Manufacturing

Special Report

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

Highlights Chinese monetary conditions have tightened on the margin, but have remained fairly stimulative compared with previous years, likely the key reason why overall growth has remained reasonably robust. Listed Chinese firms reported strong and broad based H1 earnings growth. The profit recovery is of fundamental importance to the Chinese economy, and the positive feedback between profits and business activity has further to run. Collectively the markets are likely flashing further upside in China’s growth cycle. At a minimum, there is no sign of an imminent downturn. The macro backdrop of economic and market fundamentals are conducive for higher equity prices in general, and Chinese equities in particular. Feature Recent manufacturing PMIs from a number of major countries confirm that the global economy is on a synchronized upturn. As an increasingly important driving force of the world economy, how China's growth outlook pans out matters materially. On this front, the most recent news has been encouraging. Chinese manufacturing PMIs, both official and private, accelerated in August and remained above the expansion/contraction threshold. Meanwhile, earnings of Chinese-listed companies in the first half of the year increased strongly from a year earlier across all major sectors, with both stronger sales and higher margins, confirming that the Chinese profit cycle upturn is firmly in place. This should further support business activity, especially among private enterprises. In addition, some market signals from global assets that are traditionally sensitive to Chinese growth trends have been fairly strong of late, likely signaling further upside in the Chinese business cycle. All of this is conducive for higher prices for Chinese equities, and paints a bullish backdrop for global risk assets. A Closer Look At The PMI The stronger-than-expected August Chinese PMI numbers set a firmer tone for the economic data to be released in the coming weeks. They also herald that economic growth in the third quarter will likely remain comfortably above the government's target, setting an ideal political environment for the country's top leadership going into the 19th Communist Party Congress in October. The policy setting will likely be maintained at status quo, and downside risks remain low. It is important to note that the recent rise in PMI has occurred in tandem with a continued decline in Chinese broad money growth, suggesting the improvement in Chinese industrial activity has little to do with money and credit stimuli (Chart 1). Some analysts have been preoccupied with inventing some obscure measures of "credit impulse" to guestimate China's near-term growth outlook, which in our view is misguided.1 Instead, China's growth improvement since last year has to a larger extent been due to marked easing in monetary conditions - a combination of lower real rates and a cheaper trade-weighted RMB. In this vein, Chinese monetary conditions have begun to tighten on margin, but have remained fairly stimulative compared with previous years. This is likely the key reason why overall growth has remained reasonably robust, despite falling monetary aggregates. It is particularly noteworthy that the trends of new orders and finished products inventory have diverged of late. New orders have stayed at close to multi-year highs, while inventory PMI has remained well below 50 since 2012, and has relapsed anew in recent months, leading to a significant rise in the new orders-to-inventory ratio (Chart 2). In other words, manufacturers remain decisively in a destocking mood, despite the improvement in new orders. Looking forward, this should supercharge production should new orders remain strong, and create a buffer for manufacturing activity should orders roll over. Chart 1Chinese PMI: Monetary Conditions ##br##Matter More Than Money Supply Chart 2Manufacturers Remain Decisively ##br##In Destocking Mood Another important development is that there appears to be some regained pricing power among service providers, which historically has been a leading indicator for manufacturers' producer prices (PPI), as shown in Chart 3. It appears that PPI may continue to downshift toward year end and regain some strength early next year. PPI has been a key signpost for China's reflation trend, and matters materially for manufacturers' profit margins and the real cost of funding. Any sign of PPI improvement will likely be viewed as a positive development from a market perspective. The market relevance of the PMI survey is that it often leads net earnings revisions of listed Chinese companies by bottom-up analysts (Chart 4). If history is any guide, net earnings revisions will likely improve further, notwithstanding earnings of listed companies have already recovered strongly in the first half of the year. Chart 3Early Signs Of PPI Bottoming? Chart 4PMI Leads Net Earnings Revisions Earnings Reality Check Chart 5A Sharp Profit Upturn By now, all listed firms in Chinese domestic stock exchanges have released financial statements for the first half of the year. Our calculations show that total earnings increased by 18% year-over-year for all listed firms, or 36% if banks and petroleum firms are excluded - both sharply higher compared with a year earlier. This is largely in line with the profit upturn reported by the national statistics agency2 (Chart 5, top panel). A few observations can be made: First, the sharp increase in earnings is due to a combination of rising sales and improving margins, underscoring a marked ease in deflationary pressures and a significant pickup in business activity in nominal terms. (Chart 5, bottom two panels). It is noteworthy that revenue growth stagnated for several consecutive years before the strong recovery since mid-last year. Similarly, profit margins dropped to close to record low levels between 2012 and mid-2016, and have since largely recovered. Profit margins, however, do not yet look overly excessive from a historical perspective. Second, the improvement in earnings is broad-based, as shown in Table 1. Materials producers and energy concerns have experienced a massive profit boom, particularly steelmakers. With the only notable exception being utilities, largely thermal power plants, whose profit margins have been squeezed by rising coal costs, most other sectors have also booked healthy profit gains. This means the profit upturn has been driven by improvement in the broader economy rather than specific government policies that benefit select industries. Finally, the banking sector has also experienced a pickup in earnings growth, especially among large state-controlled banks. More importantly, asset quality of bank loans has also improved, albeit marginally. Our calculation shows that non-performing loans (NPL) and "special-mention-loans," which banks place closer scrutiny on as borrowers face higher risks of default, have both begun to decline (Chart 6). This should not be surprising, given the corporate sector's rising profits. Leaders in the current profit recovery are mining companies, materials producers and some industrial firms, all of which have been regarded as major trouble spots in banks' loan books.3 It may be premature to declare the peak of China's NPL problem, but the profit improvement has certainly helped banks mend their balance sheets. Table 1Earnings Scorecard Chart 6Marginal Improvement##br## In Banks' Asset Quality In short, we maintain the view that profit recovery is of fundamental importance to the Chinese economy, a key pillar in our positive stance on China's cyclical outlook.4 Rising profits restore entrepreneurial confidence, boost private-sector capital spending, ease balance sheet stress of asset-heavy enterprises and de-escalate banking sector risk. It is certainly unrealistic to expect profit growth to perpetually accelerate, but there are no signs of a sudden contraction in profits anytime soon. We expect the positive feedback loop between profits and business activity has further to run. Reading Market Tea Leaves Stronger Chinese growth is also reflected in asset prices well beyond its borders. Some asset classes that are traditionally highly sensitive to Chinese growth cycles have been showing remarkable strength of late. Metals prices have been firm across the board. The London Metal Exchange Index has historically been a reliable leading indicator of China's business cycle (Chart 7). Stock prices of metals producers in major producing countries have significantly outperformed their respective benchmarks, likely pointing to an imminent upturn in China's leading economic indicator (Chart 8) The Baltic Dry Index, the benchmark for bulk shipping rates that is largely driven by Chinese materials demand, has stayed elevated, probably a sign that China's bulk commodities intake has remained fairly robust (Chart 9) Turning to the Chinese equity market, real estate developers have been among the star performers in the Chinese equity universe so far this year - historically, the relative performance of Chinese developers has been an excellent leading indicator for home sales, which in turn drives real estate investment (Chart 10). Chart 7Metals Point To Further Upside##br## In Chinese Business Cycle... Chart 8...So Do Metal Producers Chart 9Baltic And Chinese Commodity Imports Chart 10Developers' Relative Performance ##br##Leads Home Sales Collectively the markets are likely flashing further upside in China's growth cycle. At a minimum, there is no sign of an imminent downturn. Currently, global equity markets, including those in the Greater China region, are clouded by the escalating geopolitical risk over the Korean Peninsula, where the near term outlook remains volatile and unpredictable.5 Barring an extreme scenario, the macro backdrop of economic and market fundamentals are conducive for higher equity prices in general, and Chinese equities in particular. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report "A Chinese Slowdown: How Much Downside?" dated June 8, 2017, and Special Report, "Focusing On Chinese Money Supply", dated July 27, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations", dated August 31, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Stress-Testing Chinese Banks", dated July 27, 2016, available at cis.bcaresearch.com. 4 Please see China Investment Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, and "China Outlook: A Mid-Year Revisit", dated July 13, 2017, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge", dated August 17, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Chart 22Message From Our U.S. Stock Market ##br##Timing Model Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights The European Central Bank's ultra-dovish policies have depressed the value of the euro and, by extension, boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result of this and labor shortages, wages in central Europe are rising rapidly, and inflation is accelerating. The Polish and Czech central banks will be forced to hike rates sooner than later. Hungary's central bank will lag behind. Go long the PLN versus the IDR. Stay long the CZK versus the euro and the PLN against the HUF. Feature Inflation in central Europe is picking up and will continue to rise (Chart I-1). The main driver is surging wage growth in central Europe. Considerable acceleration in wage growth, in Poland, Hungary and the Czech Republic signifies genuine inflationary pressures that could very well spread. Based on this, our primary investment recommendation is to be long the PLN and CZK versus the euro and/or EM currencies. Labor Shortages There is a shortage of labor in the central European manufacturing economies of Poland, Hungary and the Czech Republic. This partially reflects similar trends in Germany and its increased use of outsourcing to central European countries. Escalating wage growth (Chart I-2) in central European economies denotes widening labor shortages. Chart I-1Inflation Is Rising In CE3 Chart I-2Labor Shortages = Higher Wages Indeed, our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - has surged of late across all central European countries (Chart I-3). The same measure for Germany is at a 27-year high (Chart I-3, bottom panel). Chart I-4A and Chart I-4B illustrate both components of the ratio: the number of job vacancies has skyrocketed to all-time highs and the number of unemployed people has dropped to multi-decade lows as well. Chart I-3Labor Is Scarce In CE3 And Germany Chart I-4AA Breakdown Of Labor Shortage Proxy Chart I-4BA Breakdown Of Labor Shortage Proxy Importantly, it is not the case that labor shortages are occurring because people are discouraged and giving up on their search for work. The participation rate for all these countries has risen to its highest level since data have been available. In brief, a rising share of the population in these countries is either working or actively looking for a job. (Chart I-5). Finally, their working age population is shrinking (Chart I-6), with Germany being the exception because of immigration inflows (Chart I-6, bottom panel). Chart I-5Labor Participation Rate Is ##br##High In CE3 And Germany... Chart I-6...While Working Age ##br##Population Is Declining In CE3 Robust labor demand has been occurring in central Europe because of the ongoing manufacturing boom in the region. Given central Europe's extensive supply chain linkages to German manufacturing, the artificial cheapness of the euro that the ECB engineered has boosted the German economy and by extension central Europe's manufacturing boom. Germany: A Cheap Currency And Export Boom The ECB's ultra-accommodative policy has suppressed the value of the euro, and caused German exports to mushroom (Chart I-7, top panel). Chart I-7ECB Policies Have Been ##br##A Boon For German Exports A cheap common European currency has boosted Germany's manufacturing competitiveness and has led to rising demand for German exports. An overflow of manufacturing orders in Germany in turn has led to labor shortages in central Europe via increased German outsourcing. Currency appreciation is the conventional economic adjustment in a country with a flexible exchange rate and an export boom coupled with a large current account surplus. However, this has not occurred in Germany in recent years. This is because of the ECB's ultra-easy policies. The euro has depreciated even as the German and euro area overall current account has mushroomed (Chart I-7, bottom panel). Since the currency has not been allowed to appreciate in nominal terms, the real effective exchange rate will inevitably appreciate via inflation - rising wages initially and broader inflation increases later. In our opinion, the best currency valuation measure is the real effective exchange rate based on unit labor costs. Our basis is that this measure reflects both changes in productivity and wages - i.e. it reflects genuine competitiveness. Chart I-8 demonstrates Germany's real effective exchange rate based on unit labor costs in absolute terms compared to other advanced manufacturing competitors like the U.S., Japan, Switzerland and Sweden. Based on this measure, it is clear that Germany continues to enjoy a significant comparative advantage on the manufacturing world stage among advanced manufacturing economies. It is only less competitive versus Japan. Chart I-8Germany Is Very Competitive Based On Real Effective Exchange Rates Bottom Line: The ECB's ultra-dovish policies have depressed the value of the euro and boosted German manufacturing. This has boosted central European manufacturing and demand for labor. Germany Is Passing The Inflation Baton To Central Europe Despite a historic low in the unemployment rate and ongoing labor shortages, German wages have not risen by much (Chart I-9). Our hunch is that German companies faced with some labor shortages have been increasing their use of outsourcing. Central European economy's export to Germany have boomed, especially after the euro started depreciating circa 2010 (Chart I-10). Chart I-9German Wage Inflation Is Muted Chart I-10Growing Dependence On ##br##Germany For CE3 Growth Being the lower marginal cost producer in the region, central European economies have benefited from German competitiveness and the cheap euro. Outsourcing is economically justified because German wages are still four times higher than in Poland, Hungary and the Czech Republic. (Chart I-11). Even though Germany's productivity is higher than in central Europe, manufacturing wages adjusted for productivity are still higher than in central European economies (Chart I-12). Therefore, it still makes sense for German businesses to outsource more to lower-cost producers in central Europe. Chart I-11CE3 Wage Bill Is Cheaper ##br##Than That Of Germany... Chart I-12...Even After Adjusting ##br##For Productivity Faced with strong orders as well as a lack of available labor, businesses in central European countries have been competing for labor by raising wages. Unlike in Germany, manufacturing and overall wages in Poland, Hungary and the Czech Republic have recently surged (Chart I-2 on page 3). Wages are rising more so in Hungary and the Czech Republic since they have smaller labor pools compared to Poland. Notably, wage growth has exceeded productivity growth, and unit labor costs have been rising rather rapidly (Chart I-13). Chart I-13Unit Labor Costs Are Rising Rapidly In CE3 Higher unit labor costs amid rising output denote genuine inflationary pressures. Producers faced with rising unit labor costs and shrinking profit margins will attempt to raise prices. Given that income and demand are strong, they will partially succeed - meaning genuine inflationary pressures in central Europe are likely to intensify. Since the beginning of the ECB's accommodative monetary policy, Germany has been able to avoid the fallout of higher wages because it has been able to outsource a portion of its production to other countries, namely central Europe. The problem is that the supply of labor in central Europe is now drying out, so its price will naturally rise. If Germany did not have the labor pool of CE3 available as a resource, German wage inflation would be significantly higher by now because companies would have been forced to employ Germans more rapidly, paying more in labor costs. Bottom Line: Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. Overheating In Central Europe Various inflation measures are showing signs that inflation is escalating in CE3. With rising wages and unit labor costs, these trends will continue. Consequently, output gaps in central European economies are closing or have closed, warranting further increases in inflation (Chart I-14). Money and credit growth are booming, which is further facilitating the rise in inflation (Chart I-15). Finally, employment growth is very robust and retail sales are strong (Chart I-16). Chart I-14Inflation Will Remain On An Up Trend In CE3 Chart I-15Money & Credit Will Facilitate Path To Inflation Chart I-16Employment & Retail Sales Growth Is Robust Bottom Line: A cheap euro has supercharged German demand for central European labor at the time when the pool of available labor in CE3 is shrinking. This has generated genuine inflationary pressures in the region. Conclusions And Investment Recommendations 1. The Polish and Czech central banks will hike rates sooner than later. This will boost their currencies. The Hungarian central bank will lag and the HUF will underperform its regional peers. CE3 currencies are set to appreciate, especially the CZK and the PLN: stay long the PLN versus the HUF, and the CZK versus the euro. We recommended going long PLN/HUF and long CZK/EUR on September 28 2016 due to stronger growth and rising inflationary pressures. This week's analysis reinforces our conviction on these trades. In the face of rising inflationary pressures, the Czech National Bank (CNB) and the National Bank of Poland (NBP) will be less reluctant to tighten policy than the National Bank of Hungary (NBH) and the ECB. This will drive the PLN and CZK higher relative to the EUR and HUF. The NBH is unlikely to tighten policy while credit growth is still weak. Given strong political pressure for faster economic growth, our bias is that the NBH is more interested in ending six years of non-existent credit growth rather than containing inflation. The ECB is unlikely to tighten policy either, given the still-poor structural growth outlook among the peripheral European economies. A new currency trade: go long the PLN versus the IDR, while closing our short IDR/long HUF trade with a 9% loss. This is based on our expectations that central European currencies will appreciate versus their EM peers, and the PLN will do better than the HUF. 2. Relative growth trajectory favors Central European economies relative to other EM countries. Such economic outperformance and resulting currency appreciation will be a tailwind to CE3 equity performance versus EM in common currency terms. Continue overweighting CE3 equity markets within the EM benchmark. We recommended equity traders go long CE3 banks / short euro area banks on April 6, 2016. This position has not worked out due to a significant rally in euro area banks since Brexit. However, euro area banks remain less profitable and overleveraged compared to their central European counterparts. As such they will likely underperform in the coming months. 3. In fixed income, we have the following positions: Overweight Hungarian sovereign credit within an EM sovereign credit portfolio. Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. A new trade: Receive 1-year Hungarian swap rates / Pay 10-year swap rates. As structural inflationary pressures become rampant in the Hungarian economy, the market will start pricing in rate hikes further down the curve, and the yield curve will consequently steepen (Chart I-17). Polish and Czech bonds offer better value relative to bunds as investors stand to gain from currency appreciation as well as an attractive spread. (Chart I-18). Chart I-17Bet On Yield Curve ##br##Steepening In Hungary Chart I-18Polish & Czech Bond Offer Value ##br##Relative To German Bunds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The latest reading from all the indicators confirms that the growth improvement in the manufacturing sector since early last year has moderated, while the sharp recovery in producer prices has stalled. However, it is premature to be overly alarmed by a pending Chinese growth relapse. Betting on a material Chinese slowdown solely based on some sort of credit "impulse" estimate misses the big picture. The dramatic decline in real interest rates rather than an increase in new lending is what played a pivotal role in Chinese reflation since last year. Strategically we lean against being overly bearish. The Chinese economy will likely continue to moderate, but the downside risk appears low at the moment and overall business activity will remain buoyant. Feature Investors have become less sanguine on China's growth outlook in recent weeks, as the latest macro numbers are no longer unanimously positive. Concerns about a significant relapse in the Chinese economy are re-emerging, and the authorities' recent policy tightening has further heightened investors' anxiety levels. Judging from our recent conversations with clients, "China risk" is now clearly back on the radar. China's growth recovery since early last year played a major role in boosting some global risk assets such as commodities prices and emerging market equities. By the same token, will a China slowdown end the global reflation trade? The Divergence In Manufacturing PMIs Chart 1The Divergences In PMIs Investors' anxiety over China's cyclical trend has been amplified by the recent divergence between the official manufacturing Purchasing Manager Index (PMI) and the one compiled by Caixin Media group, a private source. The official survey for May still showed expansion, while the private PMI dropped slightly below the critical 50 threshold (Chart 1, top panel). Historically such divergences are not uncommon, and the private PMI appears to show sharper swings than its official counterpart, probably due to its smaller sample size and its focus on smaller private firms. Meanwhile, there were some commonalities: the sub-indices of output and new orders for both surveys remained above the expansionary threshold, while input costs and output prices for both dropped into contractionary territory. Taken together, the latest reading from all the indicators confirms that the growth improvement in the manufacturing sector since early last year has moderated, while the sharp recovery in producer prices has stalled - consistent with other recent macro variables. Meanwhile, the service industry is still showing solid expansion, according to both surveys, underpinning overall business activity (Chart 1, bottom panel). In short, it is premature to be overly alarmed by a pending Chinese growth relapse. Credit "Price" Versus "Volume": What Matters More? A common narrative to describe the reason behind China's ongoing growth moderation is policy tightening on both the monetary and fiscal fronts. As the argument goes, last year's growth recovery was driven by a massive increase in credit and fiscal spending, which has since been scaled back. As this credit and fiscal "impulse" fades away, the Chinese economy will tumble, sending shockwaves across the world. In our view, betting on a material Chinese slowdown solely based on some sort of credit "impulse" estimate misses the big picture, and is dangerously misguided. At BCA, we have long paid close attention to credit cycles and their impact on the growth outlook. However, there is no evidence that China's growth recovery since early last year was due to a massive increase in credit expansion and fiscal spending. In fact, total new credit provided by commercial banks and the "shadow banking sector" has been largely stable in recent years, and last year's credit "impulse," measured as the annual change in credit flows, was fairly modest - especially compared with previous bouts of sharp spikes (Chart 2). Similarly, Chinese fiscal spending actually decelerated sharply throughout last year, and dropped by over 10% in December, compared with a year earlier. Even if last year's fiscal retrenchment impacts the economy with a time lag, it is important to note that fiscal spending has already rebounded in recent months, which will become a tailwind for growth down the road. In our view, China's growth recovery since last year has a lot more to do with the "price" of credit rather than "volume." (Chart 3) Real interest rates dropped from double-digit levels that prevailed between 2012 and early 2016 to negative, thanks to a sharp increase in producer prices, while credit growth remained in a broad downtrend. In other words, the dramatic decline in real interest rates rather than an increase in new lending is what played a pivotal role in Chinese reflation. Chart 2Not Much 'Impulse' Chart 3Credit: 'Price' Matters More Than 'Volume' China's PPI has rolled over, which together with the authorities' attempts to tighten has begun to lift real interest rates. This will likely continue to generate some growth headwinds - a risk that clearly warrants close attention. However, monetary conditions currently are still very accommodative, and there is no reason to expect an overkill to choke off the economy. Why Growth Will Not Falter? Moreover, the bearish argument on China's cyclical outlook is fundamentally rooted in the assumption that the country's economy is dangerously imbalanced1 - a shaky house of cards propped up by policy stimulus that will immediately fall down once the policy pump-priming stops. While the structural profile of the Chinese economy will remain a major global macro issue subject to heated debates going forward, the bearish argument underestimates the economy's resilience, and therefore exaggerates the downside risks. First, it is important to note that China's growth challenges in previous years were to a large extent due to excessively tight monetary conditions, a costly policy mistake that amplified deflationary pressures. Real interest rates were kept at double digits for 5 consecutive years between 2012 and early 2016 while other major central banks were all trying desperately to lower borrowing costs within their respective economies. Furthermore, the trade-weighted RMB appreciated by 20% between 2012 and 2015. In fact, the RMB was the only major currency that appreciated in trade-weighted terms during this period (Chart 4), essentially shouldered deflationary stress for the rest of the world. In addition, Chinese regulators tried hard to block credit flows in an ill-conceived attempt to de-lever - which only prolonged credit intermediation channels and pushed loan demand to even costlier "shadow" institutions.2 All of these factors inflicted dramatic deflationary pain on Chinese manufacturers. Indeed, that the Chinese economy did not implode under the double-whammy of weak global demand and draconian domestic policy tightening - and staged a quick turnaround when monetary conditions eased - underscores the surprising resilience of the Chinese corporate sector. Second, the growth recovery since early last year has significantly improved financial conditions within the corporate sector and eased its balance sheet stress. Overall, companies have increased earnings, reduced inventories and beefed up cash positions (Chart 5). The situation can certainly deteriorate, but the sector is also better prepared for deflationary shocks than in previous years. Chart 4The RMB Shift Chart 5Inventory Is Still Very Low Third, even if China's corporate sector, especially industrial enterprises, are indeed as fragile as some bearish analysts claim, Chinese households and the service sector have much healthier fundamentals and therefore are less vulnerable. Consumer confidence has improved significantly in recent months following the growth acceleration, which should further help household consumption. The service sector now accounts for 52% of Chinese GDP, 30% larger than manufacturing. Household consumption and the service sector will provide an important anchor for business activity and prevent a major relapse in economic growth, even if the industrial sector slows more than we currently expect. Finally, the global growth environment is also largely supportive for the Chinese economy. The European economy has been showing some remarkable strength of late, and U.S. growth is likely to pick up after the recent soft patch, as per our U.S. specialists - both of which should bode well for Chinese exports. It is worth noting the recent weaker macro numbers out of China have followed growth disappointments in the U.S. (Chart 6). In fact, the ebbs and flows of "growth surprises" in the world's two largest economies in recent years have been largely in sync, albeit with China experiencing more pronounced volatility. In addition, the risk of an immediate escalation of protectionist backlash between the U.S. and China has also been lowered following President Xi's state visit to the U.S. in April.3 Overall, the Chinese economy is unlikely to slow materially, if the U.S. economy does reasonably well. Chart 6U.S. And China: Synchronized 'Surprises' All in all, we expect the Chinese economy will likely continue to moderate, but the downside risk appears low at the moment. In a reported titled "Chinese Growth: Testing Time Ahead," dated April 6th, we warned that "growth figures coming out of China in the coming months may be viewed as less market friendly."4 Recent Chinese data and investor reactions confirm this judgment. Nonetheless, we maintain the view that the Chinese economy's growth improvement remains largely intact, which will reinforce the upturn in the global business cycle and support global risk assets. Strategically we lean against being overly bearish, and we remain cyclically positive on Chinese equities, particularly H shares. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Reports, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, and "More On The Chinese Debt Debate," dated April 20, 2017 available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Reports, "Reflecting On The Trump-Xi Summit," dated April 13, 2017 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Feature Dear Client, Instead of our usual weekly report, we are sending you a report written by my colleague Matt Gertken, Associate Editor of BCA's Geopolitical Strategy service. In this piece, Matt argues that there is more than a 50% chance that the Border Adjustment Tax (BAT) will pass and Donald Trump's support will be the decisive factor. There are also high chances that trade retaliation would unfold likely detracting from the trade benefits of the proposed tax. In addition, given the likelihood of the BAT implementation, we are highlighting U.S. equity sector investment implications and ranking industries on three variables: taxes, margins and foreign sales exposure. We trust that you will find this Special Report useful and insightful. Best Regards, Anastasios Avgeriou There are good chances that the border adjustment tax (BAT) will pass as the House GOP has a governing trifecta. Trump has not yet endorsed the BAT, which will be critical, and carve-outs will likely be made to reduce the impact on low- and middle-income households. Still, we can draw some sectoral implications from the known GOP proposal. While a lot of ink has been spilled on potential direct winners and losers from the BAT and what is priced in by the markets, we focus our sector analysis on the sweet spot of tax rates, profit margins and international sales exposure. Chart 1 shows a Venn diagram of these three factors, with the overlap representing the optimally positioned sector. We deem that industries with a combination of high tax rates, high profit margins and low or no foreign sales exposure will be prime beneficiaries of the BAT. Chart 1Sweet Spot At first glance this backdrop may appear counterintuitive, especially the international revenue exposure angle, given the preferential treatment that exporters would receive with the BAT implementation. Almost immediately upon Trump's election and news of BAT the market bought companies/industries with negative net import share and discarded sectors with high net import content (Chart 2A & Chart 2B). Chart 2AInvestors Have Been... Chart 2B... Preferring Exporters To Importers Watch The U.S. Dollar And Emerging Markets Nevertheless, what is worrisome is the market's neglect of a U.S. dollar knee jerk appreciation as our sister Global Investment Strategy service outlined in the January 20th Special Report titled: "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017." Chart 3U.S. Dollar And EM Risks It is difficult to fathom why a greenback surge will not be disruptive especially for the emerging markets (EM) and U.S. cyclical sector proxies trading in tandem with EM. According to the Bank for International Settlements, U.S. "Dollar credit to non-banks outside the United States reached $9.8 trillion at end-Q2 2015. Borrowers resident in EM accounted for $3.3 trillion of this amount, or over a third."1 The EM still have a large stock of U.S. dollar denominated debt to service, both interest payment and principal repayments/refinancing (Chart 3). While the FX straight jacket is not in place as in the 1990s, at least a mini EM crisis seems inevitable if the trade-weighted U.S. dollar moved up 10% from current levels as is likely owing to a BAT. Keep in mind that recent U.S. dollar moves of a similar magnitude (as in 2015), (Chart 3) have been rather unsettling, causing tremors in the EM that reverberated across the globe. Tack on uncertainty surrounding the Chinese renminbi that would only aggravate the U.S. dollar's rise and factors are falling into place for another troublesome EM episode. As a result, global final demand may come under pressure and U.S. exporters may initially suffer more than they benefit from the export subsidy they would enjoy. Another U.S. dollar induced global manufacturing recession would bode ill for U.S. cyclicals exposed to the EM. A Few Words On Manufacturing While the intent of bringing back manufacturing jobs to U.S. shores is appealing, practically it will prove very difficult. Developed economies are services oriented economies with manufacturing dwindling toward 10-15% of GDP (Chart 4). Moreover, the U.S. is a closed economy dominated by PCE comprising 70% of the overall economy. Thus, shifting the U.S. more toward a net export driven economy is also likely to prove challenging. Chart 4Tough To Shift The U.S. Economy's Profile Chart 5Will Capex Revive? Finally, manufacturing is tightly linked to capital expenditures and a recent post by the Atlanta Fed2 tried to shed some light as to why investment in the U.S. has lagged especially versus previous recoveries when the economy was near full employment (Chart 5 & Table 1). Interestingly, the biggest hindrance against boosting capex has been lack of skilled labor, and not the lack of financing or poor sales outlook or low return on investment for example. In fact the larger the firm (in terms of sales) the more pronounced the inaccessibility to qualified staff as a factor constraining investment. While tax reform aims to boost capex by accelerated depreciation schedule in the first year, it does not address the small business complaint of inability to find skilled labor. Table 1Impact Of "High Pressure" Labor Conditions On Capital Spending BAT Winners Therefore, we would want to bulletproof the portfolio by identifying industries that would do well owing to the BAT and resulting U.S. dollar appreciation. U.S. domestic services oriented firms fit the bill, and there is room for sizable outperformance if our thesis proves accurate. Chart 6 highlights 47 sub-industries from 9 GICS1 sectors (energy & materials are excluded) that we singled out that satisfy the domestic and services oriented prerequisite (See Appendix on page 8 for more details). U.S. manufacturers with little or no foreign sales exposure would also stand to get an earnings boost, especially relative to the broad market and to their internationally geared peers. Homebuilders, select construction materials and building products companies would be included in this category. Energy is a special case (please refer to Box 1 on page 6). Meanwhile, high profit margin businesses with sticky pricing power and high effective tax rates also come out on top of our analysis as these outfits would benefit more from overall tax reform. Table 2 shows the top 11 sectors in the S&P 500 on the three metrics. Chart 6Buy Domestic Services Table 2 Health care, utilities, and telecom services score well on all three counts. Real estate and financials also get high marks. In contrast, technology, materials, energy and industrials get poor grades on most of our metrics, with the balance of sectors falling somewhere in between. Box 1 Energy Is A Special Case Chart 7U.S. Remains A Net Importer Of Oil The energy sector is a special case. The U.S. still imports north of 7 MMb/d of oil and represents about 10% of the trade deficit (Chart 7). Were energy to be included in the BAT legislation, WTI crude oil prices would likely shoot higher by ~$10/b as U.S. oil consumers (refiners) would seek to avoid the $10+ BAT on imported light sweet crude by buying domestic oil, and U.S. oil producers would try to benefit from the export subsidy. U.S. exploration & production companies and energy servicers would be clear winners, while refiners would be losers. Nevertheless, the dollar jump would be an offsetting factor. Given the outsized impact on the consumer (gasoline price inflation sapping discretionary spending power) and the close political and energy-security relationship with Canada (60% of net U.S. petroleum imports), there is a high likelihood that energy would be exempt from the BAT. In fact, small and medium businesses (SME) would disproportionately benefit from lower corporate taxes especially compared with S&P 500 constituents that are privileged with a lower effective tax rate. Large capitalization multinationals with sizable foreign sourced sales/profits already use the "double Irish" or "Dutch sandwich" to bring down their tax bills. Keep in mind that SMEs also tend to have low or no foreign sales exposure insulating them from the looming U.S. dollar appreciation. Thus, small caps have a considerable advantage versus their large cap brethren upon implementation of the BAT and general tax reform, and we continue to recommend a small cap tilt in our size bias. For reference purposes Table 3 highlights small cap GICS1 sectors on an operating profit margin and effective tax rate basis. What follows in the appendix is a list of sub-industries per GICS1 sector we have identified that would likely stand to benefit from the BAT implementation assuming a U.S. dollar appreciation. Table 3 Bottom Line: We are comfortable maintaining a defensive versus cyclically exposed portfolio, that would shield us from the BAT implementation, especially if a greenback induced correction materialized in the coming months. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 "Dollar credit to emerging market economies" by Robert Neil McCauley, Patrick McGuire and Vladyslav Sushko, 6 December 2015, Bank for International Settlements, Quarterly Review, December 2015, available at: http://www.bis.org/publ/qtrpdf/r_qt1512e.htm 2 http://macroblog.typepad.com/macroblog/2017/02/can-tight-labor-markets-inhibit-investment-growth.html Appendix Consumer Discretionary Advertising Broadcasting Cable & Satellite Casinos & Gaming Movies & Entertainment Publishing & Printing Restaurants Specialized Consumer Services Consumer Staples Food Distributors Financials Asset Management & Custody Banks Consumer Finance Diversified Banks Insurance Brokers Investment Banking & Brokerage Life & Health Insurance Multi-line Insurance Multi-Sector Holdings Property & Casualty Insurance Regional Banks Health Care Health Care Distributors & Services Health Care Facilities Life Sciences Tools & Services Managed Health Care Industrials Diversified Support Services Environmental & Facilities Services Human Resource & Employment Services Railroads Research & Consulting Services Trading Companies & Distributors Trucking Information Technology Data Processing & Outsourced Services Electronic Manufacturing Services Internet Software & Services IT Consulting & Other Services Real Estate Health Care REITs Hotel & Resort REITs Industrial REITs Office REITs Real Estate Services Residential REITs Retail REITs Specialized REITs Telecommunication Services Alternative Carriers Integrated Telecommunication Services Utilities Electric Utilities Independent Power Producers & Energy Traders Multi-Utilities Highlights The U.S. Border Adjustment Tax is likely to pass; Yet the political pieces are not in place; Trump himself will be the decisive factor; Trade retaliation would detract from trade benefits of the tax; Stay long volatility; small caps versus large caps; and long USD versus EM currencies. Remain short China-exposed S&P 500 stocks, and German exporters versus consumer services. Feature Donald Trump is a trend-setter. After winning the U.S. election on a protectionist platform that played well to voters in the Midwest, Trump has established an anti-globalization brand of politics. His success has revealed the preferences of the American "median voter."3 Other U.S. politicians are taking notice. The "Border Adjustment Tax" (BAT) is part of this new political trend, though it did not originate with Trump. The House GOP leadership has presented it as a response to economic dislocation in the American heartland, which propelled Trump to the White House. Is it protectionism? Yes, and in this analysis we explain why. The rest of the world is highly unlikely to treat the BAT as a standard Value Added Tax (VAT). It will therefore spark trade retaliation unless Congress addresses outstanding issues. So far President Trump is on the fence, and his support is necessary for passage. We think he will ultimately go with the proposal. The prospect of turning the tables on the U.S.'s trade partners, while spurring domestic investment and capital spending, speaks to his core promises to his voters. Trump's support for the plan should be read as a headwind for markets in the short term due to the uncertainties of implementation and trade disputes. If he should oppose the plan, it would be bullish for U.S. stocks in the short term, since it would mean cutting the corporate tax without radically altering the global status quo. It would signal that he is more interested in economic growth and corporate profits than changing the world or balancing the U.S. budget. Why Reform The Corporate Tax System? American policymakers have long struggled with the country's corporate income tax system. Leaving aside party politics, there are three main complaints:4 Corporate tax revenues are weak: Revenues have disappointed as companies have shifted profits to tax havens and used deductions and loopholes to avoid paying the 35% statutory rate. This erosion of the tax base has contributed to budget deficits as well as public dissatisfaction with governing institutions (Chart 1). U.S. companies have lost competitiveness: American businesses are overtaxed relative to their developed-market peers, taking a toll on competitiveness both at home and abroad (Chart 2). The middle class is losing out: U.S. workers are not as well compensated as their developed-market peers and have lost their share of American wealth in recent decades (Chart 3). The corporate tax contributes to this because companies foist the tax onto workers. The Republican Party examined fundamental tax reform in 2005 but could not make progress on it - instead it settled for the Bush tax cuts, which focused primarily on cutting household tax rates.5 Now that the Republicans have control of all three branches of government again, its leaders are attempting broad tax reform anew. The GOP is primarily concerned with corporate competitiveness, but they also need to appease the middle class - the source of the populist angst that supported both Obama and Trump (the former being the Republicans' arch-nemesis, the latter a strange bedfellow). The GOP also wants to raise some revenue to make their desired tax rate cuts "revenue neutral," i.e. somewhat fiscally defensible, at least enough to pass the bill. Enter Paul Ryan, Speaker of the House, and Kevin Brady, Chairman of the Ways and Means Committee, and their "Better Way" tax plan, which proposes a sweeping overhaul of the U.S. tax system.6 The core idea is to pay for tax cuts by transforming the current corporate income tax system into a "destination-based cash-flow tax" (DBCFT) with border adjustability ("border adjustment tax" or BAT for short).7 We will get to the definition of that, but first, what is the ultimate point? The plan would purportedly drive corporate investment and economic growth by allowing companies to write off the expense of new investments immediately, the first year, rather than gradually through depreciation. (Depreciation schedules often mean that the tax write-off barely covers the cost of investment, thereby causing companies to err on the side of risk-aversion.) The plan would also remove the preferential treatment of corporate debt over equity, which is built into the current tax code through the deduction of interest - this change would discourage corporate indebtedness and encourage equity financing. Finally the plan would not allow U.S. companies to write off the expense of imported goods, as currently, and as such is essentially a tax on the U.S. trade deficit. Roughly, it could yield about $108 billion in revenue (assuming a 20% rate on the $538 billion deficit). The BAT is the chief tax uncertainty today for investors. That is because there are few constraints on the GOP passing some kind of corporate tax cut this year. Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. There is every reason to think it will happen fast. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power In other words, Trump and his party would need to have a train wreck to fail to pass something this year. That is not beyond belief! But the overriding question is whether the tax reform will be focused on cutting rates, or transforming the system. Currently, the market seems to think the BAT will go through. A basket of stocks based on potential winners and losers suggests that investors believe it will pass (Chart 4). Meanwhile, however, the share prices of high-tax companies (who should benefit the most if taxes are cut) have fallen back from the pop after Trump's election. This could signal the opposite expectation, or that that investors recognize that many high-tax sectors stand to lose from a tax on imports (Chart 5). There is considerable uncertainty in this measure. We think the Trump administration will ultimately accept the House GOP's BAT proposal. But the road between here and there will be tortuous, as past attempts at tax reform show. We expect dollar volatility, which is relatively restrained at present, to rise as the BAT debate intensifies, given that the proposal is bullish for the greenback (Chart 6). Bottom Line: The Trump administration and GOP would have to be unusually incompetent to fail to achieve tax reform this year. The question is whether it will be mere rate cuts or a radical reform to the tax system as a whole. This is critical to the U.S. and global economy - especially given that the passage of a BAT will intensify trade disputes with the U.S. Why Is A Border Adjustment Tax "Protectionist"? Diagram 1 provides a simple illustration of how the current U.S. corporate tax works compared to the proposed BAT. The current system is a "worldwide" corporate income tax. The U.S. government taxes American companies based on their global profits (global revenues minus global costs). No matter where they incur costs, they can write them off, and no matter where they make profits, they must pay tax on them, at least in principle. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax The new system, by contrast, would be a "destination-based" tax in which the government taxes companies only on domestic profits (domestic revenues minus domestic costs). This means that revenues earned abroad from exports or sales in foreign jurisdictions would be free from tax. However - and here is the tricky part - it also means that costs incurred abroad, imports or purchases in foreign jurisdictions, would be ignored by the tax authority, i.e. they could not be written off like domestic costs. As the "rebate" in the Diagram shows, the BAT is effectively a tax on imports and subsidy to exports. This is not as egregiously protectionist as it sounds at first, because it is very similar to a Value-Added Tax (VAT), which is the dominant tax system across the world. The U.S. is a massive outlier for not having a VAT. But notice that the amount of the rebate to the exporting company in the diagram is higher (at $40) than the amount of tax that would be due if it paid a tax on its foreign profits, since ($200 - $100) x 20% = $20. The WTO may rule against the law if it believes major U.S. exporters will pay net negative taxes as a result of the rebate. Moreover, the BAT has certain differences from a VAT that ensure that the world will see it as a protectionist affront. The BAT is a combination of a VAT, which is a tax on consumption, and an income tax, which is the current system. However, the BAT would allow companies to write off wages and salaries as costs, just like under the current system. Under VAT systems, this is not possible because wages are not consumption and therefore not deductible.8 If the GOP proposal becomes law without addressing this difference - that is, without denying corporates the wage deduction, or taxing them in some other way to compensate - it will likely prompt global trade retaliation. While the World Trade Organization may deem the BAT legal by interpreting it as a VAT, it will not do so if U.S. companies cannot show that they are not getting a leg up on their international rivals by retaining the wage deduction from the former corporate income tax code. Wages are obviously a very large part of a company's expenses. They make up about 68-72% of U.S. companies' costs (Chart 7), and have grown at about 2-4% each year for the export-oriented sector (Chart 8). If U.S. companies can write off the wage expense in their exported goods, then foreign countries will have to adjust, possibly by imposing duties to counteract the share of taxes avoided by that write-off. Bottom Line: The BAT is a hybrid of tax systems. It is likely that the WTO and U.S. trading partners will object to it as an import tax and export subsidy, particularly because of the wage deduction. The House GOP could adjust the proposal ahead of time or afterwards to avoid this conflict, but that has not happened yet. In addition, corporate lobbying against removing wage deductions would be severe. Will A BAT Get Passed Into Law? Currently, the House GOP leaders face a rising wave of criticism about the BAT proposal and have begun to signal greater flexibility in drafting the law so as to win over various stakeholders. A salient point to remember about U.S. tax legislation is that it is very rare in recent decades for a ruling party to bungle it. Only eight pieces of tax legislation have been vetoed by presidents since 1975, only two of which were serious bills, and in both cases the president vetoed the legislation pushed by an opposition-controlled Congress (Table 2). By the time a serious tax bill makes it to the president's desk, a veto is unlikely, especially if the president and Congress belong to the same party. Table 2Major Tax Legislation Is Set Up For Success Even more salient, only 23 pieces of tax legislation since 1975 have been struck down in either of the two houses. Of these, seven were attempts to amend the constitution (not likely to pass), nine were attempts to amend the internal revenue code for highly specific things (spirits, cigars, the holding of conventions on cruise ships). Only seven were major bills, and in only one of these cases did the Senate strike down the bill, which was a case of a Republican Senate defending a Republican president from an opposition Congress. In only one case did the ruling party in the House kill a serious tax bill proposed by one of its own members, but it is not comparable to the tax reform in question today.9 What this means is that the BAT is highly likely to be passed into law if the House remains loyal to its leader Paul Ryan, and to the Ways and Means Committee chair Kevin Brady, the two authors of the BAT proposal. However, Trump could derail Ryan's best laid plans. Trump seemed to throw a wrench in the gears when he cast doubt on border adjustment tax, saying that it was too complicated. However, the Trump administration has recently made comments favorable to the BAT. Peter Navarro, chief of the new National Trade Council, highlighted it as a way to bring manufacturing supply chains back into the U.S. (note the protectionist angle of the comment). Meanwhile Sean Spicer, Trump's spokesman, said it would be a good way to make Mexico pay for the infamous wall to be constructed on the border (again, note that the angle is protectionist and populist, not about balancing the budget).10 In each case, the Trump team has gone to pains to emphasize that the BAT is only one option among many. Yet the fact that they have repeatedly brought it up as a solution to their own populist promises is suggestive. We think Trump will ultimately hew to the Republican Party leadership on tax reform.11 Why? Time's a'wastin': Party control of all three branches is a fleeting boon and 2018 mid-term campaigning would make the BAT harder to pass because it could hike the prices of consumer goods. Republicans have a plan ready to go, the House ultimately controls the purse, and Trump wants to move fast on tax cuts and boosting the economy. Furthermore, Republicans remember how short-lived the Democrats' control of Congress was after 2008. Trump wants to be transformative, not merely transactional:12 Trump was elected in a populist revolution and has vowed to improve American manufacturing and trade. His protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT: remove the "tax" on corporate investment to improve U.S. capital stock and productivity, and remove incentives to locate, operate, and stash profits offshore. There is at least some positive correlation between higher VAT rates and positive trade balances, and the law is simultaneously supposed to boost productivity (Charts 9 and 10). Trump needs domestic and international "legitimacy": His protectionist platform will stand on firmer ground if he adopts policy that is at least debatable at the WTO, as opposed to imposing tariffs willy-nilly through bare executive power, which is eventually vulnerable to congressional and judicial oversight. Domestic courts have already shown an inclination to halt Trump's controversial executive orders.13 By contrast, they would almost certainly defer to Congress even on the most radical tax reforms. Trump needs a tradeoff for infrastructure spending: Unpopular presidents cannot set the legislative agenda.14 But Trump may be able to trade GOP-style corporate tax reform - which offsets tax cuts with new revenue provisions, such as the BAT - in return for infrastructure spending, which the GOP is reluctant to embrace. Trump is willing to lead a crusade against the WTO: This may be a necessary prerequisite for the passage of this bill, and Trump is heaven-sent to play the role. He would be to the WTO what George W. Bush was to the United Nations. It would be disastrous for the U.S.-built international liberal order, but it would give Trump the ability to pursue protectionism while rallying the public around the flag against America's "globalist" enemies. (Sovereignty over taxation is a cause that is hard to beat in the U.S.)15 BAT allows Trump to save face on the "Wall" with Mexico: As the White House spokesman hinted, Trump may use creative accounting to satisfy his promise that Mexico would pay for the wall. Moreover, if Trump comes out in support of the BAT, it will likely get passed: Precedent: President John F. Kennedy's and Jimmy Carter's efforts at tax reform failed because Congress was not supportive, which is not a problem today; whereas Ronald Reagan's personal support for the 1986 tax reform - despite his reservations about the attempt to transform the system and broaden the base - proved critical in helping the bill move through Congress.16 Political science: The political context is a better determinant of presidential success than individual talents, and rising political polarization in the U.S. has created an environment in which "majority presidents," those whose party has a majority in Congress, are even more likely to be successful, while "minority presidents" are more likely to fail on key initiatives. The relevant factors of political context are the party's grip on Congress, the extent of polarization, and, somewhat less significantly, whether the president is in his "honeymoon period" and enjoys public support.17 Of these factors, Trump is only weak on public support, though not among conservatives (Chart 11), who could vote their representatives out of office if they defy Trump on tax reform. The Senate could still cause a serious hang-up. But if Trump and the House GOP stand behind the legislation then Senate Republicans would have to be suicidal to oppose it.18 What about the corporate lobbies that oppose the BAT? Certainly it is highly controversial at home. The tax could hurt import-heavy U.S. businesses and punish citizens with a high propensity to consume - i.e. the poor and elderly, both constituents that make up an important part of Trump's base. But that suggests that there will be carve-outs or phased implementation for key imports like food, fuel, and clothing. Such compromises will be messy, and will mitigate any dollar appreciation and reduce the tax revenues to be gained, but would probably enable the bill to get passed. The opposition of retailers like Wal-Mart and Target is overrated in terms of their power as a lobby. Importers form a slightly larger lobby than exporters, which makes sense given that the U.S. is a net importing economy, but neither of them comprises a large share of total lobbying (Chart 12). The sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart 13). The opposition of the Koch brothers is also overrated, given their unhelpful attitude toward Trump's candidacy for president! Bottom Line: The BAT is a radical plan to spur corporate investment and production in the United States, and that goal matches Trump's vision. Trump will be hard pressed to find a more effective, structural way of achieving his goals. And the two-year window with assured GOP control of government will close faster than one might think. Risks To The View A major risk to the BAT is that Trump will fear the repercussions on his political base of higher consumer prices, as hinted above. Consumer pain is a necessary consequence of his mercantilist vision of rebalancing the U.S. from consumption to investment and bringing down the U.S. trade deficit, so Trump will have to decide whether he means what he says. Moreover, if the dollar rises sharply as a result of the BAT, as expected, it would cause pain for the economy and S&P 500 companies, which source 44% of earnings outside the U.S. According to BCA's Global Investment Strategy, the impact of a much stronger dollar on U.S. assets denominated in foreign currencies could amount to a loss worth of 13% of U.S. GDP! (Not to mention Trump's personal wealth from overseas.) Given the huge uncertainties of a totally new tax system, and potential disruption to the economy, it would be perfectly understandable if Trump refused to hitch his fate as president to this wonkish grand experiment. Further, it is not as if there is no alternative to the BAT. Since Republicans will be humiliated if they fail to deliver on tax cuts, Trump's opposition to the BAT would force the House GOP to go back to good ol' fashioned tax cuts without significant revenue raising measures, and specific add-ons to deal with concerns like corporate inversions. Trump would still likely get the repatriation of overseas earnings, a political win, and the economy would experience an increase in investment from tax rate cuts without the uncertain consequences of deeper change. Ronald Reagan's administration offers a precedent for this sequencing, since he began his term with simple tax cuts in 1981 and only later attempted the dramatic tax overhaul of 1986. There is also a risk that the business lobby against the BAT proves stronger than expected and gains traction in the media and popular opinion as a result of the feared consequences on consumer prices. Tax reform is never going to be easy and will always hang in a precarious balance. These are serious risks, but we think Trump and the GOP will move now rather than make any assumptions about their ability to win subsequent elections and enact massive tax reform. The fact that the GOP controls all three branches of government, the BAT plan is well in the making, and Trump is looking to reshape the American economy in ways that align with the BAT, make the odds of passage higher than 50%. Unfortunately, this also means the world should brace for a sharp spike in trade disputes. Bottom Line: There are plenty of reasons to think the BAT plan could collapse of its own weight. The path of least resistance is certainly not the BAT. But we think the preponderance of power in GOP hands in Washington favors radical change, even if it ends up being a policy mistake. Investment Implications: Trade War The WTO is supposed to presume innocence with a country's laws, and it might also approve the BAT on the basis that proponents argue: the U.S. imposing the BAT is not much different from a VAT country increasing its VAT rate while simultaneously slashing the payroll tax (as France has done under President Hollande's administration). This view is misguided. The WTO will rule on the statute and international trade treaties, not the special pleading of the advocates. It may or may not accept that the BAT is equivalent to a VAT; it may or may not object to the wage deduction as a holdover from the "direct" tax on income. The GOP has not yet introduced a draft law, but given the express intention - in the Ryan plan, not even to mention Trump - to put "America first" with a "pro-America approach for global competitiveness," it seems likely that a clash of interests is in the making. In other words, American proponents of the tax are not even hiding its overt protectionist intentions. The WTO will probably discover a subsidy for U.S. exporters and a violation of the principle of trade neutrality with respect to imports. WTO litigation will take years. When the European Union sued the U.S. over its use of Foreign Sales Corporations, a comparable dispute, the proceedings began in 1999 and the WTO ruled against the U.S. in 2002. Ultimately, the U.S. Congress amended the law to avoid retaliation in 2004.19 Trump and the GOP would be less likely to amend their pet project in the current environment, especially if the litigant is the EU at the WTO! Trump, as mentioned, would be inclined to take the fight to the WTO - he has even threatened to withdraw the United States from it. His support group feeds on conflict with supra-national bodies and he may see foreign retaliation as a convenient reason to impose tariffs of his own. The trade environment would deteriorate in the meantime. In 2002, it was assumed that the U.S. and EU could work out an agreement without punitive measures, but that assumption does not hold today. And it would not only be the EU leveling complaints. In short, the U.S. would face foreign retaliation, during the proceedings and likely as a consequence of the WTO ruling. The Trump administration would attempt to mitigate the blowback through a series of bilateral deals, and perhaps the U.S. law would ultimately be modified, but the entire saga would have a negative impact on global trade. Financial markets had many factors to contend with during this period (like the dot-com bubble), and they will similarly respond to large currents in the coming years aside from any BAT. Nevertheless, the tax would reinforce our themes of global multipolarity, mercantilism, and protectionism - and thus reinforce several of our existing trades: We continue to favor small caps over large caps. Small caps are insulated from global trade, will benefit most from the cut in tax rates, and will suffer least from any appreciation of the dollar. Long volatility - Long VIX 20-25 call spread for expiration in March; Long USD versus short EM currencies; Short China-exposed S&P stocks; Short German exporters versus long consumer services. If Trump comes out in opposition to the BAT, he would send a bullish signal for markets in the short term. It would mean, first, that the U.S. will have corporate tax cuts without the broader uncertainties of the BAT; and second, that Trump is actually a pragmatist who eschews radical change if he thinks it will cause too much trouble for U.S. consumers or economic growth. However, it would not necessarily mean that the U.S. would avoid a trade conflict, given Trump's executive powers.20 Of course, the BAT's failure - which is not our baseline - would also be worse for the deficit and debt, as the GOP tax cuts would have no offsetting revenue increases but would rely purely on creative accounting, "dynamic scoring," to appear fiscally acceptable. This legislation would also likely fail to simplify the tax code as much as the BAT would. Matt Gertken, Associate Editor mattg@bcaresearch.com 3 Please see BCA Geopolitical Strategy, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 4 Please see Alan J. Auerbach, "A Modern Corporate Tax," Center for American Progress, dated December 2010, available at www.americanprogress.org. 5 Please see President's Advisory Panel on Federal Tax Reform, "Final Report," dated November 1, 2005, available at govinfo.library.unt.edu. 6 Please see "A Better Way: Our Vision For A Confident America: Tax," dated June 24, 2016, available at abetterway.speaker.gov. 7 Our colleagues at BCA's Global Investment Strategy have recently provided a very helpful Q&A on the border adjustment tax (BAT), and we would refer readers to that report for a detailed discussion. Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 8 Please see Reuven S. Avi-Yonah, "Back To 1913?: The Ryan Blueprint And Its Problems," Tax Notes 153: 11 (2016), 1367-47, reprinted by University of Michigan, available at www.repository.law.umich.edu. 9 Amo Houghton, a liberal-leaning Republican from New York, proposed the Taxpayer Protection and IRS Accountability Act of 2002, a bill to streamline IRS administration. It failed in the Republican Congress under President Bush. 10 Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017, available at www.ft.com, and Bob Bryan, "Trump press secretary says the administration is considering a 20% border tax on Mexican imports to help pay for the wall," Business Insider, January 26, 2017, available at www.businessinsider.com. National Economic Council Director Gary Cohn has also indicated that the BAT is an option but not yet decided upon, see CNBC, "Squawk on the Street," February 3, 2017, available at www.cnbc.com. 11 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 13 The U.S. Ninth Circuit Court of Appeals has already issued a temporary injunction against President Trump's executive orders on immigration. Please see "State of Washington & State of Minnesota v. Trump," available at www.ca9.uscourts.gov. 14 Please see John Lovett, Shaun Bevan, and Frank R. Baumgartner, "Popular Presidents Can Affect Congressional Attention, For A Little While," Policy Studies Journal 43: 1 (2015), 22-44, available at www.unc.edu. 15 Please see BCA Geopolitical Strategy Weekly Reports, "The Trump Doctrine," dated February 1, 2017, and "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 16 Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 17 Jeffrey E. Cohen, Jon R. Bond, and Richard Fleisher, "Placing Presidential-Congressional Relations In Context: A Comparison Of Barack Obama And His Predecessors," Polity 45:1 (2013), 105-126. 18 The Senate Financial Services Committee's support will be critical. Chairman Orrin Hatch has criticized but not yet declared against the BAT. Even if he does, it would not necessarily kill the deal. One of his predecessors, Senator Bob Packwood, initially opposed the Tax Reform Act in 1986 but was ultimately persuaded to support it. If Hatch and the Finance Committee support the initiative, it will pass the Senate. First, the tax overhaul can be accomplished by "reconciliation," a congressional trick that will enable the GOP to avoid a Senate filibuster and pass the tax reform with a simple majority. Second, the Republicans today have almost exactly the proportion of seats in the Senate as the average in previous examples of successful tax reform (see Table 1). So there would have to be a higher share of Republican defectors than in the past to overturn the bill. This is possible but unlikely if Trump and the House GOP are behind the bill. 19 Please see Congressional Research Service, "A History of the Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit Controversy," dated September 22, 2006, available at digital.library.unt.edu. 20 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com.

Highlights The global economy has turned the cap and is on a sustainable uptrend. Yet, the AUD and CAD have over-discounted the improvements and are at risk of suffering a disappointment if global manufacturing activity remains firm but does not accelerate much. Moreover, the Australian and Canadian domestic economies remain too weak to justify rates moving in line with the Fed. Rate differentials will continue to weigh on both currencies. While the CAD is cheaper than the AUD and warrants an overweight position versus the Aussie, we are adding it to our short commodity currency basket trade. The ECB will not ease further, but it will not tighten this year either. Feature Since their February highs, the Australian and Canadian dollars have declined by 2.7% and 3.6% respectively. In May 2016, we wrote that commodity currencies could continue to perform well, but that ultimately, this strong performance would only prove transitory and that the AUD and the CAD would once again resume their downtrends.1 Is this recent weakness the beginning of a more pronounced selloff? We believe the answer is yes. How Great Is The Global Backdrop? Much ink has been spilled regarding the improvement in the global industrial sector. Global PMIs have perked up the world over, semi-conductor prices have been booming, metal prices have been on a tear, and Chinese excavator sales have been growing at a 150% annual rate (Chart I-1). It would seem that the world economy is out of the woods. This is true, but asset markets are not backward looking, they are forward looking. The improvement in global economic conditions that we have witnessed has driven the impressive rally in stocks, EM assets, commodity, and commodity currencies in 2016. But what matters for future asset markets' performance, and especially growth sensitive currencies like the AUD and the CAD, is future global growth. Where do we stand on that front? We do not expect an economic relapse like in 2015 and early 2016. Some key elements have changed in the global economy, suggesting it is not as hampered by deflationary forces as it once was: DM industrial capacity utilization has improved (Chart I-2). Also our U.S. composite capacity utilization indicator that incorporates both the manufacturing and service sectors has now moved into "no slack" territory. This suggests that deflationary forces that have so negatively affected the DM economy in 2015 and 2016 are becoming tamer. Chart I-1Signs Of An Economic Rebound Chart I-2Improving Global Capacity Utilization Commodity markets are much more balanced than in 2015-2016. Not only has excess capacity in the Chinese steel and coal sector been drained, but the oil market has moved from being defined by excess supply to a surplus of demand (Chart I-3). This suggests that commodities are unlikely to be the same deflationary anchors they were in the past two years. The global contraction in profits is over. Profits are a nominal concept, and in 2015 and 2016, U.S. nominal growth hovered around 2.5%, in line with the levels registered in the 1980, 1990, and 2001 recessions (Chart I-4). As a residual claim on corporate revenues, profits display elevated operating leverage. Thus, nominal GDP growth moving from 2.5% to 4% on the back of lessened deflationary forces will continue to support profits. Chart I-3Oil: From Excess Supply To Excess Demand Chart I-4Last Year Was A Nominal Recession This also means that the rise in capex intentions that began to materialize last summer is likely to genuinely support capex growth and the overall business cycle in the coming quarters, especially in the U.S. (Chart I-5). Additionally, the inventory cycle that has weighed on EM and DM economies is now over (Chart I-6). While growth is likely to be fine based on these factors, for the AUD and CAD to move higher, growth needs to accelerate further. The problem is that based on our Nowcast for global manufacturing activity, things are as good as they get now (Chart I-7). Chart I-5Improving DM ##br##Capex Outlook Chart I-6Inventories: From ##br##Drag To Boost Chart I-7If Global Industrial Activity Doesn't ##br##Improve, CAD and AUD Are Toast In China, which stands at the crux of the global manufacturing cycle, we see the following factors hampering further improvements: The Chinese fiscal impulse has rolled over. Fiscal stimulus does impact the economy with some lags. The peak in the Chinese boost was reached in November 2015, with government expenditures growing at a 24% annual rate, but today, they are growing at a 4% rate. The deleterious effect on growth of this tightening may soon be felt. Chinese liquidity conditions have deteriorated. Interbank borrowing rates are already rising (Chart I-8), and the PBoC has drained an additional RMB 90 billion out of the banking system this week alone. These dynamics could be aimed at cooling down the real estate bubble in the country. Falling activity in that sector would represent a significant drag on the industrial and commodity sectors globally. Chart I-8Tightening Chinese Liquidity Conditions Chart I-9The NZD Weakness Should Be A Bad Omen The fall in Chinese real rates may have reached its paroxysm in February. Commodity price inflation may have hit its peak last month, suggesting the same for Chinese producer prices. A slowing PPI inflation will raise real borrowing costs in that economy and further tighten monetary conditions. Corroborating these risks, Kiwi equities, a traditional bellwether of global growth continue to buckle down. In fact, the New Zealand dollar is offering the same insight. Being the G10 currency most sensitive to the combined effect of wider EM borrowing spreads and commodity prices, its recent fall may presage some problems in these spaces (Chart I-9). To be clear, we are not expecting a wholesale collapse in growth. Far from it, but an absence of acceleration or a mild deceleration, could have troubling effects on commodities. The case of oil this week is very telling. Inventories have been going up, but the frailty of the oil market was mostly a reflection of the extraordinary bullish positioning of investors (Chart I-10, left panel). The same is true for copper, investors are very long and thus, vulnerable to mild growth disappointments (Chart I-10, right panel). Chart I-10AInvestors Are Bullish Industrial Commodities Chart I-10BInvestors Are Bullish Industrial Commodities Oil is not the only commodity experiencing a large accumulation in inventories. China, the key consumer of metals, is now overloaded with large inventories of both iron ore and copper (Chart I-11). This combination of high bullishness and rising inventories represents a risk for metals, especially if the positive growth impulse in China slows somewhat from here. Chart I-11China Has ##br##Hoarded Metals Chart I-12Can Growth And Reflation Surprises Increase##br## As Policy Becomes Less Easy? Adding to these risks is the Fed. The Fed is on the path to increase rates a bit more aggressively than was recently anticipated by markets. U.S. real rates are responding in kind, and key gauges like junk bonds, gold, or silver are also highlighting that global liquidity conditions may begin to deteriorate at the margin. While this tightening is not a catastrophe, it is still happening in an environment of elevated global leverage and potentially decelerating growth. This is not the death knell for risk assets, but it does represent a risk for the asset classes that are not pricing in any potential rollover in the elevated level of global surprises and reflation (Chart I-12). Commodity currencies are not ready for this reality. To begin with, positioning on the key commodity currencies has rebounded substantially, and risk reversals on these currencies as well as EM currencies are at levels indicative of maximum bullishness amongst investors. Also, the Australian dollar is expensive relative to its fundamentals, including the terms of trade. This makes the Aussie very vulnerable to small shocks to metal or coal prices (Chart 13, left panel). The CAD is not as pricey as the AUD, but nonetheless, it has lost its previous valuation cushion (Chart I-13, right panel). It also faces its own set of risks. Chart I-13ANo Valuation Cushion In CAD And AUD Chart I-13BNo Valuation Cushion In CAD And AUD This set of circumstance highlights that the room for disappointment in these currencies is now large. Bottom Line: While 2016 was a dream come true for investors in commodity currencies, 2017 may prove to be a tougher environment. Global growth is not about to plunge, but for commodity currencies to rally more, global manufacturing activity needs to accelerate further. Here the hurdle is harder to beat. Not only is the Chinese reflationary impulse slowing exactly as the global manufacturing sector hits exceptional levels of strength, but the Fed is also marginally tightening its stance. This means that expensive currencies like the BRL and AUD, as well as the cheaper but still vulnerable CAD could suffer some downside if industrial growth temporarily flattens, an event we judge more likely than not. Domestic Considerations Chart I-14We Build Houses In Canada When it comes to the AUD and the CAD, global risk is skewed to the downside, but what about domestic considerations? Here again, signs are not as great as one might hope. When it comes to Canada, the capacity to withstand higher rates is limited. The elephant in the room is the risk posed by the U.S. border adjustment tax. BCA thinks that this tax could be implemented in a diluted form, one were apparels, food, energy, etc. are exempt from the deal. However, the industries representing the American "rust-belt" are likely to be fully covered. This means that machinery and cars in particular could be the key targets of the BAT. This is a huge problem for Canada. Take the car industry as an example. Canada exports C$80 billion in vehicles and parts to the U.S., or 15% of its merchandise exports, nearly 4% of GDP. The potential hit from this tax on the country could be large. Also, the Canadian economy is even more levered to house prices that the Australian one. As Chart I-14 illustrates, the share of residential investment in Canada is much higher than in Australia, despite the slower growth of the population in Canada than in the Australia. Additionally, Canadian consumption is much more geared to housing than in Australia. Canadian households are experiencing slower nominal and real wage gains than their Australian counterparts. Yet their consumption per head growth is similar to that of Australia, and their confidence is substantially higher, reflecting a stronger wealth effect in Canada than in Australia (Chart I-15). Furthermore, despite the rebound in commodity prices and profits in 2016, Canadian and Australian credit growth have been slowing sharply (Chart 16, top two panels); however, Canada suffers from a higher level of debt service payment than Australia, despite the fact that the Canadian household debt to disposable income is 170% versus 185% in Australia (Chart I-16, bottom panel). These factors amplify the negative potential of higher interest rates in Canada relative to Australia. But Australia also suffers from its own ills. Total hours worked continue to deteriorate in that country and job growth is even more heavily geared to the part-time sector than in Canada. Additionally, while Canada will benefit from a small amount of fiscal expansion in the coming years, Australia is tabled to experience a large degree of fiscal austerity (Chart I-17). In this context, it will be difficult for the Australian labor market to outperform that of Canada. Chart I-15Canadian Households Are ##br##More Levered To Housing Chart I-16Slowing Credit Growth In ##br##Canada And Australia Finally, while the Canadian core CPI is elevated at 2.1%, this largely reflects pass-through from the previous collapse in the CAD, and this is expected to dissipate as wage growth remains tepid at 1.2%. But the Australian situation is even more troubling. Australia has been incapable of generating much inflation, and the fall in hours worked suggests that the labor market may be easing, not tightening. With the 10% increase in the AUD from its trough in 2016, inflation is unlikely to rise enough to prompt the RBA to become much more hawkish in the coming months. Thus, we think that both Canadian and Australian rates will continue to lag U.S. ones, putting more downward pressures on the CAD and the AUD versus the USD, despite the recent improvement in trade balances in both nations. (Chart I-18). Moreover, even if the decline in Australian interest rate differentials relative to the U.S. were to be less pronounced than in Canada, the AUD is much more misaligned with differentials than the CAD, adding to the Aussie's vulnerability. Chart I-17Fiscal Policy: Canada Eases, ##br##Australia Tightens Chart I-18Rate Differentials Will Continue##br## To Help The USD Bottom Line: Domestic conditions remains challenging for Australia and Canada. In both nations, debt service payments are already elevated, suggesting it will be hard for the central bank to increase rates without prompting accidents. While Australia seems less geared to the housing sector than Canada, its labor market dynamics are poorer, it faces a more austere fiscal policy, and it has trouble generating any inflation. We expect rate differentials to continue to move against both the CAD and the AUD versus the USD. Investment Conclusions At this point, the CAD and AUD are essentially entering an ugly contest. For both of these currencies, the global backdrop could prove to be more difficult in 2017 than in 2016. Moreover, both these currencies are handicapped by fundamental domestic issues that will further prevent rates to rise vis-à-vis the U.S. As such, we are now adding the CAD to our short commodity currency basket trade against the USD. AUD/USD may move toward 0.65-0.60 and USD/CAD may rally toward 1.40-1.45. Comparatively, both the AUD and CAD suffer from different but equally important handicaps. The only thing that would put the CAD at the nicer end of the ugly contest are its valuations. Our PPP model augmented for productivity differentials continues to show that the CAD is cheap against the AUD, corroborating the message of our long-term fair value models (Chart I-19). Also, as we highlighted above, CAD is more in line with its IRP-implied fair value than the AUD. We therefore recommend investors overweight the CAD vis-à-vis the AUD. A Few Words On The ECB Yesterday, Draghi struck a cautious tone in Frankfurt. While he acknowledged that deflationary risks in the euro area have decreased relative to where they stood last year, the governing council still thinks downside risks, even if of a foreign origin, slightly overshadow upside risks to its forecast. While the ECB feels that there is less of a need to implement additional support to the economy in the future, it judges the current accommodative setting to still be warranted. We agree. It is true that headline inflation in Europe has moved to 2%, but core inflation, which strips the very important base effect in energy prices that has lifted HICP, remains flat at low levels. Moreover, wage growth in the euro area remains tepid, confirming the lack of persistent domestic inflationary pressures in Europe (Chart I-20). Thus, the ECB elected to maintain asset purchases to the end of December at EUR60 billion per months. Rates are also unlikely to rise until after the end of the purchase program. In this environment, while the trade-weighted euro may move higher, the cyclical outlook continue to be negative for EUR/USD as monetary policy divergences between the U.S. and Europe will grow as time passes. On a 3-month basis, if we are correct that global growth may not accelerate further, the potential for a correction in EM and commodity plays could provide a temporary fillip to the euro. As markets currently priced in less rate hikes from the ECB than the Fed, the scope for pricing out the anticipated rate hikes is lower in Europe than in the U.S. if risk assets experience a correction within a bull market. This means that DXY may weaken or stay flat even if the trade-weighted dollar rises during that time frame. Chart I-19AUD / CAD Is Expensive Chart I-20The ECB's Dilemma Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Pyrrhic Victories" dated April 29, 2016 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy continues to show resilience with the ADP employment change crushing expectations by 108,000. Although the USD did not react proportionately to this specific news, this is only a firmer signal of the confirmation for a rate hike next week. With the market pricing in almost a 100% probability of a hike, the Fed is unlikely to disappoint. What matters now is the messaging around the hike. In this regard, Trump's aggressive fiscal stance and the economy's consistent resilience is making a good case for the Fed to remain supportive of its forecasts. On a technical basis, the MACD line for the DXY is above the signal line, while also being in positive territory. Momentum is therefore pointing to a strong upward trend for the dollar in the short term. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB left its policy rates and asset purchase program unchanged. Although President Draghi acknowledged the euro area's resilience as risks have become "less pronounced", he also noted that risks still "remain tilted to the downside". In the press release, the Governing Council continued to highlight that they continue to expect "the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases". The message is therefore mixed. Growth is expected to remain resilient in the euro area, but significant domestic slack and global factors have forced the ECB to remain cautious. Cyclical risks to the euro are more to the downside than to the upside in the current environment. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: Machine tool orders yearly growth came in at 9.1%, the highest level since the third quarter of 2015. Labor cash earnings yearly growth came above expectations at 0.5%. However GDP growth was disappointing, coming in at 1.2% against expectations of 1.6%. We continue to be bearish on the yen on a cyclical basis. Although there has been some improvement, economic data has still been too tepid for the Bank of Japan to even consider rolling back some of its most radical policies. After all, the BoJ has established that they now have a price level target instead of an inflation target, which means that inflation would have to overshoot 2% for a significant period of time in order to switch from their easing bias. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 After the vote in the House of Lords, Theresa May has been dealt yet another blow to her Brexit hopes as the upper house of the U.K. voted for giving parliament veto power over the final exit deal of Britain from the European Union. This news have been positive for the pound at the margin, as the perception of softer Brexit increases. The prime minister will now appeal this decision to the House of Commons. If she is defeated here, the pound could rally significantly. On the economic side, recent data has been disappointing: Market Services PMI not only went down from the previous month but also underperformed expectations, coming in at 53.3. Halifax house prices yearly growth came in at 5.1%, underperforming expectations. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As expected, the RBA left its cash rate unchanged at 1.5%. The currency was little changed from this announcement. However, following last week's depreciation, the AUD followed through with further depreciation on Wednesday due to a strengthening greenback. This affected the AUD twofold: the appreciating dollar added pressure on the AUD, and on commodity prices which further exacerbated the AUD's decline - copper prices are down more than 4% and iron ore futures are down almost 3%. Risks are to the downside for the AUD: declining copper and iron ore prices foretell that the AUD's decline may continue; China's regulation on coal imports and energy production will further damage Australia's export market. On a shorter-term basis, the MACD line is below the signal line and indicates negative momentum. Additionally, the MACD line has breached negative territory, adding further downward momentum. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi continues to fall, and has now lost all of the gains from earlier this year. The outlook for the NZD against other commodity currencies is puzzling: on the one hand the NZD is very sensitive to emerging market spreads, which means that it would be the primary victim of the dollar bull market, as a rising dollar drains liquidity from EM and hurts fixed income instruments in these countries. On the other hand, domestic factors provide a tailwind for the NZD as strong inflationary pressures are emerging in the kiwi economy and New Zealand continues to be the star performer amongst its commodity peers. Overall, we are inclined to be tactically more bullish on the NZD against the AUD, as the NZD/USD has reached oversold levels, while AUD/USD has been firmer amidst the rally in the U.S. dollar. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Following up from last week's depreciation is an even weaker CAD this week. USD/CAD appreciated greatly amidst a large decline in oil prices after crude oil stocks increased by around 7 mn bbl more than the previous change and the consensus amount. This trend is likely to continue as rig counts continue to increase. A rising USD is likely to exacerbate the decline in the CAD as it will continue to weigh on oil prices. We have previously noted that the CAD will stay very affected by U.S. trade relations and rate differentials. This trend is likely to continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been encouraging: Unemployment continues to be very low at 3.3%. Headline inflation came in at 0.5%. At this level inflation now stands at its highest since 2011. Although these developments are positive, the SNB will continue to aggressively intervene in the currency and prevent further appreciation. The SNB has been keen on keeping their unofficial floor of 1.065 in EUR/CHF, even on the face of risk-off flows coming into Switzerland due to the European election cycle. In fact, the SNB reserves surged at the highest pace since December 2014, which indicates that the central bank has been having its hands full. For now the SNB will continue with this policy, however, we will continue to monitor Swiss data to assess whether a change in policy by the SNB is possible. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK rallied sharply following the 5% plunge in oil prices, as the rise in inventories came at almost 7 million barrels above expectations. The risk profile for the NOK is the opposite of the NZD. External factors should help the Norwegian economy vis-à-vis other commodity currencies, as oil should outperform industrial metals given that it has a lower beta to China and Emerging markets. On the other hand, the domestic situation has deteriorated. Nominal GDP is contracting, the output gap stands around -2% of potential GDP, and the credit impulse continues to be negative. Meanwhile, inflation is starting to recede, as the effect of the depreciation of the NOK on 2015 is dissipating. All of these factors should support a dovish bias from the Norges Bank, hurting the NOK going forward. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The krona will resume its cyclical downward trend as the USD continues to climb, being one of the currencies with the highest betas to the dollar. Our bullish case for the krona is weakened by the Riksbank's extremely cautious tone which, so to speak, stopped the krona in its tracks. EUR/SEK stopped its depreciation abruptly in the beginning of February and has since appreciated. Momentum, however, does seem to be slowing down for this cross as the Swedish economy remains inherently resilient. As a large proportion of Sweden's exports to the euro area are re-exported to EM, additional risks may emanate from China as any potential slowdown in the world's second largest economy could provide a risk to Sweden's industrial sector. This could add deflationary pressures to the economy, which can solidify the Riksbank's dovish stance even further. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global manufacturing inventories are low but this does not guarantee higher share prices for global cyclical stocks. If an increase in inventories is accompanied by strengthening final demand, it will be very bullish for the global business cycle. If final demand growth falters, global cyclical plays will relapse amid rising inventories. China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out raising the odds of a reversal in EM/China plays sooner than later. The risk/reward of EM/China plays remains unattractive. Feature Global Manufacturing Inventories Global manufacturing inventories have been depleted over the past 12 months, and inventory levels are generally low (Chart I-1 and Chart I-2). Chart I-1Global Manufacturing Inventories Are Low Chart I-2Global Manufacturing Inventories Are Low Could inventory re-stocking extend the current manufacturing cycle recovery worldwide? Will low inventories and re-stocking in China lengthen the nation's business cycle upswing? Chart I-3 demonstrates inventory cycles and manufacturing production within manufacturing-intensive economies. The correlation is not stable. Currently, this entails that low manufacturing inventories and a potential rise in inventories over the course of this year do not guarantee acceleration in industrial output growth. Having reviewed manufacturing inventory cycles and their correlation with share prices, we conclude that the key to share prices is final demand - not inventory swings. Manufacturing inventories have dropped in the past 12 months because final demand has been robust (Chart I-4). Historically, periods of re-stocking have often coincided with poor equity market performance. Indeed, Taiwanese, Korean, Japanese and German non-financial share prices have no stable correlation with their respective manufacturing inventory cycles (Chart I-5). In short, manufacturing inventories could rise in the months ahead, but this does not guarantee higher share prices in cyclical industries. Chart I-3Inventories And Production ##br##Are Not Always Correlated Chart I-4Robust Demand Has Led ##br##To Inventory Depletion Chart I-5Non-Financial Share Prices And##br## Inventories: Little Correlation By and large, the outlook for corporate profits is contingent on final demand rather than re-stocking. All of the above confirms that inventories are a residual of demand and supply. Stronger-than-expected demand is bullish for share prices, though it also often coincides with declining inventories. By contrast, rising inventories typically reflect demand falling behind output growth (one can define it as involuntary re-stocking) and these periods are not favorable for share price gains in cyclical industries. One caveat is that there could be a re-stocking cycle amid strengthening demand or, in other words, voluntary re-stocking. If this transpires in the coming months, it will be extremely bullish for share prices as it will supercharge output growth. While the latter scenario - inventory re-stocking amid strengthening final demand - could very well occur within the advanced economies this year, odds of such positive dynamics are low in EM/China. Bottom Line: Share prices in global cyclical sectors are driven by swings in final demand - not in inventories. Going forward, global manufacturing inventories will rise. If this rise is accompanied by strengthening demand, it will be very bullish for the global business cycle. Otherwise, global cyclical plays will relapse as inventories rise. What Drives China's Inventory Cycles Chart I-6 shows that China's manufacturing inventories typically deplete when the credit and fiscal impulse is rising, and vice versa. China's manufacturing inventories have been exhausted because demand has been strong in the past 12 months. In turn, demand strength has originated from the country's massive