Europe

Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Equity Market On Fire Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now bca.usis_wr_2016_11_21_c2 bca.usis_wr_2016_11_21_c2 Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? bca.usis_wr_2016_11_21_c3 bca.usis_wr_2016_11_21_c3 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? How Long Can Equities Shrug Off Rising Bond Yields? How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty bca.usis_wr_2016_11_21_c5 bca.usis_wr_2016_11_21_c5 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See bca.usis_wr_2016_11_21_c6 bca.usis_wr_2016_11_21_c6 Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner Small Caps Are A Winner Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Q&A: The Top Ten Q&A: The Top Ten Chart 9Americans Like Voting, Just Not These Candidates bca.usis_wr_2016_11_21_c9 bca.usis_wr_2016_11_21_c9 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.

Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King The Return Of The King The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Dollar And Bond Yields: Same Fight Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Groupthink In The Bond Market Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Bond Sentiment Is Depressed Bond Sentiment Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span Interest Rates Priced In A Lot In A Short Time Span Interest Rates Priced In A Lot In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Bond Yields Are Hurting EM Financial Conditions Bond Yields Are Hurting EM Financial Conditions Chart I-7A Dark ##br##Omen A Dark Omen A Dark Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More bca.fes_wr_2016_11_18_s1_c8 bca.fes_wr_2016_11_18_s1_c8 Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex bca.fes_wr_2016_11_18_s1_c9 bca.fes_wr_2016_11_18_s1_c9 Chart I-10Mind The Gap! Mind The Gap! Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Japanese IP Is Picking Up Japanese IP Is Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same USD/JPY And Bond Yields Are One And The Same USD/JPY And Bond Yields Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action The BoJ Policy In Action The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Poor Risk/Reward Tradeoff For Holding AUD/SEK Poor Risk/Reward Tradeoff For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire The Swedish Labor Market Is On Fire The Swedish Labor Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout AUD/SEK: Poised For A Shakeout AUD/SEK: Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_11_18_s2_c3 bca.fes_wr_2016_11_18_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_18_s2_c4 bca.fes_wr_2016_11_18_s2_c4 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_18_s2_c5 bca.fes_wr_2016_11_18_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_18_s2_c6 bca.fes_wr_2016_11_18_s2_c6 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_18_s2_c7 bca.fes_wr_2016_11_18_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_18_s2_c8 bca.fes_wr_2016_11_18_s2_c8 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_18_s2_c9 bca.fes_wr_2016_11_18_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights As western society has become increasingly ethnically diverse, identity politics have flourished. Technological developments have facilitated this trend by giving like-minded people the opportunity to live in their own social bubbles. The U.S. median voter is moving to the left, while the median European voter may be set to move rightward. The "Great Transatlantic Political Convergence" is afoot. Structurally favor European over U.S. stocks. Trump's victory means more fiscal stimulus and less regulation, but could also lead to a stronger dollar and a rising threat of protectionism. Feature Lessons From Papua New Guinea As far as first jobs out of college go, one could do worse than being asked to fly first class to various tropical islands around the world. Such was my luck when I joined the IMF 16 years ago. After a brief stint in the Caribbean division, I began to cover the South Pacific, first working as the desk economist for Papua New Guinea. Papua New Guinea is about as close to a Stone Age society as one will find on earth. It has a long history of violence. If two strangers meet while trekking through the mountainous terrain, the custom is to begin the conversation by listing one's relatives until a match is found. Without a common ancestor, there is little reason not to kill the other guy. Due to the country's long history of cannibalism, a portion of the population has developed a genetic resistance to Mad Cow Disease, which is spread through the consumption of infectious prions contained within the brain and other body parts. Like many societies, Papua New Guinea is highly tribal. Not unrelatedly, it is also one of the most corrupt. I once asked a local friend of mine why this was so. His response was both disheartening and revealing. The people did not want to send honest leaders to Parliament, he explained. They preferred to elect someone from their own tribe who would use his influence to extract as much wealth as possible, with the understanding that a portion of the booty would be shared with fellow tribe members. There were no philosophical differences between members of Parliament. It was simply a question of whose team you were on. What makes Papua New Guinea's political system interesting is not that it is unique, but that it is the norm. Politics in most countries is about identity, not ideology. And now the U.S. and much of Europe are moving in that direction. The Return Of Identity Politics If one looks past the vitriol, one of the most striking features of the U.S. presidential campaign was the lack of disagreement between Trump and Clinton over a wide range of substantive issues. Both candidates campaigned on increasing infrastructure spending. Both pledged not to cut sacred entitlement programs such as Medicare and Social Security. Both played up the other's Wall Street connections. Neither championed an aggressively interventionist foreign policy, with Trump, if anything, moving to the left of Clinton on the issue. Where the gulf between the two candidates was most apparent was over classic identity issues, the chief of which was immigration. Young people often assume that the Left has always supported freer immigration policy. Not so. It wasn't that long ago that Bernie Sanders described "open borders" as a "Koch Brothers idea." In 2000, The New York Times penned an editorial opposing efforts to grant amnesty to illegal immigrants on the grounds that it would depress working class wages.1 Why did things change? It wasn't because voting preferences shifted all that much. As Chart 1 shows, Hispanics have preferred Democrats over Republicans by roughly the same 30-to-40 percentage-point margin for the past 40 years. What changed was that the Hispanic share of all eligible voters rose from 4% in 1980 to 13% today, and is expected to increase to 18% in 2032 (Chart 2). For the Democrats, the allure of millions of new supporters has been simply too good to pass up. Chart 1Voting Preferences By Ethnicity ##br##In Presidential Elections Voting Preferences By Ethnicity In Presidential Elections Voting Preferences By Ethnicity In Presidential Elections Chart 2The Eligible Voters Of The Past,##br##Present, And Future The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood For the Republicans, the transformation of the U.S. into a more ethnically diverse society has led to an existential crisis of sorts. Many top Republican officials, ever focused on the next election campaign, have sought to reach out to Hispanic voters, often by talking up the prospect of passing a comprehensive immigration reform bill. The fact that open borders means lower wages for less-skilled workers has also ensured a steady flow of campaign donations into party coffers from a variety of business interests who rely on cheap labor.2 In contrast, a large chunk of the Republican base has opposed any effort to increase the size of a voting bloc that historically favored the other party, especially if such efforts lead to lower wages. Nationalism Versus Globalism Chart 3The Huddled Masses Keep Coming The Huddled Masses Keep Coming The Huddled Masses Keep Coming The U.S. has a long history of successfully integrating immigrants. Consider the once prominent Catholic/Protestant split, which was driven in large measure by the overwhelming tendency for Irish Americans to vote Democrat. Richard Nixon won 63% of the white Protestant vote in 1960, but still lost the election due to the fact that 78% of Catholics voted for John F. Kennedy.3 By the late 1960s, the Catholic/Protestant split began to recede, to the point where few people are now aware that it ever existed. There is a good chance that the current immigration wave will prove to be no different. That being said, full integration can take a long time - the Irish, for example, overwhelmingly favored the Democrats for more than a century. Three other things complicate the picture. First, the current wave is much larger than any previous one (Chart 3). Second, it is much more ethnically, racially, and religiously diverse. Third, and perhaps most importantly, it is coming at a time when government policy has moved away from fostering assimilation towards encouraging multiculturalism. As multiculturalism has gained ascendency, the traditional glue that held countries together - nationalism - has frayed. For many, this has been a welcome development. Nationalism produced two world wars and countless other bloody conflicts. Much better, it is argued, to replace squabbling nation states with regional institutions such as the European Union, or better yet, global bodies such as the United Nations. The problem is that it is very difficult to get people to expand their circle of loyalty by decree. Thomas Friedman famously asked in 2002: "Is Iraq the way it is today because Saddam Hussein is the way he is? Or is Saddam Hussein the way he is because Iraq is the way it is?"4 We now know that the answer was the latter. From this perspective, the rise of religious fundamentalism in the Middle East is a natural reaction to the vacuum created by the collapse of pan-Arab nationalism. Many of today's leaders have a lot of trouble seeing this point. For them, globalism is a natural creed. What they miss is that they themselves have formed a unique subculture that makes this possible. Today's cosmopolitan elite attend the same schools, read the same books, enjoy the same movies, eat at the same restaurants, and in most cases, can easily converse in the same language: English. They are as much at home on the streets of Manhattan as they are on the streets of London and Hong Kong. However, put them in Cynthiana, Kentucky and they become a fish out of water. In short, they are multicultural only in the narrow ethnic sense of the word. In all other respects, they are the same tribe. Political Polarization Is Growing Chart 4Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization This leads us to the crux of the problem. Today's political elites have been trying to subvert nationalist feelings without offering the masses a sufficiently attractive alternative. This has allowed once-dormant tribal cleavages to make a comeback. Technology has exacerbated this trend. When I came to Canada as a young refugee in 1979, there were just a handful of television networks to choose from, all of which were more or less the same. Today, there are hundreds of channels and countless websites. Social media has become ubiquitous. While refreshing in many respects, this trend has allowed people to live in their own social bubbles, leading to the fraying of the cultural bonds that hold society together. In some cases, it has facilitated the radicalization of impressionable youth, often with dire consequences. The polarization in the cultural realm has been mirrored in the political arena.5 According to political scientists Keith Poole and Howard Rosenthal, polarization in Congress is currently at its highest level since World War II (Chart 4). Their research shows that the liberal-conservative dimension explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension. Meanwhile, a 2014 Pew Research study documented that the middle ground between Republican and Democratic voters is breaking apart (Chart 5). This has led to growing mutual distrust. Chart 6 shows that 45% of Republicans and 41% of Democrats now regard the other party as a threat to the nation's well-being. Chart 5U.S. Political Polarization: Growing Apart The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood Chart 6Increasing Animosity The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood Gerrymandering, or "redistricting," as it is euphemistically called, has made things worse. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart 7). For most incumbents, the threat is not from the other party, but from their own. As former House Majority Leader Eric Cantor learned the hard way when he lost to primary challenger Dave Brat in 2014, failing to tow the ideological line can carry a heavy price. Needless to say, such a system discourages bipartisan cooperation. Chart 7Gerrymandering Reduces Competitive Seats Gerrymandering Reduces Competitive Seats Gerrymandering Reduces Competitive Seats Trump And The Markets After a brief selloff, risk assets have rallied hard on the heels of Trump's victory. As we discussed in greater detail last week,6 a Trump administration will mean more fiscal stimulus - chiefly in the form of lower taxes and increased infrastructure and defense expenditures - as well as a softer line on energy and financial sector regulation. Republicans are also likely to push for greater private-sector involvement in health care. Equity investors should not rejoice too much, however. Trump's saber rattling over trade issues is bad news for many multinational companies. In addition, larger budget deficits are likely to prompt the Fed to raise rates more aggressively. This will push up bond yields, reducing the relative attractiveness of stocks. Higher rates will also put upward pressure on the dollar. The real broad trade-weighted dollar has appreciated by 3% since the election and 4% since we published "Three New Controversial Calls: Trump Will Win And The Dollar Will Rally" on September 30th.7 We expect the dollar to rise by another 7% from current levels. Chart 8Immigrants Want More Government Services The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood A Leftward Shift In The U.S. Median Voter Perhaps more worrisome, as my colleague Marko Papic discussed in a recent report, Trump's victory signals that America's political center is moving to the left.8 The Republican Party is likely to become increasingly populist. Pro-business Democratic candidates such as Hillary Clinton could also turn out to be a dying breed. The future may belong more to politicians such as Massachusetts Senator Elizabeth Warren and Ohio Senator Sherrod Brown. As Wayne Gretzky likes to say, we need to look at where the puck is going, not where it has been. As noted above, this trend partly reflects demographic factors. Immigrants tend to favor redistributionist policies (Chart 8). As such, it is not surprising that California, a once solid Republican state, has become reliably Democratic. In this sense, the transformation of the U.S. electorate has parallels with the extension of the voting franchise to women in 1920. Economists John Lott and Larry Kenny have shown that this led to a substantial leftward shift in political outcomes.9 Ethnic voting preferences, however, are only one part of the story, and perhaps not even the most important part. As a larger share of the general population approaches retirement, resistance to cutting Social Security and Medicare will increase. To pay for these programs, taxes will rise. In addition, slower productivity growth and high levels of income inequality will make voters less enthusiastic about capitalism. The fact that all of this is happening in the aftermath of the worst financial crisis since the Great Depression will only serve to sour free-market sentiment. The Great Transatlantic Political Convergence There are many commonalities in political trends between Europe and the United States, but also a number of critical differences. Unlike those in the U.S., European immigrants still represent a small fraction of the electorate. Their integration into labor markets is also much worse, especially in European countries with generous welfare systems (Chart 9 and Chart 10). This suggests that public support for lavish welfare programs may begin to wane, particularly in northern Europe. As Chart 11 shows, this is already happening in the U.K. Chart 9Low Levels Of Immigrant ##br##Labor Participation In Parts Of Europe The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood Chart 10Immigration Is Straining Generous ##br##European Welfare States The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood Chart 11British Attitudes Towards Welfare ##br##Recipients Have Hardened British Attitudes Towards Welfare Recipients Have Hardened British Attitudes Towards Welfare Recipients Have Hardened Other forces will also lead to a partial rollback of the European welfare state.10 The euro crisis brought home the lesson that countries with high levels of public debt are especially vulnerable to speculative attacks when they no longer have their own printing press. Going forward, euro area governments will continue trying to pay back debt in order to keep the bond vigilantes at bay. In an environment of high capital and labor mobility, fiscal tightening is likely to come more from spending cuts than tax hikes. The failure of France's "millionaire tax" to raise significant new revenue illustrates this point. The loss of an independent monetary policy that comes with having a common currency will also make it more difficult for euro area states to maintain generous welfare programs. If a country cannot respond to an adverse economic shock by cutting rates or devaluing its currency, it must perform an "internal devaluation" instead. However, successful internal devaluations require a high degree of wage and price flexibility. Generous unemployment insurance programs, high minimum wages, and strong unions are anathema to that. This is bad news for many European workers, but good news for European corporate interests. The net effect of all these changes is that European politics are likely to move to the right, while U.S. politics will move to the left. The Great Transatlantic Political Convergence is afoot. This suggests that European equities should outperform their U.S. counterparts over the long haul. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 "Hasty Call For Amnesty," The New York Times, February 22, 2000. 2 Please see The Bank Credit Analyst Monthly Report, "The Immigration Debate: What It Means For Investors," dated February 27, 2014, available at bca.bcaresearch.com. 3 Michael Barone, "Race, Ethnicity, And Politics In American History," in Beyond the Color Line: New Perspectives on Race and Ethnicity in America, Hoover Institution Press (2002): pp. 343-358. 4 Thomas L. Friedman, "Iraq Without Saddam," The New York Times, September 1, 2002. 5 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 6 Please see Global Investment Strategy Weekly Report, "The Trumpenproletariat Strikes Back," dated November 11, 2016, available at gis.bcaresearch.com. 7 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 8 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 9 John R. Lott and Larry Kenny, "Did Women's Suffrage Change The Size And Scope Of Government?," Journal Of Political Economy, Vol. 107: 6 (part 1), (December 1999): pp. 1163-1198. 10 Please see Global Investment Strategy Weekly Report, "The End Of Europe's Welfare State," dated June 26, 2015, available at gis.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades

Highlights The 50bps spike in the JPM global government bond yield since August constitutes one of the most aggressive tightenings since the Great Recession. Higher bond yields weaken credit growth, and weaker credit growth almost always depresses subsequent GDP growth. Maintain at most a neutral weighting to equities. Lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds. Lean against the aggressive rally in Financials. Feature November 9 is an important date in the annals of history. November 9, 1989 was the day that the Berlin Wall came down. Chart of the WeekGlobalization Has Been Good For Profits, Bad For Wages Globalization Has Been Good For Profits, Bad For Wages Globalization Has Been Good For Profits, Bad For Wages Through 1961-89, the Berlin Wall divided a city. More significantly, it symbolized a divided world. So when the wall came down on November 9, 1989, it marked a new era of globalization. Goods, services, capital and people started to move around the world much more freely, resulting in greater efficiencies and lower costs. In developed economies, profits surged. Using the United States as an example, in the 27 years since the Berlin Wall came down, stock market real earnings per share have gone up 200% (Chart I-2). Chart I-2The Backdrop For Populism bca.eis_wr_2016_11_17_s1_c2 bca.eis_wr_2016_11_17_s1_c2 But globalization has exacted a heavy price: the pressure on wages means that in the 27 years since the Berlin Wall came down, U.S. median household real income has gone up just 10%. By comparison, in the 28 years that the Berlin Wall stood, the median household real income went up 60% (Chart of the Week). November 9 is also the date that Donald Trump won the presidency of the United States. So exactly 27 years after one symbolic wall fell, is another one about to go up? Will Mr. Trump's promised wall with Mexico symbolize a new era of anti-globalization, and a reversal of the economic and financial trends since the Berlin Wall came down? Flaws In The Trump Plan Economists are almost unanimous that protectionism, trade barriers and tariffs - in other words, "building walls" - depresses long-term global growth. It is conceivable that protectionism could help some parts of the U.S. economy, though other parts might lose out as trading partners retaliated. It is inconceivable that protectionism would be good for the world economy as a whole. Chart I-3One Of The Most Aggressive Tightenings ##br##Since The Great Recession bca.eis_wr_2016_11_17_s1_c3 bca.eis_wr_2016_11_17_s1_c3 But what about Trump's noise about fiscal stimulus, and specifically infrastructure spending - why would anybody not get excited about that? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield (Chart I-3), it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending would have no impact on GDP. This is because the dollar of government spending has crowded out a dollar of private sector spending. The fiscal multiplier would be zero. But doesn't the euro area debt crisis provide compelling evidence of the power of fiscal thrust and a very high fiscal multiplier? No, not exactly. The fiscal multiplier was high through the debt crisis because euro area austerity - a fiscal tightening - very unusually coincided with sharply rising bond yields - which killed private sector borrowing. In other words, fiscal tightening and private sector tightening were reinforcing each other. Through 2009-12, when the euro area debt crisis escalated, the relationship between fiscal tightening and growth in GDP per capita in 13 sampled economies had a near-perfect explanatory power (r-squared of 0.9); and its slope of 1.5 indicated an extremely high average fiscal multiplier (Chart I-4). But through 2012-15, after Mario Draghi "did whatever it takes" the unusual combination of fiscal tightening and higher bond yields no longer existed, and both the explanatory power of the relationship and fiscal multiplier collapsed (Chart I-5). Chart I-4A Very Strong Connection Between Fiscal Policy And Growth Through 2009-12... From Berlin Wall To Mexican Wall From Berlin Wall To Mexican Wall Chart I-5...But No Connection Between Fiscal Policy And Growth Through 2012-15 From Berlin Wall To Mexican Wall From Berlin Wall To Mexican Wall The lesson is that the efficacy of fiscal stimulus and infrastructure spending crucially depends on its impact on the bond yield - and thereby on private sector borrowing. Now note that the 6-month increase in the U.S. (and global) 10-year bond yield constitutes one of the sharpest tightenings since the Great Recession. Higher borrowing costs depress credit growth as captured in the 6-month credit impulse (Chart I-6). A weaker 6-month credit impulse then almost always depresses subsequent 6-month GDP growth (Chart I-7). Chart I-6Higher Borrowing Costs Depress##br## Credit Growth... bca.eis_wr_2016_11_17_s1_c6 bca.eis_wr_2016_11_17_s1_c6 Chart I-7...And Weaker Credit Growth Depresses ##br##Subsequent GDP Growth bca.eis_wr_2016_11_17_s1_c7 bca.eis_wr_2016_11_17_s1_c7 So yes, fiscal stimulus and infrastructure spending could be effective as long as the bond yield is anchored, as it is in Japan. But if the bond yield goes up sharply, the consequent drag from the private sector will partly or entirely negate any putative boost from the government. Explaining Market Shocks And Electoral Shocks In his seminal book Thinking, Fast And Slow psychologist and Nobel Laureate Daniel Kahneman1 proposed that the human brain has evolved two separate and independent systems for decision making: a fast, rapid-response, associative way of thinking which he calls "System 1" and a slow, analytical, measured way of thinking which he calls "System 2". The two ways of thinking, fast and slow, have evolved to protect us from two types of threat to our survival: immediate, and long-term. Thousands of years ago, the immediate threat to survival might have been a sudden noise in the bushes suggesting that a predator was stalking. Today, for a bond investor, the immediate threat might be a sudden noise about aggressive U.S. fiscal stimulus, suggesting that the end of deflationary pressures is nigh. Faced with this immediate but uncertain threat, using the slow and measured thinking of System 2 could be fatal. So we obey the fast-thinking, associative, emotional System 1 and run for cover - or sell bonds. Thousands of years ago, a long-term threat might have been a war of attrition against an enemy tribe. Today, for the bond investor, the long-term threat might be the end of the debt super cycle, suggesting that deflationary pressures will persist. Faced with this long war of attrition, an over-reliance on the impulsive decisions of System 1 could also be fatal. We must use the measured analysis and strategies of slow-thinking System 2. Kahneman's System 1 and 2 is also an excellent framework to help explain how the simple messages of the Brexiteers and Donald Trump led to stunning success at the ballot box. Faced with job destruction and stagnant real wages, many people intuitively believe that less globalization, less competition and less immigration must mean more jobs and a better standard of living. Associative and emotional System 1 immediately identifies with simple messages such as "take back control" or "build a wall". The success of the Brexiteers and Donald Trump was to acknowledge the deep malaise that many people are feeling and offer simple and intuitive cures. To be absolutely clear, this is neither an endorsement nor a criticism of the Brexiteers or Donald Trump, but simply an explanation of why their message hit home. Still, as we have argued, the more analytical and measured System 2 will find that the simple and intuitive cures that the Brexiteers and Donald Trump offer are not the panaceas that they might first seem. The Immediate Investment Decision Short-term traders generally use the rapid-response, associative, emotional System 1 for their decision making. Long-term investors generally use the slow, analytical, measured System 2. But after a shock, disoriented long-term investors may also switch from System 2 to System 1 and just follow the herd. Eventually though, System 2 switches back on, and the excessive herding and trend-following reverses. At the moment, several sector trends are at or near such a point of reversal according to our excessive groupthink indicator (Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12). Chart I-8Healthcare Reversals After Excessive Trend-Following Healthcare Reversals After Excessive Trend-Following Healthcare Reversals After Excessive Trend-Following Chart I-9Consumer Goods Reversals After Excessive Trend-Following bca.eis_wr_2016_11_17_s1_c9 bca.eis_wr_2016_11_17_s1_c9 Chart I-10Telecoms Reversals After Excessive Trend-Following Telecoms Reversals After Excessive Trend-Following Telecoms Reversals After Excessive Trend-Following Chart I-11Financials Reversals After Excessive Trend-Following Financials Reversals After Excessive Trend-Following Financials Reversals After Excessive Trend-Following Chart I-12Government Bond Reversals After Excessive Trend-Following Government Bond Reversals After Excessive Trend-Following Government Bond Reversals After Excessive Trend-Following Specifically, on a 3-month trading view, we would lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds; and we would lean against the aggressive rally in Financials. More generally, what does the Trump victory mean for European equities? In today's highly-connected financial markets, mainstream investments in Europe overwhelmingly depend on global developments, and not on parochial issues. The dominant components of the Eurostoxx600, FTSE100, DAX30, CAC40, AEX, SMI, and other major indices, are multinationals with a truly global footprint. So the answer rests on two subsidiary questions: What does the Trump victory mean for global monetary conditions? What does the Trump victory mean for global growth? As already mentioned, global monetary conditions have tightened significantly in recent months, and in accelerated fashion after the Trump victory. The 50bps tightening in the JPM global government bond yield since August constitutes one of the sharpest 3-month spikes since the Great Recession. But as in previous cases, the spike may be self-limiting given its squeeze on credit sensitive sectors and emerging markets. Since August, the dividend yield on equities is little changed - meaning that equities have become more expensive relative to bonds. But this is hard to justify as short-term growth prospects have, if anything, worsened. To repeat the powerful messages from Chart 6 and Chart 7, higher bond yields weaken credit growth; and weaker credit growth almost always depresses subsequent GDP growth. Putting all this together, asset allocators should maintain at most a neutral weighting to equities. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Daniel Kahneman won the Nobel Prize in economics in 2002 for his work on decision making. Fractal Trading Model* There are no new trades this week. After the big recent moves in markets, four open positions were closed at their trading-rule limits, two at profit targets, two at stop-losses. 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 1-13 Copper Vs. Tin Copper Vs. Tin * 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 bca.eis_wr_2016_11_17_s2_c1 bca.eis_wr_2016_11_17_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c2 bca.eis_wr_2016_11_17_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c3 bca.eis_wr_2016_11_17_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c4 bca.eis_wr_2016_11_17_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c5 bca.eis_wr_2016_11_17_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c6 bca.eis_wr_2016_11_17_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c7 bca.eis_wr_2016_11_17_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c8 bca.eis_wr_2016_11_17_s2_c8

Highlights The polls were not wrong in the Brexit and U.S. election cases, pundits were; Marine Le Pen is trailing her likely second round opponent by around 40%; She can win, but her probability of winning has been inappropriately inflated following the U.S. election; Buy EUR/USD if the euro breakup risk premium spikes again; we are not there yet, but may be soon. Feature There are two narratives that have emerged in the financial industry since the Trump victory: Polls are inaccurate and cannot be trusted. Marine Le Pen, leader of the Euroskeptic National Front (FN), has a high probability of winning the 2017 presidential election in France. In this brief Client Note, we want to address both of these narratives as they will be central to investors in 2017 - a year when Europe will hold three (maybe four) crucial elections. The French election - set to take place on April 23 and May 7 - is the most important geopolitical event of 2017. We have already addressed the election in some detail in our November Monthly Report and will continue to follow it closely for our clients.1 Polls Were Not Wrong, Pundits Were The polls did not get Brexit wrong, the pundits did. If anything, the polls were showing the Brexit camp comfortably ahead throughout the first two weeks of June. It was only once MP Jo Cox was tragically murdered on June 16 that polls favored the "Stay" vote for the last week of the vote. But on the day of the vote, the "Stay" camp was ahead by only 4%. That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit, in other words, should have been a lot higher than the 30% imbued by the betting markets (Chart 1). We made a case for alarm early in 2016 based on a fundamental analysis of the British electorate.2 Chart 1AOnline Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Chart 1B... Not The Polls ... Not The Polls ... Not The Polls Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory. What the modelers missed is the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for Barack Obama, and the presence of third-party challengers. We addressed these, as well as Trump's "White Hype" strategy, early on in the electoral process.3 In addition, the modelers ignored that American polls have a consistent track record of underestimating, or overestimating, performance by about 3% (Chart 2). And crucially, that the 2016 election was different in that the level of undecided voters was nearly triple the average of the previous three elections (Chart 3).4 Chart 2Election Polls Usually##br## Miss By A Few Points Will Marine Le Pen Win? Will Marine Le Pen Win? Chart 3More Undecided ##br##Voters This Time Around More Undecided Voters This Time Around More Undecided Voters This Time Around Our quantitative and qualitative models were telling us throughout the election that the race would be close. Our model gave Trump a 41% chance of winning on the day of the