Inequality

Highlights The United States has produced too many elites, while popular well-being has fallen; Elite-controlled institutions have failed to protect households from the negatives of globalization and technological change; Tribalism, polarization, and money politics are preventing political compromise; Trump won by assaulting the "elites" but neither his policies, Congress, nor the economy look to improve well-being; With recession likely by 2019, the U.S. will see a revolt of some kind by the 2020 election. Feature Crime is increasing Trigger happy policing Panic is spreading God knows where We're heading Oh, make me wanna holler They don't understand Make me wanna holler They don't understand - Marvin Gaye, "Inner City Blues," 1971 If we had to explain the election of Donald Trump and the decision by U.K. voters to exit the EU with one chart it would be Chart 1. It depicts the relationship between high income inequality and low generational mobility and suggests that highly unequal societies develop structures that perpetuate unequal income through generations.1 The U.S. and the U.K. stand at the extreme of the relationship, with Italy close behind. Chart 1 Not surprisingly, the common people, "the plebs," in all three countries are dissatisfied with the arrangement. Low social mobility perpetuates unequal economic outcomes, throwing middle- and low-income voters into a sense of desperation. They fear that both their children's lot in life and their own is already decided, i.e. cannot and will not improve. A pre-election Gallup study of 125,000 American adults confirms that President Trump's support was strongest among voters in communities with poor health and low generational mobility.2 Of no relevance was whether respondents came from areas supposed to suffer most heavily from the ills that Trump opposed, i.e. communities exposed to global competition via trade, or those with high levels of immigration, or areas with relatively high unemployment and low incomes. America is supposed to be immune to income inequality because of social mobility. Equality of opportunity matters more than equality of outcome. This is the trade-off that has existed at the heart of America since its founding. For decades this trade-off has atrophied. Donald Trump was then elected to bring the U.S. back to its default setting. In this report, we explain why it may be too late and what will happen if he fails. If BCA's House View is correct, that a recession will occur by the end of 2019 (if not earlier), then the economic and political conditions are ripe for serious socio-political instability by the 2020 election.3 The Dynamic Of Elite Overproduction In Why Nations Fail, economist Daron Acemoglu and political scientist James Robinson tell a story of "How Venice Became A Museum."4 From the eleventh to fourteenth century, Venice was one of the richest places in the world. Behind its rapid economic expansion was the commenda, an early form of a joint-stock company formed for the duration of a single trading mission. It spurred Venice's ambitious entrepreneurs to find new trading routes by allowing them to share in the profits with the owners of capital who funded the risky journeys. As new families enriched themselves, political institutions grew more inclusive to accommodate them: in 1032, for instance, Venice held elections for its doge, or leader. An independent judiciary, private contracts, and bankruptcy laws followed. By 1330, Venice was a wealthy and strikingly modern republic with a population as large as that of Paris. The commenda system, however, had a dark side: creative destruction. Each new wave of young, enterprising explorers reduced the political privileges and profits of the established elites. In the late thirteenth century, these elites began to restrict membership in the Great Council, or legislature. Such efforts culminated in La Serrata ("The Closure") in 1297, which severely restricted access to the Great Council for new members but expanded it for families of established elites. An economic serrata quickly followed the political one, and the commenda system that underpinned Venice's wealth was replaced by a state monopoly on trade in 1314. The rest is, as they say, history. Venice rapidly declined as the newly closed economic and political institutions failed to deal with the rise of Portugal and Spain, the revolution in navigation and discovery of new trade routes to the East, and various regional attempts to encroach on its wealth and power. After the seventeenth century this decline accelerated. Today, its only source of income is tourism, which parlays the pre-Serrata wonders - such as the Doge's Palace and St. Mark's Cathedral - for cash that the city desperately needs to keep itself afloat.5 Acemoglu and Robinson make the case in their research that societies with both politically and economically inclusive institutions are rare. They cite a number of reasons for this, but the one that is most relevant to this report is "elite overproduction." Elites have a perfectly human and rational desire to perpetuate their political and economic privileges and pass them on to their children. A society that truly promotes equality of opportunity is one that leaves its elites to the fates. The elite desire to pass on privileges to future generations is a constant, but human conflict and state collapse are cyclical. Peter Turchin, a biologist who studies human conflict, has noted that periods of intense conflict in societies tend to recur within 40-to-60-year cycles. He posits that elite overproduction - and its counterpart, low societal well-being - is to blame.6 In post-industrial societies, low and falling labor costs are one of the principal conditions for elite multiplication. International trade, immigration, technological advancements, and investment in human and physical capital all suppress labor costs, benefiting the consumers of labor, i.e. the elites. Globalization has played a particularly important role in suppressing wages in the modern developed world. It expanded the global supply of labor by opening up new populations to capitalism (Chart 2), leading to suppressed wage growth for the middle classes in advanced economies (Chart 3). This process has been reinforced by technological change, particularly innovation that is biased in favor of capital (i.e. saving on labor costs) (Chart 4). Chart 2Globalization Expanded ##br##The Global Supply Of Labor... Globalization Expanded The Global Supply Of Labor... Globalization Expanded The Global Supply Of Labor... Chart 3 Chart 4 As elites capture an ever-greater share of the economic pie (even a growing economic pie), they become accustomed to ever greater levels of consumption, which drives inter-elite competition for social status. Everyone tries to "keep up with the Joneses," which for many is only achievable by supplementing wages with debt (Chart 5).7 The demand for elite goods - say homes in the "right" zip codes - exhibits runaway growth as the cost of elite membership rises and as sub-elites with rising income levels compete for access (Chart 6). Chart 5Credit Supplanted Income Credit Supplanted Income Credit Supplanted Income Chart 6Middle Class Incomes Don't ##br##Buy Middle Class Goods Middle Class Incomes Don't Buy Middle Class Goods Middle Class Incomes Don't Buy Middle Class Goods Focusing on the U.S., Turchin shows that Americans are today living in the second "Gilded Age." His research shows that "elite overproduction" has not been this high, and "population well-being" this low, since the early twentieth century (Chart 7). He calculates population well-being as a combination of general health, family formation, and wage and employment prospects. All indicators are currently in decline relative to history, save for health. But even life expectancy is taking a hit, albeit for select demographic groups most negatively impacted by poor job and wage prospects (Chart 8). Chart 7 Chart 8 For elite overproduction, Turchin relies on standard measures: wealth inequality, university education cost, and political polarization. This makes intuitive sense, since major policies aimed at reversing entrenched inequality can only be enacted after polarization has fallen due to events that subdued elites, such as major economic calamities or geopolitical challenges - e.g. the New Deal following the Great Depression, or the Great Society following World War II and amidst the Cold War. The danger of extreme polarization between elite prosperity and general well-being is that it is theoretically and empirically associated with political polarization, social unrest, and war. Acemoglu and Robinson detail case after case - from ancient Mayans and Romans to modern French and Japanese - in which the competition for resources between elites and the general population led to civil strife or all-out warfare. Meanwhile Turchin's research shows that politically motivated violence in the U.S. (Chart 9), which last peaked 50 years ago in the late 1960s, is associated with large gaps in well-being between elites and the masses (Chart 10).8 Chart 9 Chart 10 Bottom Line: Elite overproduction has been identified by academic research as a constant source of social instability throughout human history. Elites subvert inclusive political and economic institutions in order to stifle creative destruction, which would enrich new entrepreneurs but dilute elite privileges. As such, societies that prevent elite overproduction and promote equality of opportunity (and creative destruction) are successful in perpetuating themselves over the long term. Repatrimonialization In The U.S. Chart 11Tax Rates Were High In The Roaring '50s Tax Rates Were High In The Roaring '50s Tax Rates Were High In The Roaring '50s A sure sign that a society is in decline? When elites strive to hold onto their status and create barriers to entry for others. In the case of Venice, these barriers were overtly political. Le Serrata was followed by the introduction of Libro d'Oro (the "Golden Book"), which created an official registry of Venetian families that would be allowed to share in the deliberations of the Great Council. As the population revolted against such measures, Venice introduced a police force in 1310, with other coercive methods to follow. Today, the U.S. exhibits similar signs of institutional capture by the elites, albeit updated for the twenty-first century. Political theorist Francis Fukuyama calls this process "repatrimonialization." It occurs amidst long periods of economic prosperity and peace, as elites lose sight of their symbiotic relationship with fellow citizens and begin to serve their own "tribal" interests.9 Note in the above Chart 7 that elite overproduction, as defined by Turchin, reaches its peak after long periods of peace: the first high point came in 1902, 37 years after the Civil War, and the second came in 2007, 62 years after World War II. The latter case in particular suggests that as threats dissipate, elites lose sight of personal sacrifices - military service, income redistribution, public service, public works - that are required for geopolitical competition with peer challengers. At the height of the Cold War (1949 to 1962), for example, the top marginal tax rate in the U.S. was 92% (Chart 11).10 The point is not the tax rate, but that elites were far more acquiescent to fiscal sacrifices on behalf of the public. Fukuyama points to the U.K. and the U.S. as the two countries that have been the least politically responsive to the challenges of globalization and technological change in the developed world. In the case of the U.S., this is because interest groups are capable of steering policy towards further globalization and technological change. Both processes have also empowered elites, which have steered policy towards less redistribution and more austerity for the middle classes. The data is clear on this point. Despite Europe's being as exposed to globalization and technological advances as the U.S., European median wage growth has kept pace with GDP growth since 2000, whereas in the U.S. it not only failed to keep up but declined over the same time period (Chart 12). Chart 12Europe Shielded ##br##Households From Global Winds Europe Shielded Households From Global Winds Europe Shielded Households From Global Winds What are some of the mechanisms of repatrimonialization in the U.S. and can they be reversed? The good news is that elite capture of state institutions is now out in the open and easy to identify. Both Donald Trump and Democratic candidate Senator Bernie Sanders campaigned explicitly against it. The bad news is that it is unlikely to be reversed endogenously, at least not without a catalyst. What follows is a short description of the most salient problems facing the country as a result of elite entrenchment. Campaign Financing The 2010 Supreme Court decision Citizens United v. Federal Election Commission gave rise to political action committees, also known as Super PACs. These groups are allowed to receive unlimited contributions from individuals and corporations as long as they do not cooperate, coordinate, or directly contribute funding to actual candidates. This supposed firewall, however, is a fig leaf. The elimination of caps on this type of campaign financing allows single-issue groups and even single individuals with deep pockets to fund fringe candidates or support single-issue ballot measures that would otherwise lack sources of funding. This is especially important in primary elections where turnout is very low. In response, incumbent legislators have to tread carefully and avoid angering individual donors or Super PACs that could single-handedly fund a campaign against them in the primary elections, especially since the average cost of a congressional election campaign is relatively low at $1.4 million (a small amount compared to the funds that can be brought to bear by activist donors). In 2012, more than 40% of the campaign donations used in all federal elections was contributed by 0.01% of the voting-age population. That means that about 24,000 people were responsible for a near-majority of all contributions.11 Two other findings reported in the academic literature provide insight on how (and if) that money might steer policy. First, a study confirmed the general belief that the wealthiest Americans are much more conservative than the general public when it comes to tax policy and economic regulation.12 Second, another study found that when the policy preferences of the top 10% of income earners diverge from the preferences of the bottom 50%, the policy outcome is more likely to reflect the intentions of the former group.13 Polarization Political polarization benefits elites by impeding the democratic process and locking in rules that are beneficial to the status quo. Chart 13 shows that income inequality and political polarization in the sphere of economic policy are correlated.14 The simple reason the two are so highly correlated is because the right-of-center Republican Party increasingly opposes redistribution, while the left-of-center Democratic Party favors it. As the two parties diverge on matters of economic principle, compromises become virtually impossible, locking redistributive efforts at the current levels favored by the elites. Polarization is subsequently reinforced by electoral-district "gerrymandering" and an extremely bifurcated and increasingly distrusted news media. Over the last two decades, both the Democrats and Republicans (but mainly the latter due to their superior position at the state level) have redrawn administrative boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart 14). Chart 13Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 14Few Congressional Seats Truly Competitive Few Congressional Seats Truly Competitive Few Congressional Seats Truly Competitive Tribalization Elite overproduction often leads to the tribalization of society. Elites, to ensure that they are not torn asunder by the plebs, mobilize the population behind various causes that divert attention away from themselves, i.e. away from the real cause of social malaise. These causes are "wedge issues," in today's parlance. They can include identity politics, religious issues, as well as foreign policy. The Democratic Party has often relied on identity issues to mobilize support, but the effort kicked into high gear as it evolved from a redistributive "Old Left" party to the more centrist, "Third Way," neo-liberal orientation of Bill Clinton's presidency. Senator Bernie Sanders attempted to reverse this trend and overtly downplayed identity politics during his presidential campaign. He saw his party's neo-liberal turn as an elite-driven effort to distract from the real problems affecting low-income households. Hillary Clinton, the neo-liberal Democrat, by contrast, suffered as a result of the perception that she was an elite. Chart 15 The problem is that these wedge issues have begun to ossify into actual identities. For example, Pew Research showed in 2012 that the difference between Americans on a list of 48 values is the greatest between Republicans and Democrats, as opposed to other elements of identity. This has not always been the case, as Chart 15 shows. We suspect that this data will grow even starker after the divisive, borderline hysterical 2016 campaign. This means that "Republican" and "Democrat" labels have become almost tribal in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Bottom Line: America's repatrimonialization is advanced. The democratic process, which is supposed to adjudicate between interest groups and regulate elite economic and political privileges, has been drawn to a halt by polarization, the political influence of big money, and emerging tribalism between non-elites. It is extremely difficult to see how these hurdles can be overcome via America's regular political process. As such, they will be resolved only after some kind of crisis, whether endogenous or exogenous. Will Trump Fix It? President Donald Trump famously said in his nomination speech at the Republican Convention, "I alone can fix it." In a way, he may be correct. Although he is very much part of the American economic elite, he