big opponent of the program. There is considerable evidence that the H-1B program hurts the wages of domestic workers, particularly in the tech sector.16 As for Trump's notorious "border wall," it is shaping up to be a change in degree, not kind. The Clinton administration's "deterrence through prevention" policy, beginning in 1994, and the Secure Fence Act of 2006, have led to extensive fencing and wall construction along the border over the past two decades. Trump will seek to fill gaps, reinforce border barriers, and probably erect better fences near population centers as more visible signs of his achievements. But he will not be building a Great Wall of Trump. The Constraints There are no major constitutional constraints on any of the proposals, since Trump is reversing the Obama administration's illegal non-enforcement of existing immigration law.17 The chief constraint Trump faces when it comes to increasing the pace of deportations and building enhanced walling and fencing is the cost. The threat to make Mexico provide all the funds is going to be watered down in negotiations.18 Trump could increase the Department of Homeland Security's budget, which slowed from 12% annual growth under Bush to 2.7% under Obama. Presumably congressional opposition would not be too virulent given the purpose. But spending on immigration enforcement already outpaces that of all other federal law enforcement agencies combined. A bigger constraint is whether, after the border is "normalized," Trump will follow through on his promise to make a "determination" on what to do with the non-criminal illegal immigrants. This language implies that he is ultimately amenable to comprehensive immigration reform and even a path to citizenship - a proposal that has already passed the Senate in an earlier form. To pass such a comprehensive reform bill, however, Trump will need to work with the Democrats in the Senate as they can and will filibuster any immigration reform bill that does not have a path towards some form of amnesty for the immigrants in the country. What of the timing? Deportations can begin promptly upon taking office - the agencies are already capable. Increasing border enforcement and structures will likely go into his first fiscal 2018 budget request - we expect the GOP Congress to be receptive. As for broader immigration reform, these will be the slowest to materialize, if ever. Previous GOP immigration reform laws passed after the midterm elections in 1986 and 1990, so 2018 may be a useful marker. The Impact On the margin, less immigration into the U.S. should raise domestic wages, particularly for the two sectors where low-skilled immigrants are most likely to be employed: agriculture and construction. Bottom Line: Trump's immigration policy is hardly revolutionary, despite his campaign focus on the issue. He has few constraints to his announced policies, but they are likely to be unimpressive in scope. There are three potential risks to our sanguine view. First, Trump decides to deport all the 11 million illegal migrants in the country, causing considerable political and social unrest. Second, he actually means what he says about Mexico paying for the wall. Third, he tries to end the H-B1 high-skilled temporary workers program. Reforming the overall immigration process - including a possible pathway to citizenship - is constrained by Democrats' control of the Senate and will therefore likely proceed on a longer timeframe (perhaps even after 2020). Trade Trump's trade protectionism is the main risk to markets and global risk assets. His victory represents a true break with the past seventy years of ever-greater globalization (Chart 14). We have expected the trend of de-globalization since, at least, 2014. However, we are surprised how quickly the issue became the electoral issue. Chart 14Globalization Peaked Before Trump Globalization Peaked Before Trump Globalization Peaked Before Trump Investors now have to re-price numerous assets for the de-globalization premium. The Plan Trump has threatened to name China a currency manipulator on day one in office, impose a 45% across-the-board tariff on Chinese goods, and a 35% tariff on Mexican goods. He has committed to canceling the U.S.'s biggest trade initiative in the twenty-first century, the Trans-Pacific Partnership (TPP), and he has threatened to renegotiate NAFTA and withdraw from the WTO, leaving U.S. tariffs with nothing but Smoot-Hawley to keep them tethered to earth. Thus Trump's victory threatens to become not only the chief symptom of "peak globalization"19 but also a great aggravator of it and cause of further de-globalization going forward (Chart 15). Chart 15De-Globalization To Continue bca.gps_sr_2016_11_30_c15 bca.gps_sr_2016_11_30_c15 There are signs that Trump may act on his rhetoric and enact a radical change in U.S. trade policy. Two of his top advisers, Dan DiMicco and Robert Lighthizer, are outspoken economic nationalists and "China bashers." DiMicco has dedicated his life to fighting Chinese mercantilism and believes that the U.S. and China are "already in a trade war; we [the U.S.] just haven't shown up yet."20 Yet there are also signs that Trump intends only to drive a hard bargain, not start a trade war. For instance, he says his first action will be to rip up the TPP, but this deal has not been ratified and was internationally controversial because it excluded China (as well as U.S. allies Korea, Thailand, and the Philippines). Moreover, while Trump says he will deem China a currency manipulator on day one in office, this is largely a symbolic act that entails no automatic, concrete punitive measures.21 Therefore Trump could take these two actions alone, or other symbolic ones, to prove that he is an economic patriot, and then settle down to "renegotiate" key trade relationships along the lines of the status quo. It is too soon to draw conclusions, but we do not think things will turn out as peachy as the best-case scenario. This is in large part due to the fact that the U.S. president has tremendous leeway on trade. The Constraints The U.S. president has few constraints when it comes to trade policy, for the following reasons:22 Delegated powers from Congress: Congress is the constitutional power that governs trade with foreign states. However, Congress passes laws that delegate authority to the executive branch to administer and enforce trade agreements and to exercise prerogative amid exigencies. Even when Congress approves a trade deal like NAFTA, it is the president who is empowered to lower tariffs - and therefore the president can issue a new proclamation raising them. The past century has produced a series of laws that give Trump considerable latitude - not only the right to impose a 15% tariff for up to 150 days, as in the Trade Act of 1974, but also unrestricted tariff and import quota powers during wartime or national emergencies, as in the Trading With The Enemy Act of 1917 (Table 1).23 A president's legal advisors are only too happy to use their imaginations. Nixon invoked the Korean War, which ended in 1952, as a justification for a 10% surcharge tariff on all dutiable goods in 1971, simply because the Korean state of emergency had never officially ended! Table 1Trump Faces Few Constraints On Trade Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Executive power over foreign policy: The executive branch is the constitutional power that governs foreign relations. Since international economics are inseparable from foreign relations and national security, the president has prerogative over matters even remotely touching trade. Both Congress and the judicial branch will tend to defer to a president in exercising these powers as well - at least until a gross subversion of national interest occurs. And even then, it is not clear how the constitutional struggle would play out - the courts always bow to the executive on matters of national security. Wars do not have to be declared for wartime trade powers, so all the U.S.'s various military operations across the world provide fodder for Trump to invoke the Trading With The Enemy Act, giving him power to regulate all forms of trade and seize foreign assets. Time is on the executive's side: Even assuming that Congress or the Supreme Court move to oppose the executive, it will likely be too late to avoid serious ramifications and retaliation from abroad. Congress is unlikely to vote to overrule the president until the damage has already been done - especially given Trump's powers delegated from Congress.24 As for the courts, the executive could swamp them with justifications for its actions; the courts would have to deem the executive likely to lose every single one of these cases in order to issue a preliminary injunction against each of them and halt the president's orders. Any final Supreme Court ruling would take at least a year. International law would be neither speedy nor binding. The Impact Trump is deeply committed to a tougher trade stance, has few constraints, and his protectionism deeply resonated with key swing voters. We doubt he will settle for cosmetic changes and the establishment Republican "business as usual." This means China relations are a major risk, especially in the long run. We will expand on these tensions, which will become geopolitical, in an upcoming report. What happens if Trump pursues protectionism wholeheartedly? First, the good. On the margin, some trade protections could attract foreign companies to relocate to the U.S. and discourage American companies from outsourcing - boosting investment and wages. It could also help slow the decline of American manufacturing employment. A simple comparison with Europe and Japan shows that the decrease of manufacturing jobs has been more dramatic in the U.S., so policy may be able to conserve what is left (Chart 16). Second, the bad. All the developed countries have seen manufacturing jobs decrease, and not only because of globalization. Technological advancement has played a major role as well. You can block off foreign goods, but you cannot roll back the march of the automatons (Chart 17), as our colleagues at U.S. Investment Strategy recently pointed out.25 Trump's blue collar workers may realize, after four years of protectionism that jobs are not coming back while the WalMart bills are getting pricier. Who will they vote for after that realization sets in? Chart 16U.S. Manufacturing Decline##br## Sharper Than In Other DM U.S. Manufacturing Decline Sharper Than In Other DM U.S. Manufacturing Decline Sharper Than In Other DM Chart 17Reasons For Robots##br## To Replace Workers Reasons For Robots To Replace Workers Reasons For Robots To Replace Workers Third, the ugly. If the U.S. goes protectionist, it will pull the rug out from neoliberalism globally and provide cover for similar protectionist realignments around the world - retaliatory as well as copy-cat. A falling tide lowers all boats. Worse than that, the decline in trade, insofar as it forces countries to rely on domestic markets, pursue spheres of influence, and protect access to vital commodities, could spark military conflict. Germany and Japan both started World War II precisely because their autarkic fantasies required expansion and pre-emptive warfare. This would be the mercantilist future that we warned clients of earlier this year.26 None of this is a foregone conclusion. There is simply too little information to judge which way the Trump administration will go - and how fast. But the fact remains that on trade, more so than anything else, Trump will be unconstrained. Bottom Line: De-globalization is the major risk of the Trump presidency.27 How Trump handles relations with China in 2017 will be the key indicator of whether he aims to revolutionize U.S. trade policy to the detriment of global exports and growth. If he blows past the rule of law and imposes steep "retribution" tariffs or quotas right away, then fasten your seat belt. Investment Conclusions For several years we have warned clients that austerity is kaput.28 It was never politically sustainable in the post-Debt Supercycle, low -growth environment that followed the 2008 Great Recession. The pendulum is swinging hard the opposite way, with Trump's heavy-handed, somewhat haphazard approach, adding momentum. Once the U.S. moves against austerity, we expect policymakers in other countries to follow. In the near term, the carnage in long-dated Treasury markets may pause as investors overthink the constraints to "G." Bond yields have already moved quite a bit. Structurally, however, the 35-year bond bull market is over.29 We continue to recommend that clients play the 2-year/30-year Treasury curve steepener, a position that is in the black by 11.2 basis points since November 1. In the long term, Trump's anti-globalization policies will impact investors the most. More protectionism, less immigration, and dollar-bullish fiscal policies will all be negative for America's MNCs. Meanwhile, fiscal spending, a stronger USD, and corporate tax reform that benefits small and medium enterprises (SMEs) paying the high marginal tax rate will benefit Main Street. As such, the way to play de-globalization in the U.S. is to go long SMEs / short MNCs, a view that we will expand upon in an upcoming collaborative report with BCA's Global Alpha Sector Strategy. Beyond the U.S., de-globalization will favor domestic consumer-oriented sectors and countries and will imperil international export-oriented sectors and countries. We particularly fear for export-heavy emerging markets, which depend on globalization for both capital and market access. Developed markets should have an easier time transitioning into a more protectionist world. As such, we continue to recommend a structural overweight in DM versus EM. For the time being, we are booking gains on our long S&P 500 / short gold trade, for a gain of 11.53% since November 8, due to our concern that equities may have already priced-in the lifting of animal spirits but not the negatives of de-globalization. Near term risk also abounds for our high-beta positions such as our long Japanese equities trade (gain of 3.99% since initiation on September 26) and long USD/JPY (gain of 3.57%, same initiation day). We will book gains and look to reinitiate both at a later date, given that our positive view on Japan remains the same. We will also close our long European versus global equities view, for a small loss of 1.34%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 3 In physics, the Heisenberg's uncertainty principle - fundamental to quantum mechanics - supposes that the more precisely the position of a particle is determined, the less precisely its momentum can be known. Trump does not merely "flip flop" on policy issues - as his opponent Secretary Hillary Clinton was often accused of doing - but literally embodies two opposing policy views at the same time. 4 #TrumpisnotLucifer. 5 Reconciliation is a legislative process in the U.S. Senate that limits debate on a budget bill to twenty hours, thus preventing the minority from using the filibuster to veto the process. The procedure has also been used to enact tax cuts. In both 2001 and 2003, the Republican-held Senate used the procedure to pass President George W. Bush's tax cuts. 6 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. For analysis, please see Jim Nunns et al, "An Analysis of the House GOP Tax Plan," Tax Policy Center, September 16, 2016, available at www.taxpolicycenter.org. 7 A "flow-through" entity passes income on to the owners and/or investors. As such, the business can avoid double taxation, where both investors and the business are taxed. Only the investors and owners of a flow-through business are taxed on revenues. 8 Several groups would see no substantial tax cuts under the plan. Those making $15,000-$19,000 would see their tax rate increase from 10% to 12%. Those making $52,500-101,500 would see their rate stay the same at 25%, while those making $127,500-$200,500 would see their rate rise from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. 9 A favorable rate of 10% (4% for non-cash assets) will be applied to accumulated earnings prior to 2017, while future overseas earnings will be subject to the corporate tax rate of 15%. The Tax Policy Center projects that $148 billion worth of unpaid tax revenue can be collected through the "deemed" (mandatory) repatriation. 10 The Bush tax cuts were extended in the American Taxpayer Relief Act of 2012, with some exceptions, like for the highest income groups. 11 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. The Trump campaign initially implied a decade-long total investment of $1 trillion "Trump Infrastructure Plan," with the government contributing a seed amount. The $1 trillion infrastructure-gap estimate comes from the National Association of Manufacturers, "Build to Win," dated 2016, available at www.donaldjtrump.com. The Trump team has reduced its total infrastructure investment goal to $550 billion, a number reaffirmed on Trump's White House transition website, www.greatagain.gov. 12 Please see Daniella Diaz, "Steve Bannon: 'Darkness is good,'" CNN, November 19, 2016, available at edition.cnn.com. Bannon, Trump's chief strategist, said: "Like (Andrew) Jackson's populism, we're going to build an entirely new political movement ... It's everything related to jobs. The conservatives are going to go crazy. I'm the guy pushing a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it's the greatest opportunity to rebuild everything. Shipyards, iron works, get them all jacked up. We're just going to throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, greater than the Reagan revolution - conservatives, plus populists, in an economic nationalist movement." 13 Dynamic-scoring, also known as macroeconomic modeling, is a favorite tool of Republican legislators when passing tax cut legislation. It allows them to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. However, there is no reason why Republicans, under Trump, could not use the methodology for infrastructure spending as well. 14 Please see BCA Geopolitical Strategy Monthly Report, "Nuthin' But A G Thang," dated August 12, 2015, available at gps.bcaresearch.com. 15 By these executive orders, the Obama administration sought to prioritize the deportation of "high-risk" illegal immigrants while delaying action on more sympathetic groups. However, only one program was actually implemented (DACA), and both ground to a halt when the Supreme Court ordered an injunction. The justices concurred with lower courts that halted the programs as a result of the burden they would place on state finances. 16 Please see BCA Geopolitical Strategy Special Report, "Immigration Wars: The Coming Battle For Skilled Migrants," dated March 13, 2013, available at gps.bcaresearch.com. 17 The courts have already done the heavy lifting. Moreover the nullification of DACA only makes illegal immigrant children eligible for deportation, it does not necessitate that Trump actually deport them - that would require increasing the budget and capacity of Immigration and Customs Enforcement to cope with an additional four million deportees, all "low risk" and politically sympathetic. We doubt Trump will do this. 18 If Trump acts on his promise to make Mexico pay for the wall - a claim notably missing from his transition website greatagain.gov - then he may need to precipitate a foreign policy crisis (not to mention court opposition) through his own series of controversial executive orders. Alternatively, he could try to get Congress to amend the Patriot Act to allow the U.S. to extract payments from remittances from the U.S. to Mexico, but he would be at risk of a Senate filibuster. Both pose significant constraints. 19 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 20 Please see Lisa Reisman, "Nucor Provides Testimony To US House Ways And Means Committee On China Exchange Rate Policy," Metal Miner, September 16, 2010, available at www.agmetalminer.com. 21 Please see BCA China Investment Strategy, "China As A Currency Manipulator?" dated November 24, 2016, available at cis.bcaresearch.com. 22 In what follows we are indebted to an excellent paper by Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 23 See in particular the Trade Expansion Act of 1962 (Section 232b), the Trade Act of 1974 (Sections 122, 301), the Trading With The Enemy Act of 1917 (Section 5b), and the International Emergency Economic Powers Act of 1977. 24 A Federal District Court and the Supreme Court ruled against Harry Truman's executive orders to seize steel mills during the Korean War, but Truman's lawyers did not provide a statutory basis for his actions - they simply argued that the constitution did not limit the president's powers! 25 Please see BCA U.S. Investment Strategy Weekly Report, "Easier Fiscal, Tighter Money?," dated November 14, 2016, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Monthly Report, "Austerity Is Kaput," dated May 8, 2013, available at gps.bcaresearch.com. 29 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com.

