Manufacturing

Highlights Deflation has decisively ended, and the economy is making a gradual transition towards inflation. The upshot is that growth is reviving rapidly in nominal terms. It is unrealistic to expect exports to be a main growth driver for the Chinese economy in the post-crisis world - even without protectionist pressures from President-elect Trump. The "Trump" wildcard serves as a wake-up call for Chinese policymakers to further focus on supporting domestic demand. There is a strengthening case for cyclical improvement in manufacturing investment. This further limits downside risk and sets the stage for potential positive surprises in the coming months. Feature Investors will be paying close attention to President-elect Donald Trump's inauguration speech this coming Friday, which may allow for a clearer understanding of his world view and economic policies, as well as their global implications. The inauguration will overshadow China's key economic statistics to be released later this week, and which we expect to show that the Chinese economy has picked up sequentially. As political uncertainty will stay elevated and deserves close monitoring going forward, it is equally important to keep in mind the economic big picture. In the next two months, China's economic data will once again be heavily distorted by the Chinese New Year holiday, making it more difficult to detect genuine growth trends. In last week's report, we laid out our view on China's growth and policy outlook for 2017.1 This week, we offer a reality check and our take on some key cyclical issues. Watch For Inflation Surprises The biggest change in China's macro condition in the past year, in our view, has been the sharp turnaround in producer prices. Rising PPI has lifted corporate pricing power, reduced real interest rates and eased financial stress in some heavy industries, the weakest link in the corporate sector - all of which are important reasons behind China's growth improvement of late. Looking forward, we expect inflation will remain well behaved. Improving producer prices is to a large extent attributable to RMB depreciation, which has already begun to crest. The trade-weighted RMB's depreciation has halted, and it is unrealistic to expect it to continue to depreciate at an ever-accelerating pace (Chart 1). This should cap the upside of PPI inflation. The headline consumer price index (CPI), the broader inflation measure, was fairly stable throughout last year's roller coaster ride in PPI (Chart 2). Moreover, the fluctuation in headline CPI was mainly attributable to food prices, which have been noisy due to seasonal factors and unexpected supply-demand disruptions, but have been largely trendless in recent years. There is no case for a food-induced inflation outbreak. Chart 1PPI Inflation Is Peaking PPI Inflation Is Peaking PPI Inflation Is Peaking Chart 2No Case For Food Inflation No Case For Food Inflation No Case For Food Inflation More fundamentally, although the Chinese economy has strengthened, it is still operating below potential. Historically, runaway inflation has always occurred when the economy overheated, which is far from the current situation (Chart 3). Without a strong growth rebound, it is difficult to expect genuine inflationary pressures. In short, the current environment is best characterized as "easing deflation" rather than "rising inflation," and our base case remains that inflationary pressures will stay at bay. Nonetheless, it is important to note that strong deflationary pressures have prevailed since the global financial crisis, which has led to major adjustments in the world economy. In China's case, for example, capital spending has slowed sharply. Meanwhile, cutting excess capacity has been an explicit policy priority, which, together with strengthening demand may lead to a quick rise in prices. Last year's sharp rebound in steel, thermal coal and some other raw materials prices provided clear evidence of this. Indeed, several factors warn against being overly complacent about the inflation outlook. For producers, the improvement in pricing power appears rather broad based, as both industrial firms and the service sector have been reporting rising levels in their respective output prices. In other words, rising prices are not just contained in resource sectors associated with global commodities prices and Chinese capacity cuts. For consumers, inflation expectations have begun to rise (Chart 4). Consumers' inflation expectations may be just a response to changes in prices rather than a leading indicator for future price moves. However, there has been a significant pickup in confidence on future income growth, which is likely a reflection of a tighter labor market and rising wages. If this trend holds, it would make it a lot easier for producers to pass through rising input costs to end users. Chart 3Inflation Vs Economic Overheating Inflation Vs Economic Overheating Inflation Vs Economic Overheating Chart 4Inflation Expectations Are On The Rise Inflation Expectations Are On The Rise Inflation Expectations Are On The Rise Overall, it is premature to worry about an inflation outbreak, and we do not consider inflation as a major policy constraint for the People's Bank of China. However, it appears that deflation has decisively ended, and the economy is making a gradual transition towards inflation. The upshot is that growth is reviving rapidly in nominal terms, supercharged by both improvement in real activity and a rising GDP deflator. Nominal GDP may reclaim a double-digit annual pace in the coming quarters. Exports: Why Has The Historical Correlation Broken Down? China's latest export numbers continued to disappoint, falling by 6.1% in dollar terms from a year ago. Part of the decline is due to falling prices measured in dollar terms; exports in volume terms are considerably stronger. Nonetheless, the export sector has been a chronic underperformer in the Chinese economy in recent years. Historically, China's export sector performance was highly predictable based on some key domestic and global variables - this correlation has clearly broken down since 2015 (Chart 5). If the historical correlation still held, export growth should have rebounded sharply. Many have viewed the divergence as a sign that Chinese exporters have lost competitiveness, which does not seem credible, as Chinese exports have continued to gain global market share. In our view, the chronic disappointment of the Chinese export sector's performance is due to several factors. First, the global financial crisis was a watershed event that marked structural breaks in economic correlations. Since then, consumers in the developed world have been focusing on deleveraging and fixing their balance sheets, and therefore the growth recovery has not led to a corresponding increase in demand - and imports for - consumer goods. Second, protectionist pressures have been on the rise since the global financial crisis, as all countries have tried to protect domestic producers in the face of weak final demand. Anti-dumping measures initiated by World Trade Organization member countries have increased notably in recent years, a growing share of which have been targeted at Chinese exporters (Chart 6). The high profile anti-dumping measures adopted by the Obama administration against Chinese tire and steel products have caused significant damage to Chinese producers and exporters.2 Chart 5Exports Have Disappointed Exports Have Disappointed Exports Have Disappointed Chart 6Protectionism Is Already On The Rise Protectionism Is Already On The Rise Protectionism Is Already On The Rise Finally, Chinese export numbers have been distorted by disguised capital flows driven by speculation on the RMB exchange rate. The sharp swings in Chinese exports to Hong Kong since the global financial crisis can be viewed as proxy for shifting expectations on the yuan (Chart 7). Immediately after the global financial crisis, the RMB was widely expected to rise against the dollar, leading to a massive surge in Chinese sales to Hong Kong as exporters overstated export revenues to bring more foreign currencies onshore. The tide completely reversed in early 2014 when the RMB began to drop against the greenback. Exporters may have been underreporting overseas sales so they could park part of their foreign revenues offshore in anticipation of a weaker RMB, weighing on overall export sector performance. Whatever the reason, the important point here is that it is unrealistic to expect exports to be a main growth driver for the Chinese economy in the post-crisis world - even without protectionist pressures from President-elect Trump. In recent years the Chinese authorities systematically overestimated the vigor of global demand, and export sector performance almost always lagged the government's annual targets, which contributed to chronic growth disappointments. In this regard, the "Trump" wildcard serves as a wake-up call for Chinese policymakers to further focus on supporting domestic demand. Has Investment Bottomed? With exports chronically disappointing, domestic capital spending holds the key for economic growth. Policy driven investment on infrastructure construction has held up strongly since 2013, while private sector investment mainly in the mining and manufacturing sectors has downshifted sharply. Looking forward, infrastructure spending will likely remain buoyant, supported by both public budgetary sources and public-private-partnerships (PPPs).3 What's changing is that capital spending in the manufacturing sector may have bottomed from a cyclical point of view. Inventory destocking in the manufacturing sector has become very advanced. Improving new orders and rising producer prices should lead to a restocking cycle. There has been a notable improvement in corporate sector profitability and confidence of late, which has historically led capital spending in the manufacturing sector (Chart 8). Consistently, the latest credit numbers show a significant pickup in medium- and long-term loans by the corporate sector, which are typically used to finance investment spending rather than replenish working capital. Chart 7Hong Kong Trade And The RMB Hong Kong Trade And The RMB Hong Kong Trade And The RMB Chart 8Manufacturing Capex Has Bottomed Manufacturing Capex Has Bottomed Manufacturing Capex Has Bottomed The long-term outlook for Chinese private capital spending hinges critically on structural reforms on many fronts. As far as the corporate sector is concerned, it is widely recognized that China's overall tax burden is not high by global standards, but is primarily shouldered by the corporate sector rather than households, and a rebalancing is long overdue. The government under incumbent Premier Li Keqiang has been focusing on reducing administrative red tape and mandatary employee benefits provided by employers as ways to cut corporate sector costs. If the Chinese authorities can implement reforms despite the populist resistance to shifting some of the tax burden from the corporate sector to households, it could further boost corporate profitability and revive animal spirits among Chinese entrepreneurs, leading to another round of investment boom. Any tax reform measures in this direction should be viewed as a major positive development. For now, we see a strengthening case for cyclical improvement in manufacturing investment, after decelerating for over six years. The current sub-par "new normal" growth trajectory rules out a sharp revival in capex, but the marginal change in "second derivatives" is still important as it diminishes a chronic growth headwind. This further limits downside risk and sets the stage for potential positive surprises in the coming months. Stay tuned. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1, 3 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Recommendation Allocation Quarterly - December 2016 Quarterly - December 2016 Highlights Growth was picking up before the election of President Trump. His election merely accelerates the rotation from monetary to fiscal policy. This is likely to cause yields to rise, the Fed to tighten and the dollar to strengthen further. That will be negative for bonds, commodities and emerging market assets, and equivocal for equities. Short term, markets have overshot and a correction is likely. But the 12-month picture (higher growth and inflation) suggests risk assets such as equities will outperform. Our recommendations mostly have cyclical tilts. We are overweight credit versus government bonds, underweight duration and, in equity sectors, overweight energy, industrials and IT (and healthcare for structural reasons). Among alts, we prefer real estate and private equity over hedge funds and structured products. We limit beta through overweights (in common currency terms) on U.S. equities versus Europe and emerging markets. We also have a (currency-hedged) overweight on Japanese stocks. Feature Overview A Shift To Reflation The next 12 months are likely to see stronger economic growth, particularly in the U.S., and higher inflation. That will probably lead to higher long-term interest rates, the Fed hiking two or three times in 2017, and further dollar strength. The consequences should be bad for bonds, but mixed for equities - which would benefit from a better earnings outlook, but might see multiples fall because of a higher discount rate. The election of Donald Trump merely accelerates the rotation from monetary policy to fiscal policy that had been emerging globally since the summer. Trump's fiscal plans are still somewhat vague,1 but the OECD estimates they will add 0.4 percentage points to U.S. GDP growth in 2017 and 0.8 points in 2018, and 0.1 and 0.3 points to global growth. Growth was already accelerating before the U.S. presidential election. Global leading indicators have picked up noticeably (Chart 1), and the Q3 U.S. earnings season surprised significantly on the upside, with EPS growth of 3% (versus a pre-results expectation of -2%) - the first YoY growth in 18 months (Chart 2). Chart 1Global Growth Picking Up bca.gaa_qpo_2016_12_15_c1 bca.gaa_qpo_2016_12_15_c1 Chart 2U.S. Earnings Growing Again bca.gaa_qpo_2016_12_15_c2 bca.gaa_qpo_2016_12_15_c2 The problem with the shift to fiscal, then, is that it comes at a time when slack in U.S. economy has already largely disappeared. The Congressional Budget Office estimates the output gap is now only -1.5%, which means it is likely to turn positive in 2017 (Chart 3). Unemployment, at 4.6%, is below NAIRU2 (Chart 4). Historically, the output gap turning positive has sown the seeds of the next recession a couple of years later, as the Fed tightens policy to choke off inflation. Chart 3Output Gap Will Close In 2017 bca.gaa_qpo_2016_12_15_c3 bca.gaa_qpo_2016_12_15_c3 Chart 4Will This Trigger Inflation Pressures? bca.gaa_qpo_2016_12_15_c4 bca.gaa_qpo_2016_12_15_c4 As the Fed signaled at its meeting on December 14, it is likely to raise rates two or three times more in 2017. But we don't see it getting any more hawkish than that. Janet Yellen has made it clear that she will not preempt Trump's fiscal stimulus but rather wait to see it passed by Congress. The market is probably about right in pricing in an 80% probability of two rate hikes in 2017, and a 50% probability of three. With the Atlanta Fed Wage Growth Tracker rising 3.9% YoY and commodity prices (especially energy) starting to add to headline inflation, the Fed clearly wants to head off inflation before it sets in. We do not agree with the argument that the Fed will deliberately allow a "high-pressure economy." The result is likely to be higher long-term rates. The 10-year U.S. yield has already moved a long way (up 100 BP since July), and our model suggests fair value currently is around 2.3% (Chart 5). Short term, then, a correction is quite possible (and would be accompanied by moves in other assets that have overshot since November 9). But stronger global growth and an appreciating dollar over the next 12 months could easily push fair value up to 3% or beyond. The relationship between nominal GDP growth (which is likely to be 4.5-5% in 2017, compared to 2.7% in 1H 2016) and long-term rates implies a rise to a similar level (Chart 6). Accordingly, we recommend investors to be underweight duration and prefer TIPs over nominal bonds. Chart 5U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value Chart 6Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Global equities, on a risk-adjusted basis, performed roughly in line with sovereign bonds in 2016 - producing a total return of 9.2%, compared to 3.3% for bonds (though global high yield did even better, up 15.1%). If our analysis above is correct, the return on global sovereign bonds over the next 12 months is likely to be close to zero. Chart 7Will Investors Reverse The Move##br## from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? The outlook for equities is not unclouded. Higher rates could dampen growth (note, for example, that 30-year fixed-rate mortgages in the U.S. have risen over the past two months from 3.4% to 4.2%, close to the 10-year average of 4.6%). The U.S. earnings recovery will be capped by the stronger dollar.3 And a series of Fed hikes may lower the PE multiple, already quite elevated by historical standards. Erratic behavior by President Trump and the more market-unfriendly of his policies could raise the risk premium. But we think it likely that equities will produce a decent positive return in this environment. Portfolio rebalancing should help. Since the Global Financial Crisis investors have steadily shifted allocations from equities into bonds (Chart 7). They are likely to reverse that over the coming quarters if bond yields continue to trend up. Accordingly, we moved overweight equities versus bonds in our last Monthly Portfolio Update.4 Our recommended portfolio has mostly pro-cyclical tilts: we are overweight credit versus government bonds, overweight most cyclical equity sectors, and have a preference for risk alternative assets such as real estate and private equity. But our portfolio approach is to pick the best spots for taking risk in order to make a required return. We, therefore, balance this pro-cyclicality by some lower beta stances: we prefer investment grade debt over high yield, and U.S. and Japanese equities over Europe and emerging markets. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Trump Do? Trump made several speeches in September with details of his tax plan. He promised to (1) simplify personal income tax, cutting seven brackets to three, with 12%, 25% and 33% tax rates; (2) cut the headline corporate tax rate to 15% (from 35%); and (3) levy a 10% tax on the $3 trillion of corporate retained earnings held offshore. He was less specific on infrastructure spending, but Wilbur Ross, the incoming Commerce Secretary, mentioned $550 billion, principally financed through public-private partnerships. The Tax Policy Center estimates the total cost of the tax plan at $6 trillion (with three-quarters from the business tax cut). But it is not clear how much will be offset by reduced deductions. Incoming Treasury Secretary Steven Mnuchin, for example, said that upper class taxpayers will get no absolute tax cut. TPC estimates the tax plan alone will increase federal debt to GDP by 25 percentage points over the next 10 years (Chart 8). The OECD, assuming stimulus of 0.75% of GDP in 2017 and 1.75% in 2018, estimates that this will raise U.S. GDP growth by 0.4 percentage points next year and by 0.8 points in 2018, with positive knock-on effects on the rest of the world (Chart 9). While there are questions on the timing (and how far Trump will go with trade and immigration measures), BCA's geopolitical strategists sees few constraints on getting these plans passed.5 Republications in Congress like tax cuts (and will compromise on the public spending element) and it is wrong to assume that Republican administrations reduce the fiscal deficit - historically the opposite is true (Chart 10). Chart 8Massive Increase In Debt Quarterly - December 2016 Quarterly - December 2016 Chart 9GDP Impact Of U.S. Fiscal Stimulus Quarterly - December 2016 Quarterly - December 2016 Chart 10A Lot of Stimulus, And Extra Debt bca.gaa_qpo_2016_12_15_c10 bca.gaa_qpo_2016_12_15_c10 Implications for markets? Short term positive for growth and inflation; longer-term a worry because of crowding out from the increased government debt. How Will The Strong USD Impact Global Earnings? We have a strong U.S. dollar view and also favor U.S. equities over the euro area and emerging markets. Some clients question our logic because conceptually a strong USD should benefit earnings growth in the non-U.S. markets, and therefore non-U.S. equities should outperform. Chart 11USD Impact On Global Earnings bca.gaa_qpo_2016_12_15_c11 bca.gaa_qpo_2016_12_15_c11 Currency is just one of the factors that we consider when we make country allocation decisions, and our weights are expressed in USD terms unhedged. We will hedge a currency only when we have very high conviction, such as our current Japan overweight with a yen hedge, which is based on our belief that the BOJ will pursue more unconventional policies to stimulate the economy. This is undoubtedly yen bearish but positive for Japanese stocks. As shown in Chart 11, a stronger USD has tended to weaken U.S. earnings growth (panel 1). However, what matters to country allocation is relative earnings growth. Panels 3 and 5 show that in local currency terms, earnings growth in emerging markets and the euro area did not always outpace that in the U.S. when their currencies depreciated against the USD. In fact, when their currencies appreciated, earnings growth in USD terms tended to outpace that in the U.S. (panels 2 and 4), suggesting that the translation impact plays a very important role. This is consistent with what we have found for relative equity market returns (see Global Equity section on page 13). Currency affects revenues and costs in different proportions. If both revenues and costs are in same currency, then only net profit is affected by the currency. But, since many companies manage their forex exposure, at the aggregate level the currency impact will always be "weaker than it should be". What Is The Outlook For Brexit And The Pound? The U.K. shocked the world on 24 June 2016 with its vote to leave the European Union. However, the process and terms of exit are yet to be finalized pending the Supreme Court's decision on the role of parliament in invoking Article 50 of the Lisbon Treaty. Depending on this decision, there is a spectrum of possible outcomes for the U.K./EU relationship. At the two ends of the spectrum are: 1) a hard Brexit - complete separation from the EU, in which case the pound will plunge further; 2) a soft Brexit - with a few features of the current relationship retained, in which case the pound will rally. Chart 12What's Up Brexit? What's Up Brexit? What's Up Brexit? The fall in the nominal effective exchange rate to a 200-year low (Chart 12) is a clear indication of the potential serious long-term damage. With the nation's dependence on foreign direct investment (FDI) to finance its large current account deficit (close to 6% of GDP), more populist policies and increased regulation will hurt corporate profitability, making local assets less profitable to foreigners. The pound is currently caught up in a vicious circle of more depreciation, leading to higher inflation expectations and depressed real rates, which adds further selling pressure. This is the likely path of the pound in the case of a hard Brexit. For U.K. equities, under a hard Brexit that adds downward pressure to the pound, investors should favor firms with global revenues (FTSE 100) and underweight firms exposed more to domestic business and a potential recession (FTSE 250). The opposite holds true in the case of a soft Brexit. Investors should also underweight U.K. REITs because of cyclical and structural factors that will affect commercial real estate. In the case of a hard Brexit, structural long-term impacts to the British economy include: 1) a decline in the financial sector - the EU will introduce regulations that will force euro-denominated transactions out of London; 2) a slowdown in FDI - the U.K. will cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign inflows; 3) weaker growth - with EU immigration into the U.K. expected to fall by 90,000 to 150,000 per year, estimates.6 point to a 3.4% to 5.4% drop in per capita GDP by the year 2030. What Industry Group Tilts Do You Recommend? In October 2015, we advocated that, because long-term returns for major asset classes would fall short of ingrained expectations, investors should increase alpha by diving down into the Industry Group level.7 How have these trades fared, and which would we still recommend? Long Household And Personal Products / Short Energy. We closed the trade for a profit of 12.2% in Q12016. This has proven to be quite timely as oil prices, and Energy stocks along with it, have rallied substantially since. Long Insurance / Short Banks. The early gains from this trade reversed in Q2 as long yields have risen rapidly, leading to yield curve steepening. However, our cyclical view is still intact. Relative performance is still holding its relationship with the yield curve (Chart 13). Historically, Fed tightening has almost always led to bear flattening. We expect the same in this cycle, which should lead to Insurance outperformance. Long Health Care Equipment / Short Materials. This trade generated early returns but has since underperformed as Materials bounced back sharply. Nevertheless, we remain bearish on commodities and EM-related plays, viewing this rise in Materials stocks as more of a technical bounce from oversold valuations (Chart 14). Commodities remain in a secular bear market. On health care, we maintain our structural bullish outlook given aging demographics, increased spending on health care and attractive valuations. Short Retail / Global Broad. We initiated trade in January after the Fed initiated liftoff. Consumer Discretionary stocks collapsed after, and this trade has provided a gain of 2.01%. We maintain this view as the recent hike and 2017 hikes will continue to dampen Retail performance (Chart 15). Additionally, Retail has only declined slightly while other Consumer Discretionary stocks have falling drastically, suggesting downside potential from convergence. Chart 13Flatter Yield Curve Is Bullish bca.gaa_qpo_2016_12_15_c13 bca.gaa_qpo_2016_12_15_c13 Chart 14An Oversold Bounce bca.gaa_qpo_2016_12_15_c14 bca.gaa_qpo_2016_12_15_c14 Chart 15Policy Tightening = Underperformance bca.gaa_qpo_2016_12_15_c15 bca.gaa_qpo_2016_12_15_c15 Global Economy Overview: The macro picture looks fairly healthy, with growth picking up in developed economies and China, though not in most emerging markets. The weak patch from late 2015 through the first half of 2016, with global industrial and profits recessions, appears to be over. The biggest threat to growth now is excessive dollar strength, which would slow U.S. exports and harm emerging markets. U.S.: U.S. growth was surprising on the upside (Chart 16) even before the election. Q2 real GDP growth came in at 3.2% and the Fed's Nowcasting models indicate 2.6-2.7% in Q4. After rogue weak ISMs in August, the manufacturing indicator has recovered to 53.2 and the non-manufacturing ISM to 57.2. However, growth continues to be driven mainly by consumption, with capex as yet showing few signs of recovery. A key question is whether a Trump stimulus will be enough to reignite "animal spirits" and push corporates to invest more. Euro Area: Eurozone growth has also been surprisingly robust. PMIs for manufacturing and services in November came in at 53.7 and 53.8 respectively; the manufacturing PMI has been accelerating all year. This is consistent with the ECB's forecasts for GDP growth of 1.7% for both this year and next. However, risk in the banking system could derail this growth. Credit growth, highly correlated with economic activity, has picked up to 1.8% YOY but could slow if banks turn cautious. Japan: Production data has reacted somewhat to Chinese stimulus, with IP growth positive (Chart 17) for the past three months and the Leading Economic Index inching higher since April. But the strength of the yen until recently and disappointing inflation performance (core CPI -0.4% YOY) have depressed exports and consumer sentiment. The effectiveness of the BoJ's 0% yield cap on 10-year government bonds, which has weakened the yen by 14% in two months, should trigger a mild acceleration of growth in coming quarters. Chart 16U.S. Economy Surprising ##br##On The Upside bca.gaa_qpo_2016_12_15_c16 bca.gaa_qpo_2016_12_15_c16 Chart 17Growth Picks Up In##br## Most DMs And China bca.gaa_qpo_2016_12_15_c17 bca.gaa_qpo_2016_12_15_c17 Emerging Markets: China has continued to see positive effects from its reflation of early 2016, with the manufacturing PMI close to a two-year high. The effects of the stimulus will last a few more months, but the authorities have reined back now and the currency is appreciating against its trade basket. The picture is less bright in other emerging markets, as central banks struggle with weak growth and depreciating currencies. Credit growth is slowing almost everywhere (most notably Turkey and Brazil) which threatens a further slowdown in growth in 2017. Interest rates: Inflation expectations have risen sharply in the U.S. following the election, but less so in the eurozone and Japan. They may rise further - pushing U.S. bond yields close to 3% - if the Trump administration implements a fiscal stimulus anywhere close to that hinted at. This could, in turn, push the Fed to raise rates at least twice more in 2017. The ECB has announced a reduction in its asset purchases starting in April 2017, too, but the Bank of Japan will allow inflation to overshoot before tightening. Chart 18Earnings Bottoming But##br## Valuation Stretched bca.gaa_qpo_2016_12_15_c18 bca.gaa_qpo_2016_12_15_c18 Global Equities Cautiously Optimistic: Global markets have embraced the "hoped for" pro-growth and inflationary policies from the new U.S. administration since Trump's win on November 8. In the latest GAA Monthly Update published on November 30,8 we raised our recommendation for global equities relative to bonds to overweight from neutral on a 6-12 month investment horizon. However, the call was driven more by underweighting bonds than by overweighting equities, given the elevated equity valuations and declining profit margins.(Chart 18) The hoped-for U.S. pro-growth policies would, if well implemented, be positive for earnings growth, but the "perceived" earnings boost has not yet shown up in analysts' earnings revisions (panel 3). In fact, only three sectors (Financials, Technology and Energy) currently have positive earnings revisions, because analysts had already been raising forward earnings estimates since early 2016. According to I/B/E/S data as of November 2016, about 80% of sectors are forecast to have positive 12-month forward earnings growth, while only about 20% have positive 12-month trailing earnings growth (panel 3). Within global equities, we continue to favor developed markets over emerging market on the grounds that most EMs are at an early stage of a multi-year deleveraging.9 We also favor the U.S. over the euro area (see more details on the next page). The Japan overweight (currency hedged) is an overwrite of our quant model: we believe that the BoJ will pursue increasingly unconventional monetary policy measures over the coming 12 months. The quant model (in USD and unhedged) has suggested a large underweight in Japan but has gradually reduced the underweight over the past two months. Our global sector positioning is more pro-cyclical than our more defensively-oriented country allocations. In line with our asset class call, we upgrade Financials to neutral and downgrade Utilities to underweight, and continue to overweight Energy, Technology, Industrials, and Healthcare while underweighting Telecom, Consumer Discretionary and Consumer Staples. Country Allocation: Still Favor U.S. Over Euro Area GAA's portfolio approach is to take risk where it is likely to be best rewarded. Having taken risk at the asset class level (overweight equities vs. bonds), at the global equity sector level with a pro-cyclical tilt, and at the bond class level with credit and inflation tilts, we believe it's appropriate to maintain our more defensive equity tilt at the country level by being market weight in euro area equities on an unhedged USD basis while maintaining a large overweight in the U.S. Chart 19Uninspiring profit Outlook bca.gaa_qpo_2016_12_15_c19 bca.gaa_qpo_2016_12_15_c19 It's true that the euro area PMI has been improving. Relative to the U.S., however, the euro area's cyclical improvement, driven by policy support, has lost momentum. It's hard to envision what would reverse this declining growth momentum, suggesting European earnings growth will remain at a disadvantage to the U.S. (Chart 19, panel 1) It's also true that the underperformance of eurozone equities versus the U.S. has reached an historical extreme in both local and common currency terms, and that euro equities are trading at significant discount to the U.S. But Europe has always traded at a discount, and the current discount is only slightly lower than its historical average. Our work has shown that valuation works well only when it is at extremes, which is not the case currently. Conceptually, a weak euro should boost euro area equity performance at least in local currency terms, yet empirical evidence does not strongly support such a claim: the severe underperformance since 2007 has been accompanied by a 43% drop in the euro versus the USD (Chart 19 panel 2). In fact, in USD terms, the euro area tended to outperform the U.S. when the euro was strong (panel 3), suggesting that currency translation plays a more dominant role in relative performance. Our currency house view is that the euro will depreciate further against the USD, given divergences in monetary and fiscal policy between the two regions. As such, we recommend clients to continue to favor U.S. equities versus the euro area, but not be underweight Europe given that it is technically extremely oversold. Sector Allocation: Upgrade Financials To Neutral Our sector quant model shifted global Financials to overweight in December from underweight, largely driven by the momentum factor. We agree with the direction of the quant model as the interest rate environment has changed (Chart 20, panel 1) and valuation remains very attractive (panels 2), but we are willing to upgrade the sector only to market weight due to our concern on banks in the euro area and emerging markets. Within the neutral stance in the sector, we still prefer U.S. and Japanese Financials to eurozone and emerging market ones. Despite the poor performance of the Financials sector relative to the global benchmark, U.S. and Japanese financials have consistently outperformed eurozone financials, driven by better relative earnings without any valuation expansion (panel 3). U.S. banks have largely repaired their balance sheets since the Great Recession, and the "promised" deregulation by the new U.S. administration will probably help U.S. banks. In the euro area, however, banks, especially in Italy, are still plagued with bad loans (panel 4). We will watch banking stress in the region very closely for signs of contagion (panel 5) The upgrade of financials is mainly financed by downgrading the bond proxy Utilities to underweight from neutral, in line with our asset class view underweighting fixed income. Chart 20Global Financials: Regional Divergence bca.gaa_qpo_2016_12_15_c20 bca.gaa_qpo_2016_12_15_c20 Chart 21Global Equities: No Style Bet bca.gaa_qpo_2016_12_15_c21 bca.gaa_qpo_2016_12_15_c21 Smart Beta Update: No Style Bet In a Special Report on Smart Beta published on July 8 2016,10 we showed that it is very hard to time style shifts and that an equal-weighted composite of the five most enduring factors (size, value, quality, minimum volatility and momentum) outperforms the broad market consistently on a risk-adjusted basis. Year-to-date, the composite has performed in line with the broad market, but over the past three months there have been sharp reversals in the performance of the different factors, with Min Vol, Quality and Momentum sharply underperforming Value and Size (Chart 21 panel 1). We showed that historically the Value/Growth tilt has been coincident with the Cyclical/Defensive sector tilt (panel 3). Panel 2 also demonstrates that the Min Vol strategy's relative performance can also be well explained by the Defensives/Cyclicals sector tilt. Sector composition matters. Compared to Growth, Value is now overweight Financials by 25.6%, Utilities by 13.2%, Energy by 8.3% and Materials by 2.5%, while underweight Tech by 23%, Healthcare by 12.7%, and Consumer Discretionary by 10%. REITs is in pure Growth, while Utilities and Telecom are in pure Value, and Energy has very little representation in Growth. In our global sector allocation, we favor Tech, REITs, Energy, and Healthcare, while underweight Utilities, Consumer Discretionary and Telecoms, and neutral on Financials and Materials. As such, maintaining a neutral stance on Value vs. Growth is consistent with our sector positioning. Government Bonds Maintain slight underweight duration. After 35 years, the secular bull market in government bonds is over. Even with Treasury yields skyrocketing since the Trump victory, the path of least resistance for yields is upward (Chart 22). Yields should grind higher slowly as inflation rises and growth indicators continue to improve. Bullish sentiment has dropped considerably, but there is further downside potential. Additionally, fiscal stimulus from Japan and further rate hikes from the Fed will provide considerable tailwinds. Overweight TIPS vs. Treasuries. Despite still being below the Fed's target, with headline and core CPI readings of 1.6% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 23). This continued rise is a result of cost-push inflation driven by faster wage growth. Trump's increased spending and protectionist trade policies are both inflationary. As real GDP growth should remain around 2% annualized and the labor market continues to tighten, this effect will only intensify. Valuations have become less attractive but very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Overweight JGBs. The BoJ has ramped up its commitment to exceeding 2% inflation by expanding its monetary base and locking in 10-year sovereign yields at zero percent. Additionally, the end of the structural decline in interest rates suggests global bonds will perform poorly going forward. During global bond bear markets, low-beta Japanese government debt has typically outperformed (Chart 24). This will likely hold true again as global growth improves and Japanese authorities increase fiscal stimulus while maintaining their cap on bond yields. Chart 22Maintain Slight Underweight Duration bca.gaa_qpo_2016_12_15_c22 bca.gaa_qpo_2016_12_15_c22 Chart 23Inflation Uptrend Intact bca.gaa_qpo_2016_12_15_c23 bca.gaa_qpo_2016_12_15_c23 Chart 24Overweight JGBs bca.gaa_qpo_2016_12_15_c24 bca.gaa_qpo_2016_12_15_c24 Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 25). Over the last quarter, the rate of deterioration actually slowed, with all six ratios improving slightly. Nevertheless, the trend toward weaker corporate health has been firmly established over the past eleven quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. In the absence of a recession, spread product will usually outperform. U.S. growth should accelerate in 2017, with consumer confidence being resilient, fiscal spending expected to increase, and the drag from inventories unwinding. Monetary conditions are still accommodative and the potential sell-off from the rate hike should be milder than it was in December 2015 (Chart 26). Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. However, there are two key risks to our view. The end of the structural decline in interest rates presents a substantial headwind to investment grade performance. Since 1973, median and average returns were slightly negative during months where long-term yields rose. During the blow-off in yields in the late 1970s, corporate debt performed very poorly. However, yields had reached very high levels. Secondly, valuations are unattractive, with OAS spreads at their lowest in about one and a half years (Chart 27). Chart 25Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 26Still Accommodative bca.gaa_qpo_2016_12_15_c26 bca.gaa_qpo_2016_12_15_c26 Chart 27Expensive Valuations bca.gaa_qpo_2016_12_15_c27 bca.gaa_qpo_2016_12_15_c27 Commodities Secular Perspective: Bearish We reiterate our negative long-term outlook on the commodity complex on the back of a structural downward shift in global demand led primarily by China's transition to a services-driven economy. With this slack in demand, global excess capacity has sent deflationary impulses across the globe, limiting upside in commodity prices.11 Chart 28OPEC To The Rescue bca.gaa_qpo_2016_12_15_c28 bca.gaa_qpo_2016_12_15_c28 Cyclical Perspective: Neutral A divergent outlook for energy and base metals gives us a neutral view for aggregate commodities over the cyclical horizon (Chart 28). Last month's OPEC deal supports our long-standing argument of increasing cuts in oil supply, which will support energy prices. However, metal markets suffer from excess supply. A stronger U.S. dollar will continue to be a major headwind over the coming months. Energy: OPEC's agreement to cut production by 1.2 mb/d has spurred a rally in the crude oil price, as prospects for tighter market conditions next year become the base case. However, with the likelihood that the dollar will strengthen further in coming months, oil will need more favorable fundamentals to rise substantially in price from here. Base Metals: The U.S. dollar has much greater explanatory power12 than Chinese demand in price formation for base metals. The recent rally in base metals is overdone with metals prices decoupling from the dollar; we expect a correction in the near-term driven by further dollar strength. Metal markets remain oversupplied as seen by rising iron ore and copper inventories. We remain bearish on industrial and base metals. Precious Metals: Gold, after decoupling from forward inflation expectations in H1 2016 - rising while inflation expectations were weak - has converged back in line with the long-term inflation gauge. Our expectation of higher inflation, coupled with rising geopolitical uncertainties, remain the two key positives for the gold price. However, our forecast of U.S. dollar appreciation will limit upside potential for the precious metal. Currencies Key Themes: USD: Much of the post-Trump rally in the dollar can be explained by the sharp rally in U.S. bond yields (Chart 29). We expect more upside in U.S. real rates relative to non-U.S. rates, driven by the U.S.'s narrower output gap and the stronger position of its household sector. As labor market slack continues to lessen and wage pressures rise, the Fed will be careful not to fall behind the curve; this will add upward pressure to the dollar. Chart 29Dollar Continues It's Dominance bca.gaa_qpo_2016_12_15_c29 bca.gaa_qpo_2016_12_15_c29 Euro: Since the euro area continues to have a wider output gap than the U.S., the euro will face additional downward pressure on the back of diverging monetary policy. As the slack diminishes, the ECB will respond appropriately - we believe the euro has less downside versus the dollar than does the yen. Yen: Although the Japanese economy is nearing fully employment, the Abe administration continues to talk about additional stimulus. As inflation expectations struggle to find a firm footing despite the stimulus, the BOJ is explicitly aiming to stay behind the curve. Additionally, with the BOJ pegging the 10-year government bond yield at 0% for the foreseeable future, we expect further downward pressure on the currency. EM: We expect more tumult for this group as rising real rates have been negative for EM assets in this cycle. EM spreads have widened in response to rising DM yields which has led to more restrictive local financial conditions. The recovery in commodity prices has been unable to provide any relief to EM currencies - a clear sign of continued weak fundamentals (rising debt, excess capacity and low productivity). Commodity currencies will face more downside driven by their tight correlation with EM equities (0.82) and with EM spreads. Alternatives Overweight private equity / underweight hedge funds. Global growth is fairly stable and has the potential to surprise on the upside. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a considerable boost to returns. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 30). Overweight direct real estate / underweight commodity futures. Commercial real estate (CRE) assets are in a "goldilocks" scenario: Growth is sufficient to generate sustainable tenant demand without triggering a new supply cycle. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 31). Overweight farmland & timberland / underweight structured products. The trajectory of Fed policy, the run-up in equity prices and the weak earnings backdrop have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, structured products tend to outperform during recessions, which is not our base case (Chart 32). Chart 30PE: Tied To Real Growth bca.gaa_qpo_2016_12_15_c30 bca.gaa_qpo_2016_12_15_c30 Chart 31Commodities: A Secular Bear Market bca.gaa_qpo_2016_12_15_c31 bca.gaa_qpo_2016_12_15_c31 Chart 32Structured Products Outperform In Recessions bca.gaa_qpo_2016_12_15_c32 bca.gaa_qpo_2016_12_15_c32 Risks To Our View Our main scenario is for stronger growth, higher inflation and an appreciating dollar in 2017, leading to equities outperforming bonds. Where could this go wrong? Growth stagnates. U.S. growth could fail to pick up as expected: the stronger dollar will hurt profits, which might lead to companies cutting back on hiring; higher interest rates could affect the housing market and consumer discretionary spending; companies may fail to increase capex, given their low capacity utilization ratio (Chart 33). In Europe, systemic banking problems could push down credit growth which is closely correlated to economic growth. Emerging markets might see credit events caused by the stronger dollar and weaker commodities prices. Political risks. An unconventional new U.S. President raises uncertainty. How much will Trump emphasize his more market-unfriendly policies, such as tougher immigration control, tariffs on Chinese and Mexican imports, and interference in companies' decisions on where to build plants? His more confrontational foreign policy stance risks geopolitical blow-ups. Elections in France, the Netherland and Germany in 2017 could produce populist government. The Policy Uncertainty Index currently is high and this historically has been bad for equities (Chart 34). Chart 33Maybe Companies Won't Increase Capex bca.gaa_qpo_2016_12_15_c33 bca.gaa_qpo_2016_12_15_c33 Chart 34Policy Uncertainty Is High bca.gaa_qpo_2016_12_15_c34 bca.gaa_qpo_2016_12_15_c34 Synchronized global growth. If the growth acceleration were not limited to the U.S. but were to spread, this might mean that the dollar would depreciate, particularly as it is already above fair value (Chart 35). In this environment, given their inverse correlation with the dollar (Chart 36), commodity prices and EM assets might rise, invalidating our underweight positions. Chart 35Dollar Already Above##br## Fair Value Dollar Already Above Fair Value Dollar Already Above Fair Value Chart 36How Would EM And Commodities Move##br## If USD Weakens? bca.gaa_qpo_2016_12_15_c36 bca.gaa_qpo_2016_12_15_c36 1 We discuss them in the "What Our Clients Are Asking," section of this Quarterly Portfolio Outlook. 2 Non-accelerating inflation rate of unemployment - the level of unemployment below which inflation tends to rise. 3 Please see "How Will The Strong USD Impact Global Earnings," in the What Our Clients Are Asking section of this Quarterly Portfolio Outlook. 4 Please see Global Asset Allocation, "Monthly Portfolio Update: The Meaning of Trump," dated November 30, 2016, available at gaa.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency", dated November 30, 2016, available at gps.bcaresearch.com. 6 According to National Institute of Economic Research.com. 7 Please see Global Asset Allocation Strategy Special Report, "Asset Allocation In A Low-Return World, Part IV: Industry Groups," dated October 25, 2015, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation,"Monthly Portfolio Update," dated November 30, 2016 available at gaa.bcaresearch.com 9 Please see Global Asset Allocation Special Report,"Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com 10 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. 11,12 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com Recommended Asset Allocation

Highlights Duration: Treasury yields will continue to rise as a December Fed rate hike is priced in. A surge in bullish dollar sentiment between now and December would cause us to back away from our below-benchmark duration stance. Spread Product: Maintain a neutral allocation to spread product, favoring convexity over credit risk. A surge in bullish dollar sentiment between now and December would cause us to downgrade spread product relative to Treasuries. TIPS: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Debt: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Feature About one month ago, we outlined how we expected our investment strategy to evolve over the remainder of this year and into 2017.1 Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product2 until a December rate hike has been fully discounted by the market. Chart 1Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Dollar Sentiment: A Key Indicator Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. The dollar has appreciated by close to +2% since early September and bullish sentiment toward the dollar has also edged higher (Chart 1). However, so far the increases appear muted compared to the rapid dollar appreciation that occurred in the run-up to last December's rate hike. The reason we care about the dollar is that a stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. For example, spread product was performing well last year until rate hike expectations started to move higher in late October. As the market began to anticipate a December Fed rate hike, it did not take long for the combination of higher rate expectations and increasingly bullish dollar sentiment to weigh on risk assets (Chart 2). The Market Vane survey of bullish sentiment toward the dollar surged above 80% last December, and this tightening of financial conditions is what prompted the sell-off in spread product and sharp decline in Treasury yields that kicked off 2016. Chart 2More Bullish Dollar Sentiment Is A Risk For Spread Product More Bullish Dollar Sentiment Is A Risk For Spread Product More Bullish Dollar Sentiment Is A Risk For Spread Product With last year's example in mind, the relevant question for current investment strategy is: How much dollar appreciation can the market tolerate before Treasury yields reverse their uptrend and credit spreads start to widen? To answer that question we make an assessment of U.S. and global growth relative to this time last year. All else equal, if U.S. growth is improved compared to last year, then it should require a greater dollar appreciation to have a similar impact on yields and spreads. Relatedly, if the growth outlook outside of the U.S. is improved, then it would mean that the dollar's reaction to rising U.S. rate expectations might not be as strong. On this note, there is some evidence pointing toward a more resilient U.S. and global economy than at this time last year. In the U.S., our preferred leading indicators suggest that growth contributions from capital spending, housing, net exports, government spending and inventories should all move higher in the coming quarters (Chart 3). This should act to offset a likely moderation in consumer spending growth (Chart 4). All in all, the domestic U.S. growth outlook appears similar to - if not slightly better than - what was seen at this time last year. There is more cause for optimism in the global growth indicators. The aggregate global PMI and LEI are tracking close to levels seen last year, but rising diffusion indexes suggest that further increases are likely (Chart 5). Already, manufacturing PMIs in all the major economic blocs have entered clear uptrends (Chart 5, bottom two panels). This suggests that the global growth outlook is actually much brighter than at this time last year, and improved diffusion indexes suggest that the global recovery has also become more synchronized. Chart 3U.S. Growth Outlook Improving... bca.usbs_wr_2016_10_25_c3 bca.usbs_wr_2016_10_25_c3 Chart 4...Outside Of Consumer Spending bca.usbs_wr_2016_10_25_c4 bca.usbs_wr_2016_10_25_c4 Chart 5Global Growth On The Upswing Global Growth On The Upswing Global Growth On The Upswing The implication of a U.S. economic outlook that is broadly similar to last year and an improved outlook for global growth is that the U.S. dollar may not react as strongly to rising Fed rate hike expectations in 2016 as it did in 2015. If this turns out to be the case, then the performance of spread product should also be more resilient and the uptrend in Treasury yields is less likely to reverse. Bottom Line: We continue to track the dollar and dollar sentiment closely to inform our near-term investment strategy. While dollar sentiment has edged higher, it has not yet reached the elevated levels seen last year. A more synchronized global growth recovery makes such a spike in bullish dollar sentiment less likely this time around. What Is A High Pressure Economy? Chart 6What A "High Pressure Economy" Looks Like bca.usbs_wr_2016_10_25_c6 bca.usbs_wr_2016_10_25_c6 Fed Chair Janet Yellen introduced a new buzzword to the market two weeks ago when she suggested in a speech3 that "it might be possible to reverse the adverse supply-side effects [of the financial crisis] by temporarily running a 'high-pressure economy' with robust aggregate demand and a tight labor market." Some investors took this to mean that the Fed would be increasingly tolerant of inflation overshooting its 2% target. We think this interpretation is incorrect, although we do think that Yellen's description of a "high pressure economy" provides a lot of information about the Fed's reaction function. More than anything, Yellen's speech was a response to recent trends in the labor market. The downtrend in the unemployment rate started to abate late last year, even though the economy has continued to add jobs at an average pace of just under +200k per month. A sharp rebound in the labor force participation rate has prevented the unemployment rate from falling, despite robust job growth (Chart 6). It is this dynamic that Yellen refers to when she talks about a "high pressure economy". Essentially, her theory suggests that, despite the low unemployment rate, the economy might be able to continue to add jobs without inflation spiking higher. Put differently, the unemployment rate might be less useful as an input to the Fed's forecast of future inflation than in past cycles. The key implication for investors is that if the Fed doesn't trust the unemployment rate to provide a signal about future inflation, then it is forced to rely on the actual inflation data for guidance. In our view, core PCE and core CPI inflation are now the two most important inputs to the Fed's reaction function. On that note, while last week's September core CPI release was soft, both core CPI and core PCE remain in uptrends that began in early 2015. Further, diffusion indexes suggest that these uptrends will persist (Chart 7). The Fed's increased focus on core inflation also has implications for our TIPS call. The sensitivity of TIPS breakevens to realized core inflation has shifted higher since the Great Recession (Chart 8). In our view, this has occurred because of how the zero-lower-bound on interest rates has constrained the Fed's ability to influence investor expectations. Chart 7The Inflation Uptrend Is Intact bca.usbs_wr_2016_10_25_c7 bca.usbs_wr_2016_10_25_c7 Chart 8TIPS Breakevens & Core Inflation TIPS Breakevens & Core Inflation TIPS Breakevens & Core Inflation When the fed funds rate was well above the zero-lower-bound, investors could reasonably assume that the Fed would act to offset any temporary price shocks. As such, long-maturity TIPS breakevens remained in a relatively narrow range and were mostly influenced by perceptions about the stance of Fed policy. In a zero-lower-bound world, investors can reasonably question whether the Fed has the ability to offset a deflationary price shock. As such, inflation expectations are increasingly driven by the actual inflation data rather than the Fed. With the Fed and the market both increasingly taking their cues from the actual inflation data, it means that the Fed will likely remain sufficiently accommodative for core PCE to return to target and also that TIPS breakevens will move higher alongside the trend in realized inflation. Bottom Line: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Credit: A Dollar Story Chart 9Sovereign Debt & The Dollar Sovereign Debt & The Dollar Sovereign Debt & The Dollar As noted above, in the current environment the path of the U.S. dollar takes on increased importance for our entire portfolio strategy. However, there is one sector of the fixed income market where the dollar is always paramount - USD-denominated sovereign debt. Specifically, we refer to the Barclays Sovereign index which consists of the U.S. dollar denominated debt of foreign governments, mostly emerging markets.4 In the long-run, the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the dollar and bullish sentiment toward the dollar (Chart 9). When the dollar appreciates it makes USD-denominated debt more expensive to service from the perspective of a foreign issuer, and therefore causes sovereign debt to underperform domestic alternatives. As stated above, we do not anticipate a near-term spike in the dollar, like what was witnessed near the end of last year. However, given that the Fed is much further along in its tightening cycle than other major central banks, the long-run bull market in the U.S. dollar should remain intact. This will continue to be a major headwind for sovereign debt. Further, the recent performance of sovereign debt relative to U.S. credit has bucked its traditional correlations with the dollar. Notice that the beta between sovereign excess returns and the dollar has moved into positive territory (Chart 9, bottom two panels). Historically, the correlation does not remain at these levels for long and sovereign debt should underperform as the more typical negative correlation is re-established. At present, there is not even an attractive valuation argument for sovereign debt relative to U.S. credit. The spread differential between the Sovereign index and an equivalently-rated, duration-matched U.S. credit index is well below zero (Chart 10), and only the USD-debt of Hungary, South Africa, Colombia and Uruguay offer spreads that appear attractive relative to the U.S. Credit index (Chart 11). Chart 10No Spread Pick-Up In Sovereigns No Spread Pick-Up In Sovereigns No Spread Pick-Up In Sovereigns Chart 11USD-Denominated Sovereign Debt By Issuing Country Dollar Watching: An Update Dollar Watching: An Update Bottom Line: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 We favor negatively convex assets (MBS) over credit within a neutral allocation to spread product, on the view that negatively convex assets will outperform as yields head higher in advance of a December rate hike. In anticipation of a December Fed rate hike we are also maintain a short position in the December 2017 Eurodollar futures contract as well as positions in 2/10 and 10/30 curve flatteners. The three trades have returned: +20bps, -23bps and +4bps respectively. 3 http://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 4 The largest issuers in the Barclays Sovereign Index are: Mexico (22%), Philippines (14%) and Colombia (11%). Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength, which could rekindle financial market volatility and cap the upside in Chinese stocks. The Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Joining the SDR does not automatically award the RMB international currency status. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Feature The resumption of the dollar bull market has once again generated downward pressure on the RMB. How long the dollar bull run will last remains to be seen, but the broader global backdrop supports its continued strength against other major currencies, at least in the near term, including the yuan. Renewed downward pressure on the RMB may be perceived as a sign of domestic economic troubles, which could expedite capital outflows, creating a self-feeding vicious circle. The saving grace is that the Chinese currency is better prepared for a stronger dollar than a year ago, and therefore the authorities should be able to maintain exchange rate stability. Interestingly, the RMB's renewed weakness came in the wake of its official inclusion in the IMF's Special Drawing Right (SDR) basket early this month. While joining the SDR bears no near-term relevance from both an economic and financial market point of view, it marks an important milestone in the internationalization process of the RMB, with potential longer term implications. The RMB: From Goldilocks To Gridlock Chart 1The RMB: Stronger Or Weaker? The RMB: Stronger Or Weaker? The RMB: Stronger Or Weaker? The relapse of the CNY/USD of late is entirely driven by the strong dollar. While the RMB has weakened against the greenback, it has strengthened in trade-weighted terms (Chart 1). This is undoubtedly bad news for China, as it has very quickly pushed the RMB from a goldilocks scenario to essentially a gridlock. The goldilocks scenario that prevailed over the past several months was ushered in primarily by the weak dollar. It allowed the RMB to stay largely stable against the dollar but weaken substantially in trade-weighted terms - an ideal combination for both the market and the economy. Investors took comfort in a stable CNY/USD, while the Chinese economy benefited from the reflationary impact of a weaker trade-weighted exchange rate. In this vein, the reversal of the dollar trend will also lead to a reversal of this positive dynamic that prevailed over the past several months. Financial markets and investors will once again pay attention to the weakening CNY/USD, while the "stealth" depreciation of the trade-weighted RMB will also be halted, removing its reflationary impact. In other words, a weaker CNY/USD and a stronger trade-weighted RMB is the least desirable combination for both financial markets and the economy. To break this gridlock, the People's Bank of China (PBoC) could either "peg" the currency to the dollar, or weaken it substantially enough to achieve a weaker RMB in trade-weighted terms, neither of which is likely in our view. The path of least resistance is for the PBoC to bear it out, with managed CNY/USD depreciation together with tightened capital account controls to prevent capital flight. This is far from optimal and may still stoke financial market volatility, similar to the several episodes last year when a weakening RMB stoked fears of Chinese financial instability. However, a few factors suggest that this time the PBoC may be better prepared: Frist, the Chinese authorities have been paying much more attention to "open-mouth" operations in communicating their intention to market participants. Overall, investors are less 'spooked" by China's foreign exchange rate policy than a year ago. Second, pressure from capital outflows from the corporate sector will likely subside going forward. Paying down foreign debt has been one of the biggest sources of capital outflows in the past year, which has substantially reduced the domestic corporate sector's foreign currency liabilities (Chart 2).1 Moreover, despite dwindling foreign debt obligations, the corporate sector still holds near-record-high foreign currency deposits (Chart 3), which should further reduce its incentive to hoard the dollar. Chart 2Corporate Sector Foreign ##br##Debt Has Dropped Substantially... bca.cis_wr_2016_10_20_c2 bca.cis_wr_2016_10_20_c2 Chart 3... But Still Hoards ##br##Lots Of Dollar Deposits bca.cis_wr_2016_10_20_c3 bca.cis_wr_2016_10_20_c3 Further, Chinese growth is a tad stronger than last year, due largely to the reflationary impact of previous easing measures, including a weaker trade-weighted RMB. Even though the headline third quarter GDP growth figures reported this week remained essentially unchanged, the industrial sector has recovered notably, with improving activity, strengthening pricing power and accelerating profits. As economic variables typically respond to policy thrusts with a time lag, we expect the economy will continue to build momentum in the coming months, even if the reflationary impact of the RMB begins to diminish. More importantly, the Chinese government appears more willing to engage in fiscal pump-priming than last year, with a focus on infrastructure and private-public-partnership projects. Improving growth momentum and expansionary fiscal policy should be supportive for the exchange rate. Finally, the CNY/USD is already 12% lower than its peak in early 2014, and is no longer significantly overvalued, according to our valuation models (Chart 4). This means that additional CNY/USD weakness will further boost market share of Chinese products in the U.S., helping China to reflate while at the same time acting as an increasingly heavier drag on the U.S (Chart 5). It is therefore in the mutual interests of both the Chinese and U.S. authorities to maintain a steady RMB exchange rate. The U.S. Treasury once again cleared China from being currency manipulator in its last week's semi-annual review, and acknowledged the PBoC's efforts in preventing rapid RMB depreciation as beneficial for both the Chinese and global economies. To be sure, the U.S. and China will not explicitly coordinate monetary policy to regulate exchange rate movements. However, a weaker CNY/USD will lead to much quicker dollar appreciation in trade-weighted terms than otherwise, which in of itself will prove self-limiting. Chart 4RMB/USD Is No Longer Overvalued RMB/USD Is No Longer Overvalued RMB/USD Is No Longer Overvalued Chart 5A Weaker RMB/USD Is ##br##Boosting Chinese Exports To The U.S. A Weaker RMB/USD Is Boosting Chinese Exports To The U.S. A Weaker RMB/USD Is Boosting Chinese Exports To The U.S. The bottom line is that the near-term RMB outlook is entirely dictated by the movement of the dollar. We expect the CNY/USD to weaken alongside broad dollar strength in the near term, but unless the dollar massively overshoots the downside will not be substantial. This could rekindle financial market volatility and cap the upside in Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares from "overweight" to "neutral" last week,2 and this view remains unchanged. At the same time, we continue to argue against being outright bearish, because of the deeply depressed valuation matrix of this asset class, especially H shares. When Will The RMB Float? We expect Chinese regulators will tighten capital account controls significantly in the coming months in order to slow capital outflows in the wake of renewed CNY/USD depreciation. The impossible trinity of international finance dictates that a country cannot target its exchange rate with independent monetary policy and simultaneously allow free capital flows. Among these three conditions, "free capital flows" is the least-costly sacrifice. There is no way the PBoC will raise interest rates to defend the currency. Tightening capital account controls goes against the long-term objective of China's foreign exchange rate reforms, but it is not only justified but necessary in the near term. Pointing at the dilemma the PBoC faces today, some pundits are now singing the "I-told-you-so" song, claiming the country should have moved to a much greater degree of exchange-rate flexibility "back when the going was good", as they had advised. In our view, this argument is completely flawed. In previous years when "the going was good", China was facing massive foreign capital inflows, unleashed by extremely aggressive monetary easing by other central banks in the wake of the global financial crisis. If the PBoC indeed took this advice back then and did not intervene to slow down RMB appreciation by hoarding massive foreign reserves, it would simply have led to a dramatic overshoot of the RMB. By the same token, when the tide turned, capital outflows would have proven overwhelming, leading to an RMB collapse. In fact, without the massive foreign reserves accumulated in previous years during the PBoC's RMB intervention, the Chinese authorities' ability to maintain exchange rate stability would have been much more seriously challenged, particularly in the past year. Chart 6Lopsided Expectations On The RMB ##br##Drive One-Way Moves Of Capital Flows bca.cis_wr_2016_10_20_c6 bca.cis_wr_2016_10_20_c6 In other words, the key problem with China's exchange rate is that expectations on the RMB have been lopsided in recent years (Chart 6). Consequently, the RMB has long been a one-way bet, accompanied by one-way moves of capital flows. The unanimous view on a rising RMB in previous years drove capital inflows; expectations completely reversed in 2015, leading to persistent outflows. In this environment, without the PBoC's intervention, a "greater degree of exchange rate flexibility" as advised by some would simply mean extreme RMB moves, inevitably leading to much greater financial and economic volatility. Therefore, the RMB should only be allowed to float when there is a healthy divergence of views among market participants, so that there are enough "buyers" and "sellers" to collectively price the RMB exchange at a market-determined "equilibrium" level. Until then, any premature and imprudent capital account deregulation would prove catastrophic, and should be avoided at all cost. We are hopeful the Chinese authorities will remain pragmatic enough not to hasten this process. The RMB's SDR Debut: Playing The Long Game The RMB has officially joined the SDR basket since the beginning of October, the first emerging country currency to join this "elite club". The RMB's SDR debut has little economic relevance in the near term. If anything, officially joining the SDR means that the RMB, under China's prevailing capital account regulations, meets the IMF's criteria as a "freely usable" currency. Therefore, it implies that the IMF endorses China's capital control measures currently in place. Some analysts suggest that the Chinese government's determination to join the SDR is largely to show off national pride. In our view, it serves more pragmatic purposes both at the private and official level. Chart 7The RMB's Rising Importance As ##br##An International Payment Currency The RMB's Near-Term Dilemma And Long-Term Ambition The RMB's Near-Term Dilemma And Long-Term Ambition At the private level, an important function of an international currency is for trade invoicing - an area where the RMB has witnessed remarkable progress in recent years. The RMB currently ranks fifth among world payment currencies, accounting for a mere 2% of world payments, which pales in comparison with the dollar's 40% and the euro's 30%. However, an increasingly large share of China-related trade has been settled directly with the RMB. Currently, the RMB accounts for about 13% for all international payments sent and received by value with China and Hong Kong (Chart 7), up from practically zero a few years ago. Moreover, RMB settlement already accounts for over half of Chinese trade with specific regions such as the Middle East and African countries. For Example, the use of the RMB in the United Arab Emirates (UAE) and Qatar accounted for 74% and 60% of their respective payments to China/Hong Kong in 2015. As the largest trade partner with a growing number of countries, China should have no problem continuing to promote RMB settlement, especially in the emerging world. At the official level, the Chinese government is certainly intent on having the RMB act as an international reserve currency, but not in such a way as to challenge the dollar's mighty dominance. Rather, the government appears to be following dual mandates in its purse. Domestically, it is aiming to use the SDR inclusion as a catalyst to reform its financial system, much like what joining the World Trade Organization (WTO) in the early 2000s did to its manufacturing sector. Globally, it is seeking to play a more active role in reforming the international monetary system. After witnessing the dramatic liquidity crunch during the global financial crisis, the Chinese authorities see the necessity to reduce the world's heavy reliance on the dollar by creating credible alternatives. Neither of these dual mandates can be easily accomplished, but it is important to keep the big picture in mind in understanding China's policy initiatives going forward. The bottom line is that joining the SDR does not automatically award the RMB international currency status, and it is naïve to expect the RMB to challenge the U.S. dollar anytime soon, if at all. However, raising the relevance of the SDR as well as the RMB is part of China's long-term strategic plan. Its determination to internationalize the RMB should not be underestimated. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Recent U.S. economic data have surprised to the upside, raising the odds of a December rate hike. U.S. GDP growth is likely to accelerate further in 2017 on the back of stronger business capex, a turn in the inventory cycle, and a pickup in government spending. Faster wage growth should also support consumption. The real broad trade-weighted dollar will appreciate by 10% over the next 12 months, as the market prices in more Fed tightening. The stronger dollar will pose a headache for U.S. multinationals, as well as emerging markets and commodity producers. However, it will be a boon for Europe and Japan. Global equities are vulnerable to a near-term correction, but the longer-term outlook for developed market stocks outside the U.S. looks reasonably good. Investors should overweight euro area and Japanese equities in currency-hedged terms. Feature Why The Fed Hit The Pause Button When the FOMC decided to hike rates last December, it signaled to investors via its "dot plot" that rates would likely rise four times this year. Ten months later, the fed funds rate remains unchanged. What caused the Fed to stand down? External factors certainly played a role: Fears of a hard landing in China permeated the markets at the start of the year. And just as these worries were beginning to recede, the Brexit vote sent investors into a hurried panic. However, the more important reason for the Fed's decision to hit the pause button is that U.S. domestic activity slowed sharply, with real GDP growing by just 0.9% in Q4 of 2015 and by an average of 1.1% in the first half of 2016. Rays Of Light Fortunately, recent data suggest that the growth drought may be ending (Chart 1): Chart 1Some Bright Spots In the U.S. Data Some Bright Spots In the U.S. Data Some Bright Spots In the U.S. Data The ISM non-manufacturing index jumped 5.7 points in September, the largest monthly increase on record. The ISM manufacturing index also surprised to the upside, with the new orders index jumping six points to 55.1. Factory orders increased by 0.2% in August, against consensus expectations for a modest decline. Initial unemployment claims continue to decline, with the four-week average falling to a 42-year low this week. The Conference's Board's consumer confidence index hit a nine-year high in September. The University of Michigan's index also rose. The key question for investors is whether the recent spate of good data is just noise or the start of a more lasting improvement in underlying demand growth. We think it's the latter. As we expand upon below, the adverse lagged effects on growth from the dollar's appreciation between mid-2014 and early this year should dissipate, pushing aggregate demand higher. Energy sector capex appears to be stabilizing after plunging nearly 70% since its peak in 2014. Stronger wage growth should also keep consumption demand elevated, even as employment growth continues to decelerate. In addition, fiscal policy is likely to loosen somewhat regardless of who wins the presidential election. Lastly, the inventory cycle appears to be turning, following five straight quarters in which falling inventory investment subtracted from growth. To what extent will better U.S. growth translate into a stronger dollar? To answer this question, we proceed in three steps: First, we estimate the magnitude by which U.S. growth will exceed its trend rate if the Fed takes no action to tighten financial conditions. Our answer is "by around one percentage point in 2017," which we think is considerably above market expectations. Second, we assess the degree to which the Fed will need to tighten financial conditions - via higher interest rates and a stronger dollar - in order to keep inflation from significantly overshooting its target. Third, we consider how developments abroad will affect the dollar. Our conclusion is that the real trade-weighted dollar will likely rise by around 10% over the next 12 months. How Quickly Will Aggregate Demand Grow If The Fed Does Not Raise Rates? As detailed below, a bottom-up analysis of the various components of GDP suggests that real GDP growth could reach 2.5% in the second half of 2016 and accelerate to 2.8% in 2017 if financial conditions remain unchanged from current levels. This would represent a significant step up in growth from the average pace of 1.6% experienced between Q1 of 2015 and Q2 of 2016. While growth of 2.8% next year might sound implausibly high, keep in mind that real final sales to private domestic purchasers - the cleanest measure of underlying private-sector demand - has grown by an average of 3% since Q3 of 2014 and increased by 3.2% in Q2 of this year, the last quarter for which data is available. Consumption Assuming that interest rates and the dollar remain unchanged, we project that real personal consumption will grow by an average of 2.7% in Q4 of this year and over the course of 2017. This is equivalent to the average growth rate of real PCE between Q1 of 2015 and Q2 of 2016, but below the 3% pace recorded in the first half of this year. Granted, employment growth is likely to slow over the coming quarters, as labor market slack is absorbed. Nevertheless, real income growth should remain reasonably robust, as real wages accelerate in response to a tighter labor market. A rough rule of thumb is that a 1% increase in real wage growth boosts real household income by the equivalent of 120,000 extra jobs per month over one full year. Thus, it would not take much of a pickup in wage growth to ensure that consumption keeps rising at a fairly solid pace. In fact, one could see a virtuous circle emerging, where accelerating wage growth pushes up consumption, leading to a tighter labor market, and even faster wage growth. At some point the Fed would raise rates by enough to cool the economy, but not before the dollar had moved sharply higher. This may explain why there is such a strikingly strong correlation between the dollar and labor's share of national income (Chart 2). Households may also end up spending a bit more of their incomes. Faster wage growth, rising consumer confidence, continued home price appreciation, and negative real deposit rates have all given households even more incentive to spend freely. While we do not expect the savings rate to fall anywhere close to the rock-bottom levels seen before the financial crisis, even a 0.5 percentage point decline from the current level of 5.7%, spread out over six quarters, would add 0.4% to GDP growth. Residential Investment Real residential investment dropped 7.7% in Q2 after growing by an average of nearly 12% over the preceding six quarters. The Q2 dip was mainly due to the warm winter, which pulled forward home-improvement spending. Housing activity has recovered since then, with new home sales, single-family housing starts, and the NAHB homebuilders index all at or near post-crisis highs (Chart 3). Chart 2The Dollar Is Redistributing Income bca.gis_wr_2016_10_14_c2 bca.gis_wr_2016_10_14_c2 Chart 3U.S. Housing Remains Robust U.S. Housing Remains Robust U.S. Housing Remains Robust The underpinnings for housing continue to look good. The ratio of household debt-to-GDP has declined nearly 20 points from its 2008 high - the lowest figure since 2003 - while the debt- service ratio is back to where it was in the early 1980s (Chart 4). Excess inventories have also been absorbed. The homeowner vacancy rate has fallen to 1.7%, completely reversing the spike experienced during the Great Recession (Chart 5). With household formation picking up and housing starts still 20%-to-25% below most estimates of how much construction is necessary to keep up with population growth, it is likely that housing activity can increase at a reasonably brisk pace over the next two years. We assume that real residential investment will expand by 4% in both Q4 and 2017. Chart 4Household Debt Burdens Have Declined bca.gis_wr_2016_10_14_c4 bca.gis_wr_2016_10_14_c4 Chart 5The Excess Supply In Housing Has Cleared bca.gis_wr_2016_10_14_c5 bca.gis_wr_2016_10_14_c5 Business Capex Growth in business capital spending has been falling since mid-2014 and turned negative on a year-over-year basis in the first quarter of this year. Initially, the deceleration in capital spending was largely confined to the energy sector. Since late last year, however, non-energy capex has also weakened sharply (Chart 6). Chart 6Easing In Energy Sector Retrenchment Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen The recent slowdown in business capex reflects three factors. First, the disaggregated data on corporate investment spending indicate that lower energy prices generated a second-round effect on businesses that are not officially classified as being part of the energy space, but that are nonetheless major suppliers to the sector. Second, the stronger dollar hurt the manufacturing sector more broadly, leading to a lagged decline in capital spending. Third, the backup in corporate borrowing spreads that began in May 2014 and the associated tightening in bank lending standards put further downward pressure on business capex. All three of these headwinds have waned over the past few months (Chart 7). The oil rig count has started to recover, suggesting that energy capex should stabilize and perhaps even improve. The dollar and corporate credit spreads have also come down, while loan growth remains robust (Chart 8). Reflecting these developments, core capital goods orders have risen for the past three months. Corporate capex intentions have also perked up (Chart 9). We project that real business capex will increase by 2.5% in Q4 and 3.5% in 2017 if the dollar and interest rates remain unchanged. Chart 7Borrowing Costs Have Fallen bca.gis_wr_2016_10_14_c7 bca.gis_wr_2016_10_14_c7 Chart 8Solid Loan Growth bca.gis_wr_2016_10_14_c8 bca.gis_wr_2016_10_14_c8 Chart 9Recent Signs Of Improving Corporate Capex Spending Intentions bca.gis_wr_2016_10_14_c9 bca.gis_wr_2016_10_14_c9 Inventories Lower inventory investment shaved 1.2 percentage points off Q2 growth. This marked the fifth consecutive quarter that inventories have been a drag on growth - the first time this has happened since 1956. Real inventory levels fell by $9.5 billion at a seasonally-adjusted annualized pace in the second quarter and are likely to be flat-to-slightly down again in Q3. However, since it is the change in inventory investment that affects growth, this should translate into a modestly positive contribution to Q3 GDP growth. Looking further out, firms are likely to start slowly rebuilding inventories as we head into 2017. The economy wide inventory-to-sales ratio is now back near its trend level (Chart 10). Durable goods inventories excluding the volatile aircraft component rose in the third quarter, as did the inventory component of the ISM manufacturing index (Chart 11). We expect inventory restocking to boost growth by 0.1 percentage points in Q4 and 2017, a big improvement over the drag of -0.6 percentage points between Q2 of 2015 and Q2 of 2016. Chart 10Room To Stock Up Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen Chart 11Inventory Rebuilding Has Commenced Inventory Rebuilding Has Commenced Inventory Rebuilding Has Commenced Government Spending Real government consumption and investment declined by 1.7% in Q2 on the back of lower state and local spending and continued weakness in defense expenditures. The drop at the state and local levels should be reversed, given that tax revenues are trending higher. Federal government spending should also pick up regardless of who wins the presidency. There is now bipartisan support for removing the sequester and increasing infrastructure spending. We are penciling in growth in real government expenditures of 1.5% in Q4 and 2.5% in 2017. Net Exports Net exports shaved 0.8 percentage points off growth in the five quarters spanning Q4 of 2014 to Q4 of 2015. Net exports made a slight positive contribution to growth in the first half of this year. Unfortunately, this was mainly a consequence of sluggish import growth against a backdrop of decelerating domestic demand. Looking out, assuming no change in the dollar index, a rebound in import demand will lead to a modest widening in the trade deficit, which will translate into a 0.2 percentage-point drag from net exports over the remainder of this year and 2017. Putting It All Together The analysis above suggests that the U.S. economy will grow by around 2.5% in Q4 - close to the pace that Q3 growth is currently tracking at - with growth accelerating to 2.8% in 2017. This is a point above the Fed's estimate of long-term real potential GDP growth based on the latest Summary of Economic Projections. How Will The Fed React To Faster Growth? We tend to agree with most FOMC officials who think that the economy is now close to full employment. We also concur that the relationship between inflation and spare capacity is not linear. When spare capacity is high, even large declines in unemployment have little effect on inflation. In contrast, when the labor market becomes quite tight, modest declines in the unemployment rate can cause inflation to rise appreciably. As Chart 12 illustrates, the existence of such a "kinked" Phillips Curve is consistent with the data. Where this publication's view differs with the Fed's is over the question of how much of an inflation overshoot should be tolerated. Considering that the Fed has undershot its inflation target by a cumulative 4% since 2009, a strong case can be made that it should aim for a sizable overshoot in order to bring the price level back to its pre-crisis trend. Most FOMC members do not see it that way, however. This point was reinforced by Chair Yellen at her September press conference when she said that "We don't want the economy to overheat and significantly overshoot our 2 percent inflation objective."1 Chart 13 shows that many measures of core inflation are already above 2%. This suggests that the Fed is unlikely to stand pat if aggregate demand growth looks set to accelerate to nearly 3% next year, as our analysis suggests it will. Chart 12The Phillips Curve Appears To Be Non-Linear Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen Chart 13Some Measures Of U.S. Core Inflation Are Already Above 2% Some Measures Of U.S. Core Inflation Are Already Above 2% Some Measures Of U.S. Core Inflation Are Already Above 2% How high will rates go? This is a tricky question to answer because it requires us to know the value of the so-called neutral rate - the short-term interest rate consistent with full employment. Complicating the matter is the fact that changes in interest rate expectations will affect the value of the dollar, and that changes in the value of the greenback, in turn, will affect the level of the neutral rate. This is because a stronger dollar means a larger trade deficit, which necessitates a lower interest rate to keep the economy at full employment. It is a "joint estimation" problem, as economists call it. One key point to keep in mind is that currencies tend to be more sensitive to changes in interest rate differentials when those differentials are expected to persist for a long time. Chart 14 makes this point using a visual example.2 The implication is that most of the tightening in financial conditions that the Fed will need to engineer is likely to occur through a stronger dollar rather than through higher interest rate expectations. Chart 14The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen A back-of-the-envelope calculation suggests that the level of aggregate demand would exceed the economy's supply-side potential by 2% of GDP by end-2019 in the absence of any effort by the Fed to tighten financial conditions.3 We estimate that in order to keep the output gap at zero, the real trade-weighted dollar would need to appreciate by 10% and the fed funds rate would need to rise to 2% in nominal terms, or 0% in real terms. Despite this month's rally, the real broad trade-weighted dollar is still down more than 2% from its January high. Thus, a 10% appreciation would leave the dollar index less than 8% above where it was earlier this year, and well below past peaks (Chart 15). Chart 15Still Far From Past Peaks Still Far From Past Peaks Still Far From Past Peaks In terms of timing, a reasonable baseline is that the Fed will raise rates in December and twice more in 2017. This would represent a more rapid pace of rate hikes than what is currently discounted by markets, but would only be roughly half as fast as in past tightening cycles. How quickly the dollar strengthens will depend on how fast market expectations about the future path of short-term rates adjust. In past episodes such as the "taper tantrum," they have moved quite rapidly. This suggests that the dollar could also rise at a fairly fast clip. The Impact From Abroad Chart 16A Stronger Dollar Could Push Up EM Spreads A Stronger Dollar Could Push Up EM Spreads A Stronger Dollar Could Push Up EM Spreads Exchange rates are nothing more than relative prices. This means that developments abroad have just as much of an effect on currencies as developments at home. Given the size of the U.S. economy, better U.S. growth would likely benefit the rest of the world. Could this impart a tightening bias on other central banks that cancels out some of the upward pressure on the dollar? For the most part, the answer is no. Both the euro area and Japan have more of a problem with deflation than the U.S. The neutral rate is also lower in both economies. This implies that neither the ECB nor the BoJ are likely to raise rates anytime soon. Thus, to the extent that stronger U.S. growth buoys these economies, this will translate into somewhat higher inflation expectations and thus, lower real rates in the euro area and Japan. This is bearish for their currencies. The possibility that the ECB will start tapering asset purchases next March, as many have speculated, would not alter our bullish view on the dollar to any great degree. Granted, if the ECB did take such a step without introducing any offsetting measures to ease monetary policy, this would cause European bond yields to rise, putting upward pressure on the euro. However, anything that strengthens the euro would weaken the dollar, giving the U.S. a competitive boost. This, in turn, would prompt the Fed to raise rates even more than it otherwise would. The final outcome would be that the dollar would still appreciate, although not quite as much as if the ECB kept its asset purchases unchanged. As far as emerging markets are concerned, a hawkish Fed is generally bad news. Tighter U.S. monetary policy will reduce the pool of global liquidity that has pushed down EM borrowing costs (Chart 16). And given that 80% of EM foreign-currency debt is denominated in dollars, a stronger greenback could cause distress among some over-leveraged borrowers. To make matters worse, a stronger dollar has typically hurt commodities - the lifeblood for many emerging economies. All of this is likely to translate into weaker EM currencies, and hence, a stronger dollar. Investment Conclusions Today's market climate is similar to the one around this time last year. Back then, the Fed was also gearing up to hike rates. Initially, stocks held their ground even as bond yields edged higher. But then, shortly after the Fed raised rates, the floodgates opened and the S&P 500 fell 13% within the course of six weeks (Chart 17). We are nearing such a precipice again. And, in contrast to earlier this year when the 10-year Treasury yield fell by 70 basis points, there is less scope for the bond market to generate an easing in financial conditions in response to plunging equity prices. The 10-year Treasury yield stood at 2.30% on December 29, just before the stock market began to sell off. Today it stands at 1.74%. Investors should position for an equity correction that sends the S&P 500 down 10% from current levels. Looking out, if U.S. growth does begin to accelerate, that should provide some support to stocks. Nevertheless, a stronger dollar and faster wage growth will weigh on corporate earnings, while stretched valuation levels will limit any further expansion in P/E multiples (Chart 18). Investors should underweight U.S. stocks relative to their global peers, at least in local-currency terms. Chart 17Beware Of A Replay Of The Last Correction Beware Of A Replay Of The Last Correction Beware Of A Replay Of The Last Correction Chart 18U.S. P/E Ratios: High, Very High U.S. P/E Ratios: High, Very High U.S. P/E Ratios: High, Very High Turning to bonds, while an equity market correction would not cause Treasurys to rally as much as they did in January, the 10-year yield could still touch 1.5% if risk sentiment were to deteriorate. Once the dust settles, however, bond yields will resume their upward grind. Lastly, a stronger dollar will pose a significant headwind for commodities. That said, as we discussed in last week's Fourth Quarter Strategy Outlook, recent cuts to capital spending are likely to generate supply shortages in some corners of the commodity complex.4 BCA's commodity strategists prefer energy over metals and are particularly bullish on U.S. natural gas heading into 2017. Peter Berezin, Senior Vice President peterb@bcaresearch.com 1 Please see "Transcript of Chair Yellen's Press Conference September 21, 2016," Federal Reserve, September 21, 2016. 2 To understand this concept in words, consider two countries: Country A and Country B. Suppose rates in both countries are initially the same, but that Country A's central bank then proceeds to raise rates by one percentage point and pledges to keep them at this higher level for five years. Why would anyone buy Country B's short-term debt given that Country A's debt yields one percent more? The answer is that people would be indifferent between investing in Country A and Country B if they thought Country A's currency would depreciate by 1% per year over the next five years. To generate the expectation of a depreciation, however, Country A's currency would first have to appreciate by 5%. Now modify the example with the only difference being that Country A's central bank pledges to keep rates higher for ten years, rather than five. For interest rate parity to hold, Country A's currency would now have to overshoot its fair value by 10%. The implication is that the longer interest rates in Country A are expected to exceed those in Country B, the more "expensive" Country A's currency must first become. 3 For the purposes of this calculation, we assume that the output gap this year will be -0.5% of GDP and that aggregate demand growth will exceed potential GDP growth by 1% in both 2017 and 2018, with the gap between demand and supply growth falling to 0.5% in 2019 and stabilizing at zero thereafter. The New York Fed's trade model suggests that a 10% appreciation in the dollar would reduce the level of real GDP by a cumulative 1.2 percentage points over a two-year period. A slightly modified Taylor Rule equation implies that an 80 basis-point increase in interest rates on average across the yield curve would reduce the level of real GDP by 0.8 percentage points after several years. We assume that Fed tightening would lead to a flatter yield curve so that short-term rates rise more than long-term yields. 4 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

The volte-face being attempted by OPEC and non-OPEC producers in an attempt to keep oil prices above a pure-competition market-clearing level arises from the dire financial circumstances key states in both camps find themselves. Now begins the arduous process of determining just how much the Gulf Arab states within OPEC, led by the Kingdom of Saudi Arabia (KSA); and non-OPEC states, chiefly Russia, can cut oil production without giving shale-oil producers in the U.S. a huge windfall.

The U.S. dollar's corrective/consolidation phase is over, and it is about to rally. The risk-reward for EM stocks and currencies is extremely unattractive. We are reiterating our recommendation to short a basket of ZAR, BRL, TRY, MYR, IDR and CLP versus the U.S. dollar. There is a value opportunity in the Mexican peso. Go long MXN versus ZAR. Also, double down on the long MXN / short BRL trade.

Our Treasury yield fair value model suggests that the 10-year Treasury yield has an additional +19bps of upside. Stay at below benchmark duration.

The Chinese manufacturing sector has remained under downward pressure, but the stress level has alleviated compared to a few months ago. The Chinese labor market will likely continue to deteriorate, which will force policymakers to stay accommodative. Despite the recent rally, Chinese investable stocks remain exceptionally cheap.

A number of divergences have emerged in global financial markets. These gaps are unsustainable. The recent improvement in Asian trade/manufacturing has been largely due to firming demand for electronics/semiconductors. Meanwhile, demand/output for industrial goods and basic materials - the areas leveraged to Chinese capital spending - remain weak. Fixed-income traders should bet on yield curve steepening in India: receive 1-year/pay 10-year swap rates.