Europe

Highlights The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia; The Trump Doctrine, as currently defined, has no room for transatlantic alliances; President Trump is pursuing both mercantilism and an isolationist foreign policy; This combination imperils the transatlantic alliance and thus the American anchor in Eurasia; If pursued to its logical conclusion, the Trump Doctrine will end American global hegemony. Feature "Who rules East Europe commands the Heartland; Who rules the Heartland commands the World-Island; Who rules the World-Island commands the world." - Sir Halford John Mackinder Geopolitics is parsimonious and predictive because it posits that states are imprisoned by their geography. For academia, geopolitics is too parsimonious. And the professors are correct! Mountainous terrain combined with ethno-linguistic heterogeneity has destined Afghanistan and Bosnia to centuries of conflict, but Switzerland seems to be doing just fine. As such, BCA's Geopolitical Strategy, despite our name, very rarely relies on pure geopolitics for its analysis. The world is just too complex and geopolitics operates on long time horizons that are rarely investment-relevant. Geography is not destiny. Rather, geography is the ultimate constraint, an immutable factor that can only be conquered with a massive effort or new technology that comes but once in a generation. To fight geography is folly, even for a hegemon. The Trump Doctrine, as it has taken shape thus far, looks to be just such a folly. In this analysis, we explain why and what the investment relevance may be for the U.S. and the world. We still think the U.S. is likely to regain power in relative terms, but Trump's "charismatic authority" and foreign policy pose a risk to this view. American Geopolitical Imperatives There are two notable "fathers" of geopolitics: Alfred Thayer Mahan and Sir Halford John Mackinder. They both dedicated their life to elucidating great power "Grand Strategy," the implicit but real geopolitical imperatives, rooted in geography, from which a country derives its day-to-day foreign policy. For Mahan, a U.S. Navy Admiral and lecturer at the Naval War College, the imperative of the U.S. was to build a navy to dominate the oceans, the global "commons" that is indispensable to modern trade, economy, and thus "hard power."1 A strong navy is the defining characteristic of a great power. It affords the hegemon military supremacy over vital trade routes and ensures that global commerce operates in its interest. If this sounds like present-day U.S. "Grand Strategy," it is because Mahan had a great influence on American policymakers in the early twentieth century. Theodore Roosevelt supported Mahan's thinking, which included building the Panama Canal. Mahan's The Influence of Sea Power Upon History, and similar work by British strategists, provided a historical and strategic framework for the naval race between the U.K. and Germany that ultimately contributed to the start of World War I.2 Mackinder, a British geographer and academic, focused on the Eurasian landmass, rather than the oceans.3 In his view - perhaps colored by Britain's history of fending off invaders from the continent - Eurasia had sufficient natural resources (Russia), population (China), wealth (Europe), and a geographic buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia, or "the World Island" as Mackinder coined it, would have no need for a navy as it would become a superpower by default (Map 1). Map 1The World According To Mackinder The Trump Doctrine The Trump Doctrine American Grand Strategy is today a combination of both Mahan's and Mackinder's thinking. The U.S. has had two explicit geopolitical imperatives since the end of World War II: Dominate the world's oceans (Mahan); Prevent any one power from dominating Eurasia (Mackinder). To accomplish the first, the U.S. has expended an extraordinary amount of resources to build and operate the world's greatest blue-water navy. To accomplish the second, the U.S. has entered two world wars, the Korean War, the Vietnam War, and spent a good part of the twentieth century containing the Soviet Union. In addition, Washington has fostered a close transatlantic alliance to ensure that Europe, its anchor in Eurasia, remains aligned with the U.S. These were not arbitrary decisions made by a corrupt, Beltway elite looking to enrich itself with the spoils of globalization. These were decisions made by American leaders looking to expand American power, establish global hegemony, and retain it against rivals for centuries to come. Both imperatives are necessary for the U.S. to remain a hegemon. And U.S. hegemony is the foundation of the global monetary and financial system. Not least, it underpins the role of the U.S. dollar as the world's reserve currency. Bottom Line: The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia. The Trump Doctrine: America First, Second, And Third Every U.S. president tries to enshrine a foreign policy "doctrine" during their presidency. There is no single document that does the job of elucidating the doctrine; scholars and journalists weave the ideas together from speeches, policy decisions, resource allocation, and rhetoric. This early in the Trump presidency, it is not fair to determine what his foreign policy doctrine will be. Already, with Trump's executive orders on immigration and refugees, it is clear that there is a process of trial and error underway, with the administration reversing its position on green card holders (U.S. permanent residents). We therefore take liberty in projecting the little information we have forward. Chances that we are wrong are high and our conviction level is low. Nevertheless, we have two broad conclusions. If the Trump Doctrine develops as these early clues suggest, then it will either be rejected by Congress and the American policy establishment, or it will initiate the collapse of the geopolitical and economic institutions of our era, ushering in something profoundly different. We see no alternatives. So what are the early outlines of the Trump Doctrine? We see three factors that stand out: Isolationism: Long-term alliances and commitments abroad must have a clear, immediate, and calculable benefit for the U.S. economic "bottom line." Therefore, Japan and South Korea should pay more for the benefits of U.S. alliance, and NATO is a drain on American resources. All alliances and American commitments are negotiable. Mercantilism: The U.S. has no permanent allies, only trade balances that must be positive. Trump has not only threatened China and Mexico with protectionism, but also longstanding allies like Germany and Japan.4 Any country that sports a significant trade surplus with the U.S. is in Washington's crosshairs (Chart 1). Chart 1Trump's Hit List The Trump Doctrine The Trump Doctrine Sovereignty: Trump said in his inaugural address, "it is the right of all nations to put their own interests first" and that America does "not seek to impose our way of life on anyone." This is a stark departure from ideologically-driven foreign policies of both the Bush and Obama White House. However, there is an ideology underpinning Trump's foreign policy: nationalism. Professor Ted Malloch, tipped as the next U.S. Ambassador to the EU, revealed in a BBC interview that the new U.S. President "is very opposed to supranational organizations, he believes in nation states." This statement makes explicit what many of Trump's speeches have implied. Under the tenets of this inchoate Trump Doctrine, NATO and the EU are not just nuisances, but are positively detrimental to U.S. interests. This marks a profound shift in U.S. foreign policy thinking, if it stands. First, both NATO and the EU break the ideological tenet of nationalism. They are international organizations that pool sovereignty for some predetermined common goal. Given that the common goal has nothing to do with the immediate, domestic and economic goals of the U.S., the two organizations are not worth supporting, under this interpretation of the emerging Trump Doctrine. Second, NATO demands a U.S. overseas commitment with little material gain in return. This is not a new argument. President Obama complained about the failure of NATO member states to pay their fair share (2% of GDP on defense) for collective self-defense (Chart 2). However, Obama's intention was to cajole European allies to boost defense spending; NATO's existence was not in question. Trump does not see a point in America paying for Germany's defense, especially when Germany sports a sizeable trade surplus with the U.S. Chart 2NATO States That Need To 'Pay Up' The Trump Doctrine The Trump Doctrine Third, the EU runs a large current account surplus in general and a trade surplus with the U.S. in particular (Chart 3). For the Trump administration, the EU is therefore a rival, perhaps more so even than Russia, which, when viewed through a purely mercantilist lens, is not a foe. Trump's foreign policy is based on an understanding that the world is multipolar and that the U.S. is in relative geopolitical decline. Our data supports President Trump's assertion (Chart 4). In that way, Trump's doctrine is similar to that of the Obama presidency. Both recognize that the U.S. can no longer act unilaterally and that it must retrench from its global responsibilities. But while Obama sought to enhance U.S. power by relying on allies and supranational organizations, Trump seeks to withdraw into Fortress America and geopolitically deleverage. Such a deleveraging, when combined with mercantilism, may cause America's traditional allies to try harder for its approval, like Trump assumes, or it may push America's traditional allies away from Washington's orbit. Chart 3Mercantilism Makes The EU A 'Bad Guy' Mercantilism Makes The EU A 'Bad Guy' Mercantilism Makes The EU A 'Bad Guy' Chart 4American Power In Relative Decline American Power In Relative Decline American Power In Relative Decline Bottom Line: President Trump believes in a "what can you do for me" world.5 This world has no room for twentieth-century alliances, which did not anticipate the disenchantment and polarization of the American public (or the benefit of Trump's wisdom!) in their original design. Transatlantic Drift The most important feature of the Trump Doctrine is that it seeks to replace transatlantic links between the U.S. and Europe with bilateral, ad-hoc alliances. The one such alliance that has received much media attention is the thaw between the U.S. and Russia. To be clear here, we are very much aware that many U.S. presidents have had deep disagreements with Europe and that every president since Reagan has tried to thaw relations with Russia early in his presidency. However, Trump is different in that he is the first U.S. president to: Openly question the very existence of NATO; Openly oppose European integration;6 Openly engage in mercantilist trade policies towards allies while simultaneously undermining geopolitical alliances with them. The problem with this course of action is that other countries will pursue alternative economic and security relationships to hedge against America's perceived lack of commitment, or outright hostility. Japan and South Korea, for example, concerned that they may face tariffs and a drop in U.S. military support, will need to turn more friendly toward China to avoid conflict and access new consumer markets. The same goes for Europe, with Germany and others eager to substitute for the U.S. by selling more to China amid U.S.-China trade conflicts.7 Thus, if we are to take the Trump Doctrine to its conclusion, we end up with an American foreign policy that pushes Eurasia towards the kind of integration - if not exactly alliance - that Mackinder feared. Since greater Eurasian coordination could eventually develop into a dynamic of its own, this process directly contravenes the second tenet of American grand strategy: Prevent any one power from dominating Eurasia. But wait, Trump supporters will cry, Trump is going to throw a wrench in Eurasian coordination by allying with Russia! No, he won't. Russia and America will not be allies. At best, they will be friends with benefits. The two countries have no shared economic interests. Russia sees both Europe and China as its economic partners. The former for supply of badly needed technology and investment (Chart 5), the latter as an energy market and another source of investment (Chart 6).8 Chart 5Russia Needs European Technology ... The Trump Doctrine The Trump Doctrine Chart 6... And Chinese Energy Demand ... And Chinese Energy Demand ... And Chinese Energy Demand Russian policymakers may be cheering Trump for the moment, but that is only because he brings relief from the extremely anti-Kremlin policies of the Obama (and potentially Hillary Clinton) presidency. The Kremlin will take advantage of the change in the White House. Bear in mind, all that Russian policymakers know of the U.S. in recent memory is conflict and realpolitik: It was the U.S. that pushed for NATO to expand into Ukraine and Georgia. Chancellor Angela Merkel, in fact, vetoed those plans at the 2008 NATO Summit; It was the Bush Administration that pushed for Kosovo's independence in 2008; Both the Bush and Obama administrations sought to construct a ballistic missile defense shield on Russia's doorstop in Central and Eastern Europe. If Trump stumbles in the next four years, who is to say that Moscow won't have to deal with an antagonistic Washington by the end of 2020? Trump's olive branches will not alter Russian thinking about the country's long-term interests. Russian President Vladimir Putin is going to do what is good for Russia, no matter how much he may think that Trump is a great guy to party with. And what is good for Russia is deeper economic integration with China and Europe. In fact, with the U.S. becoming an energy producer - and potentially a significant LNG exporter soon - America may become Russia's competitor for Europe's natural gas demand. Trump, his supporters and advisors, may believe that the twentieth century is over and that post-WWII American alliances have atrophied. They have! Russia is not the Soviet Union. It is no surprise that NATO is having an identity crisis when it no longer has a peer enemy to defend against. But geography has not changed. The U.S. is still far from Eurasia and Eurasia is still the "World Island." The Trump Doctrine ignores the entire twentieth century during which the U.S. had to intervene in Europe twice, and Asia three times, at a huge cost of blood and treasure, due to the threat of the continent unifying under a single hegemon. The international organizations that the U.S. set up after the Second World War, including NATO and the EU but also the UN, IMF, and others, were created to ensure that the U.S. did not have to intervene in Europe again. The security alliance and commercial system in Asia Pacific served a similar purpose. Bottom Line: Trans-oceanic alliances and organizations are not vestiges of a past that has changed, but vestiges of a geography that is immutable. The Trump Doctrine, such as it is, threatens to undermine an imperative of American hegemony. If pursued to its professed conclusion, it will therefore end American hegemony. Eurasian Alliance How can Europe, Russia, and China overcome their vast differences and unite in an anti-American alliance? It is not easy, but nor is it impossible. Russian point of view: The U.S. remains Russia's chief strategic threat. Sino-Russian distrust and tensions are overstated, as we discussed in a 2014 Special Report.9 Russia depends on China and Germany for 32% of its imports and 17% of its exports (Chart 7). It is deeply integrated with both economies. The U.S., meanwhile is about as relevant for the Russian economy as Poland in terms of imports and as Belarus in terms of exports. China's point of view: The U.S. is also China's chief strategic threat - and probably the only thing standing between China and regional hegemony over the course of this century. For China, integrating with the denizens of Eurasia makes a lot of sense. First, it would allow China to avoid the folly of competing with the U.S. in direct naval and maritime conflict. Overland transportation routes - which Beijing seeks to develop via its ambitious "The Silk Road Economic Belt" project - will bypass China's contentious and cramped South and East China Seas. Second, Europe has everything China needs from the U.S. (technology, aircraft, IT), and could offer them at discount rates due to a weak euro and general economic malaise (entire continent is for sale, at a discount!). Third, neither Europe nor Russia care what China does with its neighborhood in East Asia. If China wants to take some shoal from the Philippines, Berlin and Moscow will be okay with that. Europe's point of view: The European Union has never spent much time thinking seriously about the U.S. as a threat to its existence. The possibility, at very least, will promote efforts at economic substitution. Europe and Russia must overcome their differences over Ukraine in order to cooperate again. However, as we pointed out above, it was not Europe that sought to integrate Ukraine and Georgia into NATO, it was the United States. Europe needs Russian energy and Russia needs Europe's technology and investment. As long as they delineate where each sphere of influence begins and ends, which they have done before (in 1917 and 1939 if anyone is still counting!) they will be fine. Finally, trade with emerging markets is already more important for the EU than with the U.S. (Chart 8). And China remains a major potential growth market for EU products. Chart 7U.S. No Substitute For Russian Partners U.S. No Substitute For Russian Partners U.S. No Substitute For Russian Partners Chart 8Europe Relies On EM More Than U.S. Europe Relies On EM More Than U.S. Europe Relies On EM More Than U.S. We do not think that a formal EU-Russia-China axis is around the corner, or even likely. However, if the U.S. should pursue a policy of undermining its transatlantic and transpacific alliances, cheerleading the dissolution of the EU, and treating foes and allies equally when it comes to trade protectionism, the probability that it faces a united front from Eurasia increases. We are not sure that the Trump Administration understands this, or even cares. From what we can tell right now, the Trump White House is singularly focused on trade and commercial matters. It is mercantilist, pure and simple. But geopolitics is not a single dimension. It is like a game of three-dimensional chess. Foreign policy and security are on the top chess board, trade and economic matters are in the middle, and domestic politics are played on the bottom board. When the Trump administration threatens the "One China" policy or encourages EU dissolution because the bloc has "overshot its mark," it corners its counterparts on the geopolitical and political chess boards for the sake of trade and commercial interests. This is a mistake. Europe and China will give up chess pieces on the economic board to preserve their position on the geopolitical and political boards. In other words, Trump's strategy of tough-nosed negotiations - which he learned in the global real estate sector - will only strengthen opposition against the U.S. in the real world. We don't think that Trump is playing three-dimensional chess. He is singularly focused on America's economy and commercial interests and his own domestic political coalition. This is unique in post-World War Two American foreign policy. Ronald Reagan, who cajoled Japan and West Germany into the 1985 Plaza Accord, did so because both Berlin and Tokyo understood they owed their security to America. If Reagan threatened to withdraw America's security commitment to either, he would not have gotten the economic deal he wanted. Bottom Line: If pursued to its logical conclusion, the Trump Doctrine will end U.S. hegemony. Trump's foreign policy has raised a specter, however faint at present, which has not been seen since the Molotov-Ribbentrop Pact between Russia and Germany in 1939: a united Eurasian continent marshalling all its human, natural, and technological resources against the U.S. The last time that happened, 549,865 U.S. lives were needed to preserve American hegemony, not to mention the global cost in blood and treasure. Investment Implications In our 2017 Strategic Outlook we posited that investors should get used to the revival of charismatic authority.10 We borrow the concept from German sociologist Max Weber, who identified it in his seminal essay, "The Three Types of Legitimate Rule."11 Weber argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office. Today, we are seeing the revival of charismatic authority, which Weber defined as flowing from the extraordinary characteristics of an individual. Such leaders are difficult to predict as they often rise to power precisely because of their opposition to the institutions and laws that define the legal-rational authority. The Trump Doctrine is one example of how charismatic authority can lead to uncertainty. Twentieth century institutions may be flawed, but they have underpinned and continue to underpin American hegemony. The U.S. cannot, at the same time, maintain global hegemony, pursue mercantilist commercial policy, and seek to undermine its global alliances. The Trump White House threatens to push allies and foes, pursuing their own interests, to work in concert to isolate the United States. Perhaps President Trump and his advisors are comforted by the fact that the U.S. has always profited from global chaos. The U.S. benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 9). This is why Trump's election led us to believe that global multipolarity would peak in the coming year and set the stage for an American revival.12 Chart 9The U.S. Benefits From Global Chaos The U.S. Benefits From Global Chaos The U.S. Benefits From Global Chaos However, to maintain primacy while sowing global discord, the U.S. needs more than just Anglo-Saxon allies in the world. It needs an anchor in Eurasia, which is and always will be Europe. Without an anchor, Trump's policies will not sow discord, they will create concord, and unite the "World Island" against America. That is why it is important to see how the Trump Doctrine develops in terms of real policy, as opposed to a year's worth of mostly campaign statements. Already the administration has made some appropriate noises about standing "100% behind NATO" and having an "ironclad commitment" to Japan. But make no mistake, Trump's open doubts have reverberated farther and deeper than these minimal reassurances. It is critical to monitor how the Trump administration approaches NATO, the EU, and bilateral negotiations with key partners. We are already seeing evidence of serious coordination - particularly between Germany and China - that could be a counterweight to U.S. power in the marking. These two outcomes - renewed U.S. hegemony, or U.S. downfall - are essentially binary and it is too soon to know which will prevail. What is the probability of downfall? It is low, but rising. If Trump does not adjust his foreign policy - or, barring that, if the U.S. Congress or American foreign policy, defense, and intelligence establishment do not "correct" Trump's course - then U.S. hegemony will begin to unravel. And with it will go a range of "certainties" underpinning global economic growth and trade, including the U.S. dollar's reserve currency status. If America loses its hegemony, one victim may be the U.S. dollar's role as a safe haven asset. The notion that the greenback is a safe-haven asset even when the chief global risks emanate from the U.S. will be tested. We recommend that long-term investors diversify into other currencies, including the Swiss franc, euro, and, of course, gold. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Alfred Thayer Mahan, The Interest Of America In Sea Power: Present And Future (Boston: Little, Brown and Co., 1918). 2 Mahan, The Influence Of Sea Power Upon History, 1660-1783, 15th ed. (Boston: Little, Brown and Co., 1949). 3 Halford John Mackinder, Democratic Ideals And Reality: A Study In The Politics Of Reconstruction, 15th ed. (Washington, D.C.: National Defense University Press, 1996). 4 Trump has surprised U.S. ally Japan by coupling it with China in some of his statements threatening tariffs. Meanwhile Peter Navarro, chief of the new National Trade Council, has recently accused Germany of currency manipulation and structural trade imbalances. Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017 available at www.ft.com. 5 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 6 Trump has said that the U.K. was "smart" to leave the EU, and has expressed indifference to the existence of the EU and a belief that "others will leave" following the U.K. Please see "Full Transcript of Interview with Donald Trump," The Times of London, January 16, 2017, available at www.thetimes.co.uk. Also, the aforementioned Professor Malloch, potential U.S. Ambassador to the EU, said in his interview with the BBC that "Trump believes that the European Union has in recent decades been tilted strongly and most favorably towards Germany" and that "the EU has overshot its mark." 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 9 Please see Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 Please see Max Weber, "The Three Types Of legitimate Rule," Berkeley Publications in Society and Institutions 4 (1) (1958): 1-11. Translated by Hans Gerth. Originally published in German in the journal Preussiche Jahrbücher 182, 1-2 (1922). 12 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com.

Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession One Year On From A Mini Recession One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Wage Growth Is Set To Accelerate Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Comapanies' Animal Spirits On The Rise Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through China's Reflation Still Coming Through China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's When U.S. Pushed Japan In The 1980's When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Inflation Has Been Slow To Pick Up Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Euro Hasn't Weakened Much Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise TIPS Have Further to Go Room To Rise TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Interest Rate Differentials Suggest Stronger Dollar Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 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 January, the model outperformed global equities and the S&P 500 in USD terms, but underperformed in local-currency terms. For February, the model cut its weighting in stocks and increased its allocation to bonds (Chart 1). Within the equity portfolio, the weightings to both the U.S. and emerging markets were decreased. The model boosted its allocation to French bonds at the expense of Swedish and Canadian paper. The risk index for stocks, as well as the one for bonds, deteriorated in January. Feature Performance In January, the recommended balanced portfolio gained 1.4% in local-currency terms, and 3.6% in U.S. dollar terms (Chart 2). This compares with a gain of 3.2% for the global equity benchmark and a 2% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide other suggestions on currency risk exposure from time to time. The performance of bonds was a detractor from the model's performance in local currency terms in January. Chart 1Model Weights Model Weights Model Weights Chart 2Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Weights The model decreased its allocation to stocks from 57% to 53%, and upgraded its bond weighting from 43% to 47% (Table 1). Table 1Model Weights (As Of January 26, 2017) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators The model increased its equity allocation to France, Italy, and Sweden by one point each. Meanwhile, weightings were cut by 2 points in the U.S., and by 1 point in Germany, Spain, Switzerland, Emerging Asia, and Latin America. In the fixed-income space, the allocation to French paper was increased by 6 points and the U.K. by 1 point. The model cut its exposure to Swedish bonds by 2 points and Canadian 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 dollar weakened in January and our Dollar Capitulation Index fell close to neutral levels. Uncertainty over the size of the fiscal push by the U.S. administration could prolong the dollar's consolidation phase, especially if coupled with any negative economic surprises. However, this would only be a pause since continued monetary policy divergence should translate into another leg up in the dollar bull market (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 deterioration of the value and cyclical components led to a higher risk index for commodities. The model continues to shun this asset class (Chart 4). The risk index for global equities increased to a 3-year high in January due to the deterioration in the value indicator. While the global risk index for global bonds also deteriorated, it remains firmly in the low-risk zone. The model slightly decreased its allocation in equities to the benefit of bonds (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 Following the latest uptick in the risk index for U.S. equities, the allocation to this asset class was trimmed. U.S. stocks have been propped up by the growth-positive aspects of the new U.S. administration's policies and are at risk should this optimism deflate (Chart 6). The risk index for Canadian equities improved slightly in January as the better readings in the liquidity and momentum indicators offset continued worsening in value. That said, the overall risk index remains at the highest level in this business cycle. This asset remains excluded from the portfolio (Chart 7). Chart 6U.S. Stock Market And Risk U.S. Stock Market And Risk U.S. Stock Market And Risk Chart 7Canadian Stock Market And Risk Canadian Stock Market And Risk Canadian Stock Market And Risk The risk index for U.K. equities deteriorated, reaching a post-Brexit high. For the first time in over two years, the value component crossed into expensive territory (Chart 8) The model trimmed its allocation to Emerging Asian stocks following the slight uptick in the risk index. While the global reflationary pulse should bode well for this asset class, rumblings about protectionism threaten to de-rate growth expectations (Chart 9). Chart 8U.K. Stock Market And Risk U.K. Stock Market And Risk U.K. Stock Market And Risk Chart 9Emerging Asian Stock Market And Risk Emerging Asian Stock Market And Risk Emerging Asian Stock Market And Risk The unwinding of oversold conditions was the main reason behind the deterioration in the risk index for bonds in January. However, the latter is still in the low-risk zone as the bond-negative reading from the cyclical indicator remains overshadowed by the ongoing oversold conditions in the momentum indicator (Chart 10). The risk index for U.S. Treasurys deteriorated in January on the back of a less-stretched momentum indicator. While the cyclical backdrop is bond-bearish, there is arguably more room for scaling down optimism over the economy than there is to having an even more upbeat outlook. As a result, any resumption of the rise in Treasury yields could end up being very gradual (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 risk index for euro area government bonds also deteriorated in January, but unlike the U.S., it is in the high-risk zone. There are notable differences in the risk readings within euro area markets (Chart 12). Given the upcoming presidential elections, France is next in line in terms of investors' focus on political risks. French bonds are heavily oversold based on the momentum indicator, pushing the overall risk index lower. An unwinding of the risk premium would bode well for French bonds, which the model upgraded in January (Chart 13). Chart 12Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Chart 13French Bond Yields And Risk French Bond Yields And Risk French Bond Yields And Risk The risk index for Spanish government bonds ticked down slightly reflecting minor improvements in all three of its components. However, it remains much higher than the risk index for the French paper, which is preferred by the model (Chart 14). With the risk index little changed in January, Swiss government bonds remain in the high-risk zone. The model continues avoiding this asset which possesses negative yields (Chart 15). Chart 14Spanish Bond Yields And Risk Spanish Bond Yields And Risk Spanish Bond Yields And Risk Chart 15Swiss Bond Yields And Risk Swiss Bond Yields And Risk Swiss Bond Yields And Risk Currency Technicals The dollar depreciated after the 13-week momentum measure indicated last month that the greenback could face near-term resistance. Further consolidation cannot be ruled out, but the 40-week rate of change measure is not signaling an end to the dollar bull market. The monetary policy divergence between the Fed and its peers provides underlying support for the dollar, while heightened uncertainty on the fiscal front implies more volatility going forward (Chart 16). EUR/USD was not able to stay below 1.05. The short-term rate-of-change measure is approaching neutral levels, which could test the EUR/USD bounce. A risk-off episode or continued solid economic data are two factors that could provide some support for the euro in the near term (Chart 17). The 40-week rate of change measure for GBP/USD continues to hover near the most oversold level since 2000 (excluding the great recession). Meanwhile, the 13-week momentum measure crossed into positive territory, but is not extended. The pound will remain event-driven and possibly range-bound in the near term as the mood bounces within the hard Brexit / soft Brexit spectrum (Chart 18). Chart 16U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* Chart 17Euro Euro Euro Chart 18Sterling Sterling Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights Look below the surface, and the euro area economy reveals some surprising and encouraging truths: Euro area employment is near an all-time high. Euro area inflation is little different to other major economies. The euro area excluding Germany is among the world's top-performing major economies. Stay underweight German bunds versus U.S. T-bonds. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. But underweight the Eurostoxx600 because the European equity index is a play on sectors and currencies, not on the euro area economy. Feature "There's nothing so absurd that if you repeat it often enough, people will believe it." - William James In today's post-truth world, the rigorous scrutiny and analysis of facts and data has never been so important. With that in mind, this week's report puts some of the prejudices about the euro area economy under the microscope. Look below the surface, and euro area employment, inflation and growth reveal some surprising and encouraging truths. Euro Area Employment: Near An All-Time High The percentage of the euro area population in employment is close to an all-time high (Chart of the Week). Chart of the WeekThe Percentage Of The Euro Area Population In Work Is Near An All-Time High The Percentage Of The Euro Area Population In Work Is Near An All-Time High The Percentage Of The Euro Area Population In Work Is Near An All-Time High How could this be when the unemployment rate stands at a structurally elevated 10%? The answer is that euro area labour participation is in a very strong uptrend (Chart I-2). As millions of formerly inactive citizens have entered the labour market, it has structurally swelled the numbers of both the employed and the unemployed. Remember that to count as unemployed, a person has to be in the labour market looking for work. Chart I-2Euro Area Labour Participation Is In A Strong Uptrend Euro Area Labour Participation Is In A Strong Uptrend Euro Area Labour Participation Is In A Strong Uptrend The euro area's strongly rising labour participation means that we must interpret the headline unemployment rate with care. Indeed, we would argue that the healthy percentage of the working age population in employment is the truer measure of labour utilisation. One counterargument is that euro area citizens have simply flooded into the registered labour force to claim generous and long-lasting unemployment benefits. This argument might be valid during downturns, but it cannot explain the 17-year uptrend since the turn of the century. Unpalatable as it might be to the euro doomsayers, we are left with a more positive explanation. Since the monetary union, many euro area countries have succeeded in bringing down structurally high inactivity levels in the working age population that was the accepted norm in previous decades. Admittedly, Italy and Greece are the laggards in this structural movement, and still have much work to do - but even they have made substantial progress in recent years (Chart I-3). Chart I-3Italy And Greece Are The Laggards, But Even They Are Making Progess Italy And Greece Are The Laggards, But Even They Are Making Progess Italy And Greece Are The Laggards, But Even They Are Making Progess Bottom Line: the structural state of euro area employment is much better than the headline unemployment rate might suggest. Euro Area Inflation: Little Different To Other Major Economies The euro area and U.S. inflation rates are almost identical when compared on an apples for apples basis. The key words here are "apples for apples". A fair comparison between inflation rates in the euro area and the U.S. must adjust for a crucial difference in the two price baskets. The euro area's Harmonized Index of Consumer Prices - excludes the consumption costs of owner-occupied housing; whereas the U.S. CPI includes it at a substantial 25% weighting. As Eurostat explains,1 "the comparison of inflation across different countries and regions can be undermined by the use of different approaches to owner-occupied housing." To compare apples with apples, a simple approach is to exclude housing costs from the U.S. CPI too. This shows that the ex-shelter inflation rates - both headline and core - are almost identical in the euro area and the U.S. (Chart I-4 and Chart I-5). Chart I-4Apples For Apples: Little Difference In ##br##Euro Area And U.S. Headline Inflation... Apples For Apples: Little Difference In Euro Area And U.S. Headline Inflation... Apples For Apples: Little Difference In Euro Area And U.S. Headline Inflation... Chart I-5...Or Core##br## Inflation ...Or Core Inflation ...Or Core Inflation A more correct approach would be to estimate the inclusion of housing costs in the euro area consumer basket, given that they represent a sizable proportion of euro area household expenditures. The proportion of homes that are owner-occupied in the euro area, 67%, is actually higher than that in the U.S., 65%. Our approach uses two steps. First, to realise that owner-occupied housing cost inflation just follows house price inflation. Second, to observe that house price inflation in the euro area is now identical to that in the U.S. (Chart I-6 and Chart I-7). We infer that if owner-occupied housing were included in the euro area consumer basket, there would be no major difference in the euro area and U.S. inflation numbers. But what about inflation expectations? The market-based expectations for the euro area and U.S. 5 year inflation rate 5 years ahead - the so-called 5 year 5 year inflation swap - show that the euro area is consistently below the U.S., albeit by just 0.5% (Chart I-8). But again, this difference exists largely because the market is ignoring owner-occupied housing costs, which are not in the euro area's official inflation rate. Chart I-6House Price Inflation Is Now Identical ##br##In The Euro Area And U.S. House Price Inflation Is Now Identical In The Euro Area And U.S. House Price Inflation Is Now Identical In The Euro Area And U.S. Chart I-7Owner Occupied Housing Inflation##br## Follows House Price Inflation Owner Occupied Housing Inflation Follows House Price Inflation Owner Occupied Housing Inflation Follows House Price Inflation Chart I-8Inflation Expectations Move Together ##br##In The Euro Area And U.S. Inflation Expectations Move Together In The Euro Area And U.S. Inflation Expectations Move Together In The Euro Area And U.S. Bottom Line: The euro area is not suffering a noticeably greater deflation threat than any other major economy. Euro Area Growth: One Of The Best In Class Since the end of 2013, euro area real GDP per capita has outperformed both the U.S. and Japan. Once again, we must compare apples with apples. To adjust for the different demographics in the major economies, a fair comparison of economic performance must be on a per capita basis. But isn't the euro area's outperformance due mostly to Germany? Actually, no. Over the past three years, the star performers are Spain and the Netherlands, whose per capita real GDPs have grown by 9% and 4.5% respectively. By comparison, the U.S. clocks in at 3.5% and Japan at 3%. The ECB might argue that its extraordinary policy is responsible for this outperformance. However, the evidence does not support this thesis. The revival in the euro area economy began in early 2014, long before the ECB had even mooted its asset-purchases, TLTROs or negative interest rates. Instead, the turning-point can be traced back to December 31, 2013, the mark-to-market date for the bank asset quality review (AQR). As soon as euro area banks ended the aggressive de-levering that the stress tests forced upon them, a deeply negative credit impulse also eased. Which allowed the economy to begin a sustained recovery. Bottom Line: The euro area excluding Germany is among the world's top-performing major economies (Chart I-9). Chart I-9The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Investment Implications The proportion of the euro area working age population in employment is close to an all-time high, underlying inflation is almost identical to that in the U.S., and the euro area ex Germany is the world's best-performing major economy over the past three years. Yet the expected difference between ECB looseness and Federal Reserve tightness stands at a multi-decade extreme (Chart I-10). Chart I-10The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme Lean against this. Either go long the Eurodollar two year out interest rate future contract and short the equivalent Euribor contract. Or go long the U.S. 5-year T-bond and short the German 5-year bund.2 A further ramification comes in the currency market. The dominant recent driver of the euro has been the so-called fixed income portfolio channel. When global bond investors fled the euro area in search of higher safe nominal yields, the euro came under pressure. These outflows are abating, and indeed reversing, as investors come to realise that the ECB's radical and experimental policy-easing has peaked. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. Finally, contrary to popular perception, the state of the euro area economy does not translate into Eurostoxx600 relative performance. Major equity market indexes are a collection of multinational dollar-earning companies which happen to be quoted in a particular city - say, Frankfurt, London, or New York - in a particular currency - say, the euro, pound, or dollar. Therefore, as demonstrated in More Investment Reductionism,3 the main driver of equity market relative performance tends to be currency movements, or the relative performance of industry sectors that dominate the particular index. Based on this currency and sector logic, stay underweight Eurostoxx600 versus FTSE100, and underweight Eurostoxx600 versus S&P500.4 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Detailed Technical manual on Owner-Occupied Housing for Harmonised Index of Consumer Prices, Eurostat. 2 BCA strategists differ on this position. 3 Published on November 24, 2016 and available at eis.bcaresearch.com 4 BCA strategists differ on this position. Fractal Trading Model* This week's trade is to go long Norwegian krone / Russian ruble. 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-11 Long NOK/RUB Long NOK/RUB * 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-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights U.S. policy uncertainty has increased again early in the New Year. President Trump's inaugural speech highlighted that he has not tempered his "America First" policy prescription. The Trump/GOP agenda is still a moving target, but three key risks have emerged for financial markets. A border tax could see a 10% rise in the U.S. dollar. It would also be bearish for global bonds and EM stocks. Position accordingly. Second, President Trump has his sights on China. U.S. presidents face few constraints on the trade and foreign policy side. Investors seem to be under-appreciating the risk of a trade war. Third, the plan to slash Federal government spending could completely offset the fiscal stimulus stemming from the proposed tax cuts and infrastructure spending. The good news is that the major countries, including China, appear to have entered a synchronized growth acceleration. There is more to the equity market rally than a "sugar high". The global profit recession is over and the rebound has been even more impressive than we predicted. As long as any U.S. protectionist policies do not derail the growth acceleration, corporate EPS in the major countries should rival (traditionally overly-optimistic) bottom-up expectations in 2017. The Fed will hike three times this year, one more than is discounted. The Bank of Japan will continue to target a 10-year JGB yield of 0%, but the ECB will begin hinting at another taper in the fall. Our bond team tactically took profits on a short-duration position, but expect to move back to below-benchmark duration before long. The U.S. policy backdrop is very fluid but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine U.S. growth (our base case), then stocks will beat bonds by a wide margin. Investors should consider long VIX positions, but add to equity exposure on dips. Feature It has become a cliché to describe the economic and financial market outlook as "unusually uncertain". Since 2007, investors have had to deal with rolling financial crises, deleveraging, recession, deflation pressures, quantitative easing, negative interest rates, re-regulation, a collapse in oil prices and Brexit. Chart I-1Stocks Decouple From Policy Uncertainty Stocks Decouple From Policy Uncertainty Stocks Decouple From Policy Uncertainty Now, there is Donald Trump. The new President's inaugural speech highlighted that he has not tempered his "America First" policy prescription. Protectionism, de-regulation and tax reform are high on the agenda but details are scant, leaving investors with very little visibility. There are many policy proposals floating around that have conflicting potential effects on financial markets. Which ones will actually be pursued and how will they be prioritized? Is the U.S. prepared to fight a trade war? Is a border tax likely? Will President Trump push for a "Plaza Accord" deal with China? Even the prospect for fiscal stimulus is a moving target because the Trump Administration is reportedly considering a plan to slash Federal spending by $10 trillion over the next decade! Some have described the global equity rally as just a "sugar high" that will soon fade. No doubt, some of the potentially growth-enhancing parts of the Trump agenda have been discounted in risk assets. Given the highly uncertain policy backdrop, it would be easy to recommend that investors err on the side of caution if the U.S. and global economies were still stuck in the mud. The level of the S&P 500 appears elevated based on its relationship with the policy uncertainty index (shown inverted in Chart I-1). Nonetheless, what complicates matters is that there is more to the equity rally than simply hope. Both growth and profits are surprising to the upside in what appears to be a synchronized global upturn. If one could take U.S. policy uncertainty out of the equation, risk assets are in an economic sweet spot where the deflation threat is waning, but inflation is not enough of a threat to warrant removing the monetary punchbowl. Indeed, the Fed will proceed cautiously and official bond purchases will continue through the year in Japan and the Eurozone. We begin this month's Overview with two key protectionist policies being considered that could have important market implications. We then turn to the good news on the economic and earnings front. The conclusion is that we remain positive on risk assets and bearish bonds on a 6-12 month investment horizon. It will likely be a rough ride, but investors should use equity pullbacks to add exposure. Protectionism Risk #1 A U.S. border tax has suddenly emerged on the U.S. policy program. More formally, it is called a destination-based cash flow tax. Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference the between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred the U.S.). The mechanics are fairly complicated and we encourage interested clients to read a Special Report on the topic from BCA's Global Investment Strategy service.1 The result would be a significant increase in taxes on imported goods and a reduction in taxes paid by exporters. One benefit is that the border tax would generate a large amount of revenue for the Treasury, which could be used to offset the cost of corporate tax cuts. Another benefit is that the tax change would eliminate the use of international "transfer pricing" strategies that allow American companies to avoid paying tax. 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. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field! In reality, there are reasons to believe that the dollar's adjustment would not be fully offsetting. First, much depends on how the Fed responds. Second, some central banks would take steps to limit the dollar's ascent. To the extent that the dollar did not rise by the full amount (25% in our example), then the border tax would boost exports and curtail imports. The resulting tailwind for U.S. growth would eventually be reflected in higher inflation to the extent that the economy is already near full employment. The result is that a border tax would be bullish the dollar and bearish for bonds. Our base case is that a 20% border tax would lift the dollar by about 10% over a 12-month period, above and beyond our current forecast of a 5% gain. The 10-year Treasury yield could reach 3% in this scenario. Subjectively, we assign a 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. It appears that investors are underestimating the likelihood that the U.S. proceeds with this new tax, suggesting that the risks to the dollar and bond yields are to the upside. This is another reason to underweight U.S. bonds relative to Bunds on a currency-hedged basis. For stocks, any growth boost from the border tax would benefit corporate profits, at least until the Fed responded with a faster pace of rate hikes. It is another story for EM equities as a shrinking U.S. trade deficit implies less demand for EM products and shrinking international dollar liquidity. A border tax could be seen as the first volley in a global trade war, souring investor sentiment towards EM stocks. Another major upleg in the U.S. dollar could also spark a financial crisis in some EM countries with current account deficits and substantial dollar-denominated debt. Protectionism Risk #2 Chart I-2Trade War Risk Is Elevated Trade War Risk Is Elevated Trade War Risk Is Elevated While President Trump wants a smaller trade deficit generally, he has his sights on China because of the elevated U.S. bilateral trade deficit (Chart I-2). His choices for Commerce Secretary, National Trade Council and U.S. Trade Representative are all China critics. U.S. presidents face few constraints on the trade and foreign policy side. He can order tariffs on specific goods, or even impose a surcharge on all dutiable goods, as Nixon did in 1971. Congress is unlikely to be a stumbling block. Trump's election was a signal that the U.S. populace wants protectionist policies. His electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. We expect the Trump Administration to give a largely symbolic "shot across China's bow" in the first 100 days, setting the stage for formal trade negotiations in the subsequent months. The initial shot will likely rattle markets. A calming period will follow, but this will only give a false sense of security. The U.S. is in a relatively good negotiating position because China's exports to the U.S. are much larger than U.S. exports to China. However, tensions over the "One China" policy and international access to the South China Sea will greatly complicate the trade negotiations. The bottom line is that there is little hope that U.S./China relations will proceed smoothly.2 A long position in the VIX is prudent given that the market does not appear to be adequately discounting the possibility of a trade war. Synchronized Global Growth Upturn While the U.S. policy backdrop has become more problematic for investors, the global economic and profit picture has brightened considerably. We were predicting a pickup in global growth before last November's election based on our leading indicators and the ebbing of some headwinds that had weighed on economic activity early in 2016. As expected, the manufacturing sector is bouncing back after a protracted inventory destocking phase. The stabilization in commodity prices has given some relief to emerging market manufacturers. The drag on global growth from capex cuts in the energy patch is moderating even though the level of capital spending will contract again in 2017. Moreover, the aggregate fiscal thrust for the advanced economies turned positive in 2016 for the first time in six years. The major countries, including China, appear to have entered a synchronized growth acceleration. The pick-up is confirmed by recent data on industrial production, purchasing managers' surveys and the ZEW survey (Chart I-3). The global ZEW composite has been a good indicator for world earnings revisions and the global stock-to-bond return ratio. The synchronized uptick in global coincident and leading economic data, including business and consumer confidence, suggests that there is more going on than a simple post-election euphoria. Euro Area sentiment measures hooked up at the end of 2016 and the acceleration in growth appears to be broadly based (Chart I-4). A simple model based on the PMI suggests that Eurozone growth could be as much as 2% this year, which is well above trend. Chart I-3Positive Global Indicators bca.bca_mp_2017_02_01_s1_c3 bca.bca_mp_2017_02_01_s1_c3 Chart I-4Euro Area To Beat Growth Estimates Euro Area To Beat Growth Estimates Euro Area To Beat Growth Estimates While Japan will not be a major contributor to overall global growth given its well-known structural economic impediments, the most recent data reveal a slight uptick in consumer confidence, business confidence and the leading economic indicator (Chart I-5). We have noted the impressive rebound in China's leading and coincident growth indicators for some time. Some indicators are consistent with real GDP growth well in excess of the 6.7% official growth figure for 2016 Q4. Both the OECD leading indicator and our proprietary GDP growth model are calling for faster growth in 2017 (Chart I-6). A potential increase in trade or even military tensions between China and the U.S. is a potential risk to this sunny picture. Nonetheless, given what we know about the underlying economy at the moment, China looks poised to deliver another year of solid growth. Chart I-5Even Japanese Sentiment Is Turning Up Even Japanese Sentiment Is Turning Up Even Japanese Sentiment Is Turning Up Chart I-6Upside Risk To China's Growth Upside Risk To China's Growth Upside Risk To China's Growth In the U.S., President Trump appears to be stirring long-dormant animal spirits. CEOs are much more upbeat and several regional Fed surveys indicate a surge in investment intentions (Chart I-7). Spending on capital goods has the potential to soar given the historical relationship with the survey data shown in Chart I-8 (the caveat being that Congress will need to deliver). Even the long depressed small business sector is suddenly more optimistic. The December reading of the NFIB survey showed a spike in confidence, with capital expenditures, hiring plans and overall optimism returning to levels not seen in this expansion. Chart I-7Animal Spirits Reviving In The U.S.... Animal Spirits Reviving In The U.S.... Animal Spirits Reviving In The U.S.... Chart I-8...Which Will Spark Capital Spending ...Which Will Spark Capital Spending ...Which Will Spark Capital Spending There is a good chance that a deal between the White House and Congress on tax reform will occur in the first half of 2017, including a major tax windfall for the business sector that would boost the after-tax rate of return on equity. Nonetheless, past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer demand is on the upswing. In other words, consumers need to move first. On that score, a number of cyclical tailwinds have aligned for household spending. Credit scores have largely been repaired since the recession and income growth is on track to accelerate (Chart I-9). Despite a moderation in monthly payrolls, overall income growth is likely to stay perky, now that wage gains are on an upward path. And, importantly, various surveys highlight an improvement over the past year in consumer confidence about long-term job prospects. The propensity to spend rather than save is higher when households feel secure in their jobs. Chart I-10 highlights that the saving rate tends to decline when confidence is elevated. The wealth effect from previous equity and housing price gains has been a tailwind for some time but, until now, consumers have held back because it seemed to many that the recession had never ended. Chart I-9Share Of Home Mortgage Borrowers ##br##Who Recovered Pre-Delinquency Credit Score After Foreclosure February 2017 February 2017 Chart I-10Room For U.S. Consumer To Spend Room For U.S. Consumer To Spend Room For U.S. Consumer To Spend In other words, there are increasing signs that the scar tissue from the Great Recession is finally fading, at a time when tax cuts are on the way. We expect that U.S. real GDP growth will be in the 2½-3% range this year with risks to the upside, as long as the Trump Administration does not start a trade war that undermines confidence. Corporate Earnings Liftoff Chart I-11Profits Are Bouncing Back Profits Are Bouncing Back Profits Are Bouncing Back The good news on the economy carries over to corporate earnings. The profit recession is over and the rebound has been even more impressive than we predicted (Chart I-11). Eurozone EPS "went vertical" near the end of 2016. Blended S&P 500 Q4 bottom-up estimates reveal a huge increase in EPS last year to $109 (4-quarter trailing), providing an 8.5% growth rate for 2016 as a whole. The 4-quarter trailing growth figure will likely surge again to 16% in 2017 Q1, even if the sequential EPS figure is flat. Some of the growth acceleration is technical, reflecting a particularly sharp drop in profits at the end of 2015 (which will eventually fall out of the annual growth calculation). Of course, a spike in energy earnings on the back of higher oil prices made a major contribution to the overall growth rate, but there is more to it than that. Consumer Discretionary, Financials and Health Care all posted solid earnings figures last year. Earnings momentum has also picked up in Materials, Real Estate and Utilities, although profit growth in these sectors is benefiting from favorable comparisons. Dollar strength has pushed the U.S. earnings revisions ratio slightly into negative territory, while revisions have surged into positive terrain in the other major markets (Chart I-12). The sharp upturn in our short-term EPS indicators corroborates the more upbeat earnings outlook for at least the next few months (Chart I-13). Chart I-12Earnings Revisions Earnings Revisions Earnings Revisions Chart I-13Short-Term EPS Indicators Are Bullish Short-Term EPS Indicators Are Bullish Short-Term EPS Indicators Are Bullish Our medium-term profit models also paint a constructive picture for equities. These are top-down macro models that include oil prices, exchange rates, industrial production (to capture top-line dynamics), and the difference between nominal GDP and labor compensation (to capture margin effects). Given our more optimistic economic view, the model forecasts for 2017 EPS growth have been revised higher for the global aggregate and each of the major developed markets (Chart I-14). The U.S. is tricky because of the impact of comparison effects that will add volatility to the quarterly growth profile as we move through the year. We are now calling for a 10% gain for 2017 as a whole, which is just shy of the roughly 12% increase expected by bottom-up analysts. This is impressive because actual market expectations are typically well below the perennially-optimistic bottom-up estimates. A 10% EPS growth figure might seem overly optimistic in light of the dollar appreciation that has occurred since last November. Some CEOs will no doubt guide down 2017 estimates during the current earning season. However, in terms of EPS growth, the annual change in the dollar matters more than its level. Chart I-15 shows that the year-over-year rate of change in the dollar is moderating despite the recent rise in the level. This is reflected in a diminishing dollar drag on EPS growth as estimated by our model (bottom panel in Chart I-15). We highlighted in the December 2016 monthly report that it does not require a major growth acceleration to overwhelm the negative impact of a rising dollar on earnings. Chart I-14Medium-Term Profit Models Are Also Bullish Medium-Term Profit Models Are Also Bullish Medium-Term Profit Models Are Also Bullish Chart I-15Dollar Effect On U.S. EPS Dollar Effect On U.S. EPS Dollar Effect On U.S. EPS The models for Japan and the Eurozone point to 2017 EPS growth in the mid-teens. Both are roughly in line with bottom-up estimates which, if confirmed this year, would be quite bullish for stock indexes. Keep in mind that these projections do not include our base case forecast that the U.S. dollar will appreciate by another 5% this year (more if a border tax is enacted). Incorporating a 5% dollar appreciation would trim U.S. EPS growth by 1 percentage point and add the same amount to profit growth in Japan and the Eurozone. The bottom line is that we expect corporate profits to be constructive for global bourses this year. Within an overweight allocation to equities in the advanced economies, we continue to favor the European and Japanese markets versus the U.S. As we discussed in the 2017 Outlook, political risks in the Eurozone are overblown. Currency movements and relative monetary policies will work against U.S. stocks on a relative (currency hedged) basis. FOMC: Hawks Gradually Winning The Debate Fed officials are in a state of quandary over how the policies of the incoming Administration will affect the growth and inflation outlook. Nevertheless, the last FOMC Minutes confirmed that the consensus on the Committee is still shifting in a less dovish/more hawkish direction. The tone of the discussion was decidedly upbeat, especially on the manufacturing and capital spending outlook. "Most" of the meeting participants felt that the U.S. economy has reached full employment, although there is still an ongoing debate on the benefits and costs of allowing the unemployment rate to temporarily move below estimates of full employment. Running the economy "hot" for a while might draw more discouraged workers back into the workforce and thereby expand the supply side of the economy. Other members, however, highlight that past attempts by the Fed to fine tune the economy in this way have always ended in recession. Our view is that the FOMC will not follow the Bank of Japan's example and explicitly target a temporary inflation overshoot. Conversely, the Fed will not attempt to pre-emptively offset any forthcoming fiscal stimulus either (if indeed there is any net fiscal stimulus). Policymakers will watch the labor market and, especially, wage and price inflation to guide them on the appropriate pace of rate hikes. Core PCE inflation is roughly 30 basis points below target and has only edged erratically higher over the past year. The pickup in shelter inflation has been largely offset by falling core goods prices, reflecting previous dollar strength. We expect shelter inflation to soon flatten off, but goods prices will continue to contract if the dollar rises by another 5% this year. Year-ago comparison effects will also depress the annual rate of change over the next couple of months. However, the key to the underlying inflation trend will be wage pressures, which are most highly correlated with the non-shelter part of the service component. Up until recently, the structural and cyclical forces acting on wage gains were pulling in the same downward direction. Structural factors include automation and population aging; as high-paid older workers leave the workforce, the vast majority of new entrants to full-time employment do so at below-median wages, putting downward pressure on median earnings growth.3 These structural factors will not disappear anytime soon, but the cyclical forces have clearly shifted. The main measures of U.S. wage growth are all trending higher. Excess labor market slack appears to have been largely absorbed. Only the number of people working part time for economic reasons suggests that there is some residual slack remaining. To what extent will cyclical wage pressures exert upward pressure on inflation? That will depend on the ability of companies to raise prices in order to protect profit margins. Wage inflation trends do not lead, and sometimes diverge from, inflation in goods and services. Theory suggests that there is a two-way relationship between wages and prices. Sometimes inflation starts in the labor market and spills over into consumer prices (cost-push inflation), and sometimes it is the other way around (demand-pull inflation). At the moment, the corporate sector appears to have limited ability to pass on rising wage costs. Balancing off the opposing factors, we believe that core PCE inflation will grind higher and should be near the 2% target by year end. This would end the Fed's debate over whether to run the economy hot, helping to keep upward pressure on Treasury yields. Bond Bear To Return Chart I-16Watch Bond Technicals To Short Again Watch Bond Technicals To Short Again Watch Bond Technicals To Short Again Global yields troughed a full four months before the U.S. election. As discussed above, the U.S. and global economies were showing signs of increased vigor even before Trump won the Presidency. The new President's policies reinforce the bond-bearish backdrop, especially protectionism and fiscal stimulus, at a time when the economy is already near full employment. Long-term inflation expectations imbedded in bond yields have shifted up in recent months across the major markets. Real yields have been volatile, but generally have not changed much from late last year. We remain modest bond bears over a 6-12 month horizon. Inflation and inflation expectations will continue to grind higher in the major markets and we expect the FOMC to deliver three rate hikes in 2017, one more than is discounted in the Treasury market. A rise in 10-year TIPS breakevens into a range that is consistent with the Fed's 2% inflation target (2.4%-2.5% based on history) would be a strong signal that the Fed will soon lift the 'dot plot.' ECB bond purchases will limit the increases in the real component of core European yields, but any additional weakness in the euro would result in a rise in European inflation. The ECB was able to announce a tapering of monthly purchases last year while avoiding a bond rout by extending the QE program to the end of 2017, but this will be more difficult to pull off again if inflation is on the rise and growth remains above-trend this year. We expect the ECB to provide hints in September that it will further taper its QE program early in 2018. Thus, the Eurozone bond market could take over from U.S. Treasurys as the main driver of the global bond bear market late in 2017. The Japanese economy is also performing impressively well, reducing the probability of a "helicopter drop" policy. The dollar's surge has depressed the yen and lifted inflation expectations, relieving some pressure on PM Abe to ramp up fiscal spending beyond what is already included in the supplementary budgets. In any event, the BoJ will keep the 10-year yield pinned near to zero, limiting the upside for bond yields to some extent in the other major bond markets. That said, we are neutral on JGBs, not overweight, because most of the yield curve is in negative territory. We remain overweight Bunds versus both Treasurys and JGBs on a currency-hedged basis. In terms of the duration call, our bond strategists felt in early December that the global bond selloff had progressed too far, too fast (Chart I-16). They recommended temporarily taking profits on short-duration positons and shifting to benchmark, which turned out to be excellent timing. Yields have drifted lower since then and the technicals have improved enough to warrant shifting back to below-benchmark duration. Investment Conclusions Chart I-17A Better Growth ##br##Backdrop For USD Strength A Better Growth Backdrop For USD Strength A Better Growth Backdrop For USD Strength Equity markets have gone into a holding pattern as investors weigh heightened U.S. policy risk against the improving profit and global macro backdrop. The latter appears to have broken the Fed policy loop that had been in place for some time. Expectations for a less dovish Fed helped to drive the dollar and Treasury yields higher late in 2016. But, rather than sparking a correction in risk assets as has been the case in recent years, stock indexes surged to new highs (Chart I-17). The difference this time is that there has been a meaningful improvement in the growth and profit outlook that has overwhelmed the negative impact of a stronger dollar and higher borrowing rates. The protectionist policies currently being considered are clearly dollar bullish, and bearish for global bonds and EM stocks. Investors should be positioned accordingly. It is more complicated for stocks. The passing of a major tax reform package would no doubt buttress the budding revival in private sector animal spirits, but a nasty trade war has the potential to do the opposite. The multitude of policy proposals floating around greatly complicate asset allocation. It is a very fluid situation but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine global growth (our base case), then corporate earnings growth will be solid in 2017 and stocks will beat bonds by a wide margin. We wish to be clear, though, that equities are on the expensive side in most of the main markets. This means that overweighting equities and underweighting cash and bonds in a balanced global portfolio is essentially playing an equity overshoot. It may end badly, but the overshoot is likely to persist for as long as the economic and profit upswing persists. Investors should consider long VIX positions, but add to equity exposure on dips. Our view on corporate bonds is unchanged this month. Poor value and deteriorating corporate balance sheet health make it difficult to recommend anything more than a benchmark position in the U.S. relative to Treasurys. However, investors can pick up a little spread in the Eurozone corporate bond market, where balance sheet health is better and the ECB is soaking up supply. Mark McClellan Senior Vice President The Bank Credit Analyst January 26, 2017 Next Report: February 23, 2017 1 U.S. Border Adjustment Tax: A Potential Monster Issue for 2017. BCA Global Investment Strategy service, January 20, 2017. 2 For more information, please see: Trump, Day one: Let the Trade War Begin. BCA Geopolitical Strategy Weekly Report, January 18, 2017. 3 For more information in the structural and cyclical wage pressures, please see: U.S. Wage Growth: Paid in Full? U.S. Investment Strategy Service, November 28, 2016. II. Global Debt Titanic Collides With Fed Iceberg? The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. The "cash flow" effect on debt service is a headwind for growth as rising interest payments trim the cash available to spend on goods and services. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will be so severe this time that it will quickly derail the economic expansion. However, a number of factors make projecting interest payments complicated, such that back-of-the-envelope estimates are quite misleading. In order to provide a sense of the size of the cash-flow effect, in this Special Report we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates increase immediately by 100 basis points from today's levels. It would require a 300 basis point jump to really "move the dial". Interest rate shocks are more dramatic for the Japanese government interest burden due to the size of the JGB debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. We are not downplaying the risks posed by the rapid accumulation of debt since the Great Recession. Rather, our aim is to provide investors with a sense of the debt-service implications of a further rise in borrowing rates. Our main point is that the cash-flow effect of higher interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Investors are justifiably worried that the bond selloff will get ahead of itself, spark an economic setback and a corresponding flight out of risk assets. After all, there have been several head fakes during this recovery during which rising bond yields on the back of improving data and optimism were followed by an economic soft patch and a risk-off phase in financial markets. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. Indeed, global debt has swollen by 41½ percentage points of GDP since 2007 (Chart II-1). Households, corporations and governments tried to deleverage simultaneously to varying degrees in the major countries since the Great Recession and Financial Crisis, but few have been successful. Households in the U.S., U.K., Spain and Ireland have managed to reduce the level of debt relative to income. U.K. and Japanese corporations are also less geared today relative to 2007. Outside of these areas, leverage has generally increased in the private and public sectors (see Chart II-2 and the Appendix Charts beginning on page 37). The astonishing pile-up of debt in China has been particularly alarming for the investment community (Chart II-3). Chart II-1Leverage Has Increased Since 2007 Leverage Has Increased Since 2007 Leverage Has Increased Since 2007 Chart II-2Leverage In Advanced Economies Leverage In Advanced Economies Leverage In Advanced Economies Chart II-3China's Alarming Debt Pile-Up China's Alarming Debt Pile-Up China's Alarming Debt Pile-Up Governments can be excused to some extent for continuing to run fiscal deficits because automatic stabilizers require extra spending on social programs when unemployment is high. Fiscal policy was forced to at least partially offset the drain on aggregate demand from private sector deleveraging, or risk a replay of the Great Depression. More generally, history shows that it is extremely difficult for any one sector or country to deleverage when other sectors and countries are doing the same. The slow rate of nominal income growth makes the job that much harder. Borrowing Rates And The Economy There are several ways in which higher borrowing rates can affect the economy. Households will be incentivized to save rather than spend at the margin. Borrowing costs surpass hurdle rates for new investment projects, causing the business sector to trim capital spending. Uncertainty associated with rising rates might also undermine confidence for both households and firms, reinforcing the negative impact on demand. Banks, fearing a growth slowdown ahead and rising delinquencies, may tighten lending standards and thereby limit credit availability. These negative forces are normally a headwind for growth, but not something that outweighs the positive Keynesian dynamics of rising wages, profits and employment until real borrowing rates reach high levels. However, if the neutral or "equilibrium" level of interest rate is still extremely low today, then it may not require much of a rise in market rates to tip the economy over. A lot depends on confidence, which has been quite fragile in the post-Lehman world. The "cash flow" effect on debt service is another headwind for growth as rising interest payments trim the cash available to spend on goods and services. For the government sector, a swelling interest burden will add to the budget deficit and may place pressure on the fiscal authorities to cut back on spending in other areas. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will quickly derail the expansion in the U.S. and potentially in other countries as the Treasury market selloff drags up yields across the global bond market. This is an argument that has circulated at the beginning of every Fed tightening cycle as far back as we can remember. Some even predict that central banks will be forced to use financial repression for an extended period to prevent the interest burden from skyrocketing and thereby short-circuiting the economic expansion. Back-of-the-envelope estimates that simply apply a 100 or 200 basis point increase in borrowing rates to the level of outstanding debt, for example, imply a shocking rise in the debt service burdens. Fed rate hikes could be analogous to the iceberg that took down the Titanic in 1912. Key Drivers Of Interest Sensitivity However, back-of-the-envelope calculations like the one described above paint an overly pessimistic picture for three reasons. First, the starting point for debt service burdens in the corporate, household and government sectors is low (Chart II-4). These burdens have generally trended down since 2007 because falling interest rates have more than offset debt accumulation, with the major exception of China.1 Second, the maturity distribution of debt means that it takes time for interest rate shifts to filter into debt servicing costs. For example, the average maturity of corporate investment-grade bond indexes in the major economies is between 3 and 12 years (Chart II-5). The average maturity of government indexes range from 7½ to 16 years. Moreover, the majority of household debt is related to fixed-rate mortgages. Even a significant portion of consumer debt is fixed for 5-years and more in some countries. Households have been extending the maturity structure of their debt in recent decades (Chart II-5, bottom panel). Chart II-4Debt Service Has Generally Declined Debt Service Has Generally Declined Debt Service Has Generally Declined Chart II-5Average Maturity Of Debt Is Long Average Maturity Of Debt Is Long Average Maturity Of Debt Is Long Third, even following the backup in yield curves since the U.S. election, current interest rates on new loans are still significantly below average rates on outstanding household loans, corporate debt and government debt. The implication is that most older loans and bonds coming due over the next few years will be rolled over at a lower rate compared to the loans and bonds being replaced. This will even be true if current yield curves shift up by 100 basis points in many cases (except for the U.S. where current yields are closer to average coupon and loan rates). In this Special Report, we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. We could not include China in this month's analysis because data limitations precluded any degree of accuracy, but the sheer size of China's debt mountain justifies continued research in this area. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates rise immediately by 100 basis points from today's levels. It would require a 300 basis point rise in yield curves to really "move the dial" in terms of the cash-flow impact on spending. An interest rate shock of that size would be particularly dramatic for the Japanese government interest burden given the size of its debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. Consumer Sector U.S. households have worked hard at deleveraging since their net worth was devastated by the housing bust. Still, the overall debt-to-income level is elevated by historical standards. U.S. household leverage has generally trended higher since the Second World War and has been a source of angst for investors as far back as the late 1950s. Yet, we find no evidence that U.S. consumers have become more sensitive to changes in borrowing rates over the decades.2 This counter-intuitive result partially reflects the fact that consumers have partially insulated themselves from rising interest rates by adopting a greater proportion of fixed-rate debt. The bottom panel of Chart II-6 presents the two-year change in debt service payments expressed as a percent of income (i.e. the swing or the "cash flow" effect). The fact that these swings have not grown over time suggest that the cash-flow effect of changes in interest rates on debt service has not increased.3 Chart II-6U.S. Consumers Have Not Become More Sensitive To Interest Rates U.S. Consumers Have Not Become More Sensitive To Interest Rates U.S. Consumers Have Not Become More Sensitive To Interest Rates Another way to demonstrate this point is to compare disposable income growth with a measure of "discretionary" disposable income that subtracts debt service payments (Chart II-6, top panel). This is the amount of money left over after debt servicing to purchase goods and services. The annual rate of growth in disposable income and discretionary income are nearly identical. In other words, growth in spending power is determined almost exclusively by changes in the components of income (wages, hours and employment). Moreover, the fact that some households are net receivers of interest income provides some offset to rising interest payments for other households when rates go up. This conclusion applies to households in the other major countries as well. Charts II-7 to II-10 present projections for household interest payments as a percent of GDP under three scenarios: no change in yield curves, an immediate 100 basis point parallel shift up in the yield curve and a 300 basis point shift. Assuming an immediate increase in yields across the curve is overly blunt, but the scenarios are only meant to provide a sense of how much interest payments could rise on a medium-term horizon (say, one to five years). The exact timing is less important. Chart II-7U.S. Household Sector Interest Payment Projection U.S. Household Sector Interest Payment Projection U.S. Household Sector Interest Payment Projection Chart II-8U.K. Household Sector Interest Payment Projection U.K. Household Sector Interest Payment Projection U.K. Household Sector Interest Payment Projection Chart II-9Japan Household Sector Interest Payment Projection Japan Household Sector Interest Payment Projection Japan Household Sector Interest Payment Projection Chart II-10Eurozone Household Sector Interest Payment Projection Eurozone Household Sector Interest Payment Projection Eurozone Household Sector Interest Payment Projection Unsurprisingly, household interest payments as a fraction of GDP are flat-to-slightly lower in "no change" interest rate scenario for the major countries. The interest burden increases by roughly 1 percentage point in the 100 basis point shock, although the level remains well below the pre-Lehman peak in the U.S., U.K. and Eurozone. In Japan, the interest payments ratio returns to levels last seen in the late 1990s, although this is not particularly onerous. A 300 basis point shock would see interest burdens ramp up to near, or above, the pre-Lehman peak in all economies except in the U.K. For the latter, borrowing rates would still be below the 2007 peak even if they rise by 300 basis points from current levels. This scenario would see the household interest burden surge well above 3% of GDP in Japan, a level that exceeds the entire history of the Japanese series back to the early 1990s. Also shown in the bottom panel of Chart II-7, Chart II-8, Chart II-9, Chart II-10 is the associated 2-year swing in interest expense as a percent of GDP under the three scenarios. The 2-year swing moves into positive (i.e. restrictive) territory for all economies under the 100 basis point shock, although they remain in line with previous monetary tightening cycles. It is only for the 300 basis point scenario that the cash-flow effect appears threatening in terms of consumer spending power over the next two years. Corporate Sector The starting point for interest payments and overall debt-service in the corporate sector is also quite low by historical standards, although less so in the U.S. Falling interest rates have been partially offset by the rapid accumulation of American company debt in recent years. We modeled national accounts data for non-financial corporate interest paid using the stock of corporate bonds, loans and (where relevant) commercial paper, together with the associated interest or coupon rates. The model simply sums interest payments across these types of debt to generate a grand total, after accounting for the maturity structure of the loans and debt. Chart II-11, Chart II-12, Chart II-13 and Chart II-14 present the three yield curve scenarios for corporate interest payments. The interest burden is flat-to-somewhat lower if yield curves are unchanged, as old loans and bonds continue to roll over at today's depressed levels. Even if market yields jump by 100 basis points tomorrow, the resulting interest burdens would rise roughly back to 2012-2014 levels in the U.S., Eurozone and the U.K., which would still be quite low by historical standards. The resulting two-year cash-flow effect is modest overall. The rate increase feeds into corporate interest payments somewhat more quickly in the Eurozone and Japan because of the relatively shorter average maturity of the corporate debt market, but a shock of this size does not appear threatening to either economy. Chart II-11U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection Chart II-12U.K. Corporate Sector Interest Payment Projection U.K. Corporate Sector Interest Payment Projection U.K. Corporate Sector Interest Payment Projection Chart II-13Eurozone Corporate Sector Interest Payment Projection Eurozone Corporate Sector Interest Payment Projection Eurozone Corporate Sector Interest Payment Projection Chart II-14Japan Corporate Sector Interest Payment Projection Japan Corporate Sector Interest Payment Projection Japan Corporate Sector Interest Payment Projection It is a different story if yields rise by 300 basis points. The interest ratio approaches previous peaks set in the 2000s in the U.S. and Eurozone. The interest ratio rises sharply for the U.K. corporate sector as well, although it stays below the 2000 peak because interest rates were even higher 17 years ago. Japanese companies would also feel significant pain as the interest ratio rises back to where it was in the late 1990s. Government Sector Government finances are not at much risk from a modest increase in bond yields either (Chart II-15). We focus on the level of the interest burden rather than the cash-flow effect for the government sector since changes in interest payments probably have less impact on governments' near-term spending plans than is the case for the private sector. Chart II-15Government Sector Interest Payment Projection Government Sector Interest Payment Projection Government Sector Interest Payment Projection As discussed above, Treasury departments in the U.K., Eurozone and Japan have taken advantage of ultra-low borrowing rates by extending the average maturity of public debt. The average maturity of the Barclays U.K. government bond index has extended to 16 years, while it is close to 10 years in Japan and the Eurozone (Chart II-5). The U.S. Treasury has not followed suit; the Barclays U.S. index is about 7½ years in maturity. The lengthy average maturity means that index coupon rates will continue to fall for years to come if rates are unchanged in the U.K., Japan and the Eurozone, resulting in a declining interest burden. Even if rates rise by another 100 basis points, the interest burden is roughly flat as a percent of GDP for the U.K. and Eurozone, and rises only modestly in Japan. The limited impact reflects the fact that the starting point for current yields is well below the average coupon on the stock of government debt. In contrast, the U.S. interest burden is roughly flat in the "no change" scenario, and rises by a half percentage point by 2025 in the 100 basis point shock scenario. Keep in mind that we took the neutral assumption that the stock of government debt grows at the same pace as nominal GDP growth. This assumes that governments deal effectively with the impact of aging populations on entitlement programs in the coming years. As many studies have shown, debt levels will balloon if entitlements are not adjusted and/or taxes are not raised to cover rising health care and pension costs. We do not wish to downplay this long-term risk, but we are focused on the impact of higher interest rates on interest expense over the next five years for the purposes of this Special Report. As with the household and corporate sectors, the pain becomes much more serious in the event of a 300 basis point rise in interest rates. Interest payments rise by about 1 percentage point of GDP in the U.S. and U.K. to high levels by historically standards. It takes a decade for the full effect to unfold, although the ratios rise quickly in the early years as the short-term debt adjusts rapidly to the higher rate environment. For the Eurozone, the roughly 100 basis points rise takes the level of the interest burden back to about 2003 levels (i.e. it does not exceed the previous peak). Given Japan's extremely high government debt-to-GDP ratio, it is not surprising that a 300 basis point rise in interest rates would generate a whopping surge in the interest burden from near zero to almost 5% of GDP by the middle of the next decade. Nonetheless, this paints an overly pessimistic picture for two reasons. First, the Bank of Japan is likely to hold short-term rates close to zero for years as the authorities struggle to reach the 2% inflation target. This means that only long-term JGB yields have room to move higher in the event of a continued global bond selloff. Second, 40% of the JGB market is held by the central bank and this proportion will continue to rise until the Bank of Japan's QE program ends. Interest paid to the BoJ simply flows back to the Ministry of Finance. The net interest payments data used in our analysis are provided by the OECD. These data net out interest payments made between all arms of the government except for the central bank. The implication is that rising global bond yields in the coming years will not place the Japanese government under any fiscal strain. The same is true in the U.S., U.K. and Eurozone, where the respective central banks also hold a large portion of the stock of government debt (although this conclusion does not necessarily apply to the peripheral European governments). Conclusion The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs given the sea of debt that has accumulated. As discussed in our 2017 BCA Outlook, we believe that the secular bond bull market is over but foresee only a gradual uptrend in yields in the coming years. Inflation is likely to remain subdued in the major countries and bond supply will continue to be absorbed by the ECB and Bank of Japan. The stock of government bonds available to the private sector will drop by $750 billion in 2017 for the U.S., Eurozone, Japan and the U.K. as a group. This follows a contraction of $546 billion in 2016. Forward guidance from the BoJ and ECB will also help to cap the upside for global bond yields. Still, we believe that the combination of gradually rising U.S. inflation, Fed rate hikes and the Trump fiscal stimulus plan will push Treasury yields above current forward rates in 2017. Other bond markets will outperform in local currency terms, but will suffer losses via contagion from the U.S. Despite the dizzying amount of debt accumulated since the Great Recession, it does not appear that debt service will sink the economies of the advanced economies as the Fed continues to normalize U.S. monetary policy. Debt service will rise from a low starting point and the swing in interest payments as a percent of GDP is unlikely to exceed previous cycles on a 2-year horizon for a 100 basis point rise in yields. The level of the interest payments/GDP ratio should not exceed previous peaks in most cases. The picture is much more threatening if yields were to surge by 300 basis points over the next couple of years, although this scenario would require an unexpected acceleration of inflation in the U.S. and/or the other advanced economies. We are not making the case that the buildup of debt is benign. Academic research has linked excessive leverage with slower trend economic growth and a higher risk of financial crisis. For governments, elevated debt can result in a rising risk premium that will crowd out spending in important areas, such as health and pensions, in the long run. For consumers and the corporate sector, excessive leverage could result in financial distress and a spike in defaults in the next downturn, reinforcing the contraction in output. The Bank for International Settlements agrees: "Increased household indebtedness, in and of itself, is not likely to be the source of a negative shock to the economy. Rather the primary macroeconomic implication of higher debt levels will be to amplify shocks to the economy coming from other sources, particularly those that affect household incomes, most notably rises in unemployment." 4 Debt lies at the heart of BCA's longstanding Debt Supercycle thesis. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness for monetary policy. During times of economic and/or financial stress, it was relatively easy for the Fed and other central banks to improve the situation by engineering a new credit upcycle. That all ended with the 2007-09 meltdown. Since then, even zero policy rates have been unable to trigger a strong revival in private credit growth in the major developed countries because the starting point for leverage is already elevated. Growth headwinds finally appear to be ebbing, at least in the U.S., prompting the FOMC to begin the process of "normalizing" short-term interest rates. The U.S. economy could suffer another setback in 2017 for a number of reasons. Nonetheless, the key point of this report is that the cash-flow effect of rising interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Mark McClellan Senior Vice President The Bank Credit Analyst 1 For China, the BIS only provides an estimate of the debt service ratio for the household and non-financial corporate sectors combined. 2 See: U.S. Consumer Titanic Meets the Fed Iceberg? The BCA U.S. Fixed Income Analyst, July 2004. 