Asset Allocation

Highlights Sweden Yield Curve: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. Swedish Rates: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. NZ Rates: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Korea vs. Japan: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Feature The surprising U.S. election victory of President-elect Trump, on a policy platform that is both reflationary and protectionist, has shaken up the global macro landscape. The shock has been even more acute for small, open and export-oriented economies like Sweden, New Zealand and Korea. This triggers a necessary re-assessment of our positions. In this Weekly Report, we revisit three previously recommended trades included in our "Overlay Trades Portfolio" that are most exposed to the changing global backdrop. Sweden: Closing Our Flattener Trade... Last year, we were of the view that the Riksbank would shift to a more hawkish policy stance during 2016.1 Fast forward to today, and this has not panned out as we expected with the Riksbank persistently sticking with its dovish bias. We are no longer comfortable facing the stiff resolve of the Riksbank and, therefore, we are closing our recommended Swedish 5-year/10-year yield curve flattener trade (Chart 1). Chart 1Closing Our Sweden Flattener Chart 2The Dovish Rhetoric Is Paying Off The message has been clear - Sweden's central bank will stay accommodative as long as it takes to get inflation back on a sustainable upward trajectory. In a unified fashion, the most senior Riksbank officials have communicated the following: 2 Monetary policy is set to escape low inflation as fast as possible. Currency intervention to weaken the Krona cannot be ruled out. There is no problem in extending the Riksbank's asset purchase program, since it has worked well so far in keeping government bond yields at accommodative levels and helping depress the Krona. The exchange rate is now notably weaker throughout the entire Riksbank forecast period than previously assumed, but this has not been sufficient to counteract the lower underlying inflationary pressures in Sweden.3 In a nutshell, the Riksbank wants to bring about higher inflation through a depreciation of the currency. The strategy has started to work of late (Chart 2). A very accommodative monetary policy, combined with rising inflation pressures from a cheapening Krona, now points to a prolonged period of low real policy rates that will keep the Swedish yield curve under steepening pressure. Aside from the monetary policy rhetoric, the global political landscape is no longer favorable for a yield curve flattening trade either, even in Sweden. In June, when Brexit surprised the planet, our Sweden flattener trade performed well, as global uncertainty spiked and a risk-off environment supported lower longer-term bond yields. Donald Trump's upset election earlier this month had the exact opposite effect, however, triggering a massive curve steepening in most bond markets, including Sweden (Chart 3).4 Going forward, if the effects of Trump's proposed policies - such as a decent fiscal impulse and protectionist trade measures - linger, as we expect, a Swedish flattener will likely underperform. Global bond markets will continue to be heavily influenced by a steepening U.S. Treasury curve. Moreover, our optimism on Swedish growth has dimmed recently, with certain parts of the economy slowing down. At the business level, weakening new orders data signal lower industrial production growth ahead. In addition, exporter order books have rolled over, resulting in a build-up of inventories (Chart 4). Chart 3Same Populism, Different Outcome Chart 4Dimming Optimism In turn, Swedish households are feeling the pinch. Slower wages and employment growth are reducing consumption. Growth in retail sales and car registrations has decelerated and private bankruptcies have started to rise (Chart 5). Since household consumption is a vital part of Sweden's economy, the recent robust expansion will moderate in the next few quarters. Consequently, the gap between the Riksbank's dovish monetary stance and the economic backdrop can no longer be deemed unsustainable, as we have described it in the past. This reality has been well depicted in the latest Riksbank Monetary Policy Report (MPR), where 2016 GDP growth is now forecasted to be only 1.8%. This seems reasonable considering the decline in actual demand - observable through the slowing growth of Swedish imports - and the Riksbank's own forward-looking economic activity index (Chart 6). The Riksbank is now projecting only a modest growth rebound to 2.5% in 2017, but this implies a meaningful reacceleration in growth to an above-trend pace later on in the year. Chart 5Swedish Households: Feeling The Pinch Chart 6Swedish GDP Growth Will Slow Further Bottom Line: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. ...And Placing A New Bet On Rising Swedish Inflation Currently, the Swedish Overnight Index Swap (OIS) curve is expecting monetary policy stability in the first half of next year, pricing in only a 10% probability of a rate cut and a mere 2% chance of a rate hike by July 2017. Of the two, a rate hike is most likely, in our view, given the growing risks of upside inflation surprises stemming from a weaker Krona and rising energy prices. With such a low probability of a hike currently priced into the curve, the risk/reward potential for a trade is compelling. Today, we enter into a new position: paying 18-month Swedish OIS rates (Chart 7). Chart 7Pay 18-Month Sweden OIS Rates Chart 8Energy Prices Are Crucial For Swedish Inflation In the Riksbank's October MPR, the first rate increase was pushed forward from the second quarter of 2017 to the first quarter of 2018.5 At that point, the central bank's forecast becomes slightly lower than the interest rate expectation now priced in the OIS market. Even with our more sober view of the Swedish economy, the next rate hike is now expected to occur too far into the future. It will likely happen beforehand as upside surprises on inflation will force the Riksbank to begin tightening sooner than planned. Sweden's inflation path is mainly influenced by two factors: the Krona and energy prices. If the Krona's weakness accelerates and energy prices resume their uptrend, inflation will jump. In turn, if inflation reaches its target earlier, the central bank will start normalizing rates sooner than expected. Chart 9Can Sweden Still Overheat? As stated above, the Riksbank members' dovish rhetoric has been successful in pushing the Krona lower. Much to our astonishment, they seem ready to continue moving in that direction, despite the potential negative spillovers. The bubbly Swedish housing market - fueled by low interest rates and lacking the macro-prudential measures to stop its expansion - does not appear to be a major concern of the Riskbank for the time being. In addition to the exchange rate, the path of energy prices is crucial for inflation; it represents the bulk of the deflationary pressure over the last few years (Chart 8). Although this situation has changed recently, with a positive contribution to inflation in the last four months, energy prices will need to appreciate again to keep consumer price advances on track. This is likely to happen. Our Commodity strategists believe that the markets are understating the odds of Brent exceeding $50/bbl by the end of this year, given their expectation that Saudi Arabia and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30th in Vienna.6 If such meaningful production cuts come to fruition, energy prices will rise and add to Sweden's inflationary pressure. Moreover, the bigger structural picture in Sweden remains very inflationary, despite the short term cyclical weakness stated earlier. GDP, employment and hours worked are all expanding faster than the Riksbank's assessment of the long-run trend growth rates. Plus, according to the Economic Tendency Survey, companies are reporting labor shortages in all major business sectors.7 In sum, with resource utilization already stretched, keeping real interest rates low for longer can only prolong the steadfast Swedish credit expansion, potentially overheating the economy and creating additional inflation surprises (Chart 9). This will set the stage for an eventual shift by the Riksbank to a more hawkish posture. Bottom Line: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. New Zealand: Inflation To Re-Surface Here, As Well Chart 10Global Output Gaps Have Narrowed On November 9th, the Reserve Bank of New Zealand (RBNZ) cut its overnight rate to 1.75% and signaled that it would probably be on hold for the foreseeable future. From here, things could go both ways; another rate cut is not inconceivable in 2017. Yet the market is expecting a stable rate backdrop, pricing in only a 5% chance of a rate cut and a 6% probability of a rate hike by June 2017. Such an "undecided" market is not surprising. On one hand, inflation remains below target. On the other hand, the economy has been humming along with no signs of any major slowdown on the horizon. In our view, monetary policy risks are tilted towards rate hikes. Similar to Sweden's case, inflation has the potential to surprise on the upside in 2017. Several factors have contributed to the current stubbornly low inflation environment. However, going forward, those forces will abate and push inflation and, eventually, short term interest rates higher. 1.A more inflationary global backdrop New Zealand's low inflation problem comes from the tradable components. Simply put, because of the global deflationary environment of the last few years, and because of the Kiwi's strength, New Zealand has imported lower prices from abroad. But this phenomenon will move in the other direction going forward. The global inflationary backdrop has slowly changed. As noted by our Chief Global Investment Strategist, Peter Berezin, spare capacity within the developed economies has shrunk substantially over the last few years (Chart 10).8 Unemployment rates are lower than the non-accelerating inflation rates of unemployment (NAIRU) in most major countries, with the exception of France and Italy. Looking ahead, the current cyclical upswing in global growth, coming at a time of narrowing output gaps and increasing supply-side constraints, will put upward pressure on global inflation. This will eventually trigger a rise in New Zealand's import price inflation, although the impact might not be felt in the very short term. 2.A continued boost from China Closer to home for New Zealand, China's backdrop has become less deflationary. As we pointed out in a recent Special Report, China has turned into a cyclical tailwind for the global economy, putting upward pressure on inflation and bond yields in the near-term.9 Our "GFIS China Check List", composed of our favored indicators, highlights that China is in the expansionary phase of its economic cycle (Table 1). Table 1The GFIS China Checklist Most striking is that Chinese final goods producer prices have turned positive. This could prove to be a major development for New Zealand tradable goods prices, if it lasts; the correlation between Chinese PPI inflation and the tradable goods contribution to New Zealand's headline CPI has historically been elevated (Chart 11). 3.A weaker kiwi dollar Donald Trump's U.S. election victory could help raise New Zealand inflation through the exchange rate. If his ambitious fiscal plan and protectionist inclinations gain traction, the Fed might have to raise rates more aggressively than expected, putting upward pressure on the U.S. dollar. Under such a scenario, the Kiwi will re-price lower, potentially reversing the prior dampening effect on import prices from a strengthening currency. This would relieve policymakers on the RBNZ, who have consistently pointed to the currency's strength as the main reason inflation has missed the target (Chart 12). Chart 11China: A New Tailwind For Prices Chart 12The Kiwi Is Problematic 4.A stronger dairy sector Over the past couple of years, the Achilles heel for New Zealand has been its dairy sector, with plunging prices eroding confidence throughout the economy. Fortunately, this bad predicament is about to change as well. The exogenous factors depressing dairy prices are abating and prices are surging anew (Chart 13). The Global Dairy Trade price index has advanced in seven out of the last eight dairy auctions.10 If this impulse is prolonged, both New Zealand's export prices and domestic wages will begin to reflate. 5.A reversal of migration inflows The massive flow of migration into New Zealand since 2013 has been the main factor capping wage growth by increasing the supply of labor (Chart 14). The bulk of this inflow has been composed of young workers, aged between 15 & 29 years old.11 It is unclear if this migration will become permanent or prove to be transitory. Chart 13NZ Dairy Prices Have Rebounded Chart 14NZ Inward Migration To Stabilize... Much of this inflow can be explained by the weakness in the Australian economy, which has triggered migration back into New Zealand from those who left for work in Australia. As such, if the Aussie economy improves, the migration flow could conceivably reverse, at least to some extent. As a result, the domestic supply of workers would recede and the invisible ceiling on New Zealand wages would progressively disappear. This scenario is highly plausible. The latest surge in Australia's terms of trade could be an early signal of a commodity sector revival. Much of this is due to China's growth upturn this year. However, the wave of optimism towards a potential fiscal stimulus in the U.S. - especially through longer-term infrastructure projects - is a possible boost to demand that could support higher global commodity prices higher over the next few years.12 If this proves correct, New Zealand migration towards Australia could be renewed, shrinking the domestic pool of skilled labor, and pushing wages higher (Chart 15). An unwind of these disinflationary forces would coincide with improving cyclical growth prospects. A mix of strong credit growth, decent construction sector activity and robust corporate earnings should support job creation and wages in the short term (Chart 16). In this environment, consumption will accelerate. Since the output gap is already closed, faster spending will cause inflationary pressures to build (Chart 17). Chart 15...If Australian Mining Revives Chart 16An Inflationary Backdrop Chart 17Inflation Surprises Ahead Traders can benefit from a turnaround in New Zealand inflation prospects by playing the Overnight Index Swap market. Since April 12th of this year, we have recommended payer positions in 6-month New Zealand Overnight Index Swap (OIS) rates.13 This trade has not worked as planned, due to the stubbornly low trend of New Zealand inflation, and today we are closing that trade recommendation at a loss of -30bps. The market is currently pricing in a 23% chance of a rate hike by the September 28, 2017 RBNZ meeting. Due to the inflation risks cited above, the probability should be higher than that, in our view. As such, we are entering a 12-month OIS payer. This trade offers modest downside risk versus for a decent potential gain, i.e. a risk/reward ratio of about 3:1. Bottom Line: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Closing Our Japan/Korea Relative Value Trade This week, we are unwinding our Japan/Korea relative value trade, where we were long 5-year Korean government bonds versus 5-year Japanese Government Bonds (JGBs) on a currency-unhedged basis. While the currency leg did allow for a