Emerging Markets

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

Highlights 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 bca.ems_wr_2016_11_16_s1_c1 bca.ems_wr_2016_11_16_s1_c1 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 bca.ems_wr_2016_11_16_s1_c2 bca.ems_wr_2016_11_16_s1_c2 Chart I-3RMB And Emerging Asian Currencies RMB And Emerging Asian Currencies RMB 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 The Rally In Copper Prices Is Unsustainable The Rally In Copper Prices Is Unsustainable Chart I-5Industrial Metals ##br##Consumption: U.S. Versus China EM Got "Trumped" EM Got "Trumped" 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 bca.ems_wr_2016_11_16_s1_c6 bca.ems_wr_2016_11_16_s1_c6 Chart I-7AEM Local-Currency Bonds Are ##br##At Critical Technical Resistance Levels bca.ems_wr_2016_11_16_s1_c7a bca.ems_wr_2016_11_16_s1_c7a Chart I-7BEM Local-Currency Bonds Are##br## At Critical Technical Resistance Levels bca.ems_wr_2016_11_16_s1_c7b bca.ems_wr_2016_11_16_s1_c7b 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 Overweight Russian Stocks Versus The EM Equity Benchmark Overweight Russian Stocks 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 Russian Banks Have Recognized NPLs And Raised Provisions Russian Banks Have Recognized NPLs And Raised Provisions Chart II-3Russia's Credit Impulse ##br##Is Turning Positive Russia's Credit Impulse Is Turning Positive Russia's Credit Impulse Is Turning Positive Chart iI-4Russia: Banking Sector Consolidation ##br##Is Bullish For Listed Banks Russia: Banking Sector Consolidation Is Bullish For Listed Banks Russia: Banking Sector Consolidation 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 bca.ems_wr_2016_11_16_s2_c5 bca.ems_wr_2016_11_16_s2_c5 Chart II-6Malaysia And Russia: ##br##Non-Orthodox Versus Orthodox bca.ems_wr_2016_11_16_s2_c6 bca.ems_wr_2016_11_16_s2_c6 Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

Highlights We remain positive on Chinese stocks both from structural and cyclical point of view, especially on H shares. In the near term, stay on the sidelines due to developing global uncertainty. The Q3 earnings scorecard of listed companies confirms an upturn in the Chinese profit cycle. Earnings momentum will likely be carried forward to at least early next year. The Chinese economy has improved notably, especially in the industrial sector. We expect the economy will likely continue to surprise to the upside. Feature Tuesday's U.S. election surprise sent strong shockwaves to global risk assets, including Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares in early October,1 partly due to brewing global uncertainty, but were still caught off guard by the election result. World financial markets have yet to fully grasp the implication and consequences of a President Trump. Yesterday, we sent clients a Special Report titled "U.S. Election: Outcomes & Investment Implications" prepared by Marko Papic, our Chief Geopolitical Strategist, providing our initial assessment on these important issues. As far as China is concerned, the biggest threat is the harsh anti-China trade policies that dominantly featured Mr. Trump's election campaign. A full-blown protectionist backlash is undoubtedly bearish for China and the rest of the world; this is a disturbing uncertainty that has to be carefully monitored and assessed going forward. However, it is also worth noting that anti-China rhetoric has been regularly featured in all U.S. presidential election campaigns by candidates from both parties as soon as the diplomatic tie between these two countries was established in 1979, but the economic integration has continued to deepen. For now, we do not advocate any kneejerk adjustment to investment strategy, as it is utterly unpredictable how much of Mr. Trump's campaign rhetoric will become real policy. An easier bet over the near term is that the Chinese authorities will likely maintain policy support to boost domestic demand in the wake of rising external uncertainty. Strategically, China will likely press forward its ongoing long-term initiatives to expand its global influence, such as the "One Belt One Road" (OBOR) project and Asian Infrastructure Development Bank. Meanwhile, China will continue to explore bilateral and multi-lateral free trade deals with its major trade partners to foster a more predictable global trade environment. We will follow up on these issues in our future research. While Chinese stocks have suffered badly from global contagion this week, Chinese domestic factors have, ironically, continued to turn more positive of late, with an improving cyclical economic profile, a largely accommodative policy stance and a strong recovery in profits. In the near term we are staying on the sidelines, as the uncertainty unleashed by the U.S. presidential elections continues to play out. Nonetheless, barring a major protectionist backlash, we remain positive on Chinese H shares both from a structural and cyclical perspective, and expect this asset class to outperform both global and EM peers. A Strong Earnings Recovery From an investor's stand point, the most important development is the sharp recovery in earnings reported by Chinese domestically listed A-share companies in the third quarter. Specifically: A share-listed companies' average earnings increased by 22% in the third quarter from Q3 2015, or by 3% for the first three quarters compared with a year ago (Table 1). Excluding financials and petroleum firms, earnings jumped by almost 50% in Q3, according to our calculations, or 21% year-to-date. While the sharp earnings recovery in Q3 is partially attributable to last year's low base, our model suggests that earnings momentum will likely be carried forward to at least early next year (Chart 1). Table 1Earnings Scorecard Chinese Stocks: Between Domestic Improvement And External Uncertainty Chinese Stocks: Between Domestic Improvement And External Uncertainty The earnings recovery reflects both top-line growth and margin expansion. Improving producer prices have eased deflationary pressure in the economy, particularly for the corporate sector. Total sales of A share-listed firms have benefited from the pickup in nominal GDP growth, and profit margins have also continued to widen in the last quarter, both of which are conducive for earnings growth (Chart 2). Cash flow positions have also continued to improve, especially in select sectors. Overall cash and cash equivalents held by Chinese non-bank firms as a share of assets currently stand at elevated levels, underscoring an overall cautious stance on business expansion and liquid balance sheets (Chart 3).2 Specifically, real estate developers' operating cash flow continues to increase sharply, boosted by strong sales, but capital expenditures have been muted, leading to a significant hoarding of cash. This will likely reduce financial stress among developers, even if housing policies begin to be tightened. Chart 1Strong Earnings Grow... bca.cis_wr_2016_11_10_c1 bca.cis_wr_2016_11_10_c1 Chart 2... Due To Rising Sales And Improving Margin bca.cis_wr_2016_11_10_c2 bca.cis_wr_2016_11_10_c2 Chart 3Developers' Improving Cash Flow And Balance Sheet bca.cis_wr_2016_11_10_c3 bca.cis_wr_2016_11_10_c3 In short, the Q3 earnings scorecard confirms our long-held view of an upturn in the Chinese profit cycle.3 We expect bottom-up analysts will continue to upgrade earnings expectations, which will provide a positive cyclical backdrop for Chinese stocks (Chart 4). The Economy Will Remain Resilient China's recent macro numbers have largely come in stronger than expected, albeit modestly. Overall, the economy has maintained positive momentum, especially in the industrial sector. The Keqiang Index - a combination of bank loan growth, railway freight activity and electricity consumption - has strengthened sharply, underscoring significant improvement in industrial activity (Chart 5). Looking forward, we expect the economy will likely continue to surprise to the upside. Chart 4Net Earnings Revision Will Continue To Improve bca.cis_wr_2016_11_10_c4 bca.cis_wr_2016_11_10_c4 Chart 5Keqiang Index Versus GDP Growth bca.cis_wr_2016_11_10_c5 bca.cis_wr_2016_11_10_c5 Business managers have largely been cautious, and have been focused on inventory destocking instead of business expansion. Industrial production has so far been muted, despite improvement in some leading indicators (Chart 6). Meanwhile, slowing capital spending among private enterprises has been one of the key reasons for slower growth in recent years; this should turn around as profitability improves (Chart 7). At minimum, downward pressure on private sector investment should diminish going forward. This, together with government-sponsored infrastructure construction, should underpin overall capital spending. Chart 6Industrial Production Has Been Muted bca.cis_wr_2016_11_10_c6 bca.cis_wr_2016_11_10_c6 Chart 7Profit Recovery Helps Capex bca.cis_wr_2016_11_10_c7 bca.cis_wr_2016_11_10_c7 On the policy front, monetary conditions continue to be accommodative. The trade-weighted exchange rate has remained low, and real interest rates have continued to drift lower through nominal declines and rising producer prices. Furthermore, inflation is unlikely to become a meaningful policy constraint anytime soon. Headline CPI picked up slightly last month, driven by food prices (Chart 8). However, this was largely due to the base effect. Agricultural wholesale prices have been mostly flat in recent years, and there is no case for generalized food inflation. The risk of any near term policy tightening has further diminished in the wake of the global uncertainty. Meanwhile, previous stimulative policies should continue to allow the economy to build forward momentum. The housing tightening policies imposed last month have begun to have a negative impact on home sales, which introduces a new risk factor for the economy, as discussed in a previous report. Anecdotal evidence suggests that property transactions in some major cities have dropped notably, even though home sales nationwide appear to remain buoyant (Chart 9).4 In addition, new housing construction has rolled over in the past few months, as developers have also focused on destocking inventories despite rising sales. However, inventories were already headed lower, which will eventually support new construction. Already, developers' land purchases have turned positive in recent months. In short, the impact of tightened housing policies should continue to be closely monitored. For now, our base case remains that housing construction will likely remain sluggish, but will not go through another major downturn. This view is further reinforced by the strong earnings and cash positions of real estate developers in the last quarter. Chart 8No Case For Food Inflation bca.cis_wr_2016_11_10_c8 bca.cis_wr_2016_11_10_c8 Chart 9Housing: Another Major Downturn Is Unlikely bca.cis_wr_2016_11_10_c9 bca.cis_wr_2016_11_10_c9 Chinese Stocks And Global Risk Aversion As far as Chinese stocks are concerned, we are positive both from structural and cyclical point of view, especially on H shares. Structurally, this asset class has been deeply depressed in recent years with an unduly high risk premium, which will eventually be renormalized through multiples expansion. Cyclically, the economy's budding forward momentum, strong profit recovery and accommodative policy stance are all supportive for stock prices. At a minimum, Chinese H shares should continue to outperform their global and EM peers. Tactically, however, we remain cautious as knee-jerk reactions in the stock market following the U.S. election surprise will continue to dominate the broader market trends. Furthermore, even as the impact of the election shock begins to fade, investors' focus may shift back over to a possible December rate hike by the Federal Reserve and another up leg in the U.S. dollar - both of which are negative for global liquidity and risk assets. Chart 10 shows that our proxy of global dollar liquidity has deteriorated significantly of late, which historically has often been accompanied by an increase in volatility in stocks. This time around, however, the market appears to have so far been rather sanguine, and is vulnerable to negative surprises. This is especially true, as global bellwether U.S. stocks are not cheap. In addition, Chinese stocks are overbought in the near term, and a period of consolidation or even correction is overdue (Chart 11). Our technical models for both A shares and H shares remain elevated even after the recent correction, which heralded further near-term difficulties. A favorable cyclical profile and large valuation buffer, particularly for H shares, should limit the downside for Chinese stocks, but the risk-return tradeoff in the near term is not particularly attractive, and warrants a more cautious stance. Chart 10Dollar Liquidity And Equity Volatility bca.cis_wr_2016_11_10_c10 bca.cis_wr_2016_11_10_c10 Chart 11Chinese Stocks Remain Near Term Overbought Chinese Stocks Remain Near Term Overbought Chinese Stocks Remain Near Term Overbought The bottom line is that we downgraded our "bullish rating" on Chinese H shares last month, and for now remain on the sidelines. Beyond near-term volatility we reiterate our positive conviction for this asset class, and expect Chinese H shares to continue to advance both in absolute terms and against the EM and global benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Rethinking Chinese Leverage", dated October 27, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Reports, "2016: A Choppy Bottoming" , dated January 6, 2016 and "China: Four Important Charts" , dated April 13, 2016 and "Chinese Growth, Profits And Stock Prices", dated July 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The inexorable shift of refining eastward would be accelerated if the Kingdom of Saudi Arabia (KSA) and Russia fail to curb crude oil production as we expect. Prolonging the crude oil market-share war - particularly between opposing camps led by KSA and Iran within OPEC, and Russia's campaign outside the Cartel - will advantage Asian refiners in the short term. Over the longer term, the expansion of oil refining in Asia and the Middle East likely will accelerate, as these warring camps invest directly in refining capacity in Asia and expand their domestic and regional refining and trading capacity. The risk Asian product markets will become super-saturated over the next 3 - 5 years remains elevated, as local refining capacity outgrows local demand and export markets are used to dispose of product surpluses. Like their upstream counterparts, refiners can be expected to fight for market share, leading to a compression in margins. Energy: Overweight. We continue to expect a production cut by KSA and Russia to be announced at the OPEC meeting this month. Base Metals: Neutral. LME aluminum prices still have upside as the market will likely remain supply deficit in the short term. We look to buy aluminum on weakness. Precious Metals: Neutral. We remain on the sidelines ahead of the Fed's December meeting. Ags/Softs: Underweight. We still look to go long wheat versus soybeans. We also look to go long corn versus sugar. Feature We continue to expect an announcement from KSA and Russia of a net 1mm b/d production cut at this month's OPEC meeting in Vienna, after accounting for the 400k b/d or so of seasonal production declines in KSA. A failure to follow through on a cut will prolong the global market-share war among OPEC and Russian oil producers seeking long-term customers in Asian refining markets, particularly in China. China's so-called teapots, which refine 60k to 70k b/d, only started importing crude oil for their own accounts late last year. These refiners represent about one-third of China's 14.3 mm b/d refining capacity as of 2015. It's been a slow ramp - some of these teapots only got started on importing their own crude this year - but they're definitely on a growth trajectory and should catch up with KSA and India in the near future. Some of them already are using hedge markets and setting up their own trading operations, according to media reports. Also, we're expecting to see increased investment in refining in China by KSA and others in the very near future, which will bring state of the art technology to the sector. In and of itself, a failure of KSA and Russia to agree a production cut would be bullish for the growth potential of Asian refiners, as Middle Eastern and Russian crude oil supplies continue to be aggressively marketed to them, allowing them to build capacity and grow their share of global exports (Chart of the Week). Chart of the Week (A)Asia/Middle East Refining Inputs Continue to ##br##Grow As OPEC Market-Share War Drags On bca.ces_wr_2016_11_10_c1a bca.ces_wr_2016_11_10_c1a Chart of the Week (B)Asia/Middle East Refiners' Market Share Of ##br##Gasoline Exports Is Growing bca.ces_wr_2016_11_10_c1b bca.ces_wr_2016_11_10_c1b Chart of the Week (C)...As Are ##br##Diesel/Gasoil Exports bca.ces_wr_2016_11_10_c1c bca.ces_wr_2016_11_10_c1c Our expectation for crude production cuts by KSA and Russia, perhaps with sundry cuts from their allies in the market-share war, would accelerate the draws in crude and product inventories globally. Absent a cut, inventories will continue to draw slowly, based on an assessment of data provided by the Joint Oil Data Initiative (JODI), a transnational oil-data service (Chart 2). The current cycle of supply destruction is being prolonged by high global inventory levels. High inventories keep prices under pressure, which, as we have often noted, raise the odds of civil unrest in cash-strapped states. The odds of unplanned production outages and loss of exports thus remains elevated. A price spike in such a scenario cannot be ruled out. Chart 2Inventories Will Continue To Fall Slowly ##br##If KSA-Russia Don't Cut Crude Output bca.ces_wr_2016_11_10_c2 bca.ces_wr_2016_11_10_c2 Chart 3Asia/Middle East Diesel Output##br## Growth Will Continue bca.ces_wr_2016_11_10_c3 bca.ces_wr_2016_11_10_c3 Global Refining and Storage Markets Continue Transformation Longer term, we see an inexorable shift in refining eastward, as local refiners expand their capacity in China and India, and financially stronger crude and product exporters expand their refining and trading operations by investing in existing or new Asian refining capacity - e.g., KSA in China and South Korea, and Russia's Rosneft in India alongside a major trading company. This will keep high-valued-added exports growing in Asia (Chart 3 and Chart 4), and will take market share from traditional processing centers - e.g., northwest Europe, and Singapore's processing refineries (Chart 5). Chart 4Along With ##br##Gasoline Output bca.ces_wr_2016_11_10_c4 bca.ces_wr_2016_11_10_c4 Chart 5Asia/Middle East Refiners ##br##Displace Traditional Processors bca.ces_wr_2016_11_10_c5 bca.ces_wr_2016_11_10_c5 With or without a production cut by KSA and Russia, the incidence of crude-oil supply destruction will continue to fall on the poorer OPEC producers outside the Gulf Cooperation Council (GCC), which lack the wherewithal to invest in higher crude-oil output domestically, or in refining and trading capacity domestically or abroad. These cash-strapped states also will be unable to make direct investments in refining assets in end-use markets, depriving them of assured outlets for crude production enjoyed by exporters like KSA with substantial refining investments domestically and worldwide.1 This means that, unlike KSA, where refined-product sales and trading will constitute a greater share of revenues over the medium term (out to 10 years), these cash-strapped producers will continue to depend on crude oil sales alone. Chart 6U.S. Product Exports Hold Up Well bca.ces_wr_2016_11_10_c6 bca.ces_wr_2016_11_10_c6 Given its technological edge and nearby crude supplies - Canadian heavy shipped south via pipeline, conventional and light-tight oil (LTO) from shale fields, and increasing volumes of Mexican crude following the sale of deep-water acreage next month - we do not expect U.S. refiners to lose export-market share in the high-value-added light-product markets (diesel and gasoline/aviation fuels) (Chart 6). Indeed, on a 5-year seasonal basis, U.S. refined-product exports actually are increasing, as nearby refiners - e.g., Mexico - continue to find it difficult to maintain operations. Even as Asia and the Middle East refining and trading markets develop, we continue to expect a deepening of crude and product flows among North and South American producers and refiners.2 China Policy Put Could Spur Refining Output In our earlier research, we noted the implicit put provided to Chinese refiners, after the National Development and Reform Commission mandated products be sold at a minimum crude oil reference price of $40/bbl. This was done to encourage conservation and to support domestic refiners and producers.3 So, if crude oil prices go below $40/bbl for Chinese refiners, this regulation incentivizes them to refine as much as possible, then store or export output surplus to domestic needs. Unless the government steps in to tax away the refining windfall resulting from this put whenever the reference crude price falls below $40/bbl, this policy will, at the margin, pressure global refined-product prices, and keep refining margin growth potential limited as Chinese capacity increases. This pattern was seen in Chinese agricultural markets, where crop price supports resulted in a massive accumulation of corn in storage, as farmers bought cheap corn on the international market and sold it into the government storage market. The crop price supports are being unwound, but it does illustrate the Ironclad Law of Regulation - markets always find a way to game regulations to their advantage. Refining Margins Will Remain Under Pressure Chart 7Refining Margins Will Remain Under Pressure bca.ces_wr_2016_11_10_c7 bca.ces_wr_2016_11_10_c7 The rapid expansion of refining capacity in Asia and the Middle East - driven by increased domestic and foreign investment in refining and trading capacity - suggests to us refined-product markets could be in for an extended period of oversupply, which will limit refiner margins going forward. OPEC's market-share war, and the massive supplies produced by U.S. shale-oil producers made it abundantly clear that crude oil is a super-abundant resource, particularly with shale-oil production ready to come on line as soon as prices move above $50/bbl. The buildout in refining capacity by KSA and other OPEC members, along with plans to expand Asian and Middle East refining capacity and, critically, to supply that capacity with aggressively priced crude charging stock, will keep refining margins under pressure going into 2017 (Chart 7). The risk of super-saturating Asian markets in the near future with unsold refined products as crude supplies and production are ramped up in the near future, therefore, poses a risk for refiners generally, since, at the right prices, crude and product can be moved anywhere on the globe. This poses a particular risk for KSA as it readies the IPO of is state-owned oil company Aramco. KSA is simultaneously attempting to grow its own refining capacity worldwide - from a current level of ~ 6mm b/d to as much as 10mm b/d - and retain and secure long-term customers for its crude. In effect, as a refiner it will be competing with the very customers to which it provides crude oil. This doubly compounds the difficulty of IPOing Aramco, as well, since investors will want to be assured the refining side of the enterprise is not being disadvantaged by the crude-oil supply side of the enterprise. However, for KSA as a sovereign state, this expansion of revenues earned from a massive refining presence worldwide is clearly a boon. KSA could, at the end of the day, refine, export and trade product volumes that equal or surpass its current crude export volumes, as it continues to invest and build out its global refining presence. This will further distance it from its OPEC brethren and other crude oil producers worldwide, making it less a crude exporter and more a global vertically integrated portfolio manager. Bottom Line: We see an inexorable shift of refining eastward, with or without a production cut by KSA and Russia. Failure to agree and implement a production cut would prolong the crude oil market-share and provide a tailwind to Asian refiners in the short term. With or without a production cut, we see the expansion of oil refining in Asia and the Middle East continuing apace, as direct investment flows to refining and trading. The risk that Asian product markets will become super-saturated over the next 3 - 5 years remains elevated, as local refining capacity outgrows local demand and exports from Asian and Middle East refineries grow. Like their upstream counterparts, refiners can be expected to fight for market share, leading to a compression in margins. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com BASE METALS China Commodity Focus: Base Metals Aluminum: Buy On Weakness Tactically, we are bullish on LME aluminum prices and neutral on SHFE aluminum prices.4 Supply shortages will likely persist in the ex-China world over next three to six months. Strategically, we are neutral on LME aluminum prices and bearish on SHFE aluminum prices. Profitable Chinese smelters will continue boosting their aluminum production, which will eventually spill over into the global market. We recommend buying Mar/17 LME aluminum contract if it falls to $1,580/MT (current: $1,727/MT). We expect the contract price to rise to $1,900/MT over next three to five months. If the order gets filled, we suggest putting a stop-loss at $1,500/MT. Aluminum prices have gone up considerably this year (Chart 8, panel 1). Global aluminum producers cut their production sharply while global consumption only contracted slightly, reversing a deep supply-surplus market in 2015 to a significant supply-deficit market in 2016 (Chart 8, panel 2). Moreover, aluminum inventories in both LME and SHFE markets also have fallen to multi-year lows (Chart 8, panel 3). However, aluminum prices went nearly vertical in China with a 48% rally since late last November, while LME prices have been only up 21% during the same period of time (Chart 8, panel 1). Why have prices in China gone up much more than the global LME prices? Will the rallies in aluminum prices in both LME and SHFE markets continue? The answer is mainly in China. China: The Most Important Factor In The Global Aluminum Market As the world's largest aluminum producer and consumer, China accounts more than 50% of global aluminum production and consumption (Chart 9, panel 1). The country has also been the major contributor to the growth of both global supply and demand for at least the past 10 years (Chart 9, panels 2 and 3). Chart 8Aluminum: Still More ##br##Upside Ahead? bca.ces_wr_2016_11_10_c8 bca.ces_wr_2016_11_10_c8 Chart 9China: The Most Important Factor ##br##In Aluminum Market China: The Most Important Factor In Aluminum Market China: The Most Important Factor In Aluminum Market China And The Price Collapse In 2015 In November 2015, while LME aluminum prices plunged to their lowest levels since February 2009, aluminum prices in China (SHEF) collapsed to their lowest levels since at least 1994. There were four main factors driving for the price drop. Chinese aluminum output increased more than 3 million metric tons (Mn MT), which accounted 87% of global supply growth, and resulted in excessive global supply. At the same time, global aluminum demand growth experienced a sharp slowdown -- yoy growth was 6% in 2015, versus 16.1% in 2014. This was mainly led by China, where, last year, aluminum demand growth slowed from 27.5% in 2014 to 10.9% in 2015. Inventories at SHFE were boosted by about 68% in 2015, while inventories at LME remained elevated. With China producing much more than it consumed, the country started to encourage exports of semi-manufactured aluminum products last year to reduce the domestic supply surplus (Chart 9, panel 4). In April 2015, the country removed the export tariff on several major aluminum semi-manufactured products. In November 2015, the country implemented a policy of giving a 13-15% value-added tax rebate to exporters of semi-manufactured products. As a result, last year net Chinese unwrought aluminum exports increased 16.7% yoy, which have weighed on global LME aluminum prices. China And The Price Rally In 2016 Chart 10Positive Factors To Aluminum Prices Positive Factors To Aluminum Prices Positive Factors To Aluminum Prices Similarly, China was the major driving factor behind this year's rally as well. Global supply was cut massively for the last two months of 2015 and the first eight months of 2016, as extremely low aluminum prices resulted in huge losses for most global aluminum producers. According to the World Bureau of Metal Statistics (WBMS), for the first eight months of this year, China accounted for 55% of the global aluminum supply cuts, as the country suspended its high-cost producing capacity and started industry-wide coordinated production cutbacks in last December (Chart 10, panel 1). Extremely low inventory levels also spurred the price rally. Inventories at SHFE warehouses fell 76.5% from mid-March to late-September (Chart 10, panel 2). In addition, the social inventory at major cities (Wuxi, Shanghai, Hangzhou, Gongyi and Foshan) also fell to record lows. Surging coal prices and rising alumina prices have also pushed up domestic aluminum production costs (Chart 10, panel 3). In addition, China implemented its newly promulgated Road Traffic Management Regulations regarding overloaded and oversized trucks, and unsafe vehicles on September 21. It was common before these regulations were implemented for drivers to overload shipments of commodities in order to increase profits. This raised road transportation costs for commodities like steel, coal, aluminum, aluminum products and other metals. It also created a bottleneck for timely transporting of coal to aluminum smelters, which own self-generated power plants, and transporting primary aluminum from major producing provinces Xinjiang, Inner Mongolia and Ningxia to some inner-land provinces like Henan for further manufacturing. As China cut its aluminum production this year, the country's exports of semi-manufactured aluminum products also fell 1.9% yoy for the first nine months of this year. As for Chinese aluminum demand, the data are confusing: The WBMS data showed a contraction for the first eight months of 2016, but the domestic industry association reported a decent increase in Chinese aluminum demand so far this year. Based on domestic auto output and construction activity data, we are inclined to believe Chinese aluminum demand rose moderately on the back of this year's fiscal stimulus. Other Factors For The Price Rally In 2016 There are two factors besides China for this year's aluminum rally. U.S. aluminum output fell nearly 50% yoy this year as Alcoa and Century Aluminum massively cut capacity late last year in response to lower prices (Chart 10, panel 4). For the ex-China world, while its supply fell 1.2%, consumption actually grew 0.4% for the first eight months of this year. This increased the supply deficit for the world excluding China, which is positive for LME aluminum prices (Chart 10, panel 5). So, What's Next? Tactically, we are bullish on LME aluminum prices and neutral on SHFE aluminum prices. Chart 11Aluminum: Buy On Weakness bca.ces_wr_2016_11_10_c11 bca.ces_wr_2016_11_10_c11 Most of the aforementioned positive factors are still in place. Even though China has enough capacity to oversupply both its domestic market and global markets again, the key factor will be how fast China boosts its aluminum output. With new added capacity and idled capacity returned to service, China's operating capacity for aluminum has been rising every month so far this year. According to the data provided by Sublime China Information Group, as of the end of October, China's aluminum operating capacity was 35.1 MMt/y (million metric tons per year), a rise of 0.575 MMt/y from the previous month, and an increase of 2.034 mtpy from the end of 2015. Based on our calculations, so far, total aluminum output from January to September is still much lower than the same period last year. In addition, considering the possible output loss due to the Spring Festival in late January, we believe it will take another three to six months for China to meet its own domestic demand and inventory restocking. Therefore, as domestic supply becomes more ample, China's domestic prices - including SHFE aluminum prices - should have limited upside. At the same time, the downside also should be limited by low inventory and rebounding demand. We expect more upside for LME aluminum prices as the supply shortage will likely persist in the ex-China world over next three to six months. Currently, Chinese aluminum prices are about 20% higher than the LME prices (both are in USD terms), which will likely limit the supply coming from China's exports to the rest of the world. Strategically, we are neutral on LME aluminum prices and bearish on SHFE aluminum prices. Currently, about 85% of the China's aluminum operating capacity is profitable. With new low-cost capacity and more idled capacity coming back line, profitable Chinese smelters will continue boosting their aluminum production to maximize profits. This, over a longer term such as nine months to one year, should eventually spill over into the global market. Risks China has imposed stricter environmental regulations on the domestic metal smelting and refining process since 2014 to control domestic pollution. The government currently is sending environmental inspection teams to major aluminum producing provinces to check how well the smelters and refiners comply with state environment rules. Some unqualified factories may be ordered to close. If this occurs, domestic SHFE aluminum prices may go up further in the near term. On the other side, if unprofitable aluminum producers in China also increase their output quickly, in order to creating jobs and revenue for local governments, prices at both SHFE and LME may face a big drop. We will monitor these risks closely. Investment Strategy We probably will see increasing Chinese aluminum production in 2016Q4, which may induce price corrections in both LME and SHFE prices. We prefer to buy LME aluminum on weakness. We recommend buying the Mar/17 LME aluminum contract if it falls to $1,580/MT (current: $1,727/MT) (Chart 11). We expect the contract price to rise to $1,900/MT over next three to five months. If the order gets filled, we suggest putting a stop-loss level at $1,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report for an extended discussion of increasing Asian and Middle Eastern refining capacity "KSA, China, India Ramping Oil Product Exports," dated July 28, 2016, available at ces.bcaresearch.com. 2 We will be exploring inter-American crude and product flows - and the potential for expanding this trade - in future research. 3 Please see Commodity & Energy Strategy Weekly Report p. 6 of the earlier-referenced "KSA, China, India Ramping Oil Product Exports," dated July 28, 2016, available at ces.bcaresearch.com. 4 LME denotes London Metals Exchange and SHFE denotes Shanghai Futures Exchange. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights De-globalization is accelerating. Europe is holding together, with populism in check. China power consolidation reflects extreme risks. Brexit is more likely, not less, after court ruling. Feature Chart I-1America Has Soured On Globalization De-Globalization De-Globalization The world woke up on Wednesday to President-elect Donald J. Trump. It will take time for the markets to digest the new regime in Washington D.C., but something tells us that it will not be business-as-usual over the next four years. We give our post-mortem assessment in the enclosed In Focus Special Report, starting on page 28. The divisive campaign reached epic lows in decorum and polarization, but both candidates did have one major thing in common: They shared a negative view of globalization, representing a paradigm shift in geopolitics and macroeconomics. Investors often take policymakers to be agents of political supply. Political rhetoric is taken seriously, analyzed, and its implications for various assets are discussed with confidence. But this approach gets the causality all wrong. Politicians are merely supplying what the political marketplace is demanding. In those terms, Donald Trump was not an agent of change. He was merely a product of his environment. So what is the American median voter demanding? Judging by the success of Donald Trump - and Senator Bernie Sanders in the Democratic primary race - the answer is less free trade, more government spending, and a promise to keep entitlement spending at current, largely unsustainable levels. Americans empirically support globalization at a lower level than the average of advanced, emerging, or developing economies (Chart I-1). What is the problem with globalization? In our 2014 report titled "The Apex Of Globalization - All Downhill From Here," we argued that globalization was under assault due to three dynamics:1 Deflation is politically pernicious: Globalization was one of the greatest supply-side shocks in recent history and thus exerted a strong deflationary force (Chart I-2). A persistently low growth environment that flirts with deflation is unacceptable for the majority of the population in advanced economies. Citizens have already experienced a combination of wage suppression and debt escalation. And while globalization produced disinflationary forces on the price of labor and tradeable goods, it has done little to check the rising costs of education, health care, child care, and housing (Chart I-3), which cannot be outsourced to China or Mexico. Chart I-2Globalization Was A Major Supply-Side Shock Globalization Was A Major Supply-Side Shock Globalization Was A Major Supply-Side Shock Chart I-3You Can't Ship Daycare To China bca.gps_mp_2016_11_09_s1_c3 bca.gps_mp_2016_11_09_s1_c3 The death of the Debt Supercycle: The 2008 Great Recession shifted the demand curve inward. BCA coined the "debt supercycle" framework in the 1970s to characterize the overarching trend of rising debt in a world where political leaders, with the Great Depression and Second World War in the back of their mind, continually resorted to reflationary policies to overcome each new recession. However, the 2008 economic shock permanently shifted household preferences in the West, reducing demand by turning consumers into savers (Chart I-4A and Chart I-4B). This contributes to the global savings glut and reinforces the deflationary environment. Chart I-4AGlobal Demand Engine ... bca.gps_mp_2016_11_09_s1_c4a bca.gps_mp_2016_11_09_s1_c4a Chart I-4B...Is Not Coming Back bca.gps_mp_2016_11_09_s1_c4b bca.gps_mp_2016_11_09_s1_c4b Multipolarity: Global leadership by a dominant superpower can overcome ideological challenges and demand deficiencies by providing a consumer of last resort. In game-theory terms, such a global hegemon acts as an exogenous coordinator, turning a non-cooperative game into a cooperative one. But in today's world, geopolitical and economic power is becoming more diffuse. We know from history that intense competition between a number of leading nations imperils globalization (Chart I-5). This is particularly the case in a low-growth environment. Geopolitical and economic multipolarity increase market risk premiums. Chart I-5Multipolarity Imperils Globalization Multipolarity Imperils Globalization Multipolarity Imperils Globalization These factors imperiled globalization well before Donald Trump, Bernie Sanders, Jeremy Corbyn, and Nigel Farage came to dominate the news flow in 2016. The macroeconomic and geopolitical context guaranteed that anti-globalization rhetoric would prove successful at the ballot box. Chart I-6Sino-American Macroeconomic Symbiosis Ended##br## In 2008 Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over In addition to these structural challenges to globalization, the next U.S. administration will also have to handle the increasingly complex Sino-American relationship. The future of the post-Bretton Woods macroeconomic and geopolitical system will be decided by these two great powers. And we fear that both economic and geopolitical tensions will worsen.2 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart I-6). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth - moving the economy up the value chain. Or, they can use protectionism - particularly non-tariff barriers to trade - to defend their domestic market from competition.3 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West. The problem with this choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into global trade (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open up its economy as it became wealthy. Today, 45% of China's population is middle class, which makes China potentially the world's second largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism.4 What should investors expect in a world that has less globalization, more populism, and rising Sino-American tensions? We think there are five structural investment themes afoot: Chart I-7Globalization And MNCs: A Tight Embrace bca.gps_mp_2016_11_09_s1_c7 bca.gps_mp_2016_11_09_s1_c7 Inflation is back: Globalization has been one of the most important pillars of a multi-decade deflationary era. If it is imperiled, political capital will swing from capitalists to the owners of labor. Sovereign bonds are not pricing in this paradigm shift, which is why investors should position themselves for the "End Of The 35-Year Bond Bull Market."5 We are long German 10-year CPI swaps as a strategic play on this theme. USD strength: The market got the USD wrong. Trump is not bad for the greenback. More government spending and higher inflation will allow U.S. monetary policy to be tighter than that of its global peers. Furthermore, U.S. policymakers will not look to arrest the dollar bull market. "Main street" loves a strong dollar, particularly U.S. households and consumers. King Dollar will be the righteous agent of plebeian retribution against the patrician corporations used to getting their way on Capitol Hill. And finally, more geopolitical risk will mean more safe haven demand. RMB weakness: China needs to depreciate its currency in order to ease domestic monetary policy and is therefore constrained by its slowing and over-leveraged economy. But in doing so, it will export deflation and ensure that a trade war with the U.S. ensues. In addition, China's EM peers will suffer as their competitiveness vis-à-vis their main export market - China - declines. We expect that China will hasten its ongoing turn towards protectionism itself. This means that if investors want to take advantage of China's rise, they should buy Chinese companies, not the foreign firms looking to grab a share of China's middle-class market. Long defense stocks: Global multipolarity is correlated with armed conflict. We have played this theme by being long U.S. defense / short aerospace equities. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, recommends investors initiate a structural overweight in the global defense index.6 Long SMEs / Short MNCs: A world with marginally less free trade, and marginally more populism, will favor domestically oriented sectors. Small- and medium-sized enterprises (SMEs) in the U.S., for example. Multinational corporations (MNCs) have particularly benefited from free trade and laissez faire economics. The relationship between globalization and S&P 500 operating earnings has been tight for the past 50 years (Chart I-7). Not anymore. In the new environment, investors will want to be long domestically-oriented sectors and economies against externally-oriented ones. These are structural themes supported by structural trends. We would have recommended these five investment themes irrespective of who won the U.S. election. In this Monthly Report, we focus on leadership races around the world. Our In Focus section gives a post-mortem on the U.S. presidential election. The rest of this Global Overview focuses on upcoming elections in Europe (as well as the December 4 Italian constitutional referendum) and the impending Chinese leadership rotation in 2017. We also give our two cents on recent developments related to Brexit in the U.K. Europe: Election Fever Continues Chart I-8Italian Referendum: Likely A 'No' Italian Referendum: Likely A "No" Italian Referendum: Likely A "No" The Netherlands, France, Germany, and potentially, Italy could all hold elections over the next 12 months, a recipe for market volatility. These four countries are part of the EMU-5 and account for 71% of the currency union's GDP and 66% of its population. Should investors expect a paradigm shift? We think the answer is yes, but surprisingly, not towards more Euroskepticism. Our view is that continental Europe - unlike its Anglo-Saxon peers, the U.K. and the U.S. - is actually moving marginally towards the center.7 The median voter in Europe is not becoming more Euroskeptic and even appears to support modest, pro-business, structural reforms! Wait... what? Indeed. Read on. Italy The constitutional referendum being held on December 4 remains too close to call, although we suspect that it will fail (Chart I-8). However, we doubt very much that the defeat of the government's position will initiate a sequence of events that takes Italy out of the euro area. As we argued in a recent Special Report titled "Europe's Divine Comedy: Italian Inferno," Italian policymakers are using Euroskepticism to extract concessions from Europe. But Italy is structurally constrained from exiting European institutions because of its bifurcated economy.8 Moreover, a failed referendum outcome is not a strategic risk to Europe: Euro support: Italians continue to support euro area membership, albeit at a lower level than in the past (Chart I-9). As such, the Euroskeptic Five Star Movement (M5S) has political reasons to become less opposed to euro area membership, as its anti-establishment peers have done in Greece, Portugal, and Spain. Bicameralism: If the constitutional referendum fails, then the Senate will remain a fully empowered chamber in the Italian Parliament. Given Italy's complicated electoral laws, M5S will be unable to capture both houses in Italy's notoriously bicameral legislative body, unless it does very well in the next election. But M5S has consistently trailed the incumbent, pro-establishment Democratic Party (PD) in the polls (Chart I-10). Sequence: As Diagram I-1 shows, the contingent probability of the December constitutional referendum leading to an Italian exit from the euro area is 1.2%. Chart I-9Italy & Euro: OK (For Now) bca.gps_mp_2016_11_09_s1_c9 bca.gps_mp_2016_11_09_s1_c9 Chart I-10Italy: Euroskeptics Peaking? bca.gps_mp_2016_11_09_s1_c10 bca.gps_mp_2016_11_09_s1_c10 Diagram I-1From Referendum To Referendum: Contingent Probability Of Italy ##br##Leaving The Euro Area Following The Constitutional Referendum Vote De-Globalization De-Globalization Investors should not translate our sanguine view into a positive view of Italy. As we outlined in the above-cited Special Report, we remain skeptical that Italy can improve its potential growth rate by boosting productivity. But there is a big leap between more-of-the-same in Italy and a euro area collapse. The Netherlands The anti-establishment and Euroskeptic Party for Freedom (PVV) is set to perform poorly in the upcoming March 15 Dutch election. Polls suggest that it will roughly repeat its 10% performance from the 2012 election (Chart I-11). This is extremely disappointing given its polling earlier in the year. PVV's support has collapsed recently, most likely the result of the immigration crisis abating (Chart I-12) and the Brexit referendum in June. Many Dutch may be interested in casting a protest vote against the establishment, but a large majority still support euro area membership (Chart I-13). As such, they are put off by the vociferous Euroskepticism represented by the PVV. Chart I-11The Netherlands: Euroskeptics Collapsing bca.gps_mp_2016_11_09_s1_c11 bca.gps_mp_2016_11_09_s1_c11 Chart I-12Read Our Chart: Migration Crisis Is Over bca.gps_mp_2016_11_09_s1_c12 bca.gps_mp_2016_11_09_s1_c12 Chart I-13The Netherlands & Euro: Love Affair bca.gps_mp_2016_11_09_s1_c13 bca.gps_mp_2016_11_09_s1_c13 The Netherlands is a very important euro area member state. Its economy is large enough that its views matter, despite its small population. Euroskepticism in the Netherlands is notable, but it does not mean that the country's leadership will contemplate a referendum on membership. More likely, the establishment will seek to counter the populist PVV by becoming stricter on immigration and looser on budget discipline. Investors can live with both. France The French election is a two-round affair that will be held on April 23 and May 7. The key question is who will win the November 20 primary of the center-right party, Les Républicains, formerly known as the Union for a Popular Movement. According to the latest polls, former Prime Minister (1995-1997) Alain Juppé is set to win the primary over former President Nicolas Sarkozy (Chart I-14). Who is Alain Juppé? The 70-year old has been the mayor of Bordeaux since 2006, but he is better remembered for the failed social welfare reforms (the Juppé Plan) that caused epic strikes in France back in 1995. He is pro-euro, pro-EU, and pro-economic reforms. In other words, he is everything that Brexit and Trump/Sanders/Corbyn are not. According to the latest polls, Juppé is a heavy favorite against the anti-establishment candidate Marine Le Pen (Chart I-15). This is unsurprising as Le Pen's popularity peaked in 2013, as we have been stressing to clients for years (Chart I-16). Chart I-14Please Google Alain Juppe... bca.gps_mp_2016_11_09_s1_c14 bca.gps_mp_2016_11_09_s1_c14 Chart I-15...The Next President Of France De-Globalization De-Globalization Chart I-16Le Pen's Popularity In A Secular Decline bca.gps_mp_2016_11_09_s1_c16 bca.gps_mp_2016_11_09_s1_c16 Why has Le Pen struggled to gain traction in an era of terrorism, migration crises, and the success of anti-establishment peers such as Brexiters and Donald Trump? There are two major reasons. First, she continues to oppose France's membership in the euro area, despite very large support levels for the common currency in the country (Chart I-17). Second, she is holding together a coalition of northern and southern National Front (FN) members. This coalition pins together a diverse group. Northern right-wing FN members are more akin to their Dutch peers, or the "alt-right" movement in the U.S. They are anti-globalization, anti-political correctness (PC), and anti-immigration - specifically, further immigration of Muslims to France. However, this northern FN faction is ambivalent on social issues such as homosexuality (in fact, many of Le Pen's closest advisors from the north of France are openly gay), and they oppose Islam from a position that Muslim immigrants are incompatible with French liberal values. The southern FN faction is far more traditionally conservative, drawing their roots from the old anti-Gaullist, staunchly Catholic right wing. When Le Pen loses the 2017 presidential election, it will spell doom for the National Front. The only thing holding the two factions together is her leadership. Therefore, not only is France likely to elect a pro-reform president from the political establishment, but also its anti-establishment, Euroskeptic movement may be facing an internal struggle. Germany The German federal election is expected to be held sometime after August 2017. Chancellor Angela Merkel faces a decline in popularity (Chart I-18) and a challenge from the populist Alternative für Deutschland (AfD), which performed well in two Lander (state) elections this year. Nonetheless, the migration crisis that rocked Merkel's hold on power has abated. As Chart I-12 shows, migrant flows into Europe peaked at 220,000 last October and began to plummet well before the EU-Turkey deal that the press continues to erroneously cite as the reason for the reduction in migrant flows. As we controversially explained at the height of the crisis, every migration crisis ultimately abates as border enforcement strengthens, liberal attitudes towards refugees wane, and the civil wars prompting the flow exhaust themselves.9 Germany's centrist parties maintain a massive lead over the upstart AfD and Die Linke, the left-wing successor of East Germany's Communist establishment (Chart I-19). However, AfD's successes in Mecklenburg West Pomerania and Berlin have prompted investors to ask whether it will garner greater national support in the general election. Chart I-17France & Euro: Loveless Marriage,##br## But Together For The Kids bca.gps_mp_2016_11_09_s1_c17 bca.gps_mp_2016_11_09_s1_c17 Chart I-18Merkel's Popularity Has Suffered,##br## But Stabilized Merkel's Popularity Has Suffered, But Stabilized Merkel's Popularity Has Suffered, But Stabilized Chart I-19There Is A##br## Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... We doubt it. Both states are sort of oddballs in German politics. For example, Mecklenburg West Pomerania is known for a strong anti-establishment sentiment. AfD largely took votes away from the National Democratic Party (ultra-far-right, neo-Nazis) and Die Linke. These two parties won a combined 25% of the vote in 2011. In 2016, the combined anti-establishment vote, including AfD, was 33%. Clearly this is a notable gain for the non-centrist parties, but it is hardly a paradigm shift. In Berlin, the AfD gained a solid 14% of the vote, but the sensationalist media conveniently avoided mentioning that it came in fifth in the final count. By our "back-of-the-envelope" calculation, AfD managed to take only about 8% of the vote from establishment parties. The bulk of its success once again came from taking votes from other populist parties. For example, Berlin's Pirate Party - yes, "pirates" - took 8% of the vote in the last election and none in 2016. Nonetheless, we suspect that time may be running out for Angela Merkel. She has been in power since 2005 and many voters have lost confidence in her. Merkel may choose not to contest the election at the CDU party conference in early December, or she may step aside as the leader following the election. Why? Because polls suggest that Merkel's CDU will have to once again rely on a Grand Coalition with its center-left opponent, the SPD, to govern. Politically, this is a failure for Merkel as the Grand Coalition was always intended to be a one-term arrangement. If Merkel decides to retire, how will the ruling CDU choose its successor? The process is relatively closed off and dominated by the party elites. The Federal Executive Board of the CDU selects the candidates for chairperson and the party delegates must choose the leader with a majority. The outcome is largely preordained, and Merkel has typically won above 90% of the party congress delegate vote. The possibility of a chancellor from the CDU's Bavarian sister-party, the Christian Social Union (CSU), is also decided by the elites. Therefore, the likelihood of an anti-establishment candidate hijacking the CDU/CSU leadership is minimal. How will the markets react to Merkel's resignation? Investors are overstating Merkel's role as the "anchor" of euro area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent euro area fiscal backstop mechanism due to upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. In addition, her likely successor will not mark a paradigm shift in terms of Germany's pro-euro outlook (Box I-1). Bottom Line: Investors may wake up in mid-2017 to find that the U.K. is firmly on its way out of the EU and that the U.S. is embroiled in deepening political polarization. Meanwhile, France and Spain will be led by reformist governments, Italy will remain in the euro area, and Germany will be mid-way through a rather boring electoral campaign featuring pro-euro establishment parties. What is keeping the European establishment in power? In early 2016, we argued that it was its large social welfare state. Unlike the laissez-faire economies of the U.S. and the U.K., European "socialism" has managed to redistribute the gains of globalization sufficiently to keep the populists at bay. As such, European voters are not flocking to populist alternatives, despite considerable challenges such as the migration crisis and terrorism. Populists are gaining votes in Europe nonetheless. To counter that trend, we should expect to see Europe's establishment parties turn more negative towards immigration, positive on fiscal activism, and more assertive towards security and defense policy. But on the key investment-relevant issue of euro area membership and European integration, we see the consensus remaining with the status quo. China: Xi Is A "Core" Leader... So What? Chinese President Xi Jinping's recent designation as the "core" of the Chinese leadership should be seen as a marginally market-positive event in an otherwise bleak outlook. Not because the president has a new title, but because of the underlying reality that he is consolidating power ahead of the 19th National Party Congress. Set for the fall of 2017, the Congress will feature a major rotation of top Communist Party leaders and mark the halfway point of his 10-year administration. The new title was not a surprise when it trickled out of the Chinese Communist Party's Sixth Plenary meeting on October 24-27. But the media took the opportunity once again to decry President Xi's "ever-expanding power."10 As our readers know, we do not think there has been a palace coup in China. That is, we do not think Xi has overthrown the "collective leadership" model, i.e. rule by the Politburo Standing Committee, established after the death of Chairman Mao.11 Instead, we think he is presiding over a major centralization phase in Chinese politics. Xi's status as the "core" feeds into the broader idea of re-centralization that we identified as a key theme for this administration when it began its term back in 2012.12 The Sixth Plenum reinforced this view in various ways:13 Xi is clearly in charge: A smattering of local party officials started calling him the core leader earlier this year, but now it has been endorsed in official documents at the highest level. Again, it is not the title itself that matters, but the fact that Xi compelled the whole party to give him the title. This distinguishes him from his two predecessors, Presidents Hu Jintao and Jiang Zemin, and in this way he resembles his mighty predecessor Deng Xiaoping. Xi already developed a strong track record for re-centralizing the political system prior to receiving the new title.14 Collective leadership persists: Deng invented the idea of the "core" leader specifically as a way to assert the need for a top leader or chief executive without reverting to Maoist absolutism. The core leader is the supreme leader within a collective leadership system. This interpretation was expressly reaffirmed by the communique issued at the Sixth Plenum, which denounced ruling by a single person and praised the current system.15 Corruption purge has not split the party: The focus of the plenum was the Communist Party's rules for disciplining its own members. This specifically highlighted Xi's harsh anti-corruption campaign, which has netted numerous party officials, and has not yet concluded (Chart I-20). The fact that this campaign has continued longer than expected without prompting significant resistance shows that centralization is acceptable to the party (and anti-corruption is positive for the party's public image). Policy coherence could improve: A rash of rumors suggest that Xi will not only promote his allies but also tweak party rules and norms in order to ensure he retains a factional majority on the Politburo Standing Committee after 2017. This should be positive for policymaking since the cohort of leaders ready to rise up the ranks is weighted against his faction as a result of the previous administration's appointments. These developments would be negative if Xi avoids appointing successors next year and thus appears ready to cling to power beyond 2022.16 Unified government is a plus amid crisis: Deng initiated the "core leader" concept in the dark days after the Tiananmen massacre, when the party faced internal rifts and potential regime collapse. In other words, it is in times of crisis that the party needs to reaffirm that rule-by-committee still requires a final arbiter at the top. This latter point is the most relevant for investors. It suggests that China's party leadership perceives itself to be in the midst, or on the brink, of a crisis. Why should this be the case? There has been an improvement in China's economic situation in 2016 - stimulus efforts have stabilized the economy and growth momentum is picking up (Chart I-21). Economic relations with Asian nations are also improving. All of this information has supported the China bulls, who argue that China is not particularly overleveraged, still has a long way to go in terms of economic development, and needs to stimulate demand in order to outgrow any problems it faces from debt and overcapacity (Chart I-22). Chart I-20Anti-Corruption ##br##Campaign Reaccelerating Anti-Corruption Campaign Reaccelerating Anti-Corruption Campaign Reaccelerating Chart I-21Chinese Economy##br## Improved This Year Chinese Economy Improved This Year Chinese Economy Improved This Year Chart I-22Chinese Capacity Utilization: ##br##A Historical Perspective Chinese Capacity Utilization: A Historical Perspective Chinese Capacity Utilization: A Historical Perspective Nevertheless, the latest reflation efforts have peaked (Chart I-23), and there are clear warning signs for what lies ahead. The RMB continues to weaken, capital outflows may reaccelerate as a result, the yield curve is flattening, and economic policy uncertainty remains markedly elevated (Chart I-24). As such, the China bears argue that exorbitant credit growth cannot continue indefinitely (Chart I-25). When credit growth slows, the credit-reliant economy will slow too, and China will face a cascade of bad loans and insolvent companies and banks. Chart I-23Latest Mini-Stimulus##br## Is Over Latest Mini-Stimulus Is Over Latest Mini-Stimulus Is Over Chart I-24China:##br## Who Is Driving This Bus? China: Who Is Driving This Bus? China: Who Is Driving This Bus? Chart I-25China's Corporate And Household Credit: ##br##The Sky's The Limit? China's Corporate And Household Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? While economists can argue over the nature of things, politicians do not have that luxury: China's government must be prepared for the worst-case scenario. The China bears may be right even if their economic analysis proves overly pessimistic or poorly timed, because policymakers may eventually decide they must do more to tackle excessive leverage and overcapacity. Chart I-26Rebalancing Is Slowing Down Rebalancing Is Slowing Down Rebalancing Is Slowing Down An optimistic long-term assumption about Xi's consolidation of power has been that he eventually intends to use that power to pursue painful structural reforms, as outlined at the Third Plenum in 2013.17 However, the intervening three years have shown that he is pragmatic and does not want to impose aggressive reforms that would undercut an already weak and slowing economy (Chart I-26). Thus, deep reforms are only going to occur if they are forced upon the leaders as a result of an intense bout of instability, uncertainty, and market riots. The implication of this is that Xi is concentrating power in preparation for further crisis points that may be thrust upon his administration. For instance, if recent efforts to tamp down on property prices end up bursting the bubble, then eventually China could be plunged into socio-political (as well as financial) turmoil. By that time, the party would not be able to re-centralize and consolidate power carefully and gradually. It would either have loyal tools at its disposal already, or would lose precious time (and likely make mistakes) trying to assemble them. Thus Xi's moves to consolidate power are marginally market-positive in an overall negative climate. He is making himself and the Politburo Standing Committee better prepared to handle a crisis, which suggests that he believes that a crisis is either occurring or close at hand. In short, the Communist Party is girding for war; a war for regime stability if and when the massive credit risks materialize. What about the 19th National Party Congress, set to take place next fall? We will revisit this topic in the future, but for now the key point is this: It would require a surprise and/or a new political dynamic to prevent Xi from getting his way in forming the Politburo Standing Committee next year. While there is a mixed record of policy stimulus for the years preceding the Chinese midterm leadership reshuffle, we certainly do not expect aggressive structural reforms to occur before then (Chart I-27). Policy tightening in the real estate sector and SOE restructuring efforts will be gradual. Chart I-27Unimpressive Record Of Stimulus Before Five-Year Party Congresses Unimpressive Record Of Stimulus Before Five-Year Party Congresses Unimpressive Record Of Stimulus Before Five-Year Party Congresses Only around the time of the party congress will it be possible to find out whether Xi wants his administration to be remembered for anything other than power consolidation - such as ambitious reforms. One reform effort we are confident will continue amid rising centralization, however, is tougher government policy against pollution. Pollution threatens social stability, especially among the restless new middle class, and stimulus efforts perpetuate the heavily polluting industries. Environmental spending has been the biggest growth category in government spending under Premier Li Keqiang.18 To capitalize on the darkening short-term outlook for stocks and Xi's policy momentum, we suggest shorting Chinese utilities, whose profit margins and share prices trade inversely with rising environmental spending (Chart I-28). Bottom Line: We remain overweight China relative to EM: The government has resources and is unified. However, the long-term outlook is mixed. Investors should steer clear of Chinese risk assets in absolute terms. Short utilities as a play on rising environmental spending and regulation, and stay short the RMB. Brexit Update: The "Legion Memorial" Is Alive And Well Chart I-28Anti-Pollution Push Hurts Utilities Anti-Pollution Push Hurts Utilities Anti-Pollution Push Hurts Utilities The Brexit movement encountered its first apparent setback last week when the country's High Court ruled that parliament must vote on invoking Article 50 of the Lisbon Treaty to initiate the withdrawal from the European Union. We have always held a high-conviction view that parliament approval would ultimately be necessary, as we wrote in July.19 But, politically, it matters a great deal whether parliament votes before or after the exit negotiations. The High Court ruling is an obstacle to the government's Brexit plan because it could result in (1) the parliament's outright blocking Brexit, though this outcome is highly unlikely; (2) the parliament's insisting on a "soft Brexit" that leaves U.K.-EU relations substantially the same as before the referendum on matters like immigration and market access. However, the saga is nowhere near finished. The government is appealing the ruling, the Welsh assembly is contesting the appeal, and the Supreme Court will decide the matter in December. Until then, we expect U.K. markets to benefit marginally, ceteris paribus, from the belief that the odds of a soft Brexit are rising. Investors could be encouraged by the continuation of monetary stimulus and a new blast of fiscal stimulus, which we think will surprise to the upside on November 23 when the annual Autumn Statement is released by the Chancellor of the Exchequer. The High Court-prompted rebound in U.K. assets will remain vulnerable for the following reasons: The Supreme Court has not yet ruled: It is not certain that the Supreme Court will uphold the High Court's insistence on a parliamentary role. Both views have legitimate arguments and the issue is not settled until the Supreme Court rules. Parliament's role is political, not merely legal: Assuming parliament gets to vote on whether to trigger the process of leaving the EU, the decision will depend on politics. For instance, it is highly unlikely that the Commons will flatly reject the popular referendum, and the House of Lords can at best delay it. Yes, parliament is sovereign, but that is because it represents the people. While the 1689 Glorious Revolution established the Bill of Rights and parliamentary supremacy, in as early as 1701 there was a crisis over whether parliament should flatly overrule popular will. At that time, the writer Daniel Defoe, representing "the people," delivered the so-called Legion Memorial directly to the Speaker of the Commons. It read: "Our name is Legion, for we are Many."20 Parliament backed down. The politics of the moment favor the government: Polling shows a stark divergence in popular opinion since the referendum in favor of the Tories (Chart I-29). This is a clear signal - on top of the referendum outcome and the sweeping Tory election win in 2015 - that the popular will favors leaving the European Union. It is also a clear signal that Prime Minister Theresa May has the mandate to do it her way. Her approval rating has waned a bit (Chart I-30), but she is still supported by nearly half the population. If the government fails to win parliamentary support on Brexit, it would likely lead to a vote of no confidence and early elections. Yet the current dynamics suggest an early election would return a Conservative majority with a clear mandate to vote for Brexit. Until those dynamics undergo a change, "Brexit means Brexit." Economics favor the government: One danger for the anti-Brexit coalition is that the Supreme Court may compel a parliamentary vote in the near future. The economy has not yet suffered much from Brexit, whatever it may do in future, so there is little motivation for widespread "Bregret," i.e. the desire to reverse course and stay in the EU. By contrast, in two years' time, the negative economic consequences and uncertainties of the actual exit plan, combined with ebbing popular enthusiasm, would likely give parliament a stronger position from which to soften or reverse Brexit. Although Article 50 is arguably irrevocable, it seems hard to believe that the EU would not find a way to allow the U.K. to stay in the union if its domestic politics shifted in favor of staying, since that is clearly in the EU's interest. The President of the European Council Donald Tusk has implied as much.21 Chart I-29Brexit Helped Tories, Hurt Labour Brexit Helped Tories, Hurt Labour Brexit Helped Tories, Hurt Labour Chart I-30Prime Minister May's Popularity Still Strong De-Globalization De-Globalization From the arguments above we can draw three conclusions. First, parliament will not simply repudiate the popular referendum. Second, if parliament must vote, the political context suggests it will vote on a bill that substantially favors the government's approach toward Brexit. If that happens, the High Court ruling this week will be only a pyrrhic victory for the Bremain camp. However, parliamentary involvement does imply a softer Brexit than otherwise, and it is possible that parliament could extract major concessions. Third, the High Court ruling makes Brexit more, not less, likely. This is because it is forcing parliamentarians to vote on Brexit so early in the process, when Brexit's negative consequences are yet not evident. What do the latest Brexit twists and turns portend for European and global growth? We do not see them as particularly damaging. The British turn toward greater fiscal spending adds yet another to the list of those countries supporting one of our key investment themes: "The Return of G," or government spending.22 As we predicted, Canada is overshooting its budget deficits, Japan is engaging in coordinated monetary and fiscal stimulus, and Italy is expanding spending and daring Germany and the European Council to stop it, especially in the face of badly needed earthquake reconstruction and the ongoing immigration crisis (Chart I-31). Chart I-31G7 Fiscal Thrust Is Going Up De-Globalization De-Globalization This leaves the United States and Germany as two outstanding questions. The U.S. election means that Trump will launch potentially large spending increases with a GOP-held Congress. As for Germany, the CDU/CSU appears to be shifting toward more government spending, but the direction will not be clear until the election in the fall of 2017. Bottom Line: The High Court ruling has made Brexit more rather than less likely. By forcing the parliament to make a ruling on Brexit before the economic damage is clear, the High Court has put parliamentarians in the difficult position of going against the public. We are closing our long FTSE 100 / short FTSE 250 Brexit hedge in the meantime. The market may, incorrectly, price a lower probability of Brexit, while domestic stimulus will aid the home-biased FTSE 250. Nonetheless, we remain short U.K. REITs to capitalize on the long-term uncertainty, as well as negative cyclical and structural factors that are affecting commercial real estate. We also expect the GBP/USD to remain relatively weak and vulnerable relative to the pre-Brexit period. We would expect the GBP/USD to retest its mid-October-low of 1.184 over the next two years. BOX I-1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Wolfgang Schäuble, Finance Minister (CDU): The bane of the financial community, Schäuble is seen as the least market-friendly option due to his hardline position on bailouts and the euro area. In our view, this is an incorrect interpretation of Schäuble's heavy-handedness. He is by all accounts a genuine Europhile who believes in the integrationist project. At 74 years old, he comes from a generation of policymakers who consider European integration a national security issue for Germany. He has pursued a tough negotiating position in order to ensure that the German population does not sour on European integration. Nonetheless, we doubt that he will chose to take on the chancellorship if Merkel retires. He suffered an assassination attempt in 1990 that left him paralyzed and he has occasionally had to be hospitalized due to health complications left from this injury. As such, it is unlikely that he would replace Merkel, but he may stay on as Finance Minister and thus be as close to a "Vice President" role as Germany has. Ursula von der Leyen, Defense Minister (CDU): Most often cited as the likely replacement for Merkel, Leyen nonetheless is not seen favorably by most of the population. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has gone so far as to say that the refugee crisis and the debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. While the markets and pro-EU elites in Europe would love Leyen, the problem is that her Europhile profile may disqualify her from chancellorship at a time when most CDU politicians are focusing on the Euroskeptic challenge from the right. Thomas De Maizière, Interior Minster (CDU): Maizière is a former Defense Minister and a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could be a compromise candidate between the Europhiles and Eurohawks within the CDU ranks. However, he has also been implicated in scandals as Defense Minister and may be tainted by the immigration crisis due to his position as the Interior Minister. Julia Klöckner, Executive Committee Member, Deputy Chair (CDU): A CDU politician from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel. While she has taken a more right-wing stance on the immigration crisis, she has remained loyal to Merkel otherwise. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist." We think that she would be a very pro-market choice as she combines the market-irrelevant populism of anti-immigration rhetoric with market-relevant centrism of favoring further European integration. Hermann Gröhe, Minister of Health (CDU): Gröhe is a former CDU secretary general and very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Grohe, although they may take some time to get to know who he is! Volker Bouffier, Minister President of Hesse (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier may be disqualified from leadership due to his apparent close links with Deutsche Bank. Nonetheless, he is a heavyweight within the CDU's leadership and a staunch Europhile. Fritz Von Zusammenbruch, Hardline Euroskeptic (CDU): This person does not exist! Section II: U.S. Election: Outcomes & Investment Implications Highlights Trump won by stealing votes from Democrats in the Midwest. His victory implies a national shift to the left on economic policy. Checks and balances on Trump are not substantial in the short term. U.S. political polarization will continue. Trump is good for the USD, bad for bonds, neutral for equities. Favor SMEs over MNCs. Close long alternative energy / short coal. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." — Newt Gingrich, January 2, 2001 Former Speaker of the House Newt Gingrich (and a potential Secretary of State pick), was asked on NBC's Meet the Press two days before the U.S. election whether he still thought that "competition for power in the U.S. remains largely a debate between people who can work together once the election is over." Gingrich made the original statement in January 2001, merely weeks after one of the most contentious presidential elections in U.S. history was resolved by the Supreme Court. Gingrich's answer in 2016? "I think, tragically, we have drifted into an environment where ... it will be a continuing fight for who controls the country." Despite an extraordinary victory - a revolution really - by Donald J. Trump, the fact of the matter remains that the U.S. is a polarized country between Republican and Democratic voters. As of publication time of this report, Trump lost the popular vote to Secretary Hillary Clinton. His is a narrower victory than either the epic Richard Nixon win in 1968 or George W. Bush squeaker in 2000. Over the next two years, the only thing that matters for the markets is that the U.S. has a unified government behind a Republican president-elect and a GOP-controlled Congress. We discuss the investment implications of this scenario below and caution clients to not over-despair. On the other hand, we also see this election as more evidence that America remains a deeply polarized country where identity politics continue to play a key role. What concerns us is that these identity politics appear to transcend the country's many cultural, ethical, political, and economic commonalities. Republicans and Democrats in the U.S. are fusing into almost ethnic-like groupings. To bring it back to Gingrich's quote at the top, that would suggest that the U.S. is no longer that much different from Bosnia or Northern Ireland.23 Election Post-Mortem Chart II-1Election Polls Usually##br## Miss By A Few Points De-Globalization De-Globalization Donald Trump has won an upset over Hillary Clinton, but his campaign was not as much of a long-shot as the consensus believed. U.S. presidential polls have frequently missed the final tally by +/- 3% of the vote, which was precisely the end result of the 2016 election (Chart II-1). Therefore, as we pointed out in our last missive on the election, Trump's victory was not a "wild mathematical oddity."24 Why Did Trump Win The White House? Where Trump really did beat expectations was in the Midwest, and Wisconsin in particular. He ended up outperforming the poll-of-polls by a near-incredible 10%!25 His victories in Florida, Ohio, and Pennsylvania were well within the range of expectations. For example, the last poll-of-polls had Trump leading in both Florida (by a narrow 0.2%) and Ohio (by a solid 3.5%), whereas Clinton was up in Pennsylvania by the slightest of margins (just 1.9% lead). He ended up exceeding poll expectations in all three (by 2% in Florida, 6% in Ohio, and 3% in Pennsylvania), but not by the same wild margin as in Wisconsin. When all is said and done, Trump won the 2016 election by stealing votes away from the Democrats in the traditionally "blue" Midwest states of Michigan, Pennsylvania, and Wisconsin. This was a far more significant result than his resounding victories in Ohio (which Obama won in 2012) or Florida (where Obama won only narrowly in 2012). Our colleague Peter Berezin, Chief Strategist of the Global Investment Strategy, correctly forecast that Trump would be competitive in all three Midwest states back in September 2015! We highly encourage our clients to read his "Trumponomics: What Investors Need To Know," as it is one of the best geopolitical calls made by BCA in recent history.26 As Peter had originally thought, Trump cleaned up the white, less-educated, male vote in all of the three crucial Midwest states. He won 68% of this vote in Michigan, 71% in Pennsylvania, and 69% in Wisconsin. To do so, Trump campaigned as an unorthodox Republican, appealing to the blue-collar white voter by blaming globalization for their job losses and low wages, and by refusing to accept Republican orthodoxy on fiscal austerity or entitlement spending. Instead, Trump promised to outspend Clinton and protect entitlements at their current levels. This mix of an outsider, anti-establishment, image combined with a left-of-center economic message allowed Trump to win an extraordinary number of former Obama voters. Exit polls showed that Obama had a positive image in all three Midwest states, including with Trump voters! For example, 30% of Trump voters in Michigan approved of the job Obama was doing as president, 25% in Pennsylvania, and 27% in Wisconsin. That's between a quarter and a third of eventual people who cast their vote for Trump. These are the voters that Republicans lost in 2012 because they nominated a former private equity "corporate raider" Mitt Romney as their candidate. Romney had famously argued in a 2008 New York Times op-ed that he would have "Let Detroit go bankrupt." Obama repeatedly attacked Romney during the 2011-2012 campaign on this point. Back in late 2011, we suspected that this message, and this message alone, would win President Obama his re-election.27 Why is the issue of the Midwest Obama voters so important? Because investors have to know precisely why Donald Trump won the election. It wasn't his messages on immigration, law and order, race relations, and especially not the tax cuts he added to his message late in the game. It was his left-of-center policy position on trade and fiscal spending. Trump is beholden to his voters on these policies, particularly in the Midwest states that won him the election. Final word on race. Donald Trump actually improved on Mitt Romney's performance with African-American and Hispanic voters (Table II-1). This was a surprise, given his often racially-charged rhetoric. Meanwhile, Trump failed to improve on the white voter turnout (as percent of overall electorate) or on Romney's performance with white voters in terms of the share of the vote. To be clear, Republicans are still in the proverbial hole with minority voters and are yet to match George Bush's performance in 2004. But with 70% of the U.S. electorate still white in 2016, this did not matter. Table II-1Exit Polls: Trump's Win Was Not Merely About Race De-Globalization De-Globalization Congress: No Gridlock Ahead Republicans exceeded their expectations in the Senate, losing only one seat (Illinois) to Democrats. This means that the GOP control of the Senate will remain quite comfortable and is likely to grow in the 2018 mid-term elections when the Democrats have to defend 25 of 33 seats. Of the 25 Senate seats they will defend, five are in hostile territory: North Dakota, West Virginia, Ohio, Montana, and Missouri. In addition, Florida is always a tough contest. Republicans, on the other hand, have only one Senate seat that will require defense in a Democrat-leaning state: Nevada (and in that case, it will be a Republican incumbent contesting the race). Their other seven seats are all in Republican voting states. As such, expect Republicans to hold on to the Senate well into the 2020 general election. In the House of Representatives, the GOP will retain its comfortable majority. The Tea Party affiliated caucuses (Tea Party Caucus and the House Freedom Caucus) performed well in the election. The Tea Party Caucus members won 35 seats out of 38 they contested and the House Freedom Caucus won 34 seats out of 37 it contested. The race to watch now is for the Speaker of the House position. Paul Ryan, the Speaker of the incumbent House, is likely to contest the election again and win. Even though his support for Donald Trump was lukewarm, we expect Republicans to unify the party behind Trump and Ryan. A challenge from the right could emerge, but we doubt it will materialize given Trump's victory. The campaign for the election will begin immediately, with Republicans selecting their candidate by December (the official election will be in the first week of January, but it is a formality as Republicans hold the majority). Bottom Line: Trump's victory was largely the product of former Obama voters in the Midwest switching to the GOP candidate. This happened because of Trump's unorthodox, left-of-center, message. Trump will have a friendly Congress to work with for the next four years. How friendly? That question will determine the investment significance of the Trump presidency. Investment Relevance Of A United Government Most clients we have spoken to over the past several months believe that Donald Trump will be constrained on economic policies by a right-leaning Congress. His more ambitious fiscal spending plans - such as the $550 billion infrastructure plan and $150 billion net defense spending plan - will therefore be either "dead on arrival" in Congress, or will be significantly watered down by the legislature. Focus will instead shift to tax cuts and traditional Republican policies. We could not disagree more. GOP is not fiscally conservative: There is no empirical evidence that the GOP is actually fiscally conservative. First, the track record of the Bush and Reagan administrations do not support the adage that Republicans keep fiscal spending in check when they are in power (Chart II-2). Second, Republican voters themselves only want "small government" when the Democrats are in charge of the White House (Chart II-3). When a Republican President is in charge, Republicans forget their "small government" leanings. Chart II-2Republicans Are##br## Not Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Chart II-3Big Government Is Only ##br##A Problem For Opposition bca.gps_mp_2016_11_09_s2_c3 bca.gps_mp_2016_11_09_s2_c3 Presidents get their way: Over the past 28 years, each new president has generally succeeded in passing their signature items. Congress can block some but probably not all of president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed in their second term. Clinton lost on healthcare, but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). Median voter has moved to the left: Donald Trump won both the GOP primary and the general election by preaching an unorthodox, left-of-center sermon. He understood correctly that the American voter preferences on economic policies have moved away from Republican laissez-faire orthodoxies.28 Yes, he is also calling for significant lowering of both income and corporate tax rates. However, tax cuts were never a focal point of his campaign, and he only introduced the policy later in the race when he was trying to get traditional Republicans on board with his campaign. Newsflash: traditional Republicans did not get Trump over the hump, Obama voters in the Midwest did! Investors should make no mistake, the key pillars of Trump's campaign are de-globalization, higher fiscal spending, and protecting entitlements at current levels. And he will pursue all three with GOP allies in Congress. What are the investment implications of this policy mix? USD: More government spending, marginally less global trade, and pressure on multi-national corporations (MNCs) to scale back their global operations should be positive for inflation. If growth surprises to the upside due to fiscal spending, it will allow the Fed to hike more than the current 57 bps expected by the market by the end of 2018. Given easy monetary stance of central banks around the world, and lack of significant fiscal stimulus elsewhere, economic growth surprise in the U.S. should be positive for the dollar in the long term. At the moment, the market is reacting to the Trump victory with ambivalence on the USD. In fact, the dollar suffered as Trump's probability of victory rose in late October. We believe that this is a temporary reaction. We see both Trump's fiscal and trade policies as bullish. BCA's currency strategist Mathieu Savary believes that the dollar could therefore move in a bifurcated fashion in the near term. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer - or remain flat - against DM currencies such as the EUR, CHF, and JPY.29 Bonds: More inflation and growth should also mean that the bond selloff continues. In addition, if our view on globalization is correct, then the deflationary effects of the last three decades should begin to reverse over the next several years. BCA thesis that we are at the "End Of The 35-Year Bond Bull Market" should therefore remain cogent.30 As one of our "Trump hedges," our colleague Rob Robis, Chief Strategist of the BCA Global Fixed Income Strategy, suggested a 2-year / 30-year Treasury curve steepener. This hedge is now up 18.7 bps and we suggest clients continue to hold it. Fed policy: Trump's statements about monetary policy have been inconsistent. Early on in his campaign he described himself as "a low interest rate guy", but he has more recently become critical of current Federal Reserve policy - and Fed Chair Janet Yellen in particular - claiming that while higher interest rates are justified, the Fed is keeping them low for "political reasons." What seems certain is that Janet Yellen will be replaced as Fed Chair when her term expires in February 2018. Yellen is unlikely to resign of her own volition before then and it would be legally difficult for the President to remove a sitting Fed Chair prior to the end of her term. But Trump will get the opportunity to re-shape the composition of the Fed's Board of Governors as soon as he is sworn in. There are currently two empty seats on the Board need to be filled and given that many of Trump's economic advisers have "hard money" leanings, it is very likely that both appointments will go to inflation hawks. Equities: In terms of equities, Trump will be a source of uncertainty for U.S. stocks as the market deals with the unknown of his presidency. In addition, markets tend to not like united government in the U.S. as it raises the specter of big policy moves (Table II-2). However, Trump should be positive for sectors that sold off in anticipation of a Clinton victory, such as healthcare and financials. We also suspect that he will continue the outperformance of defense stocks, although that would have been the case with Clinton as well. Table II-2Election: Industry Implications De-Globalization De-Globalization In the long term, Trump's proposal for major corporate tax cuts should be good for U.S. equities. However, we are not entirely sure that this is the case. First, the effective corporate tax rate in the U.S. is already at its multi-decade lows (Chart II-4). As such, any corporate tax reform that lowers the marginal rate will not really affect the effective rate. Why does this matter? Because major corporations already have low effective tax rates. Any lowering of the marginal rate will therefore benefit the small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then Trump's policy will not necessarily benefit all firms in the U.S. equally. Chart II-4How Low Can It Go? bca.gps_mp_2016_11_09_s2_c4 bca.gps_mp_2016_11_09_s2_c4 Investors have to keep in mind that Trump has not run a pro-corporate campaign. He has accused American manufacturing firms of taking jobs outside the U.S. and tech companies of skirting taxes. It is not clear to us that his corporate tax reform will therefore necessarily be a boon for the stock market. In the long term, we like to play Trump's populist message by favoring America's SMEs over MNCs. If we are ultimately correct on the USD and growth, then export-oriented S&P 500 companies should suffer in the face of a USD bull market and marginally less globalization. Meanwhile, lowering of the marginal corporate tax rate will benefit the SMEs that do not get the benefit of K-street lobbyist negotiated tax loopholes. Global Assets: The global asset to watch over the next several weeks is the USD/RMB cross. China is forced by domestic economic conditions to continue to slowly depreciate its currency. We have expected this since 2015, which is why we have shorted the RMB via 12-month non-deliverable forwards (NDF). Risk to global assets, particularly EM currencies and equities, would be that Beijing decides to depreciate the RMB before Trump is inaugurated on January 20. This could re-visit the late 2015 panic over China, particularly the narrative that it is exporting deflation. Our view is that even if China does not undertake such actions over the next two months, Sino-American tensions are set to escalate. It is much easier for Trump to fulfill his de-globalization policies with China - a geopolitical rival with which the U.S. has no free trade agreement - than with NAFTA trade partners Canada and Mexico. This will only deepen geopolitical tensions between the two major global powers, which has been our secular view since 2011. Finally, a quick note on the Mexican peso. The Mexican peso has already collapsed half of its value in the past 18 months and we believe the trade is overdone. Investors have used the currency cross as a way to articulate Trump's victory probability. It is no longer cogent. We believe that the U.S. will focus on trade relations with China under a Trump presidency, rather than NAFTA trade partners. Our Emerging Markets Strategy believes that it is time to consider going long MXN versus other EM currencies, such as ZAR and BRL. Investors should also watch carefully the Cabinet appointments that Trump makes over the next two months. Since Carter's administration, cabinet announcements have occurred in early to mid-December. Almost all of these appointments were confirmed on Inauguration Day (usually January 20 of the year after election, including in 2017) or shortly thereafter. Only one major nomination since Carter was disapproved. These appointments will tell us how willing Trump is to reach to traditional Republicans who have served on previous administrations. We suspect that he will go with picks that will execute his fiscal, trade, and tax policies. Bottom Line: After the dust settles over the next several weeks, we suspect that Trump will signal that he intends to pursue his fiscal, trade, immigration, and tax policies. These will be, in the long term, positive for the USD, negative for bonds (including Munis, which will lose their tax-break appeal if income taxes are reduced), and likely neutral for equities. Within the equity space, Trump will be positive for U.S. SMEs and negative for MNCs. This means being long S&P 600 over S&P 100. Lastly, close our long alternative energy / short coal trade for a loss of -26.8%. Constraints: Don't Bet On Them Domestically, the American president can take significant action without congressional support through executive directives. Lincoln raised an army and navy by proclamation and freed the slaves; Franklin Roosevelt interned the Japanese; Truman tried to seize steel factories to keep production up during the Korean War. Truman's case is almost the only one of a major executive order being rebuffed by the Supreme Court. The Reagan and Clinton administrations have shown that a president thwarted by a divided or adverse congress will often use executive directives to achieve policy aims and satisfy particular interest groups and sectors. Though the number of executive orders has gone down in recent administrations (Chart II-5), the economic significance has increased along with the size and penetration of the bureaucracy (Chart II-6). The economic impact of executive orders is always debatable, but the key point is that the president's word tends to carry the day.31 Chart II-5Rule By Decree De-Globalization De-Globalization Chart II-6Executive Branch Is Growing De-Globalization De-Globalization Trade is a major area where Trump would have considerable sway. He has repeatedly signaled his intention to restrict American openness to international trade. The U.S. president can revoke international treaties solely on their own authority. Congressionally approved agreements like the North American Free Trade Agreement (NAFTA) cannot be revoked by the president, but Trump could obstruct its ongoing implementation.32 He would also have considerable powers to levy tariffs, as Nixon showed with his 10% "surcharge" on most imports in 1971.33 Bottom Line: Presidential authority is formidable in the areas Trump has made the focus of his campaign: immigration and trade. Without a two-thirds majority in Congress to override him, or an activist federal court, Trump would be able to enact significant policies simply by issuing orders to his subordinates in the executive branch. Long-Term Implications: Polarization In The U.S. Does the Republican control of Congress and the White House signal that polarization in America will subside? We began this analysis by focusing on the investment implications when Republicans control the three houses of the American government. But long-term implications of polarization will not dissipate. Investors may overstate the importance of a Republican-controlled government and thus understate the relevance of continued polarization. We doubt that Donald Trump is a uniting figure who can transcend America's polarized politics, especially given his weak popular mandate (he lost the popular vote as Bush did in 2000) and the sub-50% vote share. And, our favorite chart of the year remains the same: both Donald Trump and Hillary Clinton have entered the history books as the most disliked presidential candidates ever on the day of the election (Chart II-7). Chart II-7Clinton And Trump Are Making (The Wrong Kind Of) History De-Globalization De-Globalization According to empirical work by political scientists Keith Poole and Howard Rosenthal, polarization in Congress is at its highest level since World War II (Chart II-8). Their research shows that the liberal-conservative dimension explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension.34 Chart II-8The Widening Ideological Gulf In The U.S. Congress De-Globalization De-Globalization Meanwhile, a 2014 Pew Research study has shown that Republicans and Democrats are moving further to the right and left, respectively. Chart II-9 shows the distribution of Republicans and Democrats on a 10-item scale of political values across the last three decades. In addition, "very unfavorable" views of the opposing party have skyrocketed since 2004 (Chart II-10), with 45% of Republicans and 41% of Democrats now seeing the other party as a "threat to the nation's well-being"! Chart II-9U.S. Political Polarization: Growing Apart De-Globalization De-Globalization Chart II-10Live And Let Die De-Globalization De-Globalization Much ink has been spilled trying to explain the mounting polarization in America.35 Our view remains that politics in a democracy operates on its own supply-demand dynamic. If there was no demand for polarized politics, especially at the congressional level, American politicians would not be so eager to supply it. We believe that five main factors - in our subjective order of importance - explain polarization in the U.S. today: Income Inequality and Immobility The increase in political polarization parallels rising income inequality in the U.S. (Chart II-11). The U.S. is a clear and distant outlier on both factors compared to its OECD peers (Chart II-12). However, Americans are not being divided neatly along income levels. This is because Republicans and Democrats disagree on how to fix income inequality. For Donald Trump voters, the solutions are to put up barriers to free trade and immigration while reducing income taxes for all income levels. For Hillary Clinton voters, it means more taxes on the wealthy and large corporations, while putting up some trade barriers and expanding entitlements. This means that the correlation between polarization and income inequality is misleading as there is no causality. Rather, rising income inequality, especially when combined with a low-growth environment, shifts the political narrative from the "politics of plenty" towards "politics of scarcity." It hardens interest and identity groups and makes them less generous towards the "other." Chart II-11Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization Chart II-12Opportunity And Income: Americans Are Outliers De-Globalization De-Globalization Generational Warfare The political age gap is increasing (Chart II-13). This remains the case following the 2016 election, with 55% Millennials (18-29 year olds) having voted for Hillary Clinton. The problem for older voters, who tend to identify far more with the Republican Party, is that the Millennials are already the largest voting bloc in America (Chart II-14). And as Millennial voters start increasing their turnout, and as Baby Boomers naturally decline, the urgency to vote for Republican policymakers' increases. Chart II-13The Age Gap In American Politics The Age Gap In American Politics The Age Gap In American Politics Chart II-14Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Geographical Segregation Noted political scientist Robert Putnam first cautioned that increasing geographic segregation into clusters of like-minded communities was leading to rising polarization.36 This explains, in large part, how liberal elites have completely missed the rise of Donald Trump. Left-leaning Americans tend to live in a left-leaning community. They share their morning cup-of-Joe with Liberals and rarely mix with the plebs supporting Trump. And of course vice-versa. University of Toronto professors Richard Florida and Charlotta Mellander have more recently shown in their "Segregated City" research that "America's cities and metropolitan areas have cleaved into clusters of wealth, college education, and highly-paid knowledge-based occupations."37 Their research shows that American neighborhoods are increasingly made up of people of the same income level, across all metropolitan areas. Florida and Mellander also show that educational and occupational segregation follows economic segregation. Meanwhile, the same research shows that Canada's most segregated metropolitan area, Montreal, would be the 227th most segregated city if it were in the U.S.! This form of geographic social distance fosters increasing polarization by allowing voters to remain aloof of their fellow Americans, their plight, needs, and concerns. The extreme urban-rural divide of the 2016 election confirms this thesis. Immigration Much as with income inequality, there is a close correlation between political polarization and immigration. The U.S. is on its way to becoming a minority-majority country, with the percent of the white population expected to dip below 50% in 2045 (Chart II-15). Hispanic and Asian populations are expected to continue rising for the rest of the century. For many Americans facing the pernicious effects of low-growth, high debt, and elevated income inequality, the rising impact of immigration is anathema. Not only is the country changing its ethnic and cultural make-up, but the incoming immigrants tend to be less educated and thus lower-income than the median American. They therefore favor - or will favor, when they can vote - redistributive policies. Many Americans feel - fairly or unfairly - that the costs of these policies will have to be shouldered by white middle-class taxpayers, who are not wealthy enough to be indifferent to tax increases, and may be unskillful enough to face competition from immigrants. There is also a security component to the rising concern about immigration. Although Muslims are only 1% of the U.S. population, many voters perceive radical Islam to be a vital security threat to the nation. As such, immigration and radical Islamic terrorism are seen as close bedfellows. Media Polarization The 2016 election has been particularly devastating for mainstream media. According to the latest Gallup poll, only 32% of Americans trust the mass media "to report the news fully, accurately and fairly." This is the lowest level in Gallup polling history. The decline is particularly concentrated among Independent and Republican respondents (Chart II-16). With mainstream media falling out of favor for many Americans, voters are turning towards social media and the Internet. Facebook is now as important for political news coverage as local TV for Americans who get their news from the Internet (Chart II-17). Chart II-15Racial Composition Is Changing De-Globalization De-Globalization Chart II-16A War Of Words bca.gps_mp_2016_11_09_s2_c16 bca.gps_mp_2016_11_09_s2_c16 Chart II-17New Sources Of News Not Always Credible De-Globalization De-Globalization The problem with getting your news coverage from Facebook is that it often means getting news coverage from "fake" sources. A recent experiment by BuzzFeed showed that three big right-wing Facebook pages published false or misleading information 38% of the time while three large left-wing pages did so in nearly 20% of posts.38 The Internet allows voters to self-select what ideological lens colors their daily intake of information and it transcends geography. Two American families, living next to each other in the same neighborhood, can literally perceive reality from completely different perspectives by customizing their sources of information. Chart II-18Gerrymandering Reduces Competitive Seats bca.gps_mp_2016_11_09_s2_c18 bca.gps_mp_2016_11_09_s2_c18 In addition to these five factors, one should also reaffirm the role of redistricting, or "gerrymandering." Over the last two decades, both the Democrats and Republicans (but mainly the latter) have redrawn geographical boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart II-18). This improves job security for incumbent politicians and legislative-seat security for the party; but it also discourages legislators from reaching across the ideological aisle in order to ensure re-election. Instead, the main electoral challenge now comes from the member's own party during the primary election. For Republicans, this means that the challenge is most often coming from a candidate that is further to the right. Incumbent GOP politicians in Congress therefore have an incentive to maintain highly conservative records lest a challenge from the far-right emerges in a primary election. Given that the frequency of elections is high in the House of Representatives (every two years), legislators cannot take even a short break from partisanship. Redistricting deepens polarization, therefore, by changing the political calculus for legislators facing ideologically pure electorates in their home districts. Bottom Line: Polarization in the U.S. is a product of structural factors that are here to stay. Trump's narrow victory will in no way change that. But How Much Worse? Chart II-19Party Is The Chief Source Of Identity De-Globalization De-Globalization Political polarization is not new. Older readers will remember 1968, when social unrest over the Vietnam War was at its height. Richard Nixon barely got over the finish line that year, beating Vice-President Hubert Humphrey by around 500,000 votes.39 Another contested election in a contested era. Our concern is that the Republican and Democrat "labels" - or perhaps conservative and liberal labels - appear to be ossifying. For example, Pew Research showed in 2012 that the difference between Americans on 48 values is the greatest between Republicans and Democrats. This has not always been the case, as Chart II-19 shows. We suspect that the data would be even starker today, especially after the divisive 2016 campaign that has bordered on hysterical. This means that "Republican" and "Democrat" labels have become real and almost "sectarian" in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Why is this happening? We suspect that the shift in urgency and tone is motivated at least in part by the changing demographics of America. Two demographic groups that identify the most with the Republican Party - Baby Boomers and rural or suburban white voters - are in a structural decline (the first in absolute terms and the second in relative terms). Both see the writing on the political wall. Given America's democratic system of government, their declining numbers (or, in the case of suburban whites, declining majorities) will mean significant future policy decisions that go against their preferences. America is set to become more left-leaning, favor more redistribution, and become less culturally homogenous. Not only are Millennials more socially liberal and economically left-leaning, but they are also "browner" than the rest of the U.S. As we pointed out early this year, 2016 was an election that the GOP could reasonably attempt to win by appealing exclusively to white and older voters. The "White Hype" strategy was mathematically cogent ... at least in 2016.40 It will get a lot more difficult to pursue this strategy in 2020 and beyond. Not impossible, but difficult. We suspect that conservative voters know this. As such, there was an urgency this year to lock-in structural changes to key policies before it is too late. Donald Trump may have been a flawed messenger for many voters, but it did not matter. The clock is ticking for a large segment of America and therefore Trump was an acceptable vehicle of their fears and anger. Bottom Line: Polarization in the U.S. is likely to increase. Two key Republican/conservative constituencies - Baby Boomers and rural or suburban white voters - are backed into the corner by demographic trends. But it also means that a left counter-revolution is just around the corner. And we doubt that the Democratic Party will chose as centrist of a candidate the next time around. Final Thoughts: What Have We Learned 1. Economics trump PC: Civil rights remain a major category of the American public's policy concerns. However, the Democratic Party's prioritization of social issues on the margins of the civil rights debate has not galvanized voters in the face of persistent negative attitudes about the economy. More specifically, the surge in cheap credit since 2000 that covered up the steady decline of wages as a share of GDP has ended, leaving households exposed to deleveraging and reduced purchasing power (Chart II-20). American households have lost patience with the slow, grinding pace of economic recovery, they reject the debt consequences of low inflation with deflationary tail risks, and they resent disappointed expectations in terms of job security and quality. Concerns about certain social preferences - as opposed to basic rights - pale in comparison to these economic grievances. Chart II-20Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income 2. Polls are OK, but beware the quant models that use them: On two grave political decisions this year, in two advanced markets with the "best" quality of polling, political modeling turned out to be grossly erroneous. To be fair, the polls themselves prior to both Brexit and the U.S. election were within a margin of error. However, quantitative models relying on these polls were overconfident, leading investors to ignore the risks of a non-consensus outcome. As we warned in mid-October - with Clinton ahead with a robust lead - the problem with quantitative political models is that they rely on polling data for their input.41 To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." But combining polls is mathematically the same as combining bad mortgages into securities. The philosophy behind the methodology is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening. Well, something bad did happen. The quantitative models were massively wrong! We tried to avoid this problem by heavily modifying our polls-based-model with structural factors. Many of these structural variables - economic context, political momentum, Obama's approval rating - actually did not favor Clinton. Our model therefore consistently gave Donald Trump between 35-45% probability of winning the election, on average three and four times higher than other popular quant models. This caused us to warn clients that our view on the election was extremely cautious and recommend hedges. In fact, Donald Trump had 41% chance of winning the race on election night, according to the last iteration of our model, a very high probability.42 3. Professor Lichtman was right: Political science professor Allan Lichtman has once again accurately called the election - for the ninth time. The result on Nov. 8 strongly supports his life's work that presidential elections in the United States are popular referendums on the incumbent party of the last four years. Structural factors undid the Democrats (Table II-3), and none of the campaign rhetoric, cross-country barnstorming, or "horse race" polling mattered a whit. The Republicans had momentum from previous midterm elections, Clinton had suffered a strong challenge in her primary, the Obama administration's achievements over the past four years were negligible (the Affordable Care Act passed in his first term). These factors, along with the political cycle itself, favored the Republicans. Trump's lack of charisma did not negate the structural support for a change of ruling party. Investors should take note: no amount of mathematical horsepower, big data, or Silicon Valley acumen was able to beat the qualitative, informed, contemplative work of a single historian. Table II-3Lichtman's Thirteen Keys To The White House* De-Globalization De-Globalization 4. Non-linearity of politics: Lichtman's method calls attention to the danger of linear assumptions and quantitative modeling in attempting the art of political prediction. Big data and quantitative econometric and polling models have notched up key failures this year. They cannot make subjective judgments regarding whether a president has had a major foreign policy success or failure or a major policy innovation - on all three of those counts, the Democrats failed from 2012-16. There really is no way to quantify political risk because human and social organizations often experience paradigm shifts that are characterized by non-linearity. Newtonian Laws will always work on planet earth and as such we are not concerned about what will happen to us if we board an airplane. Laws of physics will not simply stop working while we are mid-air. However, social interactions and political narratives do experience paradigm shifts. We have identified several since 2011: geopolitical multipolarity, de-globalization, end of laissez-faire consensus, end of Chimerica, and global loss of confidence in elites and institutions.43 5. No country is immune to decaying institutions: The United States has, with few exceptions, the oldest written constitution among major states, and it ensures checks and balances. But recent decades have shown that the executive branch has expanded its power at the expense of the legislative and judicial branches. Moreover, executives have responded to major crisis - like the September 11 attacks and the 2008 financial crisis - with policy responses that were formulated haphazardly, ideologically divisive, and difficult to implement: the Iraq War and the Affordable Care Act. The result is that the jarring events that have blindsided America over the past sixteen years have resulted in wasted political capital and deeper polarization. The failure of institutions has opened the way for political parties to pursue short-term gains at the expense of their "partners" across the aisle, and to bend and manipulate procedural rules to achieve ends that cannot be achieved through consensus and compromise. 6. U.S. is shifting leftward when it comes to markets: Inequality and social immobility have, with Trump's election, entered the conservative agenda, after having long sat on the liberals' list of concerns. The shift in white blue-collar Midwestern voters toward Trump reflects the fact that voters are non-partisan in demanding what they want: they want to retain their existing rights, privileges, and entitlements, and to expand their wages and social protections. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 5 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 6 Please see BCA Global Alpha Sector Strategy Special Report, "Brothers In Arms," dated October 28, 2016, available at gss.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refuges, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 10 The BBC is exemplary of the mainstream Western press on this point. Please see Stephen McDonell, "The Ever-Growing Power Of China's Xi Jinping," BBC News, China Blog, dated October 29, 2016, available at www.bbc.com. 11 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Special Report, "China: Two Factions, One Party - Part II," dated September 12, 2012, available at gps.bcaresearch.com. 13 Please see the "Eighteenth Communist Party Of China Central Committee Sixth Plenary Session Communique," dated October 27, 2016, available at cpc.people.com.cn. 14 Jiang Zemin, China's ruler from roughly 1993 to 2002, was also referred to as the "core" leader, but he received this moniker from Deng Xiaoping. Xi is following in Deng's footsteps by declaring himself to be the core and winning support from the party. As for his centralizing efforts, prior to being named the "core leader," Xi had already waged a sweeping crackdown on political opponents and dissidents. He had used his position as head of the party, the state bureaucracy, and the armed forces to reshuffle personnel in these bodies extensively. He had already created new organizational bodies, including the National Security Commission, and initiated plans to restructure the military to emphasize joint-operations under regional battle commands. A weak leader would not have advanced so quickly. 15 Deng named Mao the "core" of the first generation of leaders, but it was evident that he sought a different leadership model. 16 Specifically, Xi could prevent the preferment of successors for 2022, he could reduce the size of the Politburo Standing Committee further to five members, or he could modify or make exceptions to the informal rule that top officials must not be promoted if they are 68 or older. Please see Minxin Pei, "A Looming Power Struggle For China?" dated October 28, 2016, available at www.cfr.org. 17 Please see "Communique of the Third Plenary Session of the 18th Central Committee of the Communist Party of China," dated January 15, 2014 [adopted November 12, 2013], available at www.china.org.cn. 18 Please see "China: The Socialist Put And Rising Government Leverage," in BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Brexit Update: Does Brexit Really Mean Brexit?" dated July 15, 2016, available at gps.bcaresearch.com. For the High Court ruling, please see the U.K. Courts and Tribunals Judiciary, "R (Miller) -V- Secretary of State for Exiting the European Union," dated November 3, 2016, available at www.judiciary.gov.uk. 20 At that time a Tory majority in the House of Commons had enraged the populace by imprisoning a group of petitioners from Kent. Both the Kentish Petition and the Legion Memorial demanded that parliament heed the will of the populace. 21 Presumably, the European Council could vote unanimously under Article 50 to extend the negotiation period for a very long time. 22 Please see BCA Geopolitical Strategy Monthly Report, "Nuthin' But A G Thang," dated August 12, 2015, available at gps.bcaresearch.com. 23 Except that it is better armed. 24 Please see BCA Geopolitical Strategy Client Note, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com. 25 However, Wisconsin polling was rather poor as most pollsters assumed that it was a shoe-in for Democrats. One problem with polling in Midwest states is that they were, other than Pennsylvania and Ohio, assumed to be safe Democratic states. Note for example the extremely tight result in Minnesota and the absolute dearth of polling out of that state throughout the last several months. 26 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Special Report, "U.S. General Elections And Scenarios: Implications," dated July 11, 2012, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 29 Please see BCA Foreign Exchange Strategy Weekly Report, "When You Come To A Fork In The Road, Take It," dated November 4, 2016, available at fes.bcaresearch.com. 30 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gps.bcaresearch.com. 31 Only a two-thirds majority of Congress, or a ruling by a federal court, can undo an executive action, and that is exceedingly rare. The real check on executive orders is the rotation of office: a president can undo with the stroke of a pen whatever his predecessor enacted. Congress has the power of the purse, but it is sporadic in its oversight and has challenged less than 5% of executive orders, even though those orders often re-direct the way the executive branch uses funds Congress has allocated. More often, Congress votes to codify executive orders rather than nullify them. 32 Trump is not alone in calling for renegotiating or even abandoning NAFTA. Clinton called for renegotiation in 2008, and Senator Bernie Sanders has done so in 2016. 33 In Proclamation 4074, dated August 15, 1971, Nixon suspended all previous presidential proclamations implementing trade agreements insofar as was required to impose a new 10% surcharge on all dutiable goods entering the United States. He justified it in domestic law by invoking the president's authority and previous congressional acts authorizing the president to act on behalf of Congress with regard to trade agreement negotiation and implementation (including tariff levels). He justified the proclamation in international law by referring to international allowances during balance-of-payments emergencies. 34 The "primary dimension" of Chart II-8 is represented by the x-axis and is the liberal-conservative spectrum on the basic role of the government in the economy. The "second dimension" (y-axis) depends on the era and is picking up regional differences on a number of social issues such as the civil rights movement (which famously split Democrats between northern Liberals and southern Dixiecrats). 35 We have penned two such efforts ourselves. Please see BCA Geopolitical Strategy Special Report, "Polarization In America: Transient Or Structural Risk?," dated October 9, 2013, and "A House Divided Cannot Stand: America's Polarization," dated July 11, 2012," available at gps.bcaresearch.com. 36 Putnam, Robert. 2000. Bowling Alone. New York: Simon and Schuster. 37 Please see Martin Prosperity Institute, "Segregated City," dated February 23, 2015, available at martinprosperity.org. 38 Please see BuzzFeedNews, "Hyperpartisan Facebook Pages Are Publishing False And Misleading Information At An Alarming Rate," dated October 20, 2016, available at buzzfeed.com. 39 Nonetheless, due to the third-party candidate George Wallace carrying the then traditionally-Democratic South, Nixon managed to win the Electoral College in a landslide. 40 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 41 Please see BCA Geopolitical Strategy Special Report, "You've Been Trumped!," dated October 21, 2016, available at gps.bcaresearch.com. 42 For comparison, Steph Curry, the greatest three-point shooter in basketball history, and a two-time NBA MVP, has a career three-point shooting average of 44%. With that average, he is encouraged to take every three-pointer he can by his team. In other words, despite being less than 50%, this is a very high percentage. 43 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, and "Strategy Outlook 2016 - Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. Section III: Geopolitical Calendar