election, a very high estimate versus other prognosticators. We used the exact same polls incorporated in the quantitative models of the New York Times, Reuters, and FiveThirtyEight.com. But ours did better. As we said on November 1, a Donald Trump victory would not be some sort of mathematical oddity. It wasn't. Bottom Line: The polls in both the Brexit referendum and the U.S. election were close. Yes, they overstated the establishment probability of victory. But not by an extraordinary figure. Marine Le Pen Can Win, But What Is Priced In? Marine Le Pen is going to face off against an "establishment" candidate in the second round of the French election on May 7. As such, she definitely can win the election. Once Le Pen becomes one of the two candidates contesting the election, her probability of winning is certainly not zero. However, her probability is not over 10% either. At least not yet. She is trailing her likely opponent, Alain Juppé, by around 40% in the polls (Chart 4). And yes, we are aware that Donald Trump trailed Hillary Clinton by 20% in July 2015. But there are significant differences between Trump and Le Pen: Marine Le Pen is not a political "unknown." She was her party's presidential candidate in the 2012 election. Her father, Jean-Marie Le Pen, contested elections in 2007, 2002, 1995, and 1988. The National Front has contested elections in France since the 1970s. Voters know what they are getting with Le Pen. As we have repeatedly stressed to clients, Marine Le Pen's personal approval rating peaked in 2012 (Chart 5). She peaked despite the European refugee crisis, multiple terrorist attacks in France, and sluggish economic growth over the past two years, which should have all helped boost her popularity. Why haven't they? France conducts a two-round electoral system, primarily to prevent anyone like Marine Le Pen from coming to power. For Le Pen to win, she has to have millions of French centrist voters swing to her, rather than to her centrist opponent, in the second round. Chart 4Are Polls Underestimating Le Pen By 40%? Will Marine Le Pen Win? Will Marine Le Pen Win? Chart 5Le Pen's Popularity In A Secular Decline Le Pen's Popularity In A Secular Decline Le Pen's Popularity In A Secular Decline The last point is a critical problem for Le Pen as she refuses to change her rhetoric toward the EU and euro membership. The problem for Le Pen is that 70% of the French support the euro (Chart 6). Leaving the euro area would mean redenomination risk for Baby Boomer retirees, default on sovereign debt, higher interest rates, higher inflation, and an immediate economic recession. Judging by the high level of support for the euro, we suspect that the French population understands these risks.5 We therefore do not doubt that Marine Le Pen is a long-shot to win the French elections. Her subjective probability of winning is around 10%. For it to improve, we would have to see: Dramatic, and immediate upward momentum in her poll figures, particularly relative to likely centrist opponents in the second round. Le Pen's probability of victory would increase if she faced an unpopular centrist politician. For example, if the incumbent President François Hollande wins the late January primary of the French Socialist Party, and somehow manages to get into the second round. Similarly, if ex-President Nicolas Sarkozy wins the November 20-27 primary of the Republicans. Both primary elections are a two-round affair. Investors will know the center-right candidate by the end of November. A re-start of the refugee crisis, which has abated significantly since October 2015 (Chart 7). We expected the crisis to unwind and clients can read our September 2015 report titled "The Great Migration - Europe, Refugees, And Investment Implications," to see why.6 Marine Le Pen changes her stance on EU membership or the currency union. On the other hand, such a rhetorical shift would cease to differentiate her from the other center-right policymakers in France. Chart 6French Support The Euro French Support The Euro French Support The Euro Chart 7Read Our Chart: Migration Crisis Is Over Read Our Chart: Migration Crisis Is Over Read Our Chart: Migration Crisis Is Over Bottom Line: Marine Le Pen can win the 2017 election in France. But she remains a long-shot. The only way that Donald Trump and Brexit increase the probability of Marine Le Pen is if the polls are systemically wrong. This is not the case. Marine Le Pen would have to narrow her gap with centrist politicians to 3-5% for us to adjust our probability. Of course, the French could decide to vote for Marine Le Pen because they want to be like Americans and British. We would advise clients not to hold their breath expecting that one. Investment Implications Investors may wake up in mid-2017 to find that the U.K. is firmly on its way out of the EU and that the U.S. is embroiled in deepening political polarization. Meanwhile, France and Spain will be led by reformist governments, Italy will remain in the euro area, and Germany will be mid-way through a rather boring electoral campaign that features pro-euro establishment parties. What is keeping the European establishment in power? In early 2016, we argued that it was its large social welfare state. Unlike the laissez-faire economies of the U.S. and the U.K., European "socialism" has managed to redistribute the gains of globalization sufficiently to keep the populists at bay. As such, European voters are not flocking to populist alternatives, despite considerable challenges such as the migration crisis and terrorism. We encourage clients to re-visit our argument, which we elaborated on in our April Special Report titled, "The End Of The Anglo-Saxon Economy?"7 Populists are gaining votes in Europe nonetheless. To counter that trend, we should expect to see Europe's establishment parties turn more negative towards immigration, positive on fiscal activism, and more assertive towards security and defense policy. But on the key investment-relevant issue of euro area membership and European integration, we see the public consensus continuing to support the status quo. Given our sanguine view, any upward movement in French sovereign debt yields or downward move in the euro could reflect an overstated euro breakup risk premium. We will monitor these assets carefully, since an entry point could develop for investors willing to bet against euro area dissolution. Betting against headline risks has certainly paid dividends in Europe since 2010. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "Europe: Election Fever Continues," in Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "It Ain't Over Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com. 5 In other words, we do not understand why the French population would otherwise support the common currency, if it were not for the risks of leaving it. 6 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?," dated April 13, 2016, available at gps.bcaresearch.com.

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

Highlights The credibility of ECB QE is set to diminish, one way or another. Stay long euro/dollar. Expect a continued compression in the German Bund yield spread versus the U.S. T-bond. Until the U.K. Supreme Court provides further legal clarity about the Brexit process, expectations for a softer Brexit should prop up the pound. In which case, the Eurostoxx600 will outperform the FTSE100 and the FTSE250 will outperform the FTSE100. Feature Nobody saw Brexit coming on June 23, and few saw a President Trump coming on November 8. Just as in the days after June 23, financial markets are trying to regain a footing after another political earthquake. The dust will settle. Our geopolitical strategists will provide a post-election analysis in a separate report. In this report, we would like to look through the immediate haze and focus on three major institutions whose policy options and degrees of freedom were becoming constrained, irrespective of the U.S. election shock. The institutions are: the ECB, the Federal Reserve, and the U.K. government. Chart of the WeekExpected Policy Rate Differential Drives ##br##The German Bund Yield Spread Versus The U.S. T-Bond bca.eis_wr_2016_11_10_s1_c1 bca.eis_wr_2016_11_10_s1_c1 The ECB Is Facing A Lose-Lose Decision Central bank quantitative easing (QE) remains one of the most misunderstood concepts within economics and finance. Contrary to the popular myth, it is not the central bank's asset purchases per se that matter. If the central bank's act of buying assets works at all, it is because QE signals a long period of ultra-low interest rates ahead.1 This then reduces the yields on other financial assets through the so-called "portfolio balance channel." Chart I-2Through 2011-13 Markets Interpreted A Lower ##br##Flow Of QE As A Monetary Tightening Through 2011-13 Markets Interpreted A Lower Flow Of QE As A Monetary Tightening Through 2011-13 Markets Interpreted A Lower Flow Of QE As A Monetary Tightening As Fed Chair Janet Yellen succinctly explains, once there is ample liquidity in the banking system: "QE has no discernible economic effects aside from those associated with communicating the central bank's commitment to the zero interest rate policy" The fundamental point is that the precise amount and asset-class composition of a QE program does not matter. The program just has to be large enough to demonstrate a credible commitment to ultra-low rates. But once a central bank establishes a monthly purchase amount, for example, the current €80bn for the ECB, the flow becomes an anchor. Financial markets then interpret a decrease in that monthly flow as a weakening commitment to ultra-low rates: in effect, a monetary tightening (Chart I-2). On the other hand, if the monthly asset-purchase promise goes on indefinitely, it also loses credibility. The financial markets know full well that there is only a finite pool of safe-assets that the central bank can buy, as the recent experience of the Bank of Japan testifies. For the ECB, the so-called "degrees of freedom" are even more limited than for the Bank of Japan. Asset purchases are constrained by politically determined upper-limits to individual euro area country exposure and by liquidity determined upper-limits to individual financial asset exposure. Hence, the ECB now faces a lose-lose decision. If it signals an intention - even a delayed intention - to taper its €80bn monthly flow of QE, the financial markets will interpret it as a de facto tightening. But if it does not signal an intention to taper it will have to use more and more smoke, mirrors, and chicanery to justify how it can keep delivering on its promise to buy. Bottom Line: one way or another, the credibility of ECB QE is set to diminish. The Federal Reserve's Track Record In Predicting Its Own Policy Is Abysmal To take a position on the euro/dollar exchange rate or the yield differential between German Bunds and U.S. T-bonds, we must now consider the other central bank in the equation: the U.S. Federal Reserve. When it comes to predicting the stance of its own monetary policy, the track record of the Federal Reserve is nothing short of abysmal. The Federal Reserve's famous dot forecasts have consistently missed the mark. In fact, they have not even come close to the mark. Just two years ago, the median Fed dot was predicting ten rate hikes by now (Chart I-3). Yes, seriously - ten! Chart I-3Two Years Ago, The Median Fed Dot Was Predicting Ten Rate Hikes By Now bca.eis_wr_2016_11_10_s1_c3 bca.eis_wr_2016_11_10_s1_c3 In its own defence, the Fed might respond that its monetary policy is "data-dependent" or even "events-dependent", and that this contingency prevented it from hiking the ten times that it had forecast. That's fine. But it then raises a bigger question about credibility. If central bank policy is contingent, then is it really possible to give credible forward guidance on the level of interest rates stretching out years ahead? We think not. Indeed, by publishing dots that turn out to be so consistently and deeply wrong, the central bank is seriously damaging its own credibility and authority. Rather than relying on Federal Reserve dots or market forecasts, investors must make up their own minds about the likely path of the Fed funds rate. For bond investors, the medium-term question is: at what level will the policy rate peak in this tightening cycle? This is because at the peak of the tightening cycle, the 0-10 year yield curve tends to be more or less flat (Chart I-4). In other words, the 10-year bond yield ends up eventually trading at the same level at which the policy rate peaks. After the election shock, the knee-jerk response has been a higher 10-year T-bond yield, and this direction may continue in the near-term. But further out, the question is: will the Fed funds rate peak above or below where today's 10-year T-bond yield of 1.9% implies that it will peak? We think below. Note that a first and second interest rate hike interspersed by a full year is unprecedented in modern economic history. And now, even the intended second hike in December might be in jeopardy. Given that the Fed has struggled to get two 25bps hikes through in two years, the idea that it will succeed in hiking another four or five times in this tightening cycle really does not seem credible to us. Bottom Line: Combined with the diminishing credibility of ECB QE, stay long euro/dollar (Chart I-5); and expect a continued compression in the German Bund yield spread versus the U.S. T-bond. In other words, maintain the pair-trade: long T-bonds, short German bunds (currency hedged) (Chart of the Week). Chart I-4At The Peak Of A Tightening Cycle, ##br##The 0-10 Year Yield Curve Is Flat bca.eis_wr_2016_11_10_s1_c4 bca.eis_wr_2016_11_10_s1_c4 Chart I-5Expected Policy Rate Differential##br## Drives Euro/Dollar bca.eis_wr_2016_11_10_s1_c5 bca.eis_wr_2016_11_10_s1_c5 The U.K. Government Has Had Its Wings Clipped The U.K. Government is another institution that has suffered a huge blow to its credibility and authority. Prime Minister Theresa May brazenly thought that she could start the legal process to exit the EU using the so-called 'royal prerogative', the power granted to governments to make certain decisions without a vote from parliament. But as we presciently warned two weeks ago in The Pound: Next Stop $1.10 Or $1.35,2 the U.K. High Court has judged the government does not have the authority to overturn domestic law - in this case, the European Communities Act (1972) and European Union Act (2011) - without obtaining parliamentary approval. The irony is that the sovereignty of the U.K. Parliament is the very thing that Brexiteers supposedly are fighting for. The High Court has clipped the U.K. Government's wings by deferring the Article 50 trigger to parliament. The government is appealing the High Court decision at the Supreme Court whose verdict is expected in January. But given that the government itself concedes that the Article 50 trigger will irrevocably change domestic law, it is hard to see how the government will win the appeal. Hence, there is a high likelihood that Members of Parliament will get to scrutinise the government's negotiating hand before it is allowed to fire the Brexit starting gun. Given that the precise form of Brexit has huge implications for British people's economic future and legal rights, parliament could water down or delay Brexit before voting it through. Bottom Line: Until the Supreme Court provides further legal clarity3 in January, expectations for a softer Brexit should prop up the pound. In which case: the Eurostoxx600 will outperform the FTSE100; the FTSE250 will outperform the FTSE100; U.K. retailers, travel and real estate equities will outperform the U.K. market; but U.K. goods exporters will underperform (Chart I-6 and Chart I-7). Chart I-6A Soft Or Hard ##br##Brexit... bca.eis_wr_2016_11_10_s1_c6 bca.eis_wr_2016_11_10_s1_c6 Chart I-7...Determines The Prospects ##br##For Most U.K. Assets bca.eis_wr_2016_11_10_s1_c7 bca.eis_wr_2016_11_10_s1_c7 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Because while an asset-purchase program is underway, it would be difficult to raise rates. 2 Published on October 27 2016 and available at eis.bcaresearch.com 3 The Supreme Court will judge the government's appeal against the High Court decision. If the appeal is lost, it may also judge what type of parliamentary approval is required to trigger Article 50: a full Bill or a simple Resolution. Fractal Trading Model* This week's recommended trade is to go long U.K. healthcare versus the market. 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-8 bca.eis_wr_2016_11_10_s1_c8 bca.eis_wr_2016_11_10_s1_c8 * 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 bca.eis_wr_2016_11_10_s2_c1 bca.eis_wr_2016_11_10_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_11_10_s2_c2 bca.eis_wr_2016_11_10_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_11_10_s2_c3 bca.eis_wr_2016_11_10_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_11_10_s2_c4 bca.eis_wr_2016_11_10_s2_c4 Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_11_10_s2_c5 bca.eis_wr_2016_11_10_s2_c5 Chart II-6Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_11_10_s2_c6 bca.eis_wr_2016_11_10_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_10_s2_c7 bca.eis_wr_2016_11_10_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_10_s2_c8 bca.eis_wr_2016_11_10_s2_c8

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

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

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