profitable trade, the Korea/Japan yield differential widened by +52bps. Several unpredictable events have negatively impacted Korean bonds since the trade was initiated. Chart 18Political Scandal = Higher Risk Premium Chart 19Trump: Catastrophic For Korean Bonds Too First, a scandal surrounding the Korean president, a.k.a. Choi-Gate, has erupted. As more details of the affair have been revealed, the president's approval rating has plunged - standing now at 5% - and the Government has become dysfunctional (Chart 18). In the near future, the geopolitical risks surrounding Korean assets should remain elevated as the prosecutors will continue the process of investigating the president and her associates; the risk premium on Korean bond yields might increase further. Chart 20The Korea 5-Year Bond Model Second, Trump's victory has been catastrophic for bond markets across the globe, including those related to open and export-oriented economies linked to the emerging markets, like Korea (Chart 19). Yet the impact on JGBs has been more contained since the Bank of Japan (BoJ) moved to a yield curve targeting framework back in September. The BoJ surprised many by adopting that policy of anchoring longer-term JGB yields. This has substantially reduced the volatility of JGBs, even during the recent backup in global yields. In turn, this has lowered the payoff potential of shorting JGBs, both in absolute terms and versus Korean bonds. Finally, the appeal of our Korea vs Japan trade has decreased from a valuation perspective. A simple model that we have developed for the Korean 5-year government bond yield now points towards rising yields in 2017 (Chart 20).14 With all of these factors now working against our trade, we are choosing to close it out. The trade has generated a profit from the currency exposure, which we decided not to hedge. However, when events move against the original reasons for putting on a trade, the prudent strategy is to unwind that position and look for other opportunities. Bottom Line: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Riksbank: Close To An Inflection Point", dated September 22, 2015, available at gfis.bcaresearch.com 2 Source: Bloomberg Finance L.P. NSN OG2NHA6JIJUO GO. NSN OGD9GRSYF01S GO. NSN OGFQO26S972O GO 3 http://www.riksbank.se/Documents/Protokoll/Penningpolitiskt/2016/pro_penningpolitiskt_161026_eng.pdf 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 For details, please see http://www.riksbank.se/en/Press-and-published/Published-from-the-Riksbank/Monetary-policy/Monetary-Policy-Report/ 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut", dated November 3, 2016, available at ces.bcaresearch.com 7 Private services, retail trade, construction and manufacturing 8 Please see BCA Global Investment Strategy Weekly Report, "Slack Around The World", dated November 4, 2016, available at gis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Special Report, "How To Assess The 'China Factor' For Global Bonds", dated November 8, 2016, available at gfis.bcaresearch.com 10 https://www.globaldairytrade.info/en/product-results/ 11 For details, please see "Understanding low inflation in New Zealand", Dr, John McDermott, October 11, 2016 available at http://www.rbnz.govt.nz/news/2016/10/understanding-low-inflation-in-new-zealand 12 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2017, available at gps.bcaresearch.com 13 Please see BCA Global Fixed Income Strategy Special Report, "New Zealand: More Than Just Dairy", dated April 12, 2016, available at gfis.bcaresearch.com 14 This model is based upon a regression of Korean yields on U.S. 5-year treasury yield, Korean Trade-weighted currency, Brent crude price in USD, and Korea's headline CPI. Forecasts are based on financial market futures data and the ministry of finance's inflation forecast. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Treasury Yields: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017 that will cause the Treasury curve to bear-steepen. Spread Product: Poor valuations and a probable Fed rate hike next month keep us cautious on spread product in the near term. But the environment for credit markets will turn more positive in the first half of 2017. Leveraged Loans: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Feature Several Fed speakers last week, including Fed Chair Janet Yellen, affirmed the case for a December rate hike, and the market has taken full notice of that message. We calculate that the market-implied odds of a rate hike next month rose to 84% as of the close of business on Friday.1 But just as critical for the path of Treasury yields is that the Fed will be taking a "wait and see" approach when it comes to the prospect of increased fiscal stimulus under the Donald Trump administration. Right now there is so much uncertainty about what the Congress will pass or not pass, what the president will propose. As a baseline, assuming a continuation of current fiscal policy has probably as good a chance as any other forecast that we are going to make up. Minneapolis Fed President Neel Kashkari2 This leads us to believe that the Fed will lift rates next month, but will also not revise its fed funds rate forecasts (dots) higher. We also expect that the Fed will be slow to respond to any pick-up in growth expectations as we head into 2017. This sets up a two-phase outlook for Treasury yields. During the next month, the uptrend in yields will meet resistance as both the market and Fed turn a more skeptical eye toward Trump's fiscal promises. But if growth picks up in early 2017, as we expect, and the Fed maintains its dovish bias, then we could enter a sweet spot where the Treasury curve resumes its bear-steepening and risk assets rally. Near-Term Pull-Back Two factors make us think it is likely that Treasury yields will at least level-off, and perhaps decline a bit, during the next month. First, market pricing has already mostly converged with the Fed's rate expectations, especially at the short-end of the curve (Chart 1). Our sense is that the Fed's dots provide a reasonable valuation anchor for yields in the absence of more concrete evidence that growth is accelerating. Second, technical measures and positioning data suggest that the rapid rise in yields is due for a pause. The fractal dimension for long-maturity Treasuries, a measure of groupthink developed by our Chief European Strategist Dhaval Joshi rests at 1.25, a level at which a trend reversal - even if only a temporary one - tends to emerge (Chart 2).3 Additionally, our composite sentiment indicator, based on the 13-week rate of change in prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a near-term reversal (Chart 3). Chart 1The Market & Dots Converge Chart 2Treasuries Face Technical Resistance Chart 3Bond Sentiment At A Bearish Extreme Cyclical Sweet Spot Once the December FOMC meeting has passed, we expect investor attention will turn toward U.S. economic growth, which should accelerate as we head into 2017 (Chart 4). Chart 4U.S. Growth: Poised To Accelerate Consumer confidence has been resilient at high levels, which supports continued strong consumer spending (Chart 4, panel 1). According to trends in public sector employment, government spending is poised to increase, even in the absence of new fiscal stimulus (Chart 4, panel 2). Inventories were an unusually large drag on growth in 2016. This drag will continue to unwind (Chart 4, panel 3). Survey measures suggest that non-residential investment will reverse its downtrend (Chart 4, panel 4). The supply of new residential housing remains tight, which will support increased construction even in the face of higher rates (Chart 4, bottom panel). On top of this, we can potentially tack on any newly enacted fiscal stimulus once Trump takes office in January. Our political strategists expect that the Trump administration will not face meaningful opposition from the Republican-controlled Congress, and will be able to enact - in relatively short order - a more stimulative fiscal policy in the form of lower taxes and increased spending for infrastructure and defense.4 A quicker pace of Fed tightening would be a powerful offset to this rosy growth outlook. In fact, Chair Yellen alluded to the notion that a large fiscal impulse would probably be counteracted by tighter monetary policy in her Congressional testimony last week: "The economy is operating relatively close to full employment at this point, so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state."5 In essence, with the economy close to full employment it is more likely that a sufficiently large growth impulse will result in rising inflation, which the Fed will lean against. However, we believe this is a story for the second half of 2017. At least initially, the Fed will be in no rush to deviate from the dovish bias embedded in its current forecasts. Market-based measures of inflation compensation have increased strongly in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart 5). The 5-year, 5-year forward TIPS breakeven inflation rate is currently 2.06%, and needs to rise another 34bps before it is consistent with its average pre-crisis level. The Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. This opens a window in the first half of 2017 when improving economic growth will be met with still-accommodative monetary policy. In this environment we would expect the Treasury curve to bear-steepen and spread product to outperform. All else equal, we are likely to shift our recommended portfolio allocation in that direction (initiate curve steepeners, increase allocation to spread product) once the near-term risk of a Fed rate hike is behind us. The major risk to the view that a cyclical sweet spot opens up in the first half of 2017 is that any improvement in growth might be quickly cut-off by overly restrictive financial conditions, specifically in the form of a much stronger dollar (Chart 6). The pace of dollar appreciation has increased since the election and overall indexes of financial conditions have tightened, but so far the tightening has not been as sharp as that which occurred around the time of last year's Fed rate hike. We anticipate that this time around, due to the improved trajectory of growth outside of the U.S., tightening of overall financial conditions will not be as severe. A second related risk is that the recent surge in bond yields will harm cyclical sectors of the economy such as housing and consumer spending on durable goods (Chart 7). This is undoubtedly true, but it is important to recall that this process is self-limiting. If yields rise too far, then growth will decelerate and yields will reverse course. Then lower yields will cause growth to re-accelerate, leading to higher yields. As long as the Fed is perceived to be "behind the curve" on inflation then the underlying trend will be one of improving growth and a bear-steepening of the Treasury curve. Chart 5Breakevens Still Too Low Chart 6A Strong Dollar Is The #1 Risk Chart 7Higher Yields Also A Drag On Growth Bottom Line: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017. This will cause the Treasury curve to bear-steepen and will be positive for spread product. Leveraged Loans: Still A Buy We recommended that investors favor leveraged loans over fixed-rate junk bonds on July 19.6 In large part, this recommendation was predicated on a high conviction view that Treasury yields were poised to increase, thus benefitting floating rate loans over fixed rate bonds. Since July 19, the S&P/LSTA Leveraged Loan 100 index has returned +196bps, compared to +176bps of total return from the Bloomberg Barclays High-Yield bond index, and flows into the largest leveraged loan ETF (BKLN) have outpaced flows into the largest junk bond ETF (HYG) since August (Chart 8). Historically, there are two reasons that leveraged loans might be expected to outperform fixed rate junk bonds (Chart 9). The first is that 3-month LIBOR is rising, causing loan coupons to reset higher. The second is that the default rate is elevated. Loans tend to benefit relative to bonds when the default rate is elevated because their senior position in the capital structure means they earn a higher recovery rate (Chart 10). Chart 8Loan Performance Is Lagging Fund Flows Chart 9Leveraged Loans Will Outperform Chart 10Loans Benefit From Higher Recoveries Taking a closer look at Chart 9 we can see that the above two factors have only led to two periods of sustained leveraged loan outperformance since 1991 (denoted by shaded regions). In 1994, loans outperformed bonds because the pace of Fed tightening surprised markets to the upside and 3-month LIBOR moved sharply higher. In this instance higher coupons were sufficient for loans to outperform even though corporate defaults were low. Loans also outperformed bonds between 1997 and 2002. In this case it was a prolonged uptrend in corporate defaults that drove the outperformance. Loans benefitted from higher LIBOR in the early stages of this period, but then the Fed began cutting rates in 2001. Loans did not outperform bonds during the 2004-2006 rate hike cycle, as defaults were very low and the rate hikes were well telegraphed - meaning that asset prices already reflected the up-move in 3-month LIBOR before it occurred. Likewise, loans did not outperform bonds during the 2008 default episode because the Fed was cutting rates sharply and, unlike in the 1990s, the spike and reversal in the default rate occurred over a relatively short period of time. The good news for loans is that the current environment very much resembles the early part of the 1997-2002 period insofar as the Fed is in the early stages of a rate hike cycle - so 3-month LIBOR can be expected to move higher - and corporate defaults have already started to increase. So far loans have only benefitted marginally from the rise in 3-month LIBOR because most have LIBOR floors. This means that the loan's coupon is only reset higher once 3-month LIBOR is increased above the stated floor. Bloomberg calculates that $221 billion of outstanding leveraged loans have LIBOR floors of 75bps and $690 billion of outstanding loans have LIBOR floors of 100bps. With 3-month LIBOR at 91bps currently, it will only take one more Fed rate hike before the floors on most loans are breached. Bottom Line: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: Stay Away We detailed our longer-term outlook for municipal bonds in a recent Special Report,7 and then downgraded our muni allocation to underweight (2 out of 5) following Trump's surprise election win. Our expectation is that the combination of lower tax rates and increased infrastructure spending will be toxic for municipal debt. That analysis, however, focused on investment grade municipal debt. This week we investigate the relative value in high-yield municipal bonds relative to high-yield corporates. The starting point of our analysis is an examination of the spread differential between high-yield munis and high-yield corporates (Chart 11). The second panel of Chart 11 shows that, compared to history, munis offer a sizeable spread advantage over similarly-rated corporate debt. However, this comparison does not adjust for differences in duration and convexity between the two indexes. In the bottom panel of Chart 11 we show the residual from a model where the spread differential between high-yield munis and high-yield corporates has been regressed against differences in duration and convexity. We see that high-yield munis look even more attractive after making these adjustments. These simple adjustments reveal that high-yield munis are attractive relative to high-yield corporates, but they do not consider the impact of a macro environment that is about to turn extremely negative for municipal debt. To control for this we created an augmented model of the spread differential between high-yield munis and corporates, adjusting for duration, convexity, the effective personal tax rate, relative ratings migration and several other factors (Chart 12). Chart 11High-Yield Muni Valuation I Chart 12High-Yield Muni Valuation II High-yield munis still appear quite attractive based on this model, but if we assume that the effective personal income tax rate reverts even to 2011 levels, then the a good chunk of the spread advantage vanishes (Chart 12, panel 2). This is an extremely conservative assumption. In reality, we expect the effective personal tax rate will fall much below 2011 levels under the new administration. Bottom Line: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculation differs somewhat from the widely reported probability that is available on Bloomberg terminals. The reason is that the Bloomberg calculation assumes a baseline fed funds rate of 37.5 bps (the midpoint of the Fed's current target range), while we use the current effective fed funds rate which has recently been stable at 41 bps. 2 http://www.bloomberg.com/news/articles/2016-11-16/fed-s-kashkari-says-election-hasn-t-changed-economic-outlook-yet 3 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 4 Please see BCA Special Report, "U.S. Elections: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 5 https://www.c-span.org/organization/?63944 6 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Chart 9Americans Like Voting, Just Not These Candidates 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.