Highlights Most narratives surrounding G7 bond yields, the U.S. dollar, Chinese credit/fiscal impulses, and the RMB exchange rate - which justified the EM rally from February's lows - have been overturned. To be consistent, this warrants a relapse in EM risk assets. In China, recent property market and marginal credit policy tightening will weigh on growth. Feature The more recent strength in Chinese and emerging markets' (EM) manufacturing PMI indexes as well as the bounce in industrial metals prices have gone against our negative view on EM/China growth and related markets. While it is hard to predict market patterns over the next several weeks, we maintain that the EM rally is on borrowed time, and that the risk-reward profile for EM risk assets (stocks, credit markets and currencies) remains very unfavorable. Tracking Correlations And Indicators The overwhelming majority of indicators and variables that supported the rally in EM since February have reversed in recent months. Specifically: China's credit and fiscal spending impulses have rolled over (Charts I-1 and Chart I-2, on page 1). This will likely lead to a rollover in mainland industrial activity early next year (Chart 1, top panel). Similarly, this bodes ill for much-followed Chinese ex-factory producer prices - i.e., producer price deflation will probably recommence early next year (Chart I-1, bottom panel). Chart I-1China: Industrial Sectors To Retreat? bca.ems_wr_2016_11_09_s1_c1 bca.ems_wr_2016_11_09_s1_c1 Chart I-2China: Credit And Fiscal Impulses China: Credit And Fiscal Impulses China: Credit And Fiscal Impulses In a nutshell, the strong credit and fiscal impulses of late 2015 and early 2016 explain the stabilization and mild improvement in the Chinese economy during the past few months. However, these same impulses project renewed weakness/rollover in the economy in early 2017. If financial markets are forward looking, they should begin pricing-in deteriorating growth momentum sooner than later - especially as Chinese policymakers are announcing marginal tightening policies (see below for more details). One of the narratives that triggered the EM and global equity rally in February was speculation that there was a "Shanghai accord" between global central banks. According to this narrative, the People's Bank of China (PBoC) promised not to devalue the RMB in exchange for the Federal Reserve not hiking rates. Since then, the RMB has continued to depreciate, both versus the greenback and the CFETS1 basket. Yet EM and global stocks have completely disregarded the RMB depreciation (Chart I-3). We do not have good explanation as to why. Indeed, the RMB has weakened meaningfully, despite the PBoC's massive currency defense: the latter's foreign exchange reserves have shrunk further since then (Chart I-4), as capital flight has exceeded the enormous current account surplus by a large margin. Chart I-3Investors Are ##br##Complacent About RMB bca.ems_wr_2016_11_09_s1_c3 bca.ems_wr_2016_11_09_s1_c3 Chart I-4China: Foreign Exchange ##br##Reserves Still Shrinking bca.ems_wr_2016_11_09_s1_c4 bca.ems_wr_2016_11_09_s1_c4 Chart I-5PBoC Liquidity Injections ##br##Have Been Enormous bca.ems_wr_2016_11_09_s1_c5 bca.ems_wr_2016_11_09_s1_c5 The PBoC's selling of U.S. dollars to prop up the yuan has drained domestic currency liquidity and one would expect interbank rates to rise. However, the PBoC has been re-injecting RMBs into the system to keep interest rates low (Chart I-5). Such RMB liquidity proliferation makes further declines in the currency's value all the more likely. We expect the RMB to continue depreciating. Yet global financial markets have become extremely complacent about the potential for additional RMB depreciation. After having been bullish on U.S./G7 bonds for the past several years, in our July 13 Weekly Report,2 we highlighted that U.S./G7 bond yields would rise and closed our strategic short EM equities/long 30-year U.S. Treasurys position. Even though U.S./G7 bond yields have risen since July, EM equities have not declined. Given that falling G7 bond yields were used as justification for the EM rally, the opposite should also hold true. We expect U.S. bond yields to rise further. Our EM Corporate Health Monitor - constructed using bottom-up financial variables of companies with outstanding U.S. dollar corporate bonds - points to a reversal in the EM corporate credit market rally (Chart I-6). Furthermore, EM sovereign and corporate credit spreads have tightened considerably and are now very overbought and expensive. As we argued in our Special Report titled EM Corporate Health Is Flashing Red3 that introduced the EM Corporate Financial Health (CFH) Monitor, EM corporate credit spreads are as expensive as they were before they began widening in 2013 and 2014 (Chart I-7). Chart I-6EM Corporate Bond Rally To Reverse? EM Corporate Bond Rally To Reverse? EM Corporate Bond Rally To Reverse? Chart I-7EM Corporate Spreads Are Too Tight EM Corporate Spreads Are Too Tight EM Corporate Spreads Are Too Tight Finally, the U.S. dollar sold off early this year, but it has held firm in recent months. Nevertheless, EM risk assets have not retreated, despite the greenback's strength (Chart I-8). Few would argue that sharp U.S. dollar appreciation is negative for EM risk assets, but there is a debate among investors and analysts about whether EM risk assets can rally amidst a gradual appreciation in the U.S. dollar. Turning to the empirical evidence, Chart I-9 reveals that in the past 30 years any U.S. dollar appreciation - whether gradual or not - even versus DM currencies has coincided with weakness in EM share prices. Chart I-8EM Investors Have ##br##Ignored U.S. Dollar Strength bca.ems_wr_2016_11_09_s1_c8 bca.ems_wr_2016_11_09_s1_c8 Chart I-9EM Equities And ##br##U.S. Dollar: A 30 Year History EM Equities And U.S. Dollar: A 30 Year History EM Equities And U.S. Dollar: A 30 Year History Bottom Line: The majority of narratives that justified the EM rally from February's lows have been overturned. To be consistent, this warrants a relapse in EM risk assets. China's Credit And Property Tightening In recent weeks, there have been numerous policy tightening efforts in China. In particular: At the annual World Bank/IMF meetings in Washington last month, PBoC Governor Zhou Xiaochuan stated that once markets stabilized there would no longer be additional large increases in bank credit. His exact words were: "With the gradual recovery of the global economy, China will control its credit growth".4 As U.S. and European PMIs have firmed up and U.S. employment and wage growth is robust, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not to repeat the massive fiscal push of early this year. In a bid to curb excessive bank credit growth and discourage "window dressing" accounting, the PBoC announced on October 255 that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Marco Prudential Assessment ratios, starting from the third quarter. The clampdown on WMP accounting will reduce banks' capital adequacy ratios (CARs). One key reason that banks had aggressively boosted the size of their off-balance-sheet WMP assets was that they were not required to have capital charges against them, helping banks extend more credit while complying with CARs. In short, Chinese banks' CARs are inflated. This policy measure along with provisioning and writing-off non-performing loans, if reinforced, could meaningfully reduce the CARs of all Chinese banks, especially small- and medium-sized ones, as well as force them to reduce the pace of credit expansion. Given that the majority of medium and small banks have been more aggressive than the country's five biggest banks in expanding credit in recent years, this may have a damping effect on credit growth in 2017. In fact, the 110 medium and small banks retain 60% of on- and off-balance-sheet credit claims on companies, while the five largest banks hold 40% (Table I-1). Hence, credit trends in small and medium banks are at least as important as those among large banks. Table I-1China: Five Largest Banks Hold Only 40% Of Credit Assets EM: Defying Gravity? EM: Defying Gravity? Finally, a number of cities have announced various tightening measures on property markets of late, including the re-launch of house purchasing restrictions and increases in minimum down payments. Similar restrictions on home purchases served as an efficient tool for curbing property purchases in 2013-14, and there is no reason why it will be different this time around. This is especially true given the market is more expensive than it was back in 2013. In addition, the government has curbed financing for property developers. The biggest economic risk remains construction activity. Even though housing sales and prices have skyrocketed by 20-40% in the past 12 months (Chart I-10, top and middle panels), residential floor space started has been very timid - it has in fact failed to recover (Chart I-10, bottom panel). As residential property sales contract again due to new purchasing restrictions, property developers will certainly curtail new investment, and housing construction activity will shrink anew. The same is true for commercial properties (Chart I-11). Chart I-10China's Residential Market: ##br##Demand, Prices And Starts China's Residential Market: Demand, Prices And Starts China's Residential Market: Demand, Prices And Starts Chart I-11China's Non-Residential ##br##Market: Demand And Starts China's Non-Residential Market: Demand And Starts China's Non-Residential Market: Demand And Starts An interesting question is why property starts have been so weak, as indicated in the bottom panels of Chart I-10 and Chart I-11 - particularly when both floor space sold (units) and property prices have surged exponentially in the past 12 months. Our view is that there is a large hidden inventory overhang in the Chinese property market. For example, government data on residential floor space started, completed and under construction attest that there is still a large gap between floor space started versus completed (Chart I-12). From these data/charts and the enormous leverage carried by property developers, we infer the latter have been accumulating / carrying on their balance sheets vast amounts of inventory in excess of what market-based sources suggest, and what is widely followed by analysts. It is very hard to make sense of the Chinese property inventory data, but we suspect these market-based data sources may track only inventories that have been completed and released to the market - and do not account for inventories classified as "under construction". For residential housing, according to government data the "under construction floor space" is 5 billion square meters (Chart I-13, top panel), which is equal to 3.5-4 years of sales at the fervent pace of the past 12 months (Chart I-13, bottom panel). Another way to assess this is as follows: Assuming an average construction cycle of three years, there will be supply of new housing in amounts of 16.7 units in each of the next three years. This compares with sales of 13.3 million units in the past 12 months that occurred amid a buying frenzy and booming mortgage lending. Faced with a potential drop in sales due to the recent purchasing restrictions, elevated inventories, enormous leverage (Chart I-14), and tighter financing, property developers will most likely curtail new starts. In turn, a reduction in property starts means less construction activity next year, and weak demand for commodities. Consistent with the rollover in the fiscal spending impulse, infrastructure spending will likely also lose its potency in early 2017. Chart I-12China's Residential ##br##Market: Hidden Inventories bca.ems_wr_2016_11_09_s1_c12 bca.ems_wr_2016_11_09_s1_c12 Chart I-13Chinese Real Estate: Massive ##br##Volumes Under Construction Chinese Real Estate: Massive Volumes Under Construction Chinese Real Estate: Massive Volumes Under Construction Chart I-14Leverage Of Chinese ##br##Listed Property Developers bca.ems_wr_2016_11_09_s1_c14 bca.ems_wr_2016_11_09_s1_c14 Bottom Line: Recent property market and marginal credit policy tightening will weigh on construction activity and depress Chinese demand for commodities and industrial goods next year. Confirmation Bias, Or Bias Based On Fundamentals? Why did we not follow the indicators discussed above from February through June, when the EM rally emerged and these indicators bottomed? Do we have a confirmation bias? We did not recommend playing the EM rebound early this year because we did not believe the rally would last this long or go this far. If we had had conviction about the duration and magnitude of the rally, we would have changed our strategy - tactically upgrading EM risk assets despite our negative structural and cyclical views. Simply put, we were wrong on strategy. In our April 13, 2016 Weekly Report,6 we argued that based on China's injection of massive amounts of fiscal and credit stimulus, growth would marginally improve in the months ahead. Yet, we stopped short of recommending chasing the EM rally given the menace of numerous cyclical and structural negatives surrounding the EM/China growth outlook. As to the reasons why we put more emphasis on some indicators and less on others at various times, we have the following points: We are biased in so far as our assessment and analysis of EM/China is based on fundamentals. In this sense, we are biased towards centering our investment strategy on fundamentals. Specifically, given our view/analysis that EM/China have credit bubbles/excesses, rapidly falling or weak productivity growth and record-low return on capital (Chart I-15), we cannot help but to have a fundamentally bearish bias on EM. This, in turn, means that we view any rally in EM risk assets or uptick in EM/China economic indicators with suspicion and likely as unsustainable. The opposite also holds true. All in all, if we are wrong on our fundamental view and analysis, we will be wrong on financial markets. When investors expect a bear market, they are better off selling rallies and not buying dips. When an asset class is in a multiyear bull market, it pays off to buy dips rather not sell rallies. Unless one can time market swings well, it is hard to make money on the long sides of bear markets. Similarly, it is difficult to profit from short positions in bull markets. In brief, countertrend moves are about timing. Timing does not depend on fundamentals. It is often a coin toss. Typically we do not recommend clients invest based on a coin toss. For example, it is impossible to rationalize why the EM rally did not begin following the August 2015 selloff, but instead started in February 2016. In late August 2015, with carnage in EM risk assets pervasive, it was clear that Chinese policymakers would stimulate and in fact the massive fiscal stimulus was initiated in August/September 2015 not in 2016. Similarly, China's manufacturing PMI bottomed in September 2015, not in 2016 (Chart I-16). Chart I-15EM Non-Financial Return ##br##On Equity Is At All Time Low EM Non-Financial Return On Equity Is At All Time Low EM Non-Financial Return On Equity Is At All Time Low Chart I-16China's Manufacturing PMI ##br##Bottomed In October 2015 China's Manufacturing PMI Bottomed In October 2015 China's Manufacturing PMI Bottomed In October 2015 In September 2015, EM and global equities rebounded, but chasing momentum at that time did not pay off as risk assets cratered in the following months. This is all to say that timing markets is often a random walk. We do attempt to time market moves that go along with our fundamental bias, but prefer not to time market moves that go against the primary trend. We assume any countertrend move is typically short-lived and unsustainable. That said, we also realize these moves can be very painful for investors if they last long enough, like this EM rally. Finally, we often get questions on fund flows. We do not make investment recommendations based on fund flows - even though we recognize they are very important in driving markets. The reason is that there is no comprehensive data on global fund flows that one can analyze and make reasonably educated bets. The often-cited EPRF dataset only tracks inflows and outflows of mutual funds and ETFs. It does not account for flows and positioning of various asset managers, sovereign funds, pension funds, insurance companies, hedge funds and private wealth managers, among many others. What's more, the EPRF dataset only covers the funds located in advanced countries and offshore jurisdictions, but not emerging countries where investment pools have become large and important. In brief, the available investment flow and portfolio positioning data are not comprehensive at all, and they cannot be relied upon too much to make investment recommendations. In this vein, a question arises: Why can't flows into EM sustain the current rally for a while even though it is not based on fundamentals? In this context, let's consider the case of the rally in euro area share prices when markets sensed the arrival of the European Central Bank's quantitative easing efforts at the beginning of 2015. There was a fervent rush to buy/overweight euro area stocks heading into the QE announcement by the ECB. European bourses surged. Nevertheless, euro area equity prices have been sliding and massively underperforming the global equity benchmark since March 2015 (Chart I-17). The reason the ECB's QE has not helped euro area stocks is because their fundamentals were bad - profits have been shrinking despite the ECB's QE. We suspect EM stocks and currencies will have a similar destiny: EM profits will disappoint considerably, and the current rally will prove unsustainable. Notably, net EPS revisions have so far failed to move into the positive territory (Chart I-18). Chart I-17Euro Area Stocks And EPS: ##br##Why The QE Rally Proved To Be Bogus Euro Area Stocks And EPS: Why The QE Rally Proved To Be Bogus Euro Area Stocks And EPS: Why The QE Rally Proved To Be Bogus Chart I-18EM Stocks And EPS: ##br##Earning Revisions Are Still Contracting bca.ems_wr_2016_11_09_s1_c18 bca.ems_wr_2016_11_09_s1_c18 Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 China Foreign Exchange Trading System. 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 15. 3 Please refer to the Emerging Markets Strategy Special Report, titled "EM Corporate Health Is Flashing Red," dated September 14, 2016; a link is available on page 15. 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 5 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 6 Please refer to the Emerging Markets Strategy Weekly Report titled, "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016; a link is available on page 15. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights There is an eternal duality between bulls and bears on the Chinese economy. We prefer to stay away from the debate, and simply monitor the situation while adjusting our portfolio recommendations as the situation evolves. From the perspective of BCA Global Fixed Income Strategy (GFIS), and in the short term, five key questions on China influence our duration stance and our core bond portfolio allocation recommendations. To answer these questions, we are following specific indicators, laid out in this Special Report. Together, those form the "GFIS China Checklist". Several of our financial stress indicators reveal the possibility that China's macro stability could be starting to fray a bit at the edges. These trends could become worrisome if they linger or re-appear. China's cyclical growth impulses are positive, suggesting a tailwind for the global economy, and upward pressure on inflation and bond yields in the near-term. At the moment, the "China Factor" reinforces our below-benchmark portfolio duration stance and our bias towards underweighting bond markets that are most exposed to Chinese demand and higher commodity prices (i.e. Australian government debt), while also favoring inflation-linked bonds over nominals across the developed world. Table 1The GFIS China Checklist How To Assess The "China Factor" For Global Bonds How To Assess The "China Factor" For Global Bonds Feature Chart 1Getting China Right Is Crucial Getting China Right Is Crucial Getting China Right Is Crucial At the macro level, several factors have a disproportionate impact on the direction of global bond yields. The evolution of monetary policies in the developed economies, globalization, new technologies, demographic changes and productivity trends are among the themes that top our list. A positive or negative shift in these factors could significantly alter the path of global growth and inflation and, by the same token, bond yields. In this Special Report, we will address the "China factor". Through its massive aggregate demand, this huge country can tip the global macro landscape into equilibrium or disequilibrium (Chart 1).1 As such, closely monitoring its developments is crucial for investors to correctly position for/against the cyclical drivers of bond markets. Unfortunately, understanding China's dynamics and seeing through the opacity of its policy-setting process is extremely challenging. Experts on the matter often disagree (even here at BCA!) on the complex issues, and sometimes even the most basic assumptions, underlying a view on China. In this Special Report, our goal is not to try to untangle the ultimate truth about China. Instead, we will cut through the fog and offer a simple framework to monitor its economy and associated risks. From an investment perspective, getting China right comes down to answering five keys questions: Is China's macro stability starting to deteriorate? Are China's growth impulses positive? Is Chinese economic momentum accelerating? Are China's business fundamentals evolving positively? Is the outlook for Chinese household consumption improving? To answer those, we follow simple indicators, laid out in this Report. Together, they form the BCA Global Fixed Income Strategy (GFIS) "China Checklist" (Table 1). The Eternal Duality In Chinese philosophy, the Yin - the dark swirl - represents shadows, the moon and the trough of a wave. In the investment world, members of the Yin camp view China's great accomplishments of the last 30 years with a doubtful eye. In its economic miracle, they see fragility and unsustainability. Those doubters are quick to raise the multiple structural problems such as regional disparities, income inequality, pollution, workers' dissatisfaction, and the unfair hukou2 system, among others. China' high debt levels and widespread, institutionalized misallocation of capital usually anchor their gloomy view. On the other end of the spectrum, the Yang - the light swirl - represents the sun and growth. For members of the Yang camp, China's policymakers have a grand master plan that will lead China to dominate economically and geopolitically for decades to come. Discarding the potential credit addiction problem, they believe that China should continue to invest at a record pace, arguing that investments will eventually lead to faster productivity, which will lift potential growth and overall prosperity. They posit that leveraging is simply a natural process for a fast-growing country with massive excess savings. To their despondency, China bears fail to recognize the merits of the country's un-paralleled meritocratic political system and the communal dynamic that makes it unique. Where does GFIS stand in this debate? Both camps have legitimate arguments and could be right in the end. The key thing about the Yin/Yang symbol is that both the black and white contain a little bit of each other. In the end, this duality might just be a healthy dynamic where one cannot exist without its opposite. For us, it leaves an important dilemma. On one hand, betting on a Chinese hard landing that never materializes could turn out to be a widow-maker trade.3 On the other hand, ignoring China's structural issues and assuming that everything will be all right is a strategy that can be prone to devastating disappointments. Instead of trying to predict the end game, we will focus our efforts on assessing how the economic momentum and the risks are evolving at each particular moment. This will inform our overall views on global growth and inflation and, in the end, the direction of bond yields and credit spreads. Bottom Line: There is eternal debate between the Yin and Yang camp in regards to China's future. We prefer to stay away from the debate, and will monitor the situation through specific indicators and adjust our investment recommendations accordingly. Is China's Macro Stability Starting To Deteriorate? Maybe Nobody knows for sure when or if China will go through an acute period of turbulence related to stresses in its financial system. Nonetheless, to properly calibrate our duration call and the pro-cyclical bets in our recommended fixed income portfolio, we need to assess if the stress points are flashing red, and to what degree. Below, we propose a set of indicators that could eventually signal a bubbling credit-related event (Chart 2 & Chart 3). Chart 2Is China's Macro Stability Deteriorating? Part I bca.gfis_sr_2016_11_08_c2 bca.gfis_sr_2016_11_08_c2 Chart 3Is China's Macro Stability Deteriorating? Part II Is China's Macro Stability Deteriorating? Part II Is China's Macro Stability Deteriorating? Part II In aggregate, they warn that China has been experiencing some instability lately. This should be taken seriously and temper any China optimism. The Renminbi If China goes through a period of instability, its currency, the Renminbi (RMB), would deteriorate as money tries to escape through any cracks in the financial system or real economy. The RMB has had several episodes of rapid depreciation (by China's standards) over the past 18 months which could be a bad omen. That said, since China's policymakers still largely have the capacity to control the evolution of its currency, the RMB could end up reflecting a serious capital outflow problem only far after the fact. Nonetheless, it is still something to follow closely. Hibor/Shibor rates When a financial system goes through episodes of turbulence, lenders tend to freeze operations until the cause is clear. Banks stop lending to each other and overnight interest rates tend to spike. It is possible that the RMB-based Hong Kong Interbank Offered rate (Hibor) or the Shanghai Interbank Offered Rate (Shibor) can offer such a signal. Since mid-2015, the Hibor has experienced three such episodes. In each case, they proved to be temporary - rates came down shortly after each spike - but we still view this with a wary eye. Since China has a closed capital account and maintains a stable currency through several interlinked instruments, it is possible that the overnight lending market might not be as relevant a signal as it would be for countries with open capital accounts. Our colleagues at the BCA China Investment Strategy have recently been sanguine about the significance of those spikes.4 Regardless, we will keep this indicator on our list of possible China stress points. Equity prices of global banks with heavy links to China & Emerging Markets Capital market data are often the first to hint that financial stress is rising. In China's case, the stock prices of major global banks that are highly exposed to China and, more broadly, emerging markets might play that role. Two such banks are Standard Chartered and HSBC. If China's internal dynamic eventually becomes shaky, the relative equity performance of those banks could quickly erode.5 For now, this does not seem to be the case, as their stocks are performing well; the stress appears to be contained. Capital outflows If China's economy is about to crumble under a pile of debt, money will leak through the cracks. Part of the money flowing out will eventually trickle through to safe assets in the rest of the world, like U.S. Treasuries and non-Chinese property markets. Since mid-2014, China capital flight has been large and clearly represents a potential source of worry. Official Holdings of U.S. Treasuries If the Chinese economy were to deteriorate meaningfully, or if there were potential undercapitalization issues stemming from any buildup of bad loans within the Chinese banking system, the authorities might be driven to sell some of China's enormous stock of U.S. Treasuries and "invest" the money domestically. Lately, China has been a net seller of U.S. Treasuries, which could be a potential sign of trouble but could also simply be the result of China having less of a need to accumulate U.S. dollar assets to fight inherent appreciation pressures on the RMB. Policy Uncertainty Capital flight out of China could be related to many factors. Pessimism towards the future or lack of domestic investment opportunities could force savings outward. Another possibility is increasing policy uncertainty and/or brewing political instability among China's leadership. Lately, China's Policy Uncertainty Index has skyrocketed.6 Before pushing the panic button, however, one has to consider mitigating factors. It is possible, considering the after-effects of the shocking U.K. Brexit referendum and the increased odds of a Donald Trump U.S. Presidency, that this jump in the China uncertainty index has been more externally than domestically driven. Bottom Line: Several of our financial stress indicators reveal the possibility that China's macro stability could be starting to fray a bit at the edges. These trends could become worrisome if they linger or re-appear. Are China's Growth Impulses Positive? Yes Economic momentum can develop as a result of several growth impulses. Below, we propose five of them (Chart 4 & Chart 5). Currently, they are trending favorably, for the most part, and suggest that China is in the expansionary phase of its economic cycle. If sustained, this tendency should have a considerable impact on global growth, inflation and bond yields. Chart 4Are The Growth Impulses Positive? Part I bca.gfis_sr_2016_11_08_c4 bca.gfis_sr_2016_11_08_c4 Chart 5Are The Growth Impulses Positive? Part II Are The Growth Impulses Positive? Part II Are The Growth Impulses Positive? Part II The monetary conditions index Both the movement in policy interest rates and the currency can influence a country's monetary conditions, which in turn impact the backdrop for growth. Since the beginning of 2015, China's policy interest rate and the reserve requirement ratio for banks have been cut several times. The Renminbi has also depreciated during the same period. Combined, these factors have eased monetary conditions, which has been a positive development for the Chinese economy. Money supply growth In most countries, a more rapidly growing money supply usually leads to greater credit expansion, which eventually leads to faster economic growth. Again, since the beginning of 2015, Chinese money supply growth has shot up markedly. This should sustain credit/growth expansion in the coming months. Corporate bond yields An abundance of money can be of little help to an economy if corporations cannot finance themselves at a reasonable yield. Historically, the average Chinese corporate bond yield has been a leading indicator of industrial output growth. As the corporate yield decreases, financing becomes more attractive and a credit boom could follow, resulting in increased economic activity. Since 2015, Chinese corporate bond yields have literally collapsed, seemingly following the trend in non-Chinese corporate bond yields. If history is any guide, this should be setting the stage for accelerating output growth. One caveat: China's private sector debt servicing ratio might have reached too high a level, such that it has reduced the ability for companies to benefit from lower corporate bond yields moving forward. This could explain why industrial output growth has not gained ground as corporate bond yields have fallen. The credit impulse Credit origination has been a vital part of China's economic success since 2000 and even more so since the 2008 global financial crisis. Our Emerging Markets Strategy team has created the credit impulse indicator - which is the second derivative of credit growth - to assess the condition of the credit impulse.7 This simple indicator has proven to be one of our more reliable leading indicators of economic growth (for China and for many other countries) Of late, this indicator has moved into positive territory. Possibly, easy monetary conditions, stronger money supply growth and lower corporate bond yields have helped push the impulse upward. We interpret that as a very powerful signal for future Chinese growth. Again, a cautionary note is warranted. For a while now, Chinese credit growth has been faster than nominal GDP growth, potentially representing an unsustainable dynamic. Hence, it is likely that the latest surge proves to be only temporary, as credit growth slows to a more desirable pace.8 So, we won't get too excited just yet. Fiscal thrust Outside the credit channel, the Chinese government embodies another major contributor to the growth impulse. Considering its relatively low debt levels, the government has the means to sustain the economy via increased fiscal expenditures, especially via infrastructure investments. Lately, to alleviate the pain from the reforms and restructuring of certain parts of the economy,9 the government has engineered a decent fiscal thrust. Many infrastructure projects have been laid out, growing at a rate up of 15% in the last four years. As long as China continues along a long-term restructuring path, reducing that rapid pace of government spending will prove to be difficult. Bottom Line: Chinese growth impulses are currently positive. Is Chinese Economic Momentum Accelerating? Yes An open liquidity tap and a positive fiscal thrust should lead to increased Chinese demand. Below, we provide six indicators showing that this occurred lately (Chart 6 and Chart 7). The synchronicity of their upward acceleration reinforces our optimism about the Chinese cyclical outlook. Chart 6Is Chinese Economic Momentum Accelerating? Part I Is Chinese Economic Momentum Accelerating? Part I Is Chinese Economic Momentum Accelerating? Part I Chart 7Is Chinese Economic Momentum Accelerating? Part II Is Chinese Economic Momentum Accelerating? Part II Is Chinese Economic Momentum Accelerating? Part II Keqiang index Since Chinese economic growth data could be described as "man-made" and potentially unreliable, an index of Premier Li Keqiang's favorite economic indicators has been used, since it was leaked to the press several years ago, to appraise the true state of the economy. Cargo volumes, electricity consumption and loans disbursed by banks comprise this indicator. In the last twelve months, the Keqiang index has hooked decisively higher. The index has a flaw - the declining role of banks loans in overall new credit - but it is still useful, and it corroborates the positive signal sent by the growth impulses mentioned previously in this report. Excavator sales Traditionally, the construction sector has been at the core of China's growth miracle. To gauge the evolution of this sector, the growth rate of excavator sales has been very reliable. After being negative since mid-2011, it has surged in 2016. With a lift off of such magnitude, one could doubt the validity of this data. However, it has followed a similar spurt seen in money supply and a burst in the "projects started" capital spending growth rate. Residential floor space sold The state of the construction sector can also be assessed through the time series of residential floor space sold, which tends to lead new housing starts by several months. Again, since the beginning of the year, this indicator has been trending higher, echoing the message sent by excavator sales growth. Import volume growth No other time series better expresses the state of China's demand than its import volume growth. If the global growth and inflation outlook were to get a boost, Chinese imports would need to gain positive momentum. Lately, they have accelerated; this constitutes a very positive sign. CRB Raw Industrials prices Since China is by far the biggest consumer of commodities globally (see Chart 1, on page 2), China's demand indicators should be correlated with global commodity prices. In theory, both should move in a similar fashion to validate one another. This year, the CRB Raw Industrials price index has indeed stabilized and confirmed the positive growth dynamic observed through other indicators. The Chinese yield curve The yield curve has traditionally been recognized as an excellent leading indicator for most economies. It usually signals slowing growth when it flattens and steepens when growth gains momentum. China's yield curve has been especially well correlated with the Chinese PMI data, for example. Lately, China's yield curve has flattened a bit, which is not a good sign. However, until it inverts, like in 2011, 2013 and 2015, we will treat its message as neutral. Bottom Line: Chinese economic momentum is accelerating. A flattening yield curve tempers our optimism to some degree, however. Chart 8Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Yes If Chinese economic momentum truly accelerates, domestic businesses should reap the benefits and their internal dynamics should improve. As per the business indicators presented below, this is currently the case (Chart 8). Final goods producer prices Producer pricing power is crucial and it has been lacking over the last few years on a global scale. Without pricing power, capital investment and employment growth tend to stay depressed, and vice versa. Since 2012, China's final goods producer prices have been contracting. This started before the beginning of the commodities collapse in 2014 and has been hugely deflationary for the rest of the world. But this might be a story of the past; final goods producer prices have turned positive lately. This could prove a major development, if it lasts. The risk here is that the U.S. dollar appreciates - due to a Fed hike and/or a more hawkish tone going forward - pushing global commodity prices lower, which has historically depressed global producer prices. However, if the Fed treads carefully after the December rate hike that we expect, waiting for the rest of the global economy to catch up to a U.S. acceleration, the dollar could end up trending sideways. Commodity prices could then continue on the current upward trend, preventing producer price growth from relapsing back into negative territory. Cash flow ratio Leveraging during the 2009-2011 period has left many Chinese firms highly indebted, especially in the industrials, materials and real estate sectors. As debts increased, debt servicing cash flows substantially shrank during the 2011-2014 period. Fortunately, since mid-2015, this situation has reversed, with the cash flow/total liabilities ratio having increased steadily. Net earnings revisions In the end, strong profits are necessary for a healthy economy. This has been lacking globally, but even more so in China; most China MSCI equity index sectors suffer from contracting earnings per share, except consumer staples. Nonetheless, the jump higher in net earnings revisions seen this year is encouraging. Bottom Line: China's business fundamentals are evolving positively. Chart 9 Is Chinese Consumption Outlook Improving? Is Chinese Consumption Outlook Improving? Is Chinese Consumption Outlook Improving? Is the Outlook For Chinese Household Consumption Improving? Yes Ultimately, improved business conditions should lead to better job creation, strong workers' income and more robust final consumer spending. Lately, the virtuous cycles in credit, demand and the business sector have indeed trickled down to the consumers. Employment and consumption are synchronously accelerating (Chart 9). PMI Employment Index Despite the questionable quality of China's employment data - making it difficult to assess the true picture of the labor market - the employment sub-index of the overall China Purchasing Managers Index (PMI) gives a relatively reasonable reading. Since 2012, it has been trending downward. However, the fact that the latest data point rose sharply above the 12-month moving average is a good sign, perhaps indicating the cyclical downtrend in Chinese employment growth truly bottomed in 2015. Auto sales If employment growth and wages are indeed in a cyclical upturn, Chinese retail consumption growth should be thriving. This has been the case in 2016, with auto sales growth shooting up sharply. Bottom Line: The outlook for Chinese household consumption is improving. Investment Implications Chart 10Investment Implications Investment Implications Investment Implications In the analysis above, we concluded that: The possibility of eroding Chinese macro stability cannot be discarded, as financial stress points are rising. This needs close monitoring. Chinese growth impulses are, for the most part, positive. Chinese economic momentum is accelerating, but a flattening yield curve tempers our optimism. China's business fundamentals are evolving positively. The outlook for Chinese household consumption is improving. In sum, despite the reigning policy uncertainty and persistent capital outflows, the current short-term dynamics are surprisingly positive. Accordingly, and taking the overall "China factor" in isolation, the following fixed income investment recommendations should be implemented (Chart 10): Maintain a below-benchmark duration bias. There is a meaningful positive contribution to global growth and inflation from China. If the Chinese economy gathers more steam, global bond yields and inflation will also move higher. Maintain low exposure to bond markets most negatively exposed to faster Chinese growth & rising commodity prices. Our positive cyclical view on China has an impact on our core recommended bond portfolio allocation. We have been underweight Australian government bonds versus global hedged benchmarks since the summer, and China's improving demand constitutes a definite plus to this view, as it is Australia's largest export destination. We have also maintained a bias to favor inflation-linked bonds versus nominals in the major developed markets. A faster pace of Chinese goods inflation should translate into an acceleration in global traded goods prices (and inflation rates) in the coming months, to the benefit of the relative performance of linkers. Maintain a neutral stance on Emerging Market hard currency bonds. Due to a very unappealing structural backdrop, we have a negative longer-term bias towards Emerging Markets sovereign and corporate bonds. However, in July, we turned neutral, from underweight, due to the improving global cyclical outlook, especially based on what was happening in China. This move has paid off so far and the position should be maintained, even if there is some upward pressure on the U.S. dollar from a Fed rate hike next month.10 Overweight Australian Semis. Since March 2016, we have had a positive bias towards Australian Semi-government debt.11 Semis outperform Australia federal government debt during global expansionary phases, and China will continue to support the current cyclical growth upturn. Finally, the biggest risk to our view is that China's structural fragilities won't allow the current cyclical recovery to be sustained beyond the next year. Our GFIS China Checklist will help us to detect any downturn if and when it becomes apparent. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Furceri, Jalles, and Zdzienicka (2016) perform time-varying coefficient analysis using local projection methods on a sample of 148 countries over 1990-2014, and show that spillovers from a 1 percentage point shock to China's final demand growth now have a cumulative impact on global GDP of about 0.25 percent, after one year. Source: http://www.imf.org/external/pubs/ft/weo/2016/02/pdf/c4.pdf 2 The hukou system was originally introduced to register China's households as part of an effort to gather population statistics. It has morphed into a government tool to control rural-urban migration flows that has made it more difficult for migrant workers to access health care or education services in China's cities. For more information, please see: http://thediplomat.com/2016/02 chinas-plan-for-orderly-hukou-reform/ 3 Here we have a thought for all those who have bet on the demise of the Japanese bond market over the years without glory. 4 For details on this issue, please see BCA China Investment Strategy Weekly Report, "HIBOR, Liquidity And Chinese Stocks", dated September 22, 2016, available at cis.bcaresearch.com 5 For details on this issue, please see http://www.imf.org/~/media/files/publications/spillovernotes/spillovernote5 6 This is part of a global suite of indicators produced by researchers Baker, Bloom and Davis, designed to measure economic policy uncertainty for the major economies. For more information, please go to www.policyuncertainty.com. 7 Please see BCA Emerging Markets Strategy Special Report, "Gauging EM/China Credit Impulses", dated August 31, 2016, available at ems.bcaresearch.com 8 For more perspective on this idea, please see BCA Emerging Market Strategy Special Report "Misconceptions About China's Credit Excesses", dated October 26, 2016, available at ems.bcaresearch.com 9 Massively decreased output and increased employee layoffs in the steel industry, for example. 10 Please see BCA Global Fixed Income Strategy Special Report, "Emerging Markets Hard Currency Debt: Time For More Optimism?", dated July 12, 2016, available at gfis.bcaresearch.com 11 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters", dated March 29, 2016, available at gfis.bcaresearch.com

Highlights Despite a tough week, the dollar bull market is intact. The U.S. economy's resilience to a strong dollar is growing. But, if Trump wins, the dollar could temporarily sell off against EUR, CHF, and JPY. Favor these currencies against EM and commodity currencies. Thanks to the High Court's Brexit ruling, the outlook for the pound is brightening. Wait for the appeal procedure to be over before implementing directional bets. Feature Despite this week's violent correction in the dollar, we remain dollar bulls. However, the recent reaction of the greenback to the rising probability of a Trump victory raises the need to hedge such an outcome. Still Bullish On The Dollar... The U.S. is unlikely to fall from its perch at the top of the distribution of G10 interest rates, a historically dollar-bullish environment (Chart I-1). Chart I-1Dollar Tailwinds Dollar Tailwinds Dollar Tailwinds The hidden slack in the U.S. labor market has dissipated. The amount of workers outside of the labor force who do want a job is at 6.2%, a level in line with the readings recorded between 2000 and 2007, when hidden slack was low (Chart I-2). Moreover, wages and salary continue to grow in the national income. Skewing the income distribution away from profits and rents is akin to a redistribution of income away from the top 1% of households, who derive nearly 50% of their income from profits. Importantly, middle-class households have a much higher marginal propensity to consume than rich ones. So great is the difference that since 1981, the 10% increase in the share of national income accruing to the top 1% of households has helped depress consumption by 3%. As a result, income redistribution will depress the U.S. savings rates going forward (Chart I-3). Since 70% of household consumption is geared toward the service sector, a component of the economy where productivity growth is hard to come by, increasing consumption is likely to directly result in job creation. Chart I-2U.S. Wages Can Rise U.S. Wages Can Rise U.S. Wages Can Rise Chart I-3The U.S. Savings Rate Has Downside bca.fes_wr_2016_11_04_s1_c3 bca.fes_wr_2016_11_04_s1_c3 With the unemployment gap being closed, consumption growth will cause wage growth to accelerate, further supporting consumption. Hence, the Fed can increase rates more aggressively than the 70 basis points priced into the OIS curve until the end of 2019. These kinds of dynamics have historically been very dollar bullish (Chart I-4). Moreover, the feedback loop linking the dollar and financial conditions to the economy is weakening. Not only is the economy increasingly driven by household expenditures, but the weight of commodity and manufacturing capex in the economy has collapsed in response to the dollar's strength (Chart I-5). Even if the sensitivity of these sectors to the dollar and financial conditions is unchanged, their impact on the broad economy has diminished. Chart I-4A Virtuous Circle##br## For The Dollar bca.fes_wr_2016_11_04_s1_c4 bca.fes_wr_2016_11_04_s1_c4 Chart I-5Lower Impact Of Manufacturing ##br##And Commodities bca.fes_wr_2016_11_04_s1_c5 bca.fes_wr_2016_11_04_s1_c5 Outside of the U.S. some key factors will prevent a normalization of policy rates in the major economies. Euro area rates will stay depressed for much longer. Conditions to generate inflation are absent. The output gap remains wide and negative, unemployment is significantly above NAIRU, and fiscal austerity, while diminished, is still de rigueur (Chart I-6). While the IMF pegs the output gap at 1.2% of GDP, the ECB estimates it to stand at 6% of GDP. Additionally, the European credit impulse is likely to roll-over. European bank stock prices have led European credit growth. They now point to slowing loan growth (Chart I-7). Even if loan growth were only to stabilize, this would imply a fall in the impulse. Chart I-6Inflationary Pressures##br## In Europe Inflationary Pressures In Europe Inflationary Pressures In Europe Chart I-7Downside Risk To The##br## Euro Area Credit Impulse bca.fes_wr_2016_11_04_s1_c7 bca.fes_wr_2016_11_04_s1_c7 These forces will weigh on the euro. The SNB floor under EUR/CHF remains credible and exercised. Therefore, USD/CHF will mostly stay a function of EUR/USD. For Japan, as we highlighted in the September 23 and October 28 reports, conditions are falling into place to see rising wages and inflation expectations. Rates being pegged at 0% until inflation greatly overshoots 2% will lower Japanese real rates along with the yen. Bottom Line: The 12-18 months outlook for the dollar remains bright. The resilience of U.S households will lead to stronger wage growth and an economy powered by consumption. The Fed will surprise markets with more rate hikes than anticipated. Meanwhile, European and Japanese real rates are unlikely to rise much if at all. ...But The Short-Term Outlook Is Bifurcated Yet, the short-term outlook is murky. BCA believes that a Trump presidency is likely to supercharge any dollar rally. Not only would his presidency imply huge infrastructure projects, his trade tactics should put upward pressure on wages and inflation, prompting an even more hawkish Fed than we anticipate. However, if recent dynamics are any clue, a Trump victory next week could also cause an immediate but temporary knee-jerk sell-off in the dollar. Since the FBI announced a re-examination of the Clinton emails affair, Trump's probability of winning has skyrocketed. While USD/MXN has rallied, so has EUR/USD, driven by a favorable move in interest rate differentials (Chart I-8). This raises the specter of a bifurcated move in the dollar over the next month or so. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer against EUR, CHF, and JPY. Why would the dollar rise against EM and commodity currencies? Cyclically and tactically, the stars are lining up against this set of currencies. The economic situation in EM and China is as good as it gets right now. The Keqiang index is near cyclical highs, suggesting that the upswing in Chinese industrial activity is unlikely to strengthen further, especially as loan demand remains tepid (Chart I-9). Chart I-8A Trump Indigestion bca.fes_wr_2016_11_04_s1_c8 bca.fes_wr_2016_11_04_s1_c8 Chart I-9China: As Good As It Gets China: As Good As It Gets China: As Good As It Gets Worryingly, Chinese fiscal stimulus is dissipating, which will act as a drag on the nation's investment and industrial activity. Chinese authorities panicked in 2015 as the Chinese economy was moving toward a hard landing. The government direct fiscal spending impulse surged (Chart I-10). Also, private-public partnerships originally expected to invest $1.2 trillion in infrastructure over three years were deployed in six months. As these tactics caused the economy to deviate from Beijing's stated goal to rebalance China away from investment, they are now being rolled back. Additionally, Chinese deflationary pressures are likely to resurface. Our bullish stance on the dollar implies a negative view on commodity prices. PPI will suffer if the dollar rallies given that Chinese producer prices are highly correlated with commodity prices (Chart I-11). This increases the likelihood that industrial activity in China will slow again. Chart I-10Vanishing Fiscal##br## Support Vanishing Fiscal Support Vanishing Fiscal Support Chart I-11Chinese PPI And Commodity Prices:##br## Brothers In Arms Chinese PPI And Commodity Prices: Brothers In Arms Chinese PPI And Commodity Prices: Brothers In Arms These risks are not priced in by EM assets and related plays. Risk reversals on EM currencies are priced in for perfection. Slowing Chinese growth would represent a negative surprise for EM debt, EM currencies, and commodity currencies (Chart I-12). An additional worry for EM currencies is momentum. A paper by the BIS shows that momentum continuation strategies are very profitable in EM FX.1 Hence, if EM currencies begin to fall, this fall will prompt further weaknesses. Finally, a Trump presidency is another headwind for EM and commodity currencies. In an earlier Special Report, we argued that a key factor that boosted the profitability of FX carry strategies was the rise of globalization (Chart I-13).2 This growing global trade mostly benefited small open economies, EM economies, and commodity producers, the so-called "carry-currencies". Trump's rhetoric promises a roll-back of this trend, a move that will disproportionally hurt such currencies. Compounding this risk, this cycle, the performance of FX carry trades has been inversely correlated to global bond yields (Chart I-14). BCA's underweight duration represents another problem for EM and commodity currencies. Chart I-12EM Plays Are Priced For Perfection EM Plays Are Priced For Perfection EM Plays Are Priced For Perfection Chart I-13Carry Trades Love Globalization Carry Trades Love Globalization Carry Trades Love Globalization Chart I-14Rising Yields Hurt Carry Currencies Rising Yields Hurt Carry Currencies Rising Yields Hurt Carry Currencies However, what could temporarily lift the euro, the Swiss franc, and the yen despite a negative cyclical outlook? Risk aversion and a global equity market correction prompted by a Trump victory. In short, a flight to safety amid uncertain times. These currencies are underpinned by current account surpluses ranging from 3% of GDP for the euro area to 10% for Switzerland. They therefore export investments abroad. This capital usually displays a strong home bias when global risks spike, and EUR, CHF, and JPY strengthen when global equities weaken. Finally, our current negative predisposition toward carry trades would also support funding currencies, currencies with deeply negative rates like EUR, CHF, or JPY. Bottom Line: In the direct aftermath of a Trump victory, the dollar could suffer from some temporary downward pressure against the EUR, CHF, and JPY. However, it will strengthen against EM and commodity currencies. On a cyclical basis, the USD will be stronger against these latter currencies than against European currencies. Key Investment Recommendations We are opening long EUR/AUD and short CAD/JPY positions. The EUR is less sensitive to EM downside than the AUD. Deteriorating EM currencies' risk reversals often coincide with a stronger EUR/AUD (Chart I-15). Also, the euro is cheaper than the Aussie, trading at a 5% discount to PPP. Additionally, EUR/USD could appreciate in the event of a Trump presidency, but its negative impact on EM economies and global trade will drag down AUD. The CAD/JPY position is primarily a Trump hedge. CAD will sell off if Trump wins as investors ponder the future of NAFTA. Meanwhile, the yen will benefit from safe-haven flows and from the eradication of any probability of MoF interventions (Chart I-16). Japan already meets two of the three criteria to be labeled a currency manipulator by the U.S. Treasury. Under a Trump presidency, such a label will have very real consequences. Chart I-15A Fall In EM Assets Would##br## Support EUR/AUD A Fall In EM Assets Would Support EUR/AUD A Fall In EM Assets Would Support EUR/AUD Chart I-16If Trump Wins, The MoF ##br##Will Not Intervene If Trump Wins, The MOF Will Not Intervene If Trump Wins, The MOF Will Not Intervene Moreover, CAD/JPY is also negatively affected by a deterioration of EM risk reversals. However, we are more worried for the JPY's long-term outlook than the EUR's. This is because of the more aggressive policy stance taken by the BoJ. Thus, this trade is more tactical than the EUR/AUD bet. Finally, investors wanting to play a Trump victory using European currencies should consider going long CHF/SEK. Sweden, a small open economy with deep trade links with EM, has been a key beneficiary of globalization. It will be a big loser if global trade shrinks. Meanwhile, CHF is likely to rally. Critically, this trade is for very nimble traders. At EUR/CHF 1.06, the SNB will intervene with all its might. The U.K.'s Über Thursday Yesterday, not only did the Bank of England announce its monetary policy decision and economic forecasts, but also, the High Court ruled that the Article 50 process preceding Brexit requires a vote from Parliament. While we expect Parliament to follow the popular vote and engage in Brexit, a parliamentary vote is much more likely to result in negotiating a "soft Brexit" rather than a "hard Brexit". In a "soft Brexit", the U.K. would retain access to the common market, and passporting of financial services would be allowed. However, freedom of movement would have to be maintained and the U.K. would have to contribute to the EU's purse. Unsurprisingly, the government is appealing the decision. Practically, this means it is still too early to aggressively bid up the pound. If the government wins its appeal, GBP/USD will move toward 1.10. If the government loses its appeal, FDI flows in the U.K. could regain some composure and help finance the large British current account deficit. This would lift GBP/USD toward 1.30 - 1.40. Probabilities are skewed toward the government losing its appeal. Economics, too, warrants caution. While the household sector's resilience has been a surprise to the Bank of England, it is unlikely to continue for long. First, the U.K. household credit impulse has rolled over and is now contracting at a GBP 1 billion pace, pointing to slowing growth. Second, in line with falling capex intentions, employers are paring their hiring intentions (Chart I-17). A slowdown in household nominal income growth should ensue. British households' real income will soon be squeezed, especially as the BoE increased it inflation forecast to 2.7% for 2018 due to the pass-through from the 15% fall in the trade-weighted GBP (Chart I-18). Additionally, the RICS survey points to further weakness in house prices. Chart I-17Deteriorating U.K. Labor Market Outlook Deteriorating U.K. Labor Market Outlook Deteriorating U.K. Labor Market Outlook Chart I-18Mechanics Of A Real Income Squeeze Mechanics Of A Real Income Squeeze Mechanics Of A Real Income Squeeze Hence, the BoE is on hold for a longer time than was anticipated in August. Moreover, Chancellor Hammond has made it clear that while the fall budget will loosen the fiscal austerity penciled in under the Osborne budgets, it is too early for investors to expect a large fiscal easing from the government. This suggests that risks remain tilted toward further easing by the "Old Lady." Bottom Line: Until we get clarity on the results of the government's appeal of yesterday's High Court Brexit ruling, we are inclined to fade strength in the pound. Any move above GBP/USD 1.25 would create a tactical shorting opportunity. A strangle with strikes at 1.27 and 1.15 and a January maturity makes sense for investors wanting to play the volatility around the ultimate ruling on the government's appeal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies", BIS Working Papers (2011). 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Policy Commentary: "The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives" - FOMC Statement (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Policy Commentary: "[On ECB Stimulus]...the initial date set to end the buying program is March, but the most advisable action is that it be a process that's as slow as possible" - ECB Governing Council Member Luis Maria Linde (October 28, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_04_s2_c5 bca.fes_wr_2016_11_04_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_04_s2_c6 bca.fes_wr_2016_11_04_s2_c6 Policy Commentary: "[On wether the BOJ would buy regional domestic bonds]..Regional domestic bonds are issued by the various local governments, and are traded separately. There are various factors that would make it difficult to consider them for monetary policy, but we will give the suggestion due consideration" - BoJ Governor Haruhiko Kuroda (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Policy Commentary: "...indicators of activity and business sentiment have recovered from their lows immediately following the referendum and the preliminary estimate of GDP growth in Q3 was above expectations. These data suggest that the near-term outlook for activity is stronger than expected three months ago" - BOE Monetary Policy Report (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_04_s2_c9 bca.fes_wr_2016_11_04_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "In Australia, the economy is growing at a moderate rate. The large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Household consumption has been growing at a reasonable pace, but appears to have slowed a little recently" - RBA Statement (November 1, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "There are unconventional monetary policies that give us more room to maneuver than previously believed...These include pushing interest rates below zero or buying longer-term bonds to compress long-term yields" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "In Switzerland the negative interest rate is currently indispensable, owing to the overvaluation of the Swiss franc and the globally low level of interest rates" - SNB President Thomas Jordan (October 24, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, In addition to this week's regular Weekly Report, you should have also received a Client Note written by my colleague Marko Papic discussing the upcoming U.S. presidential election. Marko argues that the election is now too close to call. Donald Trump's resilience in the polls continues to baffle most observers. Not us. Back in September of 2015, when most pundits were laughing off Trump's chances, we wrote a report arguing that Trump's rhetoric would resonate with voters much more than most people thought possible. That report, entitled "Trumponomics: What Investors Need To Know," is as relevant today as it was back then. Best regards, Peter Berezin Highlights Spare capacity has narrowed substantially within the developed world. Most of the decline in spare capacity is attributable to lackluster supply, rather than stronger demand. Potential GDP growth is likely to remain weak over the coming years. Narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. At least in this respect, central bankers may find themselves with a few more bullets in their arsenals. Stay long the dollar and position for gradually higher government bond yields. Global equities are highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. Feature Spare Capacity Is Dwindling A persistent shortfall of aggregate demand has been the defining feature of the global economic landscape ever since the financial crisis erupted. This chronic lack of spending has kept inflation below target in most developed economies, forcing central banks to adopt ever more radical easing policies. That is starting to change. Spare capacity continues to decline, allowing once dormant supply-side constraints to reimpose themselves. In this week's report, we take stock of where we are in this process. Mind The (Output) Gap The simplest measure of spare capacity is the so-called output gap, which estimates the difference between what economies are actually producing and what they are capable of producing without putting undue upward pressure on inflation. According to the IMF, the output gap for advanced economies has narrowed from a high of 3.8% of GDP in 2009 to 0.8% at present. The OECD's measure shows a similar decline (Chart 1). Chart 1AOutput Gaps Have Narrowed bca.gis_wr_2016_11_04_c1a bca.gis_wr_2016_11_04_c1a Chart 1BOutput Gaps Have Narrowed bca.gis_wr_2016_11_04_c1b bca.gis_wr_2016_11_04_c1b The IMF reckons that the output gap has nearly closed in the U.S. and the U.K. The Fund estimates that Japan's output gap currently stands at 1.5% of GDP. The OECD also sees the U.K. output gap as being fully closed. However, it calculates a smaller output gap for Japan but a larger output gap for the U.S. than the IMF does. Both institutions peg the euro area's output gap at around 1%-to- 1.5%. Not surprisingly, there is a fair bit of variation within continental Europe. The output gap in Germany has fully disappeared, but still stands at 2%-to-3% of GDP in Italy and Spain. Naturally, one should take these numbers with a grain of salt. Output gaps are notoriously difficult to calculate and are subject to large revisions. The OECD, for example, tends to rely on statistical approaches to estimate output gaps.1 These typically involve employing tools such as the so-called "Hodrick-Prescott filter" to smooth out historical GDP data and then treating the resulting trendline as an estimate for potential GDP. Such methods have their uses, but they can go badly awry in situations where GDP is slow to return to its "true" underlying trend. This is a particular worry in the current environment, considering that recoveries following burst asset bubbles tend to be lethargic even in the best of times. The fact that fiscal policy has been fairly tight and monetary policy has been constrained by the zero lower bound has further dampened the recovery. With that in mind, rather than relying on purely statistical techniques, it is useful to measure spare capacity directly. We do this by gauging the extent to which the existing factors of production - labor and capital - are being effectively deployed across the major developed economies. As we argue below, this approach suggests that slack may be modestly higher in Japan than what the IMF and the OECD calculate, and more meaningfully understated in peripheral Europe. The Message From Headline Unemployment Rates Unemployment has been falling in almost all major developed economies (Chart 2). In the U.S. and the U.K., the jobless rate is back to pre-crisis levels. In Germany and Japan, it is below where it was before the Great Recession. As such, it is unlikely that unemployment can decline much in these economies. Chart 2AUnemployment Rates Have Declined bca.gis_wr_2016_11_04_c2a bca.gis_wr_2016_11_04_c2a Chart 2BUnemployment Rates Have Declined bca.gis_wr_2016_11_04_c2b bca.gis_wr_2016_11_04_c2b In contrast, while unemployment rates in peripheral Europe have been trending lower over the past three years, they are still quite high by historical standards. There is some debate over whether they can fall much further. The OECD, for example, contends that Spain is already close to full employment, even though the country's unemployment rate still stands at nearly 20%. We find this implausible. The OECD essentially takes a moving average to calculate structural unemployment rates in various economies. As noted above, this can be highly misleading in circumstances where the forces pushing an economy towards full employment are impaired. In general, this suggests that both the IMF and the OECD estimates of labor market slack in the euro area are too low. This is consistent with a recent ECB research paper, which calculated that the euro area's output gap was 6% of GDP in 2015, a far cry from the European Commission's estimate of 1.1%.2 Disguised Unemployment The unemployment rate is probably the single best measure of labor market slack. However, it can understate the true amount of spare capacity during periods when many people have stopped looking for work, or when those who are employed are not working as much or as intensively as they would like. The nature of this additional labor market slack differs from region to region. In the U.S., it has mainly manifested itself in lower labor force participation rates; whereas in Europe - perhaps in keeping with the more egalitarian nature of European society - it has mainly taken the form of fewer hours worked and a higher incidence of involuntary part-time employment. Chart 3 shows that labor force participation rates among prime-age workers (those between the ages of 25-and-54) in Europe are generally higher now than they were before the financial crisis. In contrast, the share of workers who have part-time jobs but desire full-time employment remains elevated across most of continental Europe (Chart 4). The average annual number of hours worked per employee has also declined in most European economies (Chart 5). Chart 3ALabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. bca.gis_wr_2016_11_04_c3a bca.gis_wr_2016_11_04_c3a Chart 3BLabor Force Participation Rate ##br##Has Risen In Europe, But Fallen In The U.S. bca.gis_wr_2016_11_04_c3b bca.gis_wr_2016_11_04_c3b Chart 4AEurope: Higher Incidence Of ##br##Involuntary Part-Time Employment bca.gis_wr_2016_11_04_c4a bca.gis_wr_2016_11_04_c4a Chart 4BEurope: Higher Incidence ##br##Of Involuntary Part-Time Employment bca.gis_wr_2016_11_04_c4b bca.gis_wr_2016_11_04_c4b In the U.S., the prime-age labor force participation rate is still 1.9 points lower than it was in 2007. Part of this is cyclical. As long as the labor market continues to improve, participation rates among prime-age workers should continue to recover. That's the good news. The bad news is that ongoing structural forces are likely to prevent the participation rate from returning back to its pre-crisis levels. Chart 6 shows that labor force participation rates among U.S. prime-aged males has been trending lower since the 1960s. The decline has been particularly acute among less-educated workers. Why this has happened remains a source of intense debate. Conservative commentators have argued that cultural shifts have reduced the social pressure on men to maintain gainful employment. Liberal commentators have contended that falling real wages at the lower end of the skill distribution have reduced the incentive to work. Whatever the reason, it will be difficult to boost labor participation substantially from current levels. At present, 11% of U.S. prime-aged nonparticipants report wanting a job, only modestly higher than before the recession (Chart 7). It is possible that some fraction of those who do not want to work will change their minds - indeed, this year has seen a modest inflow of "disabled" people back into the labor force. Realistically, however, this is unlikely to boost labor participation by more than one percentage point. Chart 5Hours Worked ##br##In Europe Have Declined Slack Around The World Slack Around The World Chart 6U.S.: The Less Educated ##br##Are Shunning The Labor Force Slack Around The World Slack Around The World Chart 7U.S.: Fewer Potential Workers ##br##On The Sidelines bca.gis_wr_2016_11_04_c7 bca.gis_wr_2016_11_04_c7 Chart 8Japan's Underutilized Labor Force bca.gis_wr_2016_11_04_c8 bca.gis_wr_2016_11_04_c8 The incidence of involuntary part-time employment in Japan has returned to where it was prior to the Great Recession. However, in absolute terms, it remains quite high - in fact, nearly as high as in Europe. Japanese full-time employees may also not be as productively engaged as they could be. As evidence, note that output-per-hour in Japan is 37% lower than in the U.S. and 33% lower than in Germany (Chart 8). From this we conclude that there is somewhat more labor market slack in Japan than the headline unemployment rate suggests. Industrial Capacity Utilization Goods-producing sectors typically account for less than a third of GDP in most advanced economies. Nevertheless, because the demand for goods tends to be more volatile than the demand for services, fluctuations in industrial production often account for the bulk of the changes in output gaps. As Chart 9 shows, after a brisk recovery following the financial crisis, the U.S. industrial capacity utilization rate has been trending lower for the past two years. It currently stands at 75.4%, 5.6 percentage points lower than at its pre-recession peak. The Institute for Supply Management's semi-annual capacity utilization survey also suggests that many U.S. manufacturing businesses are operating substantially below potential (Chart 10). Much of the deterioration in U.S. industrial utilization reflects the effects of the energy bust and a stronger dollar. Business capex has decelerated sharply as a consequence of these forces, falling by over two-thirds in the case of energy capex. This should cut into excess capacity. Chart 9U.S.: Industrial Capacity ##br##Utilization Remains Low bca.gis_wr_2016_11_04_c9 bca.gis_wr_2016_11_04_c9 Chart 10U.S.: Less Slack In Services ##br##Than Manufacturing U.S.: Less Slack In Services Than Manufacturing U.S.: Less Slack In Services Than Manufacturing The dearth of new investment elsewhere in the world should also help prop up utilization rates (Chart 11). Industrial utilization is close to its historic average in Europe. Unlike in the case of labor markets, there is not a lot of regional variation in capacity utilization rates across the euro area. If anything, Italian spare capacity is actually closer to its pre-recession level than Germany's. Chart 11AEurope: Idle Industrial Capacity Is Shrinking Europe: Idle Industrial Capacity Is Shrinking Europe: Idle Industrial Capacity Is Shrinking Chart 11BEurope: Idle Industrial Capacity Is Shrinking bca.gis_wr_2016_11_04_c11b bca.gis_wr_2016_11_04_c11b Chart 12Excess Capacity Has Declined In Japan Excess Capacity Has Declined In Japan Excess Capacity Has Declined In Japan Capacity utilization has also returned to its long-term trend in Japan. Encouragingly, the Tankan Factor Utilization Index has risen to its highest level since the early 1990s (Chart 12). Nevertheless, the strong yen is starting to put pressure on Japan's industrial sector. This suggests that further monetary easing from the BoJ will be necessary. Economic And Investment Implications Our analysis suggests that spare capacity has narrowed substantially within the developed world, although for some countries not quite as much as output gap estimates from the IMF and the OECD indicate (particularly in the case of peripheral Europe). Unfortunately, most of the decline in spare capacity is attributable to lackluster supply, rather than faster demand growth (Chart 13). Interestingly, a cyclically-induced withdrawal of workers from the labor market has only played a modest role in explaining the slowdown in potential GDP growth and the resulting decline in output gaps. Instead, most of the deceleration in potential GDP growth stems from lower productivity gains. Chart 13AWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_11_04_c13a bca.gis_wr_2016_11_04_c13a Chart 13BWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_11_04_c13b bca.gis_wr_2016_11_04_c13b Some of the decline in productivity growth reflects cyclical factors, especially weak business investment. However, as we have discussed in past reports, much of it reflects structural forces such as declining educational achievement and a shift in focus of internet innovation away from business productivity applications towards consumer services such as social media.3 Looking out, narrowing output gaps will put upward pressure on inflation. We are long Japanese and German inflation protection via the CPI swap market. Governor Kuroda has made it clear that he wants Japanese inflation to rise above 2% to make up for the fact that inflation has perpetually undershot the BoJ's target. The Bundesbank may not want higher inflation, but the ECB's need to reflate Southern Europe all but guarantees such an outcome. As spare capacity continues to dwindle, forward guidance will become a more effective tool for central banks. The essence of forward guidance is the commitment to keeping monetary policy ultra loose even when the economy begins to overheat. If people believe that the central bank will keep the punch bowl filled, this could cause long-term inflation expectations to rise, leading to lower real yields and increased spending today. Such a commitment is likely to be regarded as more credible if people expect it to be carried out over the next few years, rather than at some distant point in the future. The Bank of Japan has already moved in that direction with its pledge to engineer an inflation overshoot by keeping the 10-year JGB yield anchored at zero. Chart 14China: On The Mend, Cyclically China: On The Mend, Cyclically China: On The Mend, Cyclically The U.S. has the smallest output gap, but the highest neutral interest rate, among the major developed economies. This week's FOMC statement strongly hinted at a December rate hike. As we discussed two weeks ago, in addition to one hike this year, we expect the FOMC to hike rates twice next year.4 This should cause the real broad trade-weighted dollar to appreciate by 10% over the next 12 months. A stronger dollar will mitigate some of the upward pressure on U.S. bond yields. Nevertheless, as slack continues to erode and inflation shifts higher, Treasury yields, along with bond yields elsewhere, should continue trending higher. Global equities are currently highly vulnerable to a near-term correction, owing to a more hawkish Fed and growing U.S. election uncertainty. We are currently short the NASDAQ 100 futures as a hedge, a trade that has gained 3.1% since we initiated it. Once the dust has settled, European and Japanese stocks will outperform their U.S. peers. This is partly because U.S. stocks are relatively expensive, but it is also because an ascending dollar will hurt U.S. multinationals. Investors should overweight Japanese and European stocks on a currency-hedged basis within the developed market universe. The outlook for emerging markets is mixed. On the one hand, the recent uptick in Chinese growth - as evidenced by this week's better-than-expected PMI data (Chart 14) - should provide some support to commodity prices and EM assets. On the other hand, a stronger dollar will weigh on commodities, while making it more onerous for some emerging market companies to refinance their dollar-denominated loans. Higher U.S. rates could also reduce the global pool of dollar liquidity, making it difficult for some emerging markets to finance their current account deficits. On balance, a modestly underweight stance towards EM assets is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 The IMF uses a more ad hoc approach. Desk economists have significant leeway in how they estimate output gaps for their respective economies. Most economists rely on statistical models and production function calculations, intermixed with educated guesswork. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see Global Investment Strategy Special Report, "Slower Potential Growth: Causes And Consequences," dated May 29, 2015; and Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades