Europe

Highlights Nothing in Trump's congressional address changes our outlook from November; Trump has reaffirmed his commitment to mercantilism; Investors should continue to favor small caps over large caps; We expect Trump to get his way on more spending, and a tax reform plan to pass by the end of the year; The Dutch election is a red herring, Le Pen's chances of winning are falling, but Italy remains a risk, especially in 2018; North Korea has evolved from a red herring into a black swan, stay short KRW/THB. Feature President Donald J. Trump delivered a reassuring speech last week. Sporting a magnanimous tone (and a new tie!) the president shocked the media by invoking a "new surge of optimism." Gone were the diatribes about "American carnage." Instead, President Trump implored Congress to work together to bring forth a major infrastructure program that would rival that of Eisenhower's interstate highway system, adopt a merit-based immigration system akin to Canada, and reform Obamacare in a way that would retain all its popular pillars. Trump concluded the speech by stating that "everything that is broken in our country can be fixed" and warning the polarized Congress that "true love for our people requires us to find common ground." After the speech, a narrative emerged in the media and financial press saying that Trump was a changed man. Should investors believe it? Not at all! There was simply nothing in the Trump speech that changes our outlook in November: that President Trump was elected on a populist platform and that he will be unconstrained on blowing out the U.S. budget and pursuing a mercantilist agenda.1 On everything else - from immigration reform to Obamacare - Trump may pursue a pragmatic set of policies. Or he may not. But what investors really care about is whether the Trump administration and Congress will: Get sweeping tax cut legislation done in 2017; Pass some infrastructure spending in 2017; Pursue protectionist policies. On all three counts, we believe that the answer is yes. Trump will get his way on both his pro-growth - anti-fiscal discipline - and mercantilist agendas. The timing is difficult to gauge, but we believe that we will see all three policy avenues aggressively pursued throughout the year and passed into law by the year's end. Trump's speech has only reinforced this view. Who Is Trump? Tax Cuts As we discussed in a recent report detailing the border adjustment tax (BAT) proposal, newly elected presidents rarely fumble on tax reform.2 Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In addition, the GOP knows that it must move fast if it wants to pass any tax cuts in 2017. President Trump is now the most unpopular president since polling began tracking the question (Chart 1). Chart 1Does President Trump Lack Political Capital? Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was However, Republican voters continue to support him at 88%. This means that the House Republicans are vulnerable both to a Democrat/Independent backlash against Trump in the midterm elections and a Trump supporter backlash in the Republican primaries. They need to pass major legislation that satisfies middle class concerns and ensure that they do not incur the wrath of the Trump voters in primary races. While it is unlikely that the Democrats could significantly eat into Republican majorities in the House of Representatives and the Senate, stranger things have happened.3 Adding fire under the GOP are two special Congressional Elections, in Georgia's sixth district and for Montana's "at large" seat, to be held in April and May respectively.4 Both were easily won in November by Republicans. A slippage by the Republicans in either would send shockwaves through Congress. There is therefore little time to waste. The Republicans know that they must strike while the iron is hot. We suspect that most representatives will abandon their demand for revenue-neutral tax reform to get any tax reform. That may mean adjusting House Speaker Paul Ryan's favorite revenue-raising proposal - the border adjustment tax (BAT) - so that it brings less revenue by exempting whole categories of imports from punitive corporate taxes. "Dynamic scoring" - an accounting method that considers the holistic impact of budget measures on revenues and thus deficits - will be used to make the "math" work and satisfy the procedural demand for budget responsibility.5 What about Obamacare? A narrative has emerged in the media that Republicans cannot work on tax reform while the issue of "repealing and replacing" the Affordable Care Act looms over their heads. We disagree. There are plenty of examples of the White House and Congress cooperating on multiple policy agendas at the same time. For example, the Obama White House used its majorities in Congress to push through a major fiscal stimulus, financial reform, and the controversial health care plan. Ronald Reagan also managed to enact comprehensive immigration and tax reform in 1986. Trump's congressional address made only one mention of government debt. But he did emphasize that his tax plan would provide "massive tax relief for the middle class." This implies that the election campaign's individual income tax proposals may have to be altered. Trump's and the GOP's plans from last year agreed that the individual income tax should be reduced from seven to three brackets, with the marginal rates at 12%, 25%, and 33%. This would have cut the top marginal rate from 39.6% to 33%, but would also have left a significant number of Americans with an increase, or no change, to their marginal tax rate.6 It is likely that this will have to change, potentially creating an even greater impact on the deficit. Bottom Line: We expect both corporate and individual tax reform by the end of 2017. We do not have clarity on how legislators will go from here to there, but we suspect that to get both passed, Republicans in Congress will err on the side of greater deficits. As such, investors should expect exemptions on many imports under the final BAT (weakening any USD spike) and likely greater middle class tax cuts than are currently priced in the market. Infrastructure Spending Trump's congressional address ended several weeks of silence from the Trump administration on infrastructure spending. Not only did Trump reference the Eisenhower interstate highway system as a model to emulate, but he also promised a considerable increase in military spending and the completion of the wall on the border with Mexico ahead of schedule. Trump referred back to the original $1 trillion price tag that he announced in the heat of the electoral campaign. This figure was revised down by Trump's transition team to a modest $550 billion, though the difference may only be due to time frame. Whatever the case, Trump is using the bigger number now. We continue to believe that GOP representatives will not obstruct Trump's spending priorities. First, "dynamic scoring" can be applied to both tax cuts and infrastructure spending to make anything look close to revenue neutral. Second, voters want infrastructure spending (Chart 2). It is in fact the only issue other than combating drug addiction that Republicans and Democrats deeply agree on (Chart 3). Chart 2Everyone Loves Infrastructure Spending Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 3Infrastructure Is Not A Partisan Issue Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Third, history is not on the side of deficit hawks. True, the national debt is higher today at $20 trillion than it has been for previous Republican administrations. However, it is not only an arithmetic fact that Republican administrations run large deficits (Chart 4), it is also a fact that they tend to get more than they ask from Congress. Chart 5 shows, with astonishing consistency, that Congress is only a check on Democratic presidents when it comes to the final size of appropriation bills, whereas Republican presidents always managed to get Congress to approve more funding than they asked for. Chart 4Fact: Republicans Run##br## Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Chart 5Budgets: Republican Presidents ##br##Get What They Want Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Bottom Line: It remains difficult to gauge the actual size or economic impact of Trump's government spending proposals. However, we expect that President Trump will get his way on more spending not only for defense, veterans, and the wall, but also for infrastructure. While the impact will be minimal in 2017, investors should see greater fiscal thrust in 2018. Mercantilism While the media focused on the magnanimous tone of Trump's speech last week, we saw little change in his commitment to mercantilism. We continue to believe that Trump is a populist protectionist and that he is serious about enacting mercantilist policies.7 Recent government appointments (Table 2) and statements from the Trump administration (Table 3) suggest that we are correct. Table 2Government Appointments That Certify That Trump Is A Protectionist Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In his speech, Trump invoked President Abraham Lincoln's words that "abandonment of the protective policy by the American Government [will] produce want and ruin among our people."8 He went on to call for "fair trade," contrasted explicitly with "free trade," and to suggest that he would support changing the U.S. corporate tax system to make U.S. exports more competitive. Trump also said on February 24, in a Reuters interview, that he thought that the border adjustment tax would boost exports and help keep jobs in the U.S.9 This should end the speculation - prompted by an early comment from Trump on the BAT - that the president and congressional GOP are irreconcilably at odds over the BAT. Table 3Protectionist Statements From The Trump Administration Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was While Trump has yet to endorse Ryan's BAT proposal officially, he does not oppose its protectionist aspects. As a reminder, the BAT is protectionist because of two key elements: The BAT would give a "rebate" on exports (implicitly or explicitly) that could be higher than the amount of tax due on foreign profits (Diagram 1). For all intents and purposes, this is a dirigiste government subsidy for export-oriented industries. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was The BAT would allow companies to write off wages and salaries as costs, just like under the current corporate income tax system. But under the value-added tax systems of the rest of the world wages are not deductible. In addition, Trump still retains a bevy of traditional tools like tariffs with which to go after potential trade rivals. As we have pointed out since November, there are few constraints on a U.S. president when imposing protectionist measures.10 Bottom Line: Donald Trump remains committed to a mercantilist agenda. Investors should expect him to live up to the hype at some point in 2017. Investment Implications If markets have been cheering Trump's pro-growth policies, in addition to improving global growth data, we suspect the stock-market party will continue. Investors can take from President Trump's March 1 speech a renewed commitment to a populist agenda that should cause government spending to increase, regulations to be cut, corporate and individual tax rates to fall, and the budget deficit to widen. Won't this pursuit of nominal GDP growth at any cost create conditions for inflation and eventually a recession? Yes, but the timing is difficult to gauge and much will depend on whether Donald Trump replaces the doves on the Fed governing board with hawks, as current conventional wisdom has it. We highly doubt that he would chose hawks, or policymakers committed to rules-based central banking, given his singular focus on reviving economic growth. But even a dovish Fed may move to raise interest rates aggressively given the slate of pro-growth policies being undertaken so late in the economic cycle. In the meantime, on a cyclical horizon, the party will continue and stocks will go higher. As we posited two weeks ago, many of our clients are cautious and tactically bearish, expecting a correction, but we cannot find a single structural bear. In this environment, where everyone expects to "buy on dips" following the correction that never seems to happen, it is hard for a correction to happen. But isn't protectionism and a trade war between the U.S. and China, or even the rest of the world, a risk to the rally? Not necessarily. First, the timing is uncertain. Second, the impact on economic growth is even more uncertain. Third, aside from any knee-jerk selloffs, protectionism will split sectors and stocks into winners and losers. Those with a greater share of revenues abroad will suffer due to potential retaliation from America's trade partners. Furthermore, much of Trump's policies will be dollar bullish - including tax cuts, greater government spending, and likely the BAT. As such, export-oriented sectors and companies will stand to suffer. We continue to believe that an overweight position in small caps will be a way to play the "Trump effect" on a strategic basis. Europe - Election Update Europe's election season is heating up, with the Dutch election just a week away and the first round of the French presidential election in just over a month. Here is a quick update on the key developments: The Netherlands According to the latest polls from the Netherlands, the Euroskeptic Party for Freedom (PVV) appears to be slipping (Chart 6). Just two months ago, the PVV was projected to capture around 35 seats, a number that has now fallen to around 25. Given that the Dutch parliament has 150 seats and that the PVV has no potential allies amongst the other 13 competitive parties, this election is largely a red herring. Should investors be worried about the Netherlands' role in European integration in the future? We don't think so. Support for the euro and the EU has not slipped in the Netherlands, at least not according to the data we have presented in these pages before.11 Instead, the PVV's support has risen due to the recent migration crisis. In fact, the number of asylum seekers has correlated almost perfectly with the PVV's support level since mid-2015 when the influx began (Chart 7). Given that the migration crisis is over (and we do not expect it to restart any time soon), we suspect that the PVV's support will moderate over the next electoral cycle. Chart 6Dutch Euroskeptics Are##br## An Overstated Threat Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 7Dutch Populists Are A##br## Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis France The French election continues to grab headlines in Europe. However, almost all the news is bad news for Marine Le Pen. First, François Bayrou, a notable centrist who captured 9.3% of the vote in the first round of the 2012 election and 18.6% in 2007, has decided not to contest the election and instead support Emmanuel Macron. Non-French media have not picked up on the significance of the endorsement. It is more important than Bayrou's 3-5% level of support in the polls suggests. While Bayrou is a centrist, he once belonged to the center-right, conservative movement and was a cabinet minister during Jacques Chirac's reign. As such, his endorsement will give Macron, a former Socialist Party minister, even more "cross-over appeal" for center-right voters in the second round against Le Pen. Chart 8Le Pen Is Facing Resistance Le Pen Is Facing Resistance Le Pen Is Facing Resistance Second, the rumored alliance between the far-left Jean-Luc Mélenchon and the left-wing candidate of the ruling Socialist Party, Benoît Hamon, has failed to materialize. Their potential alliance was one of the main concerns that many of our clients brought to us in recent meetings. Given current polling, such a marriage could have produced a singular left-wing candidacy that would have propelled either Mélenchon or Hamon into the second round. However, the alliance was always a long shot, as anyone who has followed French politics knows, given Mélenchon's staunch commitment to running on his own platform. And furthermore, arithmetically combining the polling of the two candidates makes no sense given that a singular platform would have forced compromises that would have led to serious defections by voters to other candidates. As such, the combined ticket's support level was always just a theoretical exercise. Third, the latest polls suggest that Le Pen's mini-rally has been arrested (Chart 8). She has failed to consistently break through the 40% percentile mark for the second round. Against Macron, her most likely opponent, she continues to trail by a 25-30% margin. The second-round election is on May 7, just two months away. Two months from November 8, Donald Trump trailed Hillary Clinton by just 5%. Italy Our main political concern in Europe remains Italy. Polls continue to show that Euroskeptics are gaining on the centrist parties (Chart 9). Most worryingly, Italians continue to gain confidence in life outside the EU. According to a poll that asks respondents whether they think "their country could better face the future outside of the EU," Italians are the most optimistic, next to the Brits and the historically Euroskeptic Austrians, about life outside the bloc (Chart 10). Chart 9Italian Establishment##br## Is Collapsing Italian Establishment Is Collapsing Italian Establishment Is Collapsing Chart 10AItalians Are Now The Only People In ##br##The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Chart 10BItalians Are Now The Only People In##br## The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits We therefore find the market's sanguine view on Italy to be myopic. Yes, the probability of an election in 2017 is declining. The ruling Democratic Party (PD) has set its leadership race for April 30, which rules out an election this summer, and former Prime Minister Matteo Renzi appears to have agreed to an election in February 2018.12 On a cyclical time horizon of 12 months, Italy is therefore not a major risk. However, once the election does take place, it could be source of considerable market volatility. At that point, investors would have to ask whether the election would take place under a new electoral law. If not, then the probability of a hung parliament would be considerable. Unless, that is, the Euroskeptic parties could form a coalition based solely on holding a referendum to leave the euro area. We doubt that the left-wing Five Star Movement (M5S) would be able to cooperate with the more staunchly Euroskeptic and right-wing Northern League and Brothers of Italy on this matter. Particularly since M5S has already begun to moderate on the issue of Euroskepticism. There is no point in speculating on an outcome of an election a year from now given that we are not even certain what electoral rules the contest would use. However, we do not think that investors should be sanguine because the likeliest outcome is governmental dysfunction. Chart 11SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent The one thing that may help Italy in 2018 is the outcome of the German election in September. The radically Europhile chancellor-candidate of the Social Democratic Party (SPD), Martin Schulz, has continued to do well in the polls against Angela Merkel (Chart 11). On a recent tour of highly sophisticated clients in New York we were surprised that only a handful were aware of Schulz's platform and background. Even if Schulz does not win, a renewed Grand Coalition between Merkel's Christian Democratic Union and the SPD would have to take into consideration his meteoric rise. The price for a renewed Grand Coalition could be the abandonment of Merkel's reticent leadership of the euro area. Investment Implications For now, our view that the markets will climb the wall of worry in Europe in 2017 is holding up. We suspect that investors will quickly refocus their attention on Italy once the French election is out of the way. One of the best gauges of euro area breakup risk has been the performance of French bonds versus German bonds relative to the performance of Spanish and Italian bonds versus German bonds. In our view, every time French spreads have correlated highly with Spanish and Italian spreads, the euro area faced existential threats. The shaded sections of Chart 12 largely conform to the political context in Europe over the past five years. In particular, it is interesting that French yields have decoupled from their Mediterranean peers ever since the ECB's "whatever it takes" announcement. Chart 12French Spreads Are Overstated French Spreads Are Overstated French Spreads Are Overstated Until right now, that is. We think the bond market is making a mistake. France is not a risk and euro area breakup risk over the next 12 months is essentially near zero. However, the probability of a major economy leaving the euro area over the next five years is going up. This is both because of the political situation in Italy and because Euroskeptics like Marine Le Pen could take over the mantle of the "official opposition" to the "centrist consensus" running Europe. If a country like Italy exits the euro area, would the currency union be doomed? It depends, largely on how that economy were to perform post-exit. In the ceteris paribus world of macroeconomics, a massive currency devaluation post-exit would be a clear and definitive positive. However, BCA's Geopolitical Strategy was created specifically to go beyond ceteris paribus analysis. And we doubt that the euro area exit would be undertaken by pragmatic policymakers capable of taking advantage of currency devaluation while reassuring both markets and EU member states that they would pursue orthodox economic policies. As a guide for what we think would happen to Italy, we would suggest our clients read our January 2016 report on the Greek future post euro area.13 In this think piece, we argue that Greece would not become a "land of milk and honey" after exiting, largely because the political context of exit would be turbulent and lead to populist policies that would devastate the economy. As such, we would stress that while the probability of an individual member state leaving the euro area is climbing - even one as important as Italy - it does not necessarily mean that the probability of euro area dissolution is climbing at the same rate. North Korea: No Longer A Red Herring A brief word about the Korean peninsula is in order after the four North Korean missile tests on March 6 and our report last week recommending that clients steer clear of South Korean assets.14 Simply put, the Korean peninsula is a source of real geopolitical risk right now, contrary to the status quo in which North Korea was largely a red herring. We have narrated this transition since last year,15 but it boils down to the following points: North Korea is finally "arriving" at the nuclear club: It is coming upon that horizon foreseen long ago in which it possesses the ability strike the United States with a nuclear missile, however crude. The American and Japanese defense establishments are becoming more concerned, and their public opinion can follow on command.16 Trump's policy looks to be more assertive, though that is not certain. U.S.-China relations have gone sour: The worsening of Sino-American tensions makes these two more suspicious of each other's motives and simultaneously increases economic and political pressure on both Koreas. Ironically, China is currently sanctioning both North and South Korea, the latter because it is hosting the U.S. THAAD missile defense system (Chart 13). The U.S., for its part, has been rushing THAAD, which it is just now rapidly deploying after the latest North Korean launches. North Korean internal stability is overrated: It is hard to argue that Kim Jong Un has not consolidated power impressively. But this consolidation has coincided with some loosening of internal economic control to help compensate for slower Chinese growth and worse Chinese relations. Gradual marketization threatens to undermine the regime from within, yet the standard playbook of belligerence threatens to provoke sanctions with real teeth from without, like China's proposed coal import ban for the rest of this year.17 Chart 13China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles Adding to the volatile mix, South Korea's right-of-center ruling party is collapsing, which affects the behavior of all the interested parties. The Constitutional Court is set to decide whether to uphold the president's impeachment as early as this week. Where is it all going? In the short term, markets will respond to the court case and elections. A ruling is expected immediately, but could take until June. A ruling ejecting the president would be positive for South Korean risk assets, as it would reduce the current extreme uncertainty. As to the long-term outlook, if everything were to happen according to the region's familiar patterns of rising and falling tensions, China's sanctions would force North Korea to offer de-escalation, a new left-wing government in South Korea would launch a bold new "Sunshine Policy" of engagement with the North, and the alignment of these three in favor of new diplomatic negotiations would drive Japan and the United States to give peace another chance despite their skepticism about the outcome. By 2018, a revival of something like the Six Party Talks, discontinued in 2009, would be on the horizon or even underway. The problem is that the usual cycle is less assured because of the North's improving capabilities and other factors above. Thus, until we see China verifiably enforce sanctions, North Korea step back from its provocations, and the Trump administration take a non-aggressive posture (with Japan following suit), the Korean peninsula will be at a heightened risk of producing geopolitical "black swan" events. Bottom Line: North Korea is shifting from a red herring to a potential black swan, at least until U.S.-China relations improve and lend some stability to the situation. Stay short KRW/THB. Marko Papic, Senior Vice President marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 3 For example, the 2010 "Tea Party" revolution reversed the Democrat's majority in the House with one of the most sweeping victories merely 24 months following President Obama's 2008 victory, which itself was a lot more convincing than Trump's victory over Clinton. 4 Republican Ryan Zinke won the Montana seat but left it to become Trump's Secretary of Interior; Republican Tom Price won the Georgia seat but left it to become Secretary of Health and Human Services. 5 Dynamic-scoring, also known as macroeconomic modeling, is a favorite tool of Republican legislators when passing tax cut legislation. It allows policymakers to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. The same method could be used to pass "revenue-neutral" infrastructure spending, given that it too would produce higher economic growth and thus presumably higher government revenues. 6 Several income brackets would see no substantial tax cuts under the original tax cut plan proposed by the Trump campaign. Those making $15,000-$19,000 would see their tax rate increase from 10% to 12%. Those making $52,500-101,500 would see their rate stay the same at 25%, while those making $127,500-$200,500 would see their rate rise substantively, from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 President Trump failed to mention that the U.S. was - when Lincoln made the statement in 1846 - a developing economy. Nor did he mention that Lincoln made the statements not as a president but a representative. 9 Please see Holland, Steve, Reuters, "Exclusive: Trump says Republican border tax could boost U.S. jobs," dated February 24, 2017, available at reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 12 Renzi said on February 26 that "The elections are envisaged in February 2018. Fullstop." Please see Reuters, "Decision on early Italian elections up to PM Gentiloni: Renzi," dated February 26, 2017, available at reuters.com. 13 Please see BCA Geopolitical Strategy Special Report, "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, and "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 16 Please see Mark Landler, "North Korea Nuclear Threat Cited by James Clapper, Intelligence Chief," New York Times, February 9, 2016; Siegfried S. Hecker, "The U.S. Must Talk To North Korea," New York Times, January 12, 2017, available at www.nytimes.com. See also Jeff Seldin, "N. Korea Capable of Nuclear Strike at US, Military Leader Says," Voice of America, April 7, 2015, available at www.voanews.com. In 2013, Chairman of the Joint Chiefs of Staff General Martin Dempsey said that "in the absence of concrete evidence to the contrary, we have to assume the worst case, and that's ... why we're postured as we are today," quoted in "Hagel: North Korea Near 'Red Line,'" UPI, April 10, 2013, available at www.upi.com. 17 Enforcement is as yet unclear. Please see Leo Byrne, "North Korean cargo ship moves between Chinese, DPRK coal facilities," dated March 6, 2017, available at www.nknews.org.

Highlights Assessing Our Tilts: Our decision to upgrade corporate spread product versus government debt in the U.S., and to reduce overall recommended duration exposure, at the end of January has been performing well. Maintain these tilts, with both soft and hard economic data pointing to a broadening global economic upturn and the Fed prepared to hike rates next week. Fed Vs ECB: Cyclical comparisons of the Euro Area today to the U.S. in the months prior to the Fed's 2013 "Taper Tantrum" show that the Euro Area is closer to full employment, with headline inflation at target, compared to the U.S. four years ago. The ECB may be facing its own tantrum pressures later in 2017. U.K.: Gilts have already priced in a significantly weaker U.K. economic outlook, especially with regards to consumer spending, yet inflation expectations are only now starting to peak. Raise U.K. bond exposure to neutral, from underweight. More clarity on the Brexit negotiations status is necessary to develop a firmer conviction on Gilts with yields already at rich levels. Feature Chart of the WeekAre Central Banks Getting ##br##Behind The Curve? Are Central Banks Getting Behind The Curve? Are Central Banks Getting Behind The Curve? A whiff of central bank hawkishness has quickly swept over the major bond markets. In the U.S., a series of Fed speeches, coming after a string of improving economic data amid booming asset markets, has turned a March Fed rate hike from a long-shot to a virtual certainty in little more than a week. In Europe, another round of stronger inflation data is emboldening some of the hawks at the European Central Bank (ECB) to more openly question if some tapering of the central bank's asset purchases will be necessary next year. Even in the U.K., the Bank of England (BoE) is letting its latest round of Gilt quantitative easing (QE) expire, although the BoE is not close to considering a rate hike, as we discuss later in this Weekly Report. Chart 2A Supportive Backdrop ##br##For Taking Credit Risk A Supportive Backdrop For Taking Credit Risk A Supportive Backdrop For Taking Credit Risk A move by the Fed next week now seems like a done deal, and the new question for investors is: how many more times the Fed will lift rates in 2017? The market is now pricing in "only" 75bps of hikes over the next year, even as the S&P 500 sits close to its all-time high and U.S. jobless claims hit a 43-year low last week (Chart 1). We still see three hikes - the Fed's current projection - to be the most that the Fed will deliver in 2017. Yet the fact that equity & credit markets have taken the rising odds of a March rate increase in stride might nudge the Fed towards even more hikes this year than currently forecast. Bond markets around the world will likely not take a shift higher in the Fed "dots" very well, although in the U.S. the immediate upside for yields remains tempered by the persistent short positioning in the U.S. Treasury market. We still expect Treasury yields to rise over the next 6-9 months, though, driven by additional increases in inflation expectations rather than a sharp repricing of the expected path of the funds rate. The biggest risk looming for global bonds, however, would come from any signal by the ECB that a taper is in the cards next year. That would likely result in wider term premiums and bear-steepening of yield curves in the major developed government bond markets. It would be a surprise if the ECB started preparing the markets for a less accommodative policy stance at this week's meeting, although questions about a taper will certainly be posed to ECB President Draghi by reporters after the meeting. Evaluating Our Recommendations As Global Growth Improves Back on January 31st, we shifted to a more pro-growth stance in our fixed income portfolio recommendations, moving our duration tilt back to below-benchmark, while downgrading government debt and upgrading corporate bond exposure.1 The key to that shift was a growing body of evidence pointing to a broadening global economic upturn. The latest round of global purchasing managers' indices (PMIs) released last week confirmed that the business cycle dynamics continue to accelerate to the upside (Chart 2). This will maintain upward pressure on bond yields and downward pressure on credit spreads. Our portfolio recommendations have generally done well since we made our shift. In Chart 3, we show the excess returns (on a currency-hedged basis) for the individual government debt markets versus the overall Barclays Global Treasury Index since the end of January. Our underweight positions in the U.S., Spain and Australia (up to February 21st, when we upgraded Aussie debt to neutral) performed well, as did our overweights in core Europe (Germany & France). Our worst performing tilts were our below-benchmark stances on Italy, which benefitted greatly from some diminished pressures on French government debt last week, and U.K. Gilts, which we discuss later in this report. In Chart 4, we show the excess returns (on a currency-hedged basis) for the major spread product markets, since January 31. Our decisions to upgrade U.S. investment grade (IG) to above-benchmark, and U.S. high-yield (HY) to neutral, have done well as U.S. corporate spreads continue to tighten in response to improving U.S. economic growth. Our relative exposures between the U.S. and Euro Area remain our biggest tilts between countries. Specifically, we remain overweight core Euro Area government debt versus U.S. Treasuries, while we are neutral U.S. HY and underweight Euro Area equivalents. On IG corporate debt, we are above-benchmark on both sides of the Atlantic. Our marginal preference, however, is for U.S. IG given the shifting changes in relative balance sheet health in the U.S. (improving, but from relatively poor levels) versus Europe (stable, but at relatively strong levels) suggested by our Corporate Health Monitors. On a currency-hedged and duration-matched basis, our relative U.S. vs Euro Area tilts have done well since our major allocation shift on January 31 (Chart 5), with Treasuries underperforming, U.S. HY outperforming and both U.S. and European IG performing similarly. Chart 3Our Recent Country Allocation Performance Will The Hawks Walk The Talk? Will The Hawks Walk The Talk? Chart 4Our Recent Spread Product Allocation Performance Will The Hawks Walk The Talk? Will The Hawks Walk The Talk? Chart 5Our Europe Vs U.S. Tilts Have Done Well Of Late Will The Hawks Walk The Talk? Will The Hawks Walk The Talk? Bottom Line: Our decision to upgrade corporate spread product risk versus government debt in the U.S., and to reduce overall recommended duration exposure, at the end of January has been performing well. Maintain these tilts, with both soft and hard economic data pointing to a broadening global economic upturn and the Fed prepared to hike rates next week. The Timing Of A Potential "Bund Tantrum" Looking ahead, timing a potential turn in our U.S. versus Europe tilts will likely remain the biggest call we make this year. With the Fed now set to raise rates again next week, and the ECB likely to deflect any talk of a taper to after the upcoming French elections (at the earliest), the bias will remain toward Treasury market underperformance in the near term. Yet the marginal pressures on inflation in both the U.S. and Euro Area suggest that a turning point in U.S./Core Europe bond spreads could arrive sooner than many expect. While realized inflation rates are moving higher in both regions, the underlying price pressures have a different look. In the U.S., headline inflation (using the Fed's preferred measure, the change in the personal consumption expenditure, or PCE, deflator) has risen to 1.89%, a mere 15bps above core PCE inflation with both measures now sitting just below the Fed's 2% target. Yet the breadth of the rise in core inflation has rolled over, according to our diffusion index (Chart 6). This suggests that the recent acceleration in core inflation, which we believe the Fed is most focused on, may take a pause in the next few months. The opposite is true in the Euro Area, where headline HICP inflation (the ECB's target measure) has soared to 1.9%, right at the ECB target of "at or just below" 2%. The gap between headline and core HICP inflation has been widening, though, as there has been very little follow through from the acceleration in headline inflation, largely driven by base effects related to previous rises in energy prices and declines in the euro, into core prices. Our Euro Area headline inflation diffusion index is moving higher, highlighting that the increase in headline HICP inflation is becoming more broadly based (Chart 7). Chart 6A Narrowing Increase In U.S. Inflation A Narrowing Increase In U.S. Inflation A Narrowing Increase In U.S. Inflation Chart 7A Broadening Increase In Euro Area Inflation A Broadening Increase In Euro Area Inflation A Broadening Increase In Euro Area Inflation The cyclical uptrend in Euro Area growth and inflation is also fairly broad-based at the country level, with the individual country PMIs and headline HICP inflation rates all in solid uptrends for the major countries in the region (Chart 8). At the same time, core inflation rates remain well contained. Various ECB members have pointed to the benign core inflation readings as a reason to stay the course on extraordinarily accommodative monetary policy settings. Yet with unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to get a consensus view on maintaining the status quo on ECB policy. Already, the German Bundesbank has been quite vocal in questioning the need for the ECB to maintain the current pace of its asset purchase program, and that pressure will only grow with German inflation now above 2%. So how close is the ECB to a potential asset purchase taper? Some clues emerge when comparing Europe now to the U.S. around the time of the Fed's 2013 "Taper Tantrum." In Chart 9, we show "cycle-on-cycle" comparisons for both the Euro Area and U.S. All series in the chart are lined up to the peak in our Months-To-Hike indicator, which measures the number of months to the first rate hike of the next interest rate cycle, as discounted in the Overnight Index Swap (OIS) curve. That indicator peaked in the U.S. in late 2012, several months before Ben Bernanke's infamous speech in May 2013 that signaled the Fed's QE appetite was beginning to wane. Chart 8A Consistent Upturn##br## In Europe A Consistent Upturn in Europe A Consistent Upturn in Europe Chart 9Less Spare Capacity In Europe Now Vs ##br##Pre-Taper Tantrum U.S. Less Spare Capacity in Europe Now vs Pre-Taper Tantrum U.S. Less Spare Capacity in Europe Now vs Pre-Taper Tantrum U.S. In the Euro Area, the Months-To-Hike indicator peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, the indicator remains much higher than it ever was in the U.S. during the QE era, indicating how the market believes that the ECB will have to maintain zero (or lower) interest rates for longer. Yet, by some measures, the ECB is closer to reaching its policy goals then the Fed was in 2012/13. In the 2nd panel of Chart 9, we show the "unemployment gap" - the difference between the unemployment rate and the rate consistent with inflation stability - for the U.S. and Euro Area. Note that there is far less spare capacity in labor markets today in Europe than there was in the U.S. when the Fed raised the topic of a QE taper to the markets. The U.S. unemployment rate was a full three percentage points above the full employment level in 2012, while Euro Area unemployment is now only one percentage point above full employment. In the bottom two panels of Chart 9, we show the gap between headline and core inflation in both the U.S. and Euro Area, relative to the 2% inflation targets that both the Fed and ECB aim to hit. U.S. inflation was in the vicinity of the Fed's target around the time of the Taper Tantrum. While Euro Area headline inflation is similarly close to the ECB's 2% target today, core inflation is much further away from 2% than U.S. core inflation was four years ago. If the ECB focuses on headline rather than core inflation, then Europe could be getting close to its own Taper Tantrum. Yet the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to make a rush to judgement on its asset purchase program, especially given the uncertainties presented by the upcoming French elections in April & May. We are still maintaining our overweight stance on core European government debt versus U.S. Treasuries, but we are growing increasingly worried that a turning point may be on the horizon. As can be seen in the additional cycle-on-cycle comparisons in Chart 10, the benchmark 10-year German Bund is tracing out a similar path to that of the 10-year U.S. Treasury around the time of the Fed Taper Tantrum. If the ECB focuses on the tightening labor market and accelerating pace of headline inflation in the Euro Area, a "Bund Tantrum" could become the big story for global bond markets later this year. Bottom Line: Cyclical comparisons of the Euro Area today to the U.S. in the months prior to the Fed's 2013 "Taper Tantrum" show that the Euro Area is closer to full employment, with headline inflation at target, compared to the U.S. four years ago. The ECB may be facing its own tantrum pressures later in 2017. Gilt(y) Optimism? The British economy has surprised to the upside in the last few months. Policy uncertainty has collapsed, while inflation expectations have marched higher and business optimism has stabilized. Most surprising against this backdrop, Gilt returns, on a currency hedged basis, have beaten most of their developed market fixed income peers (Chart 11). Chart 10A Bund Taper On The Horizon? A Bund Taper On The Horizon? A Bund Taper On The Horizon? Chart 11Gilts Should Have Underperformed Gilts Should Have Underperformed Gilts Should Have Underperformed This outperformance cannot be linked to factors such as the usual safe-haven status of Gilts, with no signs of major financial stresses in the Euro Area that would cause money to flow into Gilts (Chart 12). Indeed, the opposite has been happening as foreigners have been net sellers of Gilts in recent months. A better explanation might come from what has become a bond-bullish linkage between the British currency, inflation, real wages and consumption. In all likelihood, investors have already incorporated most of the impact of a weak Pound on U.K. inflation expectations and Gilt yields. Yet higher expected prices continue to erode household purchasing power, leading to weaker consumer spending (Chart 13). This dynamic is bullish for bonds. Chart 12Can't Blame The Safe Haven Status This Time Can't Blame The Safe Haven Status This Time Can't Blame The Safe Haven Status This Time Chart 13Consumers Will Feel The Pinch Consumers Will Feel The Pinch Consumers Will Feel The Pinch Already, this backdrop has become widely accepted. The Bloomberg survey of economists' forecasts is calling for U.K. consumer spending growth to decelerate to 1.6% on a year-over-year basis in 2017, down from 2.8% in 2016. The BoE adopted a more dovish stance at last month's Monetary Policy Committee (MPC) meeting, citing the downside risks to consumption from high currency-driven inflation at a time of persistent spare capacity in labor markets and modest wage increases.2 This threat to U.K. growth from a more sluggish consumer should continue, at least in the short term. BCA's U.K. real average weekly earnings model is clearly pointing towards additional declines in inflation-adjusted wages (Chart 14). This should restrain consumption growth, especially as other factors boosting spending are likely to fade. For example, the gains to disposable income growth from falling interest rates are likely done for this cycle, with mortgage rates having little room to decline further from the current 2.5% level (Chart 15). Also, consumer credit is now expanding 10% year-over-year - a pace that is most likely unsustainable with household debt still at high levels relative to income and the savings rate having fallen close to pre-recession levels (Chart 16). As a result, U.K. consumers are unlikely to continue stretching their financial situation to support spending. Chart 14Real Wages Will Constrain Consumption Real Wages Will Constrain Consumption Real Wages Will Constrain Consumption Chart 15Little Room For Lower Mortgage Rates Little Room For Lower Mortgage Rates Little Room For Lower Mortgage Rates Chart 16Structural Limits On Consumer Credit Growth Structural Limits On Consumer Credit Growth Structural Limits On Consumer Credit Growth Additionally, the housing market could dent consumer confidence in the near term. Since the beginning of 2014, all measures of house price inflation have rolled over, while mortgage approvals have moved sideways (Chart 17). Signs of increased weakness are appearing and could force households to revise their spending habits downward. There are also potential risks coming from the business side, despite some more positive data of late. BCA's U.K. capex indicator, composed of several survey measures, points to a cyclical improvement in capital spending in the next few quarters. At the same time, net lending to non-financial institutions is growing at a robust rate (Chart 18), suggesting that credit availability is not an impairment for U.K. businesses. Chart 17Housing: From Tailwind To Headwind? Housing: From Tailwind To Headwind? Housing: From Tailwind To Headwind? Chart 18Some Optimism Is Warranted... Some Optimism Is Warranted... Some Optimism Is Warranted... However, the situation remains very fragile. The upcoming Brexit negotiations will keep animal spirits well contained. Firms have become more risk averse and less willing to take balance sheet risks according to the Deloitte CFO survey (Chart 19). Until the details on the U.K.'s future economic links to Europe are resolved, corporate decision-makers will be dissuaded from making long-term investments in productivity-enhancing capital such as plant and machinery. In turn, the continued lack of productivity gains will further depress U.K. corporate profitability (Chart 19, bottom panels). This uncertain environment will mean suppressed hiring intentions, greater slack in the economy and decreasing inflationary pressure. Consequently, the BoE should remain patient. The accommodative policy measures introduced last August after the Brexit vote have been working so far. Rock bottom real yields and highly expansionary money supply growth have spurred domestically generated inflation. While the BoE's latest Gilt QE program is expiring, there is no rush to hike rates until core inflation has reached the 2% threshold or until headline inflation tops out at 2.7% in Q1 2018, as the BoE predicts.3 As such, the probability of a rate hike this year, which has collapsed from 55% to 17% since January, will fall even further, to the benefit of Gilts (Chart 20). Chart 19...But The Brexit-Induced Stalemate ##br##Effects Still Prevail ...But The Brexit-Induced Stalemate Effects Still Prevail ...But The Brexit-Induced Stalemate Effects Still Prevail Chart 20More Time Needed ##br##For The BoE More Time Needed For The BoE More Time Needed For The BoE This week, we are upgrading our recommended stance on Gilts from below-benchmark to neutral. We have maintained an underweight posture since October 18th of last year, primarily driven by our expectation that rising U.K. inflation would put upward pressure on Gilt yields. Now that the main force driving inflation higher - the exchange rate - is bottoming out and possibly set to reverse, we have to change tack. On that note, our colleagues at BCA Geopolitical Strategy have recently laid out a very compelling bullish case for the Pound.4 They disagree with the assessment that further volatility in the currency is warranted because of the Brexit process. They oppose the market narrative that: Europeans will seek to punish the U.K. severely for Brexit, to set an example to their own Euroskeptics; Exiting the common market is negative for the country's economy in the short-term; Remaining legal uncertainties about Brexit could derail the process. In their view, two events that occurred in January - the U.K. Supreme Court decision that the U.K. parliament must have a say in triggering Article 50 and Prime Minister May's "Brexit means exit" speech - have reduced political uncertainty regarding Brexit. The first because parliament would ultimately be bound by the popular referendum. The second because the main cause of European consternation - the U.K. asking for special treatment with respect to the common market - was taken off the table. Thus, going forward, Europe will exact a price, but it will not be severe. And the negative economic repercussions of leaving will only be fully registered in the coming years. If our colleagues are right, an overweight position in Gilts could be tempting, as a stronger Pound would decrease inflation expectations, pushing nominal yields lower. This case is even stronger given the economic uncertainties we've laid out above. Despite their convincing arguments, we prefer to take a cautious approach, while waiting to see on what ground the Brexit negotiations will start. Moreover, Gilt valuations now seem rich, with spreads versus U.S. Treasuries at historic lows. Thus, we are only upgrading to a neutral allocation to Gilts for now. In our model portfolio (shown on Page 16), we are funding the increased Gilt allocations by equally reducing the U.S. and German exposure, given the upward pressure on yields in those markets described earlier in this Weekly Report. Bottom Line: The U.K. economy has surprised to the upside and inflation expectations have reacted in line with the domestic currency weakness. There is now a greater chance that both of those trends will reverse, to the benefit of Gilts. Raise U.K. bond exposure to neutral, from underweight. More clarity on the Brexit negotiations status is necessary to develop a firmer conviction on Gilts, especially with yield already at rich levels. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure", dated January 31, 2017, available at gfis.bcaresearch.com 2 The BoE lowered its estimate of the full-employment level of the U.K. unemployment rate, consistent with accelerating wage growth, from 5% to 4.5% at the February MPC meeting. 3 Please see "Inflation Report", February 2017, Bank Of England, available at http://www.bankofengland.co.uk/publications/Pages/inflationreport/2017/feb.aspx 4 Please see BCA Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?", dated January 25, 2017, available at gps.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Will The Hawks Walk The Talk? Will The Hawks Walk The Talk? Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Three Controversial Calls, Five Months On Three Controversial Calls, Five Months On Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat U.S. Economic Data Are Upbeat U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Three Controversial Calls, Five Months On Three Controversial Calls, Five Months On Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Investors Still Not Entirely Convinced Japan Is Eradicating Deflation Investors Still Not Entirely Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Global Bank Shares Have Bounced Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Factors Supporting Bank Stocks Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Global Banks Are Still Fairly Cheap Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Euro Area: Improving Corporate Health Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Euro Area: Banks See Rising Loan Demand Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace This Will Not Get Le Pen Into The Elysee Palace This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature Dear Client, I am travelling this week so this report is a little different. It is the full transcript and slides of a client presentation I recently gave. The presentation summarises several years of in-house work on applying the Fractal Market Hypothesis to real-life investing. Dhaval Joshi The Efficient Market Hypothesis Is Wrong Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Good morning In the next 30 minutes or so I want to challenge the way you think about financial markets. You see, at school we are taught the mainstream models of financial markets: Modern Portfolio Theory, the Capital Asset Pricing Model and the Efficient Market Hypothesis. And we are led to believe that these models describe the real world. But I'm sad to say that these mainstream models are deeply flawed. They simply don't describe financial markets as they behave in the real world. And in your heart of hearts, you know it. Take the supposed bedrock of financial market theory, the Efficient Market Hypothesis, and look at the assumptions it makes about markets (Slide 2). Slide 2 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint One. That economic and market returns follow a Normal - which is to say a standard bell-curve - distribution. Really? Everybody knows that returns exhibit 'fat-tails' in which extreme events happen much more frequently than the bell-curve would suggest. By the way, this also means that a statement such as "the financial crisis was a five standard deviation - five-sigma - event with odds of 3 million to 1" is also complete nonsense. Accounting for the true fat-tails, the likelihood of extreme events is much higher than the flawed bell-curve models would suggest, as we should all now be painfully aware! Two. That the distribution is stationary - its mean doesn't change through time. Again, wrong. We know that economies and markets can and do experience regular regime-shifts or phase-shifts. Three. That markets have no memory - they exhibit no trends. Now this is getting silly! We all know that markets exhibit very strong trends. Four. That markets do not produce repeating patterns at any scale. Untrue. And five. That markets are continuously stable at all scales. Wrong again. I'm sure you'll all agree that none of these assumptions that underlie the Efficient Market Hypothesis describe the markets that we all know and work with. The good news is that there is a model that does describe the financial markets as they behave in the real world (Slide 3). It correctly assumes the return distribution is non-Normal, the mean can change over time, markets can trend, produce repeating patterns, and can generate instabilities at any scale. Slide 3 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint The model is called the Fractal Market Hypothesis, first proposed by Edgar Peters in 1991. Now I can see some looks of fear at the mention of this intimidating word 'fractal'. But hang in there, there really is nothing to fear. A fractal is just a pattern that repeats over and over at different scales. You come across fractals all the time, perhaps without realizing it. A cloud is a fractal - because a small part of a cloud is just a scaled-down version of the whole cloud. And for those of you who enjoy your vegetables, you will notice that cauliflowers and broccoli are fractals because the florets are just miniature versions of the whole vegetable. But perhaps the most familiar example is a tree (Slide 4). You can clearly see that a tree is just a simple pattern repeating over and over at different scales. Indeed, on this next slide (Slide 5), you see images of the twigs, branches, and trunk structure - and you could not tell them apart. Except that the twigs are on a scale of millimeters, the branches are on a scale of centimeters, and the trunk is on a scale of meters. Slide 4 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 5 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Let's switch back to financial markets. On this next slide (Slide 6), you see three images of ten successive points on the S&P500. Again, the three images look very similar. In fact, they're very different. The first is on a scale of weeks, the second on a scale of months, and the third on a scale of years. But just like the twigs, branches and trunk, you could not tell them apart without seeing the scale. In other words, financial markets are scale-invariant. They are fractals. Slide 6 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint But why? And so what? To answer these questions we must now introduce the four basic assumptions of the Fractal Market Hypothesis. One. Investors are not homogeneous. The market is composed of many participants with a large number of different time horizons (Slide 7) - ranging from the milliseconds or seconds for a high frequency trader, through the days or weeks for a hedge fund to the years or decades for a pension fund. Two. These different time horizons interpret the same fundamental information differently (Slide 8). For example, a short-term technical trader interprets a rising price as a buy signal. Whereas a long-term fundamental value investor interprets the same information as a sell signal. Slide 7 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 8 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Three. The market price reflects the combination of the short-term technical trader's interpretation of the information and the long-term value investor's interpretation of the same information (Slide 9). Crucially, this means the market is not efficient unless all time horizons are active in setting the price. Four. The stability of the market at a given price depends on plentiful liquidity - an adequate balancing of supply and demand at that price (Slide 10). When many different time horizons are active, the market is efficient and liquidity is plentiful. This is because different investors will disagree on the interpretation of the same information, and will trade with each other in volume without moving the price. Slide 9 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 10 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint However, if one time horizon becomes dominant, the market becomes inefficient and liquidity will evaporate. As investors become a 'groupthink herd', the healthy disagreement that is needed to create liquidity disappears. And the market loses its stability. So to answer the question 'why' markets are fractals, it is clear that the short-term investors generate the short-term patterns while long-term investors generate the long-term patterns. And to answer the question 'so what', it is clear that if the fractal structure breaks down, it is a warning sign that liquidity is evaporating and the market is losing its stability. Next we must discuss how we can measure the market's fractal structure, and for this I'm going to digress a little and ask you a famous question. How long is Britain's coastline? This is the question that the grandfather of fractals, Benoit Mandelbrot, first asked in 1967. Actually, it's a trick question. The answer is that there is no answer! You see a coastline is also a fractal. And the more detail you capture and measure, the longer it becomes (Slide 11). The point is that with a fractal structure you cannot measure its length or size. But the good news is that you can measure its extent of 'fractal-ness' using something called a fractal dimension. In fact the next slide (Slide 12) shows how Mandelbrot first defined the fractal dimension of Britain's coastline. Slide 11 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 12 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Then a couple of years ago we thought why don't we extend this concept to a financial market? After all, a price chart is similar to a coastline, except that distance is replaced with time. In fact, the maths is a little more complicated, but this is how we ended up defining the fractal dimension of a financial market (Slide 13). Bear in mind that you won't find this or any of the following analysis in any textbook because it is our own unique work. Rest assured, you don't need the maths to understand the concept intuitively. Think of it like this (Slide 14). A market that is not trending tends to sweep out 2-dimensional space. So its fractal dimension might be close to 2. But a market that is trending gets less and less fractal and closer and closer to a perfect 1-dimensional line. So its fractal dimension drops close to 1. Slide 13 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 14 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint And now we get to our findings, which are both remarkable and uplifting. When we applied our unique definition of fractal dimension to different financial markets in different historical timeframes, we discovered that the tipping point of instability turned out to be exactly the same across different historical eras, geographies and asset classes. We had come across a universal property of financial markets, irrespective of generation, culture or investment. Financial markets tended to reverse their near-term trend when the fractal structure between the 65-day investment horizon and the 1-day investment horizon disappeared. Specifically, when the 65-day fractal dimension dropped to 1.25. So we called this the "Universal Constant Of Finance". You can see that this universal constant applied to the top and initial bottom of the market during the 1929 Wall Street Crash (Slide 15), and to the top and bottom of the 1987 Crash (Slide 16). It also perfectly picked the tops and bottoms of the 1990 Nikkei Crash (Slide 17), and the 1993 Bond Market Crash (Slide 18). Slide 15 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 16 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 17 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 18 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Some financial markets also tended to reverse long-term trends when the fractal structure between the 60-month investment horizon and the 1-month investment horizon disappeared. Specifically, when the 60-month fractal dimension dropped to 1.25. You can see here (Slide 19) how this has perfectly picked many of the structural turning points in the dollar. And when we see the rare star-alignment of a long-term signal coinciding with a near-term signal, it can predict a very strong reversal in a short space of time. This is precisely what we saw ahead of crude oil's sharp bounce in early 2016 (Slide 20 and Slide 21). So to conclude (Slide 22): Slide 19 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 20 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 21 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 22 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Financial markets are efficient only when all investment horizons are present and active in setting the price. In other words, when the market has a rich fractal structure. When investment horizons converge to a groupthink herd, the fractal structure breaks down, and the fractal dimension nears its lower bound. This is a warning sign of an impending liquidity-triggered trend reversal, either short-term or long-term. I am now happy to take any questions. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com

How Long Is The Sweet Spot? Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Historically High Valuations Historically High Valuations Chart 2Time For A Pull-Back? Time For A Pull-Back? Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Hard Data Starting To Recover Too Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Orders To Follow Capex Intentions Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Labor Costs Putting Pressure On Prices Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Fed Policy Still Accomodative Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Retail Investors Not So Bullish Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid Equity Flows Are Still Tepid Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs EM Equities Correlated With China PMIs EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Divergent Views On U.S. Bonds Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Optimism Need Not Stop USD's Rise Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In February, the model underperformed global equities and the S&P 500 in USD and local-currency terms. For March, the model slightly increased its allocation to stocks and cut its weighting in bonds (Chart 1). Within the equity portfolio, the allocation to Europe was increased. The model boosted its weightings to French and Australian bonds at the expense of Canadian and Swedish paper. The risk index for stocks, as well as the one for bonds, deteriorated in February. Feature Performance In February, the recommended balanced portfolio gained 2.1% in local-currency terms, and 0.2% in U.S. dollar terms (Chart 2). This compares with a gain of 3% for the global equity benchmark and a 3.3% gain for the S&P 500. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide suggestions on currency risk exposure from time to time. The high allocation to bonds continued to hold back the model's performance. Chart 1Model Weights Model Weights Model Weights Chart 2Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and cut its bond weighting from 47% to 43% (Table 1). Table 1Model Weights (As Of February 23, 2017) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators The model increased its equity allocation to Dutch and Swedish equities by 4 points each, Germany and New Zealand by 2 points each, and France and Emerging Asia by 1 point each. Weightings were cut in Italy by 4 points, Latin America by 3 points, Spain by 2 points, and Switzerland by 1 point. In the fixed-income space, the allocation to Australia was boosted by 8 points, France by 6 points, and Germany by 4 points. The model cut its exposure to Swedish bonds by 9 points, Canadian bonds by 6 points, U.S. and U.K. bonds by 3 points each, and Kiwi bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The most recent bout of dollar depreciation was halted in February. Our Dollar Capitulation Index is below neutral levels. However, it is not extended, meaning that it does not preclude renewed dollar weakness in the near term. That said, assuming no major negative economic surprises, a relatively more hawkish Fed versus its peers should provide support for the dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities was little changed in February. The model continues to avoid this asset class (Chart 4). The risk index for global equities rose to its highest level since early 2010, mostly on the back of deteriorating value. Despite this, the model slightly increased its allocation to equities (Chart 5). Chart 4Commodity Index And Risk Commodity Index And Risk Commodity Index And Risk Chart 5Global Stock Market And Risk Global Stock Market And Risk Global Stock Market And Risk The rally in U.S. stocks - driven by optimism about the economic outlook - pushed the value component of the risk index into expensive territory. The model kept a small allocation in U.S. equities. A change in the perception about the ability of the new U.S. administration to boost growth remains a risk for this market (Chart 6). The risk index for euro area equities continues to deteriorate. However, it remains lower than its U.S. counterpart. The continued flow of solid economic data and a weaker currency should bode well for euro area stocks, although political uncertainty is a potential headwind (Chart 7). Chart 6U.S. Stock Market And Risk U.S. Stock Market And Risk U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk Euro Area Stock Market And Risk Euro Area Stock Market And Risk All three components of the risk index for Dutch equities are close to neutral levels. As a result, despite the recent deterioration in the overall risk index, it remains one of the lowest among the markets the model covers (Chart 8). The risk index for Swedish stocks worsened. However, the model increased its allocation to this bourse. Swedish equities would be a beneficiary of the continued risk-on environment (Chart 9). Chart 8Netherlands Stock Market And Risk Netherlands Stock Market And Risk Netherlands Stock Market And Risk Chart 9Swedish Stock Market And Risk Swedish Stock Market And Risk Swedish Stock Market And Risk The momentum indicator for global bonds is less stretched in February. Meanwhile, despite its latest decline, the cyclical indicator continues to signal that the positive global economic backdrop is firmly bond-bearish. Taken all together, the risk index for bonds deteriorated in February, although it still remains in the low-risk zone (Chart 10). U.S. Treasury yields moved sideways in February as investors await more guidance from the Fed on the timing of the next hike. A bond-negative cyclical indicator coupled with the unwinding of oversold conditions - as per the momentum measure - led to a deterioration in the risk index for U.S. Treasurys. The latter is almost back to neutral levels. The model trimmed the allocation to this asset class (Chart 11). Chart 10Global Bond Yields And Risk Global Bond Yields And Risk Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk U.S. Bond Yields And Risk U.S. Bond Yields And Risk The momentum indicator remains the main driver of the risk index for Canadian bonds. As a result, the less extreme momentum reading translated into an increase in the risk index for this asset class. (Chart 12). The risk index for Australian bonds moved lower in February, reflecting improvements in all three of its components. The model included the relatively high-yielding Aussie bonds in the portfolio. (Chart 13). Chart 12Canadian Bond Yields And Risk Canadian Bond Yields And Risk Canadian Bond Yields And Risk Chart 13Australian Bond Yields And Risk Australian Bond Yields And Risk Australian Bond Yields And Risk The cyclical indicator for euro area bonds is near expensive levels, and the momentum indicator shows heavily oversold conditions. These two measures are offsetting the cyclical one that is sending a bond-bearish message. While the overall risk index for euro area bonds is in the low-risk zone, the country allocation is concentrated in French paper (Chart 14). The risk level for French bonds is seen as low thanks to oversold momentum. French presidential elections are probably the most important political event in Europe this year. Whether the models' heavy allocation to this asset pans out hinges to a certain extent on the reduction of investor anxiety about this political risk (Chart 15). Chart 14Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Chart 15French Bond Yields And Risk French Bond Yields And Risk French Bond Yields And Risk The 13-week momentum measure for the dollar broke below the zero line, and is currently sitting on its upward-sloping trendline, drawn from the 2010 lows, that has been broken only once before. Meanwhile, the 40-week rate of change measure is still suggesting that the dollar bull market has more legs on a cyclical horizon. Monetary divergences should lend support to the dollar over the cyclical horizon, although the new administration's attempts to talk down the dollar as well as heightened policy uncertainty could translate into more volatility (Chart 16). The weakening trend in the yen hit a snag two months ago, as the 13-week momentum measure reached the lows that previously foreshadowed a consolidation phase after sharp depreciations. This short-term rate-of-change measure has bounced smartly this year reaching a critical level. Meanwhile, the 40-week rate-of-change measure is not warning of a major change in the underlying trend which remains dictated by BoJ's dovish bias (Chart 17). EUR/USD has been gravitating towards 1.05 over the course of February. The short-term rate-of-change measure seems to be holding at the neutral level, while the 40-week rate-of-change measure is in negative territory, but hardly stretched. Political uncertainty has the potential to drive the euro in near term, but the longer-term outlook is mostly a function of the monetary policy divergence between the ECB and the Fed (Chart 18). Chart 16U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* Chart 17Yen Yen Yen Chart 18Euro Euro Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Long Expansion Comparison (I) Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) Long Expansion Comparison (II) Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat March 2017 March 2017 But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds March 2017 March 2017 Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Chart I-11Gilts To Underperform Gilts To Underperform Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. 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. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. 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-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights Price inflation is paradoxically deflationary for European consumers, because there is no feedthrough from price inflation to wage inflation. Whenever price inflation has risen towards the ECB's highly-misguided 2% target, euro area real wages have gone into recession. The same is true in the U.K. Do not expect a structural sell-off in high-quality bonds. Go overweight the broad-based Eurostoxx600 versus the bank-heavy Eurostoxx50. Stay overweight the international dollar-earning FTSE100 versus the more domestic pound-earning FTSE250. Feature We have a love-hate relationship with inflation. Love, if the inflation refers to our wages. Hate, if the inflation refers to our weekly grocery bill. Put another way, inflation is good for our purchasing power when wages are going up faster than prices; it is bad when prices are going up faster than wages. Unfortunately, recent inflation has been unequivocally bad for European purchasing power. Through the past 7 years, euro area nominal wages have been growing at a remarkably steady 1-2% clip. Whereas price inflation has swung between -0.5% and 3% (Chart I-2). Therefore, whenever price inflation has stayed close to 0% (the true definition of price stability), real wages have grown very healthily. But whenever inflation has risen towards the ECB's highly-misguided 2% target, euro area real wages have gone into recession (Chart of the Week). Chart I-1The Inflation Paradox: When Price Inflation Rises to 2%, Real Wages Go Into Recession The Inflation Paradox: When Price Inflation Rises to 2%, Real Wages Go Into Recession The Inflation Paradox: When Price Inflation Rises to 2%, Real Wages Go Into Recession Chart I-2Nominal Wages Have Been Growing At A Remarkably Steady 1-2% Nominal Wages Have Been Growing At A Remarkably Steady 1-2% Nominal Wages Have Been Growing At A Remarkably Steady 1-2% The same is true in the U.K. There has been no feedthrough from price inflation to wage inflation (Chart I-3 and Chart I-4). If anything, an inverse relationship has existed. Hence, whenever inflation has declined, it has boosted real wages. And whenever inflation has risen, it has choked real wages (Chart I-5 and Chart I-6). Chart I-3Very Little Connection... Very Little Connection... Very Little Connection... Chart I-4...Between Price Inflation And Wage Inflation ... Between Price Inflation And Wage Inflation ... Between Price Inflation And Wage Inflation Chart I-5When Price Inflation Has Declined,##br## It Has Boosted Real Wages When Price Inflation Has Declined, It Has Boosted Real Wages When Price Inflation Has Declined, It Has Boosted Real Wages Chart I-6When Price Inflation Has Increased,##br## It Has Choked Real Wages When Price Inflation Has Increased, It Has Choked Real Wages When Price Inflation Has Increased, It Has Choked Real Wages Households Dislike 2% Price Inflation An argument we frequently hear is that highly indebted economies need higher inflation to 'inflate away their high debts'. But this logic only works if inflation is boosting the incomes of those burdened with the high debt, such as households. The problem, as we have just seen, is that there has been very little connection between the price inflation that central banks are targeting and the wage inflation that eases households' debt burdens. To its credit, the Bank of England recognises this paradox. "Continued moderation in pay growth and higher import prices following sterling's depreciation are likely to mean materially weaker household real income growth over the coming few years" 1 Inflation is ultimately a transfer of resources from those paying the higher prices to those receiving them. In a closed economy, the winners and losers might balance out. However, Europe is a large net importer of food and energy, whose demand is inelastic and whose prices are denominated in dollars. Therefore, currency weakness transfers resources from domestic consumers to foreign producers. As the BoE goes on to say: "Over the next few years, a consequence of weaker sterling is that the higher imported costs resulting from it will boost consumer prices... and the hitherto resilient rates of household spending growth will slow as real income gains weaken." Exactly the same dynamic applies to the euro area as a consequence of the weaker euro. The difference is that sterling's Brexit-induced slump was out of the BoE's control, whereas the euro's weakness is a direct consequence of the ECB's extreme and experimental monetary easing. The ECB is keen to tell us about the benefits of its extreme monetary easing; it is less keen to tell us about the costs. However, we believe that the benefits have diminished while the costs are rapidly rising. And absent a major shock, the ECB should end its risky experiment. What's Up With Wage Growth? The intriguing question is: why has there been little connection between price inflation and wage inflation? The BoE observes that pay growth has remained persistently subdued by historical standards - strikingly so in light of the decline in the rate of unemployment to below 5%. This outcome is likely to reflect a substantial decline in the 'equilibrium unemployment rate', the point at which wage pressures start to bubble up. The explanation comes from the type of jobs created in recent years. ECB research points out that the dynamics of wages not only reflect changes in wages at the individual level, but are also influenced by changes in the composition of employment. "The structure of recent employment creation may have contributed to low wage growth in the euro area. Since the second quarter of 2013, employment creation in the euro area has been stronger in sectors associated with relatively lower wage levels and wage growth rates. This employment composition effect puts a drag on average wage growth." 2 Automation and Artificial Intelligence (AI) are major drivers of this composition effect. Moreover, as we argued in The Superstar Economy: Part 2,3 the effect has much further to run. "Many of the jobs that AI will destroy - like credit scoring, language translation, or managing a stock portfolio - are regarded as skilled, have limited human competition and are well-paid. Conversely, many of the jobs that AI cannot (yet) destroy - like cleaning, gardening, or cooking - are relatively unskilled and are low-paid." With well-paid jobs being displaced by low-paid jobs, job creation itself might still seem very healthy and the unemployment rate might be falling to levels associated with 'full employment' - prompting some people to warn that wage inflation is about to take off. Except it won't, for two reasons: first, the AI-displaced formerly well-paid workers are downshifting to lower-paid work; second, the added supply of labour competing for the lower-paid work keeps a lid on the wages for that lower-paid work. In the U.S., the Federal Reserve Board of San Francisco points out that: "As long as employers can keep their wage bills low by replacing or expanding staff with lower-paid workers, labour cost pressures for higher price inflation could remain muted for some time." 4 A further point is that if employment creation is in jobs with lower wages, wage growth, and job security, then it will also constrain credit growth. Lacking income growth or security, households will be unwilling to borrow and banks will be unwilling to lend. Absent strong credit growth, we subscribe to a monetarist conclusion: a generalised and sustained inflation - a wage-price spiral - cannot take hold. Some Investment Considerations For the foreseeable future, there will be little feedthrough from price inflation to wage inflation. So whenever price inflation picks up - as is now happening in the U.K. and the euro area - it will choke real wages. Therefore paradoxically, price inflation will be deflationary for European consumers. This will prevent a structural sell-off in high-quality bonds. For a U.K. equity portfolio at this juncture, it means tilting towards international exposure. Stay overweight the international dollar-earning FTSE100 versus the more domestic pound-earning FTSE250 - especially given that sterling could come under renewed pressure after the U.K. formally files for its divorce from the EU (Chart I-7). For a broader European equity portfolio, prefer non-financials over financials. A very easy way to implement this is to go overweight the broad-based Eurostoxx600 versus the bank-heavy Eurostoxx50 (Chart I-8). Chart I-7Overweight The International Dollar-Earning ##br##FTSE100 Versus The FTSE250 Overweight The International Dollar-Earning FTSE100 Versus The FTSE250 Overweight The International Dollar-Earning FTSE100 Versus The FTSE250 Chart I-8Overweight The Broad Eurostoxx600##br## Versus The Bank-Heavy Eurostoxx50 Overweight The Broad Eurostoxx600 Versus The Bank-Heavy Eurostoxx50 Overweight The Broad Eurostoxx600 Versus The Bank-Heavy Eurostoxx50 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the Bank of England Monetary Policy Summary and minutes of the Monetary Policy Committee meeting on February 1, 2017. 2 From the ECB Economic Bulletin, Issue 3 / 2016: Recent wage trends in the euro area. 3 Published on January 19, 2017 and available at eis.bcaresearch.com 4 From the FRBSF Economic Letter March 7, 2016: What's Up with Wage Growth? Fractal Trading Model* This week's recommendation is a commodity pair-trade: long tin / short copper. 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-9 Long Tin / Short Copper Long Tin / Short Copper * 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 Markets are facing large tail risks - both negative and positive; Donald Trump is a "Fat-Tail" president; European politics offer both a right-tail risk - German Europhile turn ... ... And a left-tail risk - Italian election and a shock in France; Investors should turn to the options market for opportunities. Feature "Stock market hits new high with longest winning streak in decades. Great level of confidence and optimism - even before tax plan rollout!" President Donald Trump "tweet" - February 16, 2017 Global stocks continue their tear as the market shrugs off President Trump's tweets, European Black Swans, saber-rattling in the South China Sea, and fears of de-globalization. Some of the optimism is backed by economic data, but mostly by the "soft data," or survey-based indicators (Chart 1).1 Chart 1Not Much Behind The Optimism Aside From Animal Spirits Not Much Behind The Optimism Aside From Animal Spirits Not Much Behind The Optimism Aside From Animal Spirits So, why the party? It's the Animal Spirits. The bears are in retreat ... or facing deportation! We think investors are betting that the combination of the Brexit referendum and election of Donald Trump has forced policymakers to take their heads out of the sand. The market believes that policymakers have heard the angry electorate whose message is that dithering over economic policies must stop. BCA has been in this camp since last summer, when our colleague Peter Berezin penned an optimistic missive titled "The Upside To Populism."2 The hope that urgency will translate to expediency is what we think has propelled the S&P 500 to one of its best post-election performances (Chart 2). Trump's market performance is in the 83rd percentile of post-election outcomes. As promised, Trump has delivered a win. Chart 2Trump Is Winning The S&P 500 Contest Trump Is Winning The S&P 500 Contest Trump Is Winning The S&P 500 Contest The danger is that the market is extrapolating from the Trump presidency all the "right-tail" or super-positive policy outcomes without accounting for any left-tail events. Trump is a "Fat-Tails" president, an unorthodox politician that could break the gridlock and deliver positive change, but whose brand of nationalist populism may also produce paradigm-shifting crises along the way. Several indicators suggest that caution is warranted. Our U.S. Equity Strategy colleagues offer two measures of complacency, the valuation-to-volatility ratio (Chart 3) and "Complacency-Anxiety Index" (Chart 4).3 Both are stretched and suggest that the market has never been as engrossed by the right-tail narrative as today. Given our constraints-based methodology, we are concerned by how certain the market appears. It seems to believe that all the wonderful things that Trump has promised will face no constraints, while his nationalism and mercantilism will be discarded. Chart 3Market Sees Only Right Tails Market Sees Only Right Tails Market Sees Only Right Tails Chart 4Complacency Reigns Complacency Reigns Complacency Reigns First, on the domestic front, Trump faces several mounting constraints: Political capital: Trump is an unpopular president (Chart 5), at least by the standards of his peers who enjoyed a post-election "honeymoon." This could affect his relationship with the GOP-controlled Congress that hardly warmed up to him in the first place. Precedent: Congress is struggling to produce Obamacare-replacement legislation, which the GOP had six years to prepare for. This bodes poorly for the timeliness of other legislation, like tax reform. Paying for stimulus: Republicans and the White House appear to be at odds over how to pay for the coming household and corporate tax cuts. The former want to pass the controversial border adjustment tax (BAT),4 while the Trump administration may not care how tax cuts are paid for. The BAT proposal is also facing opposition from major retailers and its legality under the WTO is still in question. Infrastructure: Spending on infrastructure, which is a no-brainer and has broad public support (Chart 6), has not seen a concrete plan despite Trump's emphasis on it during his inaugural address and campaign. Chart 5Trump's Approval Ratings Dismal A Fat-Tails World A Fat-Tails World Chart 6Everyone Loves New Roads A Fat-Tails World A Fat-Tails World In addition to the domestic political agenda, investors must deal with a packed European political calendar that we elucidated in last week's report5 (Table 1) and a potential U.S.-China trade war that could spill over into military tensions in the South China Sea.6 Table 1Busy Calendar For Europe This Year A Fat-Tails World A Fat-Tails World Investors may have been lulled into complacency by the February 10 phone call between presidents Xi and Trump. During the call, Trump committed to uphold the "One China" policy that has formed the bedrock of the Beijing-Washington rapprochement since 1972. A week later, on February 16, China suspended all imports of coal from North Korea - 50% of the country's entire export haul - until the end of the year. The move was a big nod to Donald Trump, a message by Beijing that China can play the role of an indispensable partner - if not outright ally - in the region. These moves have put fears of trade protectionism, our main candidate for a catalyst of a market correction, on the backburner. Investors can certainly be disappointed by smaller-than-expected tax cuts and tepid infrastructure spending, but such policy reversals will only encourage the Fed to stay easy and thus prolong the party. In the context of a synchronized global growth recovery - with both the global (Chart 7) and U.S. (Chart 8) economies looking decent - investors will not be deterred from bullishness merely by congressional intrigue. Chart 7Global Growth Looks Solid ... Global Growth Looks Solid ... Global Growth Looks Solid ... Chart 8... And So Does U.S. Growth ... And So Does U.S. Growth ... And So Does U.S. Growth The problem for investors is that the main two risks to global markets in 2017 have no set timeline. Last week, we pointed out that the main political risk in Europe is the Italian election whose date could be in autumn, or even as late as spring 2018. Today we add the French election to the list, where Marine Le Pen is mounting a furious rally on the back of rioting in the banlieue of Aulnay-sous-Bois. Similarly, Trump's mercantilism may remain dormant as he focuses on immigration, the "dishonest media," and cabinet appointees, even though it is very real. His administration is laser-focused on correcting a major perceived ill of the U.S. economy: the current account deficit. Therefore, investors should certainly welcome the Xi-Trump phone call, but the fact that the two leaders spent valuable time reaffirming a policy set 45 years ago should not be encouraging. In fact, the Trump administration has since asked the U.S. Trade Representative's office to consider changing how it calculates the U.S. trade deficit. According to the Wall Street Journal, Trump's White House is looking to exclude "re-exports" - goods imported into the U.S. merely so they can be assembled and then exported - from the calculation of U.S. exports.7 This would naturally balloon the U.S. trade deficit and give the Trump administration greater political ammunition - particularly against Mexico - for retaliation. Given solid global growth data, extremely positive surveys, and a market narrative still focused on the "Upside of Populism," it is tempting for investors to throw caution to the wind. Every time we encounter a bear in a client meeting or conference, we ask if he or she would "buy on dips" in case a correction happened. Their answer is almost universally "yes." It is difficult to see how a correction occurs in such an environment, where nobody actually expects a bear market. Although we are throwing in the towel with our two hedges - both the S&P 500 and Eurostoxx hedges have stopped out, we continue to stress that the market has priced in none of the left-tail risks that remain. We have a Fat-Tail President in the White House and an increasingly binary resolution to the euro area saga in the making in Europe. Fat Tails In Europe Since late 2016, we have suspected that Merkel's rule is unsustainable.8 However, while most investors fretted that Merkel would be replaced by a Euroskeptic, we considered that outcome extremely unlikely (at least in the current electoral cycle). For one, the refugee crisis that befell Europe would be short-lived, and indeed it is now over (Chart 9). For another, Germans are not Euroskeptics. What is astonishing is how quickly the German political establishment has realized and sought to profit from these facts. Instead of opposing Merkel with a cautious choice, the center-left Social Democratic Party (SPD) has turned to an unabashed Europhile, former President of the European Parliament Martin Schulz. Schulz is a relative unknown in Germany and was perceived by Merkel's coterie as a lightweight. On the surface, this made sense. Schulz has no university education and worked as a bookseller before becoming a politician. However, he knows EU politics extremely well, as he has been a member of the European Parliament since 1994. He has therefore heard every Euroskeptic argument on the continent and has learned to counter it emphatically. And he seems to understand the benefits that euro area membership has bestowed upon Germany, a view he appears to share with 80% of the German public, if the latest polls are to be believed (Chart 10)! Chart 9Migrant Crisis Waning Migrant Crisis Waning Migrant Crisis Waning Chart 10Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Thus far, Schulz's campaign has focused on three main lines of attack: the traditional SPD call for greater economic redistribution, general appeal for European solidarity, and blaming Merkel for the rise of populists. To everyone's surprise - other than folks who understand how Germany works - this has been a successful approach. In just three weeks, the SPD has gone from trailing Merkel's Christian Democratic Union (CDU) by double digits to leading in the polls for the first time since 2001 (Chart 11). What should investors make of Schulz's meteoric rise? For one, nobody should get too excited, as the election is still a long seven months away. However, the SPD's resurrection suggests that the German political marketplace has been demanding a genuinely pro- euro area political alternative to the overly cautious Angela Merkel for some time. In other words, Schulz has realized that the median voter in Germany is far more Europhile than the conventional wisdom and Merkel have thought. Again... Chart 10 says it all! Unfortunately for the euro, Germany's Europhile turn may be too little too late. Italy's election is a major risk. As with the threat of American mercantilism, Italian elections are a risk that we cannot properly time. Furthermore, polls remain extremely close in Italy, suggesting that the election could go either way between the establishment and Euroskeptic parties. At this point, the best outcome may be a hung parliament. Meanwhile, the ongoing unrest in the northeast suburb of Paris, Aulnay-sous-Bois, appears to have given Marine Le Pen some wind in her sails (Chart 12). She has closed her head-to-head polling gap against Francois Fillon and Emmanuel Macron to just 12% and 20% respectively. Our net assessment is that she is not going to win, but our conviction level is declining. Her subjective probability has climbed to well over 20% at this point. Chart 11Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Chart 12Le Pen Lags By 12-20% In Second Round A Fat-Tails World A Fat-Tails World Similar rioting in 2005 launched the political career of one Nicolas Sarkozy, who, as the country's Minister of Interior, took a hard line approach to the unrest, which launched him into the presidency. The lesson from Sarkozy's rise is important for two reasons. First, unrest in France's banlieues is politically relevant. These frequent bursts of violence support the National Front (FN) narrative that the integration of migrants has failed, that the country needs full control over its borders, and that the elites in Paris are not serious about law and order. The second lesson is that centrist, establishment politicians have no problem with being tough on crime, minorities, or immigrants. Sarkozy's rhetoric in 2007 mirrored much of the FN electoral platform. There is enough time, in other words, for Macron and Fillon to do the same in 2017. This will be particularly easy for Fillon, whose immigration policies already echo those of the FN. Chart 13ECB Policy Will Stimulate Core Europe ECB Policy Will Stimulate Core Europe ECB Policy Will Stimulate Core Europe Macron, however, could be in trouble in the second round. And at the moment, he is more likely to face Le Pen in the second round than Fillon. As we pointed out in last week's missive, Macron could struggle to get right-wing voters to support him in the second round. We still do not have a historical case where right-wing voters were the ones who swung against the FN. In both the 2002 presidential election and the 2015 regional elections, it was mostly left-wing voters who swung to the center-right to keep the FN out of power. Will French conservative voters come out and support a centrist candidate like Macron who may be perceived as "soft" on crime? Time will tell. His polling appears to be holding up well against Le Pen, but her momentum is now rising. Bottom Line: Europe faces its own version of Fat Tails in 2017. On the one hand, we expect the ECB to remain easier than consensus would have it, given the mounting political risks in the periphery. We expect the ECB to ignore the broad euro area economy and focus on the interest rates that the periphery - namely Italy - needs (very low for very long time) (Chart 13). When combined with a Europhile turn in Germany and a positive fiscal thrust as the EU Commission turns against austerity, we see a Goldilocks scenario for euro area assets over the short and medium term. We are betting that this right-tail risk will ultimately prevail. On the other hand, Italian elections could knock the train off the rails at any time. Due to the announced leadership race in the ruling Democratic Party (PD), the election will most likely have to take place after the summer. Or, it may have to be put off until Q1 2018. But whenever it is announced, it will become the risk to European and global assets. For now, we continue to recommend that clients remain overweight euro area equities. However, vigilance will be needed as the market climbs the wall of worry. Investment Implications - Trading Fat Tails In A Low-Vol World What should investors do in a world that is increasingly exemplified by our Fat-Tails thesis? Current levels of the VIX suggest that the market is not pricing in a potentially higher level of volatility, which we would intuitively expect to rise in a Fat-Tail world (Chart 14). On the other hand, current low levels of volatility may merely be the calm before the storm. Investors may be "frozen" by the high probability of both left- and right-tail outcomes and thus choosing to sit on the sidelines instead of committing to any one narrative. Chart 14Volatility Extremely Low Volatility Extremely Low Volatility Extremely Low One way to think about investing in this world is to turn to the options market. The options market is unique in that it allows investors to take a view on the dispersion of the expected returns of the asset against which the option is written.9 This is because one of the critical components of a call or put option's value is the expected volatility of returns for the asset underlying the option itself. Volatility is trading-market shorthand for the annualized standard deviation of expected returns for the underlying asset. Volatility is a calculated value, whereas the other components of an option's price - i.e. the underlying asset's price, the strike price, time to expiration, and interest rates - are known inputs. Volatility, like the price of the underlying asset, is "discovered" when a trade occurs. After an option trades and its premium is known, an option-pricing model - e.g., the Black-Scholes-Merton model - can be run backwards, so to speak, to see what level of volatility solves the pricing model for the value that cleared the market. This is known as the option's implied volatility, because it is the expected standard deviation of returns implied by the price at which the option clears the market. One reason investors and traders buy and sell options is to express a view on implied volatility. Option buyers who think the market is underestimating the likelihood of sharply higher returns can express this view by buying out-of-the-money options. This can arise for any number of reasons, but they all boil down to one essential point: option buyers think there is a higher probability that returns will be higher or lower during the life of an option than what is being priced in the options market.10 Option sellers, on the other hand, are expressing the opposite view. We believe the geopolitical tail risks we have discussed in this report are not being fully reflected in the options markets most sensitive to this information, among them the gold market. Our own assessment of these risks implies much fatter tails than we currently observe in out-of-the-money gold options. For this reason, we are recommending investors consider buying $1,200/oz gold puts and $1,300/oz gold calls expiring in either June or December of this year. This is a strategic recommendation. We leave it to investors to set their own stop-loss, if they are not comfortable foregoing the full premium paid to hold these options to expiry, possibly expiring worthless. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Robert Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Downside To Full Employment," dated February 3, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 6 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?," dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 7 "Please see William Mauldin and Devlin Barrett, "Trump Administration Considers Change In Calculating U.S. Trade Deficit," Wall Street Journal, February 19, 2017, available at www.wsj.com. 8 Please see Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 9 Call options give the buyer the right to go long an underlying asset at the price at which an option contract is struck - i.e. the option's strike price. Puts give option buyers the right to go short the underlying asset at the price at which the contract is struck. While an option buyer is not required to ever exercise an option, option sellers must take the other side of the deal if the buyer chooses to exercise. Option buyers pay a premium for the put or call they purchase. 10 This probability also can be expressed in terms of price levels, which allows investors to take an explicit view of the likelihood of a particular price being realized during the life of the option being purchased. Please see Bob Ryan and Tancred Lidderdale, "Energy Price Volatility and Forecast Uncertainty," published by the U.S. Energy Information Administration (2009), for a discussion of options markets and implied volatility. "Appendix II: Derivation of the Cumulative Normal Density for Futures Prices" beginning on p. 22 shows how to transform the returns distribution into a price distribution. It is available at https://www.eia.gov/outlooks/steo/special/pdf/2009_sp_05.pdf. Geopolitical Calendar