Highlights Portfolio Strategy The strong U.S. dollar is tightening global liquidity conditions, putting the post-election jump in stock prices at risk unless growth imminently accelerates. The spike in large cap industrial stocks represents a massive knee-jerk overreaction and we are adding the sector on our high conviction underweight list. Take profits in the S&P air freight & logistics group and cut to neutral, and downgrade the S&P electrical components & equipment group to underweight. Recent Changes S&P Air Freight & Logistics - Take profits of 6% and reduce to neutral. S&P Electrical Components & Equipment - Trim to underweight from neutral. S&P Industrials Sector - Add to our high-conviction underweight list. Table 1 Feature Equities are still in a post-election honeymoon phase. The savage reaction in the bond market has not yet backlashed onto the broad stock market. Instead it has sparked a rapid and powerful rotation in intra-sector capital flows. The danger is that an unwinding of the momentum trade in the bond market is being misinterpreted as a pro-growth, pro-cyclical investment shift. Investors appear to be equating a potential increase in economic growth with better profitability. However, basing equity strategy on unknown future policies is fraught with risk, as is equating GDP with corporate profits. Trump's signature policies, protectionism and fiscal spending, are inflationary and U.S. dollar bullish, and the timing of implementation and ultimate size of spending programs, remain anyone's guess. In a closed economy driven more by consumption than investment, a strong currency can be supportive via increased purchasing power and a dampening in corporate sector input costs. But what's good for the economy should not be automatically extrapolated through to profits. Net earnings revisions fall when the currency is strong (Chart 1). Capital has won out handily vs. labor since the Great Recession, which allowed profits to boom even though economic growth was below-potential. This is changing. Labor costs are now on the upswing, and productivity has deteriorated. If the economy strengthens, it may only serve to boost wage inflation. If labor expenses accelerate, it becomes even more critical for corporate sector sales to regain traction in order to offset the squeeze on profit margins. However, just under half of S&P 500 sales come from abroad. A strong U.S. dollar means the U.S. will be importing deflationary pressures, undermining pricing power. U.S. dollar appreciation also saps growth in developing countries. Emerging market capital spending is already contracting (Chart 2), and as shown last week, financial strains are flaring back up. Ergo, U.S. companies will be less competitive, and selling into weaker demand growth abroad. Chart 1A Strong Dollar Will Sink Profits... Chart 2... And Hit Global Growth Chart 3 shows that S&P 500 sales typically contract during major dollar bull markets. A recovery has only occurred once currency depreciation occurs. The equity market reaction has been mixed during these periods, as a strong dollar has capped growth and pushed down Treasury yields, supporting a valuation expansion. We do not recommend positioning for a bullish equity outlook, given already overvalued conditions and the rise in government bond yields. It is notable that the inflation component of yields has done the heavy lifting, rather than an upgrading in economic expectations (Chart 4). In other words, there is a sequencing issue, a strong currency saps profits now, while stimulus may only arrive much later. U.S. dollar-based global financial liquidity is now contracting as a consequence of U.S. dollar strength (Chart 4). If excess liquidity and low rates were the argument for supporting high valuations previously, tighter liquidity and rising rates can't also justify current multiples, especially if global growth is soft. As discussed in our November 3, 2014 Special Report, currency strength favors a mostly non-cyclical, domestically-oriented portfolio structure. One of our favored themes over the past few months has been to tilt portfolios in favor of domestic vs. globally-oriented industries. With the U.S. dollar breaking above its trading range, a catalyst now exists to spur an imminent recovery in the domestic vs. global share price ratio. The latter had become extremely oversold as the U.S. dollar consolidated and the Chinese economy began to stabilize, but economic fundamentals are shifting decisively back in favor of the U.S. The U.S. PMI is already making small strides vs. the Chinese and euro area PMI (Chart 5, second panel), heralding a rebound in the cyclical share price momentum. Chart 3No Sales Recovery Ahead Chart 4Tighter Liquidity, Rising Inflation Chart 5Domestic Will Beat Global World export growth remains anemic, and world export prices continue to deflate, albeit at a lesser rate. Sagging Asian currencies warn that trade is at risk, over and above protectionist rhetoric and/or policies. When compared with the reacceleration in U.S. retail sales, the outlook for domestic-sourced profits is even brighter. We reiterate our theme of tilting to domestic vs. globally-oriented industries. The bottom line is that the outlook for the broad averages has soured as a consequence of a strong dollar, rising yields and the prospect for tighter Fed policy. These dynamics augur well for domestic vs. global bias, small vs. large caps and defensive vs. cyclical sector strategy. This week we are taking some cyclicality out of our portfolio following the wild market gyrations in the past two weeks. Taking Advantage Of The Industrials Sector Overreaction... Industrials have vaulted higher, in relative terms, on the back of hopes for rampant fiscal stimulus and infrastructure spending as far as the eye can see, ignoring any negatives that may arise from protectionist policies and tighter monetary conditions. While defense contractors may see an increase in activity (we continue to recommend an overweight in the BCA defense index), in aggregate, the surge in the large cap industrials sector is an opportunity to retool exposure from a position of strength. Large cap industrials companies garner approximately 45% of their revenue from outside the U.S. The industrials sector has the second worst track record among all sectors during U.S. dollar bull phases, trailing only the materials sector. Regression analysis shows that industrial sectors sales would contract by 4.5% for every 10% in the trade-weighted dollar (Chart 6). Without revenue growth, it is hard for industrial companies to generate good profitability, given high operating leverage. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure spending. Commodity prices key off the U.S. dollar. Emerging markets (EM) are also sensitive to the currency. A strong U.S. dollar undermines income in commodity producing countries, creates financial strains related to EM foreign currency denominated debt and reins in domestic liquidity in countries that need to intervene to stop their currencies falling too far lest capital flight and inflation occur. As noted last week, emerging market currencies are already rolling over, and CDX spreads have begun to widen (Chart 7). EM equity markets are underperforming the global benchmark, reinforcing the lack of a regional growth impulse (Chart 7). It is rare for the industrial sector to deviate from relative EM equity performance. There has been no evidence of EM deleveraging, and the back up in global bond yields represents a financial stress. If U.S. industrials stocks are a high-beta play on EM, then contrarians should beware recent sector action. Chart 6Top-Line Trouble Ahead Chart 7Sell The Spike Importantly, capital spending is in retreat. Business investment is a function of confidence and expected return on investment. The gap between the return on and cost of capital is narrowing fast (Chart 8). Free cash flow is paltry, especially in resource sectors, major industrial sector end markets. It is hard to envision a major capital spending turnaround if the U.S. dollar keeps climbing and the cost of capital backs up further. Policy ambiguity will act as a weight for at least the next few quarters. During this period, the negative profit impact of the contraction in private and public sector construction activity will ultimately re-exert a major influence on sector risk premia. It will take at least several quarters before any hoped for fiscal spending will benefit industrial companies. Industrials sector pricing power has shifted from a deep negative to neutral. However, that appears to represent an unwinding of the rate of change shock more than a resumption of conditions conducive to companies lifting selling prices. Chart 9 shows that capital goods import price are still deflating. As the Chinese currency devalues, putting downward pressure on its regional counterparts, deflationary pressures will re-intensify for U.S. industrial firms (Chart 9). Chart 8Fiscal Stimulus Is Needed... Right Now! Chart 9The Dollar Will Do Damage ...By Selling Electrical Components & Equipment ... In terms of specifics, were we not underweight machinery shares already, we would institute a high conviction underweight today. In addition, the S&P electrical equipment and components (ECE) index looks equally vulnerable. While less exposed to commodity prices than machinery stocks, ECE shares have benefited alongside the overall sector from the post-election buying frenzy. Hefty short positions likely played a large role in powering the spike (Chart 10), and we are uncomfortable with paying a premium valuation for a dubious earnings outlook, particularly given the sector's brutal long-term track record during U.S. dollar bull markets (Chart 11, top panel, the currency is shown inverted). From a cyclical perspective, it is premature to position for a reversal in the relative earnings bear market. New orders for electric equipment are sensitive to EM currency movements. The current message is that new orders are likely to languish (Chart 11). Relief is not imminent from domestic sources. Chart 11 shows that real investment spending on electrical equipment is contracting at a steep rate. That is consistent with the trend in overall construction spending, which represents a long-term headwind. It is no surprise that industry productivity growth is contracting (Chart 11), reinforcing that the path of least resistance for profits is lower. It would take a major resurgence in top-line growth to restore productivity to positive levels. The ECE industry is one of the few 'smokestack' parts of the economy to have added capacity in recent years. That is confirmed by persistent growth in ECE wage inflation (Chart 12). Without a pickup in demand, this backdrop is conducive to ongoing deflation (Chart 12, bottom panel). Sell into strength. Chart 10Short Covering Will Not Last... Chart 11... As Fundamentals Erode Chart 12Cost Structures Are Too High ...And Taking Profits In Air Freight Stocks ... Elsewhere, we are taking profits on our overweight S&P air freight & logistics index. While we only recently went overweight in early-September, a much shorter time horizon than our desired cyclical calls, we are concerned that the index has front run an improvement in global trade that may be slow to materialize. Our upgrade was predicated on a tightening in inventories relative to GDP, which boosts the need for just-in-time air freight services, as well as a pickup in emerging markets activity. However, our confidence in the latter has been shaken. Air freight stocks are a reflation play, and a surging U.S. dollar is a threat to global liquidity (Chart 13). Global revenue ton miles have already crested after a muted rebound (Chart 14, second panel). Chart 13A Reflation Play Chart 14Take Profits Moreover, protectionist/anti-globalization sentiment may heat up, representing a risk to a recovery in global trade. The IFO export expectations index continues to sink, a warning for relative forward earnings estimates (Chart 14). The contraction in transport and warehousing hours worked confirms that transport activity is not yet on the mend (Chart 14). Relative performance has a history of violent oscillations, and the price ratio has soared to the top end of its multiyear range. Thus, even though the structural increase in online sales bodes well for long-term growth, and value remains appealing, we are booking profits and reducing positions in this globally-exposed group back to neutral in order to de-risk in our portfolio. Bottom Line: Take profits of 6% in the S&P air freight & logistics index and reduce to neutral. Downgrade the S&P electrical equipment index to underweight and add the overall industrial sector to our high conviction underweight list. The ticker symbols for the stocks in these indexes are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD, and BLBG: S5ELCO - AME AYI EMR ETN ROK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Chart I-7A Dark ##br##Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex Chart I-10Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. 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 Chart II-6JPY Technicals 2 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. 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 Chart II-8GBP Technicals 2 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. 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 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. 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 Chart II-12NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. 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 Chart II-14CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. 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 Chart II-16CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. 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 Chart II-18NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. 