Geopolitics

Special Report

Highlights NAFTA is truly at risk - as currency markets suggest; NAFTA's impact on the U.S. economy is positive but marginal; The key question is whether Trump is a true populist or a "pluto-populist"; If the former, then NAFTA's failure is likely and portends worse to come; NAFTA's collapse would be bearish MXN, bearish U.S. carmakers versus DM peers, and supportive of higher inflation in the U.S. Feature Fifty years ago at the end of World War II, an unchallenged America was protected by the oceans and by our technological superiority and, very frankly, by the economic devastation of the people who could otherwise have been our competitors. We chose then to try to help rebuild our former enemies and to create a world of free trade supported by institutions which would facilitate it ... Make no mistake about it, our decision at the end of World War II to create a system of global, expanded, freer trade, and the supporting institutions, played a major role in creating the prosperity of the American middle class. - President Bill Clinton, Remarks at the Signing Ceremony for the Supplemental Agreements to the North American Free Trade Agreement, September 14, 1993 No Free Trade Agreement (FTA) has been more widely maligned than the North American Free Trade Agreement (NAFTA). It is, after all, the world's preeminent FTA. Signed in December 1992 by President George H. W. Bush and implemented in January 1994, it preceded the founding agreements of the World Trade Organization (WTO) and launched a two-decade, global expansion of FTAs (Chart 1). By including environmental and labor standards, as well as dispute settlement mechanisms, it created a high standard for all subsequent FTAs. President Trump's presidency began with much fear that his populist preferences would imperil globalization and trade deals such as NAFTA. Other than his withdrawal from the Trans-Pacific Partnership deal, much of the concern has been proven to be misplaced - including our own.1 Even Sino-American trade tensions have eased, with President Trump and President Xi Jinping enjoying a good working relationship so far. So should investors relax and throw caution to the wind? In this report, we argue that the answer is a resounding no. The White House rhetoric on NAFTA - a trade deal that has been mildly positive for the U.S. economy and, at worst, neutral for its workers - suggests that greater trade conflicts loom, not only within NAFTA but also with China and others. Furthermore, a rejection of NAFTA would be a symbolic blow to free trade at least as consequential as the concrete ramifications of nixing the deal itself. The deal with Mexico and Canada is not as significant to the U.S. economy as its proponents suggest (Chart 2), but by mathematical logic its detractors therefore overstate its negatives. Chart 1NAFTA: Tailwind To Globalization Chart 2U.S. Economy: Largely Unaffected By NAFTA The opposition to NAFTA by the Trump administration therefore reveals preferences that would become far more investment-relevant if applied to major global economies like China. If NAFTA negotiations are merely a ploy to play to the populist base, however, then the impact of its demise will be temporary and muted. At this time, however, it is unclear which preference is driving the Trump White House strategy and thus risks are to the downside. The Decaying Context Behind NAFTA The North American Free Trade Agreement is more than a trade deal: it is the symbolic beginning of late twentieth-century globalization. According to our trade globalization proxy, this period has experienced the fastest pace of globalization since the nineteenth century (Chart 3). Both NAFTA and the WTO enshrined new rules and standards for global trade upon which trade and financial globalization are based. Chart 3Globalization Has Peaked Chart 4Globalization And Its Indebted Discontents Underpinning this surge in globalization was the apex of American geopolitical power and the collapse of the socialist alternative, the Soviet Union. As President Clinton's remarks from 1993 suggest (quoted at the beginning of the report), NAFTA was the culmination of a "creation myth" for an American Empire. The myth narrates how the geopolitical and economic decisions made by the U.S. in the aftermath of its victory in World War II laid a foundation for both American prosperity and a new global order. With the ruins of Communism still smoldering in the early 1990s, the U.S. decided to double-down on those same, globalist impulses. Today those impulses are waning if not completely dead. As we argued in our 2014 report, "The Apex Of Globalization - All Downhill From Here," three trends have conspired to turn the tides against globalization:2 Multipolarity - Every period of intense globalization has rested on strong pillars of geopolitical "hegemony," i.e. the existence of a single world leader. Chart 3 shows that the most recent such eras consisted of British and American hegemony, respectively. However, the relative decline of American geopolitical power has imperiled this process, as rising powers look to carve out regional spheres of influence that are by definition incompatible with a globalized political and economic framework. In parallel, the hegemon itself - the U.S. - has begun to vacillate over whether the framework it designed is still beneficial to it, given its declining say in how the global system operates. Great Recession - The 2008 global financial crisis cracked the ideological, macroeconomic, and policy foundations of globalization. Deflation - Globalization is deflationary, which works swimmingly when real household incomes are rising and debts falling. Unfortunately, neither of those has been the case for American households over the past forty years (Chart 4). This is in large part the consequence of globalization, which opened trade with emerging markets and thus suppressed low-income wage growth in developed economies. What is striking about the U.S. is that its social safety net has done such a poor job redistributing the gains of free trade, at least compared to its OECD peers (Chart 5). Chart 5The 'Great Gatsby' Curve Chart 6America Belongs To The Anti-Globalization Bloc President Donald Trump shrewdly understood that the tide had turned against free trade in the U.S. (Chart 6). Ahead of the 2016 election, no one (except BCA!) seriously believed that trade and globalization would become the fulcrum of the election.3 Candidate Trump, however, returned to it repeatedly, and singled out NAFTA as "the worst trade deal maybe ever signed anywhere."4 Bottom Line: President Trump's opposition to globalization did not fall from the sky. Trump is the product of his time and geopolitical and macroeconomic context. Trends we identified in 2014 are today headwinds to globalization. Myths About NAFTA The geopolitical and macroeconomic context may be dire for globalization, but does NAFTA actually fit that narrative? The short answer is no. The long answer is that there are three myths about NAFTA that the Trump administration continues to propagate. We assume that U.S. policymakers can do simple math. As such, their ignorance of the below data suggests a broad strategy toward free trade that is based in ideology, not factual reality. Alternatively, flogging NAFTA may be motivated by narrower, domestic, political concerns and may not be indicative of a deeply held worldview. Time will tell which is true. Myth #1: NAFTA Has Widened The U.S. Trade Deficit Chart 7Long-Term Trade Deficit Is About Commodities NAFTA has resulted in a huge trade deficit for the United States and has cost us tens of thousands of manufacturing jobs. The agreement has become very lopsided and needs to be rebalanced. We of course have a five-hundred-billion-dollar trade deficit. So, for us, trade deficits do matter. And we intend to reduce them. - Robert Lighthizer, U.S. trade representative, October 17, 2017 When it comes to the U.S. trade deficit, NAFTA has had a negligible impact. Three facts stand out: The U.S. has an insignificant trade deficit with Canada - 0.06% of GDP in 2016, or $12 billion. It has a larger one with Mexico - 0.33% of GDP, or $63 billion. However, when broken down by sectors, the deepest trade deficit has been in energy. The U.S. has actually run a surplus in manufactured products with Mexico and Canada for much of the post-2008 era, which only recently dipped back into deficit (Chart 7). The U.S. has consistently run a trade deficit with the rest of the world since 1980, but the size of its trade deficit with Mexico and Canada did not significantly increase as a share of GDP post-implementation of NAFTA. The real game changer has been the widening of the trade deficit with China and the rest of the EM economies outside of China and Mexico (Chart 8). The trade relationship with Mexico and Canada, relative to that with the rest of the world, therefore remains stable. The net energy trade balance with Mexico and Canada has significantly improved due to surging U.S. shale production (Chart 9). Rising shale production has accomplished this both by lowering the need for imports from NAFTA peers, surging refined product exports to Mexico, and by inducing lower global energy prices. In addition, Canada-U.S. energy trade is governed by NAFTA's Chapter 6 rules, which prohibit the Canadian government from intervention in the normal operation of North American energy markets.5 Chart 8U.S. Trade Imbalance Is Not About NAFTA Chart 9Shale Revolution Is A Game Changer Myth #2: NAFTA Has Destroyed The U.S. Auto Industry Before NAFTA went into effect ... there were 280,000 autoworkers in Michigan. Today that number is roughly 165,000 - and would have been heading down big-league if I didn't get elected. - Donald Trump, U.S. President, March 15, 2017 What about the charge that NAFTA has negatively impacted the U.S. automotive industry by shipping jobs to Mexican and, to lesser extent, Canadian factories? Again, this reasoning is flawed. In fact, NAFTA appears to have allowed the U.S. automotive industry to remain highly competitive on a global scale, more so than its Mexican and Canadian peers. U.S. exports outside of NAFTA as a percent of total exports have surged since the early 2000s and have remained buoyant recently. Meanwhile, Mexican exports to the rest of the world have fallen, suggesting that Mexico is highly reliant on servicing Detroit (Chart 10). Chart 10NAFTA Has Made U.S. Auto##br## Manufacturing More Competitive The truth is that the American automotive industry's share of overall manufacturing activity has risen since 2008. In part, this is because American manufacturers have been able to integrate with Canadian and Mexican plants, allowing production to remain on the continent and move seamlessly across the value chain. In other words, Mexico serves as a low-wage outlet for the least-skilled part of the production chain, allowing the rest of the manufacturing process to remain in the U.S. and Canada. Without that cheap "escape valve," the entire production chain might have migrated to EM Asia. Or, worse, the American automotive industry would have become uncompetitive relative to European and Japanese peers. Either way, the U.S. would have potentially faced greater job losses were it not for easier access to Mexican auto production. Both European and Japanese manufacturers have similar low-skilled, low-cost, "labor escape valves" in the region. For Germany and France, this escape valve is in Spain and Central and Eastern Europe; for Japan, it is in Thailand. Myth #3: Mexico And Canada Cannot Retaliate Against The U.S. As far as I can tell, there is not a world oversupply of agricultural products. Unless countries are going to be prepared to have their people go hungry or change their diets, I think it's more of a threat to try to frighten the agricultural community. - Wilbur Ross, Commerce Secretary, October 11, 2017 U.S. exports to Canada and Mexico only account for about 2.6% of GDP, whereas exports to the U.S. from Mexico and Canada account for 28% and 18% of GDP respectively. Nonetheless, this does not mean that the U.S. suffers from NAFTA. As we discussed above, NAFTA has been a boon for the global competitiveness of the U.S. automotive industry. In addition, NAFTA gives American and Canadian exporters access to a large and growing Mexican middle class (Chart 11). Furthermore, the U.S. would gain little benefit from leaving NAFTA vis-à-vis Canada and Mexico. By reverting back to WTO tariff levels, the U.S. would be able to raise tariffs from 0% (under NAFTA) to the maximum of 3.4%, where the U.S. average "bound tariff" would remain. Bound tariffs differ across products and countries and represent the maximum rate of tariffs under WTO rules (i.e., without violating those rules). They are indicative of a hostile trade relationship, as trade would otherwise be set at much lower "most favored nation" tariff levels. Table 1WTO Tariff Schedule As Table 1 shows, however, Canada and particularly Mexico have the ability to raise their bound tariffs considerably higher than the U.S. can do. Mexico, in fact, has one of the highest average bound tariff rates for an OECD member state, at a whopping 36.2%! This means that, if NAFTA were to be abrogated, the U.S. would be allowed to raise tariffs, on average, to 3.4%, whereas Mexico would be free to do so by ten times more. Given that Mexico is America's main export destination for steel and corn output, the retaliation would be non-negligible for these two politically powerful sectors. This aspect of the WTO agreement is a latent geopolitical risk, as it feeds into the Trump administration's broader antagonism toward the WTO itself. Despite the hard evidence, we suspect that the Trump administration is driven by ideological and strategic goals and therefore the probability of a calamitous end to the ongoing NAFTA negotiations is high. Nevertheless, the data shows: The North American Free Trade Agreement has allowed trade between its member states to accelerate at a faster pace than global trade for much of the first decade after its signing and at the average global pace over the past decade (Chart 12); U.S. manufacturing employment as a percent of total labor force has been declining for much of the past half-century, with absolute numbers falling off a cliff as China joined the WTO and, along with EM Asia, became integrated into the global supply chain (Chart 13); Employment in auto-manufacturing follows the same pattern as overall manufacturing employment (Chart 13, bottom panel), suggesting that it was not NAFTA that caused job flight but rather competition from the rest of the world along with automation. In fact, auto-manufacturing employment has recovered post-2008, as American car manufacturers underwent structural reforms to improve competitiveness. Chart 12NAFTA Trade Has ##br##Beaten Global Trade Chart 13Who Hurt U.S. Manufacturing Employment:##br## China Or NAFTA? As with any free trade agreement, some wages in some sectors may have been lowered by NAFTA's implementation and some jobs were definitely lost due to the agreement. However, the vast majority of academic studies point out that the negative labor market impacts of NAFTA have been negligible. The most authoritative work on the subject, by economists Gary Clyde Hufbauer and Jeffrey J. Schott of the Peterson Institute for International Economics, found that the upper-bound of NAFTA-related job losses in the U.S. is 1.9 million over the first decade of the agreement. Given that U.S. employment rose by 34 million over the same period, the job losses represent "a fraction of one percent of jobs 'lost' through turnover in the dynamic U.S. economy over a decade."6 A June 2016 report by the U.S. International Trade Commission (USITC) provides a good review of academic studies on the trade deal since 2002. Overall, it concludes that NAFTA led "to a substantial increase in trade volumes for all three countries; a small increase in U.S. welfare [overall economic benefit]; and little to no change in U.S. aggregate employment."7 In addition, NAFTA had "essentially no effect on real wages in the United States of either skilled or unskilled workers." This academic work could, of course, be the product of a vast conspiracy by globalist, neo-liberal academics financed by the deep state and its corporate overlords. However, the other side of the debate has little to offer as a counter to the empirical evidence. For example, U.S. Trade Representative Robert Lighthizer, a notable trade hawk, posited that the U.S. government had "certified" that 700,000 Americans had lost their jobs owing to NAFTA. This would represent 30,000 job losses per year over the 24 years of NAFTA's existence. Lighthizer also did not say whether he was speaking in net or gross terms, probably because it is practically impossible to competently answer that question! If that is the best retort to the academic research, there is then no real counter to the conclusion that NAFTA has had a mildly positive effect on the U.S. economy and labor market. Bottom Line: NAFTA has had some positive effects on the U.S. automotive sector, allowing it to integrate the low-cost Mexican labor into its production chain and thus remain competitive vis-à-vis Asian and European manufacturers. It also holds the promise of future