3 The absence of a rise in volatility of the cash flow effect is partly due to the decline in, and the volatility of, interest rates after the 1980s. 4 Guy Debelle, "Household Debt and the Macroeconomy," BIS Quarterly Review, March 2004. Appendix Charts Chart II-16, Chart II-17, Chart II-18, Chart II-19 Chart II-16U.S. Debt By Sector U.S. Debt By Sector U.S. Debt By Sector Chart II-17U.K. Debt By Sector U.K. Debt By Sector U.K. Debt By Sector Chart II-18Japan Debt By Sector Japan Debt By Sector Japan Debt By Sector Chart II-19Euro Area Debt By Sector Euro Area Debt By Sector Euro Area Debt By Sector III. Indicators And Reference Charts Global equities have been in a holding pattern so far in 2017, consolidating the gains made at the end of last year. Our key equity indicators are mixed at the moment. The Valuation indicator continues to hover at about a half standard deviation on the expensive side. The effect of the rise in global equity indexes late last year on valuation was offset by a surge in profits. Stocks are not cheap but, at this level, valuation not a roadblock to further price gains. Our Monetary indicator deteriorated further over the past couple of months, driven by a stronger dollar and higher bond yields. A shift in this indicator below the zero line would be negative for stock markets. Sentiment is also frothy, which is bearish from a contrary perspective, although our Technical indicator is positive. 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 all turned higher from a low level for the Japanese, the European and the U.S. markets. This suggests that investors, after loading up on bonds last year, have "dry powder" available to buy stocks as risk tolerance improves. The U.S. WTP has risen the fastest and is closing in on the 0.95 level. Our tests show that, historically, investors would have reaped impressive gains if they had over-weighted stocks versus bonds when the WTP was rising and reached 0.95. The WTPs suggest that the U.S. market should outperform the Eurozone and Japanese markets in the near term, although for macro reasons we still believe the U.S. will lag the other two. We expect the global stock-to-bond total return ratio to rise through this year. The latest selloff has pushed U.S. Treasurys slightly into "inexpensive" territory based on our Valuation model. Bonds are still technically oversold and sentiment remains bullish, suggesting that the consolidation phase may last a little longer. Nonetheless, we expect to recommend short-duration positions again once the overbought conditions unwind. The U.S. dollar is near previous secular peaks according to our valuation measure. Nonetheless, policy divergences are likely to drive the U.S. dollar to new valuation highs before the bull market is over. Technically overbought conditions have almost unwound, clearing the way for the next leg of the dollar bull run. Commodities have been on a tear on the back of improving and synchronized growth across the major countries (and some dollar weakness very recently). The commodity price outlook is clouded by the prospect of a border tax, which could send the U.S. dollar soaring. The broad commodity market is also approaching overbought levels. The cyclical growth outlook is positive for commodity demand, although supply factors favor oil to base metals. 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 And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And Earnings: ##br##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-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro 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 Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights President Trump is as protectionist as Candidate Trump; USD shortage to tighten global financial conditions; Go Long MXN/RMB as a tactical play on U.S.-China trade war; Brexit risks are now overstated; EU will not twist the knife. EUR/GBP is overbought; go short. Feature "We assembled here today are issuing a new decree to be heard in every city, in every foreign capital, and in every hall of power. From this day forward, a new vision will govern our land. From this moment on, it's going to be America First." U.S. President Donald Trump, January 20, 2017, Inaugural Address What are the investment implications of an "America First" world? First, it may be useful to visualize the "America Second" world that President Trump is looking to leave in the rear-view mirror. Chart 1 shows the cost of hegemony. Since the Nixon shock in 1971, the U.S. has seen its trade balance deepen and its military commitments soar, in absolute terms. For President Donald Trump, the return on American investment has been low. Wasteful wars, crumbling infrastructure, decaying factories, stagnant wages, this is what the U.S. has to show for two decades of hegemony. Chart 1United States: The Cost Of Hegemony The "What Can You Do For Me" World? The "What Can You Do For Me" World? On the other hand, the U.S. has enjoyed the exorbitant privilege of its hegemonic position. In at least one major sense, America's allies (and China) are already paying for American hegemony: through their investments in U.S. dollar assets. Chart 2 illustrates this so-called "exorbitant privilege." Despite a deeply negative net international investment position, the U.S. has a positive net investment income.1 Chart 2The "Exorbitant Privilege" The "What Can You Do For Me" World? The "What Can You Do For Me" World? Being the global hegemon effectively lowers U.S. borrowing costs and domestic interest rates, giving U.S. policymakers and consumers an "interest rate they do not deserve." That successive administrations decided to waste this privilege on redrawing the map of the Middle East and giving the wealthiest Americans massive tax cuts, instead of rebuilding Middle America, is hardly the fault of the rest of the world! Foreigners hold U.S. assets because of the size of the economy, the sustainability and deep liquidity of the market, and the perceived stability of its political system. More importantly, they hold U.S. assets because the U.S. acts as both a global defender and a consumer of last resort. If Washington were to raise barriers to its markets and become a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and decide to diversify more rapidly. Investors can interpret Trump's "America First" agenda broadly as an effort to dramatically reduce the U.S. current account deficit. Certainly we see his statements on renegotiating NAFTA, facing off against China on trade, and encouraging U.S. exports with tax legislation as parts of a broad effort aimed at improving the U.S. trade balance. If the U.S. were to pursue these protectionist policies aggressively, the end result would be a massive shortage of U.S. dollars globally, a form of global financial tightening. The rest of the world is not blind to the dangers of an America focused on reducing its current account deficit. According to the reporting of Der Spiegel magazine, Chancellor Angela Merkel sent several delegations to meet with the Trump team starting in 2015! No doubt Berlin was nervous hearing candidate Trump's protectionist talk, given that Germany runs one of the largest trade surpluses with the U.S. (Chart 3). In the last such meeting, taking place after the election was decided, Trump's son-in-law and White House advisor, Jared Kushner, asked the Germans a point-blank question, "What can you do for us?"2 In the 1980s, the U.S. asked West Germany and Japan the same question. The result was the 1985 Plaza Accord that engineered the greenback's depreciation versus the deutschmark and the yen (Chart 4). Recent comments from Donald Trump suggest that he would like to follow a similar script, where dollar depreciation does the heavy lifting in adjusting the country's current account deficit.3 Chart 3Trump's Black List Trump's Black List Trump's Black List Chart 4The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Trump administration may have dusted off the Reagan playbook from the 1980s, but the world is playing a different game in 2017. First, the Soviet Union no longer exists and certainly no longer has more than 70,000 tanks ready to burst through the "Fulda Gap" towards Frankfurt. President Trump will find China, Germany, and Japan less willing to help the U.S. close its current account deficit, particularly if Trump continues his rhetorical assault on everything from European unity to Japanese security to the One China policy. Second, China, not U.S. allies Germany and Japan, has the largest trade surplus with the U.S. It is very difficult to see Beijing agreeing to a coordinated currency appreciation of the RMB, particularly when it is being threatened with a showdown over Taiwan and the South China Sea. Third, even if China wanted to kowtow to the Trump administration, it is not clear that RMB appreciation can be engineered. The country's capital outflows have swelled to a record level of $205 billion (Chart 5) and the PBoC has continued to inject RMB into the banking system via outright lending to banks and open-market operations (Chart 6). Unlike Japan in 1985, China is at the peak of its leveraging cycle and thus unwilling to see its currency - and domestic interest rates - appreciate. At best, Beijing can continue to fight capital outflows and close its capital account. But even this creates a paradox, since the U.S. administration can accuse it of currency manipulation even if such manipulation is preventing, not enabling, currency depreciation!4 Chart 5China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows Chart 6PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity To conclude, the world is (re)entering a mercantilist era and sits at the Apex of Globalization.5 The new White House is almost singularly focused on bringing the U.S. current account deficit down. It intends to do this by means of three primary tools: Protectionism: The Republicans in the House of Representatives have proposed a "destination-based border adjustment tax," which would effectively subsidize exports and tax imports. (It would levy the corporate tax on the difference between domestic revenues and domestic costs, thus giving a rebate to exporters who make revenues abroad while incurring costs domestically.)6 While the proponents of the new tax system argue it is equivalent to the VAT systems in G7 economies, the change would nonetheless undermine America's role as "the global consumer of last resort." In our view, it would be the opening salvo of a global trade war. Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. He has also insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption. (Details are scant: His Treasury Secretary Steven Mnuchin has denied an across-the-board tax of this nature, but has confirmed that one would apply to specific companies.) Structural Demands: Trump's approach suggests that he wishes to force structural changes on trade surplus economies in order to correct structural imbalances in the American economy - and in this process he is not adverse to lobbing strategic threats. While he holds out the possibility of charging China with currency manipulation, in fact he can draw from a whole sheet of American trade grievances not limited to the currency to demand major changes to their trade relationship. The fundamental problem for the global economy is that in order to reduce the U.S. current account deficit, the world must experience severe global tightening. Dollars held by U.S. multinationals abroad, which finance global credit markets, will come back to the U.S. and tighten liquidity abroad. And emerging market corporate borrowers who have overextended themselves borrowing in U.S. dollars will struggle to repay debts in appreciating dollars. These structural trends are set to exacerbate an already ongoing cyclical process. As BCA's Emerging Markets Strategy has recently pointed out, global demand for U.S. dollars is rising faster than the supply of U.S. dollars.7 Our EM team's first measure of U.S. dollar liquidity is "the sum of the U.S. monetary base and U.S. Treasury securities held in custody for official and international accounts." The second measure "is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents." As Chart 7 and Chart 8 illustrate, both calculations indicate that dollar liquidity is in a precipitous decline already. Meanwhile, foreign official holdings of U.S. Treasury securities is contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart 9). Chart 7Dollar Liquidity Declining... Dollar Liquidity Declining... Dollar Liquidity Declining... Chart 8... Any Way You Look At It ... Any Way You Look At It ... Any Way You Look At It Chart 9Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Chart 10It Hurts To Borrow In USD It Hurts To Borrow In USD It Hurts To Borrow In USD Concurrently, U.S. dollar borrowing costs continue to rise (Chart 10). Our EM team expects EM debtors with U.S. dollar liabilities to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Near-term U.S. dollar appreciation will only reinforce and accelerate the mercantilist push in the White House and Congress. President Trump and the GOP in the House will find common ground on the border-adjustment tax, which Trump recently admitted he did not understand or look favorably upon. The passage of the law, or some such equivalent, has a much greater chance than investors expect. So does a U.S.-China trade war, as we argued last week.8 How should investors position themselves for the confluence of geopolitical, political, and financial factors we have described above? The world is facing both the cyclical liquidity crunch that BCA's Emerging Markets Team has elucidated and the potential for a secular tightening as the Trump administration focuses its efforts on closing the U.S. current account deficit. Five investment implications are top of our mind: Chart 11Market Response To Trump Win On High End Market Response To Trump Win On High End Market Response To Trump Win On High End Chart 12Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Buy VIX. The S&P 500 has continued to power on since the election, buoyed by positive economic surprises, strong global earnings, and the hope of a pro-business shift in the White House. The equity market performance puts the Trump presidency in the upper range of post-election market outcomes (Chart 11). However, with 10-year Treasuries back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is pricing none of the political and geopolitical risks of an impending trade war between the U.S. and China, nor is it pricing the general mercantilist shift in Washington D.C. (Chart 12). As a result, we recommend that clients put on a "mercantilist hedge," like deep out-of-the-money S&P 500 puts, or VIX calls. For instance, a long VIX 20/25 call spread for March expiry. Long DM / Short EM. Mercantilism and the U.S. dollar bull market are the worst combination possible for EM risk assets. We therefore reiterate our long-held strategic recommendation of being long developed markets / short emerging markets. Overweight Euro Area Equities. Investors should overweight euro area equities relative to the U.S. As we have discussed in the 2017 Strategic Outlook, political risks in Europe this year are a red herring.9 We will expand on the upcoming French elections in next week's report. Meanwhile, investors appear complacent about protectionism and what it may mean for the S&P 500, which sources 44% of its earnings abroad. European companies, on the other hand, could stand to profit from a China-U.S. trade war. Chart 13Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Chart 14Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Long MXN/RMB. As a tactical play on the U.S.-China trade war, we recommend clients go long MXN/RMB (Chart 13). The peso is now as cheap as it was in early 1995, at the heights of the Tequila Crisis, as per the BCA's Foreign Exchange Strategy model (Chart 14). While Mexico remains squarely in Trump's crosshairs on immigration and security, the damage to the currency appears to be done and has ironically made the country's exports more competitive. In addition, Trump's pick for Commerce Secretary, Wilbur Ross, has informed his NAFTA counterparts that "rules of origin" will be central to NAFTA re-negotiation. This can be interpreted as the U.S. using every tool at its disposal to impose punitive measures on China, including forcing NAFTA partners to close off the "rules of origin" loophole.10 But the reality is that the U.S. trade deficit with its NAFTA partners is far less daunting than that with China (Chart 15). Meanwhile, we remain negative on the RMB for fundamental reasons that we have stressed in our research. Small Is Beautiful. We continue to recommend that clients find protection from rising protectionism in small caps. Small caps are traditionally domestically geared irrespective of their domicile. Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, also points out that small caps in the U.S. will benefit as the new administration follows through with promised corporate tax cuts, which will benefit small caps disproportionally to large caps given that the effective tax rate of multinationals is already low. Moreover, small companies will benefit most from any cuts in regulations, most of which have been written by multinationals in order to create barriers to entry (Chart 16). Of course, we could just be paranoid! After all, much of Trump's proposed policies - massive tax cuts, infrastructure spending, major rearmament, the border wall - would increase domestic spending and thus widen the current account deficit, not shrink it. And all the protectionism and de-globalization could just be posturing by the Trump administration, both to get a better deal from China and Europe and to give voters in the Midwest some political red meat. Chart 15China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs Chart 16Small Is Beautiful Small Is Beautiful Small Is Beautiful But Geopolitical Strategy analysts get paid to be paranoid! And we worry that much of Trump's promises that would widen U.S. deficits are being watered down or pushed to the background. Yes, we have held a high conviction view that infrastructure spending would come through, but now it appears that it will be complemented with significant spending cuts. The next 100 days will tell us which prerogatives the Trump Administration favors: rebuilding America directly, or doing so indirectly via protectionism. If the former, then the current market rally is justified. If the intention is to reduce the current account deficit, look out. Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Brexit: A Brave New World Miranda: O brave new world! Prospero: 'Tis new to thee. — Shakespeare, The Tempest The U.K. Supreme Court ruled on January 24 that parliament must have a say in triggering Article 50 of the Lisbon Treaty, which enables the U.K. to "exit" the European Union. This decision, as well as Theresa May's January 17 "Brexit means exit" speech, caught us in London while visiting clients. Reactions were mixed. The pound continues to rally. January 16 remains the low point in the GBP/USD cross since the vote to leave on June 23 last year (Chart 17). Chart 17Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Should investors expect more downside to the pound or do the recent events mark a bottom in political uncertainty? The market consensus suggests that further volatility in the pound is warranted for three reasons: Europeans will seek to punish the U.K. for Brexit, to set an example to their own Euroskeptics; Prime Minister May's assertion that the U.K. would seek to exit the common market is negative for the country's economy; Legal uncertainties about Brexit remain. We disagree with this assessment, at least in the short and medium term. Therefore, the pound rally on the day of May's speech was warranted, although we agree that exiting the EU Common Market will ultimately be suboptimal for the country's economy. First, by setting out a clean break from the EU, including the common market, Prime Minister May has removed a considerable amount of political uncertainty. As we pointed out in our original net assessment of Brexit, leaving the EU while remaining in its common market is illogical.11 Paradoxically, the U.K. stood to lose rather than regain sovereignty if it left the EU yet remained in the common market (Diagram 1). Diagram 1The Quite Un-British Lack Of Common Sense Behind Soft Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? Why? Because membership in the common market entails a financial burden, full adoption of the acquis communautaire (the EU body of law), and acceptance of the "Four Freedoms," including the freedom of movement of workers. Given that the Brexit vote was largely motivated by concerns of sovereignty and immigration (Chart 18), it did not make sense to vote to leave the EU and then seek to retain membership in the common market. Apparently May and her cabinet agree. Chart 18It's Sovereignty, Stupid! The "What Can You Do For Me" World? The "What Can You Do For Me" World? Second, now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe, à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. An FTA arrangement will be beneficial to EU exporters, who want access to the U.K. market, and it will send a message to Euroskeptics on the continent that there is no alternative to full membership. Leaving the EU means leaving the market and falling back - at best - to an FTA-level relationship that the EU shares with Mexico and (most recently) Canada. Third, leaving the EU and the common market are political, not legal, decisions, and the lingering legal battles are neither avoidable nor likely to be substantive. Theresa May had already stolen thunder when she said that the final deal with the EU would be put to a vote in parliament. The Supreme Court ruling - as well as other legal hangups - could conceivably give rise to complications that bind the government's hands, but most likely parliament will pass a simple bill or motion granting permission for the government to invoke Article 50. That is because the referendum, and public opinion since then, speak loud and clear (Chart 19). The Conservative Party remains in a comfortable lead over the Labour Party (Chart 20), which itself is not opposing the referendum outcome. In addition, the House of Commons has already approved the government's Brexit timetable by a margin of 372 seats in a 650-seat body - with 461 ayes. That is a stark contrast with a few months ago when around 494 MPs were said to be against Brexit. Chart 19No 'Bremorse' Or 'Bregret' The "What Can You Do For Me" World? The "What Can You Do For Me" World? Chart 20Tories Still Triumphant Tories Still Triumphant Tories Still Triumphant The bigger question comes down to the parliamentary vote on the deal that is to be negotiated over the next two years. Could the Parliament vote down the final agreement with the EU? Absolutely. However, it is unlikely. The economic calamity predicted by many commentators has not happened, as we discuss below. Bottom Line: The combination of the Supreme Court decision and Prime Minister May's speech has reduced political uncertainty regarding Brexit. The EU will negotiate hard with the U.K., but the main cause of consternation - the U.K. asking for special treatment with respect to the common market - is now off the table. Yes, the EU does hold all the cards when it comes to negotiating an FTA agreement, and the process could entail some alarming twists and turns (given the last-minute crisis in the EU-Canada FTA). But we do not expect EU-U.K. negotiations to imperil the pound dramatically beyond what we've already seen. Will Leaving The Common Market Hurt Britain? Does this mean that Brexit is "much ado about nothing?" In the short and medium term, we think the answer is yes. In the long-term, leaving the EU Common Market is a suboptimal outcome for three reasons: Trade - Net exports rarely contribute positively to U.K. growth (Chart 21) and the trade deficit with the EU is particularly deep. As such, proponents of Brexit claim that putting up modest trade barriers against the EU could be beneficial. However, the U.K. has a services trade surplus with the EU (Chart 22). While it is not as large as the trade deficit, there was hope that the eventual implementation of the 2006 EU's Services Directive would have opened up new markets for U.K.'s highly competitive services industry and thus reduced the trade deficit over time. As the bottom panel of Chart 22 shows, the U.K.'s service exports to the rest of the world have outpaced those to the EU, suggesting that there is much room for improvement. This hope is now dashed and the EU may go back to putting up non-tariff barriers to services that reverse Britain's modest surplus with the bloc. Free Trade Agreements rarely adequately cover services, which means that the U.K.'s hope of expanding service exports to a new high is probably gone. Chart 21U.K. Is Consumer-Driven U.K. Is Consumer-Driven U.K. Is Consumer-Driven Chart 22Service Exports At Risk After Brexit Service Exports At Risk After Brexit Service Exports At Risk After Brexit Foreign Investment - FDI is declining, whether for cyclical reasons or because foreign companies fear losing access to Europe via the U.K. It remains to be seen how FDI will respond to the U.K.'s renunciation of the common market, but it is unlikely to be positive (Chart 23). The U.K.'s financial sector will also be negatively impacted since leaving the common market will mean that London will no longer have recourse to the EU judiciary in order to stymie European protectionism.12 This is unlikely to destroy London's status as the global financial center, but it will impact FDI on the margin. Labor Growth - The loss of labor inflow will be the biggest cost of Brexit. A decrease of immigration from the EU could reduce the U.K.'s labor force growth by a maximum of two-thirds, translating to a 25% loss in the potential GDP growth rate (Chart 24). While the U.K. is not, in fact, closing off all immigration, labor-force growth will decline, and potential GDP with it. Chart 23FDI To Suffer From Brexit? FDI To Suffer From Brexit? FDI To Suffer From Brexit? Chart 24Labor Growth Suffers Most From Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? In addition, the EU Common Market forces companies to compete for market share in the developed world's largest consumer market. This competition is supposed to accelerate creative destruction and thus productivity, while giving the winners of the competition the spoils, i.e. a better ability to establish "economies of scale." In a 2011 report, the Bank of International Settlements (BIS) published an econometric study that compared four scenarios: the U.K. remains in the common market as the EU fully liberalizes trade; the U.K. remains in the EU's single market, but does not fully liberalize trade with the rest of the EU; the U.K. leaves the common market; the U.K. enters NAFTA.13 Of the four scenarios, only the first leads to an increase in wealth for the U.K., with 7.1% additional GDP over ten years. U.K. exports would increase by 47%, against 38.1% for its imports. Wages of both skilled and unskilled workers would increase as well. Meanwhile, the report finds that closer integration with NAFTA would not compensate for looser U.K. ties with the EU. In fact, the U.K. national income would be 7.4% smaller if the U.K. tied up with NAFTA instead of taking part in further trade liberalization on the continent. Why rely on a 2011 report for the assessment of benefits of the common market? Because it was written by a competent, relatively unbiased international body and predates the highly politicized environment surrounding Brexit that has since infected almost all think-tank research. And yet the more recent research echoes the 2011 report in terms of the negative consequences of leaving the common market.14 In addition, the BIS study actually attempts to forecast the benefit of further removing trade barriers in the single market, which is at least the intention of the EU Commission. That said, our concerns regarding the U.K. economy are long-term. It may take years before the full economic impact of leaving the common market can be assessed. In addition, much of our analysis hinges on the Europeans fully liberalizing the common market and removing the last remaining non-tariff barriers to trade, particularly of services. At the present-day level of liberalization, the U.K. may benefit by leaving. In addition, we do not expect a balance-of-payments crisis in the U.K. any time soon. The U.K. current account is deeply negative, unsurprisingly so given the deep trade imbalance with the EU and world. However, our colleague Mathieu Savary, Vice-President of BCA's Foreign Exchange Strategy, has pointed out that the elasticity of imports to the pound is in fact negative, a very surprising result. This reflects an extremely elevated import content of British exports. A lower pound is therefore unlikely to be the most crucial means of improving the current-account position. Certainly leaving the common market will not improve the competitiveness of British exports in the EU. Chart 25The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy But this raises a bigger question: why does the U.K. have to improve its current account deficit? As our FX team points out in Chart 25, despite having a current-account deficit of nearly 6% of GDP, the U.K. runs a basic balance-of-payments surplus of 12%, even after the recent fall in FDI inflows. The reason for the massive balance-of-payments surplus is the financial account surplus of 6.17% of GDP, a feature of the U.K. being a destination for foreign capital, which flows from its status as a global financial center and prime real estate destination. In other words, leaving the common market will not change the fundamentals of the U.K. balance of payments much. The country will remain a global financial center and will still run a capital account surplus, which will suppress the country's interest rates, buoy the GBP, and give tailwinds to imports of foreign goods. Meanwhile, exports will not benefit as they will face marginally higher tariffs as the country exits the EU Common Market. At best, new tariffs will be offset by a cheaper GBP. As such, leaving the common market is not going to be a disaster for the U.K. Nor will it be a panacea for the country's deep current account deficit. And that is okay. The U.K. will not face a crisis in funding its current account deficit. What is clear is that for the time being, the U.K. economy is holding up. Our forex strategists recently argued that U.K.'s growth has surprised to the upside and that the improvement is sustainable: Monetary and fiscal policy are both accommodative (Chart 26); Inflation is limited; Tight labor market drives up wages and puts cash in consumers' pockets (Chart 27); Credit growth remains robust (Chart 28). Chart 26Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Chart 27British Labor Market Tightening British Labor Market Tightening British Labor Market Tightening Chart 28U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good This means that the political trajectory is set for the time being. "Bremorse" and "Bregret" will remain phantoms for the time being. Bottom Line: Leaving the common market is a suboptimal but not apocalyptic outcome for the U.K. The combination of decent economic performance and lowered political uncertainty in the near term will support the pound. Given the pound's 20% correction since the June referendum, we believe that the market has already priced in the new, marginally negative, post-Brexit paradigm. The Big Picture It is impossible to say whether the long-term negative economic effects of Brexit will affect voters drastically enough and quickly enough for Scotland, or parliament, to act in 2018 or 2019 and modify the government's decision to pursue a "Hard Brexit." It seems conceivable if something changes in the fundamental dynamics outlined above, but we wouldn't bet on it. At the moment even a new Scottish referendum appears unlikely (Chart 29). Scottish voters have soured on independence, perhaps due to a combination of continued political uncertainty in the EU (Scotland's political alternative to the U.K.) and a collapse in oil prices (arguably Scotland's economic alternative to the U.K.). The issue is not resolved but on ice for the time being. Chart 29Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) More likely, the government will get its way on Brexit and the 2020 elections will mark a significant popular test of the Conservative leadership and the final deal with the EU. Then the aftermath will be an entirely new ballgame for the U.K. and all four of its constituent nations. If Britain's new beginning is founded on protectionism and dirigisme - as the government suggests - then the public is likely to be disappointed. The "brave new world" of Brexit may prove to be rather mundane, disappointing, and eerily reminiscent of the ghastly 1970s.15 Hence the Shakespeare quote at the top of this report. The political circumstances of Brexit resemble the U.K. landscape before it joined the European Economic Community in 1973: greater government role in the economy, trade protectionism, tight labor market, higher wages, and inflation. Yet this was a period when the U.K. economy underperformed Europe's. The U.K.'s eventual era of outperformance was contingent on the structural reforms of the Thatcher era and expanded access to the European market (Chart 30). It remains to be seen what happens when the U.K. leaves the market and rolls back Thatcherite reforms. The weak pound and proactive fiscal policy will fail to create a manufacturing revolution. That is because most manufacturing has hollowed out because of automation, not foreign workers stealing Britons' jobs. Moreover, as for the pound, it is important to remember that currency effects are temporary and any boost to exports that the weak pound is generating will be short-lived, as with the case of China in the 1990s and the EU in the past two years (Chart 31). Chart 30U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? Chart 31Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting In addition, we would argue that, in an environment of de-globalization - in which tariffs are rising, albeit slowly for the time being (Chart 32) - the EU Common Market provides Europe with a mechanism by which to protect its vast consumer market. The U.K. may have chosen the precisely wrong time in which to abandon the protection of continental European protectionism. It could suffer by finding itself on the outside of the common market as global tariffs begin to rise significantly. Chart 32Protectionism On The March The "What Can You Do For Me" World? The "What Can You Do For Me" World? What about the restoration of the "Special Relationship" between the U.K. and the U.S.? Could moving to the "front of the queue" on negotiating an FTA with the world's largest economy make a difference for the U.K.? Perhaps, but as the BIS study above indicates, an FTA with North America or the U.S. alone is unlikely to replace the benefits of the common market. In addition, it is difficult to imagine how a protectionist U.S. administration that is looking to massively decrease its current account deficit will help the U.K. expand trade with the U.S. By contrast, Trump's election in the United States poses massive risks to globalization, both through his protectionism and the strong USD implications of his core policies. This will reverberate negatively across the commodities and EM space. In such an environment, the U.K. may not be able to make much headway in its "Global Britain" initiatives to conclude fast trade deals with EM economies that stand to lose the most in the de-globalization era. Bottom Line: As a trading nation, the U.K. is likely to lose out in a prolonged period of de-globalization. Membership in the EU could have served as a bulwark against this global trend. Investment Implications We diverge from our colleagues in the Foreign Exchange Strategy and European Investment Strategy when it comes to the assessment of political risk looming over Brexit.16 The decision to leave the common market will alleviate the pressure on Europeans to seek vindictive punishment. Earlier, the U.K. was forcing them to choose between making an exception to the rules and demonstrating the negative consequences of leaving the bloc. Now the U.K. is self-evidently taking on its own punishment - the economic burden of leaving the common market - and the EU will probably deem that sufficient. Will the EU play tough? Yes, especially since the EU retains considerable economic leverage over Britain (Chart 33). But the stakes are far smaller now. Furthermore, investors should remember that core European states - especially France and Germany - remain major military allies of the U.K. and will continue to be deeply intertwined economically. As such, we believe that the pound has already priced in the new economic paradigm and that the expectations of political uncertainty ahead of the U.K.-EU negotiations may be overdone. We therefore recommend that investors short EUR/GBP outright. Our aforementioned forex strategist Mathieu Savary argues that, on an intermediate-term basis, the outlook for this cross is driven by interest rate differentials and policy considerations. Due to the balance-sheet operations conducted by the BoE and ECB, interest rates in the U.K. and the euro area do not fully reflect domestic policy stances. Instead, Mathieu uses the shadow rates. Currently, shadow rates unequivocally point toward a lower EUR/GBP (Chart 34). In fact, balance-sheet dynamics point toward shorting EUR/GBP. Chart 33EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation Chart 34Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP For full disclosure, Mathieu cautions clients to wait on executing a short EUR/GBP until after Article 50 is enacted. By contrast, we think that political uncertainty regarding Brexit likely peaked on January 16. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com 1 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive a much lower return on U.S. assets while the U.S. benefits from risk premia in foreign markets. 2 Please see Spiegel Online, "Donald Trump and the New World Order," dated January 20, 2017, available at Spiegel.de. 3 In a widely-quoted interview with The Wall Street Journal, Donald Trump said that the U.S. dollar is "too strong." He continued that, "Our companies can't compete with [China] now because our currency is too strong. And it's killing us." Please see The Wall Street Journal, "Donald Trump Warns on House Republican Tax Plan," dated January 16, 2017, available at wsj.com. 4 We would note that the Trump administration and its Treasury Department have considerable leeway over how they choose to interpret China's foreign exchange practices. In 1992, when the U.S. government last accused China of currency manipulation, it issued a warning in its spring report before leveling the accusation in the winter report. The RMB did not depreciate in the meantime but remained stable, and Treasury noted this approvingly; however, Treasury chose 1989 as the base level for its assessment, and found manipulation. The Trump administration could use much more aggressive interpretive methods than this to achieve its ends. 5 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 6 Please see BCA 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. 7 Please see BCA Emerging Markets Strategy Weekly Report, "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 10 Critics, including Trump supporters, claim that NAFTA sets too low of a threshold for the domestic content of a good deemed to have originated within the NAFTA countries. Goods that are nearly 40% foreign-made can thus be treated as NAFTA-made. This is one of many contentious points in the trade deal. 11 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 12 In 2015, the U.K. took the ECB to court over its decision to require financial transactions denominated in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue of legal redress will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that corral the financial industry - or at least to the parts focused on transactions in euros - out of London. 13 Please see Bank of International Settlements, "The economic consequences for the U.K. and the EU of completing the Single Market," BIS Economics Paper No. 11, dated February 2011, available at www.gov.uk. 14 Please see Her Majesty's Government, "H.M. Treasury Analysis: The Long-Term Economic Impact Of EU Membership And The Alternatives," Cmnd. 9250, April 2016, available at www.gov.uk. and Jagjit S. Chadha, "The Referendum Blues: Shocking The System," National Institute Economic Review 237 (August 2016), available at www.niesr.ac.uk. 15 We were going to use "grey" to describe Britain in the 1970s. However, our colleague Martin Barnes, BCA's Chief Economist, insisted that "grey" did not do the "ghastly" 1970s justice. When it comes to the U.K. in the 1970s, we are going to defer to Martin. 16 Please see BCA Research European Investment Strategy Weekly Report, “May’s Brexit Speech: No Substance,” dated January 19, 2017, available at eis.bcaresearch.com. Geopolitical Calendar

Highlights U.S. Investment Grade (IG): We recommend overweights in Energy, Financials, Airlines, Building Materials within an overall neutral allocation to U.S. Investment Grade. Euro Area IG: Maintain overweights in Euro Area IG vs U.S. equivalents, favoring Energy, Financials and Wireless sectors. U.K. IG: Maintain an above-benchmark stance on U.K. IG, favoring Banks, Technology and Telecommunications sectors. Feature Last September, we introduced a new element to the BCA Global Fixed Income Strategy investment framework - translating our views on individual bond markets into a model portfolio. This was intended to be a tool providing something closer to a "real world" percentage allocation among the various countries and sectors that we cover, more in line with the day-to-day decisions faced by a typical bond manager. We came up with a custom benchmark for that portfolio, combining government debt, corporate bonds and other spread products from the major developed economies. We used the market capitalization weightings of the Bloomberg Barclays bond indices to determine the relative size of each sector. Our chosen benchmark index goes into considerable detail for our government bond allocations, with several maturity buckets, to allow for more precision in our overall country and duration calls. As the next step in the evolution of our model portfolio framework, we are adding a detailed sectoral breakdown of the Investment Grade (IG) corporate bond universes for the U.S., Euro Area and U.K. This will provide more granularity in our IG recommendations, and give our clients additional investment ideas beyond our major portfolio allocation calls. Going forward, we will provide a regular update of our sector allocations in our first Weekly Report published each month. For this week, we are recommending sectors that have cheaper valuations but with riskiness close to the overall IG indices where spreads remain tight. For example, in the U.S., overweight Energy within an overall neutral IG allocation; in the Euro Area, overweight Wireless within an overall above-benchmark IG allocation; and in the U.K., overweight Basic Industries within an overall above-benchmark IG allocation (Chart of the Week). Chart of the WeekSome Of Our Preferred IG Sectors Some Of Our Preferred IG Sectors Some Of Our Preferred IG Sectors A Brief Description Of Our Sectoral Relative Value Framework Our existing sector relative value methodology assesses the attractiveness of each IG sector within a cross-sectional analysis. The option-adjusted spread (OAS) for each sector is regressed against common risk factors (interest rate duration and credit quality) with the residual spread determining the valuation of each sector. As an additional measure of the overall riskiness of each sector, we use the concept of "duration times spread" (DTS). We have shown in previous research that allocating to sectors in an IG corporate bond portfolio using a DTS weighting scheme produces better risk-adjusted returns with lower drawdown risk.1 It is our plan to eventually incorporate DTS-weightings into our asset allocation framework more directly, as we build out our model portfolio infrastructure to include quantitative risk management metrics. For now, we will look at the relationship between the OAS residuals from our sector relative value models to the DTS of each sector to give a reading on the risk/reward tradeoff for each sector. In some cases, we may not wish to overweight sectors with cheap spreads (positive residuals in our model) that have an above-average DTS, if we are relatively more cautious on taking overall spread risk. The opposite could also occur, where we could overweight sectors that do not have positive spread residuals but have a DTS close to our desired level of credit risk. At the moment, we see overall IG spreads as fully valued in the U.S., Europe and the U.K., so we are aiming for sectors with credit risk closer to the levels of the benchmark indices. Therefore, in the absence of any strong sector-specific views, we are looking for sectors with positive residuals from our relative value model, but with a DTS close to the level of the overall IG index for each region. U.S. Investment Grade - Stay Cautious In Sector Allocations, Except For Energy In Table 1, we present the output of our U.S. IG sector valuation model. The index OAS, model residual ("risk-adjusted valuation"), and DTS is provided for each sector. In addition, a four-letter abbreviation is shown which is used in Chart 2, a scatter diagram showing the residuals versus the DTS for all the sectors. TABLE 1U.S. Investment Grade Corporate Sector Valuation* Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Within the U.S. IG universe, our valuation model shows spreads are attractive in sectors within Basic Industry (most notably, Metals & Mining and Paper), Building Materials, Energy (most notably, Independent, Refining and Midstream), Communications (most notably, Cable & Satellite and Wireless), Airlines and Financials (most notably, Brokerages/Asset Mangers/Exchanges, Finance Companies, Life Insurers and Property/Casualty Insurers). Among those sectors, the names that have a DTS relatively close to, or lower than, the overall U.S. IG index DTS are: Finance Companies, Building Materials, Airlines, and Brokerages/Asset Managers/Exchanges. These are also sectors with an absolute (non-risk-adjusted) OAS above that of the overall U.S. IG index, adding to their attractiveness. Despite our overall cautiousness on spread risk, the Energy-related sectors represent a special case where we would consider overweighting these higher DTS names. As global oil markets have rebalanced in the latter half of 2016, the subsequent rise in oil prices helped reduce the large risk premiums that had built up in Energy corporate debt (both IG and high-yield). BCA's Commodity strategists see oil prices holding up well over the next year, trading in a range between $50/bbl and $65/bbl for the Brent benchmark. In that scenario, we see a full convergence of the spread between Energy related names and the U.S. IG index, which makes the case for overweighting the cheaper Energy sub-sectors a compelling one, even with the higher risk as measured by DTS. This is particularly true given the large weighting of those names in the overall IG benchmark (just over 6%). Therefore, in our recommended U.S. IG sector allocation, we are adding overweights in Independent Energy, Refining and Midstream to the other names mentioned above. The actual percentage sector allocations for our model portfolio are shown in Table 2. The table is presented in a similar format to the model portfolio tables that we present in the back of our Weekly Reports. The weightings reflect all the investment goals outlined above, including the preferred overweights, while delivering a portfolio DTS that is equal to the overall IG index DTS of 9. Bottom Line: We recommend overweights in Energy, Financials, Airlines, Building Materials within an overall neutral allocation to U.S. Investment Grade. Chart 2U.S. Investment Grade Corporate Sector Risk Vs Reward* Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework TABLE 2Our Recommended U.S. IG Corporate Sector Portfolio Allocation Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Euro Area Investment Grade - Overweight Vs U.S., Favoring Wireless, Energy & Financials In Table 3, we show the output for our Euro Area IG sector model and, in an identical fashion to the U.S. IG analysis above, we show a scatter diagram showing the model residuals versus the sector DTS scores in Chart 3. TABLE 3Euro Area Investment Grade Corporate Sector Valuation* Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Chart 3Euro Area Investment Grade Corporate Sector Risk Vs Reward* Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework In this case, we are sticking with our current model portfolio recommendation to overweight Euro Area IG, but while maintaining the same relatively cautious stance towards the DTS exposure given tight overall spread levels. Our call to overweight European IG is a relative one versus U.S. IG, given the stronger signals given by our relative Corporate Health Monitors and the ongoing presence of European Central Bank corporate bond asset purchases (Chart 4). Within Euro Area IG, the cheapest valuations within our model framework are among the Financials - specifically, within the Insurance sectors. The Insurers, however, have very high DTS scores relative to the overall index, and thus we are choosing not to overweight the names despite the wider risk-adjusted spreads on offer. From a fundamental perspective, higher Euro Area interest rates will be required to make us turn more bullish on the Insurers, which is an outcome that we do not anticipate until at least the latter half of 2017. We are recommending overweights in sectors with non-zero model residuals that have relatively neutral DTS scores: Wireless, Packaging, Integrated Energy, Banks, Brokerages/Asset Managers/Exchanges, and Other Finance. Our recommended Euro Area IG sector allocations are presented in Table 4, with the weighted DTS of our portfolio in line with the index DTS of 6. Bottom Line: Maintain overweights in Euro Area IG vs U.S. equivalents, favoring Energy, Packaging, Financials and Wireless sectors. Chart 4Continue To Favor Europe IG Over U.S. IG Continue To Favor Europe IG Over U.S. IG Continue To Favor Europe IG Over U.S. IG TABLE 4Our Recommended Euro Area IG Corporate Sector Portfolio Allocation Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework U.K. Investment Grade - Stay Overweight, Focusing on Financials, Technology & Telecommunications Table 5 contains the output from our U.K. IG sector model, while the scatter diagram of model residuals versus DTS scores is in Chart 5. Again, the Insurers look attractive in the U.K. as in the Euro Area, but the high DTS score deters us from overweightings these names. Banks and Other Financials look attractive, with lower DTS scores, as does the debt of Metals & Mining, Cable & Satellite, Wireless, & Technology. TABLE 5U.K. Investment Grade Corporate Sector Valuation* Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Chart 5U.K. Investment Grade Corporate Sector Risk Vs Reward* Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework We continue to recommend an above-benchmark allocation to U.K. IG within out model portfolio, given the highly stimulative monetary settings in the U.K. (low interest rates, a deeply undervalued currency), as well as the continued presence of Bank of England corporate bond asset purchases. Our recommended allocation within the above-benchmark allocation to U.K. IG can be found in Table 6. Again, we sought an overall DTS score in line with the U.K. IG DTS of 12. Bottom Line: Maintain an above-benchmark stance on U.K. IG, favoring Banks, Technology and Telecommunications sectors. TABLE 6Our Recommended U.K. IG Corporate Sector Portfolio Allocation Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Bond Strategy/Global Fixed Income Strategy Special Report, "Managing Bond Portfolios In A Rising Spread Environment, Part 1: Choosing The Right Benchmark", dated September 1, 2015, available at usbs.bcaresearch.com and gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework Adding Investment Grade Corporate Bond Sectors To Our Model Portfolio Framework

Dear client, This week, we are sending you an abbreviated version of our weekly bulletin as we are also publishing a piece written by our colleague Peter Berezin, Senior Vice President for our Global Investment Strategy service. This report, titled “U.S. Border Adjustment Tax: A Potential Monster Issue For 2017”, deals in great details with the Republican tax plans. In this report, Peter analyses the economic and financial market implications of the plan and concludes it is likely to be an additional support to the dollar bull market if it gets implemented in full, but not one without repercussions. I trust you will find this report very interesting and relevant. Best regards, Mathieu Savary Feature After continuing to sell off, the dollar regained some composure toward the end of the week. Not only did an elevated CPI print for December contribute to this rally, but so did Fed Chair Janet Yellen's comment that the U.S. economy was getting closer to the FOMC objectives and that the Fed was now closer to being capable of raising rates multiple times a year between now and 2019. Chart 1Froth Had Dissipated##br## From Treasury Yields Froth Had Dissipated From Treasury Yields Froth Had Dissipated From Treasury Yields Additionally, we had been expecting a correction in the dollar as we worried that U.S. bond yields would retrace some of their ascent. The pullback materialized and U.S. bond yields traded in line with our fair value estimate earlier this week (Chart 1). This meant that much of the froth in the dollar had dissipated. Based on these developments, is it time to buy the dollar again? On a cyclical basis, the dollar will make new highs in 12-18 months. However, short-term considerations remain complex. There are two President Trump out there: "Good Trump" and "Bad Trump". Good Trump is a president that talks about deregulation and tax cuts as well as various stimulus measures. This is the president that turbo charged the dollar after the election on hopes of a stronger U.S. economy. Bad Trump is the campaign Trump, the populist president that wants to revive protectionism and that promotes acrimonious international relations between the U.S. and the rest of the world, China in particular. The markets had expected Good Trump to be the first Trump to emerge, yet, the new president seems to have elected to present his Bad Trump profile first. In a way, this makes sense. Trump is focusing on the more economically painful parts of his program, campaign promises wanted by his electorate. This way, Good Trump can swoosh in and save the day by helping the economy closer to the mid-term election in late 2018, in the aim of solidifying the Republican control of Congress. With the 10-year yield back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is not pricing in any flare up of tensions with China, nor any deflationary shock that could emanate from such tensions (Chart 2). Investors were hoping that the talks of stimulus and deregulation would come first, instead they are getting a president that bullies corporations and build up tensions in Asia. The deflationary nature of the tension comes from the reality that while the Chinese economy has improved, China remains handicapped by a large debt load and a low demand for credit. It is ill equipped to handle foreign shocks. Moreover, the easing in Chinese monetary conditions will soon lose steam. Chinese monetary conditions eased because Chinese real rates fell from nearly 12% to -2% on the back of a powerful rebound in the Chinese producer prices (PPI) (Chart 3). This improvement in PPI was itself a byproduct of a rebound in commodity inflation. However, this rebound is soon behind us. Commodity prices troughed in Q1 2016, and have recently slowed their pace of ascent. This means that in the coming months, Chinese PPI will rollover as well and Chinese real borrowing costs will rise again (Chart 4). Chart 2All Must ##br##Go Well All Must Go Well All Must Go Well Chart 3Can Chinese Monetary ##br##Conditions Improve Further? Can Chinese Monetary Conditions Improve Further? Can Chinese Monetary Conditions Improve Further? Chart 4The Commodity Rebound Was A Key Factor##br## Behind The Chinese PPI Rebound The Commodity Rebound Was A Key Factor Behind The Chinese PPI Rebound The Commodity Rebound Was A Key Factor Behind The Chinese PPI Rebound This could prove problematic for China where loan demand remains very tepid, pointing to a potential down leg in Chinese industrial activity (Chart 5). This also raises the specter of renewed devaluation pressures on the Chinese yuan, as this would create another valve to alleviate deflationary pressures in the Chinese economy (Chart 6). Further RMB weakness would be welcomed neither by Trump, nor by the markets. Chart 5Chinese Loan Demand ##br##Remains Moribund Chinese Loan Demand Remains Moribund Chinese Loan Demand Remains Moribund Chart 6The RMB Is Another Relief Value For##br## Chinese Deflationary Pressures The RMB Is Another Relief Value For Chinese Deflationary Pressures The RMB Is Another Relief Value For Chinese Deflationary Pressures Taking all these factors into account, we remain warry of betting on a strong dollar against the euro and the yen in the coming weeks, at least not until bonds become cheap on our fair value gauge, reflecting these Chinese deflationary risks and a higher geopolitical risk premium. Chart 7EUR/GBP Is Misaligned##br## With Fundamentals EUR/GBP Is Misaligned With Fundamentals EUR/GBP Is Misaligned With Fundamentals Also, this means that we could see a dichotomy emerge between the narrow dollar (DXY) and the broad dollar. While lower bond yields are supportive of the euro and the yen, they do very little for EM and commodity currencies. In fact, EM and commodity currencies are highly leveraged to the Chinese economy and will be vulnerable to any flare up of tensions between China and the U.S., especially after currencies like the AUD and the CAD had already rallied 5% and 4% respectively since the last week of 2016. Thus, we would recommend investors favor risk-off currencies like the euro, the Swiss franc, and the yen at the expense of the AUD, NZD, CAD, and NOK. For the GBP, last week, we published an optimistic take on the British economy. We are looking to short EUR/GBP as rate differentials are still widely bearish of that cross (Chart 7). However, we warned that in anticipation of the actual triggering of article 50 of the Lisbon treaty, the GBP could come under duress. A risk-off event would only strengthen this case. Thus, we remain confident in our preferred strategy to short EUR/GBP once it hits 0.93. Bottom Line: The dollar correction is advanced but is now likely to become more differentiated. Tensions created by a protectionist and bellicose Trump are likely to push bonds into expensive territory. While the attending bond rally could support the euro, the Swiss franc, and the yen against the dollar, these same tensions are likely to support the dollar against EM and commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature Which of the following activities requires more brainpower: beating a grandmaster at chess, or cleaning the table underneath the chessboard? The answer is cleaning the table. This explains why Artificial Intelligence (AI) can now trounce the best human chess player, but no AI can (yet) reliably pick up the chessboard and dust underneath it. The cognitive scientist Steven Pinker points out that the human mind can understand quantum physics, send a rocket to the moon and decode the genome, but reverse-engineering simple human movements involves a mind-boggling complexity. "The hard problems are easy and the easy problems are hard." AI researchers call this Moravec's Paradox:1 the counterintuitive result that much less computing power is required for advanced problem solving than for simple sensorimotor skills.2 Feature ChartCooks, Waitresses And Bartenders Is The Fastest Growing Employment Sector Cooks, Waitresses And Bartenders Is The Fastest Growing Employment Sector Cooks, Waitresses And Bartenders Is The Fastest Growing Employment Sector Pay Deflation For The Many... The hard problems that are easy for AI are those that require the application of complex algorithms and pattern recognition to large quantities of data - such as beating a grandmaster at chess. Or a job such as calculating a credit score or insurance premium, translating a report from English to Mandarin Chinese, or managing a stock portfolio. The easy problems that are hard for AI are those that require the replication of human movement in everyday tasks. Jobs such as cleaning, gardening, or cooking. Therefore: "As the new generation of intelligent devices appears, it will be the stock analysts who are in danger of being replaced by machines... (Cleaners), gardeners, and cooks are secure in their jobs for decades to come." For societies and economies, Moravec's Paradox generates a chilling deflationary headwind. Many of the jobs that AI will destroy - like credit scoring, language translation, or managing a stock portfolio - are regarded as skilled, and require years of advanced education and training. They 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. They have unlimited human competition, and are low-paid. ...Pay Inflation For The Tiny Few As well as sensorimotor skills, humans still beat AI in three other fields: creativity, innovation, and complex communication. As Erik Brynjolfsson and Andrew McAfee3 observe in The Second Machine Age: "Computers are still machines for generating answers, not posing interesting new questions... We've never seen a truly creative machine, or an entrepreneurial one, or an innovative one." Hence, these are the skills you should encourage your children to acquire as their defence against AI. Moreover, the leaders in these fields - the very best entrepreneurs, innovators and communicators as well as top sportsmen and musicians - now find themselves in a particularly strong position. This is because a second powerful dynamic is at play. As we showed in the first Special Report in this series The Superstar Economy,4 the internet allows the very best entrepreneurs, innovators and communicators to sell their services to an effectively unlimited audience. And social media, as a large-scale validation system, reinforces the winner-takes-all dynamic. Therefore, as the proliferation and power of the internet and social media have increased dramatically, so too have both the earnings growth rate and the longevity of the superstars - exaggerating the skew in the Pareto distribution of incomes. Simply put, the superstars in sensorimotor skills, creativity, innovation, and complex communication will continue to see very strong pay inflation (Chart I-2). Chart I-2The Cost Of Living Extremely Well Continues To Rise Unabated The Cost Of Living Extremely Well Continues To Rise Unabated The Cost Of Living Extremely Well Continues To Rise Unabated The Hollowing Out Of The Middle Class Sadly, only a tiny fraction of the population can become superstars. As AI takes over mid-skill knowledge work, the vast majority of displaced workers start going after jobs lower on the skills and wage ladder. As these jobs also have lower security, this keeps a lid on credit growth, because without income security, households are less willing to borrow and banks are less willing to lend. The result is that the on-going Second Machine Age - the ushering in of Artificial Intelligence - is hollowing out the middle class. Contrast this with the First Machine Age - the ushering in of 'Artificial Strength'. The steam engine replaced muscle power, both human and animal. Thereby, it destroyed mostly low-skill work and effectively created the middle class. But does the evidence support the narrative for the Second Machine Age? The answer is yes. The changing sectoral profile of the jobs market through 1997-2017 is almost identical to the changing profile of output, as captured by GVA.5 Which means that job destruction and creation has kept relative productivity between sectors broadly unchanged through the past 20 years (Tables I-1-I-5). In other words, human jobs have disappeared where AI can do them better. And they have gone to where AI cannot do them better, because the jobs involve some degree of sensorimotor or communication skill. Table I-1U.K. Jobs Have Gone To Where Machines Cannot (Yet) Beat Humans The Superstar Economy: Part 2 The Superstar Economy: Part 2 Table I-2The U.K. Value Added Profile Is Similar To The Jobs Profile The Superstar Economy: Part 2 The Superstar Economy: Part 2 Table I-3U.S. Jobs Have Gone... The Superstar Economy: Part 2 The Superstar Economy: Part 2 Table I-4...To Where Machines Cannot (Yet) Beat Humans The Superstar Economy: Part 2 The Superstar Economy: Part 2 Table I-5The U.S. Value Added Profile Is Similar To The Jobs Profile The Superstar Economy: Part 2 The Superstar Economy: Part 2 U.S. data provides fascinating sub-sector detail. The employment sub-sectors that have grown the most are relatively low-income but which require sensorimotor skills: Food Services and Drinking Places - cooks, waitresses and bartenders - and Social Services, followed by communication-dependent Education Services (Feature Chart). And now comes the bombshell. A separate study by Ball State University carried out an attribution analysis of the 6 million U.S. manufacturing destroyed through 2000-20106 (Table I-6). The study's salutary conclusion was that only 13% of the job losses resulted from trade, and almost 90% resulted from productivity improvements - in other words, because AI can do the jobs better than humans. Table I-6Only 13% Of Manufacturing Job Losses Are Due To Trade The Superstar Economy: Part 2 The Superstar Economy: Part 2 It follows that short of reversing the advance of technology, no amount of "Take Back Control", "Build A Wall" or "Make America Great Again" can change the powerful wind of change in the employment market. The Implications Of The Superstar Economy In terms of implications for policymakers and investors, all of the conclusions in the original Special Report The Superstar Economy remain valid, so we will reiterate them. Bear in mind that we originally wrote these on March 24, 2016. Several of the predictions have already proved eerily prescient. Headline and aggregate-economy statistics such as GDP and income are no longer representative statistics for the living standards of the vast majority of the population. Therefore, politicians will need to pay close attention to the underlying distribution of these statistics. But as many politicians seem blissfully unaware of the extreme skews in the Pareto distribution, we can expect a higher frequency of shocks at the ballot box. If economic growth is mostly happening at the top-end of the Pareto distribution, the vast majority of incomes will be stagnating or declining.7 So we can expect structurally weak private sector credit growth. Lacking rampant house price inflation or confidence in income growth, households and firms will be unwilling to borrow, and banks will be unwilling to lend. Hence, the opportunities to own bank equities will be limited to short-term tactical timeframes. If economic growth is mostly happening at the top-end of the Pareto distribution, and credit growth is weak, we can expect a continued absence of generalised price inflation. Monetary policymakers need to immediately discard discredited concepts such as the Phillips curve relationship between headline growth, unemployment and the inflation rate. But as many of these conventionally-trained economists will find it difficult to change their thinking, we can expect a higher frequency of policy errors. Interest rates and bond yields will remain structurally depressed. Bond yields will move cyclically, but there will be no persistent uptrend. A long sequence of rate hikes anywhere will be unsustainable. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Named after the roboticist Hans Moravec 2 Evolutionary biology provides a good explanation for Moravec's Paradox. The part of the brain - the cerebellum - that is responsible for sensorimotor skills has experienced much more evolution and development compared with the part of the brain - the neocortex - that is responsible for problem-solving. It follows that AI requires exponentially greater computational resources to replicate even low-level sensorimotor skills than it does to replicate problem-solving. 3 Andrew McAfee spoke at our 2015 New York Conference. 4 Published on March 24, 2016 and available at eis.bcaresearch.com 5 Gross Value Added 6 The Myth and the Reality of Manufacturing in America by Michael J. Hicks and Srikant Devaraj, June 2015 Ball State University Center for Business and Economic Research. 7 Please also see Chart 10 in the Global Investment Strategy Weekly Report, titled "Low Rates Forever", dated March 4, 2016 available at gis.bcaresearch.com

Highlights The pound will suffer more in the near term as Brexit negotiations take center stage. However, this will create a buying opportunity as the pound is only getting cheaper. Moreover, the economic outlook is constructive and the BoE will be repriced. Set a limit-sell on EUR/GBP at 0.933. The U.S. border-tax proposal will not boost the dollar by an additional 25%. Feature This week, the British Supreme Court started sitting again, with Brexit its hottest case. As the ultimate ruling nears, the pound will once again move to the forefront of investors' minds. Political risks remain elevated in the near term, but the economic negatives from Brexit are well discounted. The long-term outlook for the pound is brightening. Politics Still In The Driver Seat Investors have been pinning their hopes on the likely Supreme Court decision to uphold the High Court judgment, and rule that an act of parliament is necessary to trigger Article 50 of the Lisbon Treaty. Such a move, in the eyes of pundits and market participants, greatly increases the likelihood that the U.K. will move toward a "soft Brexit" rather than a "hard Brexit". The pound already discounts some of this as a positive: since October 12, cable is flat near its closing low of 1.21, despite a nearly 5% rally in the dollar index. However, the coming months are likely to prove tumultuous. The pound will fall victim to the upcoming opening of negotiations between the EU and the U.K. The U.K. policy-uncertainty index collapsed after surging in the wake of the Brexit victory, preventing the pound from plunging against a surging dollar (Chart I-1). Nonetheless, uncertainty is set to rise anew, as Parliament will vote in favor of triggering Article 50: The political environment at home remains ardently pro-Brexit (Chart I-2). Moreover, while the May government has suggested it is willing to contribute to the EU's budget to retain access to the common market, it remains adamant on setting limitations to the free movement of people. Chart I-1Economic Uncertainty Is Too Low Economic Uncertainty Is Too Low Economic Uncertainty Is Too Low Chart I-2No Bregret No Bregret No Bregret Additionally, the EU has a built-in incentive to show to the European Union electorate that leaving the union comes at a heavy cost. Thus, EU negotiators will be intransigent and harsh when setting up their opening gambit. Chart I-3Immigration: A Key Concern In The EU GBP: Dismal Expectations GBP: Dismal Expectations With the EU holding the stronger hand in the negotiations, the headline risks for the pound will be great. Even the survival of the so-called passporting of financial services - i.e., the unfettered ability to conduct business within the European Economic Area - is looking increasingly tenuous, with TheCityUK - the country's most important financial lobby - giving up on the issue altogether. This will require an even greater discount on the pound. However, we expect calmer heads to prevail and for the U.K. to retain at least some access to the common market, with some transitional agreements likely to be struck. The U.K. has a strong incentive to keep passporting alive. Meanwhile, controlling movements of people is becoming increasingly popular in the EU. Immigration is a growing concern, now only second to unemployment for the EU as a whole, and the No. 1 worry in Germany (Chart I-3). This suggests a deal on limiting the movement of people is probable. Thus, the pound is likely to sell off as the triggering of Article 50 nears. Once this hurdle is over, political risk premia will be fully adjusted and markets will be able to focus once again on the economic fundamentals. Bottom Line: The politics of Brexit will continue to weigh on the pound until the opening rounds of the Brexit negotiations between the U.K. and the EU begin. Until then, economic factors will take the backbench, and the pound will fall against both the USD and EUR. British Economy To Best Expectations Beyond the politically dominated short-term time horizon, the pound should be driven by the economy and valuations. Let's begin with the economy. On this front, there is room for optimism, at least relative to dismal expectations. A recent survey by the Financial Times shows that 40% of economists are more pessimistic than before on the U.K. economy, and that only 13% expect some improvement relative to their prior forecasts. The first positive is that Great Britain's fiscal drag is being lessened relative to pre-Brexit expectations (Chart I-4). While the Hammond Autumn statement did not point to an outright implementation of stimulus, it did show a 1.1% and 1.3% of GDP reduction in the austerity measures that were to be implemented by the Treasury in 2017 and 2018, respectively. Moreover, the U.K. currently lags both the EU and other advanced economies in terms of public investments as a share of GDP (Chart I-5). This also suggests that, if need be, there is plenty of room to ease budgets going forward. In fact, the recent populist stance taken by May points to more spending in that realm, due to the higher multiplier associated with infrastructure spending. Chart I-4Fiscal Easing GBP: Dismal Expectations GBP: Dismal Expectations Chart I-5Scope For Stimulus GBP: Dismal Expectations GBP: Dismal Expectations Beyond the fiscal picture, the key to the U.K.'s economic future is the outlook for consumption, a sector representing 65% of GDP. Worries are very prevalent that the consumer will aggressively curtail spending, facing a surge in inflation due to the collapse of the pound. However, we are less gloomy. To begin with, the outlook for inflation is better than originally feared. Domestic price pressures, which affect nearly 70% of the consumption basket, remain well contained (Chart I-6). Moreover, while the fall in the pound could exert some upward motion on this inflation measure, their muted correlation implies that domestic prices are unlikely to rise much beyond 2-3%. Meanwhile, the British labor market remains quite tight, suggesting that the outlook for U.K. wages will remain healthy. The ILO unemployment rate stands at 4.8%, near all-time lows; and skilled-labor shortages have not been such a problem since 1990 (Chart I-7). Chart I-6Still Muted Domestic Inflation Still Muted Domestic Inflation Still Muted Domestic Inflation Chart I-7Tight U.K. Labor Market Tight U.K. Labor Market Tight U.K. Labor Market Put together, our wage and core CPI models point toward a slowdown in real wage growth, but not a contraction (Chart I-8). Since nominal wage growth is little affected by the Brexit vote and inflation is expected to be temporary, the permanent-income hypothesis suggests that households are likely to dip into their savings to absorb the slowdown in real income growth (Chart I-9). Thus, U.K. consumption growth should remain stable in 2017. Chart I-8No Contraction In Real Wages No Contraction In Real Wages No Contraction In Real Wages Chart I-9No Calamity In Consumption No Calamity In Consumption No Calamity In Consumption Another key consideration for the U.K. economy is the great easing in financial and monetary conditions registered in the past 12 months (Chart I-10). This easing first and foremost reflects collapsing borrowing costs. This is crucial as U.K. banks are very robust and are in a position to increase their lending, especially to households (Chart I-11). Chart I-10Massive Easing In British##br## Monetary Conditions Massive Easing In British Monetary Conditions Massive Easing In British Monetary Conditions Chart I-11U.K. Banks ##br##Are Strong GBP: Dismal Expectations GBP: Dismal Expectations As a result, the British credit impulse has improved considerably (Chart I-12). It is true that this improvement reflected some Brexit-related distortions, but the factors above suggest that it is likely to continue to point north, highlighting a positive outcome for the U.K. economy. Confirming this intuition, after sharply deteriorating, the RICS survey is improving anew, pointing toward higher house prices (Chart I-13). While we expect any house-price improvements to be stronger outside London than in the capital, the 16% decline in the pound since the beginning of 2016 is improving the attractiveness of this market to foreigners. The U.K. economy has historically been strongly affected by housing price dynamics, and a resilient housing market would be a key support for consumption, despite slowing real wage growth (Chart I-13, bottom panel). Chart I-12Credit Impulse Points Health Credit Impulse Points Health Credit Impulse Points Health Chart I-13Housing Is A Support Housing Is A Support Housing Is A Support Trade, too, should prove less of an issue than originally feared. In recent years, the contribution of net exports to growth has been negative, both at the global level and vis-à-vis the rest of the EU (Chart I-14). With Brexit, trade with Europe will continue to subtract from growth, but not at an accelerating pace. Meanwhile, the large decline in the pound should cushion trade with the rest of the world. Where the risk to the U.K. economy is most pronounced is in business capex. On that front, the large degree of uncertainty that the U.K. will still have to face points to a brake on capex. However, business capex only represents 9% of the U.K.'s economy and has already been contracting. Further muting the effect of uncertainty, U.K. PMIs are as strong as the U.S. equivalent measures (Chart I-15), and U.K. profits are also rebounding. Thus, we expect that the drag from U.K. capex will not deepen. If anything, U.K. capex could surprise to the upside. Chart I-14Trade Always Was A Drag On Growth Trade Always Was A Drag On Growth Trade Always Was A Drag On Growth Chart I-15U.K. Businesses Are Fine U.K. Businesses Are Fine U.K. Businesses Are Fine Bottom Line: We expect the U.K. economy to remain a positive surprise for investors. The fiscal drag is lessening; household consumption should prove robust; housing will strengthen, as the credit impulse continues to perk up; the trade drag is unlikely to deepen; and capex will not worsen, and may in fact improve going forward. Investment Conclusions In the aftermath of the Brexit vote, despite a sharp upward revision to its inflation forecast, the MPC implemented extraordinary policy easing to compensate for risks to growth looming on the horizon. The BoE cut rates to 0.25%, increased its asset purchases by GBP70 billion to GBP435 billion, and put in place the Term Funding Scheme to incentivize bank lending. This week, Governor Mark Carney highlighted that he thought the BoE had been too pessimistic regarding the outlook for U.K. growth and that, in his eyes, the MPC was likely to move away from its extraordinary easing sooner rather than later. We think this outcome is indeed warranted, and not priced into the market. While not out of control, inflation is rising, but the downside risk to the economy appears to be contained. Thus, the BoE is unlikely to extend its asset purchases and will lose its easy bias going forward. Markets are not ready for this reality. With the pound trading 25% below PPP against the USD, and 20% too cheap against the EUR, it is clearly a value play (Chart 16A and Chart 16B). While over a two-year basis, such discounts to PPP should result in an appreciation of the pound, this tells us nothing of the outlook for the next year or so. In fact, in 1984, GBP/USD traded at an even larger discount to PPP than it does today. Chart I-16AGBP Is Cheap GBP Is Cheap GBP Is Cheap Chart I-16BGBP Is Cheap GBP Is Cheap GBP Is Cheap Current-account considerations are still a worry. However, the elasticity of the current account to the pound is limited. In fact, while the elasticity of exports to the pound is of the expected sign in our modeling, for imports, it is not. This reflects the elevated import content of British exports. A lower pound is therefore unlikely to be the most crucial means to improve that current-account position. Moreover, despite its current-account deficit of nearly 6% of GDP, the U.K. still runs a basic balance-of-payments surplus of 12%, even after the recent fall in FDI inflows (Chart I-17). Instead, on an intermediate-term basis, the outlook is driven by interest rate differentials and policy considerations. Here again, the outlook for the pound is brightening, especially against the euro. Due to the balance-sheet operations conducted by the BoE and ECB, interest rates in the U.K. and the euro area do not fully reflect domestic policy stances. Instead, we like to use the shadow rates. Currently, shadow rates tentatively argue that GBP/USD should begin to roll over, and unequivocally point toward a lower EUR/GBP (Chart I-18). In fact, balance-sheet dynamics point toward shorting EUR/GBP. As such, with our core view that the USD remains in a cyclical bull market - albeit one experiencing a temporary pause - the outlook for GBP/USD may still be mired by the strength of the USD. Instead, we find it cleaner to play a better-than-expected British economy by going short EUR/GBP. Long-term technicals on this cross are also extremely stretched (Chart I-19). Chart I-17U.K. Basic Balance Is Healthy... U.K. Basic Balance Is Healthy... U.K. Basic Balance Is Healthy... Chart I-18Shadow Rates: Bullish Pound... Shadow Rates: Bullish Pound... Shadow Rates: Bullish Pound... Chart I-19EUR/GBP Has Rarely Been This Overbought EUR/GBP Has Rarely Been This Overbought EUR/GBP Has Rarely Been This Overbought Due to the political risk looming over the next few month, the timing is complex. We are reluctant to short EUR/GBP unhedged at this point in time. We expect GBP to remain weak over the next month or two. Instead, we recommend two strategies. One - very similar to the play recommended by Dhaval Joshi of our European Investment Strategy service - is to be long EUR/GBP spot while purchasing long-dated out-of-the money puts on this cross. The other, is to set a limit-sell order at EUR/GBP at 0.933. Nimble traders may want to buy EUR/GBP in the wake of the Supreme Court decision and sell it as Article 50 gets triggered. Bottom Line: This week, Carney took an upbeat stance on the U.K. economy. We agree, and think that the BoE will move away from its hyper-dovish policy stance sooner than markets expect. As such, we foresee rate differentials to move in favor of the very cheap pound. The optimal way to play this strength is against the euro. However, since we expect more volatility in the pound as the U.K. triggers Article 50, we elect to implement this view through a limit-sell order at EUR/GBP 0.933. A Few Words On Trump's Tax Policy This week, much ink has been spilled on Trump's and the GOP's tax plan, especially the border adjustment. While a 20% tax on imports, and a 0% tax on exports would in a textbook world result in a near-automatic 25% appreciation in the dollar, this is far from where the reality stands. This analysis forgets that such a move would instantaneously impair the net international investment position of the U.S. by another 10 to 15% of GDP, pushing it below -50% of GDP. Additionally, such a move would cause a complete collapse of commodity prices and a massive tightening of EM financial conditions, especially for borrowers with USD liabilities. The ensuing deflationary crisis would prevent the Fed from hiking as much as is currently priced in and may even cause a global recession. Additionally, such a policy is likely to provoke tit-for-tat responses from other nations, muting its economic repercussions and its impact on the dollar. Globalization is frittering away. Instead, as we argued in the Dirigisme theme of our 2017 outlook, such tax is bullish at the margin on the dollar as future investment by U.S. corporations will now be biased toward the U.S., especially if another component of the tax plan gets implemented: the greater expensing of capex.1 This means that the non-U.S. output gap will grow more negative relative to the U.S. than would have been the case without this piece of legislation. This would put upward pressure on U.S. rates vis-à-vis the rest of the world, but nothing on the order of 25%. Instead, we expect the U.S. dollar to appreciate by a bit more than 5% on a 12-18 months basis, with some upside risk. Peter Berezin of our Global Investment Strategy service will cover tax reforms in great detail in the coming weeks, a report whose conclusions we look forward to share with our clients. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1U.S. Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2U.S. Technicals 2 USD Technicals 2 USD Technicals 2 Since Donald Trump's widely anticipated news conference, the DXY has fallen roughly 1.7% as markets recognized the risks represented by Trump's outlook on trade and relations with China. As a reiteration, we highlight the significance of market overpricing in the DXY's previous rally. This is a clear indication of participants remaining overly reliant and hopeful on Trump's fiscal proposals in determining the greenback's value. A disappointing proposal is likely to lead to a correction in the dollar, however downside will be limited by the crucial 99 to 100 level. Although our long-term case remains bullish - especially if the border tax goes through - it is possible that markets could react to Trump's comments at his inauguration on January 20, generating substantial volatility for the dollar. Report Links: Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Party Likes It's 1999 - November 25, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 As the surging power of the dollar abates, so does the downward pressure on the euro. The common currency has made significant progress this year after bottoming below 1.04 three weeks ago. Following last week's strong data, this week's figures followed through with additional resilience: Eurozone industrial output increased 3.2% annually; French and German industrial output increased 2.2% monthly; German real GDP grew at 1.9%. More interestingly, the Czech economy recorded quite a strengthening in its economy, with retail sales increasing 7.9% on a yearly basis, and yearly inflation at 2% in December from 1.5%. Such an increase in inflation could prompt the CNB to abandon the floor on EUR/CZK to allow for the conduct of independent monetary policy and tighten rates accordingly. This should prove profitable for our short EUR/CZK trade. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 The yen continues to rally this year after its dramatic sell-off at the end of 2016. Although USD/JPY has now found support at its 10-week moving average, we expect that a repricing of growth expectations for the U.S. should push the yen up further to USD/JPY 110. On the data side, recent numbers in Japan paint a positive picture: Consumer confidence came at 43.1, against expectations of 41.3. This is the highest level of consumer confidence since July 2013. Bank lending also increased to 2.6% YoY growth versus 2.4% on November. Encouraging signs from the Japanese economy will only make the BoJ more resolute in its radical policies, given that so far they have shown to be effective. Consequently, the outlook for the yen on a cyclical basis remains very bearish. Report Links: Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In a remarkable volte-face, BoE Governor Mark Carney signaled a possible raise in economic forecast after admitting that fears of a recession triggered by Brexit were overblown. In his own words: "Having gone through the night and the day after, the scale of the immediate risks around Brexit have gone down for the U.K." We agree that Brexit will probably cause a slowdown in the economy. However what matters for the pound is not whether the U.K. slows down but rather how the slowdown compares to expectations. As we have mentioned many times we believe these expectations are overblown, as the pound is very cheap. Thus, while it is true that the pound could still suffer more downside up until when negotiations begin, once political risks dissipate, this currency will become a very attractive bargain, particularly against the euro. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Data was quite weak for Australia this week: Retail sales increased at a below-consensus monthly pace of 0.2%; Building permits contracted by 4.8% since last year in November; Job advertisements contracted by 1.9% in December; AiG Performance of Construction Index increased to 47 from 46.6 - although construction employment had the lowest reading on employment in nine months. Along with the USD's weakness, recent strength in iron ore has buoyed the AUD - even against the CAD and the NOK - lifting AUD/USD 4.8% since the beginning of this year. However, there does not seem to be a clear improvement in the Australian economy yet, which fundamentally reasons against this rally. Additionally, the 14-day RSI is approaching the crucial overbought level of 70, which may signal a potential end to this surge. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The New Zealand Dollar has been one of the best performers against the U.S. dollar since last week, appreciating by over 2%. All in all, the New Zealand economy continues to hum along as the top performer in the G10: Employment growth is around 6%, the highest pace in 23 years. The output gap is at 2% of GDP, which indicates that the economy is growing above potential and that inflationary pressures may eventually emerge in New Zealand. The last point is important because although headline inflation continues to be very low, core inflation is slowly creeping up. While it is true that the slowdown in dairy prices is concerning, it should be a matter of time before inflation starts to pick up again, a development that should lift the NZD against the AUD. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The Canadian economy has shown resilience this year, with the Business Outlook Survey suggesting that the drag from the preceding oil collapse has subsided. Investment intentions are around 25% and employment intentions are close to 40%; Both input and output price expectations have seen a huge surge, and inflation expectations have ticked up; Also, housing starts have come out much better than expected. In addition, the recent strength in the Canadian dollar has also been supported by strong oil prices, as USD/CAD has decreased by almost 3% since the end of last year. As long as the greenback's momentum remains weak, oil prices are likely to see upside, boosting the CAD. Nevertheless, this rally is likely close to burning out: both the RSI and the Coppock Curve are indicating oversold and trend reversal levels for USD/CAD. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 As we suggested last week, EUR/CHF has rallied once more after hovering under the critical level right under 1.07 at which the SNB tends to intervene to depreciate the franc. As long as Switzerland suffers from deflation, the SNB will continue to intervene whenever the franc gets near this levels. Indeed, recent data should give assurance to the SNB that their strategy is working: Real retail sales growth came at 0.9%, not only beating expectations but also returning to positive territory after being negative for the past year and a half. The unemployment rate continues to be very low at 3.3%. On a cyclical basis we are bullish on the franc given Switzerland's large current account surplus of 11%, and that monetary policy is currently as accommodative as can be and will only tighten in the future. This means that risks for the franc point to the upside. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 After rising for most of the week USD/NOK fell sharply on Wednesday, and is now near a support line established in October. The Norges Bank has repeatedly stated that inflation is bound to slow down any time soon. However recent data shows that inflation continues to stay strong in Norway: Headline inflation was unchanged in December, coming at 3.5%. Core Inflation slowed slightly, coming in at 2.5% versus 2.6% the previous month. If inflation continues to be high, the Norges Bank will eventually have to change its stand to a less dovish one, helping the NOK in the process, particularly against its crosses. Moreover, given that the U.S. is the marginal consumer of oil, and China the marginal consumer of metals, outperformance by the U.S. against China should continue to help oil producers against other commodity currencies. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 USD Technicals 2 USD Technicals 2 The Swedish economy is showing resilience: Industrial production increased by 0.1% yearly and by 1.2% monthly in November; Inflation increased 0.5% mom, and 1.7% yoy. Inflation is approaching to the Riksbank’s 2% target. The SEK rallied on the release of the news, as EUR/SEK dropped 0.5% and USD/SEK by around 0.6%. A strengthening Swedish economy will likely cause diverging rate differentials between Sweden and the Euro area, as the latter still battles deflationary pressures. This will limit EUR/SEK’s upside. USD/SEK will be dictated mostly by movements in the dollar itself. Therefore, SEK should outperform both USD and EUR for now. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades