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Highlights Investors should expect little policy initiative out of the U.S. Congress after tax cuts; Polarization is likely to rise substantively in 2018, gridlocking Congress; Chinese policymakers are experimenting with growth-constraining reforms; Global growth has peaked; underweight emerging markets in 2018; Go long energy stocks relative to metal and mining equities. Feature Last week we published Part I of our 2018 Key Views.1 In it, we presented our five "Black Swans" for 2018: Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran - throwing the Middle East into chaos - and protectionism against China. A Coup In North Korea: Chinese economic pressure overshoots its mark and throws Pyongyang into a crisis. Kim Jong-un is replaced, but markets struggle to ascertain whether the successor is a moderate or a hawk. Prime Minister Jeremy Corbyn: Markets cheer the higher probability of "Bremain" and then remember that Corbyn is a genuine socialist. Italian Election Troubles: Markets are fully pricing in the sanguine scenario of "much ado about nothing," which is our view as well. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM? Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked. These are not our core views. As black swans, they are low-probability events that may disturb markets in 2018. Our core view remains that geopolitical risks were overstated in 2017 and will be understated in 2018 (Charts 1 & 2). Most importantly, U.S. politics will be a tailwind to global growth while Chinese politics will be a headwind to global growth. While the overall effect may be neutral, the combination will be bullish for the U.S. dollar and bearish for emerging markets.2 Chart 12018 Will See Risks Dominate... 2018 Will See Risks Dominate... 2018 Will See Risks Dominate... Chart 2...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge This week, we turn to the three questions that we believe will define the year for investors: Is A Civil War Coming To America? Is The Ghost Of Deng Xiaoping Haunting China? Will Geopolitical Risk Shift To The Middle East? Is A Civil War Coming To America? On a recent visit to Boston and New York we were caught off guard by how alarmed several large institutional clients were about the risk of severe social unrest in the U.S. We share this concern about the level of polarization in the U.S. and expect social instability to rise over the coming years (Chart 3).3 When roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being," we have entered a new paradigm (Chart 4). Chart 3Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 4"A Threat To The Nation's Well-Being?" Really?! Three Questions For 2018 Three Questions For 2018 Where we differ from some of our clients is in assessing the likely trigger for the unrest and its investment implications over the next 12 months. If the Democrats take the House of Representatives in the November 6 midterm election, as is our low-conviction view at this early point, then we would expect them eventually to impeach President Trump in 2019.4 Even then, it is not clear that the Senate would have the necessary 67 votes to convict Trump of the articles of impeachment (whatever they prove to be) and hence remove him from power. Republicans are likely to increase their majority in the Senate, even if they lose the House, because more Democratic senators are up for re-election in 2018. Therefore well over a dozen Republican senators would have to vote to remove a Republican president from power. For that to happen, Trump's popularity with Republican voters would have to go into a free fall, diving well below 60% (Chart 5). Meanwhile, we do not buy the argument that hordes of gun-wielding "deplorables" would descend upon the liberal coasts in case of impeachment. There may well be significant acts of domestic terrorism, particularly in the wake of any removal of Trump from office, but they would likely be isolated and unable to galvanize broader support. Our clients should remember, however, that ultra-right-wing militant groups are not the only perpetrators of domestic terrorism.5 Any acts of violence or social unrest are likely to draw press coverage and analytical hyperbole. But our left-leaning clients in the Northeast are likely overstating the sincerity of support for President Trump. President Trump won 44.9% of the Republican primary votes, but he averaged only 35% of the vote in the early days when the races were the most competitive. Given that only 25% of Americans identify as Republicans (Chart 6), it is fair to say that only about a third of that figure - 8%-10% of all U.S. voters - are Trump loyalists. Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). Of that small percentage of genuine Trump fans, it is highly unlikely that a large share would seriously contemplate taking arms against the state in order to keep their leader in power against the constitutional impeachment process. Especially given that President Trump would be replaced by a genuine conservative, Vice President Mike Pence.6 Chart 5We Are A Long Way Away##BR##From Trump's Demise Three Questions For 2018 Three Questions For 2018 Chart 6Party Identifications##BR##Are Shrinking Party Identifications Are Shrinking Party Identifications Are Shrinking As such, we believe that it is premature to speak of a total breakdown of social order in America. It is notable that such a conversation is taking place, but other forms of polarization and social unrest are far more likely to be relevant at the moment. In terms of policy, we would expect gridlock in Congress if Democrats take the House and begin focusing on impeachment. In fact, gridlock may already be upon us, as we see little agreement between the Trump administration, its loyalists in Congress, and establishment Republican Senators like Dan Sullivan (R, Alaska), Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), Ben Sasse (R, Nebraska), and Thom Tillis (R, North Carolina). These six Senators are all facing reelection in 2020 and are likely to evolve into Democrats-in-all-but-name. If President Trump's overall popularity continues to decline, we would not be surprised if one or two (starting with Collins) even take the dramatic step of leaving the Republican Party for the 2020 election. Essentially, establishment Republicans will become effective Democrats ahead of the midterms. Post-midterm election, with Democrats potentially taking over the House, the legislative process will grind to a complete halt. Government shutdowns, debt ceiling fights, failure of proactive policymaking to deal with crises and natural disasters, will all rise in probability. As President Trump faces greater constraints in Congress, we can see him becoming increasingly reliant on his executive authority to create policy. He would not be unique in this way, as President Obama did the same. While Trump's executive policy will be pro-business, unlike Obama's, uncertainty will rise regardless. The business community will not be able to take White House policies seriously amidst impeachment and a potential Democratic wave-election in 2020. Whatever executive orders Trump signs into power over the next three years, chances are that they will be immediately reversed in 2020. What about the markets? The Mueller investigation and heightened level of polarization could create drawdowns in equity markets throughout the year. However, impeachment proceedings are not likely to begin in 2018 and have never carried more weight with investors than market fundamentals (Chart 7).7 True, the Watergate scandal under President Richard Nixon triggered a spike in volatility and a fall in equities. However, the scandal alone did not cause the correction, rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, massive insurance fraud, recession, and a global oil shock.8 Chart 7AFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets Chart 7BFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets What about the impact on the U.S. dollar? Does Trump-related political instability threaten the dollar's status as the chief global reserve currency and a major financial safe haven? The data suggest not. We put together a list of events in 2017 that could be categorized as "unorthodox, Trump-related, political risk" (Table 1). We specifically left out geopolitical events, such as the North Korean nuclear crisis, so as not to dilute our dataset's focus on domestic intrigue. As Chart 8 illustrates, the U.S. dollar rose slightly, on average, a week after each event relative to its average weekly return prior to the crisis. While this may not be a resounding vote of confidence for the greenback (gold performed better), there is no evidence that investors are betting on a paradigm shift away from the dollar as the global reserve currency. Table 1An Eventful Year 1 Of Trump Presidency Three Questions For 2018 Three Questions For 2018 Chart 8Trump Is Not A U.S. Dollar Paradigm Shift Three Questions For 2018 Three Questions For 2018 If investors should not worry about investment-relevant social strife in the U.S. in 2018, then when should they worry? Well, if Trump is actually removed from office, a first in U.S. history, at a time of extreme polarization, and in a country with easy access to arms and at least a strain of domestic terrorism, then 2019-20 will at least be a time for concern. Even without Trump's removal, we worry about unrest beyond 2018. We expect the ideological pendulum to shift to the left by the 2020 election. If our sister service - BCA's Global Investment Strategy - is correct, then a recession is likely to begin in late 2019.9 A combination of low popularity, market turbulence, and economic recession would doom Trump's chances of returning to the White House. But they would also be toxic for the candidacy of a moderate Democrat and would possibly propel a left-wing candidate to the presidency. Four years under a left-wing, socially progressive firebrand may be too much for many far-right voters to tolerate. Given America's demographic trends (Chart 9), these voters will realize that the writing is on the wall, that the window of opportunity to lock in their preferred policies has been firmly shut. The international context teaches us that disenchanted groups contemplate "exit" when the strategy of "voice" no longer works. How this will look in the U.S. is unclear at this point. Bottom Line: Investors should continue to fade impeachment-related, and Mueller investigation-related, pullbacks in the markets or the U.S. dollar in 2018. Our fears of U.S. social instability are mostly for the medium and long term. Fundamentals drive the markets and U.S. fundamentals remain solid for now. As our colleague Peter Berezin has pointed out, there is no imminent risk of a U.S. recession (Chart 10) and the cyclical picture remains bright (Chart 11).10 Chart 9A Changing America A Changing America A Changing America Chart 10No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession Chart 11U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright Where BCA's Geopolitical Strategy diverges from the BCA House View, however, is in terms of the global growth picture. While we recognize that there are no imminent risks of a global recession, we do believe that the policy trajectory in China is being obfuscated by positive global economic projections. To this risk we now turn. Is The Ghost Of Deng Xiaoping Haunting China? Our view that Chinese President Xi Jinping would reboot his reform agenda after the nineteenth National Party Congress this October is beginning to bear fruit. Investors are starting to realize that the policy tightening of 2017 was not a one-off event but a harbinger of what to expect in 2018. China's economic activity is slowing down and the policy outlook is getting less accommodative (Chart 12).11 To be clear, we never bought into the 2013 Third Plenum "reform" hype, which sought to resurrect the ghost of Deng Xiaoping and his decision to open China's economy at the Third Plenum in 1978.12 Nor will we buy into any similar hype around the upcoming Third Plenum in 2018. Instead, we focus on policymaker constraints. And it seems to us that the constraints to reform in China have fallen since 2013. The severity of China's financial and economic imbalances, the positive external economic backdrop, the desire to avoid confrontation with Trump, and the Xi administration's advantageous moment in the Chinese domestic political cycle, all suggest to us that Xi will be driven to accelerate his agenda in 2018. Broadly, this agenda consists of revitalizing the Communist Party regime at home and elevating China's national power and prestige abroad. More specifically it entails: Re-centralizing power after a perceived lack of leadership from roughly 2004-12; Improving governance, to rebuild the legitimacy and popular support of the single-party state, namely by fighting corruption; Restructuring the economy to phase out the existing growth model, which relies excessively on resource-intensive investment while suppressing private consumption (Chart 13). Chart 12China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming Chart 13Excess Investment Is A Real Problem Excess Investment Is A Real Problem Excess Investment Is A Real Problem The October party congress showed that this framework remains intact.13 First, Xi was elevated to Mao Zedong's status in the party constitution, which makes it much riskier for vested interests to flout his policies. Second, he declared the creation of a "National Supervision Commission," which will expand the anti-corruption campaign from the Communist Party to the administrative bureaucracy at all levels. Third, he recommitted to his economic agenda of improving the quality of economic growth at the expense of its pace and capital intensity. What does this mean for the economy in 2018? We expect government policy to become a headwind, after having been a tailwind in 2016-17. As Xi and the top-decision-making Politburo officially stated on December 9, the coming year will be a "crucial year" for advancing the most difficult aspects of the agenda: Financial risk: Financial regulation will continue to tighten, not only on banks and shadow lenders but also on the property sector, which Chinese officials claim will see a new "long-term regulatory mechanism" begin to be enacted (perhaps a nationwide property tax) (Chart 14). Local governments will face greater central discipline over bad investments, excessive debt, and corruption. The new leadership of the People's Bank of China, and of the just-created "Financial Stability and Development Commission," will attempt to establish their credibility in the face of banks that will be clamoring for less readily available liquidity.14 Green industrial restructuring: State-owned enterprises (SOEs) will continue to face stricter environmental regulations and cuts to overcapacity. This is in addition to tighter financial conditions, SOE restructuring initiatives, and an anti-corruption campaign that puts top managers under the microscope. SOEs that have not been identified as national champions, or otherwise as leading firms, will get squeezed.15 What are the market implications? First and foremost, the status quo in China is shifting, which is at least marginally negative for China's GDP growth, fixed investment, capital spending, import volumes, and resource-intensity. Real GDP should fall to around 6%, if not below, rather than today's 7%, while the Li Keqiang index should fall beneath the 2013-14 average rate of 7.3%. Second, a smooth and seamless conclusion of the 2016-17 upcycle cannot be assumed. The government's heightened effectiveness in economic policy will stem in part from an increase in political risk: the expansion of the anti-corruption campaign and Xi Jinping's personal power.16 The linking of anti-corruption probes with general policy enforcement means that any lack of compliance could result in top officials being ostracized, imprisoned, or even executed. Xi's measures will have sharper teeth than the market currently expects. Local economic actors (small banks, shadow lenders, local governments, provincial SOEs) will behave more cautiously. This will create negative growth surprises not currently being predicted by leading economic indicators (Chart 15). Chart 14Property Tightening##BR##Continues Property Tightening Continues Property Tightening Continues Chart 15Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Chinese