export gains to Mexico's growing middle class. Its overall effects on the U.S. budget deficit, wages, and employment are largely overstated. If the impact of NAFTA has largely been marginal to the U.S. economy outside of a select few sectors, why is the Trump administration so dead-set on renegotiating it? And why has the process been so acrimonious? What Does The Trump White House Want? Frankly, I am surprised and disappointed by the resistance to change from our negotiating partners ... As difficult as this has been, we have seen no indication that our partners are willing to make any changes that will result in a rebalancing and reduction in these huge trade deficits. - Robert Lighthizer, U.S. trade representative, October 17, 2017 Robert Lighthizer, the U.S. trade representative, closed the fourth round of negotiations with a bang, implying that Canada and Mexico would have to help the U.S. close its $500 billion trade deficit, even though the U.S. trade deficit with its two NAFTA partners is only 15% of the total. The Canadian dollar and the Mexican peso fell by 1.2% and 1.9%, respectively, in the subsequent week of trading. In fact, both the CAD and MXN have faced extended losses since the third round of NAFTA negotiations ended on September 27 (Chart 14). Chart 14NAFTA Negotiations Are FX-Relevant Is the market overreacting? We do not think so. First, the list of demands presented by the White House are quite harsh, with the first two below considered deal-breakers: Dispute Settlement: The White House wants to end the investor-state dispute settlement (ISDS) mechanism (under Chapter 11), which allows corporations to sue governments for breach of obligations under the treaty.8 More importantly, the U.S. also wants to eliminate trade dispute panels (under Chapter 19), which allow NAFTA countries to protest anti-dumping and countervailing duties. The real issue is that Chapter 19 trade dispute panels have acted as a constraint on the U.S. administration in imposing antidumping and countervailing duties in the past. Sunset clause: The White House has also proposed that NAFTA automatically expire unless it is approved by all three countries every five years. Buy American: The White House wants its "Buy American" rules in government procurement to be part of the new NAFTA deal, and yet for Canadian and Mexican government contracts to remain open to U.S. businesses. Rules of origin: The White House has called for an increase in NAFTA's regional automotive content requirement from the current 62.5% to 85%, including that 50% of the value of all NAFTA-produced cars, trucks, and large engines come from the U.S.9 Second, the U.S. Commerce Department - headed by trade hawk Wilbur Ross - has signaled that it is open to aggressively pursuing trade disputes on behalf of American companies. Since President Trump's inauguration, U.S. policy interventions have on balance harmed the commercial interests of its G20 trade partners by higher frequency than during the last three years of Barack Obama's presidency (Chart 15).10 Chart 15Trump: Game Changer In U.S. Trade Policy Specific to NAFTA partners, the Commerce Department has slapped a 20% tariff on Canadian softwood lumber in April and a 300% tariff on Bombardier C-Series in October. When combined with the demand to end trade dispute panels under NAFTA's Chapter 19 - which would resolve such trade disputes - the pickup in activity by the Commerce Department is a clear signal that the new U.S. administration intends to break the spirit of NAFTA whether the agreement remains in place or not. Third, and more broadly speaking, the Trump administration is playing a "two-level game."11 Two-level game theory posits that domestic politics creates acceptable "win-sets," which are then transported to the geopolitical theatre. Politicians cannot conclude foreign agreements that are outside of those domestic win-sets. For President Trump, his win-set on NAFTA negotiations is set by a domestic coalition that allowed him to win the election. This includes voters in the Midwest states of Wisconsin, Michigan, and Pennsylvania where Trump outperformed polls by 10%, 3%, and 3% respectively (Chart 16), and where Secretary Hillary Clinton garnered less votes in 2016 than President Barack Obama in 2012 (Chart 17). Trump promised this blue-collar base a respite from globalization and he has to deliver it if he intends to win in four years' time. Chart 16Trump Owes The Midwest Chart 17Hillary Lost Rust Belt Voters At the same time, Trump's domestic policy has thus far fallen far short of other campaign promises. First, there has been no movement on immigration or the promised border wall. Second, the Obamacare repeal and replace effort has failed in Congress. Third, proposed tax cuts are likely to benefit the country's elites, as previous tax reform efforts have tended to do. As such, we fear that the Trump White House may double down on playing hardball with NAFTA in order to fulfill at least one of its promised strategies. But why single out NAFTA if its impact on U.S. jobs and wages is miniscule compared to, for example, the U.S.-China trade relationship?12 There are two ways to answer this question: Pluto-populist scenario: President Trump is in fact a pluto-populist and not a genuine populist, i.e. he is not committed to economic nationalism.13 As such, he does not intend to fulfill any of the demands he has promised to his voters, as the current corporate and household tax cuts suggest. Given NAFTA's limited impact on the U.S. economy, abrogating that deal would have far less detrimental impact than if President Trump went after other trade relationships. As such, the NAFTA deal will either be renegotiated, or, at worst, abrogated and quickly replaced with bilateral deals with both Canada and Mexico. It is a "cheap" and "safe" way to satisfy voter demands without actually hurting business or the economy. Genuinely populist scenario: President Trump is a genuine populist and NAFTA renegotiations are setting the stage for a 2018 in which trade protectionism becomes a genuine, global market risk. Bottom Line: President Trump's negotiation stance on NAFTA is non-diagnostic. We cannot establish with any certainty whether his demands mark the start of a broader, global, protectionist trend, or whether he is merely bullying two trade partners who will ultimately have to kowtow to U.S. demands. Nonetheless, we agree with the market's pricing of a higher probability that NAFTA is abrogated, as witnessed by the currency markets. In both of our political scenarios, NAFTA's fate is uncertain. If Trump is a pluto-populist, NAFTA is an easy target and its abrogation will score domestic political points with limited economic impact. If he is a genuine economic nationalist, failed NAFTA renegotiations are the first step on the path to clashing with the WTO and rewriting global trade rules. Investment And Geopolitical Implications Can President Trump withdraw from NAFTA unilaterally? The short answer is yes. As Table 2 illustrates, Congress has passed several laws that delegate authority to the executive branch to administer and enforce trade agreements and to exercise prerogative amid exigencies.14 Article 2205 of NAFTA states that any party to the treaty can withdraw within six months after providing notice of withdrawal. We see no evidence in U.S. law that the president has to gain congressional approval of such withdrawal. Table 2Trump Faces Few Constraints On Trade Moreover, the past century has produced a series of laws that give President Trump considerable latitude - not only the right to impose a 15% tariff for up to 150 days, as in the Trade Act of 1974, but also unrestricted tariff and import quota powers during wartime or national emergencies, as in the Trading With The Enemy Act of 1917.15 The White House has already signaled that it considers budget deficits a "national security issue," which suggests that the White House is preparing for a significant tariff move in the future.16 Could President Trump's moves be challenged by Congress or the courts? Absolutely. However, time is on the executive's side. Even assuming that Congress or the Supreme Court oppose the executive, it will likely be too late to avoid serious ramifications and retaliations from abroad. Other countries will not wait on the U.S. system to auto-correct. Congress is unlikely to vote to overrule the president until the damage has already been done - especially given Trump's powers delegated from Congress. As for the courts, the executive could swamp them with justifications for its actions; the courts would have to deem the executive likely to lose every single one of these cases in order to issue a preliminary injunction against each of them and halt the president's orders. Any final Supreme Court ruling would take at least a year. International law would be neither speedy nor binding. What are the investment implications of a NAFTA collapse? Short term: Short MXN; short North American automotive sector relative to European/Asian peers. We would expect more downside risk to MXN from a collapse in NAFTA talks, similar in magnitude to the decline of the GBP after the Brexit vote. The Mexican central bank would likely take on a dovish stance towards monetary policy, creating a negative feedback loop for the peso. The automotive sectors across the three economies that make up NAFTA would obviously suffer, given the benefits of the integrated supply-chains, as would U.S. steel and select agricultural producers that export to NAFTA peers. Medium term: Canadian exports largely unaffected, buy CAD on any NAFTA-related dip. Given that 20% of Canadian exports to the U.S. are energy - and thus highly unlikely to come under higher tariffs post-NAFTA - we do not expect exports to decline significantly.17 In fact, the 1987 Canada-United States Free Trade Agreement, which laid the foundation for NAFTA, could quickly be resuscitated given that it was never formally terminated, only suspended. Canada and the U.S. have a balanced trade relationship, which means that it is highly unlikely that America's northern neighbor is in the sights of the White House administration. Long term: marginally positive for inflation. Economic globalization and immigration have both played a marginally deflationary role on the global economy. If abrogation of NAFTA is the first step towards less of both trends, than the economic effect should be mildly inflationary. This could feed into inflation expectations, reversing their recent decline. In broader terms, it is impossible to assess the long-term impact of NAFTA abrogation until we answer the question of whether the Trump administration is pluto-populist or genuinely populist. If pluto-populist, NAFTA's demise would be largely designed for domestic political consumption and would be the end of the matter. No long-term implications would really exist as, the Trump White House would conclude bilateral deals with Canada and Mexico to ensure that trade is not interrupted and that crucial constituencies - Midwest auto workers and farmers - do not turn against the administration. If genuinely populist, however, the White House would likely have to abrogate WTO rules as well in order to make a real dent to its trade deficit. The U.S. has no way to raise tariffs above an average bound tariff of 3.4%, other than for selective imports and on a temporary basis, or through a flagrant rejection of the WTO's authority. Given the likely currency moves post-NAFTA's demise, those levels would have an insignificant effect on U.S. trade with its North American neighbors. President Trump hinted as much when he sent a 336-page report to Congress titled "The President's Trade Policy Agenda," which argued that the administration would ignore WTO rules that it deems to infringe on U.S. sovereignty. The NAFTA negotiations, put in the context of that document, are a much more serious matter that might be part of a slow rollout of global trade policy that only becomes apparent in 2018.18 From a geopolitical perspective, ending NAFTA would make the U.S. less geopolitically secure. If the U.S. turned its back on its own neighbors, one of which is its closest military ally, then Canada and Mexico may seek closer trade relations with Europe and China. This could lead to the diversification of their export markets, including - most critically for U.S. national security - energy. In addition, Canada could allow significant Chinese investment into its technology sector, particularly in AI and quantum computing where the country is a global leader. Additionally, any negative consequences for the Mexican economy would likely be returned tenfold on the U.S. in the form of greater illegal immigration flows, a greater pool of recruits for Mexican drug cartels, and a rise in anti-Americanism in the country. The latter is particularly significant given the upcoming July 2018 presidential election and current solid polling for anti-establishment candidate Andrés Manuel López Obrador (Chart 18). Obrador is in the lead, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress (Chart 18, bottom panel). However, acrimonious NAFTA negotiations and a nationalist U.S. could change the fortunes for both Obrador and MORENA. Ultimately, everything depends on whether Trump's campaign rhetoric on trade is real. At this point, we lean towards Trump being a pluto-populist. The proposed tax cuts are clearly not designed with blue-collar workers in mind. They are largely a carbon-copy of every other Republican tax reform plan in the past and thus we assume that their consequences will be similar. If the signature legislation of the Trump White House through 2017-2018 will be a tax plan that skews towards the wealthy (Chart 19), than why should investors assume that its immigration and free trade rhetoric are real? Chart 18Populism On The March In Mexico Chart 19Tax Cuts Are Not Populist If ending NAFTA is merely red meat for the Midwestern base, and is quickly replaced with bilateral "fixes," then long-term implications will be muted. If, on the other hand, it is pursued as a new U.S. policy, then the significance will be much greater: it will mark the dawn of a new trend of twenty-first century mercantilism coming from the former bulwark of international liberalism. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, “The Apex Of Globalization – All Downhill From Here,” dated November 12, 2014, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, “Trumponomics: What Investors Need To Know,” dated September 4, 2015, available at gis.bcaresearch.com, and Geopolitical Strategy Special Report, “U.S. Election: The Great White Hype,” dated March 9, 2016, available at gps.bcaresearch.com. 4 Candidate Donald Trump made this comment during his first debate with Secretary Hillary Clinton. The September 26 debate focused heavily on free trade and globalization. 5 Mexico is exempt from several crucial articles in Chapter 6 due to the political sensitivity of the domestic energy industry. 6 Please see Hufbauer, Gary Clyde and Jeffrey J. Schott, "NAFTA Revisited," dated October 1, 2007, available at piie.com, and Hufbauer, Gary Clyde and Jeffrey J. Schott, NAFTA Revisited, New York: Columbia University Press, 2005. 7 Please see United States International Trade Commission, "Economic Impact of Trade Agreements Implemented Under Trade Authorities Procedures," Publication Number: 4614, June 2016, available at usitc.gov. First accessed via Congressional Research Service, "The North American Free Trade Agreement (NAFTA)," dated May 24, 2017, available at fas.org. 8 Since 1994, Canada has been sued 39 times and has paid out a total of $215 million in compensation. The U.S. is yet to lose a single case! 9 On average, vehicles produced in NAFTA member states average 75% local content; therefore, the first part of the demand is reachable if the White House is willing to budge. 10 Please see Evenett, Simon J. and Johannes Fritz, "Will Awe Trump Rules?" Global Trade Alert, dated July 3, 2017, available at globaltradealert.org. 11 Please see Robert Putnam, "Diplomacy and domestic politics: the logic of two-level games," International Organization 42:3 (summer 1988), pp. 427-460. 12 Please see Autor, David H., David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 13 Pluto-populists use populist rhetoric that appeals to the common person in order to pass plutocratic policies that benefit the elites. 14 Please see BCA Geopolitical Strategy Special Report, “Constraints & Preferences Of The Trump Presidency,” dated November 30, 2016, available at gps.bcaresearch.com. 15 See in particular the Trade Expansion Act of 1962 (Section 232b), the Trade Act of 1974 (Sections 122, 301), the Trading With The Enemy Act of 1917 (Section 5b), and the International Emergency Economic Powers Act of 1977. 16 Peter Navarro, director of the White House's National Trade Council, has argued throughout March that the U.S. chronic deficits and global supply chains were a threat to national security. 17 Unless President Trump and his advisors ignore the reality that the U.S. still imports 40% of its energy needs and will likely be doing so for the foreseeable future. 18 Please see BCA Geopolitical Strategy Weekly Report, “Political Risks Are Understated In 2018,” dated April 12, 2017, available at gps.bcaresearch.com.