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 Chart II-20SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. 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 Tighter global oil markets resulting from the production cut we expect to be announced November 30 at OPEC's Vienna meeting, along with fiscal stimulus from the incoming Trump administration in the U.S., will continue to stoke inflation expectations. We believe gold is well suited for hedging investors' medium-term inflation exposure, given its sensitivity to 5-year/5-year CPI swaps in the U.S. and eurozone. If the Fed decides to get out ahead of this expected pick-up in inflation and inflation expectations by raising rates aggressively next year, we would expect any increase in gold prices - and oil prices, for that matter - to be challenged. For OPEC and non-OPEC producers, a larger production cut may be required to offset a stronger USD next year. Near term, we still like upside oil exposure, given our expectation that production will be cut. Energy: Overweight. We remain long Brent call spreads expiring at year-end, and long WTI front-to-back spreads in 2017H2, in anticipation of an oil-production cut. Base Metals: Neutral. We expect nickel to outperform zinc in 2017. Precious Metals: Neutral. We are long gold at $1,227/oz after our buy-stop was elected on November 11. We are including a 5% stop-loss for this position. Ags/Softs: Underweight. Our long Mar/17 wheat vs. beans order was filled on November 14. We still look to go long corn vs. sugar. Feature Chart of the WeekBrent, WTI Curves Will Flatten, ##br##Then Backwardate Following Oil-Production Cut Continuing production increases from sundry sources outside OPEC, which the International Energy Agency estimates will lift output almost 500k b/d in 2017, are turning the heat up on the Kingdom of Saudi Arabia (KSA) and Russia to agree a production cut at the Cartel's meeting in Vienna later this month. It's either that or risk another downdraft that takes prices closer to the bottom of our long-standing $40-to-$65/bbl price range that defines U.S. shale-oil economics. The unexpected strength in production growth outside OPEC likely will require KSA and Russia to come up with a production cut that exceeds the 1mm b/d we projected earlier this month would be required to lift prices into the mid-$50s/bbl range. On the back of the expected cuts, we recommended getting long a February 2017 Brent call spread - long the $50/bbl strike vs. short the $55/bbl strike at $1.21/bbl. As of Tuesday's close, when we mark our positions to market every week, the position was up 9.09%. Reduced output from KSA and Russia - and, most likely, Gulf allies of KSA - will force refiners globally to draw down crude in storage, and for refined product inventories to draw as well. This will lift the forward curves for Brent and WTI futures (Chart of the Week). We expect oil prices will increase by approximately $10/bbl, following the joint cuts of 500k b/d each we expect KSA and Russia, which will be announced November 30. This also will lift 3-year forward WTI futures prices, which, as we showed in previous research, share a common trend with 5y5y CPI swaps. As stocks continue to draw next year, we expect the forward Brent and WTI curves to flatten, and, in 2017H2, to backwardate - that is to say, prompt-delivery prices will trade above the price of oil delivered in the future. For this reason, we are long August 2017 WTI futures vs. short November 2017 WTI futures, expecting the price difference between the two, which favors the deferred contract at present (i.e., a contango curve), to flip in favor of the Aug/17 contract. Chart 2Longer-dated WTI Futures, ##br##Inflation Expectations Rising Fiscal Stimulus Expected in the U.S. The election of Donald J. Trump as the 45th president of the U.S. likely will usher in significant fiscal stimulus beginning next year, particularly as Republicans now control the Presidency and Congress for the first time since 2005 - 06, when George W. Bush was president. Trump campaigned on a promise of significant fiscal stimulus, which likely will, among other things, stoke inflation expectations as money starts to flow to infrastructure projects and tax cuts toward the end of next year. Even before Trump's election 5-year/5-year (5y5y) CPI swaps were ticking higher, as oil markets rebalanced and started to discount the drawdown in global inventories this year and next (Chart 2). As the outlines of the Trump administration's fiscal policy take shape and money starts to flow to infrastructure projects, we expect inflation expectations to continue to rise. In previous research, we showed 5y5y CPI swaps and 3-year forward WTI futures are cointegrated, meaning they follow the same long-term trend. Indeed, we can specify 5y5y CPI swaps in the U.S. and eurozone directly as a function of 3-year forward WTI futures.1 Gold Will Lift With Rising Inflation Expectations... In the post-Global Financial Crisis (GFC) markets, gold prices have shared a common trend with U.S. CPI 5y5y swaps and real interest rates, which we show in a new model (Chart 3A, top panel).2 Using this specification, we find a 1% increase in the U.S. 5y5y CPI swaps increases gold prices by slightly more than 9%. Similarly, we find a 1% increase in EMU 5y5y CPI swaps increases gold prices by slightly more than 10% (Chart 3B, top panel).3 Of course, investors always can go straight to Treasury Inflation Protected Securities (TIPS) for inflation protection, given the evolution of the respective CPIs in the U.S. and eurozone drives returns for these securities (Chart 4). However, we believe gold gives investors higher leverage to actual inflation and expected inflation. Chart 3AGold Prices Ticking Higher With ##br##U.S. CPI Inflation Expectations Chart 3BEMU Inflation Expectations ##br##Vs. 3-year Forward WTI Chart 4Inflation Expectations And TIPS ##br##Are Highly Correlated, As Well ...But The USD's Evolution Matters, Too The combination of tighter oil markets and fiscal stimulus in the U.S. will continue to push inflation and inflation expectations higher. The Fed will not sit idly by and just watch inflation expectations move higher next year. Indeed, prior to the election, we expected two rate hikes next year, following a likely rate increase at the FOMC's meeting next month. With expectations of a tightening oil market, and a fresh round of fiscal stimulus from the incoming Trump administration, the odds of an even stronger USD increase. We had been expecting the USD will appreciate 10% over the next year or so, as a result of the upcoming December rate hike and two additional hikes next year. This could change, since, as, our Foreign Exchange Strategy service noted, "Trump's electoral victory only re-enforces our bullish stance on the dollar."4 A stronger USD, all else equal, is bearish for commodities generally, since it raises the cost of dollar-denominated commodities ex-U.S., and lowers the costs of commodity producers in local-currency terms. The former effect depresses demand at the margin, while the latter raises supply at the margin. Both effects would combine to reduce oil prices at the margin (Chart 5). This would, in turn, lower inflation expectations, which would feed into lower gold prices (Chart 6). Chart 5A Stronger USD Would Be Bearish For Oil Chart 6And Gold Prices As It Would Lower Inflation Expectations Our FX view, is complicated by the possibility the Fed might want to run a "high-pressure economy" next year, and the potential for additional Chinese fiscal stimulus going into the 19th Communist Party Congress next fall. If both the U.S. and China deploy significant fiscal stimulus next year, the growth in these economies could overwhelm the negative effects of a stronger USD, and industrial commodities - chiefly base metals, iron ore and steel - could rally as demand picks up. Oil demand also would be expected to pick up as a result of the combined fiscal stimulus coming out of the U.S. and China, both from infrastructure build-outs and income growth. KSA - Russia Oil-Production Cut Gets Complicated These considerations will complicate the calculus of KSA and Russia and their respective oil-producing allies as the November 30 OPEC meeting in Vienna draws near. If the Fed moves to get out ahead of increasing inflation expectations by adding another rate hike or two next year, oil prices will encounter a significant headwind. OPEC and non-OPEC producers could very well find themselves back at the bargaining table negotiating additional cuts, as prices come under pressure next year from higher U.S. interest rates. It is too early to act on any speculation regarding fiscal policy in the U.S. or China next year. However, given our expectation for an oil-production cut announcement later this month at OPEC's Vienna meeting, we are confident staying long the Brent $50/$55 call spread, and the long Jul/17 vs. short Nov/17 WTI spread position we recommended earlier this month. As greater clarity emerges on U.S. and Chinese fiscal policy going into next year, we will update our assessments. Bottom Line: We expect global oil markets to tighten as KSA and Russia engineer a production cut, which will be announced at OPEC's Vienna meeting later this month. Fiscal stimulus from the incoming Trump administration in the U.S., and possible fiscal stimulus in China next year could put a bid under commodities. However, if the Fed gets out ahead of the expected pick-up in inflation and inflation expectations by raising rates aggressively next year, any increase in commodity prices - oil and gold, in particular - will be challenged. KSA and Russia could find themselves back at the bargaining table, negotiating yet another production cut to offset a stronger USD. That said, we are retaining our upside oil exposure via a Brent $50/$55 call spread expiring at the end of this year, and our long Jul/17 WTI vs. short Nov/17 WTI futures, which will go into the money as the forward curve flattens and then goes into a backwardation. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com BASE METALS China Commodity Focus: Base Metals Nickel: A Good Buy, Especially Versus Zinc Chart 7Nickel: More Upside Ahead We are bullish on nickel prices, both tactically and strategically. Its supply deficit is likely to widen on rising stainless steel demand and falling nickel ore supply in 2017. China will continue to increase its refined nickel imports to meet strong domestic stainless steel production growth. We remain strategically bearish zinc even though our short Dec/17 LME zinc position got stopped out at $2500/MT with a 4% loss. We expect nickel to outperform zinc considerably in 2017. We recommend buying Dec/17 LME nickel contract versus Dec/17 LME zinc contract at 4.3 (current level: 4.38). If the order gets filled, we suggest putting a stop-loss level for the ratio at 4.15. Nickel prices have gone up over 50% since bottoming in February (Chart 7, panel 1). The global nickel supply deficit reached a record high of 75 thousand metric tons (kt) for the first eight months of this year, based on the World Bureau of Metal Statistics (WBMS) data (Chart 7, panel 2). More upside for nickel in 2017 On the supply side, the outlook is not promising in 2017. Global nickel ore and refined nickel production fell 5.2% and 1.1% yoy for the first eight months of this year, respectively, according to the WBMS data (Chart 7, panel 3). The newly elected Philippine government is clearly aiming for "responsible mining," and has been highly restrictive on domestic nickel mining activities, actions that likely will reduce the country's nickel ore production in 2017. The Philippines became the world's biggest nickel ore producer and exporter after Indonesia banned nickel ore exports in January 2014. The Philippines has implemented a national audit on domestic mines from July to September and has halted 10 mines for their environmental violations since July. Eight of them are nickel producers, which account for about 10% of the country's total nickel output. In late September, the government further declared that 12 more mines (mostly nickel) were recommended for suspension, and 18 firms are also subject to a further review. Stringent policy oversight will be the on-going theme for Philippine mines. We expect more suspensions in the country next year. There is no sign the export ban will be removed by the Indonesian government. Since Indonesia banned nickel ore exports in January 2014, the country's nickel ore output has declined 84% from 2013 to 2015. This occurred even though smelters were built locally, which will allow more nickel ore output in Indonesia. However, the incremental Indonesian output is unlikely to make up for the global nickel ore shortage next year. Global nickel demand is on the rise again (Chart 7, panel 4). According to the International Stainless Steel Forum (ISSF), global stainless steel production grew by 11.5% in 2016Q2 from only 3.7% yoy in 2016Q1. Comparatively, in 2015, the growth was a negative 0.3%. Due to fiscal and monetary stimulus in China this year, we expect continued growth in global stainless steel production in 2017. Why China Is Important To Global Nickel Markets China is the world's biggest nickel producer, consumer and importer. Its primary effect on nickel prices is through refined nickel imports. It also influences global stainless steel prices through stainless steel exports. In comparison to the global supply deficit of 75 kt, the deficit in China widened to 346 kt for the first eight months of this year - the highest physical shortage ever (Chart 8, panel 1). China has driven the global growth of both refined nickel production and nickel consumption since 2010 (Chart 8, panels 2 and 3). During the first eight months of this year, Chinese nickel production dropped sharply to 40.5 kt, nearly three times the global nickel output loss of 13.6 kt. For the same period, China's nickel demand growth accounted for 67% of global growth. In addition, the country produces about 53% of global stainless steel and exports about 10% of domestic-made stainless steel products to the rest of world (Chart 8, panel 4). Clearly, China is extremely important to both the global stainless steel and nickel markets. China Needs To Import More Nickel in 2017 Looking forward, China is likely to continue increasing its nickel imports to meet a growing domestic supply deficit (Chart 9, panel 1). The country's ore imports have been declining because of Indonesia's ban since 2014, and further dropped this year on the Philippine's suspensions (Chart 9, panel 2). Scarcer ore supply drove down Chinese refined nickel and nickel pig iron (NPI) output every year for the past three consecutive years (including this year). Chart 8China: A Key Factor For Nickel Market Chart 9Chinese Nickel Imports Are Set To Rise Prior to 2014, China imported nickel ores from Indonesia to produce NPI, which is used in its domestic stainless steel production. In 2013, only 20% of domestic nickel demand was met by unwrought nickel imports. After 2014, China's higher nickel ore imports from the Philippines were not able to make up the import losses from Indonesia (Chart 9, panel 3). As a result, in 2015, the percentage of domestic nickel demand met by unwrought nickel imports jumped to 47%. Furthermore, for the first eight months of this year, imports accounted for 57% of Chinese demand. Before the Indonesian ban in 2014, Chinese stainless steel producers and NPI producers built up mammoth nickel ore inventories for their stainless steel ore NPI production (Chart 9, panel 4). Now, Chinese laterite ore inventories are much lower than three years ago. Plus, most of the inventories likely are low nickel-content Philippines ore. Besides the tight ore inventory, China's stainless-steel output is accelerating. According to Beijing Antaike Information Development Co., a state-backed research firm, for the first nine months of 2016, Chinese nickel-based stainless steel output grew 11.3% yoy, a much stronger growth rate than the 4% seen during the same period last year. Given falling domestic nickel output and increasing nickel demand from the stainless steel sector, China seems to have no other choice but to import more refined nickel or NPI from overseas. Downside Risks Nickel prices could fall sharply in the near term if massive LME inventories are released to the global market. After all, global nickel inventories currently are at a high level of more than 350 kt, which is more than enough to meet the supply deficit of 75 kt (Chart 10, panel 1). However, as prices are still at the very low end of the range over the past 13 years, we believe that the odds of a massive, sudden inventory release is small. Inventory holders will be hesitant to sell their precious inventory too quickly, therefore the inventory release will likely be gradual, especially given the continuing export ban in Indonesia and a likely increase in the suspension of mines in the Philippines. In the longer term, if Indonesian refined nickel output continues growing at the pace registered in the past two years, the global nickel supply deficit may be much less than the market expects (Chart 10, panel 2). In that scenario, nickel prices will also fall. Due to power supply shortages, poor infrastructure and funding problems, many of the smelters and stainless steel plants' development have got delayed, so we believe these problems will continue to be headwinds for Indonesian nickel output growth. A five-million capacity stainless steel project, funded by three Chinese companies, potentially making Indonesia the world's second biggest stainless steel producer, will only be in production by 2018. Therefore, we believe next year is still a good window for a further rally in nickel prices. In addition, global stainless steel output may weaken again after this year's stimulus from China runs out of steam, which will also weigh on nickel prices (Chart 10, panel 3). We will monitor these risks closely. Investment strategy We expect nickel to outperform zinc considerably in 2017. Nickel has underperformed zinc massively since 2010 with the nickel/zinc price ratio tumbling to a 17-year low (Chart 11, panel 1). Chart 10Downside Risks To Watch Chart 11Nickel Likely To Outperform Zinc In 2017 Even though our short Dec/17 LME zinc position was stopped out at $2500/MT with a 4% loss due to the short-term turbulence, we remain strategically bearish zinc, as we expect supply to rise in 2017 (Chart 11, panel 2).5 Given our assessments of the nickel and zinc markets, we recommend buying Dec/17 LME nickel contract versus Dec/17 LME zinc contract at 4.3 (current level: 4.38) (Chart 11, panel 3). If the order gets filled, we suggest putting a stop-loss level for the ratio at 4.15. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Our updated estimates of the cointegrating regressions for U.S. and eurozone 5y5y CPI swaps indicate 3-year forward WTI futures explain close to 87% of the U.S. swap levels and 82% of the eurozone swaps, in the post-GFC period (January 2010 to present). Please see Commodity & Energy Strategy Weekly Report "Inflation Expectations Will Lift As Oil Rebalances," dated March 31, 2016, available at ces.bcaresearch.com. 2 We also found that, over a longer period encompassing pre-GFC markets, gold prices shared a common trend with U.S. 5y5y CPI swaps, as well. Indeed, the evolution of 5y5y CPI swaps explained 84% of gold's price from 2004, when the 5y5y CPI swap time series begins, to present. 3 Previously, we estimated a gold model using the Fed's core PCE and the St. Louis Fed's 5y5y U.S. TIPS inflation index and found a 1% increase in the core PCE translates to a 4% increase in gold prices. Please see Commodity & Energy Strategy Weekly Report "A 'High-Pressure Economy' Would Be Bullish For Gold," dated October 20, 2016, available at ces.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report "Reaganomics 2.0?," dated November 11, 2016, available at fes.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report for zinc section "The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market," dated October 27, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Feature Today’s Insight is a Special Report written by BCA’s Senior Technology Strategist, Brian Piccioni. Brian discusses the reasons for ongoing M&A in the semiconductor industry, and the investment implications. We trust you will find this report insightful and informative. Semiconductor Consolidation Makes Sense But Changes Little We have written extensively about our stance against financial engineering through M&A in the high tech sector.1 However, we view the semiconductor space as somewhat of an anomaly. Unlike most tech goods, a large portion of semiconductor products generate revenues for many years, even decades, after they are first released. Although most of the development costs of these devices are depreciated in the first few years after introduction, price deflation continues. This means that for most such devices, margins do not rise to a very high level. In addition, incremental costs may be associated with "die shrinks" (making smaller devices with the same function), and changes in IC packaging, as the cost of the package can be more than the semiconductor itself. In addition to the inherent benefits of buying a company that makes a product line with long duration revenues, most semiconductors are sold through the same channels and have similar, if not identical, customers. This can allow for the rationalization of sales and marketing efforts. On the surface it might appear there is an opportunity for economies of scale in manufacturing, but these can prove elusive. It is often not worth the effort to consolidate manufacturing for an acquired company due to large differences in manufacturing processes. This is especially true since it would require an investment in R&D for a catalog of mostly dated products. These products would have to be "re-qualified" by customers, as there is no guarantee parts produced in a different factory will function the same as the old one. While most high tech M&A destroys shareholder value, that is less likely to be the case when two mature semiconductor companies combine (Chart 1). However, industry consolidation is not likely to lead to pricing power or unusual profitability post consolidation because: Semiconductor buyers are reluctant to adopt a product made by only one vendor; There is a powerful push for the adoption of technologies based upon Open Standards in order to avoid semiconductor vendors having too much power over customers; and For the most part, with the exception of leading edge process technology used in CPU and commodity memory devices, semiconductor expertise is well understood and widely available, as are the tools for the development of new devices. Total Intangible Asset Writedowns And Restructuring Charges As A Percent ##br##Of Assets By S&P 500 Tech Sub-Sector, 2000 - 2016 Semiconductor Buyers Are Reluctant To Adopt A Product Made By Only One Vendor Large device manufacturers always had an aversion to single sourced semiconductors but exceptions were made when there was a critical need or simply no other choice. For example, if you are going to design a PC you are either going to use a single-sourced device from Intel or AMD. Things changed after the "Dot Com" bubble when equipment manufacturers found themselves unable to ship finished products because a single-source vendor had declared bankruptcy and the parts were no longer being made. Even when a single source part is specified, an effort is made to ensure there are substitutes available. This hedges against the possibility the part may no longer be available and also reduces vendor pricing power. Powerful Push For The Adoption Of Technologies Based Upon Open Standards Open standards are standards where form, fit, and function, are both defined and easily referenced. The standard itself is typically inexpensive to license and any related Intellectual Property is available for license on "fair and equitable" terms, meaning that the price is reasonable and the same for all licensees. Open standards have a long history in the semiconductor industry. The market for certain devices such as memory chips would likely have never developed if every vendor had a different way of doing things. Nevertheless, companies such as Intel were able to establish a proprietary standard CPU architecture and profited handsomely as a result. Similarly, purported abuses by companies such as Rambus and Qualcomm have resulted in all players being leery of patent suits. It is now very difficult to get manufacturers to accept a new standard unless it is open. Difficult To Benefit From Competitive Advantage, Even For Largest Players The components sold by most small semiconductor companies do not require cutting edge process technology or expertise. The largest companies such as Intel, Samsung, and TSMC may have an advantage due to their process R&D, but competition among themselves limits returns. In addition, there are very few "must have" products nowadays, and consumers and businesses can typically decide to simply not purchase a new PC, video game, etc., if prices get out of hand. Industry Consolidation Will Not Fuel Growth As we have frequently noted, semiconductor industry growth has slowed to GDP plus or minus a few points (Chart 2). The industry operates within the context of chronic high price deflation, meaning many more units have to be sold each year just to keep revenues flat. Some end markets allowed for the sale of higher value-add components with increased functionality, offsetting some of the deflation. However, the era of hyper growth in PCs, networking gear and smartphones is in the past. This places downward pressure on pricing through the value chain. Chart 2Semiconductor Industry Growth Has Slowed, ##br##Now Near GDP Growth Rate Loosely speaking the industry can be separated into commodity semiconductors and proprietary ones. Commodity devices are exact functional equivalents to devices sold by multiple vendors. Examples might be discrete devices such as transistors and diodes, memory chips, logic devices, and so on. The competition in commodity semiconductors is so extreme that for some products package costs can be similar to the cost of the semiconductor itself and saving a small amount of plastic or using slightly thinner leads influences profit margins. The product life of many commodity products extends to decades. The market for proprietary semiconductors is somewhat more complicated than for commodity devices. Intel is the prototypical example of a company that makes mostly proprietary devices, though Qualcomm, Xilinx, and others exist. Some companies such as Texas Instruments are a sort of hybrid, offering both commodity and proprietary products. It would be a mistake to assume that proprietary vendors have no competition, because substitutes are typically available. A smartphone vendor can select a high end ARM-based microprocessor from Qualcomm, make its own, or buy from any number of licensees selling similar devices, depending on the market segment and price range it is targeting. This has the effect of limiting the price of a proprietary device and the associated margins. As with any M&A transaction the opportunity arises to take associated restructuring charges, write-downs, and all manner of "one-time" items which can make "non-GAAP" earnings look better than before. Similarly, management may decide to cut costs by reducing R&D and other expenses to improve near-term performance at the expense of long term results. Company managers typically highlight "synergies" and "complimentary businesses" when selling their latest M&A transactions. Nevertheless, it is rare that the combination of two semiconductor companies actually amounts to something greater than what the two were apart. Instead, what tends to result is a mix of products and activities with varying degrees of margins and growth potential. Like any overly diversified portfolio, the combined companies are more likely to grow at the same rate as the industry than to become high-tech powerhouses. In summary there is no reason to believe that organic revenue growth will arise as a consequence of any particular semiconductor M&A transaction and it is far more likely that revenue growth and margins will trend towards the mean for the industry, setting aside the impact of "non-GAAP" adjustments. Why Is There A Buyer's Panic? As we have shown, in most cases industry consolidation will not provide much in the way of operational leverage to the consolidator's results. Similarly there is little reason to believe that companies which remain independent will be affected positively or negatively from the trend.2 This raises the question of why these transactions are occurring at such a frenetic pace. Most likely the answer has more to do with capital market trends than objective business decisions. Investors have elected to reward high tech companies for financial engineering on an equal footing with organic growth (i.e. innovation), and the capital is very cheap nowadays (Chart 3). As we have addressed previously, increasingly imaginative "non-GAAP" financial presentation means that overpaying for an acquired product line is better for the bottom line than developing it in house, so managers are focusing more on financial engineering than actual engineering. Cheap capital and less-than-rational capital markets mean that companies become acquirers or targets. As companies get larger, the targets need to be large enough to "move the needle" with respect to financial impact. This goes all the way down the food chain as mid-cap companies buy small-cap companies and large cap-companies buy mid-cap companies. There are a finite number of target firms for any given company and this creates a sort of "buyer's panic" which stimulates the buyers to move quickly before the target is acquired by a rival (Chart 4). As acquirers get bigger they become the targets of larger acquirers, as they are now large enough to provide the illusion of growth. Chart 3Capital For Financial Engineering Is Cheap Chart 4'Buyer's Panic' In Semiconductor Industry Non-S&P 500 Semiconductor Companies Are Also Targets Unless the cost of capital rises significantly or investors suddenly get concerned about actual operating results rather than "non-GAAP" performance, consolidation will continue until there is a relatively modest number of large semiconductor companies. As we explained above, this does not mean these companies will have superior margins or revenue growth. Indeed we believe the end of the consolidation period will have negative impact for semiconductor industry valuations because: Opportunities for financial engineering of revenue growth and managing "non-GAAP" earnings will be limited; Balance sheets will typically be highly leveraged; and Valuation premiums associated with M&A activity will disappear. Until the consolidation phase runs its course investors should be able to profit by assembling a portfolio of smaller names since these are more likely to be acquired. This is a major reason we have most of the smaller members of the S&P 500 Semiconductor sub-index rated Overweight. Table 1Summary Of Potential Semiconductor Targets We have identified 14 additional small semiconductor firms that are not included in the S&P 500 as likely targets (Table 1). This list is not exhaustive but represents companies which are both likely to be acquired and large and liquid enough to be investible. We selected the most attractive companies based on the Price-Earnings-to-Growth (PEG) ratio, which attempts to adjust valuation for growth prospects. These companies, which have a PEG ratio close to or below 1, are bolded in Table 1 above. We are adding these 10 companies to our Overweight list, and will track these recommendations as an equally-weighted index (Chart 5). Chart 5Small Semiconductor Companies Should ##br##Outperform Due To M&A However, due to the "buyer's panic" described above, companies that appear expensive or exhibit deteriorating financial performance are also potential acquisition targets. As such, it is important to note that our recommendations in this sub-sector are not driven by company fundamentals. Alternatively, investors might consider playing consolidation through the iShares PHLX Semiconductor ETF (SOXX). The structure of this ETF limits the weight of each constituent to approximately 8%, effectively overweighing smaller firms. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Paul Kantorovich, Research Analyst paulk@bcaresearch.com 1 Please see Technology Sector Strategy Weekly Report, "Tech Company Red Flags Part 2: Intangible Assets And Restructuring Charges," dated July 12, 2016, available at tech.bcaresearch.com 2 That would not be the case if, for example, Hynix and Samsung, two major DRAM manufacturers, were to merge which would be problematic for the #3 player Micron. However, we doubt regulators would permit such a merger.

Highlights EM risk assets will continue to plunge as U.S. bond yields and the U.S. dollar have more upside. Asset allocators should maintain an underweight allocation to EM within global equity and credit portfolios. Upgrade Russian stocks from neutral to overweight within an EM equity portfolio. Reinstate the long Russia ruble / short Malaysian ringgit trade. Feature The rout in emerging markets (EM) risk assets will persist, regardless of the direction of the U.S. equity market. While president-elect Donald Trump's potential fiscal stimulus will boost U.S. growth, it will not be sufficient to offset the negative impact on EM from rising U.S. Treasury yields and a stronger U.S. dollar. On a broader scale, risks of protectionist measures from the incoming U.S. administration are non-trivial, which will make investors even more jittery on EM. Notably, from a historical perspective, firm U.S. growth has not been a panacea for EM, particularly when the latter's domestic fundamentals were poor and commodities prices were falling. For example, EM in general and emerging Asia in particular collapsed in 1997- '98 when U.S. real GDP growth was averaging 4.5%, and European real GDP growth was 3.5%. In particular, U.S. import volumes were booming at double-digit rates, but this was insufficient to circumvent the crisis in Asia (Chart I-1). Importantly, U.S. bond yields were falling during the 1997-'98 period. Chart I-1Strong U.S. Growth Is No Panacea For EM Stocks It is hard to expect similar U.S. growth nowadays, even with Trump's potential fiscal impetus. Meanwhile, any fiscal boost in Europe so far remains a forecast. Besides, back in the 1990s, the U.S. and Europe were dominant sources of global demand - and China was not at all an economic power. Since the late 1990s, the significance of China and the rest of EM has grown enormously, while the importance of the U.S. and Europe with respect to global demand in general and EM in particular has fallen. In short, the outlook for stronger growth in the U.S. is not a reason to turn bullish on EM because the latter's fundamentals are poor. The U.S. dollar rally will persist. The greenback is close to being fairly valued, or only slightly expensive (Chart I-2). Typically, major cycles run until a market becomes considerably expensive or very cheap. It is not often that markets bottom or peak at their fair value. Odds are that the U.S. dollar will become more expensive before this bull market is over. In effect, the U.S. dollar rally is reflective of America sucking in capital. This will leave EM current account deficit countries exposed. As the currencies of these countries plummet and their local bond yields rise, their share prices will plunge and credit spreads will widen. Importantly, Trump's trade protectionist rhetoric could accelerate the depreciation in the Chinese RMB. If and when America imposes import tariffs on China, the latter will compensate via further yuan depreciation. In fact, Chinese residents will "assist" the People's Bank of China in devaluing the currency by converting their RMBs into U.S. dollars. As the RMB weakens further, probably at a faster speed, other Asian currencies will plummet (Chart I-3). In fact, odds are high that EM financial markets will once again become sensitive to the RMB. Chart I-2The U.S. Dollar Is Not Expensive Chart I-3RMB And Emerging Asian Currencies Apart from shorting the RMB versus the U.S. dollar, on October 19 we recommended shorting the KRW against the THB because the Korean won was one of most vulnerable EM currencies to continued RMB depreciation and renewed JPY weakness. We reiterate this trade today. Consistent with U.S. dollar appreciation, commodities prices will drop. One unsustainable post-U.S. presidential election move has been the rally in industrial metals in general, and copper in particular. Traders have bid up copper prices as the metal had lagged the rally in risk assets since February (Chart I-4). Nevertheless, expectations that U.S. infrastructure spending will considerably boost world demand for industrial metals are misplaced. The U.S. accounts for a very small portion of global industrial metals demand, including copper. Chart I-5 demonstrates that U.S. demand for copper is seven times smaller than that of China. On average, China accounts for about 50% of global demand for industrial metals, while the U.S. accounts for slightly less than 10%. Chart I-4The Rally In Copper ##br##Prices Is Unsustainable Chart I-5Industrial Metals ##br##Consumption: U.S. Versus China Hence, any reasonable rise in U.S. demand will not be sufficient to offset a single-digit percentage drop in China's intake of industrial metals, which we expect to occur in 2017. Finally, the Chilean mining firm Codelco - the largest copper producer in the world - in recent weeks has cut its premiums on copper shipped to Asia and Europe.1 This is a move to reduce prices - and a sign that demand is weak relative to supply. This leads us to believe that a rally driven by financial investors at a time of inferior demand-supply balance will prove short-lived. Investors should consider shorting copper on any further price strength. The selloff in U.S. and global bonds will likely persist well into December, which in turn will unravel the turmoil in bond proxies and high-multiples stocks (Chart I-6). In our July 13 Weekly Report,2 we argued that U.S. bond yields had bottomed and a selloff would prove painful as lower yields increases their duration. As a result, even a small rise in yields would lead to considerable bond price declines. Since then, while G7 bond yields initially grinded higher, they have surged over the past week. U.S. 10-year and 30-year bond yields have risen by 40 and 36 basis points, respectively since November 1. This translates into a 3.5% and 7.5% price decline for 10-year and 30-year bonds, accordingly. A similar scenario has also played out with EM bonds - both U.S. dollar and local-currency denominated. Accumulating considerable losses will force further bond liquidation. Our feeling is that many bond proxies and markets that benefited from lower yields will be seriously damaged in the coming weeks. Consistently, EM carry trades are at risk of further unraveling. Interestingly, Chart I-7 demonstrates that many high-yielding EM local bond markets are at a critical technical juncture. Odds are that their yields are heading considerably higher after troughing at their long-term moving averages. Chart I-6U.S. Bond Yields ##br##And Bond Proxies Chart I-7AEM Local-Currency Bonds Are ##br##At Critical Technical Resistance Levels Chart I-7BEM Local-Currency Bonds Are##br## At Critical Technical Resistance Levels Bottom Line: EM risk assets will continue to plunge. Stay put and remain defensive. Asset allocators should maintain an underweight allocation to EM within both global equity and credit portfolios. Currency traders who are not already short should consider shorting a basket of the following EM currencies: BRL, CLP, ZAR, TRY, IDR and MYR. In addition, we recommend maintaining our short RMB versus USD trade, as well as our short KRW / long THB position. Today, we are also reinstating the long RUB / short MYR trade (see section on Russia below). For more details on other currency, fixed-income, credit and equity positions, please refer to our Open Position Tables on pages 12-13. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please see: Codelco cuts 2017 China copper premium by 27% to $72/t.- sources (2016, November 14). Retrieved from https://www.metalbulletin.com/Article/3601613/Latest-news/Codelco-cuts-2017-China-copper-premium-by-27-to-72-sources.html 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 14. Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade Chart II-1Overweight Russian Stocks ##br##Versus The EM Equity Benchmark Russia stands out as one of the few EM countries that will likely benefit from Trump's presidency. As such, we recommend dedicated EM investors overweight Russia within both EM equity and credit portfolios. The energy and financial equity sectors together account for 75% of the Russian MSCI equity index, and we think they will continue to outperform their EM peers for the following reasons: With the ruble serving as a shock absorber, Russia's oil and gas sector has been able to weather the volatility in energy prices. If it wasn't for the ruble's massive devaluation in 2014-15, Russian energy companies would have struggled to stay solvent. While we expect oil prices to drop toward $35 per barrell, Russian energy stocks will still perform better than their EM counterparts. Furthermore, going forward, oil prices will outpace industrial metals prices. This should help Russian stocks, credit, and the currency outperform their EM peers (Chart II-1). As we argued above (please refer to page 3), the latest rally in industrial metals prices - based on expectations of U.S. infrastructure spending - does not make sense to us. In fact, the U.S. is a much more important consumer of oil than industrial metals in total world aggregate demand. Hence, strong U.S. growth and weaker Chinese growth (our baseline assumption) should be associated with oil prices outperforming base metals prices. Russia is much more advanced in its deleveraging cycle than most other EM economies. This will help banks and consumer stocks outperform their EM peers. In March 2016 we highlighted our preference for Russia's banking system relative to Malaysia's, and initiated a relative equity trade: long Russian stocks / short Malaysian stocks. This trade has already returned 30% and we believe it still has further to go. Today, we extend this positive view on Russia's banking system vis-à-vis Malaysia, to one versus the entire EM bank universe. In contrast to other emerging markets, Russian banks have been recognizing NPLs and have increased their provisions significantly (Chart II-2). Russia has now been in recession for two years and its banks have increased their NPL provisions and their credit growth has already slowed down significantly. This stands in stark contrast to other emerging markets, where banks are failing to realize NPLs and increase provisions adequately, despite substantially slower economic growth and elevated debt levels. In fact, Russia's domestic credit impulse is already starting to head into positive territory (Chart II-3), while the same indicator for the overall EM aggregate will be negative over the next 12 months or so. Russia's financial market outperformance will be aided by orthodox macro policies. This stands in contrast to unorthodox measures in many other developing countries. In terms of monetary policy, the Central Bank of Russia has refrained from injecting excess liquidity into the system or intervening in the foreign exchange market. Moreover, the central bank has been canceling the licenses of smaller banks. This is bullish for listed banks, as their market share will increase (Chart II-4). Chart II-2Russian Banks Have Recognized ##br##NPLs And Raised Provisions Chart II-3Russia's Credit Impulse ##br##Is Turning Positive Chart iI-4Russia: Banking Sector Consolidation ##br##Is Bullish For Listed Banks With respect to fiscal policy, although the government has exceeded its planned budget deficit of 3% of GDP for 2016, we believe this is not an issue given that Russia's total government debt is very low at only 16.5% of GDP. Lastly, our bias is that the recent victory of President-elect Trump will be marginally positive for the Russian economy relative to other EM. While the U.S. is not a major importer of Russian exports, investors will begin to price in sanction relief. European sanctions are particularly important for Russia and a substantive improvement in U.S.-Russia relations could lead some relatively pro-Russia European governments (Italy, Hungary, Greece, etc.) to demand that EU sanctions be either rolled back fully or significantly modified. Therefore, since Russia does not export as many goods to the U.S. compared to other emerging markets and sanctions may be easing soon, the nation is much more insulated from potential U.S. protectionist measures than many other EM countries. Investment Recommendations The Russian economy is further along its necessary adjustment path compared to the rest of the EM world, and there is less downside at the moment. Furthermore, Russian monetary and fiscal policymakers have undertaken orthodox policy measures in the face of an economic crisis - which cannot be said of many other EM countries. As such, we recommend dedicated EM investors upgrade Russia from neutral to overweight within an EM equity portfolio. We reiterate an overweight stance on Russian sovereign and corporate credit and recommend holding the following trades: Short Russian CDS / long South African CDS Long Russian and Chilean corporate credit / Short Chinese offshore corporate credit. We also recommend currency traders reinstate the long RUB / short MYR trade (Chart II-5). The two currencies are sensitive to energy prices, but the Russian economy is likely to recover soon, while the Malaysian economy has much more downside ahead. Excessive liquidity injections in Malaysia relative to somewhat tighter monetary conditions in Russia will lead to ringgit depreciation versus the ruble (Chart II-6). Lastly, the ruble offers a higher carry than the ringgit. Consistent with the currency trade, we are maintaining our long Russian / short Malaysian equity trade. Chart II-5Reinstate Long RUB / ##br##Short MYR Trade Chart II-6Malaysia And Russia: ##br##Non-Orthodox Versus Orthodox Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Trump's Win: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. Trump Stimulus & The Yield Curve: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Feature Chart of the WeekTrump Turmoil For Bonds America has been treated to a pair of major shocking events over the past couple of weeks. The Chicago Cubs won baseball's World Series for the first time in 108 years. And now, Donald Trump - real estate tycoon, reality TV star, Twitter addict - has become the 45th President of the United States. In the aftermath of that stunning election victory, investors are being treated to one more shocker that seemed impossible even just a few months ago - rapidly rising bond yields. Trump's victory has not only changed the political power structure in the U.S., but has seemingly altered many of the familiar financial market narratives as well. The idea of "deficit spending" by the government to boost growth has not been heard for many years in Washington, but Trump has made it clear that a big fiscal stimulus is coming soon to America. He has laid out a combination of large tax cuts and infrastructure spending that could result in both a surge in U.S. Treasury issuance in the coming years and a more structural rise in inflation - again, developments that have not been seen in the U.S. in quite a while. The prospect of fiscal easing amid still-accommodative monetary conditions in the U.S., with the economy running at full employment, has sent Treasury yields surging back to pre-Brexit levels, wiping out six months of positive bond returns in the process (Chart of the Week). While many details are still to be worked out with regards to Trump's proposed fiscal policy shift, the markets have taken its pro-business tilt as a bullish sign for growth and a bearish sign for bonds. There is more scope for yields to rise in the near term, in the U.S. and elsewhere, with the Fed likely to deliver another rate hike next month and the global economy now in a cyclical upswing. Duration risk remains the biggest immediate threat for bond investors, and we continue to recommend a below-benchmark portfolio duration stance. A New Sheriff In Washington Chart 2Markets Cheer Trump 'Bigly' The consensus opinion among investors going into the U.S. election was that a Trump victory would result in considerable market turmoil. This was a reasonable argument, as Trump ran a disruptive, anti-status-quo campaign that, by definition, would be expected to generate far more changes and uncertainty than a victory by Hillary Clinton. Yet outside of a few shaky moments in the wee hours of Election Night as markets began to realize that Trump would win, the big bond-bullish/equity-bearish risk-off moment never arrived. Perhaps Trump's more conciliatory tone in his victory speech helped to calm investors' fears that his caustic campaign demeanor would continue in the White House. More likely, investors saw the results in the U.S. Congressional elections and realized that the Republican Party had won a clean sweep in D.C. that would allow Trump to implement many of his campaign promises. Markets have been rapidly pricing the potential implications of a Trump presidency into many financial assets (Chart 2), from bank stocks (which would gain from Trump's proposed rollback of the Dodd-Frank regulations on bank activities and, more importantly, from the impact of higher bond yields and a steeper yield curve on profitability) to the U.S. dollar (which would benefit from Trump's protectionist trade agenda through narrower U.S. trade deficits and stronger U.S. growth that would raise the future trajectory of U.S. interest rates). Higher-quality USD-denominated credit spreads have been surprisingly well behaved, given the moves higher in U.S. yields and the USD itself. This may reflect an optimistic belief that Trump's pro-business, pro-growth policies can offset the negative impact on corporate profits from higher yields and a stronger USD. Markets are right to assume that Trump can actually deliver on his economic agenda. A detailed analysis of the implications of the Trump victory was laid in a Special Report sent last week to all BCA clients by our colleagues at BCA Geopolitical Strategy.1 One of their main conclusions was that Trump's ability to enact his plans will not be hindered much by the U.S. Congress. Republicans now control both the House of Representatives and Senate after last week's elections and Trump has been strongly supported even by the small government fiscal conservatives in Congress. After delivering such a stunning victory for the Republicans, Trump shouldn't face much serious resistance to his economic initiatives. Investors are starting to price in the potential inflationary implications of a President Trump, with the 5-year inflation breakeven, 5-years forward from the U.S. TIPS market now sitting at 1.84%. This is still well below the Fed's 2% inflation target (after adjusting for the usual historical difference between the CPI used to price TIPS and the Fed's preferred inflation gauge, the PCE deflator, which is around 0.4-0.5%). This measure can keep moving higher over the medium-term, given the timing of Trump's proposed fiscal stimulus. Bottom Line: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. The 1980s Called - They Want Their Economic Policy Back The U.S. economy is now showing few internal imbalances that would require wider government deficits as a counter-cyclical policy measure. The private sector savings/investment balance is close to zero, as the post-crisis household deleveraging phase has ended and corporate sector borrowing has skyrocketed in recent years (Chart 3, top panel). Also, measures of spare capacity in the U.S. economy like the output gap or the unemployment gap are also near zero (bottom panel), suggesting that any pickup in aggregate demand from current levels could trigger a rise in wage inflation and domestically-focused core inflation. Chart 3Deficit Spending At Full Employment: Back To The Future? The last time that such a combination of fiscal stimulus and full employment occurred was in the mid-1980s during the presidency of Ronald Reagan. Trump's plans for aggressive tax cuts and sharp increases in discretionary government spending do echo the policies of Reagan, who presided over one of the nation's largest peacetime run-ups in discretionary government budget deficits and debt (Chart 4). Perhaps there was a kernel of truth in the Trump/Reagan comparisons made during the election campaign! Chart 4Less Fiscal Space Than In The 1980s Clearly, a sharp run-up in federal budget deficits could have a much greater impact on longer-term interest rates and the shape of the yield curve, given the much higher starting point for federal debt/GDP now (74%) compared to the beginning of the Reagan presidency (26%). Especially given the potentially large budget deficits implied by Trump's campaign promises. Back in June, Moody's undertook an economic analysis of Trump's economic policies based on publically available information (i.e. Trump's campaign website) and their own assumptions based on Trump's campaign speeches.2 Moody's ran policies through its own U.S. economic model, which is similar to the forecasting and policy analysis models used by the Fed and the U.S. Congressional Budget Office. This model allows feedback from fiscal policy changes to the expected swings in growth and inflation and the likely shifts in monetary policy. The Moody's analysts used a variety of scenarios, ranging from full implementation of Trump's proposals3 to a heavily watered-down version if he faced a hostile Congress (which is clearly not the case now). We show the Moody's model forecasts for the U.S. Federal budget deficit as a percentage of GDP in Chart 5, along with the slope of the very long end of the U.S. Treasury curve. We also show the 10-year/30-year slope versus a measure of the Fed's policy stance, the real fed funds rate. According to Moody's, a full implementation of the Trump platform would push the U.S. budget deficit to double-digit levels by 2020, and would add nearly $7 trillion in debt over that time, pushing the federal debt/GDP ratio to 100%. The less extreme scenarios show smaller increases in deficits and debt, but the main point is that even if Trump implements only some fraction of his policies, the U.S. budget deficit will go up significantly during his first term in office. Looking at the historic relationship between the deficit and the slope of the Treasury yield curve, this implies that Trump's policies should put steepening pressures on the long-end of the curve as the bond market prices in greater Treasury issuance and higher future inflation rates. Of course, the bottom panel of Chart 5 shows that Fed policy also matters for the shape of the curve, and this is where the current debate over the Fed's next moves comes into play. Chart 5Trump's Deficits Will Steepen The Curve (Fed Permitting) The market is currently discounting a 70% probability that the Fed will hike at the December FOMC meeting, which has been our call for the past few months. The Fed has been projecting an increase next month and another 50bps of hikes in 2017, but these were forecasts made in the BT (Before Trump) era. The pricing from the Overnight Index Swap (OIS) curve shows that the market's expectations have started to shift upward towards the Fed's forecasts, in contrast to the BT dynamic where the Fed was having to cut its forecasts down towards the lower levels implied by the market (Chart 6). Will the Fed now look at the fiscal stimulus proposed by Trump as a reason to hike rates higher, or faster, than their latest set of projections? A big fiscal stimulus at full employment would certainly give the FOMC cover to raise its forecasts for growth and inflation, which would require a shift upwards in its interest rate projections. We do not expect that outcome at next month's FOMC meeting, as the Fed would likely want to see more specific budget details from the Trump administration in the New Year. More importantly, the Fed will want to avoid any additional strength in the U.S. dollar by moving to a more hawkish stance too soon, which would turn the dollar once again into a drag on U.S. growth, inflation and corporate profits, potentially disrupting financial markets. With the Fed unlikely to become more hawkish in the near term, the Treasury market will remain focused on the fiscal implications of Trump, placing bear-steepening pressures on the Treasury curve. For that reason, we are exiting our current Treasury curve flattener positions (2-year vs 10-year, 10-year vs 30-year) this week and moving to a neutral curve posture. We continue to maintain a below-benchmark stance on overall portfolio duration, as well as an underweight bias toward U.S. Treasuries within the developed market bond universe (on a currency-hedged basis). Treasuries are still not cheap, despite the recent run-up in yields, according to our global PMI model which incorporates variables for growth, U.S. dollar sentiment and policy uncertainty (Chart 7). Fair value has risen to 2.25% on the back of improving global growth and reduced uncertainty post-Brexit, with rising dollar bullishness providing a downward offset. Chart 6Markets Moving UP To The Fed Forecasts Chart 7USTs Not Yet Cheap If the Fed were to move too quickly to a more hawkish stance, dollar bullishness would increase and limit the cyclical rise in yields. At the same time, greater policy uncertainty under a new President could also limit yield increases although, as we have laid out above, the nature of the Trump uncertainty is not bond-bullish if it results in rising levels of government debt. For now, it is best to maintain a cautious investment stance until there is greater clarity on the U.S. policy front, while being aware that Treasuries are no longer as sharply undervalued as they were just a week ago. Looking ahead, this bond bear phase could end if the ECB announces an extension of its bond-buying program beyond the March 2017 deadline. As we discussed in a recent Weekly Report, the ECB will not be able to credibly declare that European inflation will soon return to the 2% target.4 This will force the ECB to extend the bond buying for at least another six months, with some changes to the rules of the program to allow for smoother implementation of future purchases. If, however, the ECB does indeed announce a tapering of bond purchases starting in March, bond yields will reprice higher within the main developed bond markets, led by rising term premiums (Chart 8). Given the global bond market's current worries about the inflationary implications of a switch away from extremely accommodative monetary policy to greater fiscal stimulus, a spike in yields related to a less-accommodative ECB could turn nasty fairly quickly. Chart 8A Dovish ECB Will Prevent A Deeper Global Bond Rout Bottom Line: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: More Growth, Fewer Defaults In recent discussions with clients, many have asked whether the implications of Trump's pro-growth policies, coming at a time of a cyclical upturn in the U.S. economy and inflation, should provide a boost to corporate profits that will, by extension, reduce the default risk in U.S. high-yield bonds. Chart 9Higher Nominal Growth Is Good For Junk (During Expansions) Chart 10High-Yield Valuations Have Improved Slightly It is a valid question to ask, as the excess returns on U.S. junk bonds have been historically been higher during expansions when nominal GDP growth (currently 2.8%) has been 4% or greater (Chart 9).5 With real U.S. GDP growth likely to expand by at least 2.5% in 2017, with moderately higher inflation, nominal growth should accelerate to a pace that has historically been friendlier for junk returns. Chart 11Corporate Balance Sheets Are Still A Problem Of course, the state of the corporate leverage cycle matters too, and that remains the biggest problem for high-yield. We have been maintaining an extremely cautious stance on U.S. junk bonds over the past few months, as a combination of highly-levered balance sheets and unattractive valuations led us to expect an underwhelming return performance from junk, especially with a volatility-inducing Fed rate hike likely to occur by year-end. That has not been case, however, as junk spreads declined steadily as the summer turned to autumn and have been relatively stable during the U.S. election uncertainty. Our colleagues at our sister publication, BCA U.S. Bond Strategy, recently introduced a simple model to predict junk bond excess returns as a function of lagged junk spreads and realized default losses.6 That model had been predicting excess returns over the next year of close to zero, but at today's spread levels the expected excess return over duration-matched U.S. Treasuries during the next year is closer to 157bps (Chart 10). While this is not the usual return that investors expect from an allocation to high-yield, it is better than the previous model prediction. Given this slightly more attractive level of spreads, a bond market now more prepared for a Fed rate hike, and with the default risks potentially narrowing somewhat on the back of a better nominal growth outlook for 2017, we no longer see the case for a maximum underweight position in high-yield. We still have our concerns about the state of the corporate credit cycle, and the valuations have not improved enough to justify a move back to neutral (Chart 11). Thus, we are only moving our U.S. high-yield allocation to below-benchmark (2 of 5) from maximum underweight (1 of 5). We are maintaining our below-benchmark stance on Euro Area and Emerging Market high-yield within our model portfolio, in line with our stance on U.S. junk. Bottom Line: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com. 2 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf 3 Aggressive income tax cuts, no changes to entitlement spending, increased defense outlays, and even the more controversial protectionist promises such as a 46% tariff on Chinese imports and the deportation of 11 million undocumented immigrant workers. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com. 5 Excess returns are the highest during low growth or recession periods, as this is when credit spreads are at their widest and companies are deleveraging and actively acting to reduce default risks. That is not the case at the moment. 6 Please see BCA U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. TIPS: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Yield Curve: An upward re-rating of the market's assessment of the equilibrium level of monetary conditions is necessary for the curve to steepen further from current levels. Spread Product: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Conversely, the sharp rise in yields turns us more cautious on MBS. Municipal Bonds: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Feature We had expected any flight to quality related to a Donald Trump victory to be brief, but would never have anticipated how brief it actually was. Treasury yields declined for about four hours as the results came in on election night, but since midnight EST last Tuesday the bond bear market has been supercharged. BCA's fixed income publications have maintained a below benchmark duration stance since July 19 with a year-end target of 1.95-2% for the 10-year Treasury yield. The 10-year yield is now above our year-end target, as Trump's surprise victory caused investors to question many long-held assumptions. Chief among them is the thesis of secular stagnation - the idea that a chronic imbalance between savings and investment has resulted in an extremely depressed equilibrium interest rate. The secular stagnation theory has ruled the day in U.S. bond markets, but even Larry Summers, who popularized the theory in recent years, has admitted that "an expansionary fiscal policy by the U.S. government can help overcome the secular stagnation problem and get growth back on track." 1 The market has been quick to take on board President Trump's promises of massive debt-financed infrastructure spending, and is now questioning the idea of permanently low interest rates. While much uncertainty about President Trump still abounds, one thing for certain is that the path of Treasury yields next year and beyond will be determined by whether Trumponomics can successfully tackle secular stagnation. As of now, we are cautious optimists. Last week BCA sent a Special Report2 to all clients that describes the likely outcomes of a Trump presidency. One of those outcomes is that a sizeable fiscal stimulus will be enacted next year. In this week's report we explore its potential impact on bond markets and re-assess our U.S. bond portfolio in light of this surprise change in the economic landscape. Duration The expected path of future rate hikes has moved sharply higher during the past week (Chart 1). If we assume that U.S. monetary conditions reach our estimate of equilibrium3 by the end of 2019, then the shaded region in Chart 1 shows a range of possible outcomes for the federal funds rate based on different scenarios for the U.S. dollar. The upper-bound of the shaded region corresponds to the path of the fed funds rate assuming the dollar depreciates by 2% per year, while the lower-bound assumes the dollar appreciates by 2% per year. The market's expected fed funds rate path has shifted into the upper-half of the shaded region, which assumes the U.S. dollar will depreciate. The thick black line corresponds to the assumption of a flat dollar. Chart 1The Market's Rate Hike Expectations: Pre- And Post-Election Since the U.S. dollar is very likely to appreciate in the event that a Trump administration enacts growth-enhancing fiscal stimulus, it would appear as though the market's expected interest rate path is already too high. However, we must consider the possibility that large-scale government investment could shift the savings/investment balance in the economy and lead to a higher equilibrium level of monetary conditions or that the U.S. economy reaches monetary equilibrium more quickly under President Trump. In that event, Treasury yields still have room to rise. Chart 2Not Much Gap Between Market & Fed Similarly, 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 2). The 5-year/5-year forward overnight index swap rate is now 2.05%, only about 80bps below the Fed's median estimate of the equilibrium fed funds rate. Meanwhile, our 12-month discounter - the market's expected change in the fed funds rate during the next 12 months - is already at 44bps. If there are no revisions to the Fed's interest rate forecasts at next month's meeting, then a level of 50bps on our discounter will be consistent with the Fed's expectations. This would be the first time the market and dots were lined up since 2014. The key point is that the balance of risks in the Treasury market has shifted. Prior to the election, Treasury yields had been under-estimating the potential for fiscal stimulus in 2017. Now, for Treasury yields to continue their move higher, we need to transition from a world where the Fed is continuously revising its interest rate forecasts lower to one where it is making upward revisions. To be clear, we do expect this transition to occur in 2017 but probably not during the next few months. Now that the Treasury market has reacted to the promise of fiscal stimulus, the next step is that it will demand to see some results. On that note, while Trump's infrastructure spending plan is assumed to be huge, at this point details are scarce. Further, our U.S. Investment Strategy service4 has pointed out that the effectiveness of fiscal stimulus depends critically on how well fiscal multipliers are working, and that estimates of fiscal multipliers can vary widely (Table 1). Table 1Ranges For U.S. Fiscal Multipliers Another risk to the bond bear market comes from a rapid increase in the U.S. dollar. Our modeling work shows that Treasury yields tend to rise alongside improvements in global growth (as proxied by the global manufacturing PMI), but that the impact of improving global growth on Treasury yields is dampened if bullish sentiment toward the U.S. dollar is also increasing (Chart 3). At present, the 10-year Treasury yield is very close to the fair value reading from our model, but the worry is that continued upward pressure on the dollar will cause the model's fair value to roll over in the months ahead. Another risk is the impact of a stronger dollar on emerging markets. A rebound in emerging market growth has contributed significantly to the strength in the overall global PMI since early this year (Chart 4). A strengthening dollar correlates with a weaker emerging market PMI (Chart 4, panel 2), and weakness on this front will weigh on the global growth component of our Treasury model. The possibility that President Trump will classify China as a "currency manipulator" once he takes office only exacerbates the risk from emerging markets. Chart 3Global PMI Model Chart 4EM Could Derail The Bond Bear Bottom Line: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. We therefore take this opportunity to book +35bps of profits on our tactical short December 2017 Eurodollar trade. Longer run, we expect Donald Trump will be able to deliver a sizeable fiscal stimulus package and that Treasury yields will be higher at the end of 2017. TIPS Chart 5TIPS Breakevens Still Depressed Our overweight recommendation on TIPS versus nominal Treasuries has also benefitted from Trump's win. The 10-year breakeven rate has increased +15bps since last Tuesday, but still has a long way to go before reaching levels that are consistent with the Fed hitting its inflation target (Chart 5). Trump's main economic policies - increased fiscal spending and more protectionist trade relationships - are both inflationary. The most likely candidate to derail the widening trend in breakevens would be a quicker pace of Fed rate hikes that offsets the inflationary fiscal impulse. We think a much more hawkish Fed policy is unlikely in the near term. With TIPS breakevens still so low the Fed will want to nurture their recovery toward pre-crisis levels. It is only once TIPS breakevens are much more firmly anchored at pre-crisis levels that the Fed will be enticed to significantly quicken the pace of hikes. Bottom Line: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Remain overweight TIPS versus nominal Treasuries. Yield Curve We had been positioned in Treasury curve flatteners on the view that the curve would flatten in advance of a December Fed rate hike, much as it did last year. Trump's surprise win has steepened the curve dramatically, and today we close both our curve trades taking losses of -86bps on our 2/10 flattener and -42bps on our 10/30 flattener. The best determinant of the slope of the yield curve in the long run is the deviation from equilibrium of our monetary conditions index (MCI). The curve tends to flatten as monetary conditions are being tightened toward equilibrium and steepen when monetary conditions are easing away from equilibrium. Chart 6 shows a model of the 2/10 Treasury slope versus the deviation from equilibrium of our MCI. The model works well over both pre- and post-crisis time intervals, and the trailing 52-week beta between the slope of the curve and the MCI's deviation from equilibrium is in line with the beta estimated for the entire post-1990 time interval (Chart 6, bottom panel). Chart 6The Yield Curve & Monetary Conditions The curve had appeared too flat relative to fair value prior to last week's steepening, but now appears slightly too steep (Chart 6, panel 3). Since the dollar is unlikely to depreciate substantially and the fed funds rate is unlikely to be cut, the only way that the curve can continue steepening from current levels is if the market starts to revise up its assessment of the equilibrium level of monetary conditions. This is consistent with the dynamic we observed with the level of Treasury yields. Given the rapid moves we've seen in the past week, to be confident that further curve steepening is in store we need to forecast that Trump's fiscal measures will conquer secular stagnation and that the Fed will start revising up its assessment of the equilibrium rate. Much like with the level of Treasury yields, we are reluctant to bet on further steepening in the near term, before we have seen some action on Trump's fiscal policies. However, the steepening trade has gathered enough momentum at this juncture that betting on flatteners equally does not seem wise. Bottom Line: We advocate a laddered position across the Treasury curve at the moment, while we await clarity on President Trump's fiscal proposals. The Treasury curve has room to steepen further if sizeable fiscal stimulus is implemented next year. Spread Product In recent weeks we have advocated a maximum underweight (1 out of 5) allocation to high-yield and a neutral allocation (3 out of 5) to investment grade corporates, while also avoiding the Baa credit tier. This cautious stance on corporate debt was in place for two reasons. First, the junk spread had tightened in recent months despite a slight increase in the VIX and there was a sizeable risk that a Fed rate hike in December could prompt a spike in implied volatility, with a knock-on effect on spreads. Junk spreads have since widened to be more in-line with the VIX (Chart 7), and the much steeper Treasury curve tells us that the market is now less likely to consider a Fed rate hike in December - which we still expect - a policy mistake. Consequently, we are marginally less worried about a large spike in the VIX index that would translate into wider high-yield spreads. Second, high-yield spreads were simply too low relative to our forecast for default losses in 2017 (Chart 8). A model consisting of lagged junk spreads and realized default losses explains more than 50% of the variation in excess junk returns over 12-month periods.5 Previously, this model had predicted excess junk returns of close to zero, but today's spread levels are consistent with excess junk returns of +157bps during the next 12 months. Not inspiring by any means, but still better than nothing. Given the slightly better entry level for spreads and less near-term risk of a Fed-driven volatility event, we upgrade our allocation to high-yield from maximum underweight (1 out of 5) to underweight (2 out of 5). We maintain our neutral (3 out of 5) recommendation on investment grade corporates, but remove the recommendation to avoid the Baa credit tier. The past week's large increase in Treasury yields also leads us to downgrade our allocation to MBS from overweight (4 out of 5) to underweight (2 out of 5). The low level of option-adjusted spreads makes the long-term outlook for MBS uninspiring, but we had expected that the option cost component of spreads would tighten as Treasury yields moved higher (Chart 9). Now that Treasury yields have risen sharply and the option cost has tightened, we take the opportunity to adopt a more cautious outlook on the sector. Chart 7Spreads Re-Converge With VIX Chart 8Expect Low But Positive Excess Returns Chart 9Allocate Away From MBS Bottom Line: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Now that the MBS option cost has tightened in response to higher Treasury yields, the outlook for the sector is less inspiring. Municipal Bonds A Donald Trump presidency is full-stop negative for the municipal bond market. Further, as we highlighted in a recent Special Report,6 no matter the election result the outlook for state & local government health is likely to turn more negative in the second half of next year. Trump's tax cuts de-value the tax advantage of municipal debt and will drive flows out of the sector leading to wider Municipal / Treasury (M/T) yield ratios. We had been overweight municipal bonds since August 9, anticipating that a Clinton victory might provide us with a very attractive level from which to downgrade the sector heading into 2017. It was not to be, but municipal bond yields have still not quite kept pace with the sharp increase in Treasury yields, so we are able to downgrade today with M/T ratios not far off the low-end of their post-crisis range (Chart 10). In addition to tax cuts, Trump's infrastructure plan could also be a large negative for the muni market depending on how much of it is financed at the state & local government level. While the specifics of Trump's plan are not yet known, historically, most public infrastructure spending is financed at the level of state & local government (Chart 11). Another potential risk is that if large scale tax reform is on the table in 2017, then there is always the possibility that municipal bonds will lose their tax exemption altogether. At the moment it is difficult to assign odds to such an outcome. Chart 10Municipal / Treasury ##br##Yield Ratios Chart 11State & Local Government ##br##Drives Public Investment Bottom Line: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/ 2 Please see BCA Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 3 For further details on how we estimate the equilibrium level of monetary conditions please see U.S. Bond Strategy Special Report, "Peak Policy Divergence And What It Means For Treasury Valuation", dated February 9, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, 2016, available at usis.bcaresearch.com 5 For further details on this modeling framework please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification