Europe

Highlights Our new pecking order for currencies is: yen first, euro second, pound third, dollar fourth. Long-term (real) interest rate differentials are the dominant driver of currencies right now. EUR/USD should continue to trend higher to around 1.30. Equity investors should prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50. Underweight Basic Materials equities versus Healthcare equities on a 6-9 month horizon. Feature Nine months ago, our report Euro First, Pound Second, Dollar Third 1 encapsulated our recommended pecking order for the three major currencies. Subsequent performance has fully justified the title. The euro has appreciated by 6% versus the pound, and by 13% versus the U.S. dollar (Chart I-2). Today we are tweaking our currency pecking order: yen first, euro second, pound third, dollar fourth. Chart of the WeekHigher Euro Area Inflation Has Strengthened The Euro Higher Euro Area Inflation Has Strengthened The Euro Higher Euro Area Inflation Has Strengthened The Euro Chart I-2Euro First, Pound Second, Dollar Third Euro First, Pound Second, Dollar Third Euro First, Pound Second, Dollar Third The Euro Has Moved The 'Right' Way, The Yen Has Moved The 'Wrong' Way The Chart of the Week illustrates an excellent explanation for the euro/dollar exchange rate. It shows euro area versus U.S. core inflation differentials, and provides a great rule of thumb. If the euro area's core inflation were underperforming by 2% vis-à-vis the U.S., EUR/USD should stand at 1.00. But thereafter, every half-percent of euro area inflation catch-up strengthens the euro by 10 cents. At the start of 2017, our thesis was that the underperformance of euro area inflation by almost 2% - and the associated EUR/USD rate near 1.00 - was an anomaly. And that core inflation in the euro area would converge with that in the U.S. Which it duly has. Still, if the euro area's inflation underperformance vis-à-vis the U.S. converges to its long run average of half a percent, EUR/USD should continue to trend higher to around 1.30. One equity market implication is to prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50 (Chart I-3). The puzzle is that for the yen, the same inflation relationship has worked the 'wrong' way. Through the past ten years, every half-percent of Japanese core inflation catch-up has weakened the yen by around 10 yen (Chart I-4). To complicate the puzzle, the relationship for the yen used to work the 'right' way. Through 1999-2008, every half-percent of Japanese inflation catch-up strengthened the yen by around 10 yen (Chart I-5). Chart I-3A Stronger Euro Favours The Euro Stoxx ##br##Over The Euro Stoxx 50 A Stronger Euro Favours The Euro Stoxx Over The Euro Stoxx 50 A Stronger Euro Favours The Euro Stoxx Over The Euro Stoxx 50 Chart I-4Through 2008-17 Higher Japanese##br## Inflation Weakened The Yen... Through 2008-17 Higher Japanese Inflation Weakened The Yen... Through 2008-17 Higher Japanese Inflation Weakened The Yen... Chart I-5...But Through 1999-2007 Higher Japanese##br## Inflation Strengthened The Yen! ...But Through 1999-2007 Higher Japanese Inflation Strengthened The Yen! ...But Through 1999-2007 Higher Japanese Inflation Strengthened The Yen! So higher relative inflation in the euro area has driven the euro up; whereas higher relative inflation in Japan has driven the yen down, but previously used to drive the yen up! How can we explain the puzzle? The answer is to think in terms of both inflation and its impact on long-term interest rate expectations. What Are The Drivers Of Currencies? Foreign exchange demand serves one of four broad purposes: To buy foreign exchange reserves. To buy foreign goods and services. To buy long-term investments denominated in a foreign currency, also known as foreign direct investment (FDI) To buy shorter-term financial investments like bonds and equities denominated in that currency, also known as portfolio flows.2 Of these four components, the demand for foreign exchange reserves tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.3 The net foreign demand for euro area goods and services and FDI are also not particularly volatile. Which means that the usual swing-factor in foreign exchange demand is portfolio flows (Chart I-6), and especially fixed income portfolio flows. Chart I-6Portfolio Flows Are The Swing Factor In Foreign Exchange Demand Portfolio Flows Are The Swing Factor In Foreign Exchange Demand Portfolio Flows Are The Swing Factor In Foreign Exchange Demand What causes swings in fixed income portfolio flows? The answer is expected changes in real interest rates. Fixed income investors gravitate to the bonds with the highest real yield adjusted for likely currency losses or hedging costs. So when the expected real interest rate in the euro area rises relative to that in the U.S., euro bonds becomes de facto relatively more attractive. Meaning that international fixed income investors will shift into euro bonds until the flow pushes up EUR/USD to make the currency valuation symmetrically less attractive. At this new higher level for EUR/USD, the fixed income portfolio flow will stop because a new equilibrium has been established. International investors now have more upside from the more attractive bonds, but symmetrically less upside from the less attractive currency valuation - and the two factors cancel out. Furthermore, at major turning points in monetary policy, the main issue for the largest fixed income investors is not the exact pattern of short-term interest rate changes. Whether the Fed hikes in March, June and December or whether the ECB hikes next year is largely irrelevant. The big issue centres on the so-called real terminal rate: the average real interest rate over the very long term. Solving The Currency Puzzle Let's now return to our currency puzzle. If core inflation increases, but the expected terminal interest rate increases more, it means that the expected real terminal rate will also increase - causing the exchange rate to rise. This is what tends to happen in the euro area versus U.S. comparison, and explains why the relationship between relative core inflation and EUR/USD movements works the 'right' way. In effect, the nominal terminal rate is the driving factor for the currency. It is also what tended to happen in Japan before 2008 (Chart I-7), and explains why the relationship between relative core inflation and the yen also used to work the 'right' way. However, if core inflation increases, and the expected terminal interest rate increases less, it means that the expected real terminal rate will decrease - causing the exchange rate to fall. Since 2008, this is what has happened in Japan (Chart I-8). The expected nominal terminal rate has gone into stasis, so higher core inflation has pulled down the real terminal rate. Which explains why the relationship between relative core inflation and the yen has worked the 'wrong' way. The key question is what happens next? Will the expected terminal rate in the euro area go into stasis, as it did in Japan? Almost certainly no. The euro area's expected terminal rate has already risen by over 0.5% in the past year (Chart I-9). Chart I-7Expectations For Japan's Terminal ##br##Rate Used To Fluctuate... Expectations For Japan"s Terminal Rate Used To Fluctuate... Expectations For Japan"s Terminal Rate Used To Fluctuate... Chart I-8...But After 2008, Expectations For Japan's ##br## Terminal Rate Have Gone Into Stasis ...But After 2008, Expectations For Japan"s Terminal Rate Have Gone Into Stasis ...But After 2008, Expectations For Japan"s Terminal Rate Have Gone Into Stasis Chart I-9The Terminal Interest Rate Differential##br## Is Driving EUR/USD The Terminal Interest Rate Differential Is Driving EUR/USD The Terminal Interest Rate Differential Is Driving EUR/USD More plausibly, the expected terminal rate in Japan could come out of its stasis. With every other major central bank backing away from ultra-accommodation, and Japanese growth and inflation now looking little different from other G10 economies, is it realistic - or indeed feasible - for the Bank of Japan to maintain its extreme policy? The slightest hint from the Bank of Japan that it is following other central banks out of its ultra-accommodation would cause the expected terminal rate - and the yen - to gap (up) sharply. On this basis, the one major currency that we would short the euro against is the Japanese yen. The Global Mini-Upswing Is Losing Steam Finally and briefly, an update to our 'mini-cycle' framework for global growth. Last week in The Cobweb Theory And Market Cycles, we explained the existence of these mini-cycles, and argued that the current mini-upswing - which started last May - is getting long in the tooth. Right on cue, the latest credit data out of both China and the U.S. show that their 6-month credit impulses are losing steam (Chart I-10). The implication is that global growth will experience a mini-downswing during the first half of 2018. In all of the last five such mini-downswings, cyclical sectors ended up underperforming defensive sectors (Chart I-11). Accordingly, on a 6-9 month horizon, equity investors should underweight Basic Materials versus Healthcare. Chart I-106-Month Credit Impulses Have Rolled##br## Over In The U.S. And China 6-Month Credit Impulses Have Rolled Over In The U.S. And China 6-Month Credit Impulses Have Rolled Over In The U.S. And China Chart I-11Expect A Mini-Downswing: Underweight ##br##Basic Materials Vs. Healthcare Expect A Mini-Downswing: Underweight Basic Materials Vs. Healthcare Expect A Mini-Downswing: Underweight Basic Materials Vs. Healthcare Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Euro First, Pound Second, Dollar Third' published on April 27 2017 and available at eis.bcaresearch.com 2 In this discussion, portfolio flows include short-term speculative flows. 3 For example, when the Swiss National Bank broke the franc's peg to the euro, it just stopped buying euro reserves. Fractal Trading Model* There are no new trades this week, leaving two open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Short Palladium Short Palladium The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The Japanese economy is booming. This is allowing the BoJ to move away from its QQE (Quantitive and Qualitative Easing) program. However, the YCC (Yield Curve Control) program will stay in place for the foreseeable future as inflation remains a direct function of financial conditions. Because yen positioning and valuations are so skewed, this could result in a yen rally, especially against the Euro. Short EUR/JPY. Like the Fed, the BoC will hike rates three times this year. However, the market already discounts more hikes in Canada than the U.S. We remain neutral USD/CAD. However, CAD will experience downside against the NOK. Short CAD/NOK. Feature Chart I-1JPY Vs. Bonds: The Divorce JPY Vs. Bonds: The Divorce JPY Vs. Bonds: The Divorce Something fascinating happened to USD/JPY in recent months: it began to decouple from U.S. bond yields (Chart I-1). To a large degree, this break in relationship reflected the dollar's own weakness, as the dollar index fell by 10% in 2017. But as weak as the dollar may have been last year, it has actually been flat since September 7. Another culprit behind the yen's decoupling from bond yields has been that as the European Central Bank announced the end of its own asset purchases program, the Bank of Japan has been seen as the next in line to diminish its purchases. On January 8th, the BoJ began moving in that direction, as it started to curtail its buying of long-dated JGBs. Since that day, not only have global bonds sold off, but the yen has regained vigor as well. We believe the yen bear market is not over, but a playable rally against the euro is likely to emerge. The Sun Is Rising The BoJ is justified in wanting to remove some policy stimulus. The Japanese economy is firing on all cylinders, and the improvement seems broad-based. Consumer confidence, buoyed by rising asset prices and an unemployment rate at 23-year lows, is hitting record highs (Chart I-2). This will continue to support real household spending, which is now growing at a nearly 2% pace after contracting steadily from 2015 to early 2017. Another support for household spending comes from the wage front. Contractual wages are already growing at their fastest pace since 2006, and wages excluding overtime pay are expanding at rates not seen since 1998 (Chart I-3). Moreover, the openings-to-applicant ratio is at its highest level since 1974. This increases the likelihood that Prime Minister Shinzo Abe's arm-wrestling with corporate Japan to increase wages will bear fruit, and that the upcoming spring wage negotiation will generate accelerating gains. Chart I-2Japanese Households Feel Ebullient CONSUMER CONFIDENCE SURVEY Japanese Households Feel Ebullient CONSUMER CONFIDENCE SURVEY Japanese Households Feel Ebullient Chart I-3Wage Growth Has Picked Up Wage Growth Has Picked Up Wage Growth Has Picked Up Business confidence is also surging. The Japanese manufacturing PMI number is elevated by Japanese standards, currently at 54, and small business confidence points toward an acceleration in industrial production (Chart I-4). Financial markets validate this picture as well. The surge in the Nikkei has grabbed the imagination of investors, but even more impressive has been the strength in small-cap equities, which have outperformed their large-cap counterparts by 17% since 2015 (Chart I-5). This development has coincided with a pick-up in credit growth, and is also normally associated with a robust growth outlook. The GDP model developed by our sister publication, The Bank Credit Analyst, encapsulates these various phenomena, and forecasts that Japanese real GDP growth could hit an annual rate of 3% in the first half of 2018 (Chart I-6). Thus, it would seem that the Japanese economy will continue to gain momentum. Chart I-4Japanese Companies Are Also##br## Feeling The Good Vibes Japanese Companies Are Also Feeling The Good Vibes Japanese Companies Are Also Feeling The Good Vibes Chart I-5Small Caps Point To##br## A Bright Outlook Small Caps Point To A Bright Outlook Small Caps Point To A Bright Outlook Chart I-6Japanese Growth ##br##Has Momentum Japanese Growth Has Momentum Japanese Growth Has Momentum But what underpins these improvements? First, the fiscal thrust in Japan has changed. Fiscal policy was a drag in Japan from 2012 to 2016, creating an average brake on economic activity of 0.6% of GDP per year. However, in 2017, fiscal policy eased to add 0.2% to GDP. Second, Japan has greatly benefited from the rebound in EM growth. According to the IMF, a 1% growth shock in EM affects Japanese growth by 50 basis points - nearly five times more than the effect of the same shock on the U.S. economy. This is because 43% of Japanese exports are shipped to EM economies. Third, the impact of EM activity on Japan is amplified by the countercyclical nature of the JPY. As global and EM growth expands more vigorous, the yen weakens, which eases Japanese financial conditions. This phenomenon was in full display last year, as financial conditions eased by a full standard deviation over the past 16 months. These developments are what have laid the ground for better growth and the change in the BoJ's tone. Bottom Line: Japan is doing very well. Consumers and businesses are upbeat, spending is on the rise and GDP is forecasted to accelerate even further. Easing fiscal belt-tightening, stronger EM economies, and the softening financial conditions are the factors behind these improvements. The BoJ is taking notice. How Far Can The BoJ Go? The BoJ had been itching to move policy for a few months now. In November 2017, BoJ Governor Haruhiko Kuroda was making noise about the concept of the "reversal rate." The reversal rate is the interest rate below which additional interest rate cuts become contractionary for economic activity. This is because below this level, lower rates hurt bank interest margins to such a degree that commercial banks start curtailing their lending to the private sector. The reason why the BoJ was getting more vocal about the reversal rate was because this rate is inversely related to the amount of securities held on commercial banks' balance sheets. If commercial banks hold plenty of government bonds, as interest rates fall to very low levels, the value of these securities increases, offsetting the negative impact of lower interest rate margins. The problem in Japan is that as the BoJ mopped up more JGBs than was issued by the government, and therefore the bond holdings of banks were dwindling at an alarming rate (Chart I-7). This meant that the reversal rate was rising, implying that the BoJ had less control over policy. When inflation surprised to the upside in December, financial markets reacted violently. While Japanese nominal yields did not budge much, Japanese inflation expectations surged, which prompted a collapse in Japanese real rates (Chart I-8). This produced a de facto easing in Japanese monetary conditions, creating the perfect cover for the BoJ to adjust its asset purchases: any negative impact from tweaking bond purchases would be mitigated and the BoJ, according to its view, would not lose control of financial conditions because of a falling reversal rate. Despite this shift in policy action and rhetoric, we do not yet foresee the end of the Yield Curve Control program. Inflation excluding food and energy only stands at a paltry 0.3%, still well below the BoJ's 2% target or even 1% - a level that is likely to result in a more real removal of easing. Additionally, the BoJ is in somewhat of a bind. It is true that the economy is doing much better, but this does not really help explain inflation dynamics. Japanese capacity utilization only explains 3% of the movements in Japanese core inflation; global utilization, only 10%; and inflation leads credit creation in Japan. Instead, the best factor to explain Japanese inflation has been financial conditions (FCIs). In no other country do FCIs explain inflation dynamics as much as they do in Japan. The recent movements in Japanese inflation are fully consistent with how Japanese FCIs have evolved since 2010. Based on this relationship, CPI excluding food and energy should likely peak at 0.7% in June 2018 (Chart I-9). Chart I-7Japanese Reversal Rate##br## Is Falling Because Of QQE Japanese Reversal Rate Is Falling Because Of QQE Japanese Reversal Rate Is Falling Because Of QQE Chart I-8Sudden Pick Up In##br## Inflation Expectations Sudden Pick Up In Inflation Expectations Sudden Pick Up In Inflation Expectations Chart I-9Inflation Is Picking Up Because##br## Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased However, if the BoJ removes accommodation too fast, the yen would rally and financial conditions would tighten sharply. In all likelihood, inflation would weaken substantially, nullifying the very reason to tighten policy in the first place. These very dynamics point to a continuation of YCC for at least the next 12 to 18 months. Bottom Line: Japan will soon fully do away with its QQE program. However, this is not indicative of a removal of yield curve controls. This is not only because Japanese inflation is extremely far off from the BoJ's target, but also because Japan's inflation rate is hyper-sensitive to financial conditions. Therefore, any tightening in financial conditions created by a stronger yen - the likely market response of tighter policy - will cause inflation to collapse, nullifying the very need for tighter policy. Investment Implications USD/JPY is expensive, trading 16% above the fair value implied by purchasing power parity. Additionally, the yen is supported by a generous current account surplus of 4% of GDP. Moreover, global investors have been underweighting duration. This phenomenon tends to be negative for the yen. When investors are as underweight duration as they are currently, the yen becomes more likely to rally (Chart I-10). It is true that in 2014, investors were as negative on bonds as they are today, but USD/JPY sold off. This was because back then, the BoJ announced an increase to its asset purchase program. Today, the BoJ is moving toward ditching its QQE program, which is likely to prompt a short-covering rally. Now, the key question for investors is what currency should be sold against the yen. We posit the euro is an interesting alternative to the USD. EUR/JPY is exceptionally expensive at present. On a long-term basis, EUR/JPY is trading well outside its normal range on a purchasing-power-parity basis (Chart I-11). Moreover, while USD/JPY is mildly expensive according to metrics that incorporate rate differentials and risk appetite, EUR/USD is very dear based on a similar comparison. The implication is that EUR/JPY is trading at an exceptionally demanding level in terms of short-term valuations (Chart I-12). Hence, tactically, the timing is becoming increasingly ripe to short this cross Chart I-10Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Chart I-11EUR/JPY Is Expensive EUR/JPY Is Expensive EUR/JPY Is Expensive Chart I-12Tactical Risk For EUR/JPY Tactical Risk For EUR/JPY Tactical Risk For EUR/JPY . Further arguing in favor of shorting EUR/JPY instead of USD/JPY are relative financial conditions. Euro area financial conditions have tightened much more than U.S. financial conditions relative to Japan's (Chart I-13). As a consequence, even when adjusting for sector biases, European stocks are currently underperforming Japanese equities by a greater margin than the underperformance of U.S. equities. This highlights that Japan's relative economic outlook burns brighter when compared to the euro area than when compared to the U.S. This also means that the yen has more room to rally against the euro than the USD. Finally, relative positioning between the euro and the yen is also exceptionally skewed. As Chart I-14 illustrates, when speculators are simultaneously long the euro and short the yen, EUR/JPY tends to experience subsequent corrections. Chart I-13Euro Area FCIs Tightened ##br##More Than U.S. Ones Euro Area FCIs Tightened More Than U.S. Ones Euro Area FCIs Tightened More Than U.S. Ones Chart I-14Skewed Positioning##br## In EUR Skewed Positioning In EUR Skewed Positioning In EUR The aforementioned factors point to a potentially large yen rally, but the durability of this rally is likely to be limited. The BoJ will only be dropping a QQE program that it had already only half-implemented in recent months, as bond purchases were well below its JPY80 trillion-yen objective. The BoJ is still committed to its YCC program for the foreseeable future. Only a rejection of this program will create a durable support for the yen. In the meanwhile, as any yen rally will tighten financial conditions and hurt inflation, any yen rally is to be rented rather than owned, as terminal policy rates in Japan still have little scope to rise. Bottom Line: Ditching QQE is likely to result in a yen rally. Such a rally is likely to be most pronounced against the euro as valuations, positioning, and financial conditions are especially exacerbated when compared to the European currency. To be clear, the yen rally is likely to be a countertrend move, as a strong yen will exert serious deflationary pressures on Japan, which means the BoJ's YCC program will remain firmly in place. We are shorting EUR/JPY at 133.79. CAD: Stuck Between The BoC And NAFTA Chart I-15Canada Will Experience Rising Wages Canada:##br## Inflationary Conditions Emerging Canada Will Experience Rising Wages Canada: Inflationary Conditions Emerging Canada Will Experience Rising Wages Canada: Inflationary Conditions Emerging The Bank of Canada (BoC) is meeting next week and the odds are rising that it will lift policy rates this month. The Canadian economy is very strong too, led by the domestic sector. Real consumer spending is growing at its fastest pace in nearly 10 years, the unemployment rate is at 40-year lows, and capex is recovering after having been decimated by the collapse in oil prices from 2014 to 2016. Thanks to this backdrop, the Canadian economy is hitting its own capacity constraints. The BoC estimates that the Canadian output gap has closed. Moreover, the recent Business Outlook Survey confirms this message: A record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints, and the growing number and intensity of labor shortages points to a tight labor market (Chart I-15). Tight capacity and higher wages will support the already-visible rebound in core inflation, which has already reached 1.8%. As a result, we expect the BoC to tighten rates as much as the Federal Reserve this year. However, the impact of this development on the CAD might be limited. Investors are already pricing in more hikes in Canada than in the U.S. over the next 12 months - 82 basis points versus 60 basis points, respectively. Moreover, speculators are once again very long the loonie, implying an elevated hurdle for strong economic data to actually lift CAD further. Moreover, NAFTA remains a major risk for Canada. As Marko Papic, our Chief Geopolitical Strategist, wrote in a November Special Report, President Trump does have uninhibited power when it comes to abrogating NAFTA (Table I-I).1 If NAFTA were to collapse, Canada would most likely ultimately revert to the still-preferential Canada-U.S. Free Trade Agreement. Thus, the impact on Canada-U.S. trade would likely be temporary. However, the brunt of the pain should be felt in Canadian capex spending. The high degree of uncertainty associated with unwinding NAFTA would cause companies to abandon expansion plans in Canada, and prompt them to expand their North American capacity directly in the U.S., thereby bypassing the regulatory risk created in the supply chain. This would dampen the future growth profile of Canada. Table I-1Trump Faces Few Constraints On Trade Yen: QQE Is Dead! Long Live YCC! Yen: QQE Is Dead! Long Live YCC! Oil is unlikely to fill the void for CAD. At near US$70/bbl, Brent has hit our Commodity and Energy strategists' target. OPEC 2.0 will be unwilling to accommodate much higher prices, as this would incentivize shale producers to expand capacity, recreating the supply glut dynamics that existed prior to the 2014 crash. Additionally, the West Canada Select benchmark, the oil price most relevant for Canada, remains at a substantial discount to WTI and Brent. This is because there is not enough pipeline capacity to ship oil outside of Alberta. Canada is drowning in its own oil. This situation is not about to change. Chart I-16CAD/NOK Is Stretched CAD/NOK Is Stretched CAD/NOK Is Stretched Based on this combination, we are neutral USD/CAD on a 12-month basis, even if a move back to 1.29 is likely over the coming weeks. However, while Canadian oil is trading at a discount, the CAD has performed better than the NOK, the other petrocurrency in the G10 space. This suggests that shorting CAD/NOK may be a cleaner way to play the risks inherent to the Canadian dollar. First, the Canadian dollar is very expensive relative to the Norwegian krone right now, trading 11% above its purchasing-power-parity rate (Chart I-16). Even when adjusting for other factors like productivity and commodity prices, CAD is trading at its largest premium to the NOK since 1994. This represents a risk for CAD/NOK as the loonie is exposed to trade policy risks, while the nokkie is not. Second, the balance-of-payments picture remains highly favorable for the NOK. Norway runs a current account surplus of 5.5% while Canada runs a deficit of 2.8%. Additionally, Norway sports a Net International Investment position (NIIPs) of 210% of GDP, the largest in the G10. Strong NIIPs are associated with rising real effective exchange rates. Third, while the Canadian economy's momentum is well known by investors - this is the reason why they are so long the CAD and expecting so many hikes from the BoC - the positives in Norway are being ignored. Norway's leading economic indicator is still rising, and Norwegian industrial production and real GDP growth are accelerating. Fourth, the Norges Bank is responding to weakness in the NOK. At its December meeting, it adjusted its tone, as the NOK is easing monetary conditions too much in the eyes of the Norwegian central bank. This suggests the 25-basis-point hike currently expected out of Norway could be too low. It also highlights that the exceptional 60-basis-point gap between Canada and Norway in terms of expected 12-month rate hikes is also likely to normalize. Finally, CAD/NOK is trading toward the top of both its long-term and near-term historical trading ranges. While positioning on the CAD is now quite extended on the long side, speculators are short the NOK, according to Norges Bank data. Thus, with NAFTA in question, a fully priced BoC outlook, and the unlikelihood that the WCS-Brent discount narrows, risks are skewed toward a lower CAD/NOK going forward. Bottom Line: The Canadian economy is booming. This means the BoC will keep pace with the Fed and increase rates at least thrice this year. However, markets are already discounting more hikes in Canada than they are in the U.S. Moreover, oil prices have limited upside from here, and the WCS benchmark will continue to trade at a deep discount to Brent. Thus, while USD/CAD has limited upside, it has limited downside as well. However, CAD/NOK faces plenty of downside risks from current levels. We are shorting this cross this week, with an entry point at 6.398. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism" dated November 10, 2017, available at gis.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 Recent data in the U.S. has been mixed: Nonfarm payrolls surprised to the downside, coming in at 148 thousand. Moreover, labor force participation rate surprised to the downside, coming in at 62.7%. ISM non-manufacturing PMI also underperformed expectations, coming in at 55.9. However, consumer credit change outperformed expectations, coming in at 27.95 billion dollars. The dollar began the week on a strong, which ultimately dissipated, on relatively hawkish ECB minutes and policy tweaks in Japan. Overall, we expect the market to continue to price the fed dot plot, putting upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the Euro area has been positive: Core inflation outperformed expectations, coming in at 1.1%. Moreover, the economic sentiment indicator also outperformed expectations, coming in at 116. Retail sale yearly growth also surprised to the upside, coming in at 2.8%. Finally, the unemployment rate declined from 8.8% to 8.7% In spite of the positive data the euro has fallen this weekThe Euro begun the week on the weak side but surged in the wake of the ECB's hawkish minutes. This has happened due to the surge in rate expectations in the U.S., as the market has continued to price in the fed. Overall, we expect to see downside in EUR/JPY as the BoJ has more room to back off its ultra-dovish policy than the ECB. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Labor Cash earnings yearly growth outperformed expectations, coming in at 0.9%. They also increased relative to October. However consumer confidence surprised to the downside, coming in at 44.7 and declining from the previous month. The yen has been surging this week, with USD/JPY falling by 1.7%. This was caused because the BoJ signaled that they would reduce their buying of long dated bonds. The market interpret this as a signal that the BoJ will start exiting from its ultra-dovish monetary policy. These developments should continue to provide upside to the JPY, particularly against the Euro. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production yearly growth outperformed expectations, coming in at 2.5%. Moreover, manufacturing production yearly growth also surprised to the upside, coming in at 3.5%. However, Halifax House Prices yearly growth underperformed expectations, coming in at 2.7% as the month-on-month growth contracted by 0.6%. The pound has been flat, this week against the dollar, while it has lost about 1% against the euro. Overall, the BoE is limited in the capacity to raise rates meaningfully. Moreover, inflation should start to ease following the rate hike and the rise in the pound. This will put downward pressure on the pound. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been mixed: Building permits yearly growth outperformed expectations, coming in at 17.2%. However, the trade balance in November surprised to the downside, coming in at -628 million. It also decreased from -302 million one month earlier. AUD/USD has been flat this week, however AUD/NZD has fallen by roughly 1%. While it is true that global growth continues to be strong, key indicators like Korean and Taiwanese export growth have rolled over. Moreover money supply growth in China continues to decrease. All of this points to a temporary slowdown in Chinese industrial activity, which would lead to weakness in AUD/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 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 The kiwi has rallied by nearly 5% since the start of the year, as global growth continues to stay robust. Overall, we expect that the NZD will continue to outperform the AUD this year, as New Zealand is less sensitive to a tightening in financial conditions than Australia. However on a longer time horizon, the upside for the Kiwi is limited, as the new populist government has not only vowed to decrease immigration into the country, but also for the RBNZ to have a dual mandate. Both of these policies will depress the neutral rate in New Zealand, and consequently put downward pressure on the kiwi. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been mostly positive: The unemployment rate surprised positively, as it declined to 5.7% from 5.9% Moreover, net change in employment also outperformed expectations, coming in at 78.6 thousand. Housing starts yearly growth also outperformed expectations, coming in at 217 thousand. However, the Ivey Purchasing Manager Index underperformed, coming in at 60.4. USD/CAD jumped on Tuesday following reports that Trump will exit the NAFTA accord. Overall we believe that the Canadian dollar will have limited upside from here on out, as the market is now pricing in more hikes in Canada than in the U.S. This weakness could be taken advantage of by shorting CAD/NOK, as this cross is much overvalued according to multiple metrics. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been positive: Headline inflation came in line with expectations, at 0.8%, meanwhile month on month inflation surprised to the upside, coming in at 0%. The unemployment rate also came in line with expectations, at a very low level, coming in at 3%. Finally, retail sales yearly growth surprised to the upside substantially, coming in at -0.2%, compared to 2.6% last month. EUR/CHF has stayed relatively flat since last week. Overall, we expect limited upside in the franc. As the SNB will stay active in the foreign exchange market. In order for the SNB to change its policy, inflation in Switzerland will have to stay at a high level for a considerable amount of time. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Headline inflation outperformed expectations, coming in at 1.6%. Moreover core inflation also surprised to the upside, coming in at 1.4% However, manufacturing output growth underperformed expectations, coming in at 0.3% USD/NOK is down by roughly 0.7%, as oil prices continue to approach the 70 dollar mark. Nevertheless, we believe that the upside for USD/NOK is limited from here, as the market will start pricing in more rate hikes from the Fed. That being said, investors willing to bet on more oil strength could short EUR/NOK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 After falling precipitously at the end of 2017, USD/SEK has been relatively flat this year. Overall, while Stefan Ingves continues to be very dovish, he conceded in the latest minutes that a change in monetary policy is getting closer. Meanwhile, Deputy Governor Jansson stated that while he supports to continue with asset purchases, to keep the repo rate unchanged would be "difficult to digest". Investors willing to bet on a slowdown in the Euro area caused by tightening financial conditions could short EUR/SEK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut Governments Will Want Their Cut Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Where Low Rates Have Fueled House Prices Where Low Rates Have Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Rent Growth Is Cooling Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Low Volatility Is In High Demand Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Will Bitcoin Be DeFANGed? Will Bitcoin Be DeFANGed? Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Yen Is Already Cheap... Yen Is Already Cheap... Chart 15...And Unloved ...And Unloved ...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Euro Area Economic Surprises Edging Lower Euro Area Economic Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Euro Positioning: From Deeply Short To Record Long Euro Positioning: From Deeply Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature The existence of 'mini-cycles' in economic and financial variables is an empirical fact. We encourage readers to plot for themselves the change in global bank credit flows, the global bond yield, global inflation, and metal price inflation. The very clear and regular mini-cycles should shout out at you (Chart I-2, Chart I-3, Chart I-4, Chart-5). Feature ChartThe Cobweb Theory Explains The Regular Mini-Cycles In Economic And Financial Variables The Cobweb Theory Explains The Regular Mini-Cycles In Economic And Financial Variables The Cobweb Theory Explains The Regular Mini-Cycles In Economic And Financial Variables Chart I-2Mini-Cycles In Global Credit Flows Mini-Cycles In Global Credit Flows Mini-Cycles In Global Credit Flows Chart I-3Mini-Cycles In The Global Bond Yield Mini-Cycles In The Global Bond Yield Mini-Cycles In The Global Bond Yield Chart I-4Mini-Cycles In Global Inflation Mini-Cycles In Global Inflation Mini-Cycles In Global Inflation Chart I-5Mini-Cycles In Metal Price Inflation Mini-Cycles In Metal Price Inflation Mini-Cycles In Metal Price Inflation Identifying these mini-cycles is very useful because it helps us to predict the future. Just as we know when the tide will go out and come back in, we can predict the mini-cycle's downswings and upswings. And if most market participants are unaware of the next turn in the mini-cycle, it will not be discounted in today's price - providing a compelling investment opportunity. The obvious question is: if the existence of mini-cycles is an empirical fact, what is its theoretical foundation? Dusting Down The Cobweb Theory A likely answer comes from an economic model called the Cobweb Theory, first proposed in the 1930s by several economists, among them Althus Hanau and Nicholas Kaldor. The Cobweb Theory is so called because when its predicted pattern of price and output mini-cycles is traced out on a standard price/quantity diagram, it resembles a cobweb (Chart I-6, Chart 7, Chart I-8). Chart I-6Cobweb Theory Case 1: ##br## Regular Mini-Cycles The Cobweb Theory And Market Cycles The Cobweb Theory And Market Cycles Chart I-7Cobweb Theory Case 2: ##br##Divergent Mini-Cycles The Cobweb Theory And Market Cycles The Cobweb Theory And Market Cycles Chart I-8Cobweb Theory Case 3: ##br##Convergent Mini-Cycles The Cobweb Theory And Market Cycles The Cobweb Theory And Market Cycles The Cobweb Theory is based on a simple premise: lagging supply. The demand for an item depends on its price in the current period, but the supply of the item depends on its price in the previous period. Or equivalently, the price in the current period influences the supply in the next period. In the 1930s, economists used the theory to explain the mini-cycles in agricultural output and prices. Most crops can be sown and reaped only once a year. Therefore, an unanticipated increase in demand will cause a sharp rise in price - because there can be no immediate increase in supply. This high price may lure farmers to increase their output more than is justified by future demand. So when this supply eventually comes on the market, it will cause a sharp fall in price. In turn this will result in a decrease in output for the next period to a greater extent than is justified. And so on. More generally, the Cobweb Theory applies in any market where supply lags demand. Under this simple premise, the market price will produce a two-period oscillation with the actual price being alternately above and below the equilibrium price. When the price is above equilibrium, it falls in the next period as supply adjusts upwards; and when the price is below equilibrium, it rises in the next period as supply adjusts downwards. But supply tends to over-adjust, causing both the quantity and price to overshoot and undershoot equilibrium repeatedly - effectively creating a mini-cycle (see Box I-1). Box I-1The Cobweb Theory Of Cycles The Cobweb Theory And Market Cycles The Cobweb Theory And Market Cycles The Cobweb Theory Of Credit Demand And Supply We now come to a key point: credit demand and supply often meet the conditions of the Cobweb Theory. Chart I-9 illustrates that the credit demand cycle is perfectly coincident with the bond yield cycle. Whereas Chart I-10 and Chart I-11 demonstrate that the credit supply cycle can often lag the credit demand cycle - and therefore the bond yield cycle - by several months. One obvious explanation is that unless you have an (unexpended) existing credit line to draw upon, there will be a lag between applying for credit and receiving it. Chart I-9The Credit Demand Cycle Is Coincident ##br##With The Bond Yield Cycle... The Credit Demand Cycle Is Coincident With The Bond Yield Cycle... The Credit Demand Cycle Is Coincident With The Bond Yield Cycle... Chart I-10...But The Credit Supply Cycle Lags ##br##The Credit Demand Cycle... ...But The Credit Supply Cycle Lags The Credit Demand Cycle... ...But The Credit Supply Cycle Lags The Credit Demand Cycle... Chart I-11...And The Bond ##br##Yield Cycle ...And The Bond Yield Cycle ...And The Bond Yield Cycle With credit demand and supply meeting the conditions of the Cobweb Theory, both the quantity and the price of credit (the bond yield) should exhibit mini-cycles. And as the charts in this report attest, they do. What about the mini-cycles in commodity inflation and broader CPI inflation? Given that these closely track the credit impulse mini-cycle (Feature Chart), we can deduce that they must be mostly a reflection of the mini-cycle in global demand growth. Still, could the commodity inflation mini-cycle also be impacted by the supply-side, as postulated for agricultural prices in the original Cobweb Theory? Interestingly, a recent paper, "The cobweb theorem and delays in adjusting supply in metals" markets,1 does "link the dynamics of raw material markets and commodity price fluctuations to a delayed adjustment of supply." However, the supply lags mentioned in the paper are too long to explain the half-cycle lengths typically observed in the commodity inflation mini-cycle. This would confirm that this mini-cycle is mostly a demand-side phenomenon. But the paper does also point out that speculation on futures markets may lead to higher volatility. This implies that while the phases of the mini-cycles should stay closely aligned, the amplitudes of the commodity inflation and credit impulse mini-cycles can deviate. Which is precisely what we observe in the data (Chart I-12). Chart I-12The Various Mini-Cycles Have Similar Periods But Different Amplitudes The Various Mini-Cycles Have Similar Periods But Different Amplitudes The Various Mini-Cycles Have Similar Periods But Different Amplitudes What Is The Current Message? Chart I-13The Bond Yield Cycle Explains##br## The Sector Selection Cycle The Bond Yield Cycle Explains The Sector Selection Cycle The Bond Yield Cycle Explains The Sector Selection Cycle To sum up, global credit flows, the global bond yield, global inflation, and metal price inflation exhibit clear and regular mini-cycles with a consistent half-cycle length averaging around 8 months, but not necessarily a consistent amplitude. We propose that all of these mini-cycles will continue indefinitely, and that they are manifestations of the lagging supply of credit and the Cobweb Theory. In the context of these clear and regular mini-cycles, the current mini-upswing in activity which started last May is getting long in the tooth, and we would expect it to end in early 2018. Having said that, given that the recent upswing in the global bond yield is quite modest, the next mini-downswing in the global credit impulse, and thereby activity, should be quite shallow. Nevertheless, in terms of investment implications, any mini-upswing in price since last May that has displayed an outsize amplitude would be more vulnerable to a setback. Industrial metal prices might be in this vulnerable category. Furthermore, the mini-cycle framework has been an important driver of cyclical versus defensive sector performance over the past few years (Chart I-13), and likely will continue to be an important driver. On a 6-9 month horizon, the current message would be to pare back exposure to cyclical sectors and to tilt towards defensive-biased equity markets such as Switzerland and Denmark. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 System Dynamics Review, April 2017: 'The cobweb theorem and delays in adjusting supply in metals' markets' by Glöser-Chahoud, Hartwig, Wheat and Faulstich. Fractal Trading Model* This week's trade is to expect a countertrend reversal in S&P500 versus Eurostoxx50 performance. Set a profit target of 2.0% with a symmetrical stop-loss. In other trades, long IBEX35 / short Eurostoxx50 closed in profit while short WTI crude closed at its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 14 Short S&P500 / Long Eurostoxx50 Short S&P500 / Long Eurostoxx50 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The dollar continues to suffer as global growth remains strong. The year-end performance of the dollar rarely heralds things to come for the next six to twelve months. Signs are slowly accumulating that global growth may soften, but it could take a quarter to happen. In the meanwhile, the dollar could continue to weaken. Already boosted by global growth, the euro received a further fillip as markets upgraded the anticipated terminal interest rate in Europe. The U.S. terminal rate will be upgraded too, but only when this happen will the dollar be able to rally. Stay cautious. Feature As a cold snap engulfed North America, the U.S. dollar finished 2017 falling as fast as the mercury. This move is worrisome, as it pushed the greenback to the edge of a cliff. If the DXY punches below 91, the low hit on September 7, the greenback could hit 88. For EUR/USD, a decisive break above 1.21 constitutes the same threshold, and would indicate that the euro will rally to 1.25. Vigilance is required. A December Signal? The performance of the dollar in the last two weeks of December rarely offers a reliable signal of things to come. As Table I-1 illustrates, based on more than 20 years of data, the performance of the dollar index in the last weeks of a year has been negatively correlated with the dollar's performance over the following six to 12 months. This would imply that investors fighting dominating trends over the course of the prior 12 months capitulate in the last two weeks of the year, cleaning the slate in the process. Table I-1A Cold Snap Doesn't Make A Winter A Cold Snap Doesn't Make A Winter A Cold Snap Doesn't Make A Winter When it comes to specific pairs, relationships vary. The correlation of EUR/USD's subsequent six-month and 12-month returns with its year-end performance is zero, thus there is little to glean from the euro's recent strength in terms of its implications for 2018. However, interestingly, there is a strong negative correlation between the AUD/USD's year-end performance and the Aussie's returns over the next six to 12 months. It would seem the AUD's blistering rally is to be sold, not bought. The weakness in the USD was supercharged by the greenback's countercyclical nature. Our global synchronicity indictor - which measures the proportion of DM economies with PMIs above 50 - displays a negative correlation with the dollar's returns. This indicator's extraordinarily strong performance elucidates why the dollar was so weak last year, and also why the euro performed so well (Chart I-1). Going forward, two key leading indicators of our global synchronicity measure are saying that the global upswing could lose power (Chart I-2). The performance of Swedish equities relative to U.S. stocks and the annual change in U.S. 10-year yields reveal that even if global growth remains above trend, it will decelerate from current elevated readings. This could support the dollar index. However, we should keep an eye on the performance of EM carry trades.1 EM carry trades had been indicating that the best days for global growth are also behind us (Chart I-3), but lately EM carry trades have regained some vigor. If this strength is maintained, the message from the relative performance of Swedish equities and of U.S. bond yields will be invalidated. Such a move could be associated with a DXY breaking down below 91, potentially hitting 88; and EUR/USD rallying above 1.21 to 1.25. Chart I-1Strong Global Growth Hurts The Dollar Strong Global Growth Hurts The Dollar Strong Global Growth Hurts The Dollar Chart I-2Will This Synchronized Boom Peter Off? Will This Synchronized Boom Peter Off? Will This Synchronized Boom Peter Off? Chart I-3EM Carry Trades And Growth EM Carry Trades And Growth EM Carry Trades And Growth When all these forces are taken together, the picture for the dollar remains murky. The recent weakness in the Baltic Dry Index as well as the outperformance of oil relative to metals prices suggests we are entering a late cycle environment where even if global growth remain above trend, it is likely to be peaking. Thus, even if the dollar were to sell off further in the coming weeks, the downside will be limited. Nonetheless, a rally in the USD will have to wait for clear signs that U.S. inflation is picking up. It is best to stay on the sidelines for now. Bottom Line: The performance of the dollar in the last weeks of the year is rarely a good gauge of the dollar trend for the next six to 12 months. However, the dollar has been suffering on the back of strong global growth. While important metrics are suggesting that global growth could lose some momentum, other essential indicators such as EM carry trades are regaining some vigor. For now, limiting directional dollar bets is a safer strategy. The dollar will only rally once U.S. inflation picks up. EUR/USD And Terminal Rates The recent strength in the euro is linked to strong global growth. However, EUR/USD has been supercharged by domestic factors. In December, the differential in expected terminal policy rates between the European Central Bank and the Federal Reserve moved violently in favor of the euro. This move reflected a forceful upgrade of the anticipated terminal policy rate in the euro area (Chart I-4). This sudden upgrade in Europe makes sense: the European economy is strong. Euro area PMIs are at record highs, German unemployment has hit post-unification lows and German inflation regained gumption. Moreover, Benoit Coeure, a member of the ECB's Executive Board, expressed some very hawkish views. The market is correct to upgrade the outlook for the ECB. However, interest rate markets continue to expect too-shy-a-Fed over the remainder of the cycle. This leaves room to upgrade the expected terminal interest rate for the U.S. The U.S. economy is also firing on all cylinders. The U.S. ISM came in at 59.7 this week, with the new order component standing at a very strong 69.4. Additionally, total hours worked have been accelerating (Chart I-5). Together, these point to very robust GDP growth. Already, the Atlanta Fed GDPNow tracker foresees growth of 3.2% for Q4. Chart I-4EM Carry Trades And Growth A Surge In The ECB Terminal Rate A Surge In The ECB Terminal Rate Chart I-5U.S. Growth Set To Accelerate U.S. Growth Set To Accelerate U.S. Growth Set To Accelerate Strong U.S. growth is materializing in an environment of increasingly significant capacity constraints, which has historically been associated with rising inflationary pressures (Chart I-6). The recent easing in U.S. financial conditions only reinforces this message, and argues that U.S. inflation has upside (Chart I-7). Moreover, U.S. compensation costs have been accelerating, from a low of 1.9% in 2016 to 2.5% today. Hence, U.S. inflation should perk up this year, letting the Fed increase rates more than what markets currently foresee. Chart I-6Inflationary Backdrop In The U.S. Inflationary Backdrop In The U.S. Inflationary Backdrop In The U.S. Chart I-7U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Furthermore, the relative growth picture indicates that the increase in U.S. terminal rate should outpace the eurozone's. The Goldman Sachs Current Activity Indicator in the euro area has rolled over relative to the U.S., highlighting that the euro has tightened relative financial conditions enough to now harm the growth profile of Europe vis-à-vis the U.S. (Chart I-8). Moreover, European economic surprises are slowing sharply relative to the U.S. and the Euro Stoxx is re-testing its cycle low against the S&P 500, further corroborating the message from the Current Activity Indicator (Chart I-9). Chart I-8EUR/USD Starting To Hurt European ##br## Relative Growth Prospects EUR/USD Starting To Hurt European Relative Growth Prospects EUR/USD Starting To Hurt European Relative Growth Prospects Chart I-9Strains In The ##br##Eurozone Strains In The Eurozone Strains In The Eurozone Despite these dynamics, it is not clear that making a bet today on a weak euro is the proper tactic. At the time of writing, EUR/USD was flirting with its previous high of 2017; any break above 1.21 would likely push EUR/USD toward 1.25. Thus, we recommend investors continue to play pairs like short EUR/SEK to take advantage of the tightening in euro area financial conditions rather than bet outright on EUR/USD. To make this latter bet, investors will need either a marked failure of EUR/USD to break out, thus invalidating previous bullish technical signals, or a pick-up in U.S. inflation, whose timing remains unclear. Bottom Line: The euro's rally has been supercharged by an upgrade of the market's expected terminal policy rates in Europe relative to the U.S. While upgrading the ECB makes sense, markets should also upgrade the U.S. policy path as the American economy is just as strong and closer to capacity constraints, thus more likely to generate inflation. However, fighting the momentum in EUR/USD is currently dangerous. Thus, we recommend investors to wait for U.S. inflation to pick up before selling the euro. Instead, sell EUR/SEK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, 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 Recent data in the U.S. has been positive: Personal consumption expenditure and core personal expenditure grew at 1.8% YoY and 1.5% YoY respectively. Both measures increased from last month's reading. ISM manufacturing PMI came in at 59.7, surprising significantly to the upside. This measure also increased from last month. Meanwhile, ISM prices paid came in at 69, smashing expectations. The dollar ended 2017 on a free fall, as the enigma of low inflation in an environment of very low unemployment continues to puzzle investors. Meanwhile global growth continues to be very strong, adding an additional handicap to the dollar. We continue to believe that the Fed will hike more than expected, pushing the dollar upwards. However for this process to star, inflation must first emerge in the U.S. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in Europe has been positive: M3 Money supply yearly growth surprised to the upside, coming in at 4.9%. Moreover, Europe's Markit manufacturing PMI, came in line with expectations at 60.6. Finally, Germany's headline inflation also outperformed expectations, coming in at 1.6%. However this number did decline from the previous month. EUR/USD has rallied by almost 2% since Christmas. This has been mainly due to the rhetoric by ECB members, who appear to be much less dovish than before. Indeed, ECB board member Mersch warned that the ECB "must be careful not to act too timidly and too late and to fall behind the curve". Overall, we continue to believe that the Fed will surprise the market more than the ECB will. However to have an outright bullish dollar view inflation will have to pick up in the U.S. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been positive: Retail trade yearly growth came in at 2.2%, exceeding expectations by a wide margin. Meanwhile, housing starts also surprised to the upside, as they contracted by only 0.4%. Tokyo CPI ex fresh food yearly growth also beat expectations, coming in at 0.8%. Finally, the unemployment rate declined to 2.7%. The yen has appreciated against the U.S. dollar, with USD/JPY falling by about 0.7%. Meanwhile, Kuroda continued to assert that no change is needed to the BoJ's yield curve control program. Overall, in spite of the improved global outlook which is benefiting the Japanese economy, it is unlikely that Japan will abandon its extremely dovish monetary policy unless inflation rises much further. This is unlikely to happen in the near future. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Gross domestic product growth surprised to the upside, coming in at 1.7%. However this number did decline from the previous quarter. Additionally, total business investment yearly growth also outperformed expectations, coming in at 1.7%. However, Markit manufacturing PMI underperformed expectations, coming in at 56.3. Moreover, construction PMI also surprised to the downside, coming in at 52.2. Since Christmas, cable has gone up by roughly 1.5%. Overall we believe that the BoE is unlikely to raise rates meaningfully, as they will be more cautious than otherwise as the U.K. muddles through the Brexit negotiations. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been mixed: Private sector credit yearly growth increased relatively to last month, coming in at 5.4%. However the AiG Performance of Manufacturing Index declined relatively to last month, coming in at 56.2 in December versus 57.3 in November. Finally, the RBA Commodity SDR Index, which in an early indicator of export price changes, contracted by 5.9%, a decline from last month's 4% contractions. The Australian dollar has rallied by more than 2.6% since Christmas, as multiple indicators point to continued strength in global growth. However we expect a temporary slowdown, as a result of tightening financial conditions in China. This will be negative for the AUD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 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 The kiwi has increased by roughly 1.2% since Christmas, partly because of the decline of the U.S. dollar. However the New Zealand dollar has depreciated against almost every single G10 currency. Overall, we expect the NZD to appreciate relative to the AUD, given that the Australian dollar is much more sensitive to Chinese tightening financial conditions. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been mixed: Gross Domestic Product month-on-month growth underperformed expectations, coming in at 0%. However, Markit manufacturing PMI surprised to the upside, coming in at 54.7. This measure also increased relatively to last month's. USD/CAD has plunged by nearly 2.8%. We expect the Canadian dollar to outperform the AUD and the NZD, as oil should outperform metals in the commodity space. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator surprised to the upside, coming in at 111.3 in December. This measure also increased relative to November's reading. Meanwhile, the SVME Purchasing Manager's Index also outperformed expectations, coming in at 65.2. Finally, the ZEW survey expectations component increased relatively to last month, coming in at 52. EUR/CHF has continued its appreciation into the New Year. This is good news for the SNB, as this will provide an easing in financial conditions. Overall, we expect the franc to have limited downside against the euro, as the still low inflation in Switzerland will keep the SNB intervening in currency markets. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth for November increased relatively to last month's number, coming in at 2.1%. However, registered unemployment surprised negatively, as it increased from 2.3% to 2.4%. Since Christmas, USD/NOK has plunged by nearly 3%, as it has been battered by very strong oil prices. Overall, we expect USD/NOK to find upside, however this will happen only when rate expectations in the U.S. rise meaningfully. In order for this to happen, inflation must once again accelerate. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2.8%. This measure also increased from last month's reading. Producer price inflation also increased from last month's number, coming in at 2.7%. However, Manufacturing PMI declined in December relatively to November, coming in at 60.4. In line with multiple indicators signaling that global growth continues to improve, USD/SEK has plunged by more than 2.5% since Christmas. Investors willing to bet on a temporary slowdown in the euro area, caused by tightening financial conditions should short EUR/SEK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Question #1: Will global growth remain above trend? Yes. Question #2: Will growth continue to outperform outside the U.S.? No. Question #3: Will productivity growth pick up? Yes, but only cyclically. The structural outlook remains bleak. Question #4: Will continued strong global growth finally deliver higher inflation? Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Feature Global Growth In Focus We wish all our readers a joyous and prosperous 2018. As the new year begins, four questions about the global growth outlook loom large. Question #1: Will global growth remain above trend? Our answer: Yes. It is likely that global growth will come down a notch from its current elevated pace. However, it should remain firmly above trend. For one thing, the global economy continues to exhibit a lot of positive momentum. Real-time measures of economic activity, such as the Goldman Sachs Current Activity Indicator (CAI), highlight that global real GDP is rising at a robust pace (Chart 1). Our global leading indicator, as well as a wide swath of PMI data, suggest that this trend has legs (Chart 2). Chart 1APositive Global Growth Momentum Can Be Seen Here Positive Global Growth Momentum Can Be Seen Here... Positive Global Growth Momentum Can Be Seen Here... Chart 1BPositive Global Growth Momentum Can Be Seen Here Positive Global Growth Momentum Can Be Seen Here... Positive Global Growth Momentum Can Be Seen Here... Since 1980, above-trend global growth in one year has been accompanied by above-trend growth in the following year nearly three-quarters of the time. This bodes well for 2018. Chart 2... And Here Too ... And Here Too ... And Here Too Chart 3Financial Conditions Tend To Lead Growth By Six-To-Nine Months Financial Conditions Tend To Lead Growth By Six-To-Nine Months Financial Conditions Tend To Lead Growth By Six-To-Nine Months Global financial conditions eased significantly in 2017, thanks mainly to higher equity prices and narrower credit spreads. Easier financial conditions tend to benefit growth with a 6-to-9 month lag (Chart 3). The 6-month global credit impulse, which tends to lead activity, is also positive (Chart 4). Fiscal policy should remain stimulative. The fiscal thrust moved into positive territory in advanced economies in 2016-17 and this should remain the case in 2018 (Chart 5). Tax cuts will add about 0.3 percentage points to U.S. growth, while hurricane reconstruction spending and a likely congressional agreement to raise the cap on federal discretionary spending will add another 0.2 points. Chart 4Positive Credit Impulse Is Another Tailwind For Growth Positive Credit Impulse Is Another Tailwind For Growth Positive Credit Impulse Is Another Tailwind For Growth Chart 5Fiscal Policy Has Turned More Stimulative Four Key Questions On The 2018 Global Growth Outlook Four Key Questions On The 2018 Global Growth Outlook Our political strategists expect further fiscal easing in Japan this year. They also believe that German coalition talks will produce more government spending, with the SDP extracting concessions from Merkel on public investment and the CSU securing a commitment for more defense expenditure. On the flipside, our strategists expect some fiscal tightening in France as President Macron takes steps to trim France's bloated welfare state. Question #2: Will growth continue to outperform outside the U.S.? Our answer: No. Global revisions were more favorable outside the U.S. in the first nine months of 2017, which helps explain why the dollar came under downward pressure (Chart 6). More recently, U.S. growth estimates have begun to drift higher. As a result, the U.S. surprise index has surged relative to those of other economies (Chart 7). Chart 6U.S. Growth Expectations Were Lagging... ##br## But Not Anymore U.S. Growth Expectations Were Lagging... But Not Anymore U.S. Growth Expectations Were Lagging... But Not Anymore Chart 7U.S. Economic Surprise Index Increased ##br## Relative To Those Of Other Countries U.S. Economic Surprise Index Increased Relative To Those Of Other Countries U.S. Economic Surprise Index Increased Relative To Those Of Other Countries We expect the data to continue to favor the U.S. Aggregate U.S. hours worked in November was up 3.4% at an annualized rate over Q3 levels. If we add in productivity growth, Q4 GDP growth was probably in excess of 4% - well above current consensus estimates. Financial conditions have eased a lot more in the U.S. than in the rest of the world. Fiscal policy is also set to loosen relatively more in the U.S. Euro area growth is likely to tick lower next year from its current stellar pace, as the impact of a stronger euro begins to bite. The 6-month credit impulse has already turned negative there. Japanese growth should also cool somewhat from the heady pace of 2.7% seen over the past two quarters. The Chinese economy will decelerate modestly in 2018. The authorities are tightening the screws on the shadow banking system, expediting efforts to reduce excess capacity in the industrial sector, and clamping down on corruption. All of these reforms will pay off in the long run, but they could dent growth in the short run. Question #3: Will productivity growth pick up? Our Answer: Yes, but only cyclically. The structural outlook remains bleak. U.S. nonfarm productivity rose by 1.5% over the prior year in Q3, well above the post-2010 average of 0.8%. This improvement occurred despite the fact that low-skilled workers continue to re-enter the labor market - dragging down output-per-hour in the process - a phenomenon that is not well captured by the official productivity data. Productivity growth elsewhere in the world also appears to be on the upswing (Chart 8). Increased business investment should support productivity in 2018. Corporate surveys indicate that a rising percentage of companies anticipate boosting capital budgets (Chart 9). This often happens in the last few innings of business-cycle expansions, as more companies begin to experience capacity constraints. Chart 8Productivity Growth Showing Signs Of ##br## A Tentative Recovery Four Key Questions On The 2018 Global Growth Outlook Four Key Questions On The 2018 Global Growth Outlook Chart 9Surveys Are Signaling Acceleration ##br## In Capex Surveys Are Signaling Acceleration In Capex Surveys Are Signaling Acceleration In Capex Unfortunately, while the cyclical outlook for productivity is improving, the structural backdrop remains downbeat. As we have discussed in the past, flagging educational achievement, decreased creative destruction, and a shift in technological innovation towards consumers and away from businesses all augur poorly for future productivity trends.1 The much-hyped Amazon effect makes for good news stories, but is not borne out by the data.2 Question #4: Will continued strong global growth finally deliver higher inflation? Our answer: Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Chart 10A Pick-Up In Wage Growth Would Put Upward Pressure ##br## On Service Inflation A Pick-Up In Wage Growth Would Put Upward Pressure On Service Inflation A Pick-Up In Wage Growth Would Put Upward Pressure On Service Inflation Going into 2017, the Fed had expected core PCE inflation to end the year at 1.9%. It is likely to have finished the year at only 1.5%. We expect core PCE inflation to move toward 2% by the end of 2018. Wage growth should accelerate as the labor market continues to tighten. This should put upward pressure on service inflation (Chart 10). Goods price inflation should also recover due to the lagged effects of a weaker dollar and the bleed-through of higher energy prices into several core components of the CPI (airline fares being a notable example). Slower rent growth will dampen inflation. However, this will be partially offset by higher health care prices. The cost control measures introduced in the Affordable Care Act helped push down PCE health care services inflation from 3% in late 2010 to less than 0.5% in early 2016 (Chart 11). Many of these measures have been realized, and as a consequence, health care inflation has begun to revert to its long-term trend (though in level terms, the savings to consumers remain). The Republican tax bill could put some upward pressure on health care costs. The Congressional Budget Office estimates that the repeal of the Individual Mandate will raise premiums on health care exchanges by 10% because a larger share of healthy individuals will decide to forgo buying health insurance.3 Japanese inflation should move modestly higher in 2018, but from extremely depressed levels. The Japanese unemployment rate is now a full percentage point lower than in 2007 and the ratio of job opening-to-applicants has reached the highest level since 1974 (Chart 12). Chart 11U.S. Inflation Breakdown U.S. Inflation Breakdown U.S. Inflation Breakdown Chart 12Japan's Tightening Labor Market Japan's Tightening Labor Market Japan's Tightening Labor Market Euro area inflation will be held down by the lagged effects of a stronger euro and continued high levels of slack across southern Europe. Outside Germany, labor market underutilization is still 6.3 percentage points higher than it was in 2008 (Chart 13). U.K. inflation should edge lower as the spike in import prices stemming from the post-Brexit pound depreciation dissipates. Chart 13There Is Still Labor Market Slack Outside Of Germany There Is Still Labor Market Slack Outside Of Germany There Is Still Labor Market Slack Outside Of Germany Investment Conclusions A shift in global growth leadership back towards the U.S. would benefit the beleaguered U.S. dollar. Higher U.S. inflation will prompt the Fed to raise rates four times in 2018, one more hike than implied by the dots and two more hikes than implied by current market expectations. Rising inflation should also keep Treasury yields on an upward trajectory. We expect the 10-year yield to finish 2018 at around 3%. As long as inflation is rising in response to stronger growth, and from below-target levels, both U.S. and global risk assets should continue to rally. Only once U.S. inflation rises above 2% in 2019, and growth begins to slow on the back of binding supply-side constraints, will equities flounder. Stay long stocks for now, but look to significantly trim exposure towards the end of the year. Regionally, we favor euro area and Japanese equities over U.S. stocks for the next 12 months on a currency-hedged basis. Both the euro area and Japanese stock markets are dominated by large multinational companies whose prospects are geared more towards global growth than demand in their own regions. Above-trend global growth and rising capital spending should disproportionately benefit European and Japanese bourses, given that they have a greater tilt towards cyclically-sensitive companies. Valuations also tend to favor non-U.S. stocks. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?," dated May 31, 2017; Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 3 Please see "Repealing the Individual Health Insurance Mandate: An Updated Estimate," Congressional Budget Office, dated November 8, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 Short Palladium Short Palladium For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. The good news on global growth continue to roll in. Real GDP growth is accelerating in the major advanced economies, driven in part by a surge in capital spending. Nonetheless, record low volatility and a flat yield curve in the U.S. highlight our major theme for 2018; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. We expect inflation to finally begin moving higher in the U.S. and some of the other advanced economies. This will challenge the consensus view that "inflation is dead forever", and that central banks will respond quickly to any turbulence in financial markets with an easier policy stance. The S&P 500 would suffer only a 3-5% correction if the VIX were to simply mean-revert. But the pain would likely be more intense if there is a complete unwinding of 'low-vol' trading strategies. We will be watching inflation expectations and our S&P Scorecard for signs to de-risk. Government yield curves should bear steepen, before flattening again later in 2018. Stay below benchmark in duration for now and favor bonds in Japan, Italy, the U.K. and Australia versus the U.S. and Canada (currency hedged). Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. The intensity of forthcoming Chinese reforms will have to be monitored carefully for signs they have reached an economic 'pain threshold'. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex. Bitcoin is not a systemic threat to global financial markets. Feature Chart I-1Policy Collision Course? Policy Collision Course? Policy Collision Course? Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. Ominously, though, a flatter U.S. yield curve and extraordinarily low measures of volatility hover like dark clouds over the equity bull market (Chart I-1). The flatter curve could be a sign that the Fed is at risk of tightening too far, which seems incompatible with depressed asset market volatility. This combination underscores the major theme of the BCA Outlook 2018 that was sent to clients in November; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. Analysts are debating how much of the decline in volatility is due to technical factors and how much can be pinned on the macro backdrop. For us, they are two sides of the same coin. Betting that volatility will remain depressed has reportedly become a yield play, via technical trading strategies and ETFs. Trading models encourage more risk taking as volatility declines, such that lower volatility enters a self-reinforcing feedback loop. The danger is that this virtuous circle turns vicious. On the macro front, many investors appear to believe that the structure of the advanced economies has changed in a fundamental and permanent way. Deflationary forces, such as Uber, Amazon and robotics are so strong that inflation cannot rise even if labor becomes very scarce. If true, this implies that central banks will proceed slowly in tightening, and that the peak in rates is not far away. Moreover, below-target inflation allows central banks to respond to any economic weakness or unwanted tightening in financial conditions by adopting a more accommodative policy stance. In other words, investors appear to believe in the "Fed Put". Implied volatility is a mean-reverting series. It can remain at depressed levels for extended periods, especially when global growth is robust and synchronized. Nonetheless, we believe that the "outdated Phillips curve" and the "Fed Put" consensus views will be challenged later in 2018, leading to an unwinding of low-vol yield plays. For now, though, it is too early to scale back on risk assets. Global Growth Shifts Up A Gear... The good news on global growth continue to roll in. Easy financial conditions and the end of fiscal austerity provide a supportive growth backdrop. A measure of fiscal thrust for the G20 advanced economies shifted from a headwind to a slight tailwind in 2016 (Chart I-2). Our short-term models for real GDP growth in the major countries continue to rise, in line with extremely elevated purchasing managers' survey data (Chart I-3). The major exception is the U.K., where our GDP growth model is rolling over as the Brexit negotiations take a toll. Chart I-2Fiscal Austerity Is Over Fiscal Austerity Is Over Fiscal Austerity Is Over Chart I-3GDP Growth Models Are Upbeat GDP Growth Models Are Upbeat GDP Growth Models Are Upbeat Much of the acceleration in our GDP models is driven by the capital spending components. Animal spirits appear to be taking off and it is a theme across most of the advanced economies. G3 capital goods orders pulled back a bit in late 2017, but this is more likely due to noise in the data than to a peak in the capex cycle (Chart I-4). Industrial production, the PMI diffusion index and advanced-economy capital goods imports confirm strong underlying momentum in investment spending. Chart I-4Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth In the U.S., tax cuts will give business outlays and overall U.S. GDP growth a modest lift in 2018. The House and Senate hammered out a compromise on tax cuts that is similar to the original Senate version. The new legislation will cut individual taxes by about $680 billion over ten years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability that the tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. Any infrastructure program would also augment the fiscal stimulus. The total impact is difficult to estimate given the lack of details, but it is clearly growth-positive. ...But The U.S. Yield Curve Flattens... Bond investors are unimpressed so far with the upbeat global economic data. It appears that long-term yields are almost impervious as long as inflation is stuck at low levels. In the U.S., a rising 2-year yield and a range-trading 10-year yield have resulted in a substantial flattening of the 2/10 yield slope (although some of the flattening has unwound as we go to press). Investors view a flattening yield curve with trepidation because it smells of a Fed policy mistake. It appears that the bond market is discounting that the Fed can only deliver another few rate hikes before the economy starts to struggle, at which point inflation will still be below target according to market expectations. We would not be as dismissive of an inverted yield curve as Fed Chair Yellen was during her December press conference. There are indeed reasons for the curve to be structurally flatter today than in the past, suggesting that it will invert more easily. Nonetheless, the fact that the yield curve has called all of the last seven recessions is impressive (with one false positive). The good news is that, in the seven episodes in which the curve correctly called a recession, the signal was confirmed by warning signs from our Global Leading Economic Indicator and our monetary conditions index. At the moment, these confirming indicators are not even flashing yellow.1 Our fixed-income strategists believe that the curve is more likely to steepen than invert over the next six months. If inflation edges higher as we expect, then long-term yields will finally break out to the upside and the curve will steepen until the Fed's tightening cycle is further advanced. If we are wrong and inflation remains stuck near current levels or declines, then the FOMC will have to revise the 'dot plot' lower and the curve will bull-steepen. In other words, we do not think the FOMC will make a policy mistake by sticking to the dot plot if inflation remains quiescent. Rising inflation is a larger risk for stocks and bonds than a policy mistake. A clear uptrend in inflation would shake investors' confidence in the "Fed Put" and thereby trigger an unwinding of the low-vol investment strategies. A sharp selloff at the long end of the curve in the major markets would send a chill through the investment world because it would suggest that the Phillips curve is not dead, and that central banks might have fallen behind the curve. ...As Inflation Languishes For now there is little evidence of building inflation pressure in either the CPI or the Fed's preferred measure, the core PCE price index. The latter edged up a little in October to 1.4% year-over-year, but the November core CPI rate slipped slightly to 1.7%. For perspective, core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE index. The Fed has made no progress in returning inflation to target since the FOMC started the tightening cycle. A risk to our view is that the expected inflation upturn takes longer to materialize. The annual core CPI inflation rate fell from 2.3 in January 2017 to 1.7 in November, a total decline of 0.55 percentage points. The drop was mostly accounted for by negative contributions from rent of shelter (-0.31), medical care services (-0.13) and wireless telephone services (-0.1). These categories are not closely related to the amount of slack in the economy, and thus might continue to depress the headline inflation rate in the coming months even as the labor market tightens further. Recent regulatory changes, for example, suggest that there is more downside potential in health care services inflation. We have highlighted in past research that it is not unusual for inflation to respond to a tight labor market with an extended lag, especially at the end of extremely long expansion phases. Chart I-5 updates the four indicators that heralded inflection points in inflation at the end of the 1980s and 1990s. All four leading inflation indicators are on the rise, as is the New York Fed's Underlying Inflation Indicator (not shown). Importantly, economic slack is disappearing at the global level. The OECD as a group will be operating above potential in 2018 for the first time since the Great Recession (Chart I-6). Finally, oil prices have further upside potential. Higher energy prices will add to headline inflation and boost inflation expectations in the U.S. and the other major economies. Chart I-5U.S. Inflation: Indicators Point Up U.S. Inflation: Indicators Point Up U.S. Inflation: Indicators Point Up Chart I-6Vanishing Economic Slack Vanishing Economic Slack Vanishing Economic Slack The bottom line is that we are sticking with the view that U.S. inflation will grind higher in the coming months, allowing the FOMC to deliver the three rate hikes implied by the 'dot plot' for 2018. In December, the FOMC revised up its economic growth forecast to 2.5% in 2018, up from 2.1%. The projections for 2019 and 2020 were also revised higher. Growth is seen remaining above the 1.8% trend rate for the next three years. The FOMC expects that the jobless rate will dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. With the estimate for long-run unemployment unchanged at 4.6%, this means that the labor market is expected to shift even further into 'excess demand' territory. If anything, these forecasts look too conservative. It is unreasonable to expect the unemployment rate to stabilize in 2019 and tick up in 2020 if the economy is growing above-trend. This forecast highlights the risk that the FOMC will suddenly feel 'behind the curve' if inflation re-bounds more quickly than expected, at a time when the labor market is so deep in 'excess demand' territory. The consensus among investors would also be caught off guard in this scenario, resulting in a rise in bond volatility from rock-bottom levels. How Vulnerable Are Stocks? How large a correction in risk assets should we expect? One way to gauge this risk is to estimate the historical 'beta' of risk asset prices to mean-reversions in the VIX. The VIX is currently a long way below its median. Major spikes to well above the median are associated with recessions and/or financial crises. However, as a starting point, we are interested in the downside potential for risk asset prices if the VIX simply moves back to the median. Table I-1 presents data corresponding to periods since 1990 when the VIX mean-reverted from a low level over a short period of time. We chose periods in which the VIX surged at least to its median level (17.2) from a starting point that was below 13. The choice of 13 as the lower threshold is arbitrary, but this level filters out insignificant noise in the data and still provides a reasonable number of episodes to analyze.2 Table I-1Episodes Of VIX 'Mean Reversion' January 2018 January 2018 The episodes are presented in ascending order with respect to the starting point for the 12-month forward P/E ratio. This was done to see whether the valuation starting point matters for the size of the equity correction. The "VIX Beta" column shows the ratio of the percent decline in the S&P 500 to the change in the VIX. The average beta over the 15 episodes suggests that stocks fall by almost a half of a percent for every one percent increase in the VIX. Today, the VIX would have to rise by about 7½% to reach the median value, implying that the S&P 500 would correct by roughly 3½%. Investment- and speculative-grade corporate bonds would underperform Treasurys by 22 and 46 basis points, respectively, in this scenario. Interestingly, the equity market reaction to a given jump in the VIX does not appear to intensify when stocks are expensive heading into the shock. The implication is that a shock that simply returns the VIX to "normal" would not be devastating for risk assets. The shock would have to be worse. Chart I-7Market Reaction To 1994 Fed Shock Market Reaction To 1994 Fed Stock Market Reaction To 1994 Fed Stock The episodes of VIX "mean reversion" shown in Table I-1 are a mixture of those caused by financial crises and by monetary tightening (and sometimes both). The U.S. 1994 bond market blood bath is a good example of a pure monetary policy shock. It was partly responsible for the "tequila crisis", but that did not occur until late that year. Chart I-7 highlights that the U.S. equity market reacted more violently to Fed rate hikes in 1994 than the average VIX beta would suggest. The VIX jumped by about 14% early in the year, coinciding with a 9% correction in the S&P 500. Investors had misread the Fed's intension in late 1993, expecting little in the way of rate hikes over the subsequent year. A dramatic re-rating of the Fed outlook caused a violent bond selloff that unnerved equity investors. We are not expecting a replay of the 1994 bond market turmoil because the Fed is far more transparent today. Nonetheless, the equity correction could be quite painful to the extent that the VIX overshoots the median as the large volume of low-volatility trades are unwound. A 10% equity correction in the U.S. this year would not be a surprise given the late stage of the bull market and current market positioning. Yield Curves To Bear Steepen Upward pressure on inflation, bond yields and volatility will not only come from the U.S. We expect inflation to edge higher in the Eurozone, Canada, and even Japan, given tight labor markets and diminished levels of global spare capacity. The European economy has been a star performer this year and this should continue through 2018. Even the periphery countries are participating. The key driving factors include the end of the fiscal squeeze in the periphery and the recapitalization of troubled banks. The latter has opened the door to bank lending, the weakness of which has been a major growth headwind in this expansion. Taken at face value, recent survey data are consistent with about 3% GDP growth (Chart I-3). We would dis-count that a bit, but even continued 2.0-2.5% GDP growth in the euro area would compare well to the 1% potential growth rate. This means that the output gap is shrinking and the labor market will continue tightening. Despite impressive economic momentum, the ECB is sticking to the policy path it laid out in October. Starting in January, asset purchases will continue at a reduced rate of €30bn per month until September 2018 or beyond. Meanwhile, interest rates will remain steady "for an extended period of time, and well past the horizon of the net asset purchases." If asset purchases come to an end next September, then the first rate hike may not come until 2019 Q1 at the earliest. Thus, rate hikes are a long way off, but the deceleration of growth in the Eurozone monetary base will likely place upward pressure on the long end of the bund curve (shown inverted in Chart I-8). Chart I-8ECB Tapering Will Be Bond-Bearish ECB Tapering Will Be Bond-Bearish ECB Tapering Will Be Bond-Bearish Canada is another economy with ultra-low interest rates and rapidly diminishing labor market slack. The Bank of Canada will be forced to follow the Fed in hiking rates in the coming quarters. In Japan, strong PMI and capital goods orders are hopeful signs that domestic capital spending is picking up, consistent with our upbeat real GDP model (Chart I-3). Recent data on industrial production and retail sales were weak, but this was likely due to heavy storm activity; we expect those readings to bounce back. Nonetheless, it is still not clear that the Japanese economy has moved away from a complete dependency on the global growth engine. We would like to see stronger wage gains to signal that the economy is finally transitioning to a more self-reinforcing stage. It is hopeful that various measures of core inflation are slightly positive, but this is tentative at best. That said, the BoJ may be forced to alter its current "yield curve control" strategy by modestly lifting the target on longer-term JGB yields later in 2018, in response to pressures from robust growth and rising global bond yields. Thus, the pressure for higher bond yields should rotate away from the U.S. in the latter half of 2018 towards Europe, Canada and possibly Japan. This could eventually see the U.S. dollar head lower, but we still foresee a window in the first half of 2018 in which the dollar will appreciate on the back of widening interest rate differentials. We are less bullish than we were in mid-2017, expecting only about a 5% dollar appreciation. China: Long-Term Gain Or Short-Term Pain? The Chinese cyclical outlook remains a key risk to our upbeat view on risk assets. Significant structural reforms are on the way, now that President Xi has amassed significant political support for his reform agenda. These include deleveraging in the financial sector, a more intense anti-corruption campaign focused on the shadow-banking sector, and an ongoing restructuring in the industrial sector. The reforms will likely be positive for long-term growth, but only to the extent that they are accompanied by economic reforms. This month's Special Report, beginning on page 19, highlights that 2018 will be pivotal for China's long-term investment outlook. In the short term, reforms could be a net negative for growth depending on how deftly the authorities handle the monetary and fiscal policy dials. We witnessed this tension between growth and reform in the early years of President Xi's term, when the drive to curtail excessive credit growth and overcapacity caused an abrupt slowdown in 2015. Managing the tradeoff means that China's economy will evolve in a series of growth mini cycles. China is in the down-phase of a mini cycle at the moment, as highlighted by the Li Keqiang Index (LKI; Chart I-9). The LKI is a good proxy for the business cycle. BCA's China Strategy service recently combined the data with the best leading properties for the LKI into a single indicator.3 This indicator suggests that the LKI will end up retracing about 50% of its late 2015 to early 2017 rise before the current slowdown is complete. The good news is that broad money growth, which is a part of the LKI leading indicator, has re-accelerated in recent months. This suggests that the current economic slowdown phase will not be protracted, consistent with our 'soft landing' view. The intensity of forthcoming reforms will have to be monitored carefully for signs they have reached an economic pain threshold. We will be watching our LKI leading indicator and a basket of relevant equity sectors for warning signs. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex (Chart I-10). Chart I-9China: Where Is The Bottom? China: Where Is the Bottom? China: Where Is the Bottom? Chart I-10Metals At Risk Of China Soft Landing Metals At Risk Of China Soft Landing Metals At Risk Of China Soft Landing Equity Country Allocation For now we continue to recommend overweight positions in stocks versus bonds and cash within balanced portfolios. We also still prefer Japanese stocks to the U.S., reflecting our expectation for rising bond yields in the latter and an earnings outlook that favors the former. Chart I-11 updates our earnings-per-share growth forecast for the U.S., Japan and the Eurozone. We expect U.S. EPS growth to decelerate more quickly in 2018 than in Japan, since the U.S. is further ahead in the earning cycle and is more exposed to wage and margin pressure. European earnings growth will also be solid in 2018, but this year's euro appreciation will be a headwind for Q4 2017 and Q1 2018 earnings. European and Japanese stocks are also a little on the cheap side versus the U.S., although not by enough to justify overweight positions on valuation grounds alone. We have extended our valuation work to a broader range of countries, shown in Chart I-12. All are expressed relative to the U.S. market. These metric exclude the Financials sector, and adjust for both differing sector weights and structural shifts in relative valuation. Mexico is the only one that is more than one standard deviation cheap relative to the U.S. Nonetheless, our EM team is reluctant to recommend this market given uncertainty regarding the NAFTA negotiations. Russia is not as cheap, but is in the early stages of recovery. Our EM team is overweight. Chart I-11Top-Down EPS Projection Top-Down EPS Projection Top-Down EPS Projection Chart I-12Valuation Ranking Of Nonfinancial Equity Markets Relative To The U.S. January 2018 January 2018 A Note On Bitcoin Finally, we have received a lot of client questions regarding bitcoin. The incredible surge in the price of the cryptocurrency dwarfs previous asset price bubbles by a wide margin (Chart I-13). As is usually the case with bubble, supporters argue that "this time is different." We doubt it. Chart I-13Bitcoin Bubble Dwarfs All The Rest January 2018 January 2018 BCA's Technology Sector Strategy weighed into this debate in a recent Special Report.4 In theory, blockchain technology, including cyber currencies, can be used as a highly secure, low cost, means of transfer value from one person to the next without an intermediary. However, the report highlights that bitcoin is highly subject to fraud and manipulation because it is unregulated. Liquidity and accurate market quotes are questionable on the "fly by night" exchanges. Its use as a medium of exchange is very limited, and governments are bound to regulate it because cryptocurrencies are a tool for money laundering, tax evasion and other criminal activities. Another fact to keep in mind is that, although the supply of new bitcoins is restricted, the creation of other cryptocurrencies is unlimited. Would the bursting of the bitcoin bubble represent a risk to the economy? The market cap of all cryptocurrencies is estimated to be roughly US$400 billion (US$250 billion for bitcoin alone). This is tiny compared to global GDP or the market cap of the main asset classes such as stocks and bonds. The amount of leverage associated with bitcoin is unknown, but it is hard to see that it would be large enough to generate a significant wealth effect on spending and/or a marked impact on overall credit conditions. The links to other financial markets appear limited. Investment Conclusions Our recommended asset allocation is "steady as she goes" as we move into 2018. The policy and corporate earnings backdrop will remain supportive of risk assets at least for the first half of the year. In the U.S., the recently passed tax reform package will boost after-tax corporate cash flows by roughly 3-5%. Cyclical stocks should outperform defensives in the near term. Nonetheless, we expect 2018 to be a transition year. Stretched valuations and extremely low volatility imply that risk assets are vulnerable to the consensus macro view that central banks will not be able to reach their inflation targets even in the long term. The consensus could be in for a rude awakening. We expect equity markets to begin discounting the next U.S. recession sometime in early 2019, but markets will be vulnerable in 2018 to a bond bear phase and escalating uncertainty regarding the economic outlook. If risk assets have indeed entered the late innings, then we must watch closely for signs to de-risk. One item to watch is the 10-year U.S. CPI swap rate; a shift above 2.3% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We will also use our S&P Scorecard Indicator to help time the exit from our overweight equity position (Chart I-14). The Scorecard is based on seven indicators that have a good track record of heralding equity bear markets.5 These include measures of monetary conditions, financial conditions, value, momentum, and economic activity. The more of these indicators in "bullish" territory, the higher the score. Currently, four of the indicators are flashing a bullish signal (financial conditions, U.S. unemployment claims, ISM new orders minus inventories, and momentum). We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in the subsequent months. A drop below three this year would signal the time to de-risk. Our thoughts on the risks facing equities carry over to the corporate bonds space. Our Global Fixed Income Strategy service notes that uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart I-15).6 Elevated leverage in the corporate sector adds to the risk of a re-rating of implied volatility. For now, however, investors should continue to favor corporate bonds relative to governments for the (albeit modest) yield pickup. Chart I-14Watch Our Scorecard To Time The Exit Watch Our Scorecard To Time The Exit Watch Our Scorecard To Time The Exit Chart I-15Higher Uncertainty & ##br##Vol To Hit Corporate Bonds Higher Uncertainty & Vol To Hit Corporate Bonds Higher Uncertainty & Vol To Hit Corporate Bonds Overall bond portfolio duration should be kept short of benchmark. We may recommend taking profits and switching to benchmark duration after global yields have increased and are beginning to negatively affect risk assets. While yields are rising, investors should favor bonds in Japan, Italy, the U.K. and Australia within fixed-income portfolios (on a currency-hedged basis). Underweight the U.S. and Canada. German and French bonds should be close to benchmark. Yield curves should steepen, before flattening later in the year. Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Finally, investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. Mark McClellan Senior Vice President The Bank Credit Analyst December 28, 2017 Next Report: January 25, 2018 1 Please see BCA Global ETF Strategy service, "A Guide to Spotting And Weathering Bear Markets," August 16, 2017, available at etf.bcaresearch.com 2 Note that we are not saying that a rise in the VIX "causes" stocks to correct. Rather, we are assuming that a shock occurs that causes stocks to correct and the VIX to rise simultaneously. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," November 30, 2017, available at cis.bcaresearch.com 4 Please see BCA Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" December 12, 2017, available at tech.bcaresearch.com 5 Market Timing: Holy Grail Or Fool's Gold? The Bank Credit Analyst, May 26, 2016. 6 Please see BCA Global Fixed Income Strategy service, "Our Model Bond Portfolio Allocation In 2018: A Tail Of Two Halves," December 19, 2017, available at gfis.bcaresearch.com II. A Long View Of China 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal The New Normal The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? January 2018 January 2018 Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign China's Slowdown So Far Benign China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Urban Income Targets At Risk Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship January 2018 January 2018 This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others January 2018 January 2018 China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Inequality: A Severe Problem In China Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility January 2018 January 2018 "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense January 2018 January 2018 In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart II-14Chinese Public Grievances January 2018 January 2018 Chart II-15Anti-Corruption Is Popular January 2018 January 2018 Chart II-16Productivity Requires Institutional Change Productivity Requires Institutional Change Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... January 2018 January 2018 Chart II-17B...But There's A Long Way To Go January 2018 January 2018 Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind January 2018 January 2018 Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time January 2018 January 2018 Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. III. Indicators And Reference Charts Global equity indexes remained on a tear heading into year-end on the back of robust earnings growth in the major countries and U.S. tax cuts. There are some dark clouds hanging over this rally, as discussed in the Overview section. The technicals are stretched, but none of our fundamental indicators are warning of a market top. Implied equity volatility is very low, which can be interpreted in a contrary fashion. Investor sentiment is frothy and our Speculation Indicator is very elevated. Moreover, our equity valuation indicator has finally reached one standard deviation, which is our threshold of overvaluation. Valuation does not tell us anything about timing, but it does highlight the downside risks. Our monetary indicator also deteriorated a little more in December, although not by enough on its own to justify downgrading risk assets. On a positive note, earnings surprises and the net revisions ratio are not sending any warning signs for profit growth (although net revisions have edged lower recently). Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in November for the fifth consecutive month. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The small dip in the Japanese WTP in December is a little worrying, but we need to see more weakness to confirm that flows no longer favor Japanese equities. In contrast, Europe's WTP rose sharply in December, suggesting that investors are allocating more to their European equity holdings. We are overweight both Europe and (especially) Japan relative to the U.S. (currency hedged). U.S. Treasury valuation is still very close to neutral, even following December's backup in yields. There is plenty of upside potential for yields before they hit "inexpensive" territory. Similarly, our technical bond indicator suggests that technical factors will not be headwind to a further bond selloff in 2018. Little has change for the dollar. The technicals are neutral. Value is expensive based on PPP, but less so by other valuation metrics. We see modest upside for the greenback in 2018. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart II-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart II-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart II-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart II-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart II-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart II-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart II-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart II-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart II-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart II-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart II-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart II-20Euro Technicals Euro Technicals Euro Technicals Chart II-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart II-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart II-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart II-24Commodity Prices Commodity Prices Commodity Prices Chart II-25Commodity Prices Commodity Prices Commodity Prices Chart II-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart II-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart II-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart II-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart II-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart II-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart II-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart II-33U.S. Consumption U.S. Consumption U.S. Consumption Chart II-34U.S. Housing U.S. Housing U.S. Housing Chart II-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart II-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart II-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart II-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Dear Client, We are sending you this last issue of the year, a lighter fare than usual, highlighting 10 charts we find important. The first two charts tackle two of the key economic questions of the day: U.S. inflation and Chinese construction. The next seven charts are displays of technical action that has captured our attention for key currency pairs. The last chart tackles the topic du jour, bitcoin. We will resume regular publishing on January 5th, 2018. Finally, the Foreign Exchange Strategy team would like to thank you for your continued readership, and wishes you and your families a joyful holiday season as well as a healthy, happy and prosperous 2018. Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) U.S. Inflation Chart I-1AU.S. Inflation Is On Its Merry Way (I) U.S. Inflation Is On Its Merry Way (I) U.S. Inflation Is On Its Merry Way (I) Chart I-1BU.S. Inflation Is On Its Merry Way (II) U.S. Inflation Is On Its Merry Way (II) U.S. Inflation Is On Its Merry Way (II) U.S. inflation has been moribund in 2017, dismaying believers of the Philips curve, the Federal Reserve included. A few factors have been at play. The Fed sigma models show that the negative impact of a dollar rally on U.S. inflation is at its strongest with a two-year lag. Additionally, the fall in capacity utilization that happened following the industrial recession in late 2015/early 2016 continued to affect inflation negatively this year. These headwinds are passing. As the left panel of Chart I-1 illustrates, the easing in U.S. financial conditions this past year is likely to continue and become most salient for inflation in 2018. Meanwhile, the right panel of the chart shows that as the deceleration in money velocity growth forecasted the weakness in core inflation in 2017, its recent re-acceleration points to a pick-up in inflation next year. The Fed might be able to achieve its interest rate forecast of 3.1% in 2020 after all. 2) Chinese Housing Chart I-2AFrosty Outlook For Chinese Construction (I) Frosty Outlook For Chinese Construction (I) Frosty Outlook For Chinese Construction (I) Chart I-2BFrosty Outlook For Chinese Construction (II) Frosty Outlook For Chinese Construction (II) Frosty Outlook For Chinese Construction (II) Chinese monetary conditions have been tightened in 2017, fiscal expansion has been curtailed, and the growth of the M3 broad money supply has fallen to 8.8%. So far, the Chinese economy is hanging in, still benefiting from the fact that real interest rates have collapsed since November 2015 as producer price inflation rebounded from a 6% contraction to a 6% expansion today. This increase in producer prices has also helped industrial profits, which are expanding at a 23% pace, helping put a floor under industrial production. However, the outlook for residential investment needs to be monitored. Construction contributed 17% of GDP growth during the past two years. Chinese construction also contributed to 20% and 32% of the global consumption of refined copper and steel, respectively. This means that Chinese construction was a key driver of metal prices. Yet our leading indicator for Chinese house prices points toward a marked deceleration in the coming quarters. As the right panel of Chart I-2 shows, this could get translated into additional downside for iron ore. 3) EUR/USD Chart I-3The Euro Is At A Key Threshold The Euro Is At A Key Threshold The Euro Is At A Key Threshold 1.20 continues to represent a big hurdle to cross for EUR/USD. For the euro to punch above this mark, U.S. inflation will have to remain moribund in 2018. The rally in EUR/USD tracked an improvement in market estimates of the European Central Bank's terminal policy rate relative to the Fed's. Yet this improvement did not reflect an upgrade of the ECB's terminal rate itself, but rather a major downgrade of the Fed's, as U.S. inflation disappointed. If U.S. inflation rebounds as BCA anticipates, the dollar should be able to rally toward 1.10, especially as euro area inflation is unlikely to follow suit, as euro area financial conditions have tightened massively relative to the U.S. If U.S. inflation does not rebound, a move toward 1.30 is possible. Glimpsing at Chart I-3, it should also be obvious that any strength in the dollar next year is likely to prove a long-term buying opportunity for the euro. The EUR/USD has only traded below current levels when the U.S. dollar has been in the thralls of a major bubble. Additionally, global portfolios are deeply underweight euro area assets, therefore, a long-term rebalancing of portfolios toward euro area assets will support the euro down the road. Finally, when the next recession hits, the ECB is likely to have less room to stimulate its economy than the Fed will have. This means that during the next recession, the euro could behave like the yen has over the past 20 years: because the ECB will be impotent to fight deflationary pressures, falling euro area inflation will result in rising euro area real interest rates, especially against the U.S. This helped the yen then, and it could help the euro in the future, especially as the euro area's net international investment position is set to move into positive territory over the next 24 months. 4) EUR/GBP Chart I-4Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now EUR/GBP is at an interesting juncture. EUR/GBP has rarely traded above current levels (Chart I-4). On one hand, Brexit would suggest that EUR/GBP could actually rise. The uncertainty around the U.K. leaving the EU has caused the U.K. economy to be among the rare ones to not accelerate in unison with global growth this year, despite the stimulative effect of a lower pound. This suggests that the hands of the Bank of England will remain tied, limiting its capacity to increase the cash rate. Moreover, U.K. politics continue to take an increasingly populist tone, and the growing popularity of Jeremy Corbyn suggests that the discontent is present on all sides of the political spectrum. Populist policies are rarely good for a currency. On the other hand, the GBP is trading at such a discount to its fair value against both the USD and the EUR that historically, buying the pound at current levels has generated gains for investors with investment horizons measured in years. Moreover, if the EUR weakens in the first half of 2018, historical antecedents argue that EUR/GBP would also weaken in this context. When taken altogether, these factors suggest that EUR/GBP is likely to remain stuck in its post-Brexit trading range for as long as political uncertainty remains, especially as it is unlikely that the U.K. will receive a sweetheart FTA deal from the EU. Thus, while we expect EUR/GBP to retest 0.84 over the course of the next three to six months, at these levels we would buy EUR/GBP with a target of 0.90. 5) EUR/SEK Chart I-5EUR/SEK Will Fall From 10 To 9 EUR/SEK Will Fall From 10 To 9 EUR/SEK Will Fall From 10 To 9 EUR/SEK flirted with 10 this month. As Chart I-5 illustrates, this only happened during the financial crisis. Sweden is a much more pro-cyclical economy than the euro area, hence EUR/SEK exhibits very strong counter-cyclical behavior. It only trades above 10 when global growth is in tatters, and below 9 when it is booming. The recent spate of strength in EUR/SEK is thus perplexing, since global growth has been very robust and broad-based this year. The very easy policy of the Riksbank has been the main culprit. Timing a reversal in EUR/SEK is tricky, as it remains a function of the rhetoric of the Riksbank. But today, Swedish inflation is on the rise, with the CPIF, the inflation gauge targeted by the Swedish central bank, being at target. Thus, the days of super easy monetary policy in Sweden are numbered, especially as the output gap is a positive 1%, unemployment stands nearly 1% below equilibrium, and resource utilization measures have spiked up. Today, it makes sense to buy the SEK versus the euro. However, EUR/SEK is unlikely to move below 9, as the best of the global business cycle is probably behind us. 6) USD/JPY Chart I-6A Big Move In USD/JPY Is On Its Way A Big Move In USD/JPY Is On Its Way A Big Move In USD/JPY Is On Its Way USD/JPY is at an interesting technical juncture. This pair has been forming a very large tapering wedge in recent years (Chart I-6). This type of formation can be resolved in either a bullish fashion or a bearish one. Our current inclination is to bet on a bullish resolution for USD/JPY, as global bond yields seem to finally be regaining some vigor, which historically has been poison for the yen. Supporting our bias is the fact that we see more interest rate increases in the U.S. than are currently priced in, as we foresee a pick-up in inflation in 2018. The one thing that keeps us awake at night when thinking about our bullish disposition for USD/JPY is that EM carry trades have begun to weaken. Historically, this has led to a softening in global activity which foments further EM-carry-trade reversals and weakness in USD/JPY. Investors should keep an eye on this space. 7) AUD/USD Chart I-7AUD/USD At 0.8 Is A Line In The Sand AUD/USD At 0.8 Is A Line In The Sand AUD/USD At 0.8 Is A Line In The Sand The Australian dollar possesses the poorest outlook among the G10 currencies. The Australian economy continues to be plagued by large amounts of overcapacity, inflation is still absent, and Australia is the economy most exposed to a slowdown in Chinese construction activity as Australian terms-of-trade shocks follow metals prices. Additionally, China's push to fight pollution points to weakening coal prices, another key export of Australia. Moreover, Chart I-7 illustrates that the AUD rarely trades above 0.8. To do so, it needs an especially robust global economy, with China firing on all cylinders. We do not think China is about to crash, but it is not about to accelerate either, especially when it comes to demand for metals. Thus, with AUD/USD trading at 0.77, we see more downside for this pair than upside. In fact, when observed in a broader, longer-term context, the rally since 2016 in the AUD looks like a consolidation within a larger downtrend. 8) AUD/CAD Chart I-8AUD/CAD Will Breakdown AUD/CAD Will Breakdown AUD/CAD Will Breakdown AUD/CAD seems to have hit its natural ceiling this year. Only in the first half of the 1990s and when China was reflating its economy with all its might right after the financial crisis was AUD/CAD able to punch above 1.03 (Chart I-8). We do not see a repeat of this performance in the coming two years. First, as we mentioned, BCA does not anticipate any re-acceleration in Chinese investment or EM demand. Second, AUD/CAD is expensive, trading 9% above its fair value. Third, BCA remains more bullish on oil prices than metals prices. Fourth, a weakening AUD/USD tends to be associated with a weakening AUD/CAD. Finally, if these four factors cause AUD/CAD to weaken below 0.964, a key upward trend line that has supported AUD/CAD since late 2008 will be broken, which should prompt additional selling in this cross. 9) AUD/NZD Chart I-9AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD is likely to remain stuck in its trading range established since 2013 (Chart I-9). To begin with, the Australian dollar is trading at a 10% premium to the NZD. This has happened three times over the previous 17 years. Each of these instances were followed by vicious corrections in this cross. Additionally, while the AUD is very exposed to a slowing in Chinese construction and the associated problems for base metals prices, the NZD is not. In fact, the NZD may even benefit from the new economic objectives set by China's leadership. One of these new key objectives is to rebalance the economy toward the consumer. Moreover, Chinese consumer preferences have seen a switch toward higher quality foodstuffs.1 Higher quality foodstuffs, meat and dairy in particular, are exactly what New Zealand exports. Thus, a relative negative terms-of-trade shock is likely to come for AUD/NZD. The one big negative to our view is the political situation in New Zealand. The recent wave of populism points toward a fall in the potential growth rate, and thus a fall in the terminal policy rate of the Reserve Bank of New Zealand. The limit on foreign investment in Kiwi housing is another negative.2 Thus, we are not yet willing to bet on AUD/NZD falling below parity. 10) Bitcoins Chart I-10Groupthink Points To A Bitcoin Correction Toward 11,000 Groupthink Points To A Bitcoin Correction Toward 11,000 Groupthink Points To A Bitcoin Correction Toward 11,000 Valuing bitcoins is an arduous exercise. A lack of clearly defined fundamentals is the key difficulty. It is also why bitcoin prices can move so violently. We have already covered the technological elements behind Bitcoin and the blockchain,3 but to uncover what could be driving investors' imaginations, we have to move back to the realm of economics and finance. One theory tries to value bitcoin by linking it to a mode of payment. Using this method, Dhaval Joshi, who writes our BCA European Investment Strategy service, estimates a fair value for BTC/USD. Using the quantity of money theory, he shows that if the market assumes that bitcoins can support US$0.5 trillion of global GDP, and if the velocity of money historically averages 1.5 times, with 21 million potential bitcoins in issuance, a bitcoin should be worth US$17,000.4 Changing estimates for velocity or how much of global GDP will be transacted using bitcoins varies this estimate. Another approach has been to value bitcoins as an asset with a limited supply, like gold. Using this methodology, the global gold stock is worth approximately US$7 trillion, but cryptocurrencies, with their high volatility, are unlikely to steal the yellow metal's entire market share. Instead, they might be able to carve out 25% of gold's current total market capitalization. In this case, cryptos would be worth US$1.75 trillion. Bitcoin could represent half of this amount, which equates to a total market capitalization of US$875 billion. With a stock of 21 million bitcoins, the "fair value" would be around US$42,000. A third approach exists, and it is the simplest (Occam Razor's alert?). As Peter Berezin argues in BCA's Global Investment Strategy service, global governments extract seigniorage benefits from issuing currency.5 As an example, by printing cash, the U.S. government can buy services and good worth roughly US$90 billion per year, at a near zero cost. This is a very significant amount. Governments are unlikely to ever give up this source of funding. Since crypto currencies are a direct threat to this, they will likely be made illegal as a result. This would imply a fair value of BTC/USD of zero. The current fair value is likely to be a probability weighted average of all three scenarios. We assign a 10% probability for the first case (mode of payment), a 10% probability to the second case (store of value), and an 80% probability to the last case (zero value due to illegality). This would give a current fair value of roughly US$6,000. At the current juncture, bitcoin trading is exhibiting strong herd-like tendencies. When groupthink takes over a market, as is the case right now with crypto-currencies in general and bitcoin in particular, a trend reversal is likely to materialize. Today, bitcoin's "fractal dimension" has hit the 1.25 neighborhood, where such reversals have tended to happen (Chart I-10). As such, a correction is very likely. The average correction since 2016 has been around 35%. Following similarly parabolic moves as the one observed over the past month, pullbacks have been closer to 45%. A retracement toward BTC/USD of 11,000 is very probable over the coming quarters. That being said, it is too early to call the ultimate top for bitcoin. With the narrative among the bitcoin investing public increasingly switching to bitcoin being a store of value akin to gold, a move to the US$40,000 neighborhood is, in fact, not a tail event. However, this is a move to play at one's own peril, since fair value is likely to be well below these levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Atkinson, Simon. "Why are China instant noodle sales going off the boil?" BBC News, BBC, 20 Dec. 2017, www.bbc.com/news/business-42390058. He, Laura. "China's growing middle class lose appetite for instant noodles." South China Morning Post, 20 Aug. 2017, www.scmp.com/business/companies/article/2107540/chinas-growing-middle-class-lose-appetite-instant-noodles. 2 For a more detailed discussion of the political situation in New Zealand as well as its potential impact, please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How to Transform Gold into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "Blockchain And Cryptocurrencies" dated May 12, 2017, available at fes.bcaresearch.com 4 Please see European Investment Strategy Weekly Report, titled "Bitcoins And Fractals" dated December 21, 2017, available at eis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, titled "Don't Fear A Flatter Yield Curve" dated December 22, 2017, available gis.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 U.S. data was mixed: Housing starts increased by 1.3 million units, beating expectations, building permits also outperformed; Both the Philadelphia Fed Manufacturing Survey and Chicago Fed National Activity Index outperformed expectations; However, annualized Q3 GDP growth came in at 3.2%, less than the expected 3.3%; Growth in headline and core personal consumption deflators also failed to meet expectations, coming in at 1.5% and 1.3% respectively. Easier financial conditions are expected to slowly push the core PCE deflator back to the Fed's 2% target. This will allow Jerome Powell to continue in Janet Yellen's footsteps. As credit continues to grow, the large U.S. consumer sector will become an increasingly important tailwind to growth. The fiscal thrust from the new tax plan will could also accentuate growth and inflationary pressures. Therefore, investment and consumption activity are both likely to pick up next year. This will should support the Fed as well as the USD. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: German ZEW Current Situation increased to 89.3, outperforming expectations of 88.5; European ZEW Current Situation slightly underperformed expectations of 18, coming in at 17.4; Manufacturing and services PMIs for Germany and Europe as a whole both outperformed expectations; European trade balance decreased to EUR 19 bn from EUR 25 bn, and the current account also underperformed; European CPI was in line with expectations, contracting at a monthly pace, and growing at a 0.9% annual pace, under the expected 1% rate. On the Back of strong momentum in activity indicators, the ECB upgraded its growth and inflation forecasts for the upcoming years. However, since inflation is expected to remain under target for the whole forecast horizon, the ECB is likely to tighten policy at a much slower pace than the Fed. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Annual Import growth came in at 17.2%, surprising to the downside. Moreover, the All Industry Activity Index monthly growth also underperformed expectations, coming in at 0.3%. However, export annual growth surprised to the upside, coming in at 16.2%, an acceleration relative to last month's reading. On Wednesday, the Bank of Japan left its policy rate unchanged at -0.1%. Furthermore, the yield curve control policy, in which 10-year yields are kept around 0%, has been maintained. We stay bullish on USD/JPY, as we expect U.S. bond yields to rise when inflation picks up next year. However the yen could appreciate against commodity currencies if a risk-off period is triggered by tightening in China. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Gfk Consumer confidence underperformed expectations, coming in at -13. This measure also decline from the November reading. However, CBI industrial Trend Survey for orders, surprised to the upside, coming in at 17. Finally, public sector borrowing also surprised to the upside, coming in at 8.118 Billion pounds. The pound has been flat against the U.S. dollar this week. Overall we remain skeptical in the ability of the Bank of England to tighten much in the near future, given that real disposable income growth is very depressed, house price growth continues to be tepid, and uncertainty weighs on capex. Moreover, inflation will likely come down from present levels, as the pass through from the pound depreciation dissipates. All of these factors will limit any upside to cable in the next months. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The AUD rallied solidly in recent weeks thanks to buoyant data out of Australia and China. Last week's labor numbers were especially important in this regard. The growth in full-time employment has outperformed that of part-time since summer, while the underemployment rate has declined by 0.3% since 2017Q2.. Moreover, RBA officials identified further positives in the housing market: excessive price appreciation has slowed down considerably and household's balance sheets are improving. For now, the biggest risk to the Australian dollar remains the Chinese economy. Xi Jinping's commitment to clamp down on pollution, debt and inequalities is a bearish prospect for the AUD. Additionally, Chinese house prices could decline substantially - something which would have negative repercussions for the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 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 Recent data in New Zealand has been mixed: The current account surprised to the downside, coming in at -2.6% of GDP. However this number did improve from last quarter's -2.8% reading. However, both imports and exports outperformed expectations, coming in at 5.82 billion and 4.63 billion respectively. Moreover, GDP growth outperformed expectations, coming in at 2.7%. However, this number did decline from the 2.8% reading in Q2. NZD/USD was flat this week, even as the USD weakened. We continue to believe that carry currencies like the NZD, will be affected by tightening of financial conditions in China. However, the NZD has upside against the AUD, as the New Zealand dollar is cheaper than the AUD, and it is not as levered to the Chinese industrial cycle as the Australian dollar is. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was strong this week: Retail sales increased month-on-month by 1.5%, outperforming expectations by 0.8%; core retail sales also increased by a 0.8% monthly pace; Core inflation is at 1.3%, outperforming the expected 0.8%; Headline CPI is at 2.1%, above the expected 2%; The Canadian economy is growing in line with our expectations. A strong U.S. economy has allowed the export sector to flourish, while high demand for jobs has caused the labor market to tighten substantially. As labor shortages intensify, wages should gain traction in the near future, paving way for the BoC to tighten at least twice next year. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recently, the SNB released its 4th quarter quarterly bulletin. This report highlighted that the Swiss economy continues to recover, and GDP growth is expected to reach 2% in 2018, after a 1% expansion this year. Furthermore, the bulletin remarked that the labor market continues to tighten, with unemployment reaching 3% and employment growth finally hitting its long term average. The SNB also remarked that although the output gap continues to be negative, measures of capacity utilization are very close to reaching their long term average. However, the SNB continues to be unapologetically committed to its dovish bias and to intervention in currency markets, as inflation in Switzerland continues to be too weak for the SNB to change its stance. Thus, the CHF is likely to continue depreciating. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has appreciated by nearly 1.5% since last week, even as Brent has rallied by more than 2.5%. This dynamic highlights the fact that USD/NOK continues to be more correlated to interest rate differentials between Norway and the U.S. than to oil prices. Inflationary pressures and economic activity continue to be too tepid for the Norges to adopt a much more hawkish tone than it did last week. Meanwhile, the Fed is likely to surprise the market next year, by following up on its "dot plot". These dynamics will continue to put upward pressure on USD/NOK. Nevertheless, foreign exchange investors can still use the krone to bet on higher oil prices resulting from the extension of the OPEC supply cuts. The way to do so is by shorting EUR/NOK, which is more correlated with oil prices. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data has bounced back considerably: Headline CPI increased by 1.9% annually and CPIF grew by 2% annually; The unemployment rate dropped substantially from 6.3% to 5.8%, while the seasonally adjusted figure dropped from 6.7% to 6.4%. This week, the Riksbank announced a formal end to additional bond purchases by the end of December. However, reinvestments will continue until the middle of 2019, which means that the Bank's holdings of government bonds will actually increase into 2019. Additionally, the Swedish central bank also forecasts the repo rate to begin gradually increasing in the middle of 2018. This makes sense as the Swedish economy is running beyond capacity conditions. Given Sweden's stellar growth period, an appreciation in the SEK is long-awaited, but this will have to wait until Governor Ingves convinces markets that his perennial dovish-bias is ebbing. At that point, any hint of hawkishness will cause a sharp appreciation in the SEK, especially against the euro. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.