Equities

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

Special Report

Highlights The brief history of our model portfolios is a tale of two regions: our global portfolios are beating their benchmarks by an aggregate 350 basis points ("bps"), while our U.S. portfolios lag by 55 bps. Defensive sector tilts weighed on all four portfolios, but market-cap tilts gave the U.S. portfolios a big boost, and currency-hedged country and fixed-income positions turbocharged global portfolio performance. We expect to see bond yields, the dollar and DM equity prices higher at year-end 2017 and our portfolio positioning will continue to reflect these broad themes. True inflection points are few and far between, but the U.S. will at least experience a sugar rush, and we are adding some credit risk while walking back some of our defensive equity positioning to prepare for it. Table 1Summary Portfolio Performance Feature This report presents the first review of our model portfolios, which have now been live for seven weeks. Going forward, we will review them in our first publication of every month. The reviews will have two components: an ex-post examination of portfolio performance and an ex-ante discussion of our outlook. Both components are meant to foster transparency, with the ex-post component opening a window on our ongoing efforts to improve our process, and the ex-ante component shining a light on how our views are evolving in real time. Results To Date Our model portfolios have outperformed, on balance, over their first two months, but the aggregate results cover over a fault line between U.S. and global portfolio performance. The U.S. Long-Only portfolio is just even with its benchmark and the Long/Short lags by 55 bps, (Table 1). The disparity highlights the way dollar moves can create international opportunities. Being on the right side of the greenback helped us generate alpha despite dreadful sector positioning. Portfolio Performance Attribution We track portfolio attribution on up to six applicable dimensions. For all the portfolios, we consider Asset Allocation, Equity Sector Allocation and Fixed Income Category Allocation. If the Equity portion of the portfolios has any mid- or small-cap exposures, we track Market Cap Allocation; if it has multi-country exposures, we track Country Allocation; and if it has short positions, we track Long/Short Allocation based on the contribution from its long/short pairs. Since all of the portfolios were initially set to match our benchmark asset allocations (60% Equity/37.5% Fixed Income/2.5% Cash), we have no Asset Allocation attribution to report in this update (Table 2). Table 2Applicable Attribution Sources U.S. Long-Only Our U.S. Long-Only portfolio (Table 3) outperformed its benchmark by 1 basis point through November 30.1 Market cap allocation paved the way to the outperformance, as small- and mid-cap stocks zoomed higher following the election (Table 4). Our fixed-income category allocations helped, as well, with the outperformance of our income hybrids bucket and our sizable underweight in lagging investment-grade corporates more than making up for our zero weight in outperforming high yield (Table 5, bottom panel). The gains were consumed by equity sector underperformance, which labored mightily under an inopportune defensive bias (Table 5, top panel). Table 3U.S. Long-Only Model Portfolio: Absolute Performance By Position Table 4U.S. Relative Performance Contribution From Market-Cap PositioningTable 5U.S. Relative Performance Contribution From Sector Positioning U.S. Long/Short Our U.S. Long/Short portfolio (Table 6) underperformed its benchmark by 55 basis points through November 30.2 Larger defensive sector tilts weighed on the long/short portfolio relative to its long-only counterpart, compounded by short positions in cyclical sectors (Table 7, bottom panel). Our fixed-income pairs fared better: while the HYG short/LQD long detracted from performance, the IEF short/TIP long was able to offset it (Table 7, top panel). The former, an anti-credit risk (and duration-extending) play, was poorly positioned on both counts, but the latter was well positioned to reap the benefit of the pickup in inflation expectations. Table 6U.S. Long/Short Model Portfolio: Absolute Performance By Position Table 7U.S. Relative Performance Contribution From Long/Short Pairs Global Long-Only Our Global Long-Only portfolio (Table 8) outperformed its benchmark by 188 basis points through November 30.3 Successful country positioning contributed to the sizable outperformance, as the (currency-hedged) Japan overweight was a rousing success (Table 9). Fixed-income category allocations were also big winners, driven by the currency-hedged non-U.S. aggregate exposure (BNDX) and the U.S. aggregate (AGG) and corporate holdings (LQD), which more than offset the drag from the unhedged international sovereign exposure (BWX) (Table 10, bottom panel). Only equity sector allocations weighed on the portfolio, as both Staples and Health Care were drubbed by the benchmark index (Table 10, top panel). Table 8Global Long-Only Model Portfolio: Absolute Performance By Position Table 9Global Relative Performance Contribution From Country PositioningTable 10Global Relative Performance Contribution From Sector Positioning Global Long/Short Our Global Long/Short portfolio (Table 11) outperformed its benchmark by 166 basis points through November 30.4 Just like its U.S. counterpart, the global Long/Short portfolio was weighed down by its wrong-footed long defensives/short cyclicals pairs (Table 12). Country long/short pairs paid off nicely, however, especially in November, as emerging markets with sizable current account deficits, like Turkey and Brazil, underperformed their less dollar-vulnerable peers. Our fixed-income long/short pairs also outperformed, albeit by a smaller margin. Table 11Global Long/Short Model Portfolio: Absolute Performance By Position Table 12Global Relative Performance Contribution From Long/Short Pairs How Our Views Fared Rates, Inflation And Credit Markets rewarded two of the four components of our fixed-income view. U.S. inflation expectations surged (Chart 1) and developed-world sovereigns proved to be an especially poor value, as the aggregate G7 economies' 10-year bond yield spiked faster than at any point since the taper tantrum in 2013 (Chart 2). These views, expressed as portfolio tilts - underweight fixed income, own TIPS and hold duration at or below benchmark duration - worked well when translated to portfolio positions, as noted above. Chart 1Inflation Expectations Spiked... Chart 2...And So Did Nominal Yields The bear-flattening call turned out to be a dud, as the Treasury yield curve steepened despite the looming Fed tightening cycle. Overwhelmed by our anti-duration call, though, it had no meaningful portfolio impact. Our credit-bearish call was a central fixed-income pillar in all four of our portfolios, and it did constrain performance as high yield outperformed at home and abroad. Yields may well be due to pull back following their November surge, but we see them ending 2017 higher, making credit's positive carry an attractive buffer against rising rates. Economic Growth And Corporate Earnings Our concerns that the equity rally has become uncomfortably stretched, and that U.S. corporate margins face downward pressure, did not amount to anything over the last two months. Since we maintained benchmark equity weightings across all of our portfolios, however, our too-early views did not affect performance. We expressed our defensives-over-cyclicals view in every portfolio's sector allocations to the detriment of performance across the board. Thanks to currency-hedged Japanese equities' surge, the global portfolios benefitted slightly from our view that European and Japanese multinationals would find the going easier than their U.S. counterparts, and we remain optimistic about the potential for a relative European profit inflection. New And Revised Views Rates, Inflation And Credit There are still too many unknowns about the details of policy proposals to assess whether or not the U.S. is on the cusp of sustained growth acceleration, but the incoming administration, supported by a compliant Congress, can unquestionably bestow a sugar rush. The credit upshot is that it will be harder to default if both growth and inflation get a fillip in 2017. The curve is likely to steepen on the grounds that our bond strategists expect the Fed to allow inflation expectations to gather momentum before it signals an increased pace of hikes and a higher terminal rate. The bond vigilantes could add to the upward pressure on long rates if they ever stir from their long hibernation. It would be entirely reasonable for yields to retrace at least a portion of their sudden and sizable move, and our U.S. Bond Strategy service has moved to benchmark duration to position for near-term consolidation. It still sees long rates higher a year from now, though, and we are not going to wait to add some carry to the portfolio. We are replacing our U.S. REIT exposure with business development company exposure via the BIZD ETF, which will add some beta along with credit exposure. We are going to add bank loans in the form of the BKLN ETF, providing some rate protection (bank loans carry floating rates) and allowing us to dip our toe into the most senior tranche of the high-yield space. BKLN will push our Treasuries exposure to below benchmark,5 but we will maintain Treasury duration near benchmark in line with our bond strategists' tactical guidance. We will look to exit our TLT position on a 10-year rally back to the 2-2.2% range. Chart 3Pigs Get Slaughtered Cyclicals Versus Defensives The uncertainty around the impact of the incoming administration's proposed policies keeps us from fully reversing course on our cyclicals/defensives positioning. But our conviction about higher rates increases our remorse at overstaying our welcome in Staples and Telcos (Chart 3). As an analogue to positioning for near-term economic acceleration by taking on some credit risk, we're shifting capital away from rate-driven Staples and Telecom to Discretionaries and Energy. Our exit from Swiss equities in the global portfolios furthers our move to more neutral intra-equity settings. We are adding Energy exposure to all of the portfolios to reflect our strategists' bullish take on crude oil. The recently agreed OPEC-Russia production cuts will fuel inventory drawdowns that will keep crude prices from falling below $50. Our Energy Sector Strategy service argues that U.S. shale producers will reap the greatest benefits, as $50+ crude will allow them to accelerate oilfield reinvestment and grow production in 2017. We are therefore adding FRAK, an ETF dominated by U.S. shale oil and natural gas producers, to our U.S. portfolios.6 Other Portfolio Changes Aside from dialing back our defensive equity positioning and embracing some credit risk, our biggest change has been to pull in our horns on the sector tilts across all of our portfolios. We are chastened by being off-sides with our sector calls and are pulling back until we have a better sense of direction. We are waiting in all portfolios for an opportune time to shorten duration. We expect to maintain our sizable income hybrids sleeve as the nascent bond bear market grinds along. Table 13 shows our revised U.S. Long-Only portfolio. As mentioned above, it no longer shuns cyclical sector or credit exposures and will continue to evolve with the anticipated direction of the economy. We have chosen not to rebalance our mid- and small-cap exposures and we would be happy to increase them if they retrace some of their relative gains in the near term. The U.S. Long/Short portfolio (Table 14) is effectively an amplified version of the Long-Only portfolio but its sector tilts are being trimmed considerably as well. Table 13Revised U.S. Long-Only Model Portfolio Table 14Revised U.S. Long/Short Model Portfolio The changes to our Global Long-Only portfolio mute its defensive bias and attempt to simplify it by removing standalone currency-hedging positions (Table 15). We substitute HEWU, the currency-hedged version of EWU, for our existing EWU/FXB pair, giving up some liquidity to save on ETF and borrow fees. We clean up the other currency short by exiting our Swiss equity position, which is no longer needed now that we are dialing back the portfolio's defensive cast. We exit BWX and reallocate its proceeds to BNDX and AGG to simplify the portfolio and remove incremental sovereign and currency exposure. We replace LQD with JNK to introduce a modest high-yield exposure to the portfolio. Table 15Revised Global Long-Only Model Portfolio Like its U.S. counterpart, our Global Long/Short portfolio is significantly dialing back its sector tilts (Table 16). The Staples, Telco and Utilities overweights are being eliminated, along with the Financials short. The Health Care overweight and the corresponding Industrials and Tech shorts have been reduced. As in the Long-Only portfolio, we are exiting Switzerland and redeploying the proceeds in Energy, Discretionaries and a slightly reduced U.S. underweight. We are replacing the incremental exposure to U.S. Investment Grade (LQD) with High Yield (JNK), reflecting our U.S. rates and credit view. With the addition of JNK, we are taking the opportunity to do a little housecleaning by replacing the U.S. leg of our EM junk spread-widening pair, formerly HYG, with JNK, which better aligns with our portfolio benchmark and is 10 bps cheaper per annum. Table 16Revised Global Long/Short Model Portfolio Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 Through December 5th, the U.S. Long-Only portfolio is in line with its benchmark. 2 Through December 5th, the U.S. Long/Short portfolio has underperformed by 65 basis points. 3 Through December 5th, the Global Long-Only portfolio has outperformed by 184 basis points. 4 Through December 5th, the Global Long/Short portfolio has outperformed by 160 basis points. 5 In our October 12th Special Report introducing the model portfolios, we referred to outdated Aggregate/High Yield proportions in our U.S. and global fixed income benchmarks. Based on the outstanding value of the bonds in the indexes, the correct U.S. breakdown is 90/10 AGG/HY and the correct global breakdown is 93/7 AGG/HY, not 95/5 as originally stated. Our performance attribution calculations reflect the correct benchmarks. 6 For more information on the shale producers and the effects of the OPEC cuts, please see the following Energy Sector Strategy reports, available at nrg.bcaresearch.com: Constructive On U.S. Shale Producers And Select Service Companies, published July 6, 2016; The OPEC Debate, published November 23, 2016; and Recommendation Additions & Changes Following OPEC's Cut, published December 7, 2016.

We downshifted our view on the S&P health care facilities index at mid-year, because consumer spending on health care was decelerating, which favored moving into equities that paid for medical services (managed care) vs. those that provided them. While this trend remains intact, health care facilities stocks appear to be discounting an extreme scenario. The current concern is that the Affordable Care Act (ACA) will be repealed, leaving hospitals to foot the bill for uninsured patients. While such a scenario would potentially reverse the decline in the provision for doubtful accounts (PDA), a major profit margin support, the ACA is more likely to be reworked than repealed especially in the absence of a replacement plan. Importantly, there are other offsets. PDA follows the unemployment rate, which is signaling that the former will decline further. Hospital cost inflation is beginning to recede, led by drug costs. It would take massive earnings downgrades to validate the pessimism embedded in current valuations. We will look to buy this group opportunistically in the coming months.

After the Trump election victory, we immediately upgraded our financial sector view to neutral to protect against the benefit of rising interest rates and the potential for a clear asset preference shift in favor of stocks over bonds. Trump's inflationist policy rumblings have kickstarted a steep advance in the total return of equity vs. bonds (E/B). BCA's strategists believe that this trend has long-term staying power. The E/B ratio has an excellent track record in heralding the relative performance of the S&P asset manager & custody bank (AMCB) index. If investors shift assets from bond products and into equity mutual funds and ETFs, from the current extremely depressed skew (bottom panel), then there is scope for cyclical profit margin upside at asset management firms. Current valuations do not fully discount such a shift, and we recommend an overweight position in the S&P AMCB index. The ticker symbols for the stocks in this index are: BLBG: S5AMGT - BK, BLK, STT, TROW, AMP, NTRS, BEN, IVZ, AMG.

Highlights The Chinese authorities have progressively tightened capital account control regulations to staunch capital outflows, which will likely slow the drawdown of the country's official reserves in the near term. Rising yields in China are largely reflective rather than restrictive. Monetary easing through interest rate cuts has likely run its course, but it is highly unlikely that the PBoC will raise rates to protect the RMB. The Shenzhen-Hong Kong connect program is yet another step towards China's capital account liberalization. In the near term it could give a boost to Hong Kong-listed shares due to the large valuation gap. The direct impact on the RMB is marginal. Feature The mighty U.S. dollar occupied the cover of this week's Economist magazine - it has also clearly occupied the top spot on our clients' 'worry lists'. We were in China last week talking to clients and conducting some "field research", and the yuan's depreciation was a key focal point of the discussions. Historically, Economist magazine cover stories have mostly turned out to be perfect contrarian signals, and it remains to be seen whether this one will be a blessing or curse for the greenback. What's more certain is that there is a clear consensus among Chinese investors on the one-way descent of the RMB against the dollar going forward, and the People's Bank of China (PBoC) is facing an uphill battle in containing domestic capital outflows. The latest program linking Chinese equities and the overseas market is the Shenzhen-Hong Kong connect program, which debuted early this week. This suggests the Chinese authorities are still committed to capital account deregulation. In the near term, however, capital control measures have been tightened progressively to preserves official reserves and maintain domestic liquidity. Full-Court Press Heightened concerns over the CNY/USD cross rate of late have ignored the fact that the RMB has remained one of the stronger currencies among a synchronized plunge against the seemingly unstoppable dollar. The trade-weighted RMB has picked up notably in recent weeks, even though it has depreciated against the greenback (Chart 1). Nonetheless, Chinese investors' perception of the currency matters greatly, as it could potentially create a self-fulfilling downward spiral between capital outflows and exchange rate depreciation. It is both naïve and highly risky to expect the RMB to settle down at a "market clearing" level against the dollar without a chaotic undershoot. The "Impossible Trinity" theory in international finance dictates that a country cannot simultaneously control its exchange rate with independent monetary policy and free flow of capital. Among these conditions, free flow of capital has been the least expensive sacrifice for the Chinese authorities.1 In basketball, full-court press refers to a defensive tactic in which members of a team cover their opponents throughout the court, and not just near their own basket. This is what the Chinese authorities appear to be doing in terms of their efforts at staunching capital outflows. Cracking down on underground money smugglers facilitating RMB conversions with other currencies, particularly in regions neighboring Hong Kong. Anecdotal evidence suggests a sharp slowdown in illegal money transfers. Tightening scrutiny on trade invoicing verifications to crack down on "fake" international trades. Chinese imports from Hong Kong, sky-high last year as Chinese local firms fabricated import businesses to move money offshore, have tumbled to a fraction of last year's peak level (Chart 2). Restricting Chinese nationals from purchasing insurance policies issued by Hong Kong insurance firms. The massive boom of Hong Kong insurance sales to mainland residents in recent years will likely see a significant setback (Chart 3). Chart 1The RMB's Depreciation In Perspective Chart 2Blocking Capital Leakage In Trade... Chart 3...Services... These restrictive measures have been either targeting illegal channels or activities that are of minor importance to the economy as a whole. More recently, the authorities have also begun tightening rules on direct overseas investment by Chinese firms. Projects over US$10 billion and investments in "non-core" businesses are being tightly scrutinized. As companies' overseas expansion efforts are largely strategic in nature and tend to be long term, policymakers are potentially sacrificing long-term economic interests for a near-term fix of capital leakage. This underscores the authorities' increasing anxiety over capital outflows. Chart 4 shows net FDI outflows have become a major source of China's capital outflows in recent quarters, while Chinese firms paying off foreign liabilities was previously the main reason.2 Moreover, there has been a rush to acquire foreign assets among large Chinese firms this year, which is probably partially motivated by avoiding exchange rate losses (Chart 5). Chinese overseas investment activity will likely slow down significantly in the near term. Chart 4...And Outward Direct Investment Chart 5Overseas M&A Under Scrutiny Yesterday's data release show Chinese official reserves dropped to USD 3.05 trillion in November, down USD 69 billion from October. On surface, this is a marked deterioration from previous months. Underneath, however, our calculation shows that the decline in the headline official reserve number is more than explained by the mark-to-market paper losses from both a strengthening dollar and rising interest rates in the U.S. in the past month. Non-dollar assets account for about half of Chinese official reserves, and the 5% surge in the U.S. dollar index last month alone should have led to about $75 billion paper losses in the dollar value of Chinese reserves. Meanwhile, Chinese holdings of U.S. treasuries and agency bonds amount to about USD 1.4 trillion, and the sharp spike in U.S. risk free rates last month should have shaved off at least USD 30 billion in value. Taken together, the mark-to-market losses of Chinese reserve holdings are should be substantially higher than the decline in reserves last month. This may suggest that China's all-out efforts to stabilize capital outflows have been effective and should further reduce the drawdown of the country's official reserves. P.S. Over the years, we have been running a series of Special Reports tracking the composition and evolvement of China's foreign reserves. This year's update will be published next week. Stay tuned. Chart 6Interest Rate Vs Exchange Rate Will Interest Rates Be The Next Shoe To Drop? Chinese interest rates have also begun to pick up in recent weeks, as the RMB has continued to depreciate against the dollar (Chart 6). The increase in interest rates so far has been much milder compared with mid-2015, when RMB/USD depreciation sparked widespread financial volatility. Some have attributed China's higher interest rates to a weakening currency - as a sign that the country's monetary policy independence has been undermined. Recently, a senior PBoC official hinted that the central bank can raise interest rates if necessary to counter the downward pressure of the RMB, which further reinforces this view. Raising interest rates has been a typical policy response, especially among emerging countries look to defend their exchange rates, but it has rarely been proven successful. Hiking rates at a time of currency weakness further weakens domestic growth, which can in turn reinforce additional downward pressure on the exchange rate. The PBoC could certainly raise its benchmark rate, but we doubt the central bank is at all considering this option. In our view, the recent rise in Chinese interest rates may be attributable to both domestic and global factors: Globally, the synchronized selloff of bonds in major countries may have also pushed up Chinese interest rates. Chinese 10-year government bond yields have increased by 45 basis points since their August lows, not extraordinary considering the 102-basis-point selloff in U.S. Treasurys (Chart 7). Domestically, stronger growth numbers reported of late are providing additional evidence of growth improvement, which may have led to an adjustment in Chinese interest rate expectations (Chart 8). The latest PMI numbers point to further acceleration in both manufacturing and service industries, while the growth "surprise index" has been gradually improving and the yield curve has been steepening. Chart 7Higher Chinese Yields Reflect Global Factors... Chart 8... And Growth Improvement In short, we view rising yields in China as largely reflective rather than restrictive. As such, the PBoC is unlikely to rush in to push yields down just yet. In terms of monetary policy, we maintain the view that China's monetary easing through interest rate cuts has likely run its course, at least in the near term. Nonetheless, raising interest rates to protect the RMB would be a major policy mistake that would further undermine the exchange rate. Chart 9Cheaper Hong Kong Valuation Attracts ##br##Chinese Domestic Capital The Shenzhen-Hong Kong Connect Compared with the Shanghai-Hong Kong program that started over two years ago, the Shenzhen-Hong Kong connect program that debuted early this week has been received with much less enthusiasm from investors on both sides. The muted response in the marketplace likely reflects generally depressed sentiment within both Chinese and Hong Kong bourses. Given the large gap between Chinese domestic A shares and Hong Kong-listed stocks and well-entrenched expectorations of further RMB weakness, Chinese investors' purchases of Hong Kong-listed shares, or southbound purchases, will likely continue to increase (Chart 9). The establishment of the Shenzhen-Hong Kong connect program is also another step in liberalizing China's capital account controls. While in the near term this contradicts the authorities' recent efforts to block capital outflows, the new stock connect channel is subject to daily quotas, and capital movement is under close scrutiny. Meanwhile, capital flows through the stock exchanges are tiny compared with economic activity. In the past two years, Chinese domestic investors' cumulative "southbound" net purchases of Hong Kong-listed stocks only amounted to RMB 200 billion, or US$30 billion, a fraction of the country's capital movement and foreign reserve holdings. As far as investors are concerned, a major difference between the two Chinese domestic exchanges is their sectoral composition. The Shanghai Stock Exchange is heavily concentrated in the financial sector and state-controlled enterprises (Table 1). The Shenzhen Stock Exchange, on the other hand, is more tech-heavy with larger representation of private firms, and therefore has been more dynamic, which is also reflected in its stock prices. The Shenzhen stock index has outperformed that of Shanghai massively in recent years (Chart 10). In this vein, opening Shenzhen stocks directly gives overseas investors another option to tap into some of China's fastest growing sectors. This could also increase the odds that MSCI Inc. may include Chinese domestic stocks in its widely followed EM and global indices in its next review. Table 1Sectoral Components Of Shanghai And ##br##Shenzhen Exchanges Chart 10Shenzhen Market's Secular Outperformance##br## Against Shanghai The bottom line is that the Shenzhen-Hong Kong connect program is yet another step towards China's capital account liberalization, allowing freer access between Chinese and overseas investors to each other's financial assets. In the near term it could give a boost to Hong Kong-listed shares due to the large valuation gap. The direct impact on the RMB is marginal. 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, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

The S&P railroad index has vaulted higher, along with many other industrial groups, but it may be starting to overshoot fundamental improvement. Technical conditions are becoming overbought. The 52-week rate of change is nearing previous peaks, with the exception of the spike during the GFC in 2008/2009. Relative valuations are also stretching to the point where imminent earnings improvement may be required to sustain outperformance. While rail freight growth has improved, and coal is shifting away from acting as a major drag, productivity growth is not yet showing through. For instance, weekly train speeds have eased. Meanwhile, this capital-intensive industry may be about to boost investment. The chart shows that railroad employment leads our capital spending-to-sales proxy. The latter had plunged as railroads moved aggressively to protect margins during the downturn, and any premature reversal could cut short the earnings recovery. We are overweight this group, but are putting it on downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5RAIL-UNP, CSX, NSC, KSU.

The financials sector has cheered President-elect Trump's anticipated policy changes as if they will all be enacted within very short order. While the yield curve has steepened modestly, the widening pales in comparison with the violence of the relative performance rise in financial share prices. We caution against extrapolating recent sector gains. If yields rise much further, they will be in danger of moving ahead of the rate of GDP growth, as the latter is unlikely to benefit from any fiscal stimulus for at least a few quarters. Financials (and the broad market), have trouble when this measure of liquidity tightens. The financial sector is already facing a cooling in the pace of credit creation and a decline in credit quality: financials sector ratings migration is steadily deteriorating. The bottom line is that the upward spike in financials sector relative performance is due for a breather, and only neutral weightings are recommended.

Health care stocks have consistently outperformed during the six inflationary periods we studied (top panel). Over the long haul it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is also on a secular rise around the globe: in the developed markets driven largely by the aging population and in the emerging markets by the adoption of health care safety nets. Health care pricing power is expanding at a healthy clip, outshining overall CPI (bottom panel). Importantly, recent geopolitical uncertainty had cast a shadow on the sector's pricing power prospects that suffered from a constant derating. Now that political and pricing power uncertainty is lifting, a rerating looms. Finally, the health care sector's dividend yield allure is the lowest among defensive sectors and remains 44bps below the broad market, somewhat insulating the sector from the inflation driven selloff in the bond market. Bottom Line: Stay overweight the S&P health care sector.

President-elect Trump and the specter of his spendthrift policy proposals have generated significant client interest/inquiries on equities and inflation - not asset price, but of the more traditional kind: consumer price inflation. Accelerating inflation is a modest risk, but not our base case forecast. Nevertheless, for investors that are more worried about the prospect of higher inflation, the purpose of yesterday's Special Report is to serve as an equity sector positioning roadmap if inflationary pressures become more acute sooner than we anticipate. Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be primary beneficiaries. The table shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. Utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag (please see the next Insight).

Highlights The rise in both bond yields and the U.S. dollar represents significant tightening in monetary conditions, which will be difficult for stock prices to digest. Technical indicators suggest that the rally could persist in the near term, but investors should nonetheless prepare a shopping list once prices correct. Both consumer discretionary and health care stocks are appealing longer-term plays that are less expensive than the broad market. Feature The current rally in equity prices is high risk. Since the summer, our main worry for the stock market has been the likelihood of profit disappointments, given that corporations lack pricing power and that the outlook for top-line growth is lackluster. That worry has not gone away, but now the more pressing issue has become the impact on equity prices of the swift and aggressive tightening in monetary conditions via both the bond market sell-off and rise in the dollar (Chart 1). The 10-year Treasury yield is now trading above fair value. True, in the past, equity prices have sustained gains until yields rose much further into undervalued territory, but the big difference this time is that the dollar is rising in tandem. Simultaneous powerful rises in the currency and yields are rare, and typically result in steep market pullbacks. Investors should be on high-alert for this outcome. The possibility that equity market euphoria persists for another month or two should not be ruled out, i.e. until the Fed's next meeting and until there is more clarity on the course of fiscal and trade policy. Indeed, a simple read of technical indicators and market sentiment suggest that the rally could continue, but the risk/reward balance is poor (Chart 2). Chart 1Monetary Conditions Have Changed Chart 2Technicals: Not Flashing A Warning Yet With that in mind, one of the most frequently asked (and difficult) questions we receive is, Where is the value in U.S. equities? Presently, this is akin to looking for deals on New York's Upper 5th Avenue.1 As Chart 3 shows, U.S. equity multiples remain near or at historic (ex. TMT mania) highs. This is true for both small and large caps. And relative to global equity valuations, U.S. stocks appear even more expensive. There are few sectors that we believe offer compelling absolute value today. However, on a relative basis, the Trump rally has caused a flight out of traditional safe havens that has gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis (Chart 4). According to our U.S. Equity Strategy service, forward relative returns are typically very robust when the group trades at a discount to the market. Importantly, consumer products stocks have a positive correlation with the U.S. dollar, which means that recent share price weakness represents a buying opportunity. Chart 3No Deals Here Chart 4Good Entry Point To Consumer Products? As highlighted above, we are on high-alert for an equity shakeout, triggered by the rapid rise in bond yields, and reinforced by profit disappointment. Still, we have assembled a short shopping list of sectors that we believe offer long-term upside. Health care and consumer discretionary stocks already offer better value than other areas of the market. Consumer Discretionary Will Last Longer This Cycle We have recommended favoring domestic over global exposure within U.S. equities and, in-line with our U.S. Equity Strategy service, we have favored non-cyclical holdings. But the cyclical interest rate-sensitive consumer discretionary sector deserves more attention, especially given good relative valuations. The recent back-up in bond yields has sent the relative performance of consumer discretionary stocks to a four-year low, once heavyweight Amazon is excluded (Chart 5). Admittedly, this comes on the back of an almost uninterrupted run higher since 2010. Still, since we believe it unlikely that the current back-up in yields can continue much longer, any cooling in bond yields could start a rotation back into consumer discretionary stocks. In last week's Special Report,2 we outlined the case as to why structural headwinds make it highly unlikely that the Fed will need to aggressively tighten in the coming year. In our view, the interest rate backdrop is unlikely to be an insurmountable headwind for this sector. Most importantly, fundamentals for consumer spending have been slowly improving. The labor market is now tight enough that consumers have job security (Chart 6). Incidentally, consumer confidence is now back to historically buoyant levels. The greatest ramification of this is that higher job security historically goes hand in hand with greater demand for credit. Until this point of the cycle, consumption growth has been capped by income growth trends because there has been no appetite to borrow in the aftermath of the Great Recession. We highly doubt that a new debt-fuelled spending spree will get underway, but rising job security should help fuel some credit growth. Chart 5Consumer Discretionary Stocks##br## Should Resume Outperformance Chart 6Consumers: The Future##br## Is Brighter Alongside improved job security, consumers are enjoying a tailwind from a historically light drag on their finances (Chart 6). Consumer spending on essential items, which includes energy costs, interest expense, insurance, taxes, etc. is at multi-decade lows. If BCA's benign forecast for energy prices (around $50 per barrel) and rate backdrop pans out, then there should continue to be ample spending room on discretionary items. The bottom line is that consumer discretionary stocks are one of the few sectors that are trading at historically reasonable valuations. We believe that a combination of a benign rate backdrop, better consumer confidence and a strong dollar will help this sector outperform late into the business cycle. Particular emphasis should be placed on industry groups and companies that can maintain positive pricing power. This includes movie & entertainment and restaurant stocks. Retailers should be de-emphasized until deflationary pressures ease, as we discuss on page 9. Follow The Baby Boomers To...Health Care Stocks In our Special Report last week, we explained how the aging population will continue to have implications for the labor market and wages. We also believe that demographics will eventually have important implications for equity sector outperformance. BCA Research periodically puts forward investment mania candidates. Charles Kindleberger described three conditions that must be met in order to create a financial mania and bubble: a powerful theme that captures the imagination of investors which is often the result of a major economic displacement; low interest rates; and finally, investment vehicles that allow rampant speculation (Chart 7). We believe that the aging of the population and the need for increased resources to service that population could be a powerful theme that captures investors' attention in the coming years. Chart 7A History Of Manias Since the baby boomers came of age (in the 1960s), their massive numbers relative to other age cohorts has given this generation an outsized influence on political, social and economic trends. Put simply, the baby boom generation has had the most clout because of their sheer numbers. And what do baby boomers want now? This age cohort is now focused on prolonging good health for as long as possible! It makes sense, then, any coming pent-up demand for goods and services will focus on health-related spending. As Chart 8 shows, spending on health care increases significantly for the 65-year and over cohort. This massive increase in health care spending has already begun but is likely to increase much more in the coming years. Chart 8Spending On Health Care Accelerates With Age To further highlight this point, in a Special Report last year,3 we made the case that health care will be one of the greatest sources of innovation this cycle. As we highlighted then, government R&D spending on basic research tends to lead practical applications, such as in the 1950s innovation boom after WWII (Chart 9). Currently, government R&D spending is growing much faster in healthcare than in tech. The private sector is also in agreement with tech VC investment still well below its 2000 peak, whereas healthcare is hitting new highs. Chart 9Health Care R&D Spending Is An Outlier Health care relative valuations are significantly below their post-2008 mean (Chart 10). We will explore the potential for health care as a mania candidate in an upcoming Special Report, but our preliminary work suggests that health care stocks should be on the top of investors' shopping lists. Chart 10Long-Term Value In Health Care Stocks Economic Momentum Heating Up? The surprising election results have stolen the financial media's focus away from economic and profit fundamentals in the past few weeks. Admittedly, investors who were focused on the elections did not miss much: the overall picture of economic growth has not changed in recent weeks. Indeed, the Fed's Beige Book of anecdotes on the state of the U.S. economy, released last week, indicates that growth remains mediocre, although sufficient enough for the Fed to raise rates later this month. Nevertheless, we have been monitoring consumer and business confidence closely, as we believe that this will be a key gauge to the likelihood that a more virtuous economic cycle is underway. There is some improvement: Consumer Confidence: A missing ingredient thus far in the recovery has been optimism among households. But that may be finally changing. Surveys of consumer sentiment ticked up markedly in November. As discussed above, this appears mainly to be attributed to better job security as the labor market tightens. If sustained, we view this as a very positive development, since a rising confidence in the outlook allows consumers to take on debt - or at least reduce their savings rate (Chart 6). Business Confidence: Business confidence has mirrored - and even lagged - soggy consumer confidence throughout this cycle. This makes sense, since optimism about a company's future hinges on prospects for demand for its products. In an economy where 70% of GDP is consumption, it is rational that businesses take their cue from consumer sentiment. The most recent ISM manufacturing survey was positive; new orders are rising. Respondent comments were particularly sunny. The bulk of survey responses were collected after the November 8 election and so should be reflective of business attitudes toward the new political administration. Consumer Spending: Black Friday/Cyber Monday sales were reported as lackluster relative to last year, according to the National Retail Federation (NRF). Apparently, about 3 million more shoppers than in 2015 were enticed into stores and onto their computers, but they spent about 3.5% less, while overall sales were down about 1.5% over last year. But the survey also picked up on one of our critical themes: deflation in the retailing sector is still rampant. Price discounting remains a dominant tactic to entice shoppers and over half of the NRF survey respondents reported that deals were "too good to pass up." In real terms, annual consumer spending growth has trended sideways at 2.5%. We see little risk of a slowdown, and in fact as highlighted above, now that consumer confidence has improved, any modest wage gains could lead to an improved spending outlook. All in all, the modest growth backdrop that has characterized the economic recovery since to date is still intact. We are closely watching consumer and business confidence for signs that the economy can or cannot handle the rise in bond yields and dollar: if recent optimism can be maintained, the odds of a more virtuous economic cycle will improve. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 According to Cushman & Wakefield, New York's Upper 5th Avenue had the highest average rents of any shopping street in the world in 2015. A square foot of retail space cost $3,500. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "The Next Big Thing: How To Profit From Disruptive Innovation," dated March 9, 2015, available at usis.bcaresearch.com