has no links to the D.C. establishment and owes no favors to special interest groups.15 His entire campaign personified the conclusions of this report: that the U.S. economy has been captured by economic and political elites and that the well-being of regular citizens is in the doldrums. It is unfair to judge President Trump's record and legacy based on a little over four months in office. However, we lean heavily towards the conclusion that his efforts to undermine American patricians will ultimately fail. Here is why: Policy President Trump does not have much of a legislative record. Nonetheless, his first major piece of legislation - the Obamacare repeal and replace bill - would, in its current form, leave 14 million people without health care - and an estimated 24 million by 2026. If not substantially revised, the bill is likely to impose a roughly $445 billion burden on U.S. households in order to pay for the "hyuge" tax cuts that Trump has promised (Chart 16). Further throwing Trump's plebeian credentials into doubt is his second signature legislative act: tax reform. His campaign proposal fell largely in line with previous Republican efforts, which, it should be noted, have contributed greatly to elite overproduction in the U.S. (Chart 17). Trump's original proposal would cut the top marginal rate from 39.6% to 33%, but would also leave a significant number of middle-class Americans with an increase, or no change, to their marginal tax rate.16 We expect that his White House team will adjust this original plan to offer middle-class tax cuts, but the main thrust of the effort is still to eliminate estate taxes and lower the top marginal rates significantly. Chart 16 Chart 17Tax Reform Always Benefits Elites Tax Reform Always Benefits Elites Tax Reform Always Benefits Elites On trade and immigration, Trump has little record to show. His meeting with President Xi Jinping of China revealed that he is like previous presidents in talking tough about Chinese trade on the campaign trail yet lacking the desire to take aggressive action once in office. We expect that Trump will eventually pivot towards greater protectionism, but it is not clear that it will be executed in a way that actually improves household well-being.17 Congress So far Trump has shown that he is more interested in getting legislation passed than shaping it in a populist way. For example, he has urged Congress to pass the Obamacare replacement even though many conservative Senators are wary of its negative impact on households. If he adopts the same strategy with tax reform, we would suspect that he will err on the side of "getting things done," rather than fulfilling his campaign pledges to blue-collar workers. The problem for Trump is the same problem President Obama had: polarization. Trump would be far more successful in passing populist legislation if he developed a working relationship with Democrats, who ostensibly have discarded the elitism of the Clinton years. Yet to do so he would have to "betray" his only friends, leaving himself vulnerable should the Democrats refuse to play ball. He is thus stuck with partisan Republican policies, which means voters are stuck with a lack of compromise. Macroeconomics Populists everywhere have one overarching goal when they come to power: boosting nominal GDP growth (Chart 18). We suspect that Trump will ultimately get tax reform through Congress and that it will be moderately stimulative.18 Chart 18 The problem is that the U.S. economic recovery is already far advanced. As such, even moderate stimulus could hasten the timing of an economic recession. Given the lack of major economic imbalances, it is unlikely that such a recession would freeze the financial system and be as painful as that of 2008-9. Nonetheless, the trade-off between moderate stimulus and a quicker recession is unlikely to benefit Trump's voters. Bottom Line: Donald Trump has tapped into the deep social malaise in the U.S. and responded to the populace's demands that elite overproduction be curbed. Unfortunately, his track record during the campaign and as president gives little evidence that he will be successful in restraining America's elites. Especially because he is forced to cooperate with them through Congress, and in a way that does not encourage broad compromise. Investment Implications We suspect that polarization will grow throughout Trump's term and that he will largely be unsuccessful in pursuing an agenda that genuinely increases opportunity or well-being. In fact, we would bet that most of his policies will contribute to, not reduce, elite overproduction in the U.S. What happens when Donald Trump fails to reform America and resolve its elite overproduction problem? If a recession occurs by 2019 - our House View at BCA - then the economic and political conditions suggest that a serious revolt is in the cards by the time of the 2020 election. By this we mean not just an electoral revolt, like Trump's election, but also a concrete increase in social tension and unrest. A repeat of the 2011 Occupy Wall Street protests, yet more violent, could be in cards. By the 2020 election, we would also suspect that our clients may look back fondly, with nostalgia, for Senator Bernie Sander's campaign platform, which by that point may look downright centrist. Investors should prepare for an increase in economic populist policy proposals, from both the left and the right. If economic policy begins to steer towards populism, investors should bet on higher inflation and thus higher nominal - but potentially lower real - Treasury yields. The independence of the Fed could also suffer, putting considerable downward pressure on the USD. In this environment, equities will outperform bonds, but global assets should outperform those of the U.S. Gold, which has failed as a safe-haven asset in the contemporary deflationary era, should become attractive once again.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see Miles Corak, "Income Inequality, Equality of Opportunity, and Intergenerational Mobility," Forschungsinstitut zur Zukunft der Arbeit, Discussion paper no. 7520, July 2013, available at iza.org. 2 Please see Jonathan Rothwell and Pablo Diego-Rosell, "Explaining Nationalist Political Views: The Case Of Donald Trump," Gallup, dated November 2, 2016, available at papers.ssrn.com. 3 Please see BCA's The Bank Credit Analyst Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com, and Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 4 Please see Daren Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Publishers, 2012). 5 Literally. 6 Please see Peter Turchin and Sergey Nefedov, Secular Cycles (Princeton, NJ: Princeton University Press, 2009). 7 Please see Neal Fligstein et al, "Keeping up with the Joneses: Inequality and Indebtedness, in the Era of the Housing Price Bubble, 1999-2007," presented at the Annual Meetings of the American Sociological Association, August 2015. 8 Please see Peter Turchin, "Dynamics of political instability in the United States, 1780-2010," Journal of Peace Research 49:4 (2012), pp. 577-91. 9 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus, and Giroux, 2014). 10 Today's dispersed terrorist threat does not even come close to approximating the threat that the Soviet Union during the Cold War presented to the U.S., and as such we do not consider it seriously as an existential threat to either the U.S. or the West. Please see BCA Global Investment Strategy and Geopolitical Strategy, "A Bull Market For Terror," dated August 5, 2016, available at gis.bcaresearch.com. 11 Please see Adam Bonica et al., "Why Hasn't Democracy Slowed Rising Inequality?" Journal of Economic Perspectives 27:3 (Summer 2013), pp. 103-24. 12 Please see Benjamin Page et al., "Democracy And The Policy Preferences Of Wealthy Americans," Perspectives On Politics 11:1 (March 2013), pp. 51-73. 13 Please see Martin Gilens, "Inequality And Democratic Responsiveness," Public Opinion Quarterly 69:5 (2005), pp. 778-796. 14 The latter measure of polarization is one of Turchin's factors in elite overproduction. 15 Save for the Kremlin! We jest, we jest. At least, we think we jest ... 16 Several groups would have seen no substantial tax cuts under his original campaign plan. Those making $15,000-$19,000 would have seen their tax rate increase from 10% to 12%. Those making $52,500-101,500 would have seen their rate stay the same at 25%, while those making $127,500-$200,500 would have seen their rate rise from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. For our original discussion, see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 19 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.

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

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof bca.gps_so_2016_12_14_c3 bca.gps_so_2016_12_14_c3 Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand bca.gps_so_2016_12_14_c4 bca.gps_so_2016_12_14_c4 At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... bca.gps_so_2016_12_14_c5 bca.gps_so_2016_12_14_c5 Chart 6And Now China ##br##Is Exporting Deflation bca.gps_so_2016_12_14_c6 bca.gps_so_2016_12_14_c6 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 8Sino-American ##br##Symbiosis Is Over bca.gps_so_2016_12_14_c8 bca.gps_so_2016_12_14_c8 Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Globalization: A Deflationary Shock Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Europe's Economy Is Holding Up Europe's Economy Is Holding Up Chart 19 "Mainstream Media" Is A Dirty Word For Many "Mainstream Media" Is A Dirty Word For Many We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 21The Internet Has Killed Journalism Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Get Used To Tail-Risk Events Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Support For The Euro Remains Stable Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 26The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating bca.gps_so_2016_12_14_c30 bca.gps_so_2016_12_14_c30 Chart 31There Is A Lot Of Daylight... bca.gps_so_2016_12_14_c31 bca.gps_so_2016_12_14_c31 The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's bca.gps_so_2016_12_14_c32 bca.gps_so_2016_12_14_c32 Chart 33Italy Lags Peers On Euro Support bca.gps_so_2016_12_14_c33 bca.gps_so_2016_12_14_c33 Chart 34Italy's Next Election Is Too Close To Call bca.gps_so_2016_12_14_c34 bca.gps_so_2016_12_14_c34 Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? bca.gps_so_2016_12_14_c35 bca.gps_so_2016_12_14_c35 Chart 36Italy Has Learned To Live With Its Debt Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe bca.gps_so_2016_12_14_c37 bca.gps_so_2016_12_14_c37 Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 40Iraq Is The Big, And Cheap, Hope bca.gps_so_2016_12_14_c40 bca.gps_so_2016_12_14_c40 This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 42Oil Supply Glut Is Gone In 2017 bca.gps_so_2016_12_14_c42 bca.gps_so_2016_12_14_c42 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 44Asia Sells, America Rules bca.gps_so_2016_12_14_c44 bca.gps_so_2016_12_14_c44 It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike bca.gps_so_2016_12_14_c45 bca.gps_so_2016_12_14_c45 Chart 46China Backing Away From U.S. Treasuries bca.gps_so_2016_12_14_c46 bca.gps_so_2016_12_14_c46 There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade bca.gps_so_2016_12_14_c47 bca.gps_so_2016_12_14_c47 Chart 48China Is De-Globalizing bca.gps_so_2016_12_14_c48 bca.gps_so_2016_12_14_c48 That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone bca.gps_so_2016_12_14_c49 bca.gps_so_2016_12_14_c49 The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses bca.gps_so_2016_12_14_c50 bca.gps_so_2016_12_14_c50 What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights We update the long-term structural themes that we expect will be key drivers of financial market performance over the next one to five years, drawing investment conclusions from each. Debt Supercycle. The final stage of a debt supercycle is often marked by an increase in public debt, which we may now see in the U.S. Meanwhile, the eurozone and emerging markets are still at an early stage of post-debt deleveraging. Technological Disruption. The IT revolution has reached the mature phase, and behind it is a new wave of technologies including artificial intelligence and biotech. The first and last stages of tech waves are the only times where investors typically make profits. Emerging Market Deleveraging. EM assets will continue to underperform until these countries complete structural reforms and deal with the consequences of a decade of credit excesses. Multipolar Geopolitics. The end of American hegemony raises the risk of military conflicts and will make the world less globalized. End Of The Bond Bull Market. Interest rates have been in structural decline since the early 1980s. With a rotation to fiscal policy and (eventually) higher inflation, the path of least resistance for yields is upwards. Subpar Long-Run Returns. With bond yields low and equities expensive, investors will find it hard to achieve the returns they have become accustomed to over the past 30 years. Substantially more risk will be required to achieve the same level of return. Bear Market In Commodities. Weak demand growth (as China reengineers its economy), excess resource capacity, and an appreciating dollar make this a very different environment to the 2000s. Mal-Distribution Of Income. The backlash from stagnant incomes in Anglo-Saxon economies will continue. Populism is likely to cause the labor share of GDP to rise, hurting profits and lowering investment returns. Feature I. Introduction Chart 1Major Market Cycles Major Market Cycles Major Market Cycles The key views in Global Asset Allocation (GAA), as in other BCA services, center on the cyclical time-horizon, six to 12 months. This means analyzing principally where we are in the business cycle, the impact of liquidity and monetary conditions, and the current outlook for economic and earnings growth. But it is also important to understand the long-term picture: the structural trends in asset prices, debt, demographics, technology, and other "long wave" factors that have profound and protracted impacts on investment performance. Specifically, investors need to get right long-term shifts in things such as economic growth, the U.S. dollar, commodity prices, interest rates, and the relative performance of stocks and bonds (Chart 1). Such long-term themes, therefore, represent the road-map around which GAA develops its cyclical views. Ever since the service began in 2011 (and indeed in its predecessor, the BCA Premium Service), we have published a list of Major Themes, that "should be key drivers of financial market performance over the next 1-5 years." This Special Report updates and fleshes out these major themes. We have retained five of our current themes: The End of The Debt Supercycle The End of The 35-Year Global Bond Bull Market Subpar Long-Run Returns Bear Market in Commodities The Mal-Distribution of Income &Social Unrest And have added three new themes: Technological Disruption EM in A Multi-Year Deleveraging Multipolar Geopolitics In the report we describe each of these themes and draw investment conclusions from them. The descriptions are relatively brief (since most of these themes will be familiar to BCA clients), but we spend more time on analyzing the new themes and on the Debt Supercycle, which is central to our world view. We have dropped two of our earlier themes: Financial Sector Re-Regulation: Bank regulation has indeed been drastically tightened in the years since the Global Financial Crisis. As a result, banks have deleveraged significantly in most regions (Chart 2), their profitability has declined (Chart 3), and share price performance has been poor. But this phase may be over. Bank loan growth has recovered in the U.S. and the new Trump administration may both boost demand for borrowing and ease regulation. In Europe and Japan, bank stock performance will henceforth be driven more by shifts in loan demand and the shape of the yield curve than by regulation. Chart 2Banks Have Deleveraged... bca.gaa_sr_2016_12_05_c2 bca.gaa_sr_2016_12_05_c2 Chart 3... And Become Much Less Profitable bca.gaa_sr_2016_12_05_c3 bca.gaa_sr_2016_12_05_c3 Chart 4The Lowest Interest Rates Ever bca.gaa_sr_2016_12_05_c4 bca.gaa_sr_2016_12_05_c4 A Generational Shift: Our concept was that Millennials (usually defined as those who came of age after 2000 - so born between 1977 and 1994) would behave differently: they would own less (preferring to Uber and couch-surf), depend on social media, and be less focused on their careers. Arguably, this has not been the case. Like previous generations, Millennials have started to acquire possessions. In the U.S. last year, one-half of homebuyers were under 36; Millennials bought 4 million cars (making them the second largest group of purchasers behind baby-boomers). Moreover, this is a hard theme to draw investment conclusions from. Every generation is slightly different - but how concretely does this affect asset prices? One final thought. A common thread running through our themes is that there is little new under the sun. Most phenomena in economics and markets are cyclical. Many of the charts in this report show that the same environment comes round time and again, after five, 10 or 50 years. Much analysis in investment theory is based on this (think of Kontratiev waves, "the fourth turning," Dow Theory etc.) But what is fascinating about today's world is that there are trends we are experiencing for the first time in history: Zero or negative interest rates: never in history have governments, companies, and individuals been able to borrow so cheaply (Chart 4), sometimes even being paid for the privilege. Demographics: The world population has grown continuously since the Black Death in 1350. Indeed the fastest population growth on record was as recent as the 1960s (Chart 5). But growth has slowed sharply since, and is expected to be only 0.1% a year by the end of the century. As a result, we are seeing an unprecedented slowdown - and even decline - in the size of the workforce in many countries (Chart 6). Chart 5Population Growth Has Slowed Drastically bca.gaa_sr_2016_12_05_c5 bca.gaa_sr_2016_12_05_c5 Chart 6The Workforce In Some Countries Is Shrinking bca.gaa_sr_2016_12_05_c6 bca.gaa_sr_2016_12_05_c6 The impacts of these two trends will be profound - but they won't be found by looking at historical precedents. II. Debt Supercycles One of the key ways in which BCA has long looked at the world is through the concept of debt supercycles. Our founder, Hamilton Bolton, wrote in 1967 of "the possibilities inherent in an intensive study of changes in bank credit as a major cyclical and supercyclical investment tool....History shows period after period of excessive bank credit inflation. It also shows a number of periods in which bank credit deflation has been allowed to erode the whole economic and investment structure."1 Simply put, when credit in the economy expands (and these days one needs to look more broadly than at just bank credit) it tends to boost growth, raise asset prices, and underpin the effectiveness of monetary policy. At some point, the level of credit becomes unsustainable and the subsequent deleveraging causes financial conservatism as borrowers focus on repairing their balance-sheets. This makes monetary policy relatively ineffective, and has negative effects on growth and asset prices. The two biggest debt supercycles over the past 50 years were in Japan from 1970 to 1990, and in the U.S. and parts of Europe starting in the early 1980s and culminating with the Global Financial Crisis in 2007 (Chart 7). The fallout from the end of Japan's debt supercycle has been stark: since 1990, Japanese nominal GDP has grown by only 0.4% a year (compared to 6% a year over the previous 10 years) and even today the Nikkei index is 55% below its peak. In the U.S., the early 1980s' financial deregulation and the fiscal policies of the Reagan government caused both private and government debt to begin to rise as a percentage of GDP (Chart 8). From the late 1990s, monetary policy was kept too easy, which culminated in the housing bubble of 2004-7. After that bubble burst, households reduced debt (partly through defaults) and government spending rose sharply for a few years to cushion the recession. Chart 7Debt Supercycles Everywhere Debt Supercycles Everywhere Debt Supercycles Everywhere Chart 8U.S. Debt Started To Rise From 1980 bca.gaa_sr_2016_12_05_c8 bca.gaa_sr_2016_12_05_c8 Since 2009, BCA has been talking about a "post debt supercycle" in the U.S.2 The household savings rate rose (Chart 9), as consumers became cautious, preferring to save rather than spend (Chart 10). This has meant that consumption growth has been lower than wage growth, whereas the opposite was the case up to 2007. Monetary policy also became ineffective since, in such a weak growth environment, companies were not inclined to spend on capital investment despite ultra-low interest rates (Chart 11). Chart 9Household Savings Rate Has Risen Since The Crisis bca.gaa_sr_2016_12_05_c9 bca.gaa_sr_2016_12_05_c9 Chart 10Consumers Prefer To Save Than Spend Consumers Prefer To Save Than Spend Consumers Prefer To Save Than Spend Chart 11Companies Not Spending Despite Low Rates Companies Not Spending Despite Low Rates Companies Not Spending Despite Low Rates There are two competing theories to explain the sub-trend growth of the current expansion. Larry Summers' theory of secular stagnation3 describes a world in which, even with ultra-low interest rates, desired levels of saving exceed desired levels of investment, leading to chronic shortfall in demand. BCA's debt supercycle explanation is closer to that of economists such as Kenneth Rogoff, who argues that once deleveraging and borrowing headwinds subside, growth trends might rise again.4But the two theories may not be so incompatible: secular factors, such as demographics, play a role in both. The final stage of a debt supercycle is often an increase in public debt. That has certainly been the case in Japan: while the private sector has deleveraged aggressively since 1990, government debt to GDP has risen from 67% to 250% - without having much discernible effect on boosting growth. In the U.S., government debt has stabilized as a percentage of GDP over the past two years, and the baseline projection made by the Congressional Budget Office in March this year forecasts it to increase by only 10 percentage points over the next decade. But the election of President Trump might change that. His campaign promised tax cuts and infrastructure spending amounting to about USD6 Trn which, all else being equal, would increase government debt/GDP by another 30 percentage points over a decade. There are two other regions where we see the debt supercycle being an important factor over the coming years: the Eurozone and emerging markets. In Europe, some of the most indebted countries, notably the U.K. and Spain, have made progress in deleveraging since the Global Financial Crisis - although the balance-sheet repair is likely to remain a drag on the economy for a while longer. But France and Italy have hardly delevered at all, and some smaller countries such as Belgium have seen a substantial increase in private debt/GDP (Chart 12). The Eurozone remains generally a very heavily bank-dependent economy, with total bank credit almost back to a historical peak (Chart 13). Germany, by contrast, has long had an aversion to debt: private sector debt/GDP has never been above 130% and is currently only around 100%. This unwillingness to borrow and spend by the world's fourth largest economy has been a drag on European growth. Chart 12Deleveraging In Europe Has Been Patchy Deleveraging In Europe Has Been Patchy Deleveraging In Europe Has Been Patchy Chart 13Eurozone Bank Loans Have Not Declined Eurozone Bank Loans Have Not Declined Eurozone Bank Loans Have Not Declined Emerging markets delevered after the Asian crisis in 1997-8 but the wave of global liquidity created in 2009-12 flowed into EMs, triggering excessively high credit growth. Private-sector EM debt has reached an average of 140% of GDP (Chart 14), and a higher percentage of global GDP than was U.S. debt at the peak of the housing bubble in 2006. Although the debt buildup is most extreme in China, where private-sector debt/GDP has risen by 70 percentage points over the past seven years, the same phenomenon is apparent in many other emerging markets, notably Brazil, Turkey, Russia and Malaysia (Chart 15). Chart 14The EM Debt Supercycle May Be Ending The EM Debt Supercycle May Be Ending The EM Debt Supercycle May Be Ending Chart 15And It's Not Just About China And It's Not Just About China And It's Not Just About China BCA's Emerging Markets Strategy has argued for a while that this is unsustainable and that a period of deleveraging will cause growth to slow in many emerging markets and that the strains from the excessive lending, such as rising NPL ratios, will become apparent.5 The deleveraging has already started to happen, with loan growth in Brazil, Malaysia and Turkey - but not yet China - slowing sharply (Charts 16 & 17). Chart 16EM Bank Lending Now Slowing... EM Bank Lending Now Slowing... EM Bank Lending Now Slowing... Chart 17...Almost Everywhere ... Almost Everywhere ... Almost Everywhere We draw a number of conclusions for long-term asset allocation from this analysis. The post debt supercycle is likely to remain a drag on global growth, and therefore on returns from risk assets, for some years to come. But the U.S. is likely to be less affected than the eurozone since the household sector there has already substantially deleveraged and the Trump administration is more likely to use government spending to fill the gap. Emerging markets will underperform for some years to come as they too go through a period of deleveraging. III. Disruptive Technology Technological change is a key driving force of economies and markets. As Joseph Schumpeter said, capitalism is a "process of industrial mutation...that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." Nikolai Kondratiev described 45-60 year waves that were triggered by "the irruption of a technological revolution and the absorption of its effects." Understanding where we are in the technological cycle, then, is very important for investors wanting to catch deep trends. But it is particularly hard at the moment because, at the same time as the world is still seeing ramifications coming through from personal computing (which began as long ago as 1971, with Intel's announcement of the first microprocessor) and from the internet (which started as Arpanet in 1969), there is a new wave of revolutionary technologies still mainly on the drawing-board, including robotics, artificial intelligence, and genetic engineering. The best framework for thinking about technological cycles is provided by economist Carlota Perez.6 She describes five "surges of development" starting with the Industrial Revolution, which she dates from the opening of Arkwright's cotton spinning mill in Cromford in 1771 (Table 1). Her key argument is that these revolutionary technologies have powerful and long drawn-out effects on the financial, social, institutional, and organizational framework and therefore tend to move through a similar pattern of four phases (Chart 18) lasting around 50 years in all. The fifth wave, Information Technology, for example, started in its installation phase with development of the microprocessor, PCs, and mobile phones in the 1970s and 1980s, reached frenzy in the 1990s, hit a turning-point (which often triggers a stock market crash) in 2000-2, before reaching the deployment phase in the 2000s, and may now be at maturity (growth in computers and smart phones is slowing). Table 1The Five Historic Technology ##br##'Surges Of Development' Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 18The Four Stages Of Technology Waves Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes But Perez wrote her book in 2002, and we could now be close to the beginning of the sixth wave. Think about the situation 30 years ago, in 1986. It would not have been hard to extrapolate how technology might develop over the coming years since some people already used PCs, mobile phones, and the internet but, as William Gibson said at the time, "the future is already, here - it's just not very evenly distributed." Today there are still a few further developments to come in these fifth-wave technologies (we've listed some in Table 2). But there is a whole further set of technologies (self-driving cars, graphene, distributed energy generation) which almost nobody uses now, but which could become important. Many of these build on the developments of the fifth wave (ubiquitous connectivity, cheap and powerful computing) in the same way that previous revolutions grew from their predecessors (cars wouldn't have been possible without steel, for example). Table 2Fifth And Sixth Wave Technologies Still To Come Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The implications of these new technologies are hard to predict, and many have undoubtedly been over-hyped. As Bill Gates said: "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." So how should investors deal with this? The macro implications are enormous. Every new wave of technologies has a large impact on employment, as jobs in dying industries disappear. U.S. farm workers, for example, fell from over half of the labor force in 1880 to only 12% by 1950 (Chart 19). But perhaps more relevant - given that self-driving vehicles may replace taxi, truck, and delivery drivers - is that the number of horses in the U.S. fell from 26 million to 4 million over the 50 years starting in 1915 (Chart 20). These jobs, of course, were replaced by new opportunities in manufacturing or services. And the number of drivers in the U.S. is only 3.8 million currently, or less than 3% of the workforce. Nonetheless, in the maturity phase of the technology wave (where we are now for the IT revolution), Perez points out, there is often popular unrest as "workers organize and demand...the benefits that have been promised and not delivered." Chart 19Farm Workers Were Disrupted ##br##In The Late 19th Century Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 20...And So ##br##Were Horses Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Investing in new technologies is naturally appealing to investors, but often tricky to get right. Alastair Nairn7 identifies five similar phases for investing in technology but concludes that investors can usually make money only in the first stage, when initial skepticism reigns, and in the final stage, when the technology has matured and the surviving handful of leading players can now make good profit. Analysis by economists at the Atlanta Fed showed (Table 3) that, of the 24 U.S. PC manufacturers listed on the U.S. stock market between 1983 and 2006, only 10 made a positive return for shareholders.8 Of these, only five beat the overall index. The picture is similar for other technology waves, except perhaps for the nascent auto industry when 12 of 23 listed manufacturers outperformed the index in 1912-1928. Table 3Investments In New Technology Companies Rarely Beat The Market Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Nairn also argues that it is easier to spot losers than winners: "The winners take many years to emerge and...it is well-nigh impossible to identify them early. ...Conversely, the losers tend to be more obvious, and more obvious at an early stage." Think back to the early days of the internet. Investors would have struggled to pick the eventual winners (Apple, Amazon, Google - but many might have guessed Yahoo or even Pets.com) but should have understood that the media, travel, retailing, and film-camera industries would all be disrupted. Chart 21IT And Healthcare Sectors ##br##Are Likely To Continue To Outperform IT And Healthcare Sectors Are Likely To Continue To Outperform IT And Healthcare Sectors Are Likely To Continue To Outperform So how should investors apply these conclusions? If we are in the mature phase of the Fifth Wave and the skepticism phase of the Sixth, this is a time when investors can benefit from tilts towards sectors where technological changes are taking place, most notably IT and Healthcare, which are likely to continue to outperform over the long run (Chart 21). Exposure to what our colleague Peter Berezin calls BRAIN stocks - biotech, robotics, artificial intelligence, nanotech - makes sense.9 This can be captured through venture capital funds. Potential losers might include energy companies and utilities, as improvements in solar energy lead to more distributed power. Even oil company BP reckons that renewables will provide 16% of power generation in 2035 - and 35% in the EU - up from 4% today, with the cost of solar power expected to fall by 40% over the time. Other sectors that could be disrupted include automakers, which could be challenged by developments in electric vehicles, and financial institutions, whose business model could be under threat from peer-to-peer lending, robo-advisers and other developments in fintech. IV. Emerging Markets In A Multi-Year Deleveraging BCA has recommended a structural underweight on emerging market (EM) equities relative to developed markets (DM) since 2010.10 This call worked well until the end of last year. So far this year, however, EM equities have outperformed DM by 5%, despite their sharp selloff (Chart 22) after the U.S. election. Our view is that emerging markets remain structurally challenged and that their long-run underperformance is likely to continue. We view the outperformance this year as simply a counter-trend move driven largely by two factors: a) the extreme relative undervaluation of EM vs. DM at the beginning of the year; and b) unconventional quantitative easing from the ECB and BoJ, and massive back-door liquidity injections (Chart 23) by EM central banks, such as in China and Turkey. Chart 22Counter-Trend Rally Largley Driven By... bca.gaa_sr_2016_12_05_c22 bca.gaa_sr_2016_12_05_c22 Chart 23QE / Massive Liquidity Injection By PBoC bca.gaa_sr_2016_12_05_c23 bca.gaa_sr_2016_12_05_c23 After the bounce, however, EM equities are no longer especially cheap relative to their DM counterparts, with the relative forward PE ratio now at its five-year average. Going forward, the poor profit outlook - due to persistent structural problems in the EM economies - will continue to weigh on the relative performance of EM assets. We maintain our structural underweight call on EM equities in a global portfolio. First, the factors that drove the massive outperformance of emerging markets in 2002-2010 have disappeared: the once-in-a-generation debt-fueled consumption binge in DM, and the investment-fueled double-digit growth in China which triggered a bull market in commodities (Chart 24). But EM countries did not take full advantage of these exogenous forces to reform their economies: to foster domestic demand, and optimize resource allocation and industrial structure. When China slowed and U.S. consumers went through a much-needed deleveraging after the Great Recession, exports to DM slowed and even contracted, and commodities prices declined sharply. As a result, the export-driven economic model of EM countries has broken down. The structural drivers of economic growth in the EM, both productivity and capital efficiency (Chart 25), have been in a downtrend, while debt (Chart 26) has continued to soar. Chart 24Regime Has Shifted bca.gaa_sr_2016_12_05_c24 bca.gaa_sr_2016_12_05_c24 Chart 25Structural Drivers Have Weakened bca.gaa_sr_2016_12_05_c25 bca.gaa_sr_2016_12_05_c25 Chart 26Debt Has Soared Debt Has Soared Debt Has Soared Structural problems require structural solutions. These solutions vary by country, but in general require less state intervention in the economy, flexible labor markets, and better incentive structures to encourage innovation and entrepreneurship. But structural reforms are a painful process and take strong political will to implement. A case in point is China, which delayed its announced supply-side reforms and reverted to monetary and fiscal stimulus when growth slowed. Second, history shows that no credit boom can last forever. Chart 27 shows private non-financial credit-to-GDP ratios in major developed economies. They have experienced periods of deleveraging of various magnitudes and durations, even though these nations have deep and sophisticated banking, credit, and financial markets, and some have plenty of domestic savings. Similar patterns have been observed in EM economies, although their deleveraging episodes have tended to be more frequent and of larger magnitude (Chart 28). Chart 27No Credit Boom Lasts ##br##Forever In DM Economies No Credit Boom Lasts Forever In DM Economies No Credit Boom Lasts Forever In DM Economies Chart 28Asian Economies: Many Interruptions During Structural Leveraging Process bca.gaa_sr_2016_12_05_c28 bca.gaa_sr_2016_12_05_c28 The main reason for these boom-bust credit cycles is the burden of debt servicing. As the private credit-to-GDP ratio rises, if interest rates are held constant, a larger share of income needs to be allocated to paying interest. At some point, debt service eats too much into debtors' incomes, causing debtors to default and creditors to reduce credit provision. This causes the economy to slow, followed by a painful but necessary restructuring to work off the excess leverage before a new cycle can start. We see no reason see why EM countries, China in particular, can sustain their current high and rising leverage levels. Deleveraging is inevitable. Third, this deleveraging in EM is at a very early stage, since credit in most EM countries continues to grow faster than nominal GDP (Chart 29). After years of booming corporate and household debt, a period of consolidation is inevitable. Hence, credit growth is set to slow to at least the level of nominal GDP growth. The credit impulse - the change in the rate of credit growth - is a key factor influencing GDP and profit growth. Chart 30 shows that if credit growth converges to nominal GDP growth within the next 12-24 months, the credit impulse will turn negative, ensuring a slowdown in the EM economies and a further contraction in corporate earnings, thus putting downside pressure on asset prices. Chart 29A Break In LEveraging Cycle Is Overdue bca.gaa_sr_2016_12_05_c29 bca.gaa_sr_2016_12_05_c29 Chart 30Negative Credit Impulse Bodes Ill For Profit And Equities Prices Negative Credit Impulse Bodes Ill For Profit And Equities Prices Negative Credit Impulse Bodes Ill For Profit And Equities Prices Chart 31Dismal Return on Equity Dismal Return on Equity Dismal Return on Equity Bottom Line: EM economies are at a very early stage of a multi-year deleveraging to work off credit excesses. Despite their year-to-date outperformance, we expect EM equities will continue to underperform their DM counterparts over the long run until their return on equity (Chart 31) improves significantly. V. Geopolitical Multipolarity Since the end of the Cold War, geopolitics has mostly remained in the background for investors. This is because the collapse of the Soviet Union ushered in an era of American hegemony that lasted for roughly two decades. During this period, the global concentration of economic, trade, and military power increased as the U.S. became the only true superpower (Chart 32). The world entered a period of "hegemonic stability," an era during which regional powers dared not pursue an independent foreign policy for fear of U.S. retaliation and during which the "Washington consensus" of laissez-faire capitalism and free trade was adopted by policymakers in both developed and emerging markets. Chart 32The End Of American Hegemony bca.gaa_sr_2016_12_05_c32 bca.gaa_sr_2016_12_05_c32 A central thesis of BCA's Geopolitical Strategy is that the world has entered a multipolar phase.11 Multipolarity implies that the number of states powerful enough to pursue an independent and globally-relevant foreign policy is greater than one (unipolarity) or two (bipolarity). Today, multipolarity is the product of America's decaying unipolar moment. The U.S. remains, by far, the most powerful country in the absolute sense, but it is experiencing a relative decline as regional powers become more capable on both the economic and geopolitical fronts (Chart 33). Multipolarity is not a popular theme with investors. It augurs uncertainty, rising risk premia, and unanticipated "Black Swan" events. In addition, some of our clients take issue with the thesis that the U.S. is in "decline." Although we can measure hard power and illustrate the relative decline of the U.S. empirically, perhaps the greatest evidence of global multipolarity are recent events that were unimaginable just five or ten years ago: Russia's annexation of Crimea; China's military expansion in South China Sea; Turkey's disregard for U.S. interests in Syria; U.S.-Iran détente (with little evidence that Tehran has actually curbed its nuclear capabilities); Dramatic withdrawal of U.S. troops in the Middle East. The point of a multipolar world is not that Russia, China, Turkey, Iran, and other powers seek to challenge America's global reach, but rather that each is more than capable of pursuing an independent foreign policy within their own spheres of influence. As the number of "veto players" in the global "Great Game" increases, however, equilibrium becomes more difficult to achieve. Uncertainty rises and conflicts emerge where none were expected. So what does multipolarity mean for investors? First, we know from formal modeling in political science, and from history, that a multipolar world is unstable and more likely to produce military conflict (Chart 34).12 There are three reasons: Chart 33U.S. Experiencing Relative Decline U.S. Experiencing Relative Decline U.S. Experiencing Relative Decline Chart 34Geopolitical Risk Is The Outcome Of Global Multipolarity bca.gaa_sr_2016_12_05_c34 bca.gaa_sr_2016_12_05_c34 During periods of multipolarity, more states can effectively pursue foreign policies that lead to war, thus creating more potential "conflict dyads" in the parlance of International Relations theory. In fact, evidence shows that this has already happened (and continues to happen), with the number of international or internationalized conflicts rising since 2010 dramatically (Chart 35). Power imbalances between states are more likely if there are more states that matter geopolitically. And power imbalances invite conflict as they are more likely to produce a situation in which one country's rising capabilities threaten another. During the Cold War, it didn't matter that Iran was more powerful than Saudi Arabia because the U.S. was present in the Middle East and willing to balance against Tehran. In a multipolar world, the weaker states are on their own. The probability of miscalculation rises due to the number of relevant states making geopolitical decisions simultaneously. For example, last year's shooting down of a Russian jet by the Turkish air force over Syria is an example of an incident that is mathematically more likely in a multipolar world. During the Cold War, the chances that Turkey would independently make the decision to shoot down a Soviet jet was far smaller as its foreign policy was closely aligned with that of its NATO ally the U.S. Chart 35Multipolarity Increases ##br##The Frequency Of Conflict Multipolarity Increases The Frequency Of Conflict Multipolarity Increases The Frequency Of Conflict There are a number of derivatives from the multipolarity thesis that will be relevant for investors. For example, despite Brexit, a multipolar world will support European integration.13 With geopolitical uncertainty rising in Europe's neighborhood - particularly in the Middle East and with Russia reasserting itself - Europe's core countries will not follow down the "exit" path that the U.K. pursued. On the other hand, the geopolitical disequilibrium in East Asia is deepening, with China's pursuit of a sphere of influence in the South and East China Seas likely to continue to raise tensions in the region. But the overarching concern for investors should be how multipolarity impacts the global economy. Global macroeconomic imbalances - such as the current combination of insufficient demand and excessive capacity - can be overcome either by unilateral policy from the hegemon or through coordination among the major economic and political powers. A multipolar world, however, lacks such coordination. Globalization is therefore at risk from multipolarity.14 Not only are regional powers pursuing spheres of influence, which is by definition incompatible with a globalized world, but the world lacks the hegemon that normally provides the expensive, and hard to come by, global public goods: namely economic coordination and geopolitical stability. History teaches us that the ebb and flow of trade globalization has been closely associated in the past with the shifting global balance of power (Chart 36). Trade globalization collapsed right around 1880, when the rise of a unified Germany and the ascendant U.S. undermined the century-old Pax Britannica. This trend ushered in a rise of competitive tariffs as the laggards of industrialization attempted to catch up with the established powers. Trade globalization recovered and began to grown again in the early twentieth century and immediately after the First World War, but both attempts were aborted by the lack of a clear hegemon willing to undertake the coordinating role necessary for globalization to take root and persevere. Chart 36Back To The 1930's? bca.gaa_sr_2016_12_05_c36 bca.gaa_sr_2016_12_05_c36 The lack of a clear hegemon and the diffusion of geopolitical power amongst multiple states can act as a headwind to global coordination. In the late nineteenth and early twentieth century, the U.K. was too weak to enforce global rules and norms, and the surging U.S. was unwilling to do so. Today, the U.S. is (relatively) too weak and unwilling to do the job of a hegemon, while China is understandably unwilling to coordinate its economic policy with a strategic rival. The investment implications of multipolarity center on three broad themes: Apex globalization: Going forward, the world is going to be less, not more, globalized. This will favor domestic over global sectors and consumer-oriented economies over the export-oriented ones. Globalization is also a major deflationary force, which would suggest that, on the margin, a world that is less globalized should be more inflationary. DM over EM: Multipolarity is more likely to produce a number of conflicts, some of which lay dormant throughout the Cold War and subsequent era of American hegemony. These conflicts tend to be in emerging or frontier markets. Safe Havens: With the frequency of geopolitical conflict on the rise, safe haven assets like the U.S. Treasurys, U.S. dollar, gold, and Swiss and Japanese government bonds, should continue to hold an important place in investors' asset allocation. VI. End Of The 35-Year Global Bond Bull Market Since the early 1980s, interest rates have been in a structural decline on the back of falling inflation expectations. Thirty-five years later, the global bond bull market has reached its end (Chart 37). Importantly, this is not to suggest that a secular bear market in bonds is beginning. The global economy is still suffering from significant spare capacity and markets usually go through a volatile bottoming process before a new secular trend is established. Nevertheless, the path of least resistance for yields is upwards. Chart 37Long-Term Yields Have Bottomed Long-Term Yields Have Bottomed Long-Term Yields Have Bottomed The most significant shift regarding sovereign yields is the global transition from monetary to fiscal stimulus. Over the next few years, central bank asset purchases will be negligible at best, with normalization in central bank balance sheets being far more likely, albeit at a muted pace. From the fiscal perspective, the rotation has already occurred in several regions, with the liberal government in Canada promising to increase infrastructure spending, Japanese Prime Minister Shinzo Abe postponing next year's planned VAT tax hike, and incoming U.S. President Donald Trump expected to ramp up fiscal spending. Sovereign bond yields have been weighed down by the rise in inequality. IMF studies found that this increase in inequality has had substantial negative effects on real GDP growth and therefore the real component. Populism is growing, as evidenced by the surprising outcome of the Brexit vote, the rise of anti-establishment parties in Europe, and the highly polarizing candidates in the U.S. elections. However, as populism continues to mount, policymakers will be further pressured to take on additional reflationary measures, inevitably leading to higher inflation. Anemic productivity growth has dampened aggregate demand and applied downward pressure to bond yields. Initially, weak productivity gains are deflationary as they reduce the incentive for firms to invest and consumers to reduce their spending. The longer term effect however, is that the supply side catches up, causing the economy to overheat and inflation to rise (Chart 38). This was the case in low productivity economies in Africa and Latin America. Chart 38A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Nevertheless, not all factors are pointing to higher yields. Demographic trends have been unfavorable, as working age population growth in the major countries has decelerated sharply since 2007. Conditions will likely worsen, with the UN forecasting growth to reach zero in the latter half of the next decade. The effect is further compression in the real component of bond yields as slower labor force growth reduces the incentive for firms to build new factories, shopping malls and office towers. Overall, while the global economy has been plagued by deflation, these signs suggest that the tide is finally turning. Higher consumer prices will not only lead to an increase in the inflation expectations component, but also the inflation risk premium, which compensates investors over the inflation outlook. As the majority of the rise in bond yields will come via the inflation component and not the real component, we advocate a long-term allocation to TIPS. VII. Subpar Long-Run Returns Asset prices have surged following the global financial crisis and have reached fairly expensive valuations. While this not to say that a bear market is imminent, it certainly makes financial assets more vulnerable to correction and it does suggest that long-term return prospects are bleak. Lower future returns will shift the efficient frontier inward, requiring substantially more risk to achieve the same level of returns. Investors will find it far more difficult to achieve returns they have become accustomed to over the past 30 years. Sovereign Bonds: After 35 years, the structural decline in interest rates is at an end. While we do not expect an outright bond bear market, the path of least resistance for yields is up (Chart 39). Across all major countries and regions, starting long-term real yields have been an excellent predictor for future five-year returns. Given that yields are at multi-century lows, and even negative in some regions, future returns will be meager. Investors should reduce their long-term allocation to sovereign debt. Chart 39Yields: The Path Of Least Resistance Is Up Yields: The Path Of Least Resistance Is Up Yields: The Path Of Least Resistance Is Up Corporate Bonds: Corporate debt is also priced expensively relative to its long-term history. The credit cycle is in its late stages, and while accommodative monetary policy will extend this phase, defaults will eventually grind higher and low starting yields will limit long-term returns. Investment grade real returns can be mostly explained by their starting real yields. In fact, real yields have been an even better predictor for investment grade returns than they have for sovereigns. Investment grade spreads are less important as they have historically been stable, and defaults are fairly rare in this space. For high yield, while starting real yields are important, spreads and defaults are also crucial determinants for performance. All valuation metrics suggest that both future investment grade and high-yield returns will fall far short of investors' ingrained expectations (Chart 40). Equities: The relationship between cyclically-adjusted price-to-earnings ratios (CAPEs) and real returns is well established, as a simple regression generates a high r-squared (Chart 41). Current valuations are expensive, suggesting low to mid single digit returns. However, there is reason to believe that this scenario is overly optimistic. First, global equities have benefitted from the structural decline in interest rates. Going forward however, the end of the bond bull market removes a substantial tailwind. Secondly, the Debt Supercycle, in which each cycle begins with more indebtedness than the one that preceded it, is played out in the developed world. The implication is that household credit demand will be weak and businesses are less likely to spend on capex, thereby dampening economic growth. Chart 40Low Starting Yields = Low Future Returns bca.gaa_sr_2016_12_05_c40 bca.gaa_sr_2016_12_05_c40 Chart 41Shiller P/E Suggests Below-Average Long-Run Equity Returns Shiller P/E Suggests Below-Average Long-Run Equity Returns Shiller P/E Suggests Below-Average Long-Run Equity Returns In order for investors to reach their return targets, we recommend several options. The end of the structural decline in interest rates does not bode well for sovereign bond returns. Instead, allocators should increase their structural exposure to equities. Investors should also focus more on bottom-up analysis and differentiating at lower levels, i.e. industry groups (GICS level 2). Finally, we advocate a long-term allocation to alternative assets. Alternatives provide downside protection through volatility reduction and substantial return enhancement potential given their active management and an illiquidity premium. VIII. Structural Bull Market In Resources Is Over Commodities experienced an unusually strong bull market in the 2000s, driven by very supportive global economic and financial conditions (Chart 42): 1) the U.S. dollar spent the decade in decline; 2) investment in mining capacity