Highlights The bill is bullish for growth and therefore for the equity markets and the U.S. dollar; The bill consists mostly of tax cuts, not reforms, that favor corporations and the wealthiest taxpayers; The bill is bullish for growth in the short term, but also inflationary and hence a risk to growth in the medium term; A non-populist White House is a relief to the markets, particularly on trade policy, but may mean a more hawkish foreign policy. Feature Chart 1Trump: A Boon For##BR##Main Street And Wall Street Since the November 2016 election, and particularly since President Donald Trump's inauguration, financial markets have celebrated. This is ironic given that on the campaign trail, Trump often adopted populist rhetoric indistinguishable from that of Bernie Sanders, the bête noire of the business community. Trump's cabinet, however, quickly took on a pro-business outlook following the inauguration. Despite appointing several notable trade hawks, the administration sported half a dozen former Goldman Sachs employees. Business confidence soared, especially among small businesses, while regulatory worries hanging over CEO's melted away (Chart 1). Both Wall Street and Main Street took one look at President Trump's cabinet at the end of January and decided that there was not an iota of genuine populism in the White House. This view was reinforced by three early decisions by the Trump administration: China: President Trump reneged on his promise to designate China a currency manipulator formally on day one of his administration.1 Instead, he hosted President Xi Jinping at the Mar-A-Lago Summit in April and agreed to engage in trade talks over the rest of the year. (He again declined to accuse China of currency manipulation in October.) Budget: President Trump's "skinny budget" proposal in May oozed with Republican Party orthodoxy, bolstering spending on defense and border security, while calling for drastic cuts to domestic programs. The implication was that future tax cuts would ultimately be "paid for" via draconian fiscal austerity in the distant future. "Breitbart clique" ousted: Steve Bannon, the White House Chief Strategist and self-described economic nationalist, was fired in mid-August, with several prominent allies ousted in the wake of his departure. Bannon's departure left Treasury Secretary Steven Mnuchin, chief economic advisor Gary Cohn, and Commerce Secretary Wilbur Ross firmly in charge of economic policy. Enter Tax Cuts The coup-de-grâce of Republican orthodoxy is the just-proposed tax cut plan. The proposal by the House Ways and Means Committee is heavily stacked in favor of corporations and the top-income brackets. As Table 1 clearly illustrates, the household component of the plan is nearly balanced - and therefore deserving of the moniker "reform" - whereas the corporate side of the ledger is closer to a pure and simple cut. Table 12017-2018 Republican Tax Cut Proposal - House Ways And Means Committee (Oct. 2017) Some of the more prominent measures proposed by the House and Ways Committee are: Household Income The highest tax rate remains 39.6%, but would now only kick in at $1 million in taxable income;2 The Alternative Minimum Tax (AMT) will be repealed, which hurts the upper middle class and wealthy by limiting tax benefits from a variety of deductions; The estate tax will be fully eliminated by 2024; The standard deduction will be doubled from $12,700 to $24,000, one of the few direct benefits to lower-income families; The plan would repeal the state and local income and sales tax deductions, while capping the state and local property tax deduction to $10,000; Almost all itemized deductions will be eliminated - such as medical expenses, property losses, casualty losses, etc.; The mortgage interest rate deduction for future home purchases will be capped, with only homes up to $500,000 covered. Corporate Income The corporate tax rate will be cut from 35% to 20%; Companies will be able to deduct the full amount of business investments in the year that they are made, although the provision would expire at the end of 2022; The tax rate on income from pass-through businesses would fall to 25%, considerably below the top household income tax rate; Several deductions would be eliminated, including the deduction of interest on debt; The "worldwide" tax system would be overhauled and foreign earnings repatriated: U.S. multinational corporations would pay a 12% tax rate on past profits that they repatriate, while future overseas earnings would be taxed at the new 20% corporate rate. We would caution clients from parsing too carefully through the proposal, lest they waste their time. The Senate is likely to pass a completely different set of proposals. The GOP plan is to get to a "conference committee" as fast as possible, where a new draft legislation can be hammered out from the two disparate proposals. We suspect that this entire process will miss the self-imposed target of "before Christmas," and probably last until the end of the first quarter.3 Nonetheless, we can discern the priorities of the House Republicans by gauging the winners and losers of their proposal. Our immediate take is that the tax cuts greatly benefit upper-income filers (households making over $423,000), moderately hurt upper-middle-class / lower-upper-class filers (those making between $260,000 and $423,000), and are largely neutral for the rest of households. First, the highest income groups are the clear beneficiaries: households making between roughly $450,000 and $1,000,000 will see their income tax rates fall by nearly 5%, by far the largest decrease planned. And, obviously, it is upper-income households that benefit from repealing the estate tax. Meanwhile, the upper middle class takes on the brunt of the burden of "reform": households making between $260,000 and $423,000 will see far fewer benefits under the proposed legislation. First, they are the only income bracket that will see a tax increase, from 33% to 35%. Second, they will not necessarily have the wherewithal to reclassify their income as pass-through business income. Third, many of the itemized deductions that will be eliminated will make a real difference in their filings. Fourth, they were the most likely to purchase homes between $500,000 and $1,000,000, which will no longer be eligible for interest-rate deduction. Fifth, the repeal of the estate tax will make less of a difference for this income group. Sixth, if they are domiciled in high-tax rate states and municipalities, these households will now be limited to how much they can deduct from federal taxes.4 Overall, the proposed tax cut plan fits general Republican orthodoxy.5 It tries to stimulate growth by favoring corporations and the wealthy. For economic growth, the plan is bullish in the short term. Particularly bullish is the ability of corporations to fully deduct the amount of business investment for the next five years. This provision could significantly increase investment in the short term, especially given the implicit threat that the opportunity will expire in 2022.6 Will the plan fail? It could, if enough Republican voters turn against it. The latest polling from Pew research - albeit from April of this year - shows that Americans no longer think that they pay too much in taxes (Chart 2). On the other hand, Republican and Republican-leaning voters do have a problem with the complexity of the tax code (Chart 3), and the proposed plan simplifies taxes for some middle-income households by doubling the standard deduction and repealing the AMT. The White House has already begun stressing this feature given that it polls well with voters. Chart 2American Voters Think Taxes Are Fair... Chart 3...But Republican Voters Think They Are Too Complex Polling suggests that President Trump remains relatively popular with Republican voters despite his dismal polling with the general public (Chart 4). He is polling only slightly below the average of previous Republican presidents at this point in his term in office. As long as Trump remains more popular with Republican voters than his Republican peers in Congress, we think that he will be able to force the tax plan through both the Senate and the House. In fact, we could even see some Democrats in the Senate supporting these tax cuts. Table 2 lists the 2018 Senate races to watch, particularly the vulnerable Democrats campaigning in red states that President Trump carried in 2016. Senators Nelson (D - Florida), Donnelly (D - Indiana), McCaskill (D - Missouri), Tester (D - Montana), Heitkamp (D - North Dakota), Brown (D - Ohio), and Baldwin (D - Wisconsin) are especially vulnerable. That makes seven potential votes for the Trump tax cut, potentially enough "slack" for the Republicans in the Senate to lose one or two votes on the tax bill. Chart 4Trump Remains Popular With GOP Voters Table 22018 Senate Races To Watch Is it even worthwhile to contemplate a scenario in which Republicans pass the tax cuts with Democrat support in the Senate? The short answer is yes. The 2001 Economic Growth and Tax Relief Reconciliation Act, the first of two Bush-era tax cuts, passed with 58 votes in favor, including 12 Democrats. Of the 12 that voted with Republicans, only three were from blue states, while the other nine were from red states that President Bush had carried in 2000. The 2003 tax-cut bill, Jobs and Growth Tax Relief Reconciliation Act of 2003, also passed with Democratic support with only 51 votes in favor. Senators Bayh (D - Indiana), Miller (D - Georgia), and Nelson (D - Nebraska) all crossed the aisle. Bayh was facing reelection in 2004, as was Nelson in 2006, in their respective red states. Bottom Line: The proposed tax cuts will benefit corporations and the upper-income Americans. The Senate may make some symbolic changes to the proposal to make it more palatable to the median American - given that senators have to capture the median voter in their state to win reelection. For example, the estate tax repeal may be scrapped and rules on deducting state and local taxes may be modified. Regardless of how the horse-trading goes, we believe that the U.S. economy will receive a modest stimulus in the form of a roughly $1.5 trillion tax cut (over ten years). Given that the U.S. economy is at full employment and firing on all cylinders, the proposed tax cuts should be marginally bullish for growth and inflation (Chart 5). Chart 5Regardless Of Tax Cuts, U.S. Economy Is Ripped What Do The Tax Cuts Tell Us About President Trump? We are big believers in the theory of "revealed preferences." While this concept was formally applied by economist Paul Samuelson to consumer behavior, we like to apply it to policymakers. The idea is to ignore the rhetoric and focus on what patterns of behavior reveal about genuine preferences. Politicians talk a lot, particularly during an election campaign. As a presidential candidate, Donald Trump was a clear populist candidate. He only revealed his tax reform plan in late September 2015 and then rarely mentioned it on the campaign trail. While his tax cut proposal languished on the campaign website, Trump focused on rallying voters around a combination of populist promises. These were, in no particular order, to build the border wall (and make Mexico pay for it), to rebuild American infrastructure, to repeal Obamacare, to destroy the Islamic State terrorist movement while disengaging the U.S. from global affairs, and to punish the unfair practices of trade partners like China and Mexico. Fast forward 12 months and we are now half-way to the 2018 mid-term election, with the Republicans controlling all three branches of government, and yet the only electoral promise that President Trump is even close to achieving is the just-announced tax cut.7 The revealed preference of the Trump administration, at least at this point, is Republican orthodoxy. Trump is a pro-growth, pro-business, anti-tax, anti-spending, red-blooded Republican. He has eschewed trade conflict with China, ignored infrastructure proposals, largely toed-the-line of foreign policy orthodoxy, and left hedge fund managers - a punching bag on the campaign trail - alone.8 To put it bluntly, Trump's behavior thus far suggests that he is a pluto-populist. A pluto-populist is someone who rules on the behalf of a plutocracy - an oligarchy controlled by the wealthiest citizens - but whose main tactic is to rally the plebeians (the common people) through populist policies. The House's draft tax plan provides sweeping gains for the wealthiest. It also preserves or expands some benefits for the poorest groups, so as to make it politically achievable. The upper middle class - the professional class - stands to suffer the most under the new tax scheme. If this analysis is correct, what does it reveal about President Trump's strategy going forward? Anti-globalization rhetoric is just talk: The fourth round of NAFTA renegotiations ended with a bang: the U.S. delivered four new demands, two of which both Ottawa and Mexico City have identified as non-starters.9 However, in the pluto-populist scenario, even if NAFTA is ultimately abrogated, the Trump administration will ensure that the critical components are preserved in bilateral agreements with Canada and Mexico. While those agreements are negotiated, the Trump Administration will not raise tariffs to the maximum, "bounded," level as allowed by the WTO. Meanwhile, trade relations with China may still sour in 2018, but they will not produce a trade war. Social unrest could increase: As we argued in a recent Special Report, the American structural context is ripe for more social unrest due to "elite overproduction."10 Trump's policies are likely to feed this condition. Meanwhile, his rhetoric and symbolic gestures will fuel the flames of division in order to play to his base, and force Democrats to argue about how to respond. This would be the populist part of pluto-populism. Hawkish foreign policy: With most of his domestic policies stymied, President Trump will pivot to the foreign theatre. We would particularly watch the growing tensions in the Middle East between Saudi Arabia and Iran, which could soon involve Lebanon.11 President Trump has also decertified the Iran nuclear deal, setting the stage for Congress to decide whether it will impose new sanctions and thus abrogate the deal. Plus, there is always North Korea. Bottom Line: Essentially, President Trump's strategy will be to pass pro-business, pro-market economic policies while distracting his largely anti-business, anti-market voters through ancillary issues. Investment Implications On the one hand, this analysis implies a very bullish policy mix as the Trump administration will not do anything domestically that hurts the ongoing bull market. On the other hand, some of those "ancillary" issues could flare up and impact the market, particularly if they involve a ratcheting up of tensions with Iran and North Korea. Chart 6No Debate: There Is No##BR##Trickle-Down From Tax Cuts The one risk that we remain concerned about is protectionism. We expected Trump to be more disruptive this year, and the above analysis suggests that protectionism, too, is merely hot air. However, Trump has only been in office for ten months. The absence of trade tensions with China may be a function of ongoing negotiations with North Korea: the U.S. needs China's cooperation in order to force North Korean leader Kim Jong-Un to the table. Ironically, then, a resolution of North Korean tensions could increase America's maneuvering vis-à-vis China, allowing Trump to become a lot more protectionist in 2018.12 Moreover, investors may be overemphasizing headline trade negotiations such as NAFTA or the China talks. The Trump administration may pursue protectionist aims through selective tariffs, such as countervailing and anti-dumping duties, in selective fashion. In other words, investors should pay attention to individual tariff decisions rather than overall negotiations.13 As for his electoral base, as long as President Trump can continue to ensure that they are focused on social disputes at home and hawkish rhetoric abroad, they may not notice the lack of movement on domestic promises. In particular, we have a high-conviction view that the just-proposed tax cuts will do nothing to curb income inequality in the U.S., and will likely deepen it, as previous such GOP-efforts did (Chart 6). Will this hurt President Trump in his 2020 reelection bid? We doubt it. But it does portend still greater socio-economic tensions and political populism in the long run. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The promise was made in a Wall Street Journal opinion piece that then-candidate Trump penned on November 9, 2015. Please see Donald J. Trump, "Ending China's Currency Manipulation," dated November 9, 2015, available at wsj.com. 2 The top marginal tax rate of 39.6% is currently applied to single individuals making more than $418,401, a head of household making more than $444,501, and married couples, filing jointly, making more than $470,701. Technically, according to the current draft bill, the top tax rate in the House plan is supposedly about 45.6% between $1-$1.2 million, after which it falls back to 39.6%. A quirk in the proposal holds that once a filer hits $1 million of income, the IRS starts clawing back the $12,000 that the filer saved from having a 12% tax rate on his first $90,000 of income instead of a 25% tax rate. That clawback comes in the form of 6% surtax on income above $1 million. The $12,000 is completely reclaimed once the filer hits $1.2 million. By extension, everyone who makes over $1.2 million has had to pay that extra $12,000 in taxes. 3 For more on how the reconciliation process works, and how it will affect the timeline, please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 4 From a political perspective, the GOP may have simply made a bet that high-tax-rate, blue-state households making $260,000-to-$430,000 do not vote Republican. 5 The congressional budget resolution that sets out the reconciliation instructions for these tax cuts also includes draconian spending cuts, which would presumably help balance the books. Although none of those cuts will pass Congress, they reveal the traditional preference of the Republican party: cut taxes, pay for the cuts by means of a smaller government delivering fewer services. 6 And perhaps this investment boost will come just in time to help re-elect Trump in 2020! 7 Although he deserves some credit for bringing to conclusion the pre-existing fight against the Islamic State. 8 In fact, the House tax bill leaves the "carried interest" tax break in the code. 9 For more on NAFTA, please see our upcoming Special Report with BCA's Global Investment Strategy, to be published on November 10. 10 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 11 Lebanese Sunni Prime Minister Saad Harriri recently resigned while visiting Saudi Arabia, claiming that he feared for his life due to Iranian influence in Lebanon; Saudi Arabia itself is engaged in deep political struggle. 12 Indeed, in our original forecast of Trump's trade policy, we surmised that 2017 would largely be a year of negotiations, while 2018 would see the real fireworks. Please see BCA Geopolitical Strategy, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 13 An important such decision looms by January 12, 2018, which is the deadline by which President Trump must decide whether to impose "safeguard" tariffs on imports of solar panels and washing machines.

Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. 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-14 * 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. 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Special Report

Dear Client, The attached report on China’s just-completed nineteenth National Party Congress marks the culmination of six years of political analysis by BCA’s Geopolitical Strategy. In it, my colleague Matt Gertken posits that President Xi Jinping’s domestic political constraints have significantly eased, allowing his administration to intensify its preference for structural reform. Our cardinal analytical rule holds that policymaker preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. As a matter of methodology, we focus on constraints. In China, Xi faced formidable constraints when he took power five years ago, which is why we pushed against the enthusiastic narrative at the time that he would transform China through supply-side reforms. This narrative, strongest in the wake of the October 2013 Third Plenum, has not materialized in line with investor expectations thus far. In this report, we argue that it is time to adjust the view on China. Xi has amassed substantial political capital thanks to his anti-corruption campaign, centralization of power, and other actions largely popular with the middle class. Investors are today missing this point because they are disappointed with the lack of genuine progress since 2012. We expect that President Xi will begin spending this political capital by favoring supply-side reforms, especially by reining in the rampant credit growth that has underpinned China’s investment-led economic model. In the short term, this means that politics in China will evolve from a tailwind to a headwind to growth. In the long term, it is too soon to say what it means. For investors, however, it means that today’s synchronized global growth recovery may be at risk of a policy-induced growth slowdown in China. I sincerely hope you enjoy our report. If you are interested in similar investment-relevant geopolitical analysis, please do not hesitate to contact us for a sample of our work. Kindest Regards, Marko Papic, Senior Vice President Chief Geopolitical Strategist Highlights Xi Jinping has shed domestic political constraints that have been in place since 2012; The lack of constraints suggests his reform agenda will intensify over the next 12 months; The use of anti-corruption agencies to enforce economic policy suggests that reform implementation will become more effective; Chinese politics are shifting from a tailwind to a headwind for global growth and EM assets. Feature Chart 1Stability Continues After Party Congress? China's nineteenth National Party Congress concluded on October 25 with the new top seven leaders - the members of the Politburo Standing Committee (PSC) - taking the stage in the Great Hall of the People. The party congress is a five-year leadership reshuffle that, in this case, marks the halfway point of President Xi Jinping's term in office.1 President Xi was the center of attention throughout the event. It is widely perceived that he is the most powerful Chinese leader since Deng Xiaoping. The Communist Party chose to elevate his personal power in conspicuous ways that raises political uncertainties about the succession in 2022 as well as about the future trajectory of Chinese policy, including economic policy. BCA's Geopolitical Strategy has awaited this transition since 2012, when President Xi and Premier Li Keqiang took over the top two positions in China.2 While we are inherently skeptical of Xi's grandiose reform agenda, we are also deeply aware of the importance of political constraints in determining economic policy outcomes - and Xi has just overcome significant domestic constraints. If Xi accelerates and intensifies his reforms next year - particularly deleveraging and industrial restructuring - he will add volatility to Chinese risk assets and create a drag on Chinese growth. Xi's personal concentration of power could be an enabling factor in driving reforms. But it will certainly be a source of higher political uncertainty over the next five years (Chart 1), especially as the 2022 succession approaches. Therefore a lack of reform would be a noxious combination. Finally, China's ascendancy increases the phenomenon of global multipolarity - it is a challenge to the U.S.-led system and will eventually produce a reaction, most likely a negative one.3 In short, Chinese political and geopolitical risk is understated. This situation presents a range of risks and opportunities for investors, but it is broadly a headwind for global growth and EM assets. A Chinese "policy mistake" is also a risk to our House View of being overweight equities and underweight bonds for the next 12 months. Back To 2012 When Xi rose to power in 2012, it was widely known that China's economy had reached a pivotal moment. Exports were declining as a share of GDP in the wake of the Great Recession and end of the U.S. "debt super-cycle," and investment was weakening as the country's massive fiscal and credit stimulus wore off (Chart 2). Meanwhile the Communist Party faced a crisis of legitimacy, with an emergent middle class making ever greater demands on the system (Chart 3). The rapid rise in household income over preceding years, combined with high income inequality and poor quality of life, raised the prospect of serious socio-political challenges to single-party rule.4 President Hu Jintao searched for ways to strengthen state control over an increasingly restless society, while outgoing Premier Wen Jiabao warned openly that China's economy was unsustainable and imbalanced and that political reform would be an "urgent task." Hu Jintao's farewell address at the eighteenth party congress (2012) reflected the party's grave concerns. His successor, Xi Jinping, was in charge of drafting the report. This relationship highlighted an important degree of party consensus. The report called for fighting corruption and disciplining the party, while doing more to protect households from the negative externalities of the past decade's rapid growth, including pollution (Chart 4). Chart 2Xi Took Power Amid Economic Transition Chart 3The Communist Party's Newest Constraint Chart 4Xi Took Power Amid Instability Risks It also outlined China's hopes of becoming a more consequential global player through acquiring naval power and forging a new, peer relationship with the United States. The overriding imperative was to win back support and legitimacy for the party, lest it fall victim to the fate of the world's other Marxist-Leninist regimes - i.e. internal socio-economic sclerosis and external pressure from the U.S.-led, democratic-capitalist world order. Xi Jinping took over at this juncture, using the 2012 work report as his guideline for an ambitious policy agenda. Xi's main goals centered on power: namely, ensuring regime survival at home and increasing China's international clout abroad. Specifically, the Xi administration sought to (1) centralize political control so that difficult choices could be made and implemented effectively; (2) improve governance so that public discontent could be mitigated over the long run; and (3) restructure the economy so that productivity growth could remain robust in the face of sharply declining labor force growth, thus stabilizing the potential GDP growth rate.5 Obviously there was no guarantee that Xi would be successful. China's response to the Global Financial Crisis had required a large-scale decentralization of control: local governments, banks, state-owned enterprises and shadow lenders were encouraged to lever up and grow amid the global collapse (Chart 5). This created imbalances and liabilities for the central leadership while also creating new economic (and hence political) centers of power outside Beijing. Chart 5aLocal Government Spending Unleashed... Chart 5b...And Shadow Lending Too The central leadership also seemed to be losing control of the provinces: regional and institutional powerbrokers had emerged, challenging the party's hierarchy, and there was even reason to believe that the armed forces were deviating from central leadership.6 Without control of the local governments and other key institutions, any reform agenda would get bogged down. Finally, the political cycle was not particularly favorable to Xi. While the line-up of the all-powerful PSC looked favorable from 2012-17, the next crop of Communist leaders set to move up the ladder in 2017 seemed likely to constrain him. Moreover, the previous two presidents had chosen Xi's successors for 2022, according to party norms. Xi had very little room for maneuver - and this was negative for his policy outlook overall. As such, BCA's Geopolitical Strategy poured cold water on the more enthusiastic forecasts of economic reforms throughout Xi's first term. Our assessment was that he would focus on anti-corruption and governance reforms first and only attempt genuine economic reforms once his political capital grew significantly. Bottom Line: Xi Jinping faced major obstacles to his policy agenda of centralization, governance and economic reform in 2012. He faced a large and restless middle class, the difficulty of reining in local governments and state institutions, and the likelihood that China's previous top leaders would constrain his maneuverability in 2017 and 2022. Xi's First Term A lot has changed over the past five years. First, both global demand for Chinese goods and Chinese domestic demand have held up rather well, giving China a badly needed cushion during its economic transition. Steady consumption growth has partially offset the blow from declining investment, while Chinese exports have grown well, often faster than global trade (Chart 6).7 Second, Xi has consolidated power extensively within the party, the army, and other institutions. He executed the most aggressive purge that the party has seen in decades, enabling him to rebuild some public trust among a middle class worn out by corruption, as well as to remove political rivals (Chart 7). He also launched an extensive restructuring of the People's Liberation Army, its organizational structure and personnel, ensuring that "the party controls the gun."8 And he intensified social control, particularly in the online realm. Chart 6Changing The Economic Model Chart 7Anti-Corruption Campaign Still Going Symbolically, Xi was anointed the "core" of the Communist Party by the political elite in late 2016. Economic reform, however, has been compromised by Xi's focus on consolidating political power. True, he and Premier Li Keqiang tinkered with various policies to cut red tape, simplify domestic taxes, attract foreign investment, and encourage better SOE management, but none of the reforms launched over the past five years were painful and thus none were significant.9 Nowhere was this more apparent than during 2015-16, when economic and financial instability caused the Xi administration to delay reform initiatives and focus on reforming the economy. Beijing increased infrastructure spending, bailed out the local governments, depreciated the RMB, and imposed capital controls (Chart 8). "Old China," state-owned China, was the primary beneficiary. The stimulus-fueled rebound helped stabilize the global economy in 2016-17, particularly commodity-producing emerging markets, but it exacerbated China's internal problems - slow productivity growth, excessive debt creation, weak private sector investment, and waning foreign investment (Chart 9). Chart 8State Interventions In 2015-16 Chart 9Economic Reforms Still Needed The upside, however, was stability, which enabled Xi to approach the nineteenth National Party Congress from a position of strength. Now that the party congress has concluded, we can say that Xi has notched a series of significant "victories" and that his political capital is overflowing: Xi Jinping Thought: The congress voted to enshrine Xi's name into its constitution (Table 1), with a phrasing that echoes "Mao Zedong Thought," hence elevating Xi to immense moral authority within the party. The name of Xi's philosophy, "Socialism with Chinese Characteristics for a New Era," makes a slight adjustment to Deng Xiaoping's market-friendly philosophy. In other words, Xi's authority stems from his providing a synthesis of the regime's greatest two leaders: Mao's single-party Communist rule is being reaffirmed, but Deng's attention to economic reality and the need for pragmatic policies has also been preserved. As we have argued, this constitutional change is a reflection of the fact that Xi has already positioned himself to be the most influential leader well into the 2020s. Table 1Xi Jinping Thought Xi removes his successors: Xi managed to exclude any of China's "sixth generation" of leaders from the Politburo Standing Committee. He thus broke a very important (albeit informal) party norm. The norm was created under Deng Xiaoping to ensure a smooth transition of power, unlike the power struggle that occurred upon Mao's death. Now Xi will have a greater hand in choosing his successor, or even staying in power beyond 2022. This aids in the process of centralization, but it may well prove a step backwards in terms of governance and reform - that remains to be seen. It is a source of higher political uncertainty going forward. Xi dominates the Politburo: Xi prevented his predecessor Hu Jintao's loyalists from gaining a majority on the Politburo Standing Committee, as they seemed lined up to do in 2012. The line-up of the new Politburo and Politburo Standing Committee broadly indicates that Xi and his faction are the dominant force (Table 2). Taken with Xi's personal power, this is significant political capital with which the new administration can push its priorities, whatever they may be. Xi gets a new inquisitor: The Central Commission for Discipline Inspection (CDIC) is the party's internal watchdog. It has taken the leading role in the sweeping party purge and anti-corruption campaign over the past five years. Xi removed its chief, the hugely influential Wang Qishan, by reinforcing the retirement age and two-term PSC limit - a notable case of institutional norms being upheld. He put one of his loyalists, Zhao Leji, in this role instead. The CDIC will have a huge role over the next five years, and a market-relevant one, as we discuss below. Table 2The Magnificent Seven: China's New Politburo Standing Committee The above conclusions raise the possibility that Xi has become excessively powerful, that political institutions in China are being eroded by personal rule, and that political risks are set to explode upward in the near future. However, it is too soon to declare that Xi has staged a Maoist "power grab." There are reasons to think that Xi's accumulation of power has not overturned the delicate internal balances within the top leadership bodies.10 The result is in keeping with what we expected in our Strategic Outlook last December: Xi Jinping has amassed formidable political capital, but he has not destabilized the Chinese political system.11 He is a strongman leader within the established political system of an authoritarian state - he is not a tyrant seizing power in a bloodless revolution. (At least, not yet.) This is broadly positive for China's policy continuity and political framework - and in this sense it is also broadly market-positive, being an outgrowth of the status quo rather than a disruptive break from it. China's leaders continue to be career politicians, trained in law or economics, with considerable executive experience in governing and limited business or military experience, all unified in the name of regime preservation (Chart 10). Over the long run, this suggests that China's "Socialist Put" remains intact, i.e. that the state will intervene to prevent a crash landing.12 Nevertheless, an important corollary of the above is that Xi holds the balance, and hence there are no longer any major domestic political or governmental constraints to prevent him from pursuing his policy agenda - especially over the next 12 months, when his political capital is still fresh and the economic backdrop is favorable. The fact that Xi emphasized "sustainable and sound" growth, deliberately excluded GDP growth targets beyond 2021, and altered the definition of the Communist Party's so-called "principal contradiction" in order to prioritize quality-of-life improvements, suggests that the reform agenda is about to get rebooted. Bottom Line: Xi Jinping has consolidated power extensively, but he has not staged a silent coup d' état or overthrown the balance of power within the Communist Party. This suggests that Xi's policies and reforms will intensify over the next year. Chart 10Characteristics Of Chinese Rulers Mostly Unchanged Since 2012 Xi's Second Term: What To Expect Instead of playing it safe in the lead-up to the all-important party congress over the past twelve months, Xi surprised the markets with a series of regulatory actions designed to tamp down the property bubble, regulate the financial markets, punish speculation, and reduce industrial overcapacity and pollution (Chart 11).13 This tightening of policy strongly signaled that Xi's appetite for political risk is rising in keeping with his growing political capital. Beijing is signaling that it aims to continue with tougher financial, industrial and environmental reforms in the aftermath of the party congress. In particular, systemic financial risk has been identified as a risk to the state's overall stability. Of course, China is unlikely to sharply reduce the ratio of total debt-to-GDP out of an ill-advised, self-imposed bout of austerity. But the Xi administration is likely to suppress its growth rate (Chart 12), as well as to continue cracking down on specific institutions and financial practices deemed to be excessively risky or under-regulated, as has occurred this year in insurance and shadow lending.14 Chart 11China's Borrowing Costs Rising Chart 12Debt Growth Faces Tougher Controls This financial focus is clear from top-level appointments and meetings in 2017, including a special Politburo meeting on financial risks in April and the once-in-five-years Central Financial Work Conference in July.15 The latter declared new regulatory powers for the central bank that will be put into place in the coming 12 months. The head of the new Financial Stability and Development Committee to oversee this work will likely be named, along with a replacement for the long-serving People's Bank of China Governor Zhou Xiaochuan. This change will initiate a new generation of leadership in the central bank, and one ostensibly directed at overseeing stricter macro-prudential controls.16 Another outcome of the financial conference was the warning that, going forward, local government officials will be held accountable over the course of their entire lives if they allow excessive financial risks and debt to build up under their watch.17 These developments suggest that policy will become a headwind to growth next year. We would expect downside risks to China's implicit 6.5% growth target. Why should the new deleveraging campaign have any more effect than similar efforts in the past? Aside from Xi's stronger position to enforce policies - explained above - the nineteenth party congress reinforced an important trend in policy implementation. The Xi administration has been using the CDIC, the party's anti-corruption unit, as a political tool to ensure broader policy enforcement. We have observed this trend over the past year both in the financial regulatory crackdown and the anti-pollution and overcapacity crackdown.18 Anti-corruption officials can compel more serious implementation from local governments, SOE managers, and others because they threaten to impose job losses or jail time, rather than mere fines. The CDIC appointed two new officials to oversee its operations in China's financial regulators just as the party congress was getting underway. Moreover, on the final day of the party congress, officials have announced that corruption investigations will be conducted into the commercial housing sector.19 The message is that the regulatory storm will expand - and will have teeth. Xi went a step further at the party congress by declaring