fiscal and credit stimulus push from the first half of 2016. Chart I-6China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction That said, China's aggregate fiscal and credit impulse seems to have recently rolled over, pointing to a top in its manufacturing mini-cycle and commodities prices (Chart I-7). This signals a potential deceleration in final demand. On the whole, the ongoing modest tightening by the People's Bank of China and by the bank regulator (the China Banking Regulatory Commission) amid a lingering credit bubble is raising the odds of a moderate credit slowdown in the months ahead. Even modest credit growth deceleration will result in a negative credit impulse (Chart I-8, top panel). Meanwhile, the mainland's fiscal impulse has already dropped (Chart I-8, bottom panel). Chart I-7China: Aggregate Credit And Fiscal##br## Stimulus Has Topped Out Chart I-8China: A Breakdown Of Credit ##br##And Fiscal Impulses On the whole, these developments are leading us to maintain our negative bias toward EM risk assets and China plays. What has gone wrong in our view/analysis on China in the past 12 months is that the nation's credit growth has stayed much stronger than we expected. In our April 13, 2016 report,1 we did a scenario analysis and argued that China's large fiscal stimulus push would be offset by a negative credit impulse if credit growth slowed from 11.5% to below 10%. In reality, credit growth has been between 11.5-12.5%, producing a positive credit impulse. Barring tightening by the central bank or bank regulators, mainland banks can continue originating loans/money at a double-digit pace, as they have been doing for many years (Chart I-9). In general, commercial banks do not need savings to create money/loans and there are few limits on Chinese banks originating loans "out of thin air," as we argued in our Trilogy of Special Reports on money/loan creation, savings and investment.2 Chart I-9China's Credit/Money Growth##br## Remains Rampant Therefore, if credit growth does not slow, our negative view on China's growth will be off-the-mark again. The pressure point in such a case will be the exchange rate. Unlimited money creation/oversupply of local currency is bearish for the value of the RMB. The RMB will continue depreciating, but it is not certain if it will hurt EM risk assets. It is a major consensus view nowadays that the Chinese authorities will not allow growth to suffer ahead of the Party Congress in autumn of this year. Yet, the PBoC and bank regulators are modestly tightening to "normalize" credit growth. Some clients may wonder why we are placing so much emphasis on the rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend that unwinds excesses. Similarly, moderate tightening in a healthy credit system should not be feared. From a big picture perspective, we turned bearish on China's growth several years ago due to the formation of a credit bubble. The bubble has only gotten larger and an adjustment has not yet even started. This does not justify altering our fundamental assessment of China's growth outlook. It would have been ideal to turn positive tactically on EM/China plays a year ago. Unfortunately, we did not do that. Presently, chasing the market higher might not be the best investment idea. Based on all this and given: the sharp rally in EM/China plays and widespread investor complacency and consensus that "everything" will be fine before the end of this year; modest tightening in Chinese monetary policy amid lingering credit and asset (property and the corporate bond market) bubbles; our outlook for higher U.S. bond yields and a stronger U.S. dollar; the fact that financial markets are forward looking, and timing is impossible; We believe the risk/reward of EM/China plays remains unattractive. In regard to EM ex-China, as we documented in last week's report, domestic demand in the developing economies has not recovered at all, or is mixed at best. DM final demand strength and global manufacturing inventory rebuilding will certainly help Korea and Taiwan, but not other emerging economies. The most important variables for other EM economies including China are domestic demand and/or commodities prices. If commodities prices relapse along with China's credit and fiscal impulse (Chart I-7, bottom panel), EM financial markets will suffer regardless of the growth trends within advanced economies. In fact, strong U.S. growth could lead to higher U.S. interest rate expectations and prop up the U.S. dollar. This will also be a bad omen for EM and commodities. Bottom Line: China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out, raising the odds of a reversal in EM/China plays sooner than later. Industrial Metals Inventories And Prices There is no good data reflecting industrial metals inventories globally. London Metal Exchange and Shanghai Futures Exchange data are likely not indicative of global metals stockpiles. China accounts for close to 50% of global demand for industrial metals, and its demand is critical to prices. Given that the large spike in metals prices in the past several months has coincided with improving Chinese economic data, one would expect the mainland to be the driving force behind the rally. However, Chart I-10 demonstrates that China's imports of industrial metals actually contracted in 2016. This is puzzling, but we have to take it at face value. The top panel of Chart I-11 depicts that traders' net long positions in copper are at a six-year high. This might partially explain the rally in copper in the recent months. Chart I-10China's Import Of Base Metals##br## And Base Metals Prices Chart I-11Traders Are Long ##br##Copper And Oil Clearly, China has been depleting its stock of industrial metals, and is likely primed to increase its imports. Nevertheless, periods of metals re-stocking by the mainland have historically not entailed higher industrial metals prices (Chart I-10). On the contrary, rising Chinese imports of metals have actually coincided with falling prices. One can interpret this relationship as China buying industrial metals when prices are falling. This is consistent with China attempting to buy commodities on dips. As to metals inventories in China, the picture is as follows: Steel inventories have plummeted and are low (Chart I-12). One can safely argue that there will be an inventory re-stocking cycle in China. Nevertheless, it is highly uncertain if this will be bullish for steel prices and steel stocks. In fact, there has been a mild negative correlation between steel prices and inventories; historically, when inventories have risen, prices declined (Chart I-12, top panel). This confirms that inventory levels are a residual of demand and supply, and prices are often driven by final demand - not inventories. This is also corroborated by the bottom panel of Chart I-12, which illustrates that share prices of global steel companies are sometimes negatively correlated with China's steel inventories. Stock prices occasionally sell off when inventories rise, and rally when inventories are shrinking. In contrast to steel and steel products, iron ore inventories have risen, and it seems the re-stocking cycle is well advanced (Chart I-13). Chart I-12China: Steel Inventories And Prices Chart I-13China: Iron Ore Inventories And Prices Yet, again there is no strong correlation between inventories and prices of iron ore (Chart I-13). In our discussions with clients, investors often attribute the rally in industrial metals in general and steel prices in particular over the past 12 months to supply cutbacks in China. While supply reductions have helped in the case of certain metals, it is also evident that the rally in industrial commodities has been driven by rising demand globally and in China. First, China's aggregate credit and fiscal impulse was positive until very recently, implying strengthening demand and thereby higher metals prices. Second, if there were only production cutbacks in steel and other commodities and not demand recovery, the mainland's manufacturing PMI would not have risen (Chart I-14). Finally, steel production has risen both in China and the rest of the world (Chart I-15). Hence, world steel supplies have expanded in the past 12 months. Given this has coincided with rising steel prices, it confirms there has been notable improvement in demand for steel. Chart I-14China: Steel Prices Are Up ##br##Because Of Strong Demand Chart I-15Chinese And Global ##br##Steel Production We are not experts in the ebbs and flows of commodities supplies, but it seems the Chinese government's mandated steel capacity cutbacks have not prevented rising steel output in China. In the meantime, rising prices amid rising production and falling inventories are indicative of robust final demand for many metals. Bottom Line: Industrial metals prices have risen because demand in the real economy and among financial investors has been strong. That said, a rollover in China's fiscal and credit impulse and a strong U.S. dollar will likely create headwinds for industrial metals prices over the course of this year. A Word About Oil Inventories OECD oil product inventories have continued to rise, despite supply cuts (Chart I-16, top panel). At the same time, our proxy for change in China's oil inventories has been very elevated for a while, depicting strategic and/or commercial inventory building on the mainland (Chart I-16, bottom panel). It is true that supply curtailments have been instrumental to the rally in oil prices, but the continued inventory buildup also indicates that supply is still outpacing demand. Besides, traders' net long positions in crude have spiked close to their 2014 highs (Chart I-11, bottom panel). This corroborates that demand for crude, like for copper, has partially been financial rather than from final consumers. Finally, U.S. rig counts have recovered somewhat, which may be indicative of a continued rise in America's oil output (Chart I-17). Chart I-16Oil Inventories Keep On Rising Chart I-17U.S. Rig Counts And Oil Production Bottom Line: While we do not have expertise to follow or forecast oil supply dynamics, we are biased in believing that the risk-reward for oil prices is unattractive because of a strong U.S. dollar and potentially weak EM/China asset prices, which could trigger a reduction in net long positions in crude. Investment Conclusions Complacency reigns in the global financial markets. EM equity volatility has fallen close to its cycle lows, the U.S. VIX is depressed, U.S. equity investor sentiment is very elevated and EM corporate credit spreads have plummeted to a ten-year low (Chart I-18). While the timing of a reversal is impossible, the risk-reward profile of EM financial markets is greatly unattractive. The U.S. trade-weighted dollar has consolidated recently, and might be primed for another upleg. As the U.S. dollar resumes its uptrend, EM risk assets will likely sell off. Finally, EM share prices have failed to outperform the developed bourses much, despite the rally in commodities and amelioration in Chinese growth (Chart I-19). Chart I-18Complacency Reigns Chart I-19EM Equities Have Not Yet Outperformed Remarkably, analysts' net earnings revisions for EM stocks have so far failed to turn positive (Chart I-20). Either analysts' EPS expectations were originally still too high, or companies are failing to deliver profits. Whatever the reason, the implication is that the consensus is more bullish on EM than is suggested by the underlying fundamentals. Within an EM equity portfolio, our overweights remain Taiwan, Korea, India, China, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. We are neutral on other bourses. Finally, the EM equity benchmark is at a critical technical resistance level (Chart I-21) but odds do not favor a sustainable breakout. Chart I-20EM EPS Net Revisions Are Still Negative Chart I-21EM Stocks: A Breakout Attempt Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Revisiting China's Fiscal And Credit Impulses", dated April 13, 2016, available at ems.bcaresearch.com 2 Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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 Chart 2No 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 Chart 4Inflation 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 Chart 6Protectionism 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 Chart 8Manufacturing 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 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 Chart 2U.S. Earnings Growing Again 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 Chart 4Will This Trigger Inflation Pressures? 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 Chart 6Rise 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? 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 Chart 9GDP Impact Of U.S. Fiscal Stimulus Chart 10A Lot of Stimulus, And Extra Debt 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 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? 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 Chart 14An Oversold Bounce Chart 15Policy Tightening = Underperformance 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 Chart 17Growth Picks Up In##br## Most DMs And China 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 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 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 Chart 21Global Equities: No Style Bet 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 Chart 23Inflation Uptrend Intact Chart 24Overweight JGBs 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 Chart 26Still Accommodative Chart 27Expensive Valuations 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 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 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 Chart 31Commodities: A Secular Bear Market Chart 32Structured Products Outperform In Recessions 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 Chart 34Policy Uncertainty Is High 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 Chart 36How Would EM And Commodities Move##br## If USD Weakens? 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