was depressed following the bear market of the 1990s; 3) rapid industrialization and double-digit growth in China. The bull market of 2000s lasted longer than its predecessors and was driven more by demand growth than by supply shortages. Commodities have never been a long-term buy. While there have been cyclical bull markets, the commodity complex in real terms has been in a structural downtrend for the past two centuries (Chart 43). This is despite a 20-fold increase in real GDP, a sign that rapid economic growth and weaker commodity prices can go hand in hand. The simple reason is that humans constantly find ways to extract commodities from the ground more cheaply and use them more efficiently. The current cyclical downturn is likely to continue for some years. Demand: A number cyclical and structural factors (Chart 44) will weigh on marginal demand for commodities in the long run: Chart 42Very SUpportive Backdrop In The 1990s bca.gaa_sr_2016_12_05_c42 bca.gaa_sr_2016_12_05_c42 Chart 43Not A Good Long-Term Investment Not A Good Long-Term Investment Not A Good Long-Term Investment Chart 44Shaky Demand Outlook bca.gaa_sr_2016_12_05_c44 bca.gaa_sr_2016_12_05_c44 Anemic Global Growth: Despite rising incomes, per capita consumption of base metals has been flat in most developed nations. With growth in the working age population slowing to 0.7% in 2010 - 2050, down from 1.7% in 1970 - 2010, the long-term outlook for consumer demand is poor. China: China consumes more zinc, aluminium and copper than the U.S., Japan, and Europe combined. It comprises more than 40% of global base metal demand, while it has only a 15% share of global GDP. With China's plans to transition into a consumer-driven services economy, this magnitude of incremental demand is highly unlikely in the future. Alternatives & Technological Advancements: Improved energy efficiency, the transition to renewable sources, and growth in electric-hybrid vehicles will weigh on demand for traditional sources of energy. A large-scale push towards nuclear energy, led by China's plans for 80GW of installed capacity by 2020, will pose a serious threat to marginal demand. Supply: Coordinated production cuts are a thing of the past. Underutilization (Chart 45) and market share-wars by countries that need to finance rising fiscal deficits have changed supply dynamics: Excess Capacity: Following the Global Financial Crisis, completion of projects which had been previously committed to, led to enormous capacity expansion when global growth was struggling. Both mining and oil & gas extraction capacity have reached new highs led by the U.S. This will continue to put downward pressure on both metals and energy prices until excess capacity has been removed. Proven Reserves: Known reserves of most metals have risen over the past decade and reached new highs: for example, in the case of copper, nearly three tons have been added to reserves for every ton consumed. In the crude oil market, technological progress has led to discovery of unconventional deposits, the best-known being Canadian oil sands, which by some estimates contain more than twice Saudi Arabia's crude oil reserves. Price Elasticity: The shale revolution brought with it leaner drilling operations which have a much shorter supply response time. The key to the price of crude is how quickly U.S. shale oil producers respond once the oil price rises above their current average cash cost of $50. This will limit the upside potential to crude oil for the next few years. U.S. Dollar & Real Rates: The dollar (Chart 46) has much more explanatory power for commodity prices than Chinese demand does. Given monetary policy and growth divergence between the U.S. and the rest of the world, the U.S. dollar will continue to appreciate. When real rates are low, the opportunity cost of keeping resources in the ground is also low. As growth starts to stabilize, rising real rates will add downward pressure on prices. Chart 45Relentless Supply Response bca.gaa_sr_2016_12_05_c45 bca.gaa_sr_2016_12_05_c45 Chart 46U.S. Dollar Vs Chinese Growth bca.gaa_sr_2016_12_05_c46 bca.gaa_sr_2016_12_05_c46 We remain structurally bearish on the overall commodity complex, but expect short-lived divergences within the group. As more nations agree on production cuts in oil, we expect energy markets to outperform metals. Precious metals will continue to stage mini-rallies on the back of heightened equity market volatility. Agricultural commodities will continue to bear the brunt of poor global demographics. IX. Mal-Distribution Of Income And Social Unrest The decision by the U.K. in June's referendum to leave the EU and Donald Trump's victory in the U.S. presidential election suggest a high degree of dissatisfaction with the status quo in Anglo-Saxon economies. This is hardly surprising given the stagnation of median wages in developed economies since the early 1980s, especially among the less educated (Chart 47), and growing inequality. The middle class (defined as those with disposable income between 25% below and 25% above the median) in the U.S. has fallen to 27% of the population from 33% in the early 1980s, and in the U.K. to 33% from 40% (Chart 48). Note that the decline in the middle class is much less prominent in continental Europe and Canada. Chart 47Wages For Less Educated Have Stagnated bca.gaa_sr_2016_12_05_c47 bca.gaa_sr_2016_12_05_c47 Chart 48Middle Class Has Shrunk In U.S. And U.K. But Not In Continental Europe Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The Gini coefficient in the U.S. has risen to as high a level as during the 1920s (Chart 49). Branko Milanovic, the leading academic working on global inequality, explains the reasons are follows: "The forces that pushed U.S. inequality up in the roaring twenties were, in many ways, similar to the forces that pushed it up in the 1990s: downward pressure on wages (from immigration and/or increased trade), capital-based technological change (Taylorism and the Internet), monopolization of the economy (Standard Oil and large banks), suppression or decreasing attractiveness of trade unions, and a shift toward plutocracy in government."15 Chart 49U.S. Inequality Back To 1920's Level Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The backlash has begun. BCA's Geopolitical Strategy service has described how the median voter in the Anglo-Saxon world is shifting to the left.16 Around the world governments are abandoning austerity and moving to fiscal stimulus and spending to improve infrastructure. Many, for example, are raising the minimum wage. In the U.K., it is due to go up from GBP7.20 to 60% of the median wage (about GBP9.35) by 2020, and in California from $10 to $15 by 2022. The 40 years of a falling labor share of GDP and rising capital share have started to reverse in the U.S. over the past two or three years (Chart 50). These shifts also threaten growth of global trade. Trump opposes the Trans-Pacific Partnership (TPP) trade agreement and says he will renegotiate or scrap the North America Free Trade Agreement (NAFTA). Global trade, after continuous growth as a percentage of GDP since World War Two, has slowed since the Great Recession (Chart 51). The WTO reports an increase in trade-restrictive measures and a fall in trade-facilitating measures over the past 12 months (Chart 52). Chart 50Fall In Labor Share ##br##Of GDP Starting To Reverse Fall In Labor Share Of GDP Starting To Reverse Fall In Labor Share Of GDP Starting To Reverse Chart 51Trade Globalization* bca.gaa_sr_2016_12_05_c51 bca.gaa_sr_2016_12_05_c51 Chart 52Trade Measures Are Getting ##br##Increasingly Restrictive Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 53Populism Could Cause ##br##Profit Margins To Mean Revert Populism Could Cause Profit Margins To Mean Revert Populism Could Cause Profit Margins To Mean Revert These trends have significant implications for investors. The shift to populist politics is likely to be inflationary, as governments increasingly fall back on stimulative fiscal policy. A faster rise in wages will hurt corporate profit margins which, in the U.S., are likely to mean-revert from their current near-record highs (Chart 53). The popular discontent (and the growing unreliability of opinion polls) will make election results more unpredictable, as witnessed in the Brexit vote and the U.S. presidential election. A further pullback in global trade will hurt exporting sectors and export-dependent countries. All these factors lead to the conclusion that returns from investment assets over coming years are likely to be lower, and volatility higher, than has been the case over the past 40 years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com 1 Money And Investment Profits, A. Hamilton Bolton, Dow-Jones-Irwin Inc, 1967, pp74, 304. 2 For our most recent detailed analysis of this, please see BCA Special Report, "The End Of The Debt Supercycle, An Update," dated May 11, 2016, available at reports.bcaresearch.com 3 Please see, for example, Summers' article in Foreign Affairs, "The Age of Secular Stagnation," dated February 15, 2016. 4 Please see, for example, Rogoff's article, "Debt Supercycle, not secular stagnation," Centre for Economic Policy Research, dated April 22, 2015. 5 Please see, for example, Emerging Markets Strategy Special Report, "Gauging EM/China Credit Impulses," dated August 31, 2016, available at ems.bcaresearch.com 6 Please see, for example, her book Technological Revolutions and Financial Capital, published in 2002. 7 Please see Alasdair Nairn, "Engines That Move Markets," Wiley, dated January 4, 2002. 8 Measured either over the whole period, or between the dates that they were listed during the period. 9 Please see The Bank Credit Analyst, "Human Intelligence And Economic Growth," March 2013, available at bca.bcaresearch.com. 10 Please see Emerging Markets Strategy Weekly Report, "EM Equities: Downgrade To Underweight," dated April 20, 2010, available at ems.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "Stay The Course: EM Risk - DM Reward," dated January 23, 2014, available at gps.bcaresearch.com. 12 Please see Mearsheimer, John "The Tragedy Of Great Power Politics," New York: W.W. Norton & Company (2001). 13 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-Exit?," dated July 13, 2016, available at gps.bcaresearch.com, and BCA The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014. 15 Please see Branco Milanovic, "Global Inequality: A New Approach for the Age of Globalization," Harvard University Press, 2016. 16 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com.

Highlights The pace of globalization is slowing, reflecting the culmination of a decades-long process of integrating China and other emerging economies into the international trading system. Most commentators overstate the benefits of globalization, while glossing over the increasingly large distributional effects. A modest retreat from globalization would not irrevocably harm global growth, but a full-fledged trade war certainly would. Investors are underestimating the likelihood of disruptive trade measures from a Trump administration. Tactically underweight global equities. U.S. large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H-1B visa issuance under Trump's immigration plan. EM stocks could also come under pressure. Treasurys are oversold, but the structural trend for bond yields remains to the upside. The trade-weighted dollar could rally another 5% from current levels. And Take Your Damn Trump Hat With You If there is one sure way to get thrown out of a Davos party, it is by telling the assembled guests that globalization is not all that it is cracked up to be. After all, don't all cultured people know that globalization has made the world vastly richer? Well, maybe it has, but the evidence is not nearly as clear-cut as most people might imagine. Twenty years ago, the consensus among economists and policymakers was that international capital mobility should be strongly encouraged. Poor countries had a myriad of profitable investment opportunities, but lacked the savings to finance them, so the argument went. The solution, they were told, was to borrow from wealthier countries, which had a surfeit of savings. In the early 1990s, everything seemed to be going to plan. Emerging markets were running large current account deficits, using the proceeds from capital inflows to finance all sorts of investment projects. And then the Peso Crisis struck. And then the Asian Crisis. And just as quickly as the money came in, it came straight out. The result was mass defaults and depressed economies. Since then, most emerging economies have been trying to maintain current account surpluses - exactly the opposite of what theory would predict. Not to worry, the experts reassured us. What happened in emerging markets could not happen to developed economies with their strong institutions and sophisticated methods for allocating capital. The global financial crisis and later, the European sovereign debt crisis, put these claims to shame. Faced with this reality, the IMF published an official report in 2012 acknowledging that "rapid capital inflow surges or disruptive outflows can create policy challenges." It concluded that "there is ... no presumption that full liberalization is an appropriate goal for all countries at all times."1 This was a stunning about-face for an institution that, among other things, had sharply criticized Malaysia for imposing capital controls in 1998. Diminishing Returns To Globalization In contrast to capital account liberalization, the case for free trade in goods and services stands on sturdier ground. That said, proponents of free trade tend to overstate the benefits. As Paul Krugman has noted, the widely-used Eaton-Kortum model suggests that only about 5% of the increase in global GDP since 1990 can be attributed to higher trade flows.2 Moreover, it appears that the benefits to middle class workers in advanced economies from globalization have fallen over time. This is partly because trade liberalization, like most aspects of economic life, is subject to diminishing returns. Chart 1 shows that each succeeding round of trade liberalization has resulted in ever-smaller declines in average tariff rates. With tariffs on most tradeable goods now close to zero in the U.S. and most other advanced economies, there is less scope to liberalize trade further. As a result, proposed trade deals such as the Trans-Pacific Partnership (TPP) have focused on harmonizing business regulations and expanding patent and copyright protections. To call these deals "free trade agreements" is a stretch. Chart 1Tariffs Have Little Room To Decline Further bca.gis_wr_2016_11_25_c1 bca.gis_wr_2016_11_25_c1 Granted, many "invisible" barriers continue to stymie trade. John Helliwell has documented that a typical firm in Toronto generates roughly ten times as much sales from customers in Vancouver as it does from a similarly-sized, equidistant city in the U.S. such as Seattle.3 As it turns out, differences in legal systems and labor market institutions across countries, as well as differing social networks, can be as important an obstacle to trade flows as tariffs and quotas. But think about what this implies: If globalization were the key to economic development, then Canada, as a small economy situated next to a much larger neighbour, could prosper by dismantling these massive invisible trade barriers. However, we know that this proposition cannot be true: Canada is already a very rich economy, so any further trade liberalization would only boost incomes at the margin. What's Behind The Trade Slowdown? The analysis above helps put the much-discussed slowdown in global trade into context (Chart 2). As the IMF concluded in its most recent World Economic Outlook, while much of the deceleration in trade growth is attributable to cyclical factors, structural considerations also loom large.4 In particular, the boost to global trade over the past few decades stemming from the collapse of communism, the progressive elimination of most trade barriers, and the decision by most developing economies to abandon import-substitution policies appears to have run its course (Chart 3). In addition, the regional disaggregation of the global supply chain is slowing. These days, motor vehicle parts are shipped across national borders many times over before the final product rolls off the assembly line. The manufacturing process can only be broken down so much before diminishing returns set in. Chart 2Global Trade ##br##Growth Is Slowing Global Trade Growth Is Slowing Global Trade Growth Is Slowing Chart 3The Low-Hanging Fruits Of ##br##Globalization Have Been Picked bca.gis_wr_2016_11_25_c3 bca.gis_wr_2016_11_25_c3 Productivity gains in the global shipping industry are also moderating. As Marc Levinson argued in his book "The Box," the widespread adoption of containerization in the 1970s completely revolutionized the logistics and transportation industry. As a consequence, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are long gone. Nowadays, huge cranes move containers off ships and place them into waiting trucks or trains. To the extent that there are still technological advances on the horizon - think self-driving trucks - these are likely to reduce intranational transport costs more than international costs. This could result in even slower trade growth by encouraging onshoring. Trade And Income Distribution Chart 4China's Rise Came Partly At ##br##The Expense Of U.S. Rust Belt Workers bca.gis_wr_2016_11_25_c4 bca.gis_wr_2016_11_25_c4 As every first-year economics student learns, David Ricardo's Theory of Comparative Advantage predicts that real wages will rise when countries specialize in the production of goods that they can manufacture relatively well. Students who stick around (and manage to stay awake) for second-year economics might learn about the Heckscher-Ohlin model. This model qualifies Ricardo's findings. Yes, free trade raises average real wages, but there can be large distributional effects. In particular, low-skilled workers could actually suffer a decline in real wages when rich countries increase trade with poorer countries. As trade ties between advanced and developing countries have grown, these distributional issues have become more important. David Autor has documented that increasing Chinese imports have had a sizable negative effect on manufacturing employment in the U.S. (Chart 4).5 It is thus not surprising that voters in Rust Belt states were especially receptive to Donald Trump's protectionist rhetoric. A Tale Of Two Globalizations: China Versus Mexico Most economists agree that trade liberalization has disproportionately benefited developing economies. Nevertheless, there too the benefits are often overstated. China, of course, is frequently cited as an example of a country that has prospered by integrating itself into the global economy. But what about Mexico? It also made a massive push to liberalize trade starting in the mid-1980s, which culminated in NAFTA in 1994. As a consequence, the ratio of Mexican exports-to-GDP rose from 13% in 1994 to 35% at present. Yet, as Chart 5 shows, GDP-per-hour worked has actually declined relative to the U.S. over this period. One key reason why China benefited more from globalization than Mexico is that China had a much better educated workforce. This allowed it to quickly absorb technological know-how from the rest of the world, setting the stage for the spectacular growth of its own domestic industries. Sadly, when it comes to human capital, China is more the exception than the rule across developing economies (Chart 6). Chart 5Trade Liberalization Has Not ##br##Improved Mexico's Relative Productivity bca.gis_wr_2016_11_25_c5 bca.gis_wr_2016_11_25_c5 Chart 6Educational Achievement ##br##In Emerging Economies: China Stands Out The Elusive Gains From Globalization The Elusive Gains From Globalization Noble... And Not So Noble Lies To be clear, the discussion above should not be interpreted as arguing that globalization is bad for growth. Trade openness does matter for economic development. However, other things, such as the level of human capital and the quality of domestic economic institutions, matter even more. How can one reconcile this view with the near-apocalyptic terms in which many commentators discuss the anti-globalization sentiment sweeping across many developed economies? Let me suggest two explanations: one noble, one less so. The noble explanation goes beyond economics. Proponents of trade liberalization often argue that the 1930 Smoot-Hawley Tariff Act was a leading cause of the Great Depression. On purely economic grounds, this argument makes little sense. Exports accounted for less than 6% of U.S. GDP in 1929. While trade volumes did fall rapidly between 1929 and 1932, this was mainly the result of the economic slump, rather than the cause of it. In fact, trade volumes actually fell more in the immediate aftermath of the 2008 financial crisis (Chart 7). Yet, from a political perspective, the importance of Smoot-Hawley is hard to deny. At a time when Nazi Germany was on the rise, the U.S. and its allies were squabbling over trade issues. As such, the main problem with Smooth-Hawley was not that it pushed the U.S. into a Depression, but that it sabotaged diplomatic coordination at a time when it was most needed. One suspects that something similar underlies much of the angst over Trump's trade policies. The Global Trade Alert, currently the most comprehensive database for all types of trade-related measures imposed since the global financial crisis, shows an increase in protectionist measures over the last few years (Chart 8). The risk is that this trend will accelerate after Donald Trump is sworn in as President. Chart 7Global Trade Fell More ##br##During The Great Recession The Elusive Gains From Globalization The Elusive Gains From Globalization Chart 8Protectionist Measures ##br##Are On The Rise The Elusive Gains From Globalization The Elusive Gains From Globalization Considering that globalization ran into diminishing returns some time ago, a modest unwinding of globalization would probably not have the calamitous impact that many fear. However, just like a plane that fails to fly sufficiently fast will fall to the ground, a "modest unwind" may prove difficult to achieve in practice. Globalization, in other words, may be approaching stall speed. And given the large number of issues that require global cooperation - terrorism, migration, climate change - that is a risk which requires attention. Money Talks If that were all to the story, it would be easy to forgive those who overstate the economic benefits from globalization in order to preserve the political ones. One suspects, however, that there may also be a self-serving motive at work. The integration of millions of workers from China and other developing economies into the global labor market has put downward pressure on wages, boosting profit margins in the process. Not surprisingly, CEOs, hedge fund managers, and other titans of industry have benefited greatly from this development. Chart 9 shows that most of the increase in income equality since 1980 has occurred not at the 99th percentile, but at the 99.99th percentile and higher. It would be naïve to think that the colossal gains that some have enjoyed from globalization would not color what they say on the subject. Chart 9The (Really) Rich Got Richer The Elusive Gains From Globalization The Elusive Gains From Globalization Investment Conclusions U.S. equities have been in rally mode since the election. Many aspects of Trump's agenda are good for stocks - corporate tax cuts, deregulation, and fiscal stimulus, just to name a few. These factors make us somewhat constructive on equities over a long-term horizon. Chart 10Tech Stocks Are Heavily ##br##Exposed To Globalism The Elusive Gains From Globalization The Elusive Gains From Globalization Nevertheless, it cannot be denied that Trump's anti-globalization rhetoric represents a direct threat to corporate earnings. While some of Trump's protectionist proposals will undoubtedly be watered down, investors are underestimating the likelihood of disruptive trade measures. Unlike on most issues where he has flip-flopped repeatedly, Trump has consistently espoused a mercantilist view on trade since the 1980s. He is also the sort of person that strives to reward his supporters while disparaging those who slight him. Rust Belt voters awarded Trump the presidency. Their loyalty will not be forgotten. This means the stock market's honeymoon with Donald Trump may not last much longer. We remain tactically cautious global equities and are expressing that view by shorting the NASDAQ 100 futures. Globally-exposed large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H1-B visa issuance under Trump's immigration plan (Chart 10). Emerging market equities are also likely to feel the heat from rising protectionist sentiment in developed economies. A stronger dollar will only add to EM woes by putting downward pressure on commodity prices and making it more expensive for EM borrowers to service dollar-denominated loans. As we discussed in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Will Win, And The Dollar Will Rally," the three key elements of Trump's policy agenda - fiscal stimulus, tighter immigration controls, and higher tariffs - are all inflationary, and hence are likely to prompt the Fed to raise rates more than it otherwise would.6 Higher U.S. rates, in turn, will keep the greenback well bid. We expect the real trade-weighted dollar to strengthen another 5% from current levels. The flipside of a stronger dollar is increasing monetary policy divergence between the U.S. and the rest of the world. U.S. bond yields have risen significantly since the election. Tactically, we would not be adding to short duration positions at current levels. Structurally, however, the 35-year bond bull market is over. As we discussed in our latest Strategy Outlook,7 weak potential GDP growth is eroding excess capacity around the world, which is bad news for bonds. Population aging could also shift from being bullish to bearish for bonds, as more people retire and begin to draw down their savings. Meanwhile, central banks are looking for ever more creative ways to boost inflation, while the populist wave is forcing governments to abandon austerity measures. Lastly, and most relevant to this week's discussion, globalization - an inherently deflationary force - is in retreat. This, too, suggests that the longer-term risks to inflation are to the upside. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see "The Liberalization And Management Of Capital Flows: An Institutional View," IMF Executive Summary, November 14, 2012. 2 Paul Krugman, "The Gains From Hyperglobalization (Wonkish)," The New York Times, October 1, 2013. 3 John F. Helliwell and Lawrence L. Schembri, "Borders, Common Currencies, Trade And Welfare: What Can We Learn From The Evidence?" Bank of Canada Review, Spring 2005. 4 Please see "Global Trade: What's behind the Slowdown?" in "Subdued Demand: Symptoms and Remedies," IMF World Economic Outlook (October 2016). 5 David Autor, David Dorn, and Gordon Hanson, "The China Syndrome: Local Labor Market Effects Of Import Competition In The United States," The American Economic Review, Vol. 103, No. 6, (2013): pp. 2121-2168. 6 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com 7 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Trump won by stealing votes from Democrats in the Midwest. His victory implies a national shift to the left on economic policy. Checks and balances on Trump are not substantial in the short term. U.S. political polarization will continue. Trump is good for the USD, bad for bonds, neutral for equities. Favor SMEs over MNCs. Close long alternative energy / short coal. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." — Newt Gingrich, January 2, 2001 Former Speaker of the House Newt Gingrich (and a potential Secretary of State pick), was asked on NBC's Meet the Press two days before the U.S. election whether he still thought that "competition for power in the U.S. remains largely a debate between people who can work together once the election is over." Gingrich made the original statement in January 2001, merely weeks after one of the most contentious presidential elections in U.S. history was resolved by the Supreme Court. Gingrich's answer in 2016? "I think, tragically, we have drifted into an environment where ... it will be a continuing fight for who controls the country." Despite an extraordinary victory - a revolution really - by Donald J. Trump, the fact of the matter remains that the U.S. is a polarized country between Republican and Democratic voters. As of publication time of this report, Trump lost the popular vote to Secretary Hillary Clinton. His is a narrower victory than either the epic Richard Nixon win in 1968 or George W. Bush squeaker in 2000. Over the next two years, the only thing that matters for the markets is that the U.S. has a unified government behind a Republican president-elect and a GOP-controlled Congress. We discuss the investment implications of this scenario below and caution clients to not over-despair. On the other hand, we also see this election as more evidence that America remains a deeply polarized country where identity politics continue to play a key role. What concerns us is that these identity politics appear to transcend the country's many cultural, ethical, political, and economic commonalities. Republicans and Democrats in the U.S. are fusing into almost ethnic-like groupings. To bring it back to Gingrich's quote at the top, that would suggest that the U.S. is no longer that much different from Bosnia or Northern Ireland.1 Election Post-Mortem Chart II-1Election Polls Usually ##br##Miss By A Few Points De-Globalization De-Globalization Donald Trump has won an upset over Hillary Clinton, but his campaign was not as much of a long-shot as the consensus believed. U.S. presidential polls have frequently missed the final tally by +/- 3% of the vote, which was precisely the end result of the 2016 election (Chart II-1). Therefore, as we pointed out in our last missive on the election, Trump's victory was not a "wild mathematical oddity."2 Why Did Trump Win The White House? Where Trump really did beat expectations was in the Midwest, and Wisconsin in particular. He ended up outperforming the poll-of-polls by a near-incredible 10%!3 His victories in Florida, Ohio, and Pennsylvania were well within the range of expectations. For example, the last poll-of-polls had Trump leading in both Florida (by a narrow 0.2%) and Ohio (by a solid 3.5%), whereas Clinton was up in Pennsylvania by the slightest of margins (just 1.9% lead). He ended up exceeding poll expectations in all three (by 2% in Florida, 6% in Ohio, and 3% in Pennsylvania), but not by the same wild margin as in Wisconsin. When all is said and done, Trump won the 2016 election by stealing votes away from the Democrats in the traditionally "blue" Midwest states of Michigan, Pennsylvania, and Wisconsin. This was a far more significant result than his resounding victories in Ohio (which Obama won in 2012) or Florida (where Obama won only narrowly in 2012). Our colleague Peter Berezin, Chief Strategist of the Global Investment Strategy, correctly forecast that Trump would be competitive in all three Midwest states back in September 2015! We highly encourage our clients to read his "Trumponomics: What Investors Need To Know," as it is one of the best geopolitical calls made by BCA in recent history.4 As Peter had originally thought, Trump cleaned up the white, less-educated, male vote in all of the three crucial Midwest states. He won 68% of this vote in Michigan, 71% in Pennsylvania, and 69% in Wisconsin. To do so, Trump campaigned as an unorthodox Republican, appealing to the blue-collar white voter by blaming globalization for their job losses and low wages, and by refusing to accept Republican orthodoxy on fiscal austerity or entitlement spending. Instead, Trump promised to outspend Clinton and protect entitlements at their current levels. This mix of an outsider, anti-establishment, image combined with a left-of-center economic message allowed Trump to win an extraordinary number of former Obama voters. Exit polls showed that Obama had a positive image in all three Midwest states, including with Trump voters! For example, 30% of Trump voters in Michigan approved of the job Obama was doing as president, 25% in Pennsylvania, and 27% in Wisconsin. That's between a quarter and a third of eventual people who cast their vote for Trump. These are the voters that Republicans lost in 2012 because they nominated a former private equity "corporate raider" Mitt Romney as their candidate. Romney had famously argued in a 2008 New York Times op-ed that he would have "Let Detroit go bankrupt." Obama repeatedly attacked Romney during the 2011-2012 campaign on this point. Back in late 2011, we suspected that this message, and this message alone, would win President Obama his re-election.5 Why is the issue of the Midwest Obama voters so important? Because investors have to know precisely why Donald Trump won the election. It wasn't his messages on immigration, law and order, race relations, and especially not the tax cuts he added to his message late in the game. It was his left-of-center policy position on trade and fiscal spending. Trump is beholden to his voters on these policies, particularly in the Midwest states that won him the election. Final word on race. Donald Trump actually improved on Mitt Romney's performance with African-American and Hispanic voters (Table II-1). This was a surprise, given his often racially-charged rhetoric. Meanwhile, Trump failed to improve on the white voter turnout (as percent of overall electorate) or on Romney's performance with white voters in terms of the share of the vote. To be clear, Republicans are still in the proverbial hole with minority voters and are yet to match George Bush's performance in 2004. But with 70% of the U.S. electorate still white in 2016, this did not matter. Table II-1Exit Polls: Trump's Win Was Not Merely About Race De-Globalization De-Globalization Congress: No Gridlock Ahead Republicans exceeded their expectations in the Senate, losing only one seat (Illinois) to Democrats. This means that the GOP control of the Senate will remain quite comfortable and is likely to grow in the 2018 mid-term elections when the Democrats have to defend 25 of 33 seats. Of the 25 Senate seats they will defend, five are in hostile territory: North Dakota, West Virginia, Ohio, Montana, and Missouri. In addition, Florida is always a tough contest. Republicans, on the other hand, have only one Senate seat that will require defense in a Democrat-leaning state: Nevada (and in that case, it will be a Republican incumbent contesting the race). Their other seven seats are all in Republican voting states. As such, expect Republicans to hold on to the Senate well into the 2020 general election. In the House of Representatives, the GOP will retain its comfortable majority. The Tea Party affiliated caucuses (Tea Party Caucus and the House Freedom Caucus) performed well in the election. The Tea Party Caucus members won 35 seats out of 38 they contested and the House Freedom Caucus won 34 seats out of 37 it contested. The race to watch now is for the Speaker of the House position. Paul Ryan, the Speaker of the incumbent House, is likely to contest the election again and win. Even though his support for Donald Trump was lukewarm, we expect Republicans to unify the party behind Trump and Ryan. A challenge from the right could emerge, but we doubt it will materialize given Trump's victory. The campaign for the election will begin immediately, with Republicans selecting their candidate by December (the official election will be in the first week of January, but it is a formality as Republicans hold the majority). Bottom Line: Trump's victory was largely the product of former Obama voters in the Midwest switching to the GOP candidate. This happened because of Trump's unorthodox, left-of-center, message. Trump will have a friendly Congress to work with for the next four years. How friendly? That question will determine the investment significance of the Trump presidency. Investment Relevance Of A United Government Most clients we have spoken to over the past several months believe that Donald Trump will be constrained on economic policies by a right-leaning Congress. His more ambitious fiscal spending plans - such as the $550 billion infrastructure plan and $150 billion net defense spending plan - will therefore be either "dead on arrival" in Congress, or will be significantly watered down by the legislature. Focus will instead shift to tax cuts and traditional Republican policies. We could not disagree more. GOP is not fiscally conservative: There is no empirical evidence that the GOP is actually fiscally conservative. First, the track record of the Bush and Reagan administrations do not support the adage that Republicans keep fiscal spending in check when they are in power (Chart II-2). Second, Republican voters themselves only want "small government" when the Democrats are in charge of the White House (Chart II-3). When a Republican President is in charge, Republicans forget their "small government" leanings. Chart II-2Republicans Are Not ##br##Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Chart II-3Big Government Is Only ##br##A Problem For Opposition bca.gps_mp_2016_11_09_s2_c3 bca.gps_mp_2016_11_09_s2_c3 Presidents get their way: Over the past 28 years, each new president has generally succeeded in passing their signature items. Congress can block some but probably not all of president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed in their second term. Clinton lost on healthcare, but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). Median voter has moved to the left: Donald Trump won both the GOP primary and the general election by preaching an unorthodox, left-of-center sermon. He understood correctly that the American voter preferences on economic policies have moved away from Republican laissez-faire orthodoxies.6 Yes, he is also calling for significant lowering of both income and corporate tax rates. However, tax cuts were never a focal point of his campaign, and he only introduced the policy later in the race when he was trying to get traditional Republicans on board with his campaign. Newsflash: traditional Republicans did not get Trump over the hump, Obama voters in the Midwest did! Investors should make no mistake, the key pillars of Trump's campaign are de-globalization, higher fiscal spending, and protecting entitlements at current levels. And he will pursue all three with GOP allies in Congress. What are the investment implications of this policy mix? USD: More government spending, marginally less global trade, and pressure on multi-national corporations (MNCs) to scale back their global operations should be positive for inflation. If growth surprises to the upside due to fiscal spending, it will allow the Fed to hike more than the current 57 bps expected by the market by the end of 2018. Given easy monetary stance of central banks around the world, and lack of significant fiscal stimulus elsewhere, economic growth surprise in the U.S. should be positive for the dollar in the long term. At the moment, the market is reacting to the Trump victory with ambivalence on the USD. In fact, the dollar suffered as Trump's probability of victory rose in late October. We believe that this is a temporary reaction. We see both Trump's fiscal and trade policies as bullish. BCA's currency strategist Mathieu Savary believes that the dollar could therefore move in a bifurcated fashion in the near term. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer - or remain flat - against DM currencies such as the EUR, CHF, and JPY.7 Bonds: More inflation and growth should also mean that the bond selloff continues. In addition, if our view on globalization is correct, then the deflationary effects of the last three decades should begin to reverse over the next several years. BCA thesis that we are at the "End Of The 35-Year Bond Bull Market" should therefore remain cogent.8 As one of our "Trump hedges," our colleague Rob Robis, Chief Strategist of the BCA Global Fixed Income Strategy, suggested a 2-year / 30-year Treasury curve steepener. This hedge is now up 18.7 bps and we suggest clients continue to hold it. Fed policy: Trump's statements about monetary policy have been inconsistent. Early on in his campaign he described himself as "a low interest rate guy", but he has more recently become critical of current Federal Reserve policy - and Fed Chair Janet Yellen in particular - claiming that while higher interest rates are justified, the Fed is keeping them low for "political reasons." What seems certain is that Janet Yellen will be replaced as Fed Chair when her term expires in February 2018. Yellen is unlikely to resign of her own volition before then and it would be legally difficult for the President to remove a sitting Fed Chair prior to the end of her term. But Trump will get the opportunity to re-shape the composition of the Fed's Board of Governors as soon as he is sworn in. There are currently two empty seats on the Board need to be filled and given that many of Trump's economic advisers have "hard money" leanings, it is very likely that both appointments will go to inflation hawks. Equities: In terms of equities, Trump will be a source of uncertainty for U.S. stocks as the market deals with the unknown of his presidency. In addition, markets tend to not like united government in the U.S. as it raises the specter of big policy moves (Table II-2). However, Trump should be positive for sectors that sold off in anticipation of a Clinton victory, such as healthcare and financials. We also suspect that he will continue the outperformance of defense stocks, although that would have been the case with Clinton as well. Table II-2Election: Industry Implications De-Globalization De-Globalization In the long term, Trump's proposal for major corporate tax cuts should be good for U.S. equities. However, we are not entirely sure that this is the case. First, the effective corporate tax rate in the U.S. is already at its multi-decade lows (Chart II-4). As such, any corporate tax reform that lowers the marginal rate will not really affect the effective rate. Why does this matter? Because major corporations already have low effective tax rates. Any lowering of the marginal rate will therefore benefit the small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then Trump's policy will not necessarily benefit all firms in the U.S. equally. Chart II-4How Low Can It Go? bca.gps_mp_2016_11_09_s2_c4 bca.gps_mp_2016_11_09_s2_c4 Investors have to keep in mind that Trump has not run a pro-corporate campaign. He has accused American manufacturing firms of taking jobs outside the U.S. and tech companies of skirting taxes. It is not clear to us that his corporate tax reform will therefore necessarily be a boon for the stock market. In the long term, we like to play Trump's populist message by favoring America's SMEs over MNCs. If we are ultimately correct on the USD and growth, then export-oriented S&P 500 companies should suffer in the face of a USD bull market and marginally less globalization. Meanwhile, lowering of the marginal corporate tax rate will benefit the SMEs that do not get the benefit of K-street lobbyist negotiated tax loopholes. Global Assets: The global asset to watch over the next several weeks is the USD/RMB cross. China is forced by domestic economic conditions to continue to slowly depreciate its currency. We have expected this since 2015, which is why we have shorted the RMB via 12-month non-deliverable forwards (NDF). Risk to global assets, particularly EM currencies and equities, would be that Beijing decides to depreciate the RMB before Trump is inaugurated on January 20. This could re-visit the late 2015 panic over China, particularly the narrative that it is exporting deflation. Our view is that even if China does not undertake such actions over the next two months, Sino-American tensions are set to escalate. It is much easier for Trump to fulfill his de-globalization policies with China - a geopolitical rival with which the U.S. has no free trade agreement - than with NAFTA trade partners Canada and Mexico. This will only deepen geopolitical tensions between the two major global powers, which has been our secular view since 2011. Finally, a quick note on the Mexican peso. The Mexican peso has already collapsed half of its value in the past 18 months and we believe the trade is overdone. Investors have used the currency cross as a way to articulate Trump's victory probability. It is no longer cogent. We believe that the U.S. will focus on trade relations with China under a Trump presidency, rather than NAFTA trade partners. Our Emerging Markets Strategy believes that it is time to consider going long MXN versus other EM currencies, such as ZAR and BRL. Investors should also watch carefully the Cabinet appointments that Trump makes over the next two months. Since Carter's administration, cabinet announcements have occurred in early to mid-December. Almost all of these appointments were confirmed on Inauguration Day (usually January 20 of the year after election, including in 2017) or shortly thereafter. Only one major nomination since Carter was disapproved. These appointments will tell us how willing Trump is to reach to traditional Republicans who have served on previous administrations. We suspect that he will go with picks that will execute his fiscal, trade, and tax policies. Bottom Line: After the dust settles over the next several weeks, we suspect that Trump will signal that he intends to pursue his fiscal, trade, immigration, and tax policies. These will be, in the long term, positive for the USD, negative for bonds (including Munis, which will lose their tax-break appeal if income taxes are reduced), and likely neutral for equities. Within the equity space, Trump will be positive for U.S. SMEs and negative for MNCs. This means being long S&P 600 over S&P 100. Lastly, close our long alternative energy / short coal trade for a loss of -26.8%. Constraints: Don't Bet On Them Domestically, the American president can take significant action without congressional support through executive directives. Lincoln raised an army and navy by proclamation and freed the slaves; Franklin Roosevelt interned the Japanese; Truman tried to seize steel factories to keep production up during the Korean War. Truman's case is almost the only one of a major executive order being rebuffed by the Supreme Court. The Reagan and Clinton administrations have shown that a president thwarted by a divided or adverse congress will often use executive directives to achieve policy aims and satisfy particular interest groups and sectors. Though the number of executive orders has gone down in recent administrations (Chart II-5), the economic significance has increased along with the size and penetration of the bureaucracy (Chart II-6). The economic impact of executive orders is always debatable, but the key point is that the president's word tends to carry the day.9 Chart II-5Rule By Decree De-Globalization De-Globalization Chart II-6Executive Branch Is Growing De-Globalization De-Globalization Trade is a major area where Trump would have considerable sway. He has repeatedly signaled his intention to restrict American openness to international trade. The U.S. president can revoke international treaties solely on their own authority. Congressionally approved agreements like the North American Free Trade Agreement (NAFTA) cannot be revoked by the president, but Trump could obstruct its ongoing implementation.10 He would also have considerable powers to levy tariffs, as Nixon showed with his 10% "surcharge" on most imports in 1971.11 Bottom Line: Presidential authority is formidable in the areas Trump has made the focus of his campaign: immigration and trade. Without a two-thirds majority in Congress to override him, or an activist federal court, Trump would be able to enact significant policies simply by issuing orders to his subordinates in the executive branch. Long-Term Implications: Polarization In The U.S. Does the Republican control of Congress and the White House signal that polarization in America will subside? We began this analysis by focusing on the investment implications when Republicans control the three houses of the American government. But long-term implications of polarization will not dissipate. Investors may overstate the importance of a Republican-controlled government and thus understate the relevance of continued polarization. We doubt that Donald Trump is a uniting figure who can transcend America's polarized politics, especially given his weak popular mandate (he lost the popular vote as Bush did in 2000) and the sub-50% vote share. And, our favorite chart of the year remains the same: both Donald Trump and Hillary Clinton have entered the history books as the most disliked presidential candidates ever on the day of the election (Chart II-7). Chart II-7Clinton And Trump Are Making (The Wrong Kind Of) History De-Globalization De-Globalization According to empirical work by political scientists Keith Poole and Howard Rosenthal, polarization in Congress is at its highest level since World War II (Chart II-8). Their research shows that the liberal-conservative dimension explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension.12 Chart II-8The Widening Ideological Gulf In The U.S. Congress De-Globalization De-Globalization Meanwhile, a 2014 Pew Research study has shown that Republicans and Democrats are moving further to the right and left, respectively. Chart II-9 shows the distribution of Republicans and Democrats on a 10-item scale of political values across the last three decades. In addition, "very unfavorable" views of the opposing party have skyrocketed since 2004 (Chart II-10), with 45% of Republicans and 41% of Democrats now seeing the other party as a "threat to the nation's well-being"! Chart II-9U.S. Political Polarization: Growing Apart De-Globalization De-Globalization Chart II-10Live And Let Die De-Globalization De-Globalization Much ink has been spilled trying to explain the mounting polarization in America.13 Our view remains that politics in a democracy operates on its own supply-demand dynamic. If there was no demand for polarized politics, especially at the congressional level, American politicians would not be so eager to supply it. We believe that five main factors - in our subjective order of importance - explain polarization in the U.S. today: Income Inequality And Immobility The increase in political polarization parallels rising income inequality in the U.S. (Chart II-11). The U.S. is a clear and distant outlier on both factors compared to its OECD peers (Chart II-12). However, Americans are not being divided neatly along income levels. This is because Republicans and Democrats disagree on how to fix income inequality. For Donald Trump voters, the solutions are to put up barriers to free trade and immigration while reducing income taxes for all income levels. For Hillary Clinton voters, it means more taxes on the wealthy and large corporations, while putting up some trade barriers and expanding entitlements. This means that the correlation between polarization and income inequality is misleading as there is no causality. Rather, rising income inequality, especially when combined with a low-growth environment, shifts the political narrative from the "politics of plenty" towards "politics of scarcity." It hardens interest and identity groups and makes them less generous towards the "other." Chart II-11Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization Chart II-12Opportunity And Income: Americans Are Outliers De-Globalization De-Globalization Generational Warfare The political age gap is increasing (Chart II-13). This remains the case following the 2016 election, with 55% Millennials (18-29 year olds) having voted for Hillary Clinton. The problem for older voters, who tend to identify far more with the Republican Party, is that the Millennials are already the largest voting bloc in America (Chart II-14). And as Millennial voters start increasing their turnout, and as Baby Boomers naturally decline, the urgency to vote for Republican policymakers' increases. Chart II-13The Age Gap In American Politics The Age Gap In American Politics The Age Gap In American Politics Chart II-14Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Geographical Segregation Noted political scientist Robert Putnam first cautioned that increasing geographic segregation into clusters of like-minded communities was leading to rising polarization.14 This explains, in large part, how liberal elites have completely missed the rise of Donald Trump. Left-leaning Americans tend to live in a left-leaning community. They share their morning cup-of-Joe with Liberals and rarely mix with the plebs supporting Trump. And of course vice-versa. University of Toronto professors Richard Florida and Charlotta Mellander have more recently shown in their "Segregated City" research that "America's cities and metropolitan areas have cleaved into clusters of wealth, college education, and highly-paid knowledge-based occupations."15 Their research shows that American neighborhoods are increasingly made up of people of the same income level, across all metropolitan areas. Florida and Mellander also show that educational and occupational segregation follows economic segregation. Meanwhile, the same research shows that Canada's most segregated metropolitan area, Montreal, would be the 227th most segregated city if it were in the U.S.! This form of geographic social distance fosters increasing polarization by allowing voters to remain aloof of their fellow Americans, their plight, needs, and concerns. The extreme urban-rural divide of the 2016 election confirms this thesis. Immigration Chart II-15Racial Composition Is Changing De-Globalization De-Globalization Much as with income inequality, there is a close correlation between political polarization and immigration. The U.S. is on its way to becoming a minority-majority country, with the percent of the white population expected to dip below 50% in 2045 (Chart II-15). Hispanic and Asian populations are expected to continue rising for the rest of the century. For many Americans facing the pernicious effects of low-growth, high debt, and elevated income inequality, the rising impact of immigration is anathema. Not only is the country changing its ethnic and cultural make-up, but the incoming immigrants tend to be less educated and thus lower-income than the median American. They therefore favor - or will favor, when they can vote - redistributive policies. Many Americans feel - fairly or unfairly - that the costs of these policies will have to be shouldered by white middle-class taxpayers, who are not wealthy enough to be indifferent to tax increases, and may be unskillful enough to face competition from immigrants. There is also a security component to the rising concern about immigration. Although Muslims are only 1% of the U.S. population, many voters perceive radical Islam to be a vital security threat to the nation. As such, immigration and radical Islamic terrorism are seen as close bedfellows. Media Polarization The 2016 election has been particularly devastating for mainstream media. According to the latest Gallup poll, only 32% of Americans trust the mass media "to report the news fully, accurately and fairly." This is the lowest level in Gallup polling history. The decline is particularly concentrated among Independent and Republican respondents (Chart II-16). With mainstream media falling out of favor for many Americans, voters are turning towards social media and the Internet. Facebook is now as important for political news coverage as local TV for Americans who get their news from the Internet (Chart II-17). Chart II-16A War Of Words bca.gps_mp_2016_11_09_s2_c16 bca.gps_mp_2016_11_09_s2_c16 Chart II-17New Sources Of News Not Always Credible De-Globalization De-Globalization The problem with getting your news coverage from Facebook is that it often means getting news coverage from "fake" sources. A recent experiment by BuzzFeed showed that three big right-wing Facebook pages published false or misleading information 38% of the time while three large left-wing pages did so in nearly 20% of posts.16 The Internet allows voters to self-select what ideological lens colors their daily intake of information and it transcends geography. Two American families, living next to each other in the same neighborhood, can literally perceive reality from completely different perspectives by customizing their sources of information. Chart II-18Gerrymandering ##br##Reduces Competitive Seats bca.gps_mp_2016_11_09_s2_c18 bca.gps_mp_2016_11_09_s2_c18 In addition to these five factors, one should also reaffirm the role of redistricting, or "gerrymandering." Over the last two decades, both the Democrats and Republicans (but mainly the latter) have redrawn geographical boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart II-18). This improves job security for incumbent politicians and legislative-seat security for the party; but it also discourages legislators from reaching across the ideological aisle in order to ensure re-election. Instead, the main electoral challenge now comes from the member's own party during the primary election. For Republicans, this means that the challenge is most often coming from a candidate that is further to the right. Incumbent GOP politicians in Congress therefore have an incentive to maintain highly conservative records lest a challenge from the far-right emerges in a primary election. Given that the frequency of elections is high in the House of Representatives (every two years), legislators cannot take even a short break from partisanship. Redistricting deepens polarization, therefore, by changing the political calculus for legislators facing ideologically pure electorates in their home districts. Bottom Line: Polarization in the U.S. is a product of structural factors that are here to stay. Trump's narrow victory will in no way change that. But How Much Worse? Political polarization is not new. Older readers will remember 1968, when social unrest over the Vietnam War was at its height. Richard Nixon barely got over the finish line that year, beating Vice-President Hubert Humphrey by around 500,000 votes.17 Another contested election in a contested era. Chart II-19Party Is The Chief Source Of Identity De-Globalization De-Globalization Our concern is that the Republican and Democrat "labels" - or perhaps conservative and liberal labels - appear to be ossifying. For example, Pew Research showed in 2012 that the difference between Americans on 48 values is the greatest between Republicans and Democrats. This has not always been the case, as Chart II-19 shows. We suspect that the data would be even starker today, especially after the divisive 2016 campaign that has bordered on hysterical. This means that "Republican" and "Democrat" labels have become real and almost "sectarian" in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Why is this happening? We suspect that the shift in urgency and tone is motivated at least in part by the changing demographics of America. Two demographic groups that identify the most with the Republican Party - Baby Boomers and rural or suburban white voters - are in a structural decline (the first in absolute terms and the second in relative terms). Both see the writing on the political wall. Given America's democratic system of government, their declining numbers (or, in the case of suburban whites, declining majorities) will mean significant future policy decisions that go against their preferences. America is set to become more left-leaning, favor more redistribution, and become less culturally homogenous. Not only are Millennials more socially liberal and economically left-leaning, but they are also "browner" than the rest of the U.S. As we pointed out early this year, 2016 was an election that the GOP could reasonably attempt to win by appealing exclusively to white and older voters. The "White Hype" strategy was mathematically cogent ... at least in 2016.18 It will get a lot more difficult to pursue this strategy in 2020 and beyond. Not impossible, but difficult. We suspect that conservative voters know this. As such, there was an urgency this year to lock-in structural changes to key policies before it is too late. Donald Trump may have been a flawed messenger for many voters, but it did not matter. The clock is ticking for a large segment of America and therefore Trump was an acceptable vehicle of their fears and anger. Bottom Line: Polarization in the U.S. is likely to increase. Two key Republican/conservative constituencies - Baby Boomers and rural or suburban white voters - are backed into the corner by demographic trends. But it also means that a left counter-revolution is just around the corner. And we doubt that the Democratic Party will chose as centrist of a candidate the next time around. Final Thoughts: What Have We Learned Chart II-20Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income 1. Economics trump PC: Civil rights remain a major category of the American public's policy concerns. However, the Democratic Party's prioritization of social issues on the margins of the civil rights debate has not galvanized voters in the face of persistent negative attitudes about the economy. More specifically, the surge in cheap credit since 2000 that covered up the steady decline of wages as a share of GDP has ended, leaving households exposed to deleveraging and reduced purchasing power (Chart II-20). American households have lost patience with the slow, grinding pace of economic recovery, they reject the debt consequences of low inflation with deflationary tail risks, and they resent disappointed expectations in terms of job security and quality. Concerns about certain social preferences - as opposed to basic rights - pale in comparison to these economic grievances. 2. Polls are OK, but beware the quant models that use them: On two grave political decisions this year, in two advanced markets with the "best" quality of polling, political modeling turned out to be grossly erroneous. To be fair, the polls themselves prior to both Brexit and the U.S. election were within a margin of error. However, quantitative models relying on these polls were overconfident, leading investors to ignore the risks of a non-consensus outcome. As we warned in mid-October - with Clinton ahead with a robust lead - the problem with quantitative political models is that they rely on polling data for their input.19 To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." But combining polls is mathematically the same as combining bad mortgages into securities. The philosophy behind the methodology is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening. Well, something bad did happen. The quantitative models were massively wrong! We tried to avoid this problem by heavily modifying our polls-based-model with structural factors. Many of these structural variables - economic context, political momentum, Obama's approval rating - actually did not favor Clinton. Our model therefore consistently gave Donald Trump between 35-45% probability of winning the election, on average three and four times higher than other popular quant models. This caused us to warn clients that our view on the election was extremely cautious and recommend hedges. In fact, Donald Trump had 41% chance of winning the race on election night, according to the last iteration of our model, a very high probability.20 3. Professor Lichtman was right: Political science professor Allan Lichtman has once again accurately called the election - for the ninth time. The result on Nov. 8 strongly supports his life's work that presidential elections in the United States are popular referendums on the incumbent party of the last four years. Structural factors undid the Democrats (Table II-3), and none of the campaign rhetoric, cross-country barnstorming, or "horse race" polling mattered a whit. The Republicans had momentum from previous midterm elections, Clinton had suffered a strong challenge in her primary, the Obama administration's achievements over the past four years were negligible (the Affordable Care Act passed in his first term). These factors, along with the political cycle itself, favored the Republicans. Trump's lack of charisma did not negate the structural support for a change of ruling party. Investors should take note: no amount of mathematical horsepower, big data, or Silicon Valley acumen was able to beat the qualitative, informed, contemplative work of a single historian. Table II-3Lichtman's Thirteen Keys To The White House* De-Globalization De-Globalization 4. Non-linearity of politics: Lichtman's method calls attention to the danger of linear assumptions and quantitative modeling in attempting the art of political prediction. Big data and quantitative econometric and polling models have notched up key failures this year. They cannot make subjective judgments regarding whether a president has had a major foreign policy success or failure or a major policy innovation - on all three of those counts, the Democrats failed from 2012-16. There really is no way to quantify political risk because human and social organizations often experience paradigm shifts that are characterized by non-linearity. Newtonian Laws will always work on planet earth and as such we are not concerned about what will happen to us if we board an airplane. Laws of physics will not simply stop working while we are mid-air. However, social interactions and political narratives do experience paradigm shifts. We have identified several since 2011: geopolitical multipolarity, de-globalization, end of laissez-faire consensus, end of Chimerica, and global loss of confidence in elites and institutions.21 5. No country is immune to decaying institutions: The United States has, with few exceptions, the oldest written constitution among major states, and it ensures checks and balances. But recent decades have shown that the executive branch has expanded its power at the expense of the legislative and judicial branches. Moreover, executives have responded to major crisis - like the September 11 attacks and the 2008 financial crisis - with policy responses that were formulated haphazardly, ideologically divisive, and difficult to implement: the Iraq War and the Affordable Care Act. The result is that the jarring events that have blindsided America over the past sixteen years have resulted in wasted political capital and deeper polarization. The failure of institutions has opened the way for political parties to pursue short-term gains at the expense of their "partners" across the aisle, and to bend and manipulate procedural rules to achieve ends that cannot be achieved through consensus and compromise. 6. U.S. is shifting leftward when it comes to markets: Inequality and social immobility have, with Trump's election, entered the conservative agenda, after having long sat on the liberals' list of concerns. The shift in white blue-collar Midwestern voters toward Trump reflects the fact that voters are non-partisan in demanding what they want: they want to retain their existing rights, privileges, and entitlements, and to expand their wages and social protections. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Except that it is better armed. 2 Please see BCA Geopolitical Strategy Client Note, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com. 3 However, Wisconsin polling was rather poor as most pollsters assumed that it was a shoe-in for Democrats. One problem with polling in Midwest states is that they were, other than Pennsylvania and Ohio, assumed to be safe Democratic states. Note for example the extremely tight result in Minnesota and the absolute dearth of polling out of that state throughout the last several months. 4 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "U.S. General Elections And Scenarios: Implications," dated July 11, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "When You Come To A Fork In The Road, Take It," dated November 4, 2016, available at fes.bcaresearch.com. 8 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gps.bcaresearch.com. 9 Only a two-thirds majority of Congress, or a ruling by a federal court, can undo an executive action, and that is exceedingly rare. The real check on executive orders is the rotation of office: a president can undo with the stroke of a pen whatever his predecessor enacted. Congress has the power of the purse, but it is sporadic in its oversight and has challenged less than 5% of executive orders, even though those orders often re-direct the way the executive branch uses funds Congress has allocated. More often, Congress votes to codify executive orders rather than nullify them. 10 Trump is not alone in calling for renegotiating or even abandoning NAFTA. Clinton called for renegotiation in 2008, and Senator Bernie Sanders has done so in 2016. 11 In Proclamation 4074, dated August 15, 1971, Nixon suspended all previous presidential proclamations implementing trade agreements insofar as was required to impose a new 10% surcharge on all dutiable goods entering the United States. He justified it in domestic law by invoking the president's authority and previous congressional acts authorizing the president to act on behalf of Congress with regard to trade agreement negotiation and implementation (including tariff levels). He justified the proclamation in international law by referring to international allowances during balance-of-payments emergencies. 12 The "primary dimension" of Chart II-8 is represented by the x-axis and is the liberal-conservative spectrum on the basic role of the government in the economy. The "second dimension" (y-axis) depends on the era and is picking up regional differences on a number of social issues such as the civil rights movement (which famously split Democrats between northern Liberals and southern Dixiecrats). 13 We have penned two such efforts ourselves. Please see BCA Geopolitical Strategy Special Report, "Polarization In America: Transient Or Structural Risk?," dated October 9, 2013, and "A House Divided Cannot Stand: America's Polarization," dated July 11, 2012," available at gps.bcaresearch.com. 14 Putnam, Robert. 2000. Bowling Alone. New York: Simon and Schuster. 15 Please see Martin Prosperity Institute, "Segregated City," dated February 23, 2015, available at martinprosperity.org. 16 Please see BuzzFeedNews, "Hyperpartisan Facebook Pages Are Publishing False And Misleading Information At An Alarming Rate," dated October 20, 2016, available at buzzfeed.com. 17 Nonetheless, due to the third-party candidate George Wallace carrying the then traditionally-Democratic South, Nixon managed to win the Electoral College in a landslide. 18 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "You've Been Trumped!," dated October 21, 2016, available at gps.bcaresearch.com. 20 For comparison, Steph Curry, the greatest three-point shooter in basketball history, and a two-time NBA MVP, has a career three-point shooting average of 44%. With that average, he is encouraged to take every three-pointer he can by his team. In other words, despite being less than 50%, this is a very high percentage. 21 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, and "Strategy Outlook 2016 - Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com.

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

As the U.S. median voter is shifting to the left, redistributive policy could come into play. A strong dollar helps to achieve this goal as it results in a bigger share of labor income in the economy. EM and commodity currencies could bear the brunt of the pain. Favor the euro on its crosses. Stay short CAD/NOK, but tighten stops.

The populist backlash, if left unchecked, could spiral out of control, leading to severe losses for investors. Concerns about lax financial regulation, rising inequality, unfettered globalization, and fiscal austerity are understandable. Addressing these grievances will hurt corporate profits short-term, but could lead to a more resilient economy longer-term. Investors should position for modestly higher inflation and steepening yield curves. Near-term, equities are technically overbought, but will benefit from the shift to more stimulative fiscal and monetary policies.