Highlights The basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. Even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. Trade friction between the U.S. and China may increase with product-specific tariffs, but that a broader escalation in protectionism is unlikely, at least in the near term. The changing correlation between the RMB and Chinese stocks suggests that investors may be becoming less worried about the RMB and China's foreign exchange policy. Over the long run, the "normal" negative correlation between the performance of exchange rate and that of the stock market should also emerge with regards to the RMB and Chinese stocks. Feature Financial markets will continue to grapple with what U.S. President-elect Donald Trump will bring to the global economy as we head into the final trading weeks of 2016. His signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - have already led to a significant repricing of risk asset, and will continue to unsettle investors. As far as China is concerned, the upshot is that more fiscal stimulus under President Trump will generate stronger American demand, which could spill over to China. The downside risk is undoubtedly protectionism, which will cast a long shadow on an economy that is still heavily dependent on overseas markets.1 President-elect Trump declared on the campaign trail that he would name China a currency manipulator on his first day in office, accompanied by punitive tariffs on Chinese imports that could reach 45%. This adds a major uncertainty to the growth outlook for China next year. Conditions And Remedies For A Currency Manipulator For now, it is impossible to predict what President Trump will do. He has become notably more pragmatic since his election victory. In his first policy statement, he declared his intentions to withdraw the U.S. from the Trans-Pacific Partnership (TPP) negotiations as his top priority on trade, while avoiding further China-bashing. However, the true color of his trade policy remains unclear. What is more certain is that the basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. The existing Treasury review process of foreign exchange practices is a formal process laid out in statutory law that governs the reporting process, the need for negotiations in cases of manipulation, and the recommended trade remedies if negotiations fail. Specifically, there are three conditions a nation must meet to be labeled a currency manipulator: It runs a significant bilateral trade surplus with the U.S.; It has a material current account surplus; and It has engaged in persistent one-sided intervention in the foreign exchange market. In China's case, the country does run a significant bilateral trade surplus with the U.S., but its current account surplus as a share of GDP has declined from a peak of 10% in 2007 to 2.5% currently (Chart 1). More importantly, while China's foreign exchange market intervention has indeed been one-sided since 2014, the effort has been to prop up the RMB against the dollar. Without the PBoC's intervention, the RMB would have fallen further, potentially substantially. The RMB may have met all three criteria for currency manipulation before the global financial crisis, but the case is a lot harder to make at the moment. Chart 1Conditions For A Currency Manipulator Conditions For A Currency Manipulator Conditions For A Currency Manipulator Moreover, even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. The U.S. Treasury is required to negotiate with alleged currency manipulators, utilizing several "sticks" if negotiations fail: Prohibit the Overseas Private Investment Corporation from financing (including providing insurance to) new projects in that country; Prohibit the federal government from procuring from that country; Seek additional surveillance of the macroeconomic and exchange rate policies of that country through the International Monetary Fund; Take into account the currency practices in negotiating new bilateral or regional trade agreements with that country. While these "sticks" may be intimidating enough for small open economies, for a country like China, they are largely irrelevant. There is no ongoing negotiation for bilateral trade agreement between the two countries, and on a federal level the U.S. government rarely procures in China, if at all. Therefore, labeling China a currency manipulator may be a highly symbolic move aimed at satisfying Trump supporters, but the real economic consequences are rather small. To be sure, the U.S. president has enough administrative authority to bypass existing legal constraints and take unilateral action on trade issues. However, that would require extraordinary political capital. Barring this rather "extreme" scenario, we expect trade frictions between the U.S. and China to increase in the form of product-specific tariffs. A broader escalation in protectionism is unlikely, at least in the near term. The Impact On Investment Flows From a balance-of-payment point of view, a country running a trade deficit should not be viewed as a sign that it is losing in bilateral trade. Rather, it reflects capital flows from a surplus country to a deficit country in the form of exported domestic savings. In this vein, China running a chronic current account surplus with the U.S. implies that the country as a whole has been accumulating U.S. assets. By the same token, so long as China runs a current account surplus, it means it is still a net creditor to the rest of the world, and the nation's foreign asset holdings, official and private sector combined, continue to increase. In previous years, it was the Chinese central bank that had increased its holdings of foreign assets, primarily in the form of U.S. Treasurys and other low-risk liquid assets. More recently, as the RMB has been depreciating against the dollar, the Chinese domestic private sector been accumulating foreign assets, particularly denominated in U.S. dollars. In fact, the private sector has taken over as the main source of demand for foreign assets, primarily in risker asset classes such as corporate equities, bonds and real estate. The official sector, on the other hand, has been selling foreign asset holdings, as reflected in China's declining official reserves. In other words, rather than experiencing an exodus of capital, there has been a gigantic "swap" of foreign assets between private and public sector in China. Indeed, Chart 2 shows China's official reserves have dropped significantly in the past two years. Chinese official holdings of Treasurys currently stand at USD 1157 billion, down from USD 1315 billion in 2011. Meanwhile, anecdotal evidence suggests that buoyant demand among Chinese households for foreign assets, particularly real estate. For the corporate sector, there has been a dramatic increase in overseas mergers and acquisitions (M&A) and other investment activity by Chinese companies, particularly in the U.S. (Chart 3). So far this year, total announced M&A deals by Chinese firms in the U.S. have already tripled compared to last year, however, most are still in progress and pending. Chart 2The Official Sector Is##br## Shedding Foreign Assets... The Official Sector Is Shedding Foreign Assets... The Official Sector Is Shedding Foreign Assets... Chart 3... While The Private ##br##Sector Accumulates China As A Currency Manipulator? China As A Currency Manipulator? Looking forward, if the business environment in the U.S. under President Trump becomes less foreign-friendly, it may impact Chinese enterprises' confidence in acquiring U.S. assets, and complicate Chinese companies' M&A deals. At a minimum, the massive increase in Chinese M&A interest in the U.S. will pause until policy visibility improves, while the outlook for many already announced pending deals will remain murky. This may deter further capital flows to the U.S. by the Chinese private sector. Changing Correlation Between The RMB And Stocks? The RMB has continued to drift lower against the dollar in the past week in both the onshore and offshore markets. Interestingly, Chinese stocks have appeared to have largely ignored the RMB's slide and have continued to move higher. This is in stark contrast to last year's panic selloffs that happened whenever RMB appreciation against the dollar appeared to quicken (Chart 4). In August 2015 and January 2016, the RMB's outsized moves against the dollar caused major disruptions in both A shares and H shares, sending shockwaves across the globe. It is too soon to draw definitive conclusions from very short-term moves. However, the changing correlation between the RMB and Chinese stocks suggests that investors may have become less worried about the RMB and China's foreign exchange policy. First, investors may be getting more accustomed to the RMB's rising volatility. The trade-weighted RMB in recent days has been stable, a sign that the RMB's weakness against the dollar is mainly a reflection of the strong dollar. The People's Bank of China and other relevant authorities have also been paying more attention when communicating to market participants, which may also help anchor investors' expectations. Second, in previous episodes of "sharper" RMB depreciation, the Chinese economy was clearly decelerating, and the RMB weakness further amplified investors' anxiety on China's macro conditions. Currently the Chinese economy is showing notable signs of improvement, particularly in the industrial sector, which also lessens investors' concerns. Chart 4The RMB Is Less Troubling ##br##To Market bca.cis_wr_2016_11_24_c4 bca.cis_wr_2016_11_24_c4 Chart 5The Mirror Image Between Yen ##br##And Japanese Stocks The Mirror Image Between Yen And Japanese Stocks The Mirror Image Between Yen And Japanese Stocks Finally, the market may be starting to reflect the reflationary impact of a weaker currency rather than the negative consequences of RMB depreciation. China's growth improvement is in no small part attributable to the falling exchange rate. This in and of itself limits the RMB's downside, rather than leading to an endless downward spiral. It remains to be seen whether Chinese stocks will stay calm as the RMB continues to depreciate against a surging dollar. Our hunch is that global equity markets, particularly in the U.S., have become complacent with a strong dollar and rising U.S. interest rates, both of which tighten global liquidity conditions. Therefore, global equities are vulnerable to downside risk, which could spill over to the Chinese market. For now, we are staying on the sidelines and do not suggest investors chase the rally in Chinese equities. However, over the long run, we expect investors will eventually come to terms with the "new normal" for the RMB as it becomes an important macro factor for the economy and stock market. Chart 5 shows that the performance of Japanese stocks has almost been a mirror image of the yen/dollar exchange rate, in which a weaker yen boosts Japan's growth profile as well as stock prices, and vice versa. Barring a crisis scenario, such a correlation will also emerge between the RMB and Chinese stocks over the long run. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Investors are betting that Trump's expansionary agenda will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. We doubt that Trump's fiscal and regulatory plan will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place. We expect that Trump will find most common ground with Congress on the fiscal side. It will be difficult, politically, for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform. We expect a meaningful fiscal stimulus package to be passed in the U.S. that will boost growth temporarily. We cannot rule out a trade war that more than offsets the fiscal impulse. Nonetheless, Trump's desire for growth means that he may tread carefully on protectionism. A window may open next year that will favor risk assets for a period of time. A temporary U.S. growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Our bias is to upgrade risk assets to overweight, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new Administration's policy intentions. In the meantime, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. The bond selloff is likely to pause until there is more concrete evidence that Congress will accept tax cuts and infrastructure spending, but global yields eventually have more upside potential. Value and relative monetary policies favor the Japanese and European stock markets versus the U.S., at least in local currencies. We are less bearish on high-yield bonds in relative terms, although we are still slightly below-benchmark. Feature Initial fears that a Trump victory would be apocalyptic for the economy and financial markets quickly morphed into an equity celebration on hopes that the Republican sweep would usher in policies that will shift American growth into high gear. Major U.S. stock indexes have broken above recent trading ranges, despite the surge in the dollar and the devastation in bond markets. Investors are betting that Trump's expansionary policies will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. In the meantime, investors should remain long the dollar and short duration within bond portfolios, although a near-term correction of recent market action appears likely. Our geopolitical strategists argued through the entire campaign that Trump had a better chance of winning than the consensus believed because he was riding a voter preference wave that is moving left. Trump campaigned as an unorthodox Republican, appealing to white, blue collar voters by blaming globalization for their job losses and low wages, and by refusing to accept Republican (GOP) orthodoxy on fiscal austerity or entitlement spending. Chart I-1Big Government Is Only ##br##A Problem For The Opposition bca.bca_mp_2016_12_01_s1_c1 bca.bca_mp_2016_12_01_s1_c1 The polarization of U.S. voters and comparisons with the U.K. Brexit vote are well trodden themes that we won't rehash here. The important point is that the GOP now holds both the White House and Congress. The investment implications hinge critically on how friendly Congress is to Trump's policy prescriptions. Many pundits argue that House and Senate Republican's will block Trump's ambitious tax cut and infrastructure spending plan because it would blow out the budget deficit. The reality is more complex. It will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Our post-election Special Report pointed out that, over the past 28 years, each new president has generally succeeded in passing their signature items.1 Moreover, the GOP is less fiscally conservative than is widely believed. Fiscal trends under the Bush and Reagan administrations highlighted that Republicans do not always keep spending in check (Chart I-1). The key pillars of Trump's campaign were renegotiating trade deals, immigration reform, increased infrastructure and defense spending, tax cuts, protecting entitlements, repealing Obamacare and reducing regulations. However, there is a big difference between election promises and what can actually be delivered. It is early going, but our first Special Report, beginning on page 19, presents a Q&A from our geopolitical team on what we know in terms of political constraints and possible outcomes in the coming year. Common Ground On Fiscal Policy We expect that Trump will find most common ground with Congress on the fiscal side. Infrastructure spending has bipartisan support, as highlighted by last year's highway funding bill. Democratic senators and House Republicans have promised to work with the new President on infrastructure spending. Trump is likely to offer tax reform in exchange for his infrastructure plan. Trump wants to cut the top marginal corporate tax rate (from 39.6% to 33%), repeal the Alternative Minimum Tax, and slash the corporate tax rate (from 35% to 15%). His plan also includes increased standard deduction limits and a full expensing of business capital spending. The Tax Policy Center estimates that Trump's tax plan alone would increase federal debt by $6.2 trillion over the next ten years (excluding additional interest).2 An extra $1 trillion in infrastructure outlays over the next decade, together with a growing defense budget, could add another $100-$200 billion to total federal spending per year. The problem, of course, is that few sources of new revenue have been suggested to cover the costs of these policy changes. The Tax Policy Center's scoring of the Trump plan implies a jump in the U.S. debt/GDP ratio from 77% today to 106% in 2026. Other studies claim that the budget damage will be far less than this because government revenues will boom along with the economy. We doubt that will be the case. The outlook for U.S. trade policy is even more nebulous. Trump has threatened to kill the Trans-Pacific Partnership (TPP), renegotiate the North American Free Trade Agreement (NAFTA) and potentially place tariffs of 35% and 45%, respectively, on imports from Mexico and China (among other protectionist measures). He has even threatened to take the U.S. out of the WTO.3 These threats are no more than posturing ahead of negotiations, but Trump needs to show his base of support that he is working to "make America great again". Protectionism will probably generate more pushback from Republicans in the House and Senate than Trump's fiscal measures. The Economic Implications Of Trumponomics Table I-1Ranges For U.S. Fiscal Multipliers December 2016 December 2016 In terms of the overall economic impact, there are many moving parts and it is unclear how much the Trump Administration will push fiscal stimulus versus trade protectionism. As discussed in the Special Report, it is possible that the tax cuts will be implemented as quickly as the second quarter of 2017, while infrastructure spending could begin ramping up in the second half of the year. However, we cannot rule out a lengthy bargaining process that would delay the economic stimulus into 2018. We doubt that Trump will get everything on his wish list. Moreover, the multiplier effects of tax cuts, which will benefit the upper-income classes the most, are smaller than for direct government spending (Table I-1). Nevertheless, even if he gets one quarter of what he is seeking, it could be enough to boost aggregate demand growth by up to 1% per year over a two year period. In terms of trade, Trump will undoubtedly kill the TPP immediately following his inauguration to show he means business. The President also has the power to implement tariffs without Congressional consent. It is unclear whether he can also cancel NAFTA unilaterally, but at a minimum he can impose higher tariffs and trade restrictions on Canada and Mexico. Nonetheless, comments from his advisors suggest that president-elect Trump wants stronger growth above all else. This means that he may tread carefully to avoid the negative growth effects of a trade war. Some high-profile studies of the impact of the Trump economic plan paint a grim picture. The Peterson Institute points out that "withdrawal from the WTO would lead to the unraveling of all tariff negotiations and the reversion of rates to the MFN level of a preexisting agreement, conceivably all the way back to the Smoot-Hawley rates that were in effect in 1934." Another Peterson study reported the results of a simulation of the impact of returning to the Smoot-Hawley tariff levels, using a large general equilibrium global model.4 They find that U.S. real GDP would contract by about 7½%, or roughly $1 trillion. Thus, a "doomsday trade scenario" is possible, but it seems inconceivable that Trump would withdraw from the WTO given his desire for growth. More likely, he will settle for higher tariffs placed on Mexico and China. Such tariffs would undermine U.S. growth on their own, but we believe that some recent studies discussed in the press overstate the negative impact of these tariffs. Back-of-the-envelope estimates suggest that the tariff increases would reduce U.S. real GDP by roughly 1.2%, including retaliation by Mexico and China in the form of higher tariffs on U.S. exports (see Box I-1 for more details). The negative shock would likely be stretched over a couple of years.5 Box 1 Importantly, not all of any tariff increase would be "passed-through" to U.S. businesses and households. Studies show that, historically, the pass-through of tariff increases into U.S. prices was actually quite low, at about 0.5. A large portion of previous tariff hikes have been absorbed by foreign producers as they endeavored to protect market share. This means that a 35% tariff on Mexican imports would result in a roughly 17½% rise in import prices from Mexico. A 45% tariff on Chinese goods would result in a 22½% rise in import prices from China. Moreover, the import price elasticity of U.S. demand, or the sensitivity of U.S. demand to a change in the price of imported goods, is estimated to be about 1. That is, a 22½% rise in import prices from China leads to a 22½% drop in import volumes from that country. Roughly one-half of the drop in imports is replaced by purchases from other countries and one-half from U.S. sources. This so-called "expenditure switching" effect actually boosts U.S. real GDP on its own. Of course, this lift is more than offset by the fact that households and businesses suffer a loss of purchasing power due to higher import prices. Chinese and Mexican imports represent 2.7% and 1.7%, respectively, of U.S. GDP. With these figures and the elasticities discussed above, we can calculate a back-of-the-envelope estimate of the impact of the Trump tariffs. The expenditure switching effect would boost U.S. real GDP by about 0.4%. This is offset by the purchasing power effect of -0.7% (including a multiplier of 1.5), leaving a net loss of only 0.3%. Of course, China and Mexico will retaliate by imposing higher tariffs on U.S. exports. This has a larger negative impact on the U.S. because American export volumes decline and there is no offsetting expenditure-switching effect. We estimate that retaliation with equal tariffs on U.S. exports would reduce U.S. GDP by about 1% using reasonable elasticities. Adding it all up, the proposed Trump tariffs on China and Mexico would result in a roughly 1.2% hit to U.S. real GDP. This could overstate the negative shock to the extent that the tariff revenues are spent by the U.S. government.6 Moreover, some studies of the Trump agenda assume that business spending would wither under a stronger dollar, waning business confidence and higher interest rates. We are not so pessimistic. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Such worries were a key reason why Japanese automobile companies began to invest in new U.S. production capacity starting in the 1980s. Moreover, U.S. corporate capital spending has been lackluster since the Great Recession due to "offshoring". Higher tariffs would promote "onshoring", helping to lift capital spending within the U.S. economy. We are not arguing that trade protectionism will be good for the U.S. economy. We are merely pointing out that there are positive offsets to the negative aspects of protectionism, and that many studies are overly pessimistic on the impact on growth. That said, all bets are off if Trump does the unthinkable and cancels NAFTA outright and/or takes the U.S. out of the WTO. The Fed's Reaction The economic and financial market dynamics over the next couple of years depend importantly on how the Fed responds to the Trump policy mix. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked the Fed Chair and current monetary policy settings. A review of the Fed may happen at some point, but we assert that an investigation will not be a priority early in Trump's mandate. Some have raised concerns that Trump could stack the FOMC with hawks when he fills the openings next year. More likely, he will opt for doves because he will not want a hawkish Fed prematurely shutting down the expansion. The studies that warn of a major U.S. recession under Trump's policies assume that the Fed tightens aggressively as fiscal stimulus lifts the economy's growth rate. For example, the Moodys' report assumes that the fed funds rate rises to 6½% by 2018!7 No wonder Moodys' foresees a downturn that is longer than the Great Recession. No doubt, it would have been better if fiscal stimulus arrived years ago when there was a substantial amount of economic slack. With the economy close to full employment today, aggressive government pump-priming could set the U.S. up for a typical end to the business cycle; overheating followed by a Fed-induced recession. Indeed, many investors are wondering if the U.S. is overdue for a recession anyway. The current expansion phase is indeed looking long-in-the-tooth by historical standards. However, the old adage is apt: "expansions don't die of old age, they are murdered by the Fed". In Charts I-2A, Chart I-2B and Chart I-2C, we split the U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from the medium and long expansions is the speed by which the most cyclical parts of the economy accelerate, and the time it takes for the unemployment rate to reach a full employment level. Long expansion phases were characterized by a drawn-out rise in the cyclical parts of the economy and a slow return to full employment in the labor market, similar to what has occurred since the Great Recession (Chart I-2C). Chart I-2ALong bca.bca_mp_2016_12_01_s1_c2a bca.bca_mp_2016_12_01_s1_c2a Chart I-2BMedium Expansions bca.bca_mp_2016_12_01_s1_c2b bca.bca_mp_2016_12_01_s1_c2b Chart I-2CA Short Expansion bca.bca_mp_2016_12_01_s1_c2c bca.bca_mp_2016_12_01_s1_c2c Of course, the Fed did not begin to tighten policy immediately upon reaching full employment in the past. The Fed began hiking rates an average of 13 months after reaching full employment in the short cycles, 30 months for medium cycles, and more than 60 months in the "slow burn" expansions (Table I-2). Even if we exclude the 1960s expansion, when the Fed delayed for too long and fell behind the inflation curve, the Fed has waited an average of 45 months before lifting rates in the other long expansions (beginning in 1982 and 1991). The longer delay compared to the shorter expansions reflected the slow pace at which inflationary pressures accumulated. During these periods, inflation-adjusted earnings-per-share (EPS) expanded by an average of 25% and the real value of the S&P 500 index increased by 28%. Table I-1U.S. Expansions Can Last Long After Full Employment Is Reached December 2016 December 2016 The lesson is that risk assets can still perform well for a long time after the economy reaches full employment. Admittedly, however, equity valuation is more stretched today than was the case at similar points in past long cycles. Before the U.S. election, the current expansion appeared to be heading for a similar long, drawn-out conclusion. Inflationary pressures are beginning to emerge, but only slowly, and from a low starting point. Moreover, evidence suggests that the Phillips curve8 is quite flat at low levels of inflation. This implies that the Fed has plenty of time to normalize interest rates because inflation is unlikely to surge. However, a sea change in trade and fiscal policy could change the calculus. To the extent that fiscal stimulus is front-loaded relative to trade protection, and that any trade restrictions add to inflation, Trump's policy agenda could force the Fed to normalize rates more quickly. The FOMC Will Wait And See Chart I-3Inflation Expectations Moving To Target Inflation Expectations Moving To Target Inflation Expectations Moving To Target Yellen's congressional testimony in November revealed that the Fed is not yet preparing for a more aggressive tightening cycle. There was nothing to suggest that the Fed is revising its economic forecasts following the election. Similarly, the Fed is not making any upward revisions to its estimate of the long-run neutral rate, which remains "quite low by historical standards." The implication is that the Fed will raise rates in December, but it will keep its "dot" forecast unchanged. The FOMC is prudently awaiting the details of the fiscal package before changing its economic and interest rate projections. We doubt that the Fed will be aggressive in offsetting the fiscal stimulus. We have argued in the past that the consensus on the FOMC would not follow the Bank of Japan and officially target a temporary overshoot of the 2% inflation target. Nonetheless, most Fed officials would not be upset if, with hindsight, they tighten too slowly and inflation overshoots modestly. The inflation target is supposed to be symmetric, which means that 2% is not meant to be a hard ceiling. Moreover, the Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. Market-based measures of inflation compensation have surged in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart I-3).9 Investors should continue to hold inflation protection in the bond market. A window may open sometime in 2017 in which improving economic growth is met with a cautious Fed. In this environment, we would expect the Treasury curve to bear-steepen and risk assets to outperform. The window will likely close once inflation moves up and inflation expectations converge at a level consistent with the 2% target. Bond Strategy The implications of Trump's policy agenda are clearly bond bearish, although yields have shifted a long way in a short time. The gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart I-4). The 5-year/5-year forward overnight index swap rate is now 2.1%, only 82 bps below the Fed's median estimate of the equilibrium fed funds rate. The U.S. 10-year yield has already converged with two measures of fair value, although yields remain well below fair value in the other major countries according to estimates of nominal potential output growth (Charts I-5 and I-6). The fact that the gap between the Fed's dots and market expectations has almost closed, means that a lot of bond-bearish news has been discounted in the U.S. We would not be surprised to see a partial retracement of the recent bond selloff. Investors will want to see concrete plans for substantial fiscal stimulus before the next leg of the bond bear market takes place. Speculators may wish to take profits on short bond plays, but investors with a 6-12 month horizon should remain short of duration benchmarks. Chart I-4Market Expectations Converging With Dots Market Expectations Converging With Dots Market Expectations Converging With Dots Chart I-5Bond Fair Value Method (I) Bond Fair Value Method (I) Bond Fair Value Method (I) Chart I-6Bond Fair Value Method (II) bca.bca_mp_2016_12_01_s1_c6 bca.bca_mp_2016_12_01_s1_c6 On a long-term horizon, the Trump agenda reinforces our view that the secular bull market in bonds is over. Larry Summers' Secular Stagnation thesis will be challenged and investors will come to question the need for ultra-low real interest rates in the U.S. well into the next decade. A blowout in the U.S. budget deficit will temper the excess global savings story to some extent. Tax cuts, infrastructure spending, full expensing of capital goods and reduced regulation may also boost the long-run potential growth rate in the U.S. All of this suggests that equilibrium interest rates and bond yields will shift higher. Nonetheless, poor demographic trends and other impediments to both the supply- and demand-sides of the U.S. and global economies have not disappeared. The ECB is likely to extend its bond purchase program beyond next March, while the Bank of Japan has capped the 10-year JGB yield at close to zero, both of which should limit the amount by which yields in the other developed markets can rise. We could even see global yields fall back to near previous lows if the Fed winds up tightening too aggressively and sparks the next recession. Is Trump Bullish For Stocks? Chart I-7Equity Market Breakouts Equity Market Breakouts Equity Market Breakouts Developed country stock markets cheered the U.S. election outcome, presumably betting that the positives will outweigh the negatives. The main indexes in the U.S. and Japan have broken out of their trading ranges (Chart I-7). Bourses in Europe have also moved higher, but have not yet broken out. On the plus side, deregulation and stronger growth are bullish for U.S. corporate profits. Trump's proposal for a major corporate tax cut is another positive for equities, although the effective corporate tax rate in the U.S. is already at multi-decade lows. Cutting the marginal rate will thus not affect the effective rate much for large corporations. Any lowering of the marginal rate will benefit small and medium enterprises, as well as domestically-oriented S&P 500 corporations. On the negative side, dollar strength will be a headwind given that about a third of S&P 500 earnings are sourced from abroad. This raises the question of which factor will dominate profit growth over the next year; better economic growth or dollar strength? Table I-3 presents a matrix of different scenarios for the dollar and economic growth applied to our U.S. EPS model. Our base-case assumptions, implemented before the election, generated 5-6% earnings growth in 2017. We assumed that real and nominal GDP growth would be on par with the conservative IMF forecast. The bullish case assumes that real GDP growth is about a percentage point stronger, with modestly higher inflation. The opposite is assumed in the bear case. These three cases are combined with various scenarios for the dollar. The key point of Table I-3 is that the growth assumptions dominate the dollar effects. If growth is significantly stronger than the base case, then it would require a massive dollar adjustment to offset the positive impact on earnings. For example, our EPS estimate rises from 5-6% in the base case to almost 13% in the strong growth scenario, even if the dollar appreciates by 5%.10 The elephant in the room is the prospect of a trade war. Anti-globalization polices are negative for equities generally, although the boost for domestically-oriented firms provides some offset. As we argued above, higher tariffs on Mexico and China alone would not fully counteract a major fiscal push next year, especially if the trade impediments are implemented with a lag. Nonetheless, a broader anti-trade initiative that draws retaliation from many of America's trading partners cannot be ruled out. This is the main reason why we remain tactically cautious on equities. Table I-3U.S. Earnings Scenarios December 2016 December 2016 Country Equity Allocation In common currency terms, the U.S. equity market has a lot going for it relative to Japan and Europe. There will be spillovers from stronger U.S. growth to other countries, but the U.S. will benefit the most from Trump's fiscal stimulus plan. Continuing policy divergence will prop up the dollar, boosting returns in common-currency terms. The dollar has appreciated by about 4% in trade-weighted terms since we first predicted a 10% rise, suggesting that there is another 6% to go. Chart I-8Eurozone Still Has Lots Of Slack bca.bca_mp_2016_12_01_s1_c8 bca.bca_mp_2016_12_01_s1_c8 However, it is a tougher call in local currency terms. Monetary policy will remain highly accommodative in both Japan and Europe. As we highlighted in last month's Overview, we still expect Japan to implement a major fiscal stimulus plan. In the context of the Bank of Japan's fixing of the 10-year yield, government spending will amount to a helicopter drop policy that could generate a substantial yen depreciation. The central bank will continue to hold the yield curve down even when growth picks up, to drive real yields lower via rising inflation expectations. In the Eurozone, the ECB is likely to extend its asset purchase program beyond next March because it cannot credibly argue that inflation is on track to meet the target on any reasonable timetable. While the Eurozone economy has been growing well above trend this year, the fact that wage growth is languishing highlights that significant labor market slack persists (Chart I-8). Easy-money policies in Europe and Japan will be bullish for stocks in both markets in absolute terms and relative to the U.S. Stocks are also cheaper in Japan and the Eurozone. Earlier this year, we presented a methodology for valuing Eurozone stocks relative to the U.S. from a top-down perspective. The methodology accounted for different sector weightings and the fact that European stocks generally trade at a discount to the U.S. This month's second Special Report, beginning on page 27, applies the same methodology to Japanese/U.S. relative valuation. Combining seven relative valuation measures into a single composite metric, we find that both the Eurozone and Japanese equity markets are about one standard deviation cheap relative to the U.S. (Chart I-9). History shows that investors would have made substantial (currency hedged) excess returns if they had favored Eurozone and Japanese stocks to the U.S. on a six-month or longer investment horizon whenever our composite valuation index reached one standard deviation on the cheap side. Our recommended (hedged) overweight in Europe and Japan has not worked out yet, as tepid global growth has instead flattered the lower-beta U.S. market. That tide should turn, however, if the rise in global bond yields reflects a credibly reflationary growth pulse in the U.S. A stronger dollar would redistribute some of that growth to other countries. Chart I-10 shows that higher beta markets like Europe and Japan can outperform the U.S. when bond yields rise. The financial sectors in both Europe and Japan, so punished relative to the broad market as a result of deleveraging and negative interest rates, would then be poised to outperform as well. Chart I-9Equity Valuation Equity Valuation Equity Valuation Chart I-10U.S. Equities ##br##Underperform When Yields Rise U.S. Equities Underperform When Yields Rise U.S. Equities Underperform When Yields Rise Investment Conclusions: Hopes are running high that fiscal stimulus and a more business-friendly regulatory framework will stir animal spirits, rekindle business investment and lift the U.S. economy out of its growth funk. The violent reaction in financial markets to the election has probably gone too far in discounting a transformative policy change. We doubt that Trump's fiscal and regulatory agenda will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place, such as: the end of the Debt Supercycle; deteriorating demographics; elevated corporate leverage; and nose-bleed levels of government debt. A lot of good (policy) news is already discounted in equity prices, implying that the market is vulnerable to policy or economic disappointments. That said, a window may open next year that would favor risk assets for a period of time. A temporary growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Markets will front-run the growth pulse (some of it is admittedly already discounted). Our bias is therefore to upgrade these asset classes, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new administration's policy intentions. Until there is more clarity, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. EM assets appear to us like a lose-lose proposition. A trade war would obviously be disastrous for this asset class. But EM also loses if U.S. protectionism takes a back seat to growth initiatives to the extent that this results in a stronger dollar. EM risk assets have never escaped periods of dollar strength unscathed. The possibility of RMB depreciation versus the U.S. dollar adds to EM vulnerability. Our other investment recommendations include the following: avoid peripheral European government bonds within European bond portfolios due to Italian referendum risk; avoid U.S. municipal bonds, as tax cuts would devalue the tax advantage of muni debt; remain overweight inflation-linked bonds versus conventional issues within government bond portfolios, as inflation expectations have more upside potential; we are marginally less bearish on high-yield bonds since better growth will temper defaults. We also see less near-term risk of a Fed-driven volatility event. Nonetheless, concerns about corporate health still justify a slight underweight relative to Treasurys in the U.S. Overweight investment-grade corporates in Europe versus European governments due to ongoing ECB support; overweight European and Japanese equities versus the U.S. in currency-hedged terms. within the U.S. equity market, remain overweight small caps since Trump's corporate tax reform will benefit small firms disproportionately. Dollar strength also favors small versus large caps. Mark McClellan Senior Vice President The Bank Credit Analyst November 24, 2016 Next Report: December 20, 2016 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes and Investment Implications," November 9, 2016, available at gps.bcaresearch.com 2 Please see Jim Nunns, Len Burman, Ben Page, Jeff Rohaly, and Joe Rosenberg, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016. 3 World Trade Organization. 4 Scott Bradford, Paul Grieco and Gary Clyde Hufbauer, "The Payoff to America from Global Integration," Peterson Institute for International Economics. 5 These calculations capture the demand-side effects of the tariffs. There will also be supply-side effects, in terms of reduced productivity, but this will be relatively small and affect the economy largely over the medium term. 6 The elasticities and methodology for these calculations are based on the report; "Trump's Tariffs: A Dissent," J.W. Mason, November 2016. 7 "The Macroeconomic Consequences of Mr.Trump's Economic Policies," Moody's Analytics, June 2016. 8 The short-term tradeoff between unemployment and inflation. 9 Inflation breakeven rates have historically exceeded 2% because of the presence of risk premia. 10 The impact of dollar appreciation on profits shown in Table 3 may seem too low to some readers given that S&P 500 companies derive a third of their earnings from abroad. However, some of these earnings are hedged, while dollar strength will benefit the earnings of domestically-oriented U.S. companies. II. A Q&A On Political Dynamics In Washington In this Special Report, BCA's Geopolitical Strategy service answers some key questions posed by clients surrounding the incoming Trump administration. The situation could evolve quickly in the coming months, but these answers convey our preliminary thoughts. What support will President-elect Trump's infrastructure plans have from Republicans in Congress? The support for infrastructure spending can be gauged by popular opinion and the bipartisan highway funding bill passed by Congress late last year. The $305 billion bill to fund roads, bridges and rail lines received support from both parties (83-16 vote in the Senate and 359-65 vote in the House). The dissenting votes included fiscal conservatives and Tea Party/Freedom Caucus members. And yet many of their voters supported Trump, whose victory shows the political winds shifting against "austerity." Moreover, new presidents normally receive support from their party on major initiatives early in their term. Democratic Senators and House Representatives have suggested they may work with Trump on infrastructure spending, most notably Bernie Sanders, Elizabeth Warren, Chuck Schumer and even Nancy Pelosi. This could mark an instance of bipartisanship in the context of still-growing polarization. The 2018 mid-term elections will be difficult for the Democrats, with 10 Democratic senators facing elections in states which Donald Trump won, including key "Rust Belt" swing states where the infrastructure argument is appealing (Michigan, Wisconsin, Pennsylvania, Ohio). Thus, there are political incentives for Democrats to cooperate with the White House on infrastructure. Trump owes his victory to swing voters who favor infrastructure. As we discuss below, he may give the GOP Congress some concessions (for instance, on tax reform) in exchange for cooperation on infrastructure spending. How many votes would he need to get an infrastructure bill passed in Congress? Trump will likely get the votes. He needs 218 votes in the House and 51 votes in the Senate, assuming his infrastructure plan is not so partisan (or so entwined with partisan measures like his tax cuts) as to draw a Senate filibuster. The GOP has 239 seats in the House and at least 51 in the Senate (Louisiana could make it 52). One way of overcoming any Democratic filibuster in the Senate is by "Reconciliation," a process for speeding up bills affecting revenues and expenditures. Under this process, which requires the prior passage of a budget resolution, a simple majority in the Senate is enough to allow a reconciliation bill to pass. The process can be used for passing tax cuts as well, after procedural changes in 2011 and 2015. If passed, what is the earliest we could expect more spending? Congress passed President Obama's $763 billion stimulus package, the American Recovery and Reinvestment Act (ARRA), in February 2009, the month after he was sworn in. About 20% of the investment outlays went out the door by the end of fiscal 2009 and 40% by the end of fiscal 2010.1 Today, infrastructure outlays are less urgent, as the country is not in the mouth of a financial crisis, but the roll-out could be expedited by the administration. Trump's plan calls for building infrastructure through public-private partnerships, which could involve longer negotiation periods but also faster completion once started. Trump's team claims they can accelerate the spending process by cutting red tape. What is a 'best guess' on the final amount of deficit-financed infrastructure spending? Trump is currently committed to $550 billion in new infrastructure investment, down from initial suggestions of $1 trillion over a decade. A detailed plan has not been released, however. Trump's campaign promised to induce infrastructure spending via public-private partnerships, with tax credits for private investors. The plan was said to be "deficit neutral" based on assumptions about revenue recuperated from taxing the labor that works on the projects and the profits of companies involved, taxed at Trump's proposed 15% corporate tax rate.2 The government tax credit would have amounted to 13.7% of the total investment. Earlier proposals can easily be revised or scrapped. Already, Trump has reversed his earlier opposition to Hillary Clinton's proposal of setting up an infrastructure bank, potentially financed by repatriated earnings of U.S. corporations. His potential Treasury Secretary, Steven Mnuchin, raised the possibility on November 16. Who are key players in this process and what are their backgrounds? The aforementioned leading Democrats could become key players, if they prove willing to work with Trump on infrastructure. Comments by Paul Ryan and the Congressional GOP should be monitored, as infrastructure spending was not a major part of their policy platform, called "A Better Way," released in June of this year.3 The only infrastructure that Ryan mentioned in the GOP policy paper was energy infrastructure. Not the "roads, bridges, railways, tunnels, sea ports, and airports" that President-elect Trump has promised repeatedly, in addition to energy. Asked during the Washington Ideas Forum in September whether he supports infrastructure spending, Ryan said it is not part of the GOP's proposal. Other notable personalities to watch: Wilbur Ross, an American investor and potential Commerce Secretary pick, was one of the authors of Trump's original, public-private infrastructure plan. Peter Navarro, UC-Irvine business professor and another economic advisor, co-authored that proposal. Also watch: Steven Mnuchin, Finance Chairman of the Trump campaign and former Goldman Sachs partner, and potential Treasury Secretary pick. Stephen Moore, a member of Trump's economic advisory team and the chief economist for the Heritage Foundation. John Paulson, President of Paulson & Co. Also watch fiscal hawks such as House Majority Leader Kevin McCarthy of California, who has recently softened on infrastructure spending, saying it could be "a priority" and "a bipartisan issue." Representative David Brat of Virginia, another ultra-conservative Freedom Caucus member, who has softened on infrastructure. House Appropriations Chairman Hal Rogers, and Representative Bill Flores, Chairman of the conservative Republican Study Committee, could also send signals. Chairman of the House Committee on ways and Means, Kevin Brady, has already admitted that some tax receipts from repatriated corporate earnings may go to infrastructure. Would deficit spending on infrastructure revive problems with the debt ceiling? The debt ceiling legislation is technically separate from the budget process. It is the statuary threshold on the level of government debt. It currently stands at $20.1 trillion. Congress voted last fall to "suspend" the debt ceiling until March of 2017. This means it will come due right around the time that negotiations over the fiscal 2018 budget resolution take place. But debt ceiling negotiating tactics are unlikely to recur in Trump's first year with his own party in control of Congress. Trump and the GOP could vote to "suspend" the debt ceiling indefinitely. Or, the GOP could set the debt ceiling limit so high that it no longer matters in the near term. Where do the GOP and Trump disagree on tax reform? Tax reform is a major GOP demand in recent years; it was also a focus, albeit less central, in Trump's campaign. Both want to flatten the personal income tax structure from 7 brackets to 3 brackets, with 12%, 25%, and 33% tax rates. Trump revised his initial tax plan, which called for 10%, 20%, and 25% rates, late in his campaign to be more compatible with the GOP. In terms of corporate taxes, President-elect Trump proposes a 15% rate for all businesses, with partnerships eligible to pay the 15% rate instead of being taxed under a higher personal income tax rate. By contrast, the GOP has called for a 20% corporate tax rate and a 25% rate for partnerships. How difficult is it to simplify the tax code? It is certainly not easy, but it can be done in 2017 given that the GOP controls both the White House and Congress. GOP leaders claim that a proposal will go public early in the year and a vote will occur within 2017. GOP leaders want a comprehensive law, including income and corporate tax reform, but there are rumors of splitting the two. Income tax reform may take longer to pass because it is more complex. There has not been comprehensive tax reform in the U.S. since Ronald Reagan signed the Tax Reform Act of 1986. The Republicans obtained lower tax rates in exchange for a broadening of the base that the Democrats favored. It would be difficult to strike a similar deal next year, given that Republicans seek to slash taxes on corporations and top earners, and Democrats are staunchly opposed. There is likely to be some horse trading between Trump and the GOP. The GOP may use tax reform as the price of their support for Trump's infrastructure investment. Alternatively, Trump could hold out his Supreme Court appointments in exchange for GOP acquiescence on taxes and infrastructure. He could, for example, threaten to appoint centrist justices if the GOP does not play ball on other matters. What are the obstacles and timeline to a repatriation tax on overseas corporate earnings? An estimated $2.5-$3 trillion in corporate earnings are currently held "offshore," which means that taxes on this income is deferred until it is repatriated to the U.S. There is growing bipartisan support for a deemed repatriation tax. This means a one-off tax imposed on all overseas income not previously taxed. Obama, Hillary Clinton, Trump, and GOP representatives have all presented proposals to tap this source of tax revenue. For that reason there are various avenues through which it could be legislated. Trump put forth a plan to tax un-repatriated earnings at a 10% rate for cash (4% for non-cash earnings), with the liability payable over a 10-year period. As mentioned, this could be combined with his infrastructure plan as a way to finance an infrastructure bank or encourage the same corporations to invest in infrastructure development via tax breaks. According to the Tax Policy Center, Trump's repatriation plan would raise $147.8 billion in revenue over 2016-2026. Overall, this is a paltry sum of $14 billion per year. In a similar vein, President Obama's plan called for a 14% rate on repatriated earnings and was projected to raise $240 billion. The GOP offers a different plan from Trump. The party supports a repatriation tax at an 8.75% rate, payable over eight years. The GOP's plan would raise an estimated $138.3 billion during the same period. The GOP proposes to overhaul the entire U.S. corporate taxation system, while Trump does not. The GOP would change it from the worldwide system (i.e. the same corporate tax rate for U.S. corporations on profits everywhere), to a more typical destination-based system, in which U.S. corporations would be exempt from U.S. taxes on profits earned overseas. The latter would reduce the incentive for offshoring and tax inversions, that is, moving head offices outside of the U.S. to take advantage of lower tax rates. The 2004 tax holiday was a disappointment. Findings from the Center on Budget and Policy Priorities, NBER, Congressional Research Service, and others, indicate that the repatriated earnings did not significantly improve long-term fiscal deficits, boost employment, or increase domestic investment. Will Trump accuse China of "currency manipulation" on his first day in office as promised? It seems likely that Trump will follow through with his pledge of naming China a "currency manipulator." The question is whether he does so through the existing, formal Treasury Department review process or whether he would bypass that system and take independent action as the executive. Adhering to the formal process would show that Trump wants to keep tensions contained even as he draws a tougher line on economic relations with China. The "currency manipulation" charge is a mostly symbolic act that does not automatically initiate punitive measures. The move will not be unprecedented, as the U.S. labeled China a manipulator from 1992-1994. The label requires bilateral negotiations and could lead to Treasury recommending that Congress, or Trump, take punitive measures. The 2015 update to the law specifies what trade remedies Treasury might suggest, but the remedies are not particularly frightful. The options might prevent the U.S. government from supporting some private investment in China, cut China out of U.S. government procurement contracts, or cut China out of trade deals. The latter point, however, will be overshadowed by Trump's withdrawing the U.S. from the Trans-Pacific Partnership, a net gain for China since that strategic trade initiative had excluded China from the beginning. The real risk - higher than ever before, but still low probability - is that Trump could act unilaterally to impose tariffs or import quotas under a host of existing trade laws (1917, 1962, 1974, 1977) which give him extensive leeway. Some of these would be temporary, but others allow him to do virtually whatever he wants, especially if he declares a state of emergency or invokes wartime necessity (his lawyers could use any existing overseas conflict for this purpose).4 Presidents have been unscrupulous about such rationalizations in the past. Congress and the courts would not be able to stop Trump for the first year or two if he proceeded independently by executive decree. WTO rulings would take 18 months. China would not wait to retaliate, leading to a trade conflict of some sort. Would Congressional Republicans support punitive measures against China? How would China respond? There are two possibilities. First, Trump is free to set his own executive timeline if his administration makes a special case and he acts through executive directives. Second, Trump could proceed under the Treasury Department's existing timeline. An investigation would be launched in the April Treasury report, leading to negotiations with China. If there is no satisfactory outcome of the negotiations, then the October Treasury Report could label China as a currency manipulator. Under the 2015 law, there would be a necessary one-year waiting period before punitive measures are implemented. But again, Trump could override that. China would cause a diplomatic uproar; it would level similar accusations at the U.S. of distortionary trade policies. China would likely respond unilaterally as well as go to the WTO to claim that the U.S. has abrogated the purpose of the agreement, giving it an additional path to retaliate within international law. China's unilateral sanctions could target U.S. high-quality imports, services, or production chains. Or China could sell U.S. government debt in an attempt to retaliate, though it is not clear what the net effect of that would be. However, China would suffer worse in an all-out trade war. Xi Jinping has been very pragmatic about maintaining stability, like previous Chinese presidents since Deng. He is tougher than usual, but as long as Trump proposes credible negotiations, rather than staging a full frontal assault, Xi would likely attempt to strike a deal, perhaps cutting pro-export policies while promising faster structural rebalancing, to avoid a full-blown confrontation. We have seen with Russia that authoritarian leaders can use external threats and economic sanctions as a way to rally the population "around the flag." Trump's campaign threats, combined with other macro-economic trends, pose the risk that over the next four years China could face intensified American economic pressure and internal economic instability simultaneously. That would be a volatile mix for U.S.-China relations and global stability. But, once in office, it remains to be seen how Trump will conduct relations with China. Most likely, the currency manipulation accusation will cause a period of harsh words and gestures that dies down relatively quickly. The two powers will proceed to negotiations over a "new" economic relationship, highlighting the time-tried ability of the U.S. and China to remain engaged and "manage" their differences. Nevertheless, any shot across the bow will point to Sino-American distrust that is already growing over the long run. That distrust is signaled by Trump's success in key swing states by pitching protectionism, specifically against China. Will Trump's border enforcement policies add to fiscal stimulus? Yes, it would add marginally to the fiscal thrust that we expect from other infrastructure and defense spending. How will Trump approach the deportation of illegal immigrants? Trump will probably maintain Obama's stance on illegal immigration and deportation. Obama has deported around 2.5 million illegals between 2009 and 2015, the most of any president. These are mostly deportable illegals and non-citizens with criminal convictions. Trump stated in an interview on 60 Minutes that he plans to deport 2 to 3 million undocumented immigrants. The execution of this order will be swift as the Department of Homeland Security (DHS) has already exhibited this capacity under Obama. It is difficult to gage the economic impact of deportation. A study done by the University of Southern California found that undocumented immigrants are paid 10% lower than natives with similar skills in California.5 About half of farm workers and a quarter of construction workers are undocumented immigrants. If this source of cheap labor is removed, the cost for business in these sectors will increase. Are there other policy areas where you see a significant divergence between Congressional Republicans and Trump? Trump and the GOP establishment obviously have an awkward relationship that is only beginning to heal. Both sides are making progress in bridging the gap, but on trade protectionism, infrastructure, immigration, entitlement spending, and foreign policy Trump will continue to sit uneasily with Republican orthodoxy. This will give rise to a range of disagreements, separate from those listed above, of which we note only two here that have caught our attention during the post-election transition. How to deal with Putin: Trump has received renewed criticism from Sen. John McCain over a possible thaw in relations with Russia. This could affect the sanctions on Russia imposed by the U.S. and EU after the intervention in Ukraine in 2014, as well as broader Russia-NATO relations. H1B Visa: Trump is in favor of expanding H1B1 visas and allowing the "best" immigrants to stay in the U.S. once they complete their university education. But his White House chief strategist Steve Bannon has vilified the GOP for doing this. Thus there could be disagreement between the GOP and Trump's team on the issue of highly skilled immigrants. The BCA Geopolitical Team 1 Please see the White House, "The Economic Impact Of The American Recovery And Reinvestment Act Five Years Later," in the "2014 Economic Report of the President," available at www.whitehouse.gov. 2 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. 3 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. 4 Please see Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 5 Please see Manuel Pastor et al, "The Economic Benefits Of Immigrant Authorization In California," Center for the Study of Immigrant Integration, dated January 2010, available at dornsife.usc.edu. III. Japanese Equities: Good Value Or Value Trap? Japanese stocks have experienced a long stretch of underperformance versus the U.S. since the early 90's. The deflationary macro backdrop and poor corporate profitability are the main underlying factors, although there are many others. More recently, some corporate fundamentals have shifted in favor of Japanese stocks relative to the U.S., but investors remain skeptical, sending Japanese valuations to near all time lows in absolute terms and relative to the U.S. In this Special Report, we take a top-down approach to determine whether Japanese stocks are cheap versus the U.S. after adjusting for persistent differences in underlying profit fundamentals. Our mechanical and fundamental valuation indicators provide an impressive historical track record of "buy" and "sell" signals when the metrics reach extreme levels. The story is corroborated at the sector level. The implication is that there is plenty of "kindling" to drive a reversal in Japanese stock relative performance, but it needs a spark. We believe the catalyst could be a major fiscal push that would be like a "helicopter drop" under the current monetary regime. Unfortunately, the timing is uncertain. A major fiscal package may not occur until the spring. Japanese equities have been a perennial underperformer versus the U.S. for almost three decades, in both local- and common-currency terms (Chart III-1). There was a ray of light in the early years of Abenomics, when the aggressive three-arrow approach appeared to be finally lifting the Japanese economy out of Secular Stagnation. Yen weakness contributed to a surge in earnings-per-share (EPS) in absolute terms and relative to both the U.S. and world. Equity multiples also rose between 2012 and 2015. Unfortunately, Abe's honeymoon with equity markets has since faded. Yen strength, collapsing inflation expectations and weakening business confidence have caused investors to question the upside potential for Japanese corporate top-line growth (Chart III-2). EPS have fallen by 11% percent this year in absolute local currency terms, and are down by 10.7% versus the U.S. In turn, Japanese equities have dropped from the mid-2015 peak (Chart III-3). The decline in Japanese multiples this year is in marked contrast to a rise in the U.S. Chart III-1Japanese Equities ##br##Have Underperformed Japanese Equities Have Underperformed Japanese Equities Have Underperformed Chart III-2A Challenging ##br##Macro Backdrop bca.bca_mp_2016_12_01_s3_c2 bca.bca_mp_2016_12_01_s3_c2 Chart III-3Japanese EPS Growth ##br##Has Been Strong Until 2016 bca.bca_mp_2016_12_01_s3_c3 bca.bca_mp_2016_12_01_s3_c3 Japanese equities currently appear very cheap to the U.S. market based on standard valuation measures (Chart III-4). However, these ratios are always lower in Japan, except for price-to-forward earnings. Japanese companies generally have a much higher interest coverage ratio compared to Corporate America. Nonetheless, they tend come up short in terms of profitability. Operating margins in the U.S. have typically been double that of Japan (Chart III-5A). Japan's return-on-equity (RoE) has been dismal because of low levels of corporate leverage and loads of low-yielding cash sitting on balance sheets (Chart III-6). Table III-1 shows that Japan has a much larger sector weighting in consumer discretionary and a much lower weighting intechnology. Still, the story does not change much when we adjust financial ratios for differences in sector weights between the two markets (Chart III-5B). Chart III-4Japan Is Always Cheaper Japan Is Always Cheaper Japan Is Always Cheaper Chart III-5A...Adjusted For Common Sector Weights Japanese Vs. U.S. Fundamentals... Japanese Vs. U.S. Fundamentals... Chart III-5BJapanese Vs. U.S. Fundamentals... ...Adjusted For Common Sector Weights ...Adjusted For Common Sector Weights Chart III-6RoE Is Consistently Lower In Japan bca.bca_mp_2016_12_01_s3_c6 bca.bca_mp_2016_12_01_s3_c6 Table III-1Japanese Vs. U.S. Sector Weights December 2016 December 2016 The lower level of RoE by itself justifies a price discount on Japanese equities. But by how much? Are Japanese stocks still cheap once they are adjusted for structurally depressed profitability relative to the U.S.? This report assesses relative valuation, employing the same methodology used in our previous work on Eurozone equity valuation.1 While many cultural nuances make direct comparison of the Japanese market difficult, investment decisions are made within the scope of the available set of alternatives. With Japanese equity valuations at the lowest levels in recent history, the key question is whether this represents an opportunity to load up, or an example of a "value trap". We conclude that valuation justifies an overweight in Japanese equities (currency hedged), although the fiscal stimulus required to unlock the value may not arrive until February. Mechanical Approach We excluded the financial sector from our market valuation work since analysts use different fundamental statistics to judge profitability and value compared to non-financial companies. We also recalculated all of the Japanese aggregates using U.S. weights in order to avoid the problem that differing sector weights could bias measures of relative value for the overall market. The mechanical approach adjusts the valuation measures by subtracting the 5-year moving average (m.a.) from both markets. For example, the calculation for the price-to-sales ratio (P/S) is: VG = (US P/S - 5-year m.a.) - (EMU P/S - 5-year m.a.) Then we divided the Valuation Gap (VG) by the 5-year moving standard deviation of the VG. This provides a valuation indicator that is mean-reverting and fluctuates roughly between -2 and +2 standard deviations: Valuation Indicator = VG/(5-year moving standard deviation of VG) The same methodology is applied to the other valuation measures shown in Charts III-7A, 7B, 7C, 7D and III-8A, 8B, 8C. This approach suggests that the U.S. market is trading expensive to Japan in all seven cases except for the Shiller P/E. Japan is around 1-sigma cheap on most of the other valuation measures, with forward P/E the highest at almost 2 standard deviations. Chart III-7AMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7a bca.bca_mp_2016_12_01_s3_c7a Chart III-7BMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7b bca.bca_mp_2016_12_01_s3_c7b Chart III-7CMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7c bca.bca_mp_2016_12_01_s3_c7c Chart III-7DMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7d bca.bca_mp_2016_12_01_s3_c7d Chart III-8AMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8a bca.bca_mp_2016_12_01_s3_c8a Chart III-8BMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8b bca.bca_mp_2016_12_01_s3_c8b Chart III-8CMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8c bca.bca_mp_2016_12_01_s3_c8c The underlying logic is that using a longer-term moving average should remove the structurally lower bias in Japanese valuations. Standardizing relative valuations in such a way should provide extreme valuation signals that can be used to gauge major trading opportunities. One potential pitfall of using a 5-year moving average to discount the structurally lower valuation of Japanese equities versus U.S. is that it fails to capture an extended period of either over- or under-valuation. For example, the U.S. may enter a bubble phase that does not occur in Japan. The 5-year moving average would move higher over time, eventually giving the false signal that the U.S. is back to fair value if the bubble persists. This is a fair criticism, although the track record of these valuation metrics shows that extended bubbles have not been a large source of false signals. Valuation By Sector We applied the same methodology at the sector level. Due to space constraints, we cannot present the 70 charts covering the seven relative valuation metrics across the 10 sectors. However, we present the latest reading for the 70 indicators in Table III-2, which reveals whether the U.S. is expensive (e) or cheap (c) versus Europe. A blank entry means that relative valuation is in the range of fair value. Table III-2Story Holds At The Sector Level December 2016 December 2016 The sector valuation indicators corroborate the message from the aggregate valuation analysis; over 60% of valuation metrics suggest that the U.S. is at least modestly expensive versus Japanese stocks. The U.S. is cheap in only 13% of the cases, with 26% at fair value. Value measures that most consistently place U.S. sectors in expensive territory are P/CF, P/B and EV/EBITDA. The U.S. sectors that are most consistently identified as expensive are financials, consumer discretionary, industrials, utilities, tech and basic materials. U.S. healthcare received a fairly consistent "cheap" rating while U.S. telecoms were consistently "cheap" or "fair" across all valuation measures. Predictive Value? Having a standardized tool of relative valuation is well and good but multiple divergence between regions is only useful if it translates into excess returns. Valuation is generally a poor timing tool but proves to be useful in predicting returns over a longer investment horizon. Theoretically, forward relative returns between Japanese and U.S. equities should be positively correlated with the size of the gap in their relative valuation metrics. In order to test the efficacy of the mechanical valuation indicator we calculated forward relative returns at points of extreme valuation divergences (in local currency). The trading rule is set such that, when the mechanical indicator reaches positive one or two standard deviations, we short the more expensive U.S. market and go long Japanese equities. Conversely, the opposite investment stance is taken for value readings of negative one and two standard deviations. Forward returns are calculated on 3, 6, 12, and 24 month horizons. Overall, the indicators performed well when the valuation gap between U.S. and Japanese multiples reached (+/-) 1 and 2 standard deviations from the long-term mean. Valuation measures exhibiting the highest returns were P/CF and forward P/E. For brevity, we present only these two measures in Table III-3. At two standard deviation extremes, the mechanical indicator produced a two-year forward return of 84% and 44% for P/CF and forward P/E, respectively. Table III-3 also presents the indicator's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. For P/CF, the batting average is between 50-60% for a 1 standard deviation valuation reading and mostly 100% for 2 standard deviations. The batting average for the forward P/E ranges from 53-92% for 1 standard deviation, and 83-100% for 2 standard deviations. Table III-3Select Mechanical Indictor Returns And Batting Averages December 2016 December 2016 Presently, all of the indicators are at or above the zero line signaling that the U.S. market is overvalued versus Japan. The valuation metric sending the strongest signal of U.S. overvaluation has interestingly been one of the better predictors of positive excess returns; the forward P/E mechanical indicator has just recently touched the +2 standard deviation level. Given the information provided by our back tested results above, investors are poised to enjoy strong positive returns by overweighting Japanese equities versus their U.S. peers. Fundamental Approach Chart III-9Japan Has A Lower Cost Of Debt bca.bca_mp_2016_12_01_s3_c9 bca.bca_mp_2016_12_01_s3_c9 Japanese companies trade at a discount relative to their U.S. peers due to more volatile Japanese profit fundamentals and a structurally depressed RoE. To compensate for structural differences in fundamentals we regressed U.S./Japanese value gaps on spreads in underlying financial statistics such as earnings-per-share growth, the interest coverage ratio, free-cash-flow growth, operating margins, and forward earnings-per-share growth. A dummy variable was used to exclude the "tech bubble" years in the late 90's to early 00's since the surge in tech stocks had an outsized effect on overall relative valuations, distorting the true underlying trend. The fundamental approach used in our previous Special Report comparing the U.S. and Eurozone did not work as well as hoped and we had an inkling that an analysis of Japan versus the U.S. might yield similar results. Once again we were underwhelmed by the results, although some valuation measures did produce decent outcomes. These included P/S, P/B, and P/CF. Unfortunately, fundamental models for EV/EBITDA, P/E and forward P/E either had low explanatory power or had coefficients with the wrong sign. The financial variable that appears most frequently as being significant in our fundamental models is the interest coverage ratio. Japanese firms have experienced a massive reduction in net debt post-GFC, while those in the U.S. have been taking advantage of lower rates to issue debt and perform share buybacks. Weak aggregate demand has dissuaded Japanese corporations from performing any sort of intensive capital expenditure programs and they have therefore been using free cash flow to build up cash reserves on their balance sheet and pay down debt. Not to mention, the more dramatic decrease in borrowing rates for Japanese firms has reduced their interest burden vis-à-vis U.S. corporates (Chart III-9). Chart III-10 presents the modeled fair values along with the corresponding valuation indicator. The U.S. market is expensive compared to Japan for all three models, with the most extreme cases being P/S and P/CF. Chart III-10AFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators Chart III-10BFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators Chart III-10CFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators While the fundamental approach gave results that are less than spectacular, they still corroborate the message given by the mechanical approach. Japanese equities are undervalued compared to their U.S. peers and are reaching extreme levels, even after adjusting for structural trends in the underlying financials. Chart III-11Combined Fundamental Indicator Returns December 2016 December 2016 The next step is to verify the predictive power of our fundamental models. We analyzed forward returns implementing the same methodology used for the mechanical indicators. A (+/-) 1 standard deviation threshold was used as an investment signal to either overweight Japanese equities versus the U.S., if positive, or take the opposite stance if negative. Chart III-11 shows the returns categorized by time horizon and the number of valuation measures flashing a positive investment signal. The results were mixed; strong positive returns occurred when only one or two measures displayed valuation extremes, but excess returns were less than spectacular during periods when all three metrics provided the same signal. This is counter-intuitive, but when analyzing Chart III-10 it becomes apparent that the periods where all three indicators simultaneously entered extreme territory are concentrated in the last two years of history when U.S. market returns have trounced Japan. For periods during which our indicator flashed one or two positive signals, mostly before the past two years, returns were in line with those achieved by the mechanical indicators. Table III-4 shows the probability of success for the combined fundamental approach. Overall it has a batting average lower than that of the mechanical approach, with 60-89% for one signal and 70-86% for two signals. The batting average was generally poor when there were three signals for the reason discussed above.2 Since the beginning of 2015, all three indicators have been signaling that Japanese stocks are extremely cheap versus the U.S. Indeed, relative valuation continues to stretch as U.S. equity prices rise versus Japan, bucking the recent relative shifts in balance sheet fundamentals that favor the Japanese market. Table III-4Combined Fundamental Indicator Batting Averages December 2016 December 2016 Conclusion We are pleased with the results of the mechanical approach. The majority of valuation measures show that investors will make positive returns by overweighting and underweighting Japanese equities versus the U.S. when relative valuation reaches extreme levels. The consistency of these excess returns highlights that the indicators add value to global equity investors. We had hoped that a fundamentals based approach to valuation would have worked better. Conceptually, it would be more intellectually gratifying for company financials to better explain excess returns compared to technical measures. In a liquidity-driven world, this may be too much to ask. Although our fundamental models did not pan out perfectly, they still provided support for our underlying thesis that Japanese equities offer excellent value relative to the U.S. market. These models highlight that Japanese balance sheet and income statement trends favor this equity market versus the U.S. at the moment. Investors have been ignoring the fundamentals, frowning on Japanese equities in absolute terms and, especially, relative to the U.S. The sour view on Japan likely reflects disappointment in Abenomics. This includes not only fears that Abenomics is failing to lift the economy out of the liquidity trap, but also fading hopes for changes in corporate governance that would force firms to make better use of their cash hoards to the benefit of shareholders. All the valuation metrics presented above say that it is a good time to overweight Japan versus the U.S. in local currency terms. Of course, so much depends on policy these days. Our valuation metrics highlight that there is plenty of "kindling" in place for a reversal in relative performance given the right spark. As discussed in the Overview section, the catalyst could be a major fiscal stimulus package. When combined with a yield curve that is fixed by the Bank of Japan, it would amount to a "helicopter drop". Such a policy would drive up inflation expectations, push down real borrowing rates and dampen the yen. This self-reinforcing virtuous circle would be quite positive for growth in real and nominal terms, lifting the outlook for corporate profit growth and sparking a substantial re-rating of Japanese stocks. The timing is admittedly uncertain. A smaller fiscal package could be implemented as part of a third supplementary budget before year-end. A major fiscal push is most likely to occur only in February, when the next full budget is announced. Still, rock-bottom valuations make Japan an attractive market for longer-term investors, although the currency risk must be hedged. Michael Commisso Research Analyst 1 Please see The Bank Credit Analyst, "Are Eurozone Stocks Really Cheap?" July 2016, available at bca.bcaresearch.com 2 Except for the 24-month column, which shows a 100% batting average. However, this can be ignored. There was only a single episode of three positive signals that occurred more than 24 months ago, allowing a 24-month return calculation.

Highlights The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. However, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. in China's total trade peaked in the late 1990s. The case of China U.S. steel trade dispute suggests that unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. Feature Global financial markets have gradually been coming to terms with the concept of President Donald Trump. Interestingly, U.S. equity market participants appear to be cheering on a potentially sizable fiscal spending package under the new administration, which has boosted industrial sector stocks over the past week. Markets in Asia, particularly Chinese H shares, however, have been less upbeat and have focused more on a possible protectionism backlash emanating from the U.S. under the new leadership. Tough talk on China has featured in every U.S. presidential campaign going back to Nixon reaching out to China in the early 1970s - from Jimmy Carter's strong condemnation of Nixon-Kissinger's "immoral" secret diplomacy of "ass kissing" the Chinese, to Bill Clinton's harsh warnings to the "butchers of Beijing", to repeated pledges by Obama in the 2008 campaign to label China as a "currency manipulator" - all of which signaled an immediate confrontation. Once in office, however, all candidates significantly softened their rhetoric, as government policies require much more realistic and thoughtful discussion, negotiation and compromise. Furthermore, given the huge importance of trade for both economies, a full-fledged trade war between the U.S. and China would risk the growth recession and enormous financial volatility around the globe, a lose-lose outcome hardly conceivable to anyone, no matter how much chest-thumping and aggrandizing is involved. To be sure, the threat of protectionism should not be downplayed. It appears clear that president-elect Trump will be less accommodative to free trade than his predecessors, which is confirmed by his choice of Mr. Dan Dimicco, a former CEO of an American steelmaker and an outspoken critic of U.S. trade policy, particularly with China, to head his trade transition team. However, it is unpredictable at the moment what specific measures he would take to be able to assess potential consequences. It is therefore more useful to take a step back and look at the big picture of trade relations between the two countries. China-U.S. Bilateral Trade Chinese sales to the U.S. far outnumber its purchases, leading to an ever-growing trade surplus in China's favor (Chart 1). In fact, the U.S. accounts for over half of China's total trade surplus - a key piece of evidence supporting some American politicians' accusation of China's purported currency manipulation and unfair trade practices. The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. Underneath, however, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. as part of China's total trade peaked in the late 1990s (Chart 2). The share of U.S.-bound Chinese exports has remained roughly unchanged since the global financial crisis, and down significantly from pre-crisis levels. Chinese sales to the U.S. in recent years have been largely in line with overall export growth. On the contrary, American shipments to China have increased sharply as a share of total exports. Over the past five years, China has accounted for almost 20% of the net increase in U.S. exports, far outpacing any other American trade partner. Chart 1U.S.-China##br## Bilateral Trade U.S.-China Bilateral Trade U.S.-China Bilateral Trade Chart 2China Depends More ##br##On The U.S. Than Vice Versa China Depends More On The U.S. Than Vice Versa China Depends More On The U.S. Than Vice Versa Conventional wisdom holds that protectionist policies will be of more benefit to those countries running deficits in bilateral trade. However, a trade war with China would also remove the biggest source of marginal demand for American goods, which would be met with strong domestic resistance. Anti-Dumping And China's Trade Performance China is no stranger to anti-dumping measures in global trade. The country accounts for 30% of all anti-dumping actions initiated by World Trade Organization (WTO) members in recent years, even though Chinese products account for only about 14% of total global goods exports. China has not been regarded as a "market economy" by major developed countries, making it an easier target for punitive tariffs and other barriers under WTO rules. A case in point is steel products, which remain center stage in the ongoing trade dispute between China and the U.S. President George W. Bush in 2002 imposed tariffs of up to 30% on a broad range of Chinese steel products, while the Obama administration further upped the ante with various product-specific punitive measures during his tenor. These measures have dramatically changed steel trade for both countries: From the U.S. side, total American steel imports have remained largely range-bound in the past 20 years, but Chinese steel products have had a dramatic rollercoaster ride (Chart 3). Punitive tariffs led to a collapse of Chinese steel in the U.S. market, accounting for a mere 3% of total U.S. steel imports, down from a peak of almost 20% in 2008. However, the losses to Chinese steelmakers have simply been filled by other exporting countries. For example, U.S. steel imports from Brazil have roared back to historical high levels as Chinese products plummeted (Chart 3, bottom panel). On the Chinese side, Chinese steel products suffered huge market share losses in the U.S., but the country's total steel exports have continued to make new record highs, as it has dramatically expanded sales to other markets, particularly developing countries (Chart 4). The U.S. currently accounts for about 1% of total Chinese steel exports, down from about 10% at the peak, while Vietnam has rapidly replaced the U.S. as a key market for Chinese steelmakers to expand overseas sales. Chart 3China In U.S. Steel Imports China In U.S. Steel Imports China In U.S. Steel Imports Chart 4U.S. In Chinese Steel Exports U.S. In Chinese Steel Exports U.S. In Chinese Steel Exports Moreover, the punitive measures imposed by the U.S. have pushed Chinese steelmakers into higher value-added products. The top panel of Chart 5 shows the average price of American steel imports from China was roughly comparable to U.S. steel purchases from other developing countries in the late 1990s, while Germany and Japanese steelmakers traditionally occupied the higher-priced segments. The situation has shifted quickly in the past two decades: The unit price of Chinese steel sales in the U.S. has risen rapidly relatively to their peers, increasingly challenging producers in more advanced countries. Other emerging countries have filled the space left by China and remained at the lower end of the spectrum. Similarly, on the Chinese side, the average price of Chinese steel exports to the U.S. has increased sharply in recent years relative to other major markets, particularly developing countries (Chart 5, bottom panel). Currently, the average price of China's steel products exported to the U.S. is far higher than to other countries - almost triple that to other emerging countries. This confirms that Chinese steelmakers have been moving up the value-added ladder in the U.S. market, but have been "dumping" cheaper products to other developing countries. The important point here is that the punitive tariffs have indeed significantly reduced Chinese sales to the U.S., but other steel-producing countries have simply "stolen" China's lunch. By the same token, unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. Moreover, President Trump may still target Chinese steel products as a highly symbolic gesture to show his toughened stance on China and to keep his campaign trail promises of reviving rust-belt states - the relevance of which, however, has diminished dramatically, as steel products now account for only a tiny fraction of total trade between these two countries (Chart 6). Chart 5Chinese Steelmakers##br## Are Moving Up The Value Chain Chinese Steelmakers Are Moving Up The Value Chain Chinese Steelmakers Are Moving Up The Value Chain Chart 6Steel Is No Longer ##br##Relevant For China-U.S. Trade China-U.S. Trade Relations: The Big Picture China-U.S. Trade Relations: The Big Picture U.S. And China In Global Trade A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. For tradable goods, it is well known that China has long surpassed the U.S. as the world top exporter. For imports of goods, the U.S. is still bigger, but the gap has narrowed dramatically (Chart 7). China has already become a bigger market than the U.S. for a growing list of countries, particularly commodities producers and China's Asian neighbors. What is much less known is that Chinese imports of services just this year also surpassed that of the U.S., marking an important milestone in China's global reach and influence (Chart 8). Moreover, China's exports of services are much smaller, leaving a deficit almost as large as U.S. service surpluses with the rest of the world. Chart 7U.S. And China##br## In Global Trade Of Goods U.S. And China In Global Trade Of Goods U.S. And China In Global Trade Of Goods Chart 8China Surpassed##br##The U.S. In Service Imports China Surpassed The U.S. In Service Imports China Surpassed The U.S. In Service Imports In a world starving for growth, China remains a bright spot. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. China will inevitably continue to explore bilateral and multilateral free-trade agreements (FTA) with its main trade partners. China currently has 19 FTAs under construction, among which 14 agreements have been signed and implemented. Together, FTAs cover an increasingly bigger share of Chinese exports, higher than Chinese sales to the U.S. (Chart 9). Chart 9China Sells More To FTA##br## Countries Than To The U.S. China Sells More To FTA Countries Than To The U.S. China Sells More To FTA Countries Than To The U.S. Meanwhile, China will likely take a more active role in negotiating the "Regional Comprehensive Economic Partnership (RCEP)" - an ambitious multilateral agreement on trade and investments that covers almost half of the world population and output. On the other hand, the outlook of the Trans-Pacific Partnership (TPP) under President Trump has become more uncertain, which may also push other emerging countries to participate in China-initiated trade deals. If President Trump indeed turns more inward, the center of global trade will further shift toward China. A Word On The RMB And Industrial Stocks The RMB has continued to drift lower against the greenback in recent days, which still reflects the dollar's broad strength rather than RMB weakness. In fact, the trade-weighted RMB has strengthened notably (Chart 10). Conspiracy theories abound that China may engineer a flash-crash of the RMB before President Trump takes office to "preempt" any protectionist pressures. This scenario certainly cannot be ruled out, but it is highly unlikely in our view, as it may further intensify trade tensions between the two countries, making Trump's trade policy on China even less predictable. In short, we maintain the view that the near-term RMB outlook is entirely dictated by the movement of the dollar, and that the Chinese authorities should be able to maintain exchange rate stability, as discussed in recent reports.1 Turning to the stock market, Chinese industrial stocks have not joined the sharp post-Trump rally of their U.S. counterparts, likely a reflection of investors' conviction that protectionism in the U.S. may benefit domestic firms at the expense of foreign entities, particularly Chinese firms. (Chart 11). However, similar to almost all other major sectors, the profitability of Chinese industrial names is almost identical to their American peers, but they are trading at hefty discounts based on conventional valuation indicators, reflecting a much larger risk premium in Chinese stocks. For now, we remain on the sidelines with respect to Chinese stocks due to developing global uncertainty, as discussed in detail last week.2 Beyond near-term tactical consideration, we expect Chinese shares to resume their uptrend both in absolute terms and against EM and global benchmarks. Chart 10The RMB Remains Stable##br## In Trade-Weighted Terms The RMB Remains Stable In Trade-Weighted Terms The RMB Remains Stable In Trade-Weighted Terms Chart 11Industrial Stocks:##br## Spot The Differences Industrial Stocks: Spot The Differences Industrial Stocks: Spot The Differences Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, and "Greater China Currencies: An Overview", dated November 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Trump's election victory means that there is potential for policy settings to flip from "easy money, tight fiscal" to "tight money, easy fiscal" The market implications of that shift are dollar bullish, bond bearish and equity mixed. The major risk is that violent currency and bond market moves rekindle emerging market stress and/or choke off the recovery before fiscal spending kicks in. Trump's trade reform risks being a tax on growth. Businesses may opt to automate instead of hire. A variety of factors now make small caps appealing relative to large caps. Feature Contrary to the pre-election consensus, Donald Trump's election victory has prompted a risk-on rally, based on the notion that Trump's vision of fiscal largesse will be realized (Chart 1). Ultimately, it will only become clear what policy changes are on the table once Trump takes office in January. The consensus at BCA is that Trump will be "unbound" in his first two years as President. Thus, if Trump lives up to his campaign promises, fiscal stimulus and trade restriction will be tabled early in 2017. Chart 1Trump Moves Trump Moves Trump Moves As we argue below, trade restrictions should be viewed as a tax on growth. We have doubts about the link between job creation and tariffs. If anything, imposing tariffs on imports could incite a more intense wave of automation. After all, the cost of capital is still attractive relative to labor costs. Meanwhile, fiscal spending - if delivered even close to the size and scope that Trump has hinted at in his pre-election speeches - will boost GDP growth well above trend in 2017. If that occurs, the dynamic that has existed since 2010, i.e. "tight fiscal, exceptionally easy money policy" will rapidly flip to "easy fiscal, tight money". For the bond market and the U.S. dollar, the investment implications are clear: Treasuries are likely to head higher, and the pressure will be for the U.S. dollar to rise. Implications for equities are less certain. If the U.S. dollar rises, it might rekindle emerging world financial stress and undermine U.S. corporate profits. The rapid rise in yields may not easily be digested by the equity market and it is notable that corporate spreads have not rallied along with other risk assets in recent days. We are comfortable maintaining a defensive stance. Donald Trump said a lot of things to a lot of people during the campaign process. He can't possibly deliver on all of his promises, but earlier this week, BCA sent out a Special Report to all clients, outlining the implications of the election results and what we expect he can accomplish.1 We believe there are three that are especially important for investors to monitor: the potential for trade restrictions, gauging fiscal stimulus and monetary policy settings in this possibly new environment. Stagflation? Trump has repeatedly signaled his intention to restrict American openness to international trade and the U.S. president can revoke international treaties solely on their own authority. Trump can also impose tariffs. All of this is of course inflationary, and it's the nasty kind. We have repeatedly written in this publication that, historically, the U.S. economy only falls into recessions for two reasons. The first is growth-restrictive monetary policy and the second is an adverse supply shock that acts like a tax on growth, e.g. an oil price spike. Tariffs are akin to the latter. Chart 2 shows that as import penetration rose over the past 30 years, tradeable goods price inflation steadily fell. A simple read of the chart suggests that with barriers in place and as import penetration recedes, the process of the past 30 years will reverse and consumer goods prices will rise. This can easily be absorbed if it is accompanied by rising wages via the "onshoring" of jobs. But that is not a foregone conclusion. Instead of bringing manufacturing jobs back to the U.S., a more logical decision might be for businesses to further automate production. After all, earlier studies have already concluded that nearly half of all existing jobs are at high risk of being automated over the next decade or so.2 As Chart 3 shows, with the price of capital equipment and software still falling and the cost of capital so low relative to the cost of labor, the incentive to automate instead of hire is high. Chart 2Trade And Inflation Trade And Inflation Trade And Inflation Chart 3Tariffs May Lead To Robots, Not Jobs Tariffs May Lead To Robots, Not Jobs Tariffs May Lead To Robots, Not Jobs The bottom line is that increased tariffs will increase prices in the near term. But it is hardly clear that this will improve the lives of voters or create a more virtuous economic recovery. Opening The Fiscal Taps... In last week's report, we explored the potential for fiscal spending to turbocharge the U.S. economy. We warned that fiscal multipliers are probably not overly high in the current environment and the effectiveness of fiscal spending is highly dependent on the type of fiscal stimulus. Trump has called for significantly lowering both income and corporate taxes, although his main pitch has been infrastructure spending. The latter tends to have the highest multiplier effects, but can often take a long time to get underway. However, one important point is that Trump will face little political restraint, at least in his first two years in office. Gridlock will not be a problem given that all three Houses are now in GOP hands. And it will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Over the past 28 years, each new president has generally succeeded in passing their signature items. Moreover, the GOP has historically not been that fiscally conservative. Overall, a Trump government will more than make up for the drag from weak state and local spending that we wrote about last week. Exactly how big of an impulse will only become clear once Trump takes office. ...And Tightening The Money Supply? Forecasts about the impact of fiscal spending on 2017 GDP growth are premature, since it is impossible to decipher an action plan from campaign rhetoric. And the severity of stagflation due to trade restrictions will be highly dependent on the form and scope of trade reform. Ergo, it is too early to make bold new assumptions about the path of Fed rate hikes. An aggressive fiscal plan that boosts GDP well above trend growth would force policymakers to revise their expected path of rate hikes higher. That would be a sea change from the past four years, when policymakers have consistently revised the neutral rate down. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked Janet Yellen and current monetary policy settings. A review of the Fed may happen at some point, but we assert that investigating the Fed will not be a priority early in Trump's mandate. Market Action The bond market has already priced in more inflation and more growth for 2017 since Trump's victory. 10-year Treasury yields have surged to 2.15% and momentum selling could lift the 10-year Treasury yield even further into oversold territory. But that is not a case to become aggressively underweight duration. Dollar strength and rising bond yields have already tightened financial conditions significantly over the past several weeks. The risk is that these trends go too far in the near term, inflicting economic damage before fiscal spending kicks in. Given the easy monetary stance of central banks around the world, lack of significant fiscal stimulus elsewhere, economic growth outperformance in the U.S. and rising interest rates, the dollar should rise in the medium term. We remain dollar bulls. We have been surprised by the equity market action since November 8. Although we repeatedly wrote that a Trump victory was unlikely to have meaningful negative consequences for risk asset prices, we did not anticipate a rally. As for equities, our cautiousness toward risk assets in 2016 has been primarily focused on the ongoing headwinds for profits in a demand-deficient economy, especially while margins are falling and valuations are elevated (Chart 4). Greater fiscal spending would surely help to alleviate our concern, although that conclusion seems premature given the lack of contour to Trump's plans so far. Perhaps the greatest downside risk is a reaction from China. After all, Trump's anti-trade rhetoric has been pointed (mostly) at China and Asia. Recall that in August, 2015, the RMB was devalued just weeks ahead of an expected rate hike from the Fed. That devaluation sent shock waves through financial markets and ultimately delayed the Fed rate hike until the end of the year (Chart 5). A similar proactive policy move from Chinese policymakers should be on investors' radars. Overall, we remain comfortable with our cautious equity stance, albeit recent market action has created an entry point in favor of small relative to large cap stocks. Chart 4Equity Fundamentals Still Poor Equity Fundamentals Still Poor Equity Fundamentals Still Poor Chart 5China: Global Stability Risk? China: Global Stability Risk? China: Global Stability Risk? Enter Small Cap Bias We upgraded small caps relative to large caps to neutral in August. We now recommend investors make the full switch to a small cap bias relative to large caps. Small cap stocks were hit harder than large caps in the weeks leading up to the election, as investors shed riskier assets; we believe this provides a good entry point to a cyclical uptrend in small cap performance (Chart 6). True, at first glance, advocating for small cap exposure appears inconsistent with our overall defensive equity strategy. After all, small cap outperformance tends to be associated with risk-on phases. However, small cap stocks have a variety of other characteristics that currently make them appealing relative to larger caps. Chart 6(Part I) Favor Small/Large Caps (Part I) Favor Small/Large Caps (Part I) Favor Small/Large Caps Chart 7(Part II) Favor Small/Large Caps (Part II) Favor Small/Large Caps (Part II) Favor Small/Large Caps Small cap companies tend to be more domestically focused. We expect that U.S. growth will continue to outpace growth overseas. And particularly important, small cap companies, with their domestic focus, are better insulated from dollar strength (Chart 7). Small cap weightings are no longer geared toward cyclical sectors. As part of our cautious strategy, we remain focused on defensive vs. cyclical sectors. There are no major differences between large and small cap defensive and cyclical sector weightings (Table 1). Trump corporate tax reform, if implemented, will favor small, domestic firms. Because major corporations already have low effective tax rates, any lowering of the marginal rate will benefit small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then this would diminish their current tax advantage vis-à-vis smaller companies. Table 1Similar Weightings For Small And Large Cap Cyclicals And Defensives Easier Fiscal, Tighter Money? Easier Fiscal, Tighter Money? Bottom Line: Small cap outperformance is typically associated with risk-on equity phases. However, valuations now favor small caps. Importantly, small caps are better insulated from dollar strength and are one way to play the domestic vs. global theme. Additionally, smaller firms will be the relative winners from corporate tax reform. Small caps are set to outperform large caps. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Geopolitical Strategy Special Report "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com 2 "The Future Of Employment: How Susceptible Are Jobs To Computerisation?" Carl Frey and Michael Osborne, September 2013. Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process Chart 8. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical component of the equity model still has a "buy" signal, the breadth indicator has moved into less favorable territory relative to the momentum indicator. The monetary component has also slightly weakened but retains its positive bias for equities. The earnings-driven component continues to warrant caution as expectations for the outlook of corporate profits would need to be bolstered through stronger economic stronger growth over the medium term. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model. Even so, despite that the "buy signals" of the cyclical and technical components of the bond model still persist, the preference for Treasuries has diminished to some extent. Nevertheless, the valuation component continues trending towards expensive territory and a "buy signal" remains in place Chart 9. Chart 8Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 9Current Model Recommendations Current Model Recommendations Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.

BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer Reaganomics 2.0? Reaganomics 2.0? In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Room To Increase Infrastructure Spending Room To Increase Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them bca.fes_wr_2016_11_11_s1_c3 bca.fes_wr_2016_11_11_s1_c3 Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Populism Can Boost Growth Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too bca.fes_wr_2016_11_11_s1_c5 bca.fes_wr_2016_11_11_s1_c5 Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Reaganomics 2.0? Reaganomics 2.0? Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Household Debt Load Can Grow Again Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates bca.fes_wr_2016_11_11_s1_c8 bca.fes_wr_2016_11_11_s1_c8 Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump Reaganomics 2.0? Reaganomics 2.0? We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China Reaganomics 2.0? Reaganomics 2.0? This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall bca.fes_wr_2016_11_11_s1_c11 bca.fes_wr_2016_11_11_s1_c11 Chart I-12China Is The Giant In The Room Reaganomics 2.0? Reaganomics 2.0? The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals bca.fes_wr_2016_11_11_s1_c13 bca.fes_wr_2016_11_11_s1_c13 Chart I-14Better Supply/Demand Backdrop For Oil bca.fes_wr_2016_11_11_s1_c14 bca.fes_wr_2016_11_11_s1_c14 We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump bca.fes_wr_2016_11_11_s1_c15 bca.fes_wr_2016_11_11_s1_c15 Chart I-16European Labor Market##br## Slack Is Evident European Labor Market Slack Is Evident European Labor Market Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally bca.fes_wr_2016_11_11_s1_c17 bca.fes_wr_2016_11_11_s1_c17 Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? bca.fes_wr_2016_11_11_s1_c18 bca.fes_wr_2016_11_11_s1_c18 Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 bca.fes_wr_2016_11_11_s2_c2 bca.fes_wr_2016_11_11_s2_c2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_11_s2_c4 bca.fes_wr_2016_11_11_s2_c4 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_11_s2_c5 bca.fes_wr_2016_11_11_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_11_s2_c6 bca.fes_wr_2016_11_11_s2_c6 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_11_s2_c7 bca.fes_wr_2016_11_11_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_11_s2_c8 bca.fes_wr_2016_11_11_s2_c8 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_11_s2_c9 bca.fes_wr_2016_11_11_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 bca.fes_wr_2016_11_11_s2_c20 bca.fes_wr_2016_11_11_s2_c20 Policy Commentary: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights All three of Trump's signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - are dollar bullish. The implementation of these policies could cause the U.S. economy to overheat, forcing the Fed to raise rates more than it otherwise would. A Trump presidency is unlikely to lead to major institutional changes at the Fed. Trump is okay with a stronger dollar and higher rates, as long as these do not cause growth to stall. Investors have gone from too bearish to too bullish about what a Trump victory means for equities. A tactically cautious stance is still appropriate. Feature Trump Triumphant Chart 1Trumpism Trumps Unfavorability Trumpism Trumps Unfavorability Trumpism Trumps Unfavorability The late film critic Pauline Kael allegedly once said that there was no way that Richard Nixon could have won the 1972 election because she didn't know a single person who voted for him. Kael actually never said this, but the story rings true because one can imagine many people saying something like that. I spent the last few days meeting clients in New York City. The expression on the faces of people while walking down the streets in Manhattan - which went 87%-to-10% for Clinton over Trump - said it all. Most people seemed dazed and confused by what happened on November 8th. Trump did not win because of his personality. He won in spite of it. As I have emphasized over the past 18 months - starting with my presentation at the 2015 BCA New York Conference, which featured the prediction that "The Trumpists Will Win" - Trumpism is a lot more popular than Trump. How else can someone with a 62% unfavorability rating become the next president of the United States (Chart 1)? The reason that Trump won is because he addressed many of the legitimate grievances of blue collar workers in swing states that establishment politicians had long ignored. As we discussed last year in a report entitled "Trumponomics: What Investors Need To Know,"1 trade with China has led to a hollowing out of the U.S. manufacturing base; low-skilled immigration has dragged down blue collar wages; and the flow of drugs into the U.S. from across the southern border is a legitimate problem. Donald Trump And The Markets I will have much more to say about the long-term economic and political consequences of Trump's victory in a special report that I intend to publish next week. For now, however, let me concentrate on the near-term investment implications. Global equities plunged in the immediate aftermath of the election results, while the dollar weakened and Treasurys rallied. This knee-jerk reaction largely stemmed from the fear that a Trump presidency would be highly destabilizing for the global economy. In such an environment, the Fed would not be able to raise rates very much, which is a clear negative for the greenback. Trump's conciliatory victory speech helped soothe frayed nerves, sending both the dollar and Treasury yields higher. This was consistent with our expectations. As we argued in "A Trump Victory Would Be Bullish For The Dollar" and in "Three New Controversial Calls: Trump Wins And The Dollar Rallies," all three of Trump's signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - are bullish for the dollar and bearish for bonds.2 Fiscal Stimulus On The Horizon Now that Donald Trump has a Republican House and Senate to work with, there is a high probability that he will be able to push through a sizable infrastructure bill (sidebar: I am writing these words from the Kabul-like departure area at LaGuardia airport. My flight to Montreal is delayed because Trump's plane, which he dubs Trump Force One, will be taking off soon). In addition to increasing infrastructure spending, Trump has pledged to raise defense expenditures and enact sizable tax cuts. The Tax Policy Center estimates that Trump's tax plan alone would increase the federal debt by $6.2 trillion over the next ten years (excluding additional interest), representing approximately 2.6% of GDP of fiscal stimulus per year.3 We doubt that Congress will approve anything close to that. Nevertheless, even if he gets one quarter of the revenue and expenditure measures that he is seeking, this would be enough to boost aggregate demand growth by 0.5%-to-1% per year over the next two years. Pulling Back The Welcome Mat Chart 2Trump's Hard Line On Trade ##br##And Illegal Immigration Would##br## Benefit Low-Skilled Workers Trump's Hard Line On Trade And Illegal Immigration Would Benefit Low-Skilled Workers Trump's Hard Line On Trade And Illegal Immigration Would Benefit Low-Skilled Workers Immigration policy is one of those areas where the president can do a lot without congressional approval. Existing U.S. immigration laws are already very strict; they just happen to be enforced in a highly haphazard manner. High-skilled workers who want to go through the proper legal channels to gain residency must jump through all sorts of burdensome hoops; in contrast, low-skilled workers who enter the country illegally can generally evade detection and prosecution. This obviously makes for a suboptimal immigration system. Trump's campaign rhetoric has generally focused on combating illegal immigration. Although his official immigration policy paper - allegedly ghost-written by Senator Jeff Sessions - mentions cutting back on high-skill H1-B visas, at times Trump has appeared to disavow that view, stressing his desire to bring in only "the best" immigrants. Our suspicion is that a Trump presidency would generally take a fairly soft stance towards high-skilled immigrants, focusing instead on curbing illegal immigration through increased border security and the rollout of a mandatory national E-Verify system. Since illegal immigrants are generally poorly educated, such an outcome would raise the wages of low-skilled workers. Chart 2 shows that the pool of unemployed low-skilled workers has largely evaporated in recent years. Higher wage growth, in turn, could cause the Fed to hike rates more aggressively than it otherwise would, helping to push up the value of the dollar. Protectionism And The Dollar As with immigration, the executive branch has a lot of discretion over trade policy. There is an ongoing debate about whether sitting presidents can withdraw from trade deals that they do not like without congressional approval. The prevailing legal view is that they can, but even if that turns out not to be the case, they can certainly take other measures that increase import barriers. Such tactics have often been used by Republican presidents who liked to portray themselves as free traders. For instance, Ronald Reagan imposed voluntary export restraints on Japanese automakers and major foreign steel producers, raised tariffs on Japanese motorcycles, and tightened quotas on sugar imports. George W. Bush also increased tariffs on steel imports and imposed quotas on Chinese textiles. It goes without saying that Donald Trump would not be averse to taking similar steps. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Such worries were a key reason why Japanese automobile companies began to invest in new U.S. production capacity starting in the 1980s. This could help reduce the U.S. trade deficit. A smaller trade deficit, in turn, would increase aggregate demand. This, in conjunction with the adverse supply-side effects that protectionist measures typically result in, would cause the output gap to narrow further, forcing the Fed to step up the pace of rate hikes. In addition, standard trade theory suggests that higher trade barriers would raise real wages for low-skilled workers. Since such workers tend to have the highest marginal propensity to consume, this, too, would boost aggregate demand. Trump And The Fed While Trump's policy proposals are all dollar bullish and bond bearish, where does Trump himself want the dollar and bond yields to go? The answer will obviously influence his relationship with the Fed and how he responds to any dollar strength. As with many of his policy ideas, it is hard to know exactly where Trump stands. Investors are accustomed to politicians who constantly flip-flop on the issues. Trump takes it a step further. He may be the first "quantum" candidate to run for office: Just like an electron can have a different spin and position at the same time, Trump seems capable of believing multiple things at the same time and spinning any position to his liking. With that caveat in mind, we think that a Trump presidency would not represent a significant departure from existing monetary policy. While Trump has said that he would like to replace Janet Yellen with a Republican once her term expires in 2018, he has also said he has "great respect" for the Fed Chair, and that he is "not a person who thinks Janet Yellen is doing a bad job." As far as the direction of interest rates is concerned, Trump has acknowledged that "as a real estate person, I always like low interest rates," but "from the country's standpoint, I'm just not sure it's a very good thing, because I really do believe we're creating a bubble." Chart 3Still Below Past Peaks Still Below Past Peaks Still Below Past Peaks He also seemed to acknowledge that there is a limit to how strong the dollar can get. "If we raise interest rates," he said, "and if the dollar starts getting too strong, we're going to have some very major problems." Our conclusion is that Trump would welcome higher rates, so long as any dollar appreciation does not choke off growth. As we discussed last month in a report entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen," the combination of a rebound in business capex, less inventory destocking, and continued strong personal consumption growth thanks to rising wages could cause aggregate demand growth to rise to 2.5%-to-3% this year.4 Trump's victory increases the risk to these numbers to the upside. Since we published that report, the broad real trade-weighted dollar has gained about 1.5%. We are still comfortable with our view that the dollar will rise by another 8.5% over the next 11 months. As Chart 3 shows, this would still leave the greenback below its previous 1985 and 2001 highs. Trump And Other Central Banks A more difficult issue to handicap is how a Trump presidency will influence policy outside the U.S. Would China, for example, feel the need to prop up the RMB in order to avoid Trump's wrath? Would Japan be less willing to pursue an accommodative monetary policy in an indirect effort to weaken the yen, if this led to the threat of higher tariffs on Japanese exports to the U.S.? Our sense is that yes, a Trump administration will, to some extent, constrain the ability of other nations to weaken their currencies. That said, the impact is unlikely to be especially dramatic. China does manipulate its currency. But lately it has been selling foreign-exchange reserves in an effort to keep the RMB from falling more than it otherwise would. Thus, an end to China's intervention would mean a weaker yuan, not a stronger one. Likewise, as long as the Bank of Japan is not engaged in direct foreign asset purchases, the ability of the Trump administration to cry foul is limited. Equity Implications We must admit that we are surprised that global equities were so quick to shrug off their losses. Our expectation had been that stocks would weaken somewhat in the wake of a Trump victory. What happened? A few things come to mind. First, there has probably been a fair amount of short-covering from investors who had bought insurance against a Trump win. Second, investors, like all humans, tend to draw on analogies in making their decisions. The best analogy for what happened on November 8th is what occurred after the Brexit vote. The lesson from that episode is that one should buy stocks after a supposedly negative voting outcome. That is exactly what investors did Wednesday morning. Third, there are in fact some legitimate reasons why President Trump may be good for stocks. In addition to the prospect of lower corporate tax rates and fiscal stimulus, a Trump administration is likely to go soft on financial regulation. This, in tandem with a steeper yield curve, could prove to be a positive development for banks. A Trump administration is also good news for energy companies, particularly coal. Defense contractors should benefit from increased military expenditures. The implications for health care stocks is harder to gauge. While the potential repeal of the Affordable Care Act could hurt some companies, it may benefit others. Our hunch is that the net effect for health care earnings will be positive. Even if Obamacare is repealed, it is likely to be replaced with something that looks a lot like the existing legislation, just with more subsidies and giveaways for health care providers and drugmakers (think of Medicare Part D). Having said all this, investors now seem to be a bit too complacent about what a Trump presidency means for stocks. The risk of a trade war is still present. And even if Trump pulls in his protectionist horns, a tighter labor market, exacerbated by a potential shortage of immigrant workers, is likely to eat into corporate profit margins. Higher rates and a stronger dollar will also hurt. As such, we are maintaining our tactically cautious stance on global equities. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," (Call #1: Trump Wins, And The Dollar Rallies), dated September 30, 2016, available at gis.bcaresearch.com. 3 Please see Jim Nunns, Len Burman, Ben Page, Jeff Rohaly, and Joe Rosenberg, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016. 4 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. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength, which could rekindle financial market volatility and cap the upside in Chinese stocks. The Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Joining the SDR does not automatically award the RMB international currency status. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Feature The resumption of the dollar bull market has once again generated downward pressure on the RMB. How long the dollar bull run will last remains to be seen, but the broader global backdrop supports its continued strength against other major currencies, at least in the near term, including the yuan. Renewed downward pressure on the RMB may be perceived as a sign of domestic economic troubles, which could expedite capital outflows, creating a self-feeding vicious circle. The saving grace is that the Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Interestingly, the RMB's renewed weakness came in the wake of its official inclusion in the IMF's Special Drawing Right (SDR) basket early this month. While joining the SDR bears no near-term relevance from both an economic and financial market point of view, it marks an important milestone in the internationalization process of the RMB, with potential longer term implications. The RMB: From Goldilocks To Gridlock Chart 1The RMB: Stronger Or Weaker? The RMB: Stronger Or Weaker? The RMB: Stronger Or Weaker? The relapse of the CNY/USD of late is entirely driven by the strong dollar. While the RMB has weakened against the greenback, it has strengthened in trade-weighted terms (Chart 1). This is undoubtedly bad news for China, as it has very quickly pushed the RMB from a goldilocks scenario to essentially a gridlock. The goldilocks scenario that prevailed over the past several months was ushered in primarily by the weak dollar. It allowed the RMB to stay largely stable against the dollar but weaken substantially in trade-weighted terms - an ideal combination for both the market and the economy. Investors took comfort in a stable CNY/USD, while the Chinese economy benefited from the reflationary impact of a weaker trade-weighted exchange rate. In this vein, the reversal of the dollar trend will also lead to a reversal of this positive dynamic that prevailed over the past several months. Financial markets and investors will once again pay attention to the weakening CNY/USD, while the "stealth" depreciation of the trade-weighted RMB will also be halted, removing its reflationary impact. In other words, a weaker CNY/USD and a stronger trade-weighted RMB is the least desirable combination for both financial markets and the economy. To break this gridlock, the People's Bank of China (PBoC) could either "peg" the currency to the dollar, or weaken it substantially enough to achieve a weaker RMB in trade-weighted terms, neither of which is likely in our view. The path of least resistance is for the PBoC to bear it out, with managed CNY/USD depreciation together with tightened capital account controls to prevent capital flight. This is far from optimal and may still stoke financial market volatility, similar to the several episodes last year when a weakening RMB stoked fears of Chinese financial instability. However, a few factors suggest that this time the PBoC may be better prepared: Frist, the Chinese authorities have been paying much more attention to "open-mouth" operations in communicating their intention to market participants. Overall, investors are less 'spooked" by China's foreign exchange rate policy than a year ago. Second, pressure from capital outflows from the corporate sector will likely subside going forward. Paying down foreign debt has been one of the biggest sources of capital outflows in the past year, which has substantially reduced the domestic corporate sector's foreign currency liabilities (Chart 2).1 Moreover, despite dwindling foreign debt obligations, the corporate sector still holds near-record-high foreign currency deposits (Chart 3), which should further reduce its incentive to hoard the dollar. Chart 2Corporate Sector Foreign ##br##Debt Has Dropped Substantially... bca.cis_wr_2016_10_20_c2 bca.cis_wr_2016_10_20_c2 Chart 3... But Still Hoards ##br##Lots Of Dollar Deposits bca.cis_wr_2016_10_20_c3 bca.cis_wr_2016_10_20_c3 Further, Chinese growth is a tad stronger than last year, due largely to the reflationary impact of previous easing measures, including a weaker trade-weighted RMB. Even though the headline third quarter GDP growth figures reported this week remained essentially unchanged, the industrial sector has recovered notably, with improving activity, strengthening pricing power and accelerating profits. As economic variables typically respond to policy thrusts with a time lag, we expect the economy will continue to build momentum in the coming months, even if the reflationary impact of the RMB begins to diminish. More importantly, the Chinese government appears more willing to engage in fiscal pump-priming than last year, with a focus on infrastructure and private-public-partnership projects. Improving growth momentum and expansionary fiscal policy should be supportive for the exchange rate. Finally, the CNY/USD is already 12% lower than its peak in early 2014, and is no longer significantly overvalued, according to our valuation models (Chart 4). This means that additional CNY/USD weakness will further boost market share of Chinese products in the U.S., helping China to reflate while at the same time acting as an increasingly heavier drag on the U.S (Chart 5). It is therefore in the mutual interests of both the Chinese and U.S. authorities to maintain a steady RMB exchange rate. The U.S. Treasury once again cleared China from being currency manipulator in its last week's semi-annual review, and acknowledged the PBoC's efforts in preventing rapid RMB depreciation as beneficial for both the Chinese and global economies. To be sure, the U.S. and China will not explicitly coordinate monetary policy to regulate exchange rate movements. However, a weaker CNY/USD will lead to much quicker dollar appreciation in trade-weighted terms than otherwise, which in of itself will prove self-limiting. Chart 4RMB/USD Is No Longer Overvalued RMB/USD Is No Longer Overvalued RMB/USD Is No Longer Overvalued Chart 5A Weaker RMB/USD Is ##br##Boosting Chinese Exports To The U.S. A Weaker RMB/USD Is Boosting Chinese Exports To The U.S. A Weaker RMB/USD Is Boosting Chinese Exports To The U.S. The bottom line is that the near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength in the near term, but unless the dollar massively overshoots the downside will not be substantial. This could rekindle financial market volatility and cap the upside in Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares from "overweight" to "neutral" last week,2 and this view remains unchanged. At the same time, we continue to argue against being outright bearish, because of the deeply depressed valuation matrix of this asset class, especially H shares. When Will The RMB Float? We expect Chinese regulators will tighten capital account controls significantly in the coming months in order to slow capital outflows in the wake of renewed CNY/USD depreciation. The impossible trinity of international finance dictates that a country cannot target its exchange rate with independent monetary policy and simultaneously allow free capital flows. Among these three conditions, "free capital flows" is the least-costly sacrifice. There is no way the PBoC will raise interest rates to defend the currency. Tightening capital account controls goes against the long-term objective of China's foreign exchange rate reforms, but it is not only justified but necessary in the near term. Pointing at the dilemma the PBoC faces today, some pundits are now singing the "I-told-you-so" song, claiming the country should have moved to a much greater degree of exchange-rate flexibility "back when the going was good", as they had advised. In our view, this argument is completely flawed. In previous years when "the going was good", China was facing massive foreign capital inflows, unleashed by extremely aggressive monetary easing by other central banks in the wake of the global financial crisis. If the PBoC indeed took this advice back then and did not intervene to slow down RMB appreciation by hoarding massive foreign reserves, it would simply have led to a dramatic overshoot of the RMB. By the same token, when the tide turned, capital outflows would have proven overwhelming, leading to an RMB collapse. In fact, without the massive foreign reserves accumulated in previous years during the PBoC's RMB intervention, the Chinese authorities' ability to maintain exchange rate stability would have been much more seriously challenged, particularly in the past year. Chart 6Lopsided Expectations On The RMB ##br##Drive One-Way Moves Of Capital Flows bca.cis_wr_2016_10_20_c6 bca.cis_wr_2016_10_20_c6 In other words, the key problem with China's exchange rate is that expectations on the RMB have been lopsided in recent years (Chart 6). Consequently, the RMB has long been a one-way bet, accompanied by one-way moves of capital flows. The unanimous view on a rising RMB in previous years drove capital inflows; expectations completely reversed in 2015, leading to persistent outflows. In this environment, without the PBoC's intervention, a "greater degree of exchange rate flexibility" as advised by some would simply mean extreme RMB moves, inevitably leading to much greater financial and economic volatility. Therefore, the RMB should only be allowed to float when there is a healthy divergence of views among market participants, so that there are enough "buyers" and "sellers" to collectively price the RMB exchange at a market-determined "equilibrium" level. Until then, any premature and imprudent capital account deregulation would prove catastrophic, and should be avoided at all cost. We are hopeful the Chinese authorities will remain pragmatic enough not to hasten this process. The RMB's SDR Debut: Playing The Long Game The RMB has officially joined the SDR basket since the beginning of October, the first emerging country currency to join this "elite club". The RMB's SDR debut has little economic relevance in the near term. If anything, officially joining the SDR means that the RMB, under China's prevailing capital account regulations, meets the IMF's criteria as a "freely usable" currency. Therefore, it implies that the IMF endorses China's capital control measures currently in place. Some analysts suggest that the Chinese government's determination to join the SDR is largely to show off national pride. In our view, it serves more pragmatic purposes both at the private and official level. Chart 7The RMB's Rising Importance As ##br##An International Payment Currency The RMB's Near-Term Dilemma And Long-Term Ambition The RMB's Near-Term Dilemma And Long-Term Ambition At the private level, an important function of an international currency is for trade invoicing - an area where the RMB has witnessed remarkable progress in recent years. The RMB currently ranks fifth among world payment currencies, accounting for a mere 2% of world payments, which pales in comparison with the dollar's 40% and the euro's 30%. However, an increasingly large share of China-related trade has been settled directly with the RMB. Currently, the RMB accounts for about 13% for all international payments sent and received by value with China and Hong Kong (Chart 7), up from practically zero a few years ago. Moreover, RMB settlement already accounts for over half of Chinese trade with specific regions such as the Middle East and African countries. For Example, the use of the RMB in the United Arab Emirates (UAE) and Qatar accounted for 74% and 60% of their respective payments to China/Hong Kong in 2015. As the largest trade partner with a growing number of countries, China should have no problem continuing to promote RMB settlement, especially in the emerging world. At the official level, the Chinese government is certainly intent on having the RMB act as an international reserve currency, but not in such a way as to challenge the dollar's mighty dominance. Rather, the government appears to be following dual mandates in its purse. Domestically, it is aiming to use the SDR inclusion as a catalyst to reform its financial system, much like what joining the World Trade Organization (WTO) in the early 2000s did to its manufacturing sector. Globally, it is seeking to play a more active role in reforming the international monetary system. After witnessing the dramatic liquidity crunch during the global financial crisis, the Chinese authorities see the necessity to reduce the world's heavy reliance on the dollar by creating credible alternatives. Neither of these dual mandates can be easily accomplished, but it is important to keep the big picture in mind in understanding China's policy initiatives going forward. The bottom line is that joining the SDR does not automatically award the RMB international currency status, and it is naïve to expect the RMB to challenge the U.S. dollar anytime soon, if at all. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Its determination to internationalize the RMB should not be underestimated. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

As the U.S. median voter is shifting to the left, redistributive policy could come into play. A strong dollar helps to achieve this goal as it results in a bigger share of labor income in the economy. EM and commodity currencies could bear the brunt of the pain. Favor the euro on its crosses. Stay short CAD/NOK, but tighten stops.