economic policy uncertainty, credit default swaps, and equity volatility should trend upward, as investors become accustomed to sectors disrupted by government scrutiny and a government with a higher tolerance for economic pain (Chart 16). How should investors play this scenario? Despite the volatility, we still expect Chinese equities, particularly H-shares, to outperform the EM benchmark, assuming the economy does not spiral out of control and cause a global rout. Reforms will improve China's long-term potential even as they weigh on EM exports, currencies, corporate profits and share prices. On a sectoral basis, BCA's China Investment Strategy has shown that China's health care, tech, and consumer staples sectors (and arguably energy) all outperformed China's other sectors in the wake of the party congress, as one would expect of a reinvigorated reform agenda (Chart 17). These sectors should continue to outperform. Going long the MSCI Environmental, Social, and Governance (ESG) Leaders index, relative to the broad market, is one way to bet on more sustainable growth.17 Chart 16Stability Continues##BR##After Party Congress? Stability Continues After Party Congress? Stability Continues After Party Congress? Chart 17China's Reforms Will Create##BR##Some Winners And Losers China's Reforms Will Create Some Winners And Losers China's Reforms Will Create Some Winners And Losers More broadly, investors should prefer DM over EM equities, since emerging markets (especially Latin America) will suffer from a slower-growing and less commodity-hungry China (Chart 18). Within the commodities complex, investors should expect crosswinds, with energy diverging upward from base metals that are weighed down by China.18 Chart 18Who Is Exposed To China? Three Questions For 2018 Three Questions For 2018 What are the risks to this view? How and when will we find out if we are wrong? Chart 19All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead First, the best leading indicators of China's economy are indicators of money and credit, as BCA's Emerging Markets Strategy and China Investment Strategy have shown.19 The credit and broad money (M3) impulses have finally begun to tick back up after a deep dip, suggesting that in six-to-nine months the economy, which has only just begun to slow, will receive some necessary relief (Chart 19). The question is how much relief? Strong spikes in these impulses, or in the monetary conditions index or housing prices, would indicate that stimulus is still taking precedence over reform. Second, our checklist for a reform reboot, which we have maintained since April and is so far on track, offers some critical political signposts for H1 2018 (Table 2).20 For instance, if China is serious about deleveraging, then authorities will restrain bank lending at the beginning of the year. A sharp increase in credit growth in Q1 would greatly undermine our thesis (while likely encouraging exuberance globally).21 Also, in March, the National People's Congress (NPC), China's rubber-stamp parliament, will hold its annual meeting. NPC sessions can serve to launch new reform initiatives (as in 1998 and 2008) or new stimulus efforts (as in 2009 and 2016). This year's legislative session is more important than usual because it will formally launch Xi Jinping's second term. The event should provide more detail on at least a few concrete reform initiatives. If the only solid takeaways are short-term growth measures and more infrastructure investment, then the status quo will prevail. Table 2China Reform Checklist Three Questions For 2018 Three Questions For 2018 By the end of May, an assessment of the concrete NPC initiatives and the post-NPC economic data should indicate whether China's threshold for economic pain has truly gone up. If not, then any reforms that the Xi administration takes will have limited effect. It is important to note that our view does not hinge on China's refraining from stimulus altogether. We do not expect Beijing to self-impose a recession. Rather, we expect stimulus to be of a smaller magnitude than in 2015-16. We also expect the complexion of fiscal spending to continue to become less capital intensive as it is directed toward building a social safety net (Chart 20). Massive old-style stimulus should only return if the economy starts to collapse, or closer to the sensitive 2020-21 economic targets timed to coincide with the anniversary of the Communist Party.22 Chart 20China's Fiscal Spending Is Becoming Less Capital Intensive Three Questions For 2018 Three Questions For 2018 Bottom Line: The Xi administration has identified financial instability, environmental degradation, and poverty as persistent threats to the regime and is moving to address them. The consequences are, on the whole, likely to be negative for growth in the short term but positive in the long term. We expect China to see greater volatility but to benefit from better long-term prospects. Meanwhile China-exposed, commodity-reliant EMs will suffer negative side-effects. Will Geopolitical Risk Shift To The Middle East? The U.S. geopolitical "pivot to Asia" has been a central theme of our service since its launch in 2012.23 The decision to geopolitically deleverage from the Middle East and shift to Asia was undertaken by the Obama administration (Chart 21). Not because President Obama was a dove with no stomach to fight it out in the Middle East, but because the U.S. defense and intelligence establishment sees containing China as America's premier