Mexico

Highlights President Trump is as protectionist as Candidate Trump; USD shortage to tighten global financial conditions; Go Long MXN/RMB as a tactical play on U.S.-China trade war; Brexit risks are now overstated; EU will not twist the knife. EUR/GBP is overbought; go short. Feature "We assembled here today are issuing a new decree to be heard in every city, in every foreign capital, and in every hall of power. From this day forward, a new vision will govern our land. From this moment on, it's going to be America First." U.S. President Donald Trump, January 20, 2017, Inaugural Address What are the investment implications of an "America First" world? First, it may be useful to visualize the "America Second" world that President Trump is looking to leave in the rear-view mirror. Chart 1 shows the cost of hegemony. Since the Nixon shock in 1971, the U.S. has seen its trade balance deepen and its military commitments soar, in absolute terms. For President Donald Trump, the return on American investment has been low. Wasteful wars, crumbling infrastructure, decaying factories, stagnant wages, this is what the U.S. has to show for two decades of hegemony. Chart 1United States: The Cost Of Hegemony The "What Can You Do For Me" World? The "What Can You Do For Me" World? On the other hand, the U.S. has enjoyed the exorbitant privilege of its hegemonic position. In at least one major sense, America's allies (and China) are already paying for American hegemony: through their investments in U.S. dollar assets. Chart 2 illustrates this so-called "exorbitant privilege." Despite a deeply negative net international investment position, the U.S. has a positive net investment income.1 Chart 2The "Exorbitant Privilege" The "What Can You Do For Me" World? The "What Can You Do For Me" World? Being the global hegemon effectively lowers U.S. borrowing costs and domestic interest rates, giving U.S. policymakers and consumers an "interest rate they do not deserve." That successive administrations decided to waste this privilege on redrawing the map of the Middle East and giving the wealthiest Americans massive tax cuts, instead of rebuilding Middle America, is hardly the fault of the rest of the world! Foreigners hold U.S. assets because of the size of the economy, the sustainability and deep liquidity of the market, and the perceived stability of its political system. More importantly, they hold U.S. assets because the U.S. acts as both a global defender and a consumer of last resort. If Washington were to raise barriers to its markets and become a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and decide to diversify more rapidly. Investors can interpret Trump's "America First" agenda broadly as an effort to dramatically reduce the U.S. current account deficit. Certainly we see his statements on renegotiating NAFTA, facing off against China on trade, and encouraging U.S. exports with tax legislation as parts of a broad effort aimed at improving the U.S. trade balance. If the U.S. were to pursue these protectionist policies aggressively, the end result would be a massive shortage of U.S. dollars globally, a form of global financial tightening. The rest of the world is not blind to the dangers of an America focused on reducing its current account deficit. According to the reporting of Der Spiegel magazine, Chancellor Angela Merkel sent several delegations to meet with the Trump team starting in 2015! No doubt Berlin was nervous hearing candidate Trump's protectionist talk, given that Germany runs one of the largest trade surpluses with the U.S. (Chart 3). In the last such meeting, taking place after the election was decided, Trump's son-in-law and White House advisor, Jared Kushner, asked the Germans a point-blank question, "What can you do for us?"2 In the 1980s, the U.S. asked West Germany and Japan the same question. The result was the 1985 Plaza Accord that engineered the greenback's depreciation versus the deutschmark and the yen (Chart 4). Recent comments from Donald Trump suggest that he would like to follow a similar script, where dollar depreciation does the heavy lifting in adjusting the country's current account deficit.3 Chart 3Trump's Black List Trump's Black List Trump's Black List Chart 4The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Trump administration may have dusted off the Reagan playbook from the 1980s, but the world is playing a different game in 2017. First, the Soviet Union no longer exists and certainly no longer has more than 70,000 tanks ready to burst through the "Fulda Gap" towards Frankfurt. President Trump will find China, Germany, and Japan less willing to help the U.S. close its current account deficit, particularly if Trump continues his rhetorical assault on everything from European unity to Japanese security to the One China policy. Second, China, not U.S. allies Germany and Japan, has the largest trade surplus with the U.S. It is very difficult to see Beijing agreeing to a coordinated currency appreciation of the RMB, particularly when it is being threatened with a showdown over Taiwan and the South China Sea. Third, even if China wanted to kowtow to the Trump administration, it is not clear that RMB appreciation can be engineered. The country's capital outflows have swelled to a record level of $205 billion (Chart 5) and the PBoC has continued to inject RMB into the banking system via outright lending to banks and open-market operations (Chart 6). Unlike Japan in 1985, China is at the peak of its leveraging cycle and thus unwilling to see its currency - and domestic interest rates - appreciate. At best, Beijing can continue to fight capital outflows and close its capital account. But even this creates a paradox, since the U.S. administration can accuse it of currency manipulation even if such manipulation is preventing, not enabling, currency depreciation!4 Chart 5China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows Chart 6PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity To conclude, the world is (re)entering a mercantilist era and sits at the Apex of Globalization.5 The new White House is almost singularly focused on bringing the U.S. current account deficit down. It intends to do this by means of three primary tools: Protectionism: The Republicans in the House of Representatives have proposed a "destination-based border adjustment tax," which would effectively subsidize exports and tax imports. (It would levy the corporate tax on the difference between domestic revenues and domestic costs, thus giving a rebate to exporters who make revenues abroad while incurring costs domestically.)6 While the proponents of the new tax system argue it is equivalent to the VAT systems in G7 economies, the change would nonetheless undermine America's role as "the global consumer of last resort." In our view, it would be the opening salvo of a global trade war. Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. He has also insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption. (Details are scant: His Treasury Secretary Steven Mnuchin has denied an across-the-board tax of this nature, but has confirmed that one would apply to specific companies.) Structural Demands: Trump's approach suggests that he wishes to force structural changes on trade surplus economies in order to correct structural imbalances in the American economy - and in this process he is not adverse to lobbing strategic threats. While he holds out the possibility of charging China with currency manipulation, in fact he can draw from a whole sheet of American trade grievances not limited to the currency to demand major changes to their trade relationship. The fundamental problem for the global economy is that in order to reduce the U.S. current account deficit, the world must experience severe global tightening. Dollars held by U.S. multinationals abroad, which finance global credit markets, will come back to the U.S. and tighten liquidity abroad. And emerging market corporate borrowers who have overextended themselves borrowing in U.S. dollars will struggle to repay debts in appreciating dollars. These structural trends are set to exacerbate an already ongoing cyclical process. As BCA's Emerging Markets Strategy has recently pointed out, global demand for U.S. dollars is rising faster than the supply of U.S. dollars.7 Our EM team's first measure of U.S. dollar liquidity is "the sum of the U.S. monetary base and U.S. Treasury securities held in custody for official and international accounts." The second measure "is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents." As Chart 7 and Chart 8 illustrate, both calculations indicate that dollar liquidity is in a precipitous decline already. Meanwhile, foreign official holdings of U.S. Treasury securities is contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart 9). Chart 7Dollar Liquidity Declining... Dollar Liquidity Declining... Dollar Liquidity Declining... Chart 8... Any Way You Look At It ... Any Way You Look At It ... Any Way You Look At It Chart 9Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Chart 10It Hurts To Borrow In USD It Hurts To Borrow In USD It Hurts To Borrow In USD Concurrently, U.S. dollar borrowing costs continue to rise (Chart 10). Our EM team expects EM debtors with U.S. dollar liabilities to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Near-term U.S. dollar appreciation will only reinforce and accelerate the mercantilist push in the White House and Congress. President Trump and the GOP in the House will find common ground on the border-adjustment tax, which Trump recently admitted he did not understand or look favorably upon. The passage of the law, or some such equivalent, has a much greater chance than investors expect. So does a U.S.-China trade war, as we argued last week.8 How should investors position themselves for the confluence of geopolitical, political, and financial factors we have described above? The world is facing both the cyclical liquidity crunch that BCA's Emerging Markets Team has elucidated and the potential for a secular tightening as the Trump administration focuses its efforts on closing the U.S. current account deficit. Five investment implications are top of our mind: Chart 11Market Response To Trump Win On High End Market Response To Trump Win On High End Market Response To Trump Win On High End Chart 12Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Buy VIX. The S&P 500 has continued to power on since the election, buoyed by positive economic surprises, strong global earnings, and the hope of a pro-business shift in the White House. The equity market performance puts the Trump presidency in the upper range of post-election market outcomes (Chart 11). However, with 10-year Treasuries back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is pricing none of the political and geopolitical risks of an impending trade war between the U.S. and China, nor is it pricing the general mercantilist shift in Washington D.C. (Chart 12). As a result, we recommend that clients put on a "mercantilist hedge," like deep out-of-the-money S&P 500 puts, or VIX calls. For instance, a long VIX 20/25 call spread for March expiry. Long DM / Short EM. Mercantilism and the U.S. dollar bull market are the worst combination possible for EM risk assets. We therefore reiterate our long-held strategic recommendation of being long developed markets / short emerging markets. Overweight Euro Area Equities. Investors should overweight euro area equities relative to the U.S. As we have discussed in the 2017 Strategic Outlook, political risks in Europe this year are a red herring.9 We will expand on the upcoming French elections in next week's report. Meanwhile, investors appear complacent about protectionism and what it may mean for the S&P 500, which sources 44% of its earnings abroad. European companies, on the other hand, could stand to profit from a China-U.S. trade war. Chart 13Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Chart 14Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Long MXN/RMB. As a tactical play on the U.S.-China trade war, we recommend clients go long MXN/RMB (Chart 13). The peso is now as cheap as it was in early 1995, at the heights of the Tequila Crisis, as per the BCA's Foreign Exchange Strategy model (Chart 14). While Mexico remains squarely in Trump's crosshairs on immigration and security, the damage to the currency appears to be done and has ironically made the country's exports more competitive. In addition, Trump's pick for Commerce Secretary, Wilbur Ross, has informed his NAFTA counterparts that "rules of origin" will be central to NAFTA re-negotiation. This can be interpreted as the U.S. using every tool at its disposal to impose punitive measures on China, including forcing NAFTA partners to close off the "rules of origin" loophole.10 But the reality is that the U.S. trade deficit with its NAFTA partners is far less daunting than that with China (Chart 15). Meanwhile, we remain negative on the RMB for fundamental reasons that we have stressed in our research. Small Is Beautiful. We continue to recommend that clients find protection from rising protectionism in small caps. Small caps are traditionally domestically geared irrespective of their domicile. Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, also points out that small caps in the U.S. will benefit as the new administration follows through with promised corporate tax cuts, which will benefit small caps disproportionally to large caps given that the effective tax rate of multinationals is already low. Moreover, small companies will benefit most from any cuts in regulations, most of which have been written by multinationals in order to create barriers to entry (Chart 16). Of course, we could just be paranoid! After all, much of Trump's proposed policies - massive tax cuts, infrastructure spending, major rearmament, the border wall - would increase domestic spending and thus widen the current account deficit, not shrink it. And all the protectionism and de-globalization could just be posturing by the Trump administration, both to get a better deal from China and Europe and to give voters in the Midwest some political red meat. Chart 15China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs Chart 16Small Is Beautiful Small Is Beautiful Small Is Beautiful But Geopolitical Strategy analysts get paid to be paranoid! And we worry that much of Trump's promises that would widen U.S. deficits are being watered down or pushed to the background. Yes, we have held a high conviction view that infrastructure spending would come through, but now it appears that it will be complemented with significant spending cuts. The next 100 days will tell us which prerogatives the Trump Administration favors: rebuilding America directly, or doing so indirectly via protectionism. If the former, then the current market rally is justified. If the intention is to reduce the current account deficit, look out. Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Brexit: A Brave New World Miranda: O brave new world! Prospero: 'Tis new to thee. — Shakespeare, The Tempest The U.K. Supreme Court ruled on January 24 that parliament must have a say in triggering Article 50 of the Lisbon Treaty, which enables the U.K. to "exit" the European Union. This decision, as well as Theresa May's January 17 "Brexit means exit" speech, caught us in London while visiting clients. Reactions were mixed. The pound continues to rally. January 16 remains the low point in the GBP/USD cross since the vote to leave on June 23 last year (Chart 17). Chart 17Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Should investors expect more downside to the pound or do the recent events mark a bottom in political uncertainty? The market consensus suggests that further volatility in the pound is warranted for three reasons: Europeans will seek to punish the U.K. for Brexit, to set an example to their own Euroskeptics; Prime Minister May's assertion that the U.K. would seek to exit the common market is negative for the country's economy; Legal uncertainties about Brexit remain. We disagree with this assessment, at least in the short and medium term. Therefore, the pound rally on the day of May's speech was warranted, although we agree that exiting the EU Common Market will ultimately be suboptimal for the country's economy. First, by setting out a clean break from the EU, including the common market, Prime Minister May has removed a considerable amount of political uncertainty. As we pointed out in our original net assessment of Brexit, leaving the EU while remaining in its common market is illogical.11 Paradoxically, the U.K. stood to lose rather than regain sovereignty if it left the EU yet remained in the common market (Diagram 1). Diagram 1The Quite Un-British Lack Of Common Sense Behind Soft Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? Why? Because membership in the common market entails a financial burden, full adoption of the acquis communautaire (the EU body of law), and acceptance of the "Four Freedoms," including the freedom of movement of workers. Given that the Brexit vote was largely motivated by concerns of sovereignty and immigration (Chart 18), it did not make sense to vote to leave the EU and then seek to retain membership in the common market. Apparently May and her cabinet agree. Chart 18It's Sovereignty, Stupid! The "What Can You Do For Me" World? The "What Can You Do For Me" World? Second, now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe, à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. An FTA arrangement will be beneficial to EU exporters, who want access to the U.K. market, and it will send a message to Euroskeptics on the continent that there is no alternative to full membership. Leaving the EU means leaving the market and falling back - at best - to an FTA-level relationship that the EU shares with Mexico and (most recently) Canada. Third, leaving the EU and the common market are political, not legal, decisions, and the lingering legal battles are neither avoidable nor likely to be substantive. Theresa May had already stolen thunder when she said that the final deal with the EU would be put to a vote in parliament. The Supreme Court ruling - as well as other legal hangups - could conceivably give rise to complications that bind the government's hands, but most likely parliament will pass a simple bill or motion granting permission for the government to invoke Article 50. That is because the referendum, and public opinion since then, speak loud and clear (Chart 19). The Conservative Party remains in a comfortable lead over the Labour Party (Chart 20), which itself is not opposing the referendum outcome. In addition, the House of Commons has already approved the government's Brexit timetable by a margin of 372 seats in a 650-seat body - with 461 ayes. That is a stark contrast with a few months ago when around 494 MPs were said to be against Brexit. Chart 19No 'Bremorse' Or 'Bregret' The "What Can You Do For Me" World? The "What Can You Do For Me" World? Chart 20Tories Still Triumphant Tories Still Triumphant Tories Still Triumphant The bigger question comes down to the parliamentary vote on the deal that is to be negotiated over the next two years. Could the Parliament vote down the final agreement with the EU? Absolutely. However, it is unlikely. The economic calamity predicted by many commentators has not happened, as we discuss below. Bottom Line: The combination of the Supreme Court decision and Prime Minister May's speech has reduced political uncertainty regarding Brexit. The EU will negotiate hard with the U.K., but the main cause of consternation - the U.K. asking for special treatment with respect to the common market - is now off the table. Yes, the EU does hold all the cards when it comes to negotiating an FTA agreement, and the process could entail some alarming twists and turns (given the last-minute crisis in the EU-Canada FTA). But we do not expect EU-U.K. negotiations to imperil the pound dramatically beyond what we've already seen. Will Leaving The Common Market Hurt Britain? Does this mean that Brexit is "much ado about nothing?" In the short and medium term, we think the answer is yes. In the long-term, leaving the EU Common Market is a suboptimal outcome for three reasons: Trade - Net exports rarely contribute positively to U.K. growth (Chart 21) and the trade deficit with the EU is particularly deep. As such, proponents of Brexit claim that putting up modest trade barriers against the EU could be beneficial. However, the U.K. has a services trade surplus with the EU (Chart 22). While it is not as large as the trade deficit, there was hope that the eventual implementation of the 2006 EU's Services Directive would have opened up new markets for U.K.'s highly competitive services industry and thus reduced the trade deficit over time. As the bottom panel of Chart 22 shows, the U.K.'s service exports to the rest of the world have outpaced those to the EU, suggesting that there is much room for improvement. This hope is now dashed and the EU may go back to putting up non-tariff barriers to services that reverse Britain's modest surplus with the bloc. Free Trade Agreements rarely adequately cover services, which means that the U.K.'s hope of expanding service exports to a new high is probably gone. Chart 21U.K. Is Consumer-Driven U.K. Is Consumer-Driven U.K. Is Consumer-Driven Chart 22Service Exports At Risk After Brexit Service Exports At Risk After Brexit Service Exports At Risk After Brexit Foreign Investment - FDI is declining, whether for cyclical reasons or because foreign companies fear losing access to Europe via the U.K. It remains to be seen how FDI will respond to the U.K.'s renunciation of the common market, but it is unlikely to be positive (Chart 23). The U.K.'s financial sector will also be negatively impacted since leaving the common market will mean that London will no longer have recourse to the EU judiciary in order to stymie European protectionism.12 This is unlikely to destroy London's status as the global financial center, but it will impact FDI on the margin. Labor Growth - The loss of labor inflow will be the biggest cost of Brexit. A decrease of immigration from the EU could reduce the U.K.'s labor force growth by a maximum of two-thirds, translating to a 25% loss in the potential GDP growth rate (Chart 24). While the U.K. is not, in fact, closing off all immigration, labor-force growth will decline, and potential GDP with it. Chart 23FDI To Suffer From Brexit? FDI To Suffer From Brexit? FDI To Suffer From Brexit? Chart 24Labor Growth Suffers Most From Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? In addition, the EU Common Market forces companies to compete for market share in the developed world's largest consumer market. This competition is supposed to accelerate creative destruction and thus productivity, while giving the winners of the competition the spoils, i.e. a better ability to establish "economies of scale." In a 2011 report, the Bank of International Settlements (BIS) published an econometric study that compared four scenarios: the U.K. remains in the common market as the EU fully liberalizes trade; the U.K. remains in the EU's single market, but does not fully liberalize trade with the rest of the EU; the U.K. leaves the common market; the U.K. enters NAFTA.13 Of the four scenarios, only the first leads to an increase in wealth for the U.K., with 7.1% additional GDP over ten years. U.K. exports would increase by 47%, against 38.1% for its imports. Wages of both skilled and unskilled workers would increase as well. Meanwhile, the report finds that closer integration with NAFTA would not compensate for looser U.K. ties with the EU. In fact, the U.K. national income would be 7.4% smaller if the U.K. tied up with NAFTA instead of taking part in further trade liberalization on the continent. Why rely on a 2011 report for the assessment of benefits of the common market? Because it was written by a competent, relatively unbiased international body and predates the highly politicized environment surrounding Brexit that has since infected almost all think-tank research. And yet the more recent research echoes the 2011 report in terms of the negative consequences of leaving the common market.14 In addition, the BIS study actually attempts to forecast the benefit of further removing trade barriers in the single market, which is at least the intention of the EU Commission. That said, our concerns regarding the U.K. economy are long-term. It may take years before the full economic impact of leaving the common market can be assessed. In addition, much of our analysis hinges on the Europeans fully liberalizing the common market and removing the last remaining non-tariff barriers to trade, particularly of services. At the present-day level of liberalization, the U.K. may benefit by leaving. In addition, we do not expect a balance-of-payments crisis in the U.K. any time soon. The U.K. current account is deeply negative, unsurprisingly so given the deep trade imbalance with the EU and world. However, our colleague Mathieu Savary, Vice-President of BCA's Foreign Exchange Strategy, has pointed out that the elasticity of imports to the pound is in fact negative, a very surprising result. This reflects an extremely elevated import content of British exports. A lower pound is therefore unlikely to be the most crucial means of improving the current-account position. Certainly leaving the common market will not improve the competitiveness of British exports in the EU. Chart 25The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy But this raises a bigger question: why does the U.K. have to improve its current account deficit? As our FX team points out in Chart 25, despite having a current-account deficit of nearly 6% of GDP, the U.K. runs a basic balance-of-payments surplus of 12%, even after the recent fall in FDI inflows. The reason for the massive balance-of-payments surplus is the financial account surplus of 6.17% of GDP, a feature of the U.K. being a destination for foreign capital, which flows from its status as a global financial center and prime real estate destination. In other words, leaving the common market will not change the fundamentals of the U.K. balance of payments much. The country will remain a global financial center and will still run a capital account surplus, which will suppress the country's interest rates, buoy the GBP, and give tailwinds to imports of foreign goods. Meanwhile, exports will not benefit as they will face marginally higher tariffs as the country exits the EU Common Market. At best, new tariffs will be offset by a cheaper GBP. As such, leaving the common market is not going to be a disaster for the U.K. Nor will it be a panacea for the country's deep current account deficit. And that is okay. The U.K. will not face a crisis in funding its current account deficit. What is clear is that for the time being, the U.K. economy is holding up. Our forex strategists recently argued that U.K.'s growth has surprised to the upside and that the improvement is sustainable: Monetary and fiscal policy are both accommodative (Chart 26); Inflation is limited; Tight labor market drives up wages and puts cash in consumers' pockets (Chart 27); Credit growth remains robust (Chart 28). Chart 26Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Chart 27British Labor Market Tightening British Labor Market Tightening British Labor Market Tightening Chart 28U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good This means that the political trajectory is set for the time being. "Bremorse" and "Bregret" will remain phantoms for the time being. Bottom Line: Leaving the common market is a suboptimal but not apocalyptic outcome for the U.K. The combination of decent economic performance and lowered political uncertainty in the near term will support the pound. Given the pound's 20% correction since the June referendum, we believe that the market has already priced in the new, marginally negative, post-Brexit paradigm. The Big Picture It is impossible to say whether the long-term negative economic effects of Brexit will affect voters drastically enough and quickly enough for Scotland, or parliament, to act in 2018 or 2019 and modify the government's decision to pursue a "Hard Brexit." It seems conceivable if something changes in the fundamental dynamics outlined above, but we wouldn't bet on it. At the moment even a new Scottish referendum appears unlikely (Chart 29). Scottish voters have soured on independence, perhaps due to a combination of continued political uncertainty in the EU (Scotland's political alternative to the U.K.) and a collapse in oil prices (arguably Scotland's economic alternative to the U.K.). The issue is not resolved but on ice for the time being. Chart 29Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) More likely, the government will get its way on Brexit and the 2020 elections will mark a significant popular test of the Conservative leadership and the final deal with the EU. Then the aftermath will be an entirely new ballgame for the U.K. and all four of its constituent nations. If Britain's new beginning is founded on protectionism and dirigisme - as the government suggests - then the public is likely to be disappointed. The "brave new world" of Brexit may prove to be rather mundane, disappointing, and eerily reminiscent of the ghastly 1970s.15 Hence the Shakespeare quote at the top of this report. The political circumstances of Brexit resemble the U.K. landscape before it joined the European Economic Community in 1973: greater government role in the economy, trade protectionism, tight labor market, higher wages, and inflation. Yet this was a period when the U.K. economy underperformed Europe's. The U.K.'s eventual era of outperformance was contingent on the structural reforms of the Thatcher era and expanded access to the European market (Chart 30). It remains to be seen what happens when the U.K. leaves the market and rolls back Thatcherite reforms. The weak pound and proactive fiscal policy will fail to create a manufacturing revolution. That is because most manufacturing has hollowed out because of automation, not foreign workers stealing Britons' jobs. Moreover, as for the pound, it is important to remember that currency effects are temporary and any boost to exports that the weak pound is generating will be short-lived, as with the case of China in the 1990s and the EU in the past two years (Chart 31). Chart 30U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? Chart 31Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting In addition, we would argue that, in an environment of de-globalization - in which tariffs are rising, albeit slowly for the time being (Chart 32) - the EU Common Market provides Europe with a mechanism by which to protect its vast consumer market. The U.K. may have chosen the precisely wrong time in which to abandon the protection of continental European protectionism. It could suffer by finding itself on the outside of the common market as global tariffs begin to rise significantly. Chart 32Protectionism On The March The "What Can You Do For Me" World? The "What Can You Do For Me" World? What about the restoration of the "Special Relationship" between the U.K. and the U.S.? Could moving to the "front of the queue" on negotiating an FTA with the world's largest economy make a difference for the U.K.? Perhaps, but as the BIS study above indicates, an FTA with North America or the U.S. alone is unlikely to replace the benefits of the common market. In addition, it is difficult to imagine how a protectionist U.S. administration that is looking to massively decrease its current account deficit will help the U.K. expand trade with the U.S. By contrast, Trump's election in the United States poses massive risks to globalization, both through his protectionism and the strong USD implications of his core policies. This will reverberate negatively across the commodities and EM space. In such an environment, the U.K. may not be able to make much headway in its "Global Britain" initiatives to conclude fast trade deals with EM economies that stand to lose the most in the de-globalization era. Bottom Line: As a trading nation, the U.K. is likely to lose out in a prolonged period of de-globalization. Membership in the EU could have served as a bulwark against this global trend. Investment Implications We diverge from our colleagues in the Foreign Exchange Strategy and European Investment Strategy when it comes to the assessment of political risk looming over Brexit.16 The decision to leave the common market will alleviate the pressure on Europeans to seek vindictive punishment. Earlier, the U.K. was forcing them to choose between making an exception to the rules and demonstrating the negative consequences of leaving the bloc. Now the U.K. is self-evidently taking on its own punishment - the economic burden of leaving the common market - and the EU will probably deem that sufficient. Will the EU play tough? Yes, especially since the EU retains considerable economic leverage over Britain (Chart 33). But the stakes are far smaller now. Furthermore, investors should remember that core European states - especially France and Germany - remain major military allies of the U.K. and will continue to be deeply intertwined economically. As such, we believe that the pound has already priced in the new economic paradigm and that the expectations of political uncertainty ahead of the U.K.-EU negotiations may be overdone. We therefore recommend that investors short EUR/GBP outright. Our aforementioned forex strategist Mathieu Savary argues that, on an intermediate-term basis, the outlook for this cross is driven by interest rate differentials and policy considerations. Due to the balance-sheet operations conducted by the BoE and ECB, interest rates in the U.K. and the euro area do not fully reflect domestic policy stances. Instead, Mathieu uses the shadow rates. Currently, shadow rates unequivocally point toward a lower EUR/GBP (Chart 34). In fact, balance-sheet dynamics point toward shorting EUR/GBP. Chart 33EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation Chart 34Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP For full disclosure, Mathieu cautions clients to wait on executing a short EUR/GBP until after Article 50 is enacted. By contrast, we think that political uncertainty regarding Brexit likely peaked on January 16. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com 1 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive a much lower return on U.S. assets while the U.S. benefits from risk premia in foreign markets. 2 Please see Spiegel Online, "Donald Trump and the New World Order," dated January 20, 2017, available at Spiegel.de. 3 In a widely-quoted interview with The Wall Street Journal, Donald Trump said that the U.S. dollar is "too strong." He continued that, "Our companies can't compete with [China] now because our currency is too strong. And it's killing us." Please see The Wall Street Journal, "Donald Trump Warns on House Republican Tax Plan," dated January 16, 2017, available at wsj.com. 4 We would note that the Trump administration and its Treasury Department have considerable leeway over how they choose to interpret China's foreign exchange practices. In 1992, when the U.S. government last accused China of currency manipulation, it issued a warning in its spring report before leveling the accusation in the winter report. The RMB did not depreciate in the meantime but remained stable, and Treasury noted this approvingly; however, Treasury chose 1989 as the base level for its assessment, and found manipulation. The Trump administration could use much more aggressive interpretive methods than this to achieve its ends. 5 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 6 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. 7 Please see BCA Emerging Markets Strategy Weekly Report, "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 10 Critics, including Trump supporters, claim that NAFTA sets too low of a threshold for the domestic content of a good deemed to have originated within the NAFTA countries. Goods that are nearly 40% foreign-made can thus be treated as NAFTA-made. This is one of many contentious points in the trade deal. 11 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 12 In 2015, the U.K. took the ECB to court over its decision to require financial transactions denominated in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue of legal redress will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that corral the financial industry - or at least to the parts focused on transactions in euros - out of London. 13 Please see Bank of International Settlements, "The economic consequences for the U.K. and the EU of completing the Single Market," BIS Economics Paper No. 11, dated February 2011, available at www.gov.uk. 14 Please see Her Majesty's Government, "H.M. Treasury Analysis: The Long-Term Economic Impact Of EU Membership And The Alternatives," Cmnd. 9250, April 2016, available at www.gov.uk. and Jagjit S. Chadha, "The Referendum Blues: Shocking The System," National Institute Economic Review 237 (August 2016), available at www.niesr.ac.uk. 15 We were going to use "grey" to describe Britain in the 1970s. However, our colleague Martin Barnes, BCA's Chief Economist, insisted that "grey" did not do the "ghastly" 1970s justice. When it comes to the U.K. in the 1970s, we are going to defer to Martin. 16 Please see BCA Research European Investment Strategy Weekly Report, “May’s Brexit Speech: No Substance,” dated January 19, 2017, available at eis.bcaresearch.com. Geopolitical Calendar

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

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

Highlights With inflation probably having bottomed, especially in the U.S., investors are starting to worry about inflation tail-risk and wonder whether inflation-linked bonds (ILBs) are an efficient way to hedge this risk. This Special Report explains how ILBs work in different countries and analyzes their performance characteristics over time. We find that ILBs, a rapid growing asset class, can be a beneficial addition to a balanced global portfolio even though recent history does not show as strong portfolio diversification benefits as a longer history. The lower nominal duration of ILBs is a useful feature for portfolio duration management. ILBs have proven to be a good inflation hedge in a rising inflationary environment, but they underperform nominal bonds in a disinflationary environment. As such, the balance between ILBs and nominal bonds should be managed tactically based on an investor's views on inflation dynamics and valuation. Overweight U.S. TIPS; avoid U.K. linkers. Australian TIBS are a cheap yield enhancer, but higher yielding Mexican Udibonos are a dangerous yield trap. Feature BCA's view is that the 35-year bull market in bonds is ending and that the path of least resistance for bond yields globally is up.1 Even though the level of inflation in the U.S. is still below the Fed's target of 2%, we think it's clear that U.S. inflation has bottomed for this cycle. Globally, loose monetary policy together with the likelihood of more fiscal stimulus, present the risk of higher inflation down the road. Global Asset Allocation has recommended investors to overweight U.S. TIPS (Treasury Inflation Protected Securities) relative to nominal U.S. government bonds throughout 2016. Many clients have asked for details on how TIPS work, whether there are similar securities in other countries, and how ILBs fit into a balanced global portfolio. In this Special Report, we take a detailed look at inflation-linked bond markets globally and recommend some strategies for asset allocators to use them to help navigate a world of low returns and possibly higher inflation. 1. What Are Inflation-Linked bonds (ILBs)? Inflation Protection: Inflation-linked bonds are designed to hedge inflation risk by indexing the bonds' principal to the official inflation index in the issuer country. While the methodology and what the bonds are called differ from country to country, the underlying concept is the same: the holders of ILBs will get the stated real return even in an inflationary environment since both the nominal face value and the nominal coupon payments change based on an official inflation measure. Deflation Floor: In the case of sustained deflation such that the final nominal face value falls below the initial face value, however, the repayment of principal at maturity is guaranteed in the majority of the countries, but not, for example, in the U.K., Canada, Brazil, or Mexico (Table 1). Table 1Basic Information Of Global ILB Markets TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Inflation Measure: ILBs are linked to actual inflation with a time lag. As shown in Table 1, the inflation measure used varies slightly by country: in the U.S. it's the non-seasonally adjusted CPI; in the U.K. it's the retail price index (RPI); while in the euro area, France and Italy both have ILBs linked to local CPI ex tobacco and EU HICP ex tobacco, with the former primarily for domestic retail investors. The time lag is three months in most countries, but can vary from one to eight months as shown in Table 1. A Rapidly Growing Asset Class: The earliest recorded ILBs were issued by the Commonwealth of Massachusetts in 17802 during the Revolutionary War. Finland introduced indexed bonds in 1945, Israel and Iceland in 1955. Brazil introduced its indexed bonds in 1964 and has become the largest ILB market in the emerging markets and the third largest globally. When the U.K. issued its first "linkers", it originally used eight months of inflation lag to make sure the next coupon payment is known at the current coupon payment date. In 1991 Canada issued its first ILBs and the "Canadian Model", which uses a three-month lag to the inflation index and calculates a daily index ratio using linear extrapolation, has been adopted widely since; even the U.K. adopted it in 2005. The largest ILB market now is the U.S. TIPS with a market cap of USD 1.2 trillion. TIPS were first issued in 1997, using the Canadian model. Chart 1 shows the evolution of the ILB markets globally. Since the Bloomberg Barclays Universal Government Inflation-linked Bond Index was constructed in July 1997, the market cap has increased to over USD 3.2 trillion from a mere USD 145 million at the end of 1997. It's worth noting that the actual amount of ILBs outstanding globally is slightly larger than this because not all debts are included in the index.3 Even though many countries have issued ILBs, and emerging markets (EM) grew very fast in the 2000s, the global market is still dominated by the top three countries (the U.S., U.K., and Brazil) with a combined share of 70% of global market cap. Chart 1ILBs: A Fast Growing Asset Class bca.gaa_sr_2016_10_28_c1 bca.gaa_sr_2016_10_28_c1 Chart 2U.S. BEI Vs. Inflation Expectations bca.gaa_sr_2016_10_28_c2 bca.gaa_sr_2016_10_28_c2 Country Differentiation: Nominal government bonds come with different features in different countries, and the same is true with ILBs. Table 2 shows that even though the U.S. accounts for 43.6% of the developed markets (DM) index in terms of market cap, it contributes only 28.8% to overall duration while the U.K. accounts for 53% of the overall duration, because the U.K. linkers have much longer duration than the U.S. TIPS. The Canadian real return bonds (RRBs) have the second longest average duration at 16 years. Table 2Key Features of the Bloomberg Barclays Government ILB Indexes* TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds 2. How Do ILBs Compare To Nominal Bonds? Break-Even Inflation (BEI) And Inflation Expectations: The difference between the yield on a nominal bond and the yield on a comparable ILB (a comparator) is defined as the BEI, the market-based inflation rate at which an investor is indifferent between holding a real or a nominal bond. If realized inflation over an ILB's life turns out to be higher than the BEI at purchase, then holding the ILB is better than holding its nominal counterpart. BEI on its own is not an accurate gauge of inflation expectations, because it is the sum of inflation expectations, the inflation risk premium, and the liquidity premium. One of the long-term inflation expectation measures that the U.S. Fed keeps track of is the five-year forward five-year inflation calculated using the Fed's own fitted yield curves.4 Even this measure, however, contains the inflation term premium and the relative supply/demand of 10-year BEI vs 5-year BEI. Three important observations from Chart 2 for investors to pay attention to when assessing the inflation outlook are: U.S. breakeven inflation rates have been consistently below the Fed's inflation target of 2% since 2014 (panel 4); The CPI swaps markets priced in a much higher inflation rate than the TIPS market and the Fed's measure derived from fitted curves (panels 2 & 3), largely caused by the supply and demand imbalance in the inflation swaps market: there is excess demand to receive inflation, but no natural regular payer of inflation other than the U.S. Treasury via TIPS, therefore a higher fixed rate has to be paid to receive inflation; The 10-year inflation expectation from the Cleveland Fed's model5 (panel 1), exhibits very different behavior from the other measures. It has been below the 2% target since 2011. This model attempts to combine survey-based inflation expectations and that derived from the CPI swaps market. It's intended to be a "superior" measure of inflation expectations from a monetary policy perspective.6 For investors, however, it's advisable to take into account all these measures when assessing inflation dynamics. Duration and Yield Beta: Duration is measured as the bond price change in relation to the yield change. Chart 3 shows that ILBs have higher duration than their nominal counterparts. These two durations, however, are not directly comparable because ILB duration is related to "real yield" while nominal bond duration is related to "nominal yield". The conversion from one to another is not straightforward because the relationship between real and nominal yields can be complex.7 In practice, however, we can run a simple regression to get ILB's yield beta to change in nominal yield.8 Some practitioners simply assume 0.5 in the emerging market.9 Our research shows that in the developed market the relationship between real yield and nominal yield can vary over different time periods and in different countries, but the moving 3-year and 5-year yield betas are always less than 1 and mostly above 0.5, which is the full sample average.(Chart 4). This is a useful feature for duration management and curve positioning. For example, everything else being equal, 1) replacing nominal government bonds with comparable ILBs can reduce portfolio duration, and 2) replacing a short-dated nominal bond with a longer-dated ILB could maintain the same duration. Chart 3Average Government Bond Duration Average Government Bond Duration Average Government Bond Duration Chart 4ILBs' Yield Beta TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Total Return: By design, ILBs should do well in an inflationary environment and they should outperform their nominal bonds when realized inflation is higher than the break-even inflation rate. How have ILBs performed in the real world? Unfortunately, we do not have a long enough data history to cover different inflation cycles. Chart 5 confirms that in nominal terms ILBs outperform their nominal counterparts when inflation rate trends higher. What's interesting, however, is that it is disinflation, rather than deflation, that hurts ILBs the most. Within the available data history, only 2009 experienced a brief deflation scare globally, yet the rebound in ILBs actually led economies out of the deflationary environment. Over the long run, U.K. linkers have underperformed nominal gilts since their first issuance in 1981 when inflation was running at 12%. Since 1997 when the Bloomberg/Barclays ILB indexes were constructed, however, ILBs have performed slightly better than their nominal comparable bonds in most countries, with the exception of the euro area where ILBs have fared slightly worse (Chart 5). Risk-Adjusted Return: On a risk-adjusted basis, the available data history shows that ILBs performed slightly better in the U.S. and Australia, and also the DM aggregate on a hedged basis, but slightly worse in the euro area, the U.K. and Canada. It's worth emphasizing, however, that in either case the difference is not significant (Table 3). Chart 5ILB Performance Vs Inflation ILB Performance Vs Inflation ILB Performance Vs Inflation Table 3ILBs Approximately Equal To Nominal Bonds TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds 3. What's The Role Of ILBs In A Balanced Portfolio? Bridgewater Associate showed that adding ILBs to a balanced euro zone stock/bond portfolio significantly improved the efficient frontier over the very long run, from 1926 to 2010.10 Since there were no ILBs in the early part of that history, ILB returns were calculated based on inflation. Our research, based on data from the Bloomberg/Barclays Inflation-Linked Government Bond Index with a much shorter history, however, does not yield the same results, probably because the much shorter recent history does not include any highly inflationary periods from which ILBs benefit the most. Table 4 shows the statistics of replacing a certain portion of the nominal bonds with comparable ILBs in a DM 60/40 stocks/bonds portfolio. On a standalone basis, the hedged USD DM ILBs are less volatile and have the best risk-adjusted return of 1.3 in the sample period (Portfolio 8). When combined with equities, however, the nominal bonds are a slightly better diversifier than the ILBs. Why? The answer lies in the correlation. Chart 6 shows that the ILBs have much higher correlation with equities than the nominal bonds do with equities. This makes sense because equities could rise in an inflationary environment if the higher inflation were driven by stronger growth, while inflation is always bad for nominal bonds. Again, the differences in risk-adjusted returns are not significant, varying from 0.77 to 0.7 (Portfolios 2-6) in line with the findings in Section 2. Table 4Balanced Global Portfolio Statistics* TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Chart 6Global Stocks-Bonds Correlations bca.gaa_sr_2016_10_28_c6 bca.gaa_sr_2016_10_28_c6 4. Inflation Has Bottomed BCA's Fixed Income Strategy team has written extensively about the outlook for U.S. and global inflation.11 We concur with their view that, even though inflation in most DM countries is still below the targets set by their central banks (Chart 7), in most countries it has probably bottomed (top three panels in Chart 7), and especially in the U.S., where all indicators point to rising wage pressures as labor market slack diminishes (Chart 8). Chart 7Inflation Still Below Target Inflation Still Below Target Inflation Still Below Target Chart 8Accelerating Wage Pressure bca.gaa_sr_2016_10_28_c8 bca.gaa_sr_2016_10_28_c8 5. Investment Implications Overweight U.S. TIPS Over Nominal Treasuries: We have shown that ILBs outperform comparable nominal bonds in a rising inflation environment and have argued that inflation has bottomed in the U.S. These views support our recommendation to overweight U.S. TIPS relative to nominal U.S. Treasuries. In addition, our TIPS valuation models (Chart 9) show that breakeven inflation rates in the U.S. are still below fair values based on underlying economic and financial drivers. Being the largest ILB market with a market cap of over USD 1.2 trillion, TIPS are very easy to trade. Currently, only five-year TIPS have a negative yield, so there are plenty of opportunities for investors to preserve real purchasing power by holding longer maturity TIPS. Avoid U.K. Linkers: The U.K. linkers market is the second largest after the U.S., with a market cap of about USD 810 billion. Unfortunately, these linkers are among the most expensively priced real return bonds, with negative yields at all maturities (Chart 10, panel 3). For example, 10-year linkers are currently yielding -1.98%, which means that investors are guaranteed to lose 18% of real purchasing power in 10 years by holding the bonds to maturity. Granted, the U.K. linkers have always traded at a premium to U.S. TIPS and many other ILB markets due to the nature of the U.K. pension schemes which link pension liabilities to inflation (CPI or RPI). With insatiable appetite from pension funds, demand greatly exceeds what the linkers and inflation swaps markets can supply. U.K. real yields have been driven lower and lower, causing an increasing funding gap which in turns drives yield further down.12 In addition, our fair value model (Chart 10, panels 1 and 2) shows that the U.K. linkers' current breakeven rates are above fair value. The collapse in the linkers' yields after the Brexit vote is also consistent with a skyrocketing in the CPI swaps rate, indicating that the probable rise in inflation due to the collapse of the GBP has now largely been priced in (panel 4). Investors who are not constrained by U.K. pension regulations should avoid U.K. linkers. Chart 9Overweight U.S. TIPS bca.gaa_sr_2016_10_28_c9 bca.gaa_sr_2016_10_28_c9 Chart 10Avoid U.K. Linkers bca.gaa_sr_2016_10_28_c10 bca.gaa_sr_2016_10_28_c10 Yield Enhancement From Australia, Not From Mexico: The U.S. TIPS market is liquid but yields are low, albeit higher than U.K. linkers. Among the smaller markets with higher yields, we prefer Australian Treasury Indexed Bonds (TIBS) over Mexican Udibonos, even though the 10-year Udibonos have a higher yield of 2.8% compared to the 10-year TIBS yield of 0.62%. As shown in Chart 11 and Chart 12, the Australian TIBS are very cheap while the Mexican Udibonos are very expensive. The BEI in Mexico is above the central bank's target of 3% while in Australia it's still at the lower end of the target range of 2-3%. Chart 11 Australian TIBS: A Cheap Yield Enhancer bca.gaa_sr_2016_10_28_c11 bca.gaa_sr_2016_10_28_c11 Chart 12 Mexico ILBS: Too Expensive Mexico ILBS: Too Expensive Mexico ILBS: Too Expensive 6. ETFs Some of our clients always want to know if there are ETFs for the asset classes we cover. For ILBs, the most liquid ETF is the iShares TIPS Bond ETF with an AUM of USD 19 billion and an expense ratio (ER) of 20 bps. For non-U.S. global ILBs, the SPDR Citi International Government Inflation-Protected Bond ETF has an AUM of USD 620 million and an expense ratio of 50bps. The Appendix on page 14 gives a sample list of the exchange traded ILB funds. For more information about ETFs, please see BCA's newly launched Global ETF Strategy service. AppendixSample List Of ILB ETFs*** TIPS For Inflation-Linked Bonds TIPS For Inflation-Linked Bonds Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The End of the 35-year Bond Bull Market," July 5, 2016, available at gis.bcaresearch.com. 2 Robert Shiller, "The Invention of Inflation-Linked Bonds in Early America," NBER Working Paper 10183, December 2003. 3 Barclays Index Methodology, July 17, 2014. 4 Refet S. Gurkaynak et al., "The TIPS Yield Curve and Inflation Compensation," May 2008, Federal Reserve publication. 5 Joseph G Haubrich et al., "Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps," Working Paper 11-07, March 2011, Federal Reserve Bank Of Cleveland. 6 Joseph G. Haubrich And Timothy Bianco, "Inflation: Nose, Risk, and Expectations," Economic Commentary, June 28, 2010, Federal Reserve Bank Of Cleveland. 7 Francis E. Laatsch and Daniel P. Klein, "The nominal duration of TIPS bonds," Review of Financial Economics 14 (2005). 8 Mattheu Gocci, "Understanding the TIPS Beta," University of Pennsylvania, 2013. 9 Thor Schultz Christensena and Eva Kobeja, "Inflation-Linked Bond from emerging markets provide attractive yield opportunities," Danske Capital, May 2015. 10 Werner Kramer, "Introduction to Inflation-Linked Bonds," Lazard Asset Management, 2012.

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

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

In a February <i>Special Report</i> titled "Assessing Fair Value In FX Markets" we introduced a set of long-term valuation models based on various fundamentals. We have updated the results and added KRW, INR, PHP, HKD, CLP and COP to our analysis. The dollar still remains expensive, albeit with no signs of a dangerous overvaluation. The yuan is now at its cheapest level since 2009.

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

The RMB has been steadily depreciating versus the U.S. dollar and has dropped to a new cyclical low versus its trade-weighted basket. All the while, Chinese domestic interest rates have lately drifted higher. When global investors wake up to these dynamics, global share prices and EM risk assets will likely sell off anew. In Mexico, initiate a new yield curve trade: receive 10-year / pay 1-year swap rates.

We are introducing a new set of fair value models for currencies. On a cyclical basis, the dollar is expensive. However, this is not enough of a reason to expect an imminent fall in the greenback. The yen is extremely cheap, and its fair value is rising on the back of a positive terms-of-trade shock. The yuan is fairly valued. Most commodity currencies are not yet cheap.