the creation of a National Supervisory Commission, which will oversee the next phase of the anti-corruption campaign.20 This commission will expand the campaign outside the ranks of the Communist Party - where it has operated so far - to the government as a whole, i.e. the state administration and bureaucracy. It implies that every official from China's top ministries down to its lowest-level governments will be subjected to new forces of scrutiny. If this effort resembles the CDIC's role in hastening compliance in other areas of economic policy, then it will be a powerful tool for the Xi administration as it attempts to engineer a top-down restructuring of China's governance and economy. An aggressive new regulatory push, with the threat of corruption charges, in China's financial and industrial sectors would create a powerful drag on economic growth. It could easily send a chill down the spines of government officials, prompting them to cut or delay key investment decisions, as the initial anti-corruption campaign did in 2013-14.21 China's leaders will eventually attempt to offset any disorderly slowdown from reform measures with additional stimulus. However, given that the deleveraging campaign cuts to the heart of the financial sector, and that sharp new tools are being put to use, we would think that the probability of a "policy mistake" is going up. Bottom Line: Risks to Chinese economy and assets are rising as politics shifts from being a tailwind to a headwind. Xi Jinping faces few policy constraints and has shown appetite for greater political risk in the pursuit of his reform agenda. His administration has signaled that China's financial imbalances pose a threat to overall stability and require tougher regulation. New enforcement mechanisms - particularly those connected with anti-corruption efforts - threaten to bring the financial sector, as well as local government debt, under the spotlight and to create a chilling-effect among local officials. Investment Conclusions On one hand, any genuine attempt to hasten the transition of China's economy to consumer-led growth, de-emphasize GDP growth targets, and pare back overbuilt and heavy-polluting industry is highly consequential and will redistribute global growth.22 Table 3Post-Party Congress Scenarios And Probabilities Broadly speaking, the transition is negative for Chinese growth in the short term, but positive in the long term, as productivity trends would improve. It is negative for China's heavy industry, yet positive for technology, health and education; negative for commodities tied to the old economy (e.g. coal, iron ore, and diesel), but positive for commodities tied to consumers (oil/gasoline, aluminum, nickel, and zinc); negative for emerging markets that are commodity- and export-reliant and China-exposed, yet positive for domestic-oriented and/or China-insulated EMs. On the other hand, there is no longer a convincing excuse for poor implementation of central government policies. If China does not take concrete steps in pursuit of Xi's reform agenda - an agenda of "supply-side reform" that is now enshrined in the party's constitution - then it follows that Xi himself is unwilling to practice what he preaches. The first big test will be whether, when the economy starts to wobble, policymakers stimulate the "old economy" with the usual fervor, or whether they hold true to a course of re-ordering the economy and concentrating any stimulative credit flows more heavily into the social safety net and consumer-led industries and services. Given Xi's and China's rare opportunity, a failure to undertake difficult reforms in the coming months and years would be a clear sign that China will never pursue significant reforms of its own accord. It would have to be forced to do so by an internal or external crisis. This would mean that China's potential GDP would continue to decline for the foreseeable future (Table 3). Chart 13China's Ascendancy Challenges The U.S. If that were the case, declining potential GDP growth would combine with political uncertainty over Xi's 2022 succession to create a noxious brew of social malaise. A final and very important consideration is China's relationship with the United States and its allies, given the ongoing strains over U.S.-China trade, North Korea's nuclear and missile advances, China's militarization of the South China Sea, Taiwan's widening ideological distance from the mainland, and Japan's accelerating re-armament. The party congress was a highly visible display of Chinese power and self-confidence, in which Xi broke with the past to suggest that China is moving into "center stage" in the world. Xi not only reaffirmed state-led growth but also emphasized that China's foreign policy assertiveness is here to stay over the long run. This is a poignant reminder of our long-term investment theme of global multipolarity. The United States is not likely to relinquish global or even regional leadership easily. So while relations may be pacified in the short term, the risk of conflict, whether economic or military, is rising over time (Chart 13). Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 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. 4 Popular unrest was boiling up due to grievances over corrupt officials, mismanagement of internal migration, local government land seizures, a weak justice system, and a host of labor disputes and environmental incidents. 5 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. See also BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013. 6 The arrest and excommunication of Chongqing Party Secretary Bo Xilai in 2012 epitomizes the regional and institutional challenge, since Bo had a network of alliances that fell under Xi Jinping's anti-corruption dragnet and sprawled across the energy sector and public security agencies. The regional problem was highlighted again this year when one of Bo's successors, Chongqing Party Secretary Sun Zhengcai, was ousted for allegedly failing to extirpate Bo's influence. Meanwhile, the People's Liberation Army became more vocal and independent in ways that raised concerns among foreign observers, such as U.S. Defense Secretary Robert Gates, who suggested that the PLA took China's civilian leadership by surprise when it conducted a test flight of its stealth J-20 fifth generation fighter during Gates's visit to Beijing in January 2011. 7 Please see BCA China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade," dated October 26, 2017, available at cis.bcaresearch.com. 8 For the military reshuffle, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 9 The most important reform was the loosening of the one-child policy, which was a social change with long-term economic benefits. Reforms to household registration, land rights, the property sector, SOEs, fiscal policy, private property, and the judicial system have moved slowly. 10 The PSC has a three-way balance of sorts, with two representatives of each faction (Jiang Zemin, Hu Jintao, and Xi Jinping), plus Xi presiding over all. Please see Cheng Li, "The Paradoxical Outcome Of China's 19th Party Congress," Brookings Institution, October 26, 2017. Our own analysis of the 2017 result, drawing on Cheng Li's work, shows that the party bureaucracy, state bureaucracy and the military are represented at roughly the same levels as before on the 25-member Politburo. Further, the profile of the PSC members is relatively continuous with the previous PSC profiles. Namely, the relatively high share of leaders who have spent their careers ruling the provinces, or who have mostly worked in central government, is no higher than it was before, while the relatively low share of leaders who served on the military or managed state-owned enterprises is no lower than it was before. The division between rural and urban regions on the PSC is also the same as before. Thus, the only substantial change in the character profile of the PSC is the fact that China's leaders are increasingly coming from an educational background in the "soft sciences" rather than the "hard sciences": which is to be expected as the society evolves from manufacturing and construction to a services-oriented economy, even though it also suggests growing ideological orthodoxy. 11 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 13 Please see BCA China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 16 Please see "China: A Preemptive Dodd-Frank," in BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 18 Please see note 15 above. See also Barry Naughton, “The General Secretary’s Extended Reach: Xi Jinping Combines Economics And Politics,” dated September 11, 2017, available at www.hoover.org. 19 Please see "China To Launch Nationwide Inspection On Commercial Housing Sales," Xinhua, October 25, 2017, available at www.chinadaily.com. 20 Supervisory commissions will be created at every level of administration in all regions to ensure that the anti-corruption campaign is enforced across all government, not only within the Communist Party. The commissions will be based on experiences gained from trial programs in Beijing, Zhejiang, and Shanxi. Please see Viola Zhou, "Super anti-graft agency pilot schemes extended across China," South China Morning Post, October 30, 2017, available at www.scmp.com. 21 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Policy Mistakes And Silver Linings," dated October 7, 2015, available at cis.bcaresearch.com. 22 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com.

Special Report

Highlights Xi Jinping has shed domestic political constraints that have been in place since 2012; The lack of constraints suggests his reform agenda will intensify over the next 12 months; The use of anti-corruption agencies to enforce economic policy suggests that reform implementation will become more effective; Chinese politics are shifting from a tailwind to a headwind for global growth and EM assets. Feature Chart 1Stability Continues After Party Congress? China's nineteenth National Party Congress concluded on October 25 with the new top seven leaders - the members of the Politburo Standing Committee (PSC) - taking the stage in the Great Hall of the People. The party congress is a five-year leadership reshuffle that, in this case, marks the halfway point of President Xi Jinping's term in office.1 President Xi was the center of attention throughout the event. It is widely perceived that he is the most powerful Chinese leader since Deng Xiaoping. The Communist Party chose to elevate his personal power in conspicuous ways that raises political uncertainties about the succession in 2022 as well as about the future trajectory of Chinese policy, including economic policy. BCA's Geopolitical Strategy has awaited this transition since 2012, when President Xi and Premier Li Keqiang took over the top two positions in China.2 While we are inherently skeptical of Xi's grandiose reform agenda, we are also deeply aware of the importance of political constraints in determining economic policy outcomes - and Xi has just overcome significant domestic constraints. If Xi accelerates and intensifies his reforms next year - particularly deleveraging and industrial restructuring - he will add volatility to Chinese risk assets and create a drag on Chinese growth. Xi's personal concentration of power could be an enabling factor in driving reforms. But it will certainly be a source of higher political uncertainty over the next five years (Chart 1), especially as the 2022 succession approaches. Therefore a lack of reform would be a noxious combination. Finally, China's ascendancy increases the phenomenon of global multipolarity - it is a challenge to the U.S.-led system and will eventually produce a reaction, most likely a negative one.3 In short, Chinese political and geopolitical risk is understated. This situation presents a range of risks and opportunities for investors, but it is broadly a headwind for global growth and EM assets. A Chinese "policy mistake" is also a risk to our House View of being overweight equities and underweight bonds for the next 12 months. Back To 2012 When Xi rose to power in 2012, it was widely known that China's economy had reached a pivotal moment. Exports were declining as a share of GDP in the wake of the Great Recession and end of the U.S. "debt super-cycle," and investment was weakening as the country's massive fiscal and credit stimulus wore off (Chart 2). Meanwhile the Communist Party faced a crisis of legitimacy, with an emergent middle class making ever greater demands on the system (Chart 3). The rapid rise in household income over preceding years, combined with high income inequality and poor quality of life, raised the prospect of serious socio-political challenges to single-party rule.4 President Hu Jintao searched for ways to strengthen state control over an increasingly restless society, while outgoing Premier Wen Jiabao warned openly that China's economy was unsustainable and imbalanced and that political reform would be an "urgent task." Hu Jintao's farewell address at the eighteenth party congress (2012) reflected the party's grave concerns. His successor, Xi Jinping, was in charge of drafting the report. This relationship highlighted an important degree of party consensus. The report called for fighting corruption and disciplining the party, while doing more to protect households from the negative externalities of the past decade's rapid growth, including pollution (Chart 4). Chart 2Xi Took Power Amid Economic Transition Chart 3The Communist Party's Newest Constraint Chart 4Xi Took Power Amid Instability Risks It also outlined China's hopes of becoming a more consequential global player through acquiring naval power and forging a new, peer relationship with the United States. The overriding imperative was to win back support and legitimacy for the party, lest it fall victim to the fate of the world's other Marxist-Leninist regimes - i.e. internal socio-economic sclerosis and external pressure from the U.S.-led, democratic-capitalist world order. Xi Jinping took over at this juncture, using the 2012 work report as his guideline for an ambitious policy agenda. Xi's main goals centered on power: namely, ensuring regime survival at home and increasing China's international clout abroad. Specifically, the Xi administration sought to (1) centralize political control so that difficult choices could be made and implemented effectively; (2) improve governance so that public discontent could be mitigated over the long run; and (3) restructure the economy so that productivity growth could remain robust in the face of sharply declining labor force growth, thus stabilizing the potential GDP growth rate.5 Obviously there was no guarantee that Xi would be successful. China's response to the Global Financial Crisis had required a large-scale decentralization of control: local governments, banks, state-owned enterprises and shadow lenders were encouraged to lever up and grow amid the global collapse (Chart 5). This created imbalances and liabilities for the central leadership while also creating new economic (and hence political) centers of power outside Beijing. Chart 5aLocal Government Spending Unleashed... Chart 5b...And Shadow Lending Too The central leadership also seemed to be losing control of the provinces: regional and institutional powerbrokers had emerged, challenging the party's hierarchy, and there was even reason to believe that the armed forces were deviating from central leadership.6 Without control of the local governments and other key institutions, any reform agenda would get bogged down. Finally, the political cycle was not particularly favorable to Xi. While the line-up of the all-powerful PSC looked favorable from 2012-17, the next crop of Communist leaders set to move up the ladder in 2017 seemed likely to constrain him. Moreover, the previous two presidents had chosen Xi's successors for 2022, according to party norms. Xi had very little room for maneuver - and this was negative for his policy outlook overall. As such, BCA's Geopolitical Strategy poured cold water on the more enthusiastic forecasts of economic reforms throughout Xi's first term. Our assessment was that he would focus on anti-corruption and governance reforms first and only attempt genuine economic reforms once his political capital grew significantly. Bottom Line: Xi Jinping faced major obstacles to his policy agenda of centralization, governance and economic reform in 2012. He faced a large and restless middle class, the difficulty of reining in local governments and state institutions, and the likelihood that China's previous top leaders would constrain his maneuverability in 2017 and 2022. Xi's First Term A lot has changed over the past five years. First, both global demand for Chinese goods and Chinese domestic demand have held up rather well, giving China a badly needed cushion during its economic transition. Steady consumption growth has partially offset the blow from declining investment, while Chinese exports have grown well, often faster than global trade (Chart 6).7 Second, Xi has consolidated power extensively within the party, the army, and other institutions. He executed the most aggressive purge that the party has seen in decades, enabling him to rebuild some public trust among a middle class worn out by corruption, as well as to remove political rivals (Chart 7). He also launched an extensive restructuring of the People's Liberation Army, its organizational structure and personnel, ensuring that "the party controls the gun."8 And he intensified social control, particularly in the online realm. Chart 6Changing The Economic Model Chart 7Anti-Corruption Campaign Still Going Symbolically, Xi was anointed the "core" of the Communist Party by the political elite in late 2016. Economic reform, however, has been compromised by Xi's focus on consolidating political power. True, he and Premier Li Keqiang tinkered with various policies to cut red tape, simplify domestic taxes, attract foreign investment, and encourage better SOE management, but none of the reforms launched over the past five years were painful and thus none were significant.9 Nowhere was this more apparent than during 2015-16, when economic and financial instability caused the Xi administration to delay reform initiatives and focus on reforming the economy. Beijing increased infrastructure spending, bailed out the local governments, depreciated the RMB, and imposed capital controls (Chart 8). "Old China," state-owned China, was the primary beneficiary. The stimulus-fueled rebound helped stabilize the global economy in 2016-17, particularly commodity-producing emerging markets, but it exacerbated China's internal problems - slow productivity growth, excessive debt creation, weak private sector investment, and waning foreign investment (Chart 9). Chart 8State Interventions In 2015-16 Chart 9Economic Reforms Still Needed The upside, however, was stability, which enabled Xi to approach the nineteenth National Party Congress from a position of strength. Now that the party congress has concluded, we can say that Xi has notched a series of significant "victories" and that his political capital is overflowing: Xi Jinping Thought: The congress voted to enshrine Xi's name into its constitution (Table 1), with a phrasing that echoes "Mao Zedong Thought," hence elevating Xi to immense moral authority within the party. The name of Xi's philosophy, "Socialism with Chinese Characteristics for a New Era," makes a slight adjustment to Deng Xiaoping's market-friendly philosophy. In other words, Xi's authority stems from his providing a synthesis of the regime's greatest two leaders: Mao's single-party Communist rule is being reaffirmed, but Deng's attention to economic reality and the need for pragmatic policies has also been preserved. As we have argued, this constitutional change is a reflection of the fact that Xi has already positioned himself to be the most influential leader well into the 2020s. Table 1Xi Jinping Thought Xi removes his successors: Xi managed to exclude any of China's "sixth generation" of leaders from the Politburo Standing Committee. He thus broke a very important (albeit informal) party norm. The norm was created under Deng Xiaoping to ensure a smooth transition of power, unlike the power struggle that occurred upon Mao's death. Now Xi will have a greater hand in choosing his successor, or even staying in power beyond 2022. This aids in the process of centralization, but it may well prove a step backwards in terms of governance and reform - that remains to be seen. It is a source of higher political uncertainty going forward. Xi dominates the Politburo: Xi prevented his predecessor Hu Jintao's loyalists from gaining a majority on the Politburo Standing Committee, as they seemed lined up to do in 2012. The line-up of the new Politburo and Politburo Standing Committee broadly indicates that Xi and his faction are the dominant force (Table 2). Taken with Xi's personal power, this is significant political capital with which the new administration can push its priorities, whatever they may be. Xi gets a new inquisitor: The Central Commission for Discipline Inspection (CDIC) is the party's internal watchdog. It has taken the leading role in the sweeping party purge and anti-corruption campaign over the past five years. Xi removed its chief, the hugely influential Wang Qishan, by reinforcing the retirement age and two-term PSC limit - a notable case of institutional norms being upheld. He put one of his loyalists, Zhao Leji, in this role instead. The CDIC will have a huge role over the next five years, and a market-relevant one, as we discuss below. Table 2The Magnificent Seven: China's New Politburo Standing Committee The above conclusions raise the possibility that Xi has become excessively powerful, that political institutions in China are being eroded by personal rule, and that political risks are set to explode upward in the near future. However, it is too soon to declare that Xi has staged a Maoist "power grab." There are reasons to think that Xi's accumulation of power has not overturned the delicate internal balances within the top leadership bodies.10 The result is in keeping with what we expected in our Strategic Outlook last December: Xi Jinping has amassed formidable political capital, but he has not destabilized the Chinese political system.11 He is a strongman leader within the established political system of an authoritarian state - he is not a tyrant seizing power in a bloodless revolution. (At least, not yet.) This is broadly positive for China's policy continuity and political framework - and in this sense it is also broadly market-positive, being an outgrowth of the status quo rather than a disruptive break from it. China's leaders continue to be career politicians, trained in law or economics, with considerable executive experience in governing and limited business or military experience, all unified in the name of regime preservation (Chart 10). Over the long run, this suggests that China's "Socialist Put" remains intact, i.e. that the state will intervene to prevent a crash landing.12 Nevertheless, an important corollary of the above is that Xi holds the balance, and hence there are no longer any major domestic political or governmental constraints to prevent him from pursuing his policy agenda - especially over the next 12 months, when his political capital is still fresh and the economic backdrop is favorable. The fact that Xi emphasized "sustainable and sound" growth, deliberately excluded GDP growth targets beyond 2021, and altered the definition of the Communist Party's so-called "principal contradiction" in order to prioritize quality-of-life improvements, suggests that the reform agenda is about to get rebooted. Bottom Line: Xi Jinping has consolidated power extensively, but he has not staged a silent coup d' état or overthrown the balance of power within the Communist Party. This suggests that Xi's policies and reforms will intensify over the next year. Chart 10Characteristics Of Chinese Rulers Mostly Unchanged Since 2012 Xi's Second Term: What To Expect Instead of playing it safe in the lead-up to the all-important party congress over the past twelve months, Xi surprised the markets with a series of regulatory actions designed to tamp down the property bubble, regulate the financial markets, punish speculation, and reduce industrial overcapacity and pollution (Chart 11).13 This tightening of policy strongly signaled that Xi's appetite for political risk is rising in keeping with his growing political capital. Beijing is signaling that it aims to continue with tougher financial, industrial and environmental reforms in the aftermath of the party congress. In particular, systemic financial risk has been identified as a risk to the state's overall stability. Of course, China is unlikely to sharply reduce the ratio of total debt-to-GDP out of an ill-advised, self-imposed bout of austerity. But the Xi administration is likely to suppress its growth rate (Chart 12), as well as to continue cracking down on specific institutions and financial practices deemed to be excessively risky or under-regulated, as has occurred this year in insurance and shadow lending.14 Chart 11China's Borrowing Costs Rising Chart 12Debt Growth Faces Tougher Controls This financial focus is clear from top-level appointments and meetings in 2017, including a special Politburo meeting on financial risks in April and the once-in-five-years Central Financial Work Conference in July.15 The latter declared new regulatory powers for the central bank that will be put into place in the coming 12 months. The head of the new Financial Stability and Development Committee to oversee this work will likely be named, along with a replacement for the long-serving People's Bank of China Governor Zhou Xiaochuan. This change will initiate a new generation of leadership in the central bank, and one ostensibly directed at overseeing stricter macro-prudential controls.16 Another outcome of the financial conference was the warning that, going forward, local government officials will be held accountable over the course of their entire lives if they allow excessive financial risks and debt to build up under their watch.17 These developments suggest that policy will become a headwind to growth next year. We would expect downside risks to China's implicit 6.5% growth target. Why should the new deleveraging campaign have any more effect than similar efforts in the past? Aside from Xi's stronger position to enforce policies - explained above - the nineteenth party congress reinforced an important trend in policy implementation. The Xi administration has been using the CDIC, the party's anti-corruption unit, as a political tool to ensure broader policy enforcement. We have observed this trend over the past year both in the financial regulatory crackdown and the anti-pollution and overcapacity crackdown.18 Anti-corruption officials can compel more serious implementation from local governments, SOE managers, and others because they threaten to impose job losses or jail time, rather than mere fines. The CDIC appointed two new officials to oversee its operations in China's financial regulators just as the party congress was getting underway. Moreover, on the final day of the party congress, officials have announced that corruption investigations will be conducted into the commercial housing sector.19 The message is that the regulatory storm will expand - and will have teeth. Xi went a step further at the party congress by declaring the creation of a National Supervisory Commission, which will oversee the next phase of the anti-corruption campaign.20 This commission will expand the campaign outside the ranks of the Communist Party - where it has operated so far - to the government as a whole, i.e. the state administration and bureaucracy. It implies that every official from China's top ministries down to its lowest-level governments will be subjected to new forces of scrutiny. If this effort resembles the CDIC's role in hastening compliance in other areas of economic policy, then it will be a powerful tool for the Xi administration as it attempts to engineer a top-down restructuring of China's governance and economy. An aggressive new regulatory push, with the threat of corruption charges, in China's financial and industrial sectors would create a powerful drag on economic growth. It could easily send a chill down the spines of government officials, prompting them to cut or delay key investment decisions, as the initial anti-corruption campaign did in 2013-14.21 China's leaders will eventually attempt to offset any disorderly slowdown from reform measures with additional stimulus. However, given that the deleveraging campaign cuts to the heart of the financial sector, and that sharp new tools are being put to use, we would think that the probability of a "policy mistake" is going up. Bottom Line: Risks to Chinese economy and assets are rising as politics shifts from being a tailwind to a headwind. Xi Jinping faces few policy constraints and has shown appetite for greater political risk in the pursuit of his reform agenda. His administration has signaled that China's financial imbalances pose a threat to overall stability and require tougher regulation. New enforcement mechanisms - particularly those connected with anti-corruption efforts - threaten to bring the financial sector, as well as local government debt, under the spotlight and to create a chilling-effect among local officials. Investment Conclusions On one hand, any genuine attempt to hasten the transition of China's economy to consumer-led growth, de-emphasize GDP growth targets, and pare back overbuilt and heavy-polluting industry is highly consequential and will redistribute global growth.22 Table 3Post-Party Congress Scenarios And Probabilities Broadly speaking, the transition is negative for Chinese growth in the short term, but positive in the long term, as productivity trends would improve. It is negative for China's heavy industry, yet positive for technology, health and education; negative for commodities tied to the old economy (e.g. coal, iron ore, and diesel), but positive for commodities tied to consumers (oil/gasoline, aluminum, nickel, and zinc); negative for emerging markets that are commodity- and export-reliant and China-exposed, yet positive for domestic-oriented and/or China-insulated EMs. On the other hand, there is no longer a convincing excuse for poor implementation of central government policies. If China does not take concrete steps in pursuit of Xi's reform agenda - an agenda of "supply-side reform" that is now enshrined in the party's constitution - then it follows that Xi himself is unwilling to practice what he preaches. The first big test will be whether, when the economy starts to wobble, policymakers stimulate the "old economy" with the usual fervor, or whether they hold true to a course of re-ordering the economy and concentrating any stimulative credit flows more heavily into the social safety net and consumer-led industries and services. Given Xi's and China's rare opportunity, a failure to undertake difficult reforms in the coming months and years would be a clear sign that China will never pursue significant reforms of its own accord. It would have to be forced to do so by an internal or external crisis. This would mean that China's potential GDP would continue to decline for the foreseeable future (Table 3). Chart 13China's Ascendancy Challenges The U.S. If that were the case, declining potential GDP growth would combine with political uncertainty over Xi's 2022 succession to create a noxious brew of social malaise. A final and very important consideration is China's relationship with the United States and its allies, given the ongoing strains over U.S.-China trade, North Korea's nuclear and missile advances, China's militarization of the South China Sea, Taiwan's widening ideological distance from the mainland, and Japan's accelerating re-armament. The party congress was a highly visible display of Chinese power and self-confidence, in which Xi broke with the past to suggest that China is moving into "center stage" in the world. Xi not only reaffirmed state-led growth but also emphasized that China's foreign policy assertiveness is here to stay over the long run. This is a poignant reminder of our long-term investment theme of global multipolarity. The United States is not likely to relinquish global or even regional leadership easily. So while relations may be pacified in the short term, the risk of conflict, whether economic or military, is rising over time (Chart 13). Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 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. 4 Popular unrest was boiling up due to grievances over corrupt officials, mismanagement of internal migration, local government land seizures, a weak justice system, and a host of labor disputes and environmental incidents. 5 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. See also BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013. 6 The arrest and excommunication of Chongqing Party Secretary Bo Xilai in 2012 epitomizes the regional and institutional challenge, since Bo had a network of alliances that fell under Xi Jinping's anti-corruption dragnet and sprawled across the energy sector and public security agencies. The regional problem was highlighted again this year when one of Bo's successors, Chongqing Party Secretary Sun Zhengcai, was ousted for allegedly failing to extirpate Bo's influence. Meanwhile, the People's Liberation Army became more vocal and independent in ways that raised concerns among foreign observers, such as U.S. Defense Secretary Robert Gates, who suggested that the PLA took China's civilian leadership by surprise when it conducted a test flight of its stealth J-20 fifth generation fighter during Gates's visit to Beijing in January 2011. 7 Please see BCA China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade," dated October 26, 2017, available at cis.bcaresearch.com. 8 For the military reshuffle, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 9 The most important reform was the loosening of the one-child policy, which was a social change with long-term economic benefits. Reforms to household registration, land rights, the property sector, SOEs, fiscal policy, private property, and the judicial system have moved slowly. 10 The PSC has a three-way balance of sorts, with two representatives of each faction (Jiang Zemin, Hu Jintao, and Xi Jinping), plus Xi presiding over all. Please see Cheng Li, "The Paradoxical Outcome Of China's 19th Party Congress," Brookings Institution, October 26, 2017. Our own analysis of the 2017 result, drawing on Cheng Li's work, shows that the party bureaucracy, state bureaucracy and the military are represented at roughly the same levels as before on the 25-member Politburo. Further, the profile of the PSC members is relatively continuous with the previous PSC profiles. Namely, the relatively high share of leaders who have spent their careers ruling the provinces, or who have mostly worked in central government, is no higher than it was before, while the relatively low share of leaders who served on the military or managed state-owned enterprises is no lower than it was before. The division between rural and urban regions on the PSC is also the same as before. Thus, the only substantial change in the character profile of the PSC is the fact that China's leaders are increasingly coming from an educational background in the "soft sciences" rather than the "hard sciences": which is to be expected as the society evolves from manufacturing and construction to a services-oriented economy, even though it also suggests growing ideological orthodoxy. 11 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 13 Please see BCA China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 16 Please see "China: A Preemptive Dodd-Frank," in BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 18 Please see note 15 above. See also Barry Naughton, “The General Secretary’s Extended Reach: Xi Jinping Combines Economics And Politics,” dated September 11, 2017, available at www.hoover.org. 19 Please see "China To Launch Nationwide Inspection On Commercial Housing Sales," Xinhua, October 25, 2017, available at www.chinadaily.com. 20 Supervisory commissions will be created at every level of administration in all regions to ensure that the anti-corruption campaign is enforced across all government, not only within the Communist Party. The commissions will be based on experiences gained from trial programs in Beijing, Zhejiang, and Shanxi. Please see Viola Zhou, "Super anti-graft agency pilot schemes extended across China," South China Morning Post, October 30, 2017, available at www.scmp.com. 21 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Policy Mistakes And Silver Linings," dated October 7, 2015, available at cis.bcaresearch.com. 22 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com.

Special Report

Dear Client, In addition to this Special Report, we are publishing our monthly Tactical Asset Allocation table and supporting indicators today. These can be accessed directly from our website. Best regards, Peter Berezin, Chief Global Strategist Highlights Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. Feature In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart 1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart 2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart 3). Cognitive skills among 65 year-olds have also declined over this period. Chart 1Our Aging World Chart 2Savings Over The Life Cycle Chart 3Climbing Those Stairs Is Getting More And More Difficult We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart 4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart 5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart 4The Ratio Of Workers To Consumers Has Peaked Chart 5China On Course To Lose More Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table 1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart 6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table 1Economic Benefits Of Open Borders Chart 6Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart 7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart 8). Chart 7Low Levels Of Immigrant Labor Participation In Parts Of Europe Chart 8Immigration Is Straining Generous European Welfare States All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart 9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart 10). Chart 9Hispanic Educational Attainment Lags Behind Chart 10Worries About Immigrant Assimilation Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart 11The Projected Expansion In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart 11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: ­­­Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart 12). Chart 12U.S. Political Polarization: Growing Apart When people can no longer see eye to eye, established institutions lose legitimacy. Chart 13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart 14). It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart 15). Chart 13The Erosion Of Trust In Media Chart 14Who Needs Democracy When You Have Tinder? Chart 15People Versus Companies The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart 16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table 2). Chart 16Do You Still Want To Move Downtown? Table 2Crime Rates Are Creeping Higher In Europe Chart 17Homicides And Inflation Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart 17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firms to expand capacity, causing investment demand to fall. Aggregate savings also rise, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rise, real rates will decrease. At the margin, lower real rates will encourage investment and discourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders Chart II-6Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe Chart II-8Immigration Is Straining Generous ##br##European Welfare States All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind Chart II-10Worries About Immigrant Assimilation Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart Chart II-13The Erosion Of Trust In Media It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? Chart II-15People Versus Companies The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? Table II-2Crime Rates Are Creeping Higher In Europe Chart II-17Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017).

Highlights The macro environment remains positive for risk assets. Nonetheless, the shadow of the '87 stock market crash is a reminder that major market corrections can occur even when the earnings and economic growth backdrop is upbeat. Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of easier financial conditions and the likelihood of some fiscal stimulus next year. Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should overweight Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments). High-yield relative value is decent after accounting for the favorable default outlook. It is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late cycle phase. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. The risk of disappointment is therefore elevated. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons and provide dry powder to boost exposure after the correction. Feature The October anniversary of the '87 stock market crash was a reminder to investors that major market corrections can arrive out of the blue. With hindsight, there were some warning signs evident before the crash. Nonetheless, the speed and viciousness of the correction caught the vast majority of investors by surprise, in large part because the economy was performing well (outside of some yawning imbalances such as the U.S. current account deficit). Many worried that the 20% drop in the S&P 500 would trigger a recession, but the economy did not skip a beat and it was not long before the equity market recouped the losses. We view the '87 crash as a correction rather than a bear market. BCA's definition of a bear market is a combination of magnitude (at least a 15% decline) and duration (lasting at least for six months). Bear markets are usually associated with economic recessions. Corrections tend to be short-lived because they are not associated with an economic downturn. None of our forward-looking indicators suggest that a recession is in the cards in the near term for any of the major economies. Even the risk of a financial accident or economic pothole in China has diminished in our view. As discussed below, the global economy is firing on almost all cylinders. Chart I-1Valuation Today Is Very Stretched Vs. 1987 Nonetheless, there are some parallels today with the mid-1980s. A Special Report sent to all BCA clients in October provides a retrospective on the '87 crash.1 One concern is that the proliferation of financial computer algorithms and derivatives is a parallel to the popularity of portfolio insurance in the 1980s, which was blamed for turbocharging the selling pressure when the market downturn gathered pace in October. My colleague Doug Peta downplays the risks inherent in the ETF market in the Special Report, but argues that automatic selling will again reinforce the fall in prices once it starts. It is also worrying that equity valuation is much more stretched than was the case in the summer of 1987 based on the cyclically-adjusted P/E ratio (CAPE, Chart I-1). The CAPE is currently at levels only previously reached ahead of the 1929 and 2000 peaks. In contrast, the CAPE was close to its long-term average in 1987. Quantitative easing and extremely low interest rates have pulled forward much of the bond and stock markets' future returns. It has also contributed to today's extremely low readings on implied volatility. The fact that the Fed is slowly taking away the punchbowl and that the ECB is dialing back its asset purchase program only add to the risk of a sharp correction. The Good News For now though, investors are focusing on the improving global growth backdrop and the still-solid earnings picture. While the S&P 500 again made new highs in October, it was the Nikkei that stole the show among the major countries. Impressively, the surge in the Japanese stock market was not on the back of a significantly weaker yen. As we highlighted last month, risk assets are being supported by the three legged stool of robust earnings growth, low volatility and yield levels in government bonds, and the view that inflation will remain quiescent for the foreseeable future. The fact that the global growth impulse is broadly-based is icing on the cake because it reduces lingering fears of secular stagnation. Even emerging economies have joined the growth party, while a weak U.S. dollar has tempered fears of a financial accident in this space. Our forward-looking growth indicators are upbeat (Chart I-2). Our demand indicators in the major economies remain quite bullish, especially for capital spending (not shown). Animal spirits are beginning to stir. Moreover, financial conditions remain growth-friendly, especially in the U.S., and subdued inflation is allowing central banks to proceed cautiously for those that are tightening or tapering. The global PMI broke to a new high in October, and the economic surprise index for the major economies has surged in recent months. Our global LEI remains in a strong uptrend and its diffusion index shifted back into positive territory, having experiencing a worrisome dip into negative territory earlier this year. We expect the global growth upturn will persist for at least the next year. The U.S. will be the first major economy to enter the next recession, although this should not occur until 2019. It is thus too early to expect the equity market to begin to anticipate the associated downturn in profit growth. Earnings: Japan A Star Performer It is still early days in the Q3 earnings season, but the mini cyclical rebound from the 2015/16 profit recession in the major economies is still playing out. The bright spots at the global level outside of energy are industrials, materials, technology and consumer staples (Chart I-3). All four are benefitting from strengthening top line growth and rising operating margins. Chart I-2Upbeat Global Economic Indicators Chart I-3Global Earnings By Sector The U.S. is further advanced in the mini-cycle and EPS growth is near its peak on a 4-quarter moving total basis. The expected topping out in profit growth is more a reflection of challenging year-on-year comparisons than a deterioration in the underlying fundamentals. The hurricanes will take a bite out of third quarter earnings, but this effect will be temporary. Moreover, oil prices are turbocharging earnings in the energy patch and we expect this to continue. Our commodity strategists recently lifted their 2018 target price for both Brent and WTI to $65/bbl and $63/bbl, respectively. The global uptick in GDP growth, along with continued production discipline from OPEC 2.0 are the principal drivers of our revised outlook. We expect the fortuitous combination of fundamentals to accelerate the drawdown in oil inventories globally, which also will be supportive for prices. While U.S. financials stocks have cheered the prospects that Congress may pass a tax bill sometime in early 2018, sell-side analysts have been brutally downgrading financial sector EPS estimates. This has dealt a blow to net earnings revisions in the sector. Expected hurricane-related losses are probably the main culprit, especially in the insurance sector. Nonetheless, our equity sector strategists argue that such indiscriminate downgrades are unwarranted, and we would lean against such pessimism.2 Recent profit results corroborate our positive sector bias, although we are still early in the earnings season. European profits will suffer to some extent in the third quarter due to the lagged effects of previous euro strength. The same will be true in the fourth quarter, although we expect this headwind to diminish early in 2018. That leaves Japan as the star profit performer among the majors in the near term. The recent surge in foreign flows into the Japanese market suggests that global investors are beginning to embrace the upbeat EPS story. Abe's election win in October means that the current monetary stance will remain in place. The ruling LDP's shift away from austerity (e.g. abandoning the primary balance target) may also be lifting growth expectations. A Return To The Great Moderation? Chart I-4Market Correlation And The ERP A lot of the good news is already discounted in equity prices. The depressed level of the VIX and the drop in risk asset correlations this year signal significant complacency. Large institutional investors are reportedly selling volatility and thus dampening vol across asset classes. But there is surely more to it. It appears that investors believe we have returned to the pre-Lehman period between 1995 and 2006 when the Great Moderation in macro volatility contributed to low correlations among stocks within the equity market (Chart I-4). The idea is that low perceived macroeconomic volatility during that period had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. Of course, the Great Recession and financial market crisis brought the Great Moderation to a crashing end. Correlations rocketed up and investors demanded a higher equity risk premium to hold stocks. Today, dispersion in the outlooks for growth and interest rates have fallen back to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart I-5). Some of this can be justified by fundamentals. The onset of a broadly-based global expansion phase has likely calmed lingering fears that the global economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has moderated as well (bottom panel). Historically, implied volatility tended to fall during previous periods when global industrial production was strong and global earnings were rising across a broad swath of countries (Chart I-6). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to fall as earnings fundamentals become more important performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. Similarly, the VIX can fluctuate at low levels for an extended period when global growth is broadly based. Chart I-5A Less Uncertain Macro Outlook? Chart I-6Broad-Based Growth Lower Implied Volatility Still, current levels of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table I-1 shows the drop in the S&P 500 index during non-recession periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during the nine episodes, with a range of -3.6 to -18.1%. Table I-1Episodes When VIX Spiked The Equity Risk Premium Chart I-7Still Some Value In High-Yield On a positive note, the equity risk premium (ERP) is not overly depressed. There are many ways to define the ERP, but we present it as the 12-month forward earnings yield minus the 10-year Treasury yield in Chart I-4. It has fallen from about 760 basis points in 2011 to 310 basis points today. We do not believe that the ERP can return to the extremely low levels of 1990-2000. At best, the ERP may converge with the level that prevailed during the last equity bull market, from 2003-2007 (about 200 basis points). The current forward earnings yield is 550 basis points and the 10-year Treasury yield is 2.4%. The ERP would need to fall by 110 basis points to get back to the 2% equilibrium. This convergence can occur through some combination of a lower earnings yield or higher bond yield. If the 10-year yield is assumed to peak in this cycle at about 3% (our base case), then this leaves room for the earnings yield to fall by 50 basis points. This would boost the forward earnings multiple from 18 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We are not betting on any further multiple expansion but the point is that stocks at least have some padding in the event that bond yields adjust higher in a gradual way. It is the same story for speculative-grade bonds, which are not as expensive as they seem on the surface. The average index OAS is currently 326 bps, only about 100 bps above its all-time low. However, junk value appears much more attractive once the low default rate is taken into account. Chart I-7 presents the ex-post default-adjusted spreads, along with our forecast based on unchanged spreads and our projection for net default losses over the next year. The spread padding offered by the high-yield sector is actually reasonably good by historical standards, assuming there is no recession over the next year. We are not banking on much spread tightening from here, which means that high-yield is largely a carry trade now. Nonetheless, given a forecast for the default and recovery rate, we expect U.S. high-yield excess returns to be in the range of 2% and 5% (annualized) over the next 6-12 months. The bottom line is that the positive growth backdrop does not rule out a correction in risk assets, especially given rich valuations. But at least the profit, default and growth figures will remain a tailwind in the near term. The main risk is a breakout in inflation, which financial markets are not priced for. Inflation And Hidden Slack The September CPI report did little to buttress the FOMC's view that this year's inflation pullback is temporary. The report disappointed expectations again with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. The inflation debate continues to rage inside and outside the Fed as to whether the previous relationship between inflation and growth have permanently changed, whether low inflation simply reflects long lags, or whether it will require tighter labor markets in this business cycle to fuel wage and price pressures. We back the latter two of these three explanations but, admittedly, predicting exactly when inflation will pick up is extremely difficult and we must keep an open mind. A Special Report in the October IMF World Economic Outlook sheds some light on this vexing issue.3 Their work suggests that the deceleration in wage growth in the post-Lehman period in the OECD countries can largely be explained by traditional macro factors: weak productivity growth, lower inflation expectations and labor market slack. The disappointing productivity figures alone account for two-thirds of the drop in wage growth. However, a key point of the research is that the headline unemployment figures are not as good a measure of labor market slack as they once were. This is because declining unemployment rates partly reflect workers that have been forced into part-time jobs, referred to as involuntary part-time employment (IPT). The rise in IPT employment could be associated with automation, the growing importance of the service sector, and a diminished and more uncertain growth outlook that is keeping firms cautious. The IMF's statistical analysis suggests that the number of involuntary part-time workers as a share of total employment (IPT ratio) is an important measure of slack that adds information when explaining the decline in wage growth. Historically, each one percentage point rise in the IPT ratio trimmed wage growth by 0.3 percentage points. Chart I-8 and Chart I-9 compare the unemployment rate gap (unemployment rate less the full-employment estimate) with the deviation in the IPT ratio from its 2007 level. The fact that the IPT ratio has had an upward trend since 2000 in many countries makes it difficult to identify a level that is consistent with full employment. Nonetheless, the change in this ratio since 2007 provides a sense of how much "hidden slack" the Great Recession generated due to forced part-time employment. Chart I-8Measures Of Labor Market Slack (I) Chart I-9Measures Of Labor Market Slack (II) For the OECD as a whole, labor market slack has been fully absorbed based on the unemployment gap. However, the IPT ratio was still elevated at the end of 2016 (latest data available), helping to explain why wage growth has remained so depressed across most countries. The IPT ratio is still above its 2007 level in three-quarters of the OECD countries. Of course, there is dispersion across countries. Japan has no labor market slack by either measure. In the U.S., the unemployment gap has fallen into negative territory, but only about half of the post-2007 rise in the IPT ratio has been unwound. For the Eurozone, the U.K. and Canada, the unemployment gap is close to zero (or well into negative territory in the U.K.). Nonetheless, little of the under-employment problem in these economies has been absorbed based on the IPT ratio. Our discussion in last month's report highlighted the importance of the global output gap in driving inflation in individual countries. Consistent with this, the IMF finds that there have been important spillover effects related to labor market slack, especially since 2007. This means that wage growth can be held down even in countries where slack has disappeared because of the existence of a surplus of available labor in their trading partners. Phillips Curve Is Not Dead That said, we still believe that the U.S. is at a point in the cycle when inflationary pressures should begin to build, even in the face of persisting labor market slack at the global level. Chart I-10 shows the ECI and the Atlanta Fed wage tracker, which are the best measures of wages because they are less affected by composition effects. Both have moved higher along with measures of labor market tightness. Wage and consumer price inflation have ebbed this year, but when we step back and look at it over a longer timeframe, the Phillips curve still appears to be broadly operating. Moreover, inflation is a lagging indicator. Table I-2 splits the post-war U.S. business cycles into short, medium, and long buckets based on the length of the expansion phase. It presents the number of months from when full employment was reached to the turning point for consumer price inflation in each expansion. There was a wide variation in this lag in the short- and medium-length expansions, but the lags were short on average. Chart I-10Phillips Curve Still (Weakly) Operating Table I-2Inflation Reacts With A Lag It is a different story for long expansions, where the lag averaged more than two years. We have pointed out in the past that it takes longer for inflation pressures to reveal themselves when the economy approaches full employment gradually, in contrast to shorter expansions when momentum is so strong the demand crashes into supply constraints. The fact that U.S. unemployment rate has only been below the estimate of full employment for eight months in this expansion suggests that perhaps we and the Fed are just being too impatient in waiting for the inflection point. Turning to Europe, the IPT ratio confirms the ECB's view that there is an abundance of under-employment, despite the relatively low unemployment rate. This suggests that the Eurozone remains behind the U.S. in the economic cycle. As expected, the ECB announced a tapering in its asset purchase program to take place next year. While policymakers are backing away from QE in the face of healthy growth and a shrinking pool of bonds to purchase, they will continue to emphasize that rate hikes are a long way off in order to avoid a surge in the euro and an associated tightening in financial conditions. U.S./Eurozone bond yield spreads are still quite wide by historical standards and thus it is popular to bet on spread narrowing and a stronger euro/weaker dollar. However, some narrowing in short-term rate spreads is already discounted based on the OIS forward curve (Chart I-11). The real 5-year, 5-year forward OIS spread - the market's expectation of how much higher U.S. real 5-year rates will be in five years' time relative to the euro area - stands at about 70 basis points. This spread is not wide by historical standards, and thus has room to widen again if market expectations for the fed funds rate moves up toward the Fed's 'dot plot' over the next 6-12 months. While market pricing for the ECB policy rate path appears about right in our view, market expectations for rate hikes in the U.S. are too complacent. This implies that long-term spreads could widen in favor of the U.S. dollar over the coming months, especially if U.S. growth accelerates while euro area growth cools off a bit. The fact the U.S. economic surprise index has turned positive is early evidence that this process may have already begun. Moreover, the starting point is that the dollar has been weaker than interest rate differentials warrant, such that there is some room for the dollar to 'catch up', even if interest rate differentials do not move (Chart I-12). We see EUR/USD falling to 1.15 by the end of the year. Chart I-11Room For U.S./Eurozone Spreads To Widen... Chart I-12...Giving The Dollar A Lift A New Fed Chair? Our forecast for yield spreads and currencies is not overly affected by the choice of Fed Chair for next year. President Trump's meeting with academic John Taylor reportedly went well, but we think the President will prefer someone with a less hawkish bent. Keeping Chair Yellen is an option, but she has strong views on financial sector regulation that Trump does not like. The prevailing wisdom is that Jerome Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. In any event, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. As discussed above, uncertainty is elevated, but our base case sees inflation rising enough in the coming months for the Fed to maintain their 'dot plot' forecast. The market and the Fed are correct to 'look through' the near-term growth hit from the hurricanes, to the rebound that always follows the destruction. The U.S. housing sector is a little more worrying because some softness was evident even before the hurricanes hit. Since the early 1960s, a crest in housing led the broader economic downturn by an average of seven quarters. Nonetheless, we continue to expect that the housing soft patch does not represent a peak for this cycle. Residential investment should provide fuel to the economy for at least the next two years as pent up demand is worked off, related to depressed household formation since the 2008 financial crisis. Affordability will still be favorable even if mortgage rates were to rise by another 100 basis points (Chart I-13). Robust sentiment in the homebuilder sector in October confirms that the hurricane setback in housing starts is temporary. China And Base Metals Turning to China, economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at double-digit rates, albeit down from recent peak levels (Chart I-14). Various price indexes also reveal a fairly broadly-based inflation pickup to levels that will unnerve the authorities. Growth will likely slow in 2018 as policymakers continue to pare back stimulus. We do not foresee a substantial growth dip next year, but it could be hard on base metals prices. Chart I-13Housing Affordability Outlook Housing ##br##Affordability Under Various Rate Assumptions Chart I-14China: Healthy ##br##Growth Indicators Policy shifts discussed in Chinese President Xi's speech in October to the Party Congress are also negative for metals prices in the medium term. The speech provided a broad outline of goals to be followed by concrete policy initiatives at the National People's Congress (NPC) in March 2018. He emphasized that policy will tackle inequality, high debt levels, overcapacity and pollution. Globalization will also remain a priority of the government. The supply side reforms required to meet these goals will be positive in the long run, but negative for growth in the short run. Restructuring industry, deleveraging the financial sector and fighting smog will all have growth ramifications. The government could use fiscal stimulus to offset the short-term hit to growth. However, while overall growth may not slow much, the shift away from an investment-heavy, deeply polluting growth model, will undermine the demand for base metals. Our commodity strategists also highlight the supply backdrop for most base metals is not supportive of an extended rally in prices. The implication is that investors who are long base metals should treat it as a trade rather than a strategic position. Despite our expectation that policy will continue to tighten, we believe that investors should overweight Chinese stocks relative to other EM markets. Investment Conclusions: Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of the easing in U.S. financial conditions that has taken place this year and the likelihood of some fiscal stimulus next year. The U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to reach President Donald Trump's desk by the end of the first quarter of next year. Surveys show that investors have all but given up on the prospect of tax cuts, which means that it will be a positive surprise if it finally arrives (as we expect). Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should favor Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments) in the major developed fixed-income markets. Our base-case outlook implies that it is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late-cycle phase. Calm macro readings and still-easy monetary policy have generated signs of froth. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Upside inflation surprises would destabilize the three-legged stool supporting risk assets, especially at a time when the Fed is shrinking its balance sheet. Black Monday is a reminder that major market pullbacks can occur even when the economic outlook is bright. Thus, investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons, and to ensure that they have dry powder to exploit them when they materialize. Mark McClellan Senior Vice President The Bank Credit Analyst October 26, 2017 Next Report: November 20, 2017 1 Please see BCA Special Report, "Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis," October 19, 2017, available at bca.bcaresearch.com 2 Please see BCA U.S. Equity Strategy Weekly Report, "Banks Hold The Key," October 24, 2017, available at uses.bcaresearch.com 3 Recent Wage Dynamics In Advanced Economies: Drivers And Implications. Chapter 2, IMF World Economic Outlook. October 2017. II. Three Demographic Megatrends Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders Chart II-6Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe Chart II-8Immigration Is Straining Generous ##br##European Welfare States All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind Chart II-10Worries About Immigrant Assimilation Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart Chart II-13The Erosion Of Trust In Media It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? Chart II-15People Versus Companies The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? Table II-2Crime Rates Are Creeping Higher In Europe Chart II-17Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). III. Indicators And Reference Charts Global equity markets partied in October on solid earnings and economic growth figures, and the rising chances of a tax cut in the U.S. among other bullish developments. The Nikkei has been particularly strong in local currency terms following the re-election of Abe. Our equity indicators remain upbeat on the whole, although the rally is looking stretched by some measures. The BCA monetary indicator is hovering at a benign level. Implied equity volatility is very low, investor sentiment is frothy and our Speculation Indicator is elevated. These suggest that a lot of good news is already discounted. Our valuation indicator is also closing in on the threshold of overvaluation at one standard deviation. Our technical indicator is rolling over, although it needs to fall below the zero line to send a 'sell' signal. On a constructive note, the solid rise in earnings-per-share is likely to continue in the near term, based on positive earnings surprises and the net revisions ratio. Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in September for the third consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and European WTPs rose in October after a brief sideways move in previous months, suggesting that equity flows have turned more constructive. But the Japanese WTP is outshining the others. Given that the Japanese WTP is rising from a low level, it suggests that there is more 'dry powder' available to purchase Japanese stocks, especially relative to the U.S. market. We favor Japanese stocks relative to the other two markets in local currency terms, as highlighted in the Overview section. Oversold conditions for the U.S. dollar have now been absorbed based on our technical indicator, but there is plenty of upside for the currency before technical headwinds begin to bite. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys has moved above the zero line, but has not reached oversold territory. Bond valuation is close to fair value based on our long-standing valuation model. These factors suggest that yields have more upside potential before meeting resistance. Other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still about 20 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Chart III-8Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Our out-of-consensus call on oil prices - Brent and WTI are expected to trade to $65 and $63/bbl, respectively, next year - has the most upside risk from unplanned production outages in Iraq and Venezuela. The potential for export losses from Libya, while not as acute, remains high. Downside price risks - e.g., a meaningful softening of demand, or sharply higher U.S. shale-oil production - are not as elevated as upside price risks, in our view. Favorable global macro conditions will continue to support the synchronized global upturn in GDP, keeping oil demand growth on track. The strained balance sheets of many U.S. shale-oil producers and deepwater-producing Majors likely will limit their ability to fund drilling, as recent earnings calls from oil-services companies attest.1 We continue to monitor global monetary conditions, particularly in the U.S. With global oil markets tightening as supply contracts and demand expands, the broad trade-weighted USD will become more of a factor in oil-price determination next year. Energy: Overweight. Our long $55/bbl WTI calls vs. short $60/bbl WTI call spreads in Jul/18 and Dec/18 recommended last week are up 9.3% and 5.8%, respectively. Base Metals: Neutral. Copper has been well bid, and is up 8.5% since the beginning of the month. The proximate cause of the price strength is investor optimism regarding global growth, particularly in China. However, following their biannual meeting earlier this week, the International Copper Study Group kept its projected 2017 deficit unchanged, and downgraded their 2018 projection to 105k MT, from 170k MT. Precious Metals: Neutral. Gold is under pressure as markets weigh the possibility President Trump will appoint a more hawkish Fed Chair to succeed Janet Yellen. Ags/Softs: Neutral. Following a backlash from Midwestern politicians, the Environmental Protection Agency (EPA) abandoned proposed changes to the U.S. Renewable Fuel Standard. The EPA also will keep 2018 renewable fuel volume mandates at or above current proposed levels. Corn gained 2.4% since this announcement last week. Our corn-vs.-wheat spread is up 1.6% since inception. Feature Our out-of-consensus call on Brent and WTI prices for next year has a significant amount of daylight between the prices we expect - $65 and $63/bbl for Brent and WTI, respectively - and price estimates we derive using the U.S. EIA's supply, demand and inventory expectations, which are $15.1 and $13.8/bbl lower (Chart of the week). Chart of the WeekPrices Derived Using BCA And EIA##BR##Global Balance Estimates Our bullish oil price call is predicated on stronger global demand growth than EIA and other forecasters' estimates (Chart 2 & Table 1), and an extension of the OPEC 2.0 production cuts to end-June 2018 (Chart 3).2 These fundamentals combine to sustain a supply deficit for the better part of 2018 (Chart 4), which results in stronger inventory draws in the OECD (Chart 5). Net, we expect OECD stocks to fall below their five-year average level by year-end 2018. Chart 2Stronger Global Demand Growth ... Chart 3...And Continued OPEC 2.0 Discipline... Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Chart 4...Produce A Supply Deficit For Most Of 2018... Chart 5...Leading To OECD Inventory Normalization Upside Price Risks Dominate In 2018 In assessing the "known unknown" risks to our call, those on the upside clearly dominate in 2018. Chief among these risks are unplanned production outages, which have been somewhat under control versus the past two years (Chart 6). Nonetheless, we believe the risk of unplanned outages within OPEC - in Iraq and Venezuela, in particular - are elevated. The potential for export losses from Libya, while not as acute, remains high (Chart 7). Chart 6Unplanned Outages Are Down ... Chart 7...But Key States Are At Risk The risk of unplanned outages is highest in Iraq, where production is running at ~ 4.5mm b/d in 3Q17 (Chart 7, panel 1). Exports on the Ceyhan pipeline from Iraq's northern Kurdish region through Turkey to the Mediterranean fell by more than half to as low as 225k b/d, following a non-binding independence referendum in Iraq's restive Kurdistan region at the end of September. This led to armed conflict between Iraqi and Kurdish forces.3 Independence for the semi-autonomous region was supported by more than 90% of Iraqi Kurds. However, the Iraqi government in Baghdad, along with its neighbors in Turkey and Iran, opposed the referendum, as did the U.S. This lack of support likely prompted the Kurdistan Regional Government's (KRG) offer to "freeze" the referendum this week, and to seek immediate cease-fire talks with Baghdad. Export flows from Kirkuk and the Kurdish region have been restored this week to ~ 300k b/d, or half of the volumes exported prior to the referendum, according to Bloomberg.4 Even with the offer to freeze the referendum - presumably, this means the semi-autonomous Kurdish government will abstain from pressing for independence if its offer is accepted and Baghdad agrees to negotiate an immediate cease-fire - this issue is far from settled. BCA's Geopolitical Strategy noted last month, the critical issue for the oil market remains sustained conflict between the Iraqi central government and the KRG. The question that cannot be answered yet is what "would (a conflict) do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production."5 A huge "known unknown" resides in Venezuela, where we have production running at ~ 1.96mm b/d in 3Q17, sharply down from 2.4mm b/d during 2011-2015. The state oil company, Petroleos de Venezuela, SA, or PDVSA, is struggling to amass enough cash to meet critical near-term international interest and debt payment obligations, and can no longer afford to buy the chemicals and equipment required to make the country's heavy oil suitable for refining. This lack of cash is causing oil quality from Venezuela to deteriorate, as more exports are showing up with high levels of water, salt or metals. This is raising the odds refiners from the U.S. to China could turn barrels away in the near future unless the situation is reversed.6 Indeed, Reuters reported Phillips 66, a U.S. refiner, cancelled "at least eight crude cargoes because of poor oil quality in the first half of the year and demanded discounts on other deliveries, according to ... PDVSA documents and employees from both firms. The cancelled shipments - amounting at 4.4 million barrels of oil - had a market value of nearly $200 million." Venezuela's financial condition has steadily worsened following the collapse of oil prices at the end of 2014. Production is at its lowest level in 30 years, and banks have stopped extending letters of credit, which are critical to trading in the international oil market, in the wake of U.S. sanctions ordered by President Trump, as Reuters notes. In addition, PDVSA has been denied access to storage facilities in St. Eustatius terminal, because it owes the owner of the facility, Texas-based NuStar Energy, some $26 million in fees.7 Markets will be watching closely to see if Venezuela performs on $2 billion in USD-denominated bond payments, one of which is due tomorrow, and the other due next week (November 2). Venezuela missed debt coupon payments of some $350mm earlier this month, and has a total outstanding obligation for this year of $3.4 billion.8 In all likelihood, Venezuela will once again turn to Russia for additional financial support, which has stepped in as a "lender of last resort" replacing China.9 Venezuela owes Russia some $17 billion. Of this, Rosneft Oil Co., a Russian oil company, has loaned PDVSA $6 billion.10 In Libya, where we have production at 910k b/d in 3Q17 (Chart 7, panel 3), the risk of unplanned production outages is not as acute as the risks in Iraq and Venezuela, but important nonetheless. As a failed and fractured state, Libya faces particular challenges in maintaining production. Wood Mackenzie believes Libyan production likely has plateaued. The oil consultancy believes Libya's max production is limited to 1.25 million b/d.11 However, "Reaching this would be quite an achievement, given ongoing challenges, including international oil companies' reluctance to recommit capital and expertise, a national oil company starved of funding - and, not least, the propensity for violence to flare up and armed groups to hinder oil output." Downside Price Risks Less Daunting In 2018 Chart 8The USD Will Become More Important##BR##As Oil Markets Tighten Next Year Downside price risks - e.g., a meaningful softening of demand, or sharply higher U.S. shale-oil production - are not as elevated as risks to the upside, in our view. The favorable global macro conditions we discussed in last week's forecast will continue to support the synchronized global upturn in GDP. This will keep global oil demand growing at ~ 1.67mm b/d on average in 2017 and 2018, based on our estimates. We expect U.S. shale production to increase to 5.17 mm b/d in 2017 and to 6.09 mm b/d next year, as higher prices incentivize renewed drilling activity. However, the strained balance sheets of many shale-oil producers and a renewed - although perhaps only temporary - push from equity investors for shale producers to focus on improving economic returns rather than merely pursuing maximal production growth, likely will limit their ability to fund drilling, as recent earnings calls from oil-services companies attest. Away from fundamentals, we are monitoring U.S. monetary policy closely, given the potential for the USD to become a headwind once again for commodity prices generally, and oil prices in particular. As we noted last week, we expect the tightening of oil markets globally to restore the linkage between the USD and oil prices - i.e., the inverse correlation between them (a stronger USD is bearish for crude oil prices, and vice versa). The transitory noise surrounding the next Fed Chair will dissipate within the next few weeks, allowing the U.S. central bank and markets to focus on the evolution of monetary policy next year, following a widely expected rate hike in December. During the transitional phase the oil market is currently passing through - falling supply and stout demand are tightening the market globally - the USD's importance will increase as a determinant of oil prices (Chart 8). Bottom Line: Our oil-price call for next year - $65/bbl for Brent and $63/bbl for WTI - is predicated on stronger global demand growth, and an extension of the OPEC 2.0 production cuts to end-June 2018. These fundamentals will produce stronger inventory draws in the OECD, and bring stocks below their five-year average by year-end 2018. In our view, upside price risks clearly dominate in 2018. Chief among these risks are unplanned production outages in key OPEC states - Iraq, Venezuela and Libya - which account for ~ 7.4mm b/d of production at present. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Oilfield Service Quarterly Update: U.S. Stagnation," published October 25, 2017. It is available at nrg.bcaresearch.com. 2 OPEC 2.0 is the producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Please see last week's feature article in Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," for a discussion of our assumptions, models and estimates. It is available at ces.bcaresearch.com. 3 Please see "Update 2 - Iraqi Kurdistan faces first major oil outage since referendum," published by uk.reuters.com October 18, 2017. See also "Iraq's NOC vows to maintain Kirkuk oil flows after ousting Kurds," published by S&P Global Platts October 17, 2017, for additional background. 4 Please see "Iraqi Kurds Offer To Freeze Independence Referendum Results," published October 25, 2017, by Bloomberg.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report "Iraq: An Emergent Risk," p. 23 in the September 20, 2017 issue. It is available at gps.bcaresearch.com. 6 Please see "Venezuela's deteriorating oil quality riles major refiners," published by reuters.com October 18, 2017. 7 Please see "Exclusive: PDVSA blocked from using NuStar terminal over unpaid bills," published by uk.reuters.com October 20, 2017. 8 Please see "Venezuela is blowing debt payments ahead of a huge, make-or-break bill," published by cnbc.com on October 20, 2017. 9 Please see "Special Report: Vladimir's Venezuela - Leveraging loans to Caracas, Moscow snaps up oil assets," published by reuters.com on August 11, 2017. 10 Rosneft's majority owner is the Russian government. See "Glencore sells down stake in Russia's Rosneft," published by telegraph.co.uk on September 8, 2017. Glencore's 14.6% stake in Rosneft was sold to CEFC China Energy, according to the Telegraph. 11 Please see "WoodMac: Libya's oil production might have reached near-term potential," in the October 20, 2017, issue of Oil & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016