twenty-first century challenge. Chart 21U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East The grand strategy of containing China has underpinned several crucial decisions by the U.S. since 2011. First, the U.S. has become a lot more aggressive about challenging China's military expansion in the South China Sea. Second, the U.S. has begun to reposition military hardware into East Asia. Third, Washington concluded a nuclear deal with Tehran in 2015 - referred to as the Joint Comprehensive Plan of Action (JCPA) - in order to extricate itself from the Middle East and focus on China.24 President Trump, however, while maintaining the pivot, has re-focused his rhetoric back on the Middle East. The decision to move the U.S. embassy to Jerusalem, while largely accepting a fait accompli, is an unorthodox move that suggests that this administration's threshold for accepting chaos in the Middle East is a lot lower. Our concern is that the Trump administration may set its sights on Iran next. President Trump appears to believe that the U.S. can contain China, coerce North Korea into nuclear negotiations, and reverse Iranian gains in the Middle East at the same time. In our view, he cannot. The U.S. military is stretched, public war weariness remains a political constraint, regional allies are weak, and without ground-troop commitments to the Middle East Trump is unlikely to change the balance of power against Iran. All that the abrogation of the JCPA would do is provoke Iran, which could lash out across the Middle East, particularly in Iraq where Tehran-supported Shia militias remain entrenched. Investors should carefully watch whether Trump approves another six-month waiver for the Iran Freedom and Counter-Proliferation Act (IFCA) of 2012. This act imposes sanctions against all entities - whether U.S., Iranian, or others - doing business with the country (Table 3). In essence, IFCA is the congressional act that imposed sanctions against Iran. The original 2015 nuclear deal did not abrogate IFCA. Instead, Obama simply waived its provisions every six months, as provided under the original act. Table 3U.S. Sanctions Have Global Reach Three Questions For 2018 Three Questions For 2018 BCA's Commodity & Energy Strategy remains overweight oil. As our energy strategists point out, the last two years have been remarkably benign regarding unplanned production outages. Iran, Libya, and Nigeria all returned production to near-full potential, adding over 1.5 million b/d of supply back to the world markets (Chart 22). This supply increase is unlikely to repeat itself in 2018, particularly as geopolitical risks are likely to return in Iraq, Libya, and Nigeria, and already have in Venezuela (Chart 23). Chart 22Unplanned Production Outages Are At The Lowest Level In Years Three Questions For 2018 Three Questions For 2018 Nigeria is on the map once again with the Niger Delta Avengers vowing to renew hostilities with the government. Nigeria's production has been recovering since pipeline saboteurs knocked it down to 1.4 million b/d in the period from May 2016 to June 2017, but rising tensions could threaten output anew. And Venezuela remains in a state of near-collapse.25 Iraq is key, and three risks loom large. First, as we have pointed out since early 2016, the destruction of the Islamic State is exposing fault lines between the Kurds - who have benefited the most from the vacuum created by the Islamic State's defeat - and their Arab neighbors.26 Second, remnants of the Islamic State may turn into saboteurs since their dream of controlling a Caliphate is dead. Third, investors need to watch renewed tensions between the U.S. and Iran. Shia-Sunni tensions could reignite if Tehran decides to retaliate against any re-imposition of economic sanctions by Washington. Not only could Tehran retaliate against Sunnis in Iraq, throwing the country into another civil war, but it could even go back to its favorite tactic from 2011: threatening to close the Straits of Hormuz. Another critical issue to consider is how the rest of the world would respond to the re-imposition of sanctions against Iran. Under IFCA, the Trump administration would be able to sanction any bank, shipping, or energy company that does business with the country, including companies belonging to European and Asian allies. If the administration pursued such policy, however, we would expect a major break between the U.S. and Europe. It took Obama four years of cajoling, threatening, and strategizing to convince Europe, China, India, Russia, and Asian allies to impose sanctions against Iran. For many economies this was a tough decision given reliance on Iran for energy supplies. A move by the U.S. to re-open the front against Iran, with no evidence that Tehran has failed to uphold the nuclear deal itself, would throw U.S. alliances into a flux. The implications of such a decision could therefore go beyond merely increasing the geopolitical risk premium. Chart 23Iraq, Libya, And Venezuela Are##BR##At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Chart 24Buy Energy,##BR##Short Metals Buy Energy, Short Metals Buy Energy, Short Metals Bottom Line: BCA's Commodity & Energy Strategy has set the average oil price forecast at $67 per barrel for 2018.27 We believe that the upside risk to this view is considerable. As a way to parlay our relatively bearish view on the Chinese economy with the bullish oil view of our commodity colleagues, we would recommend that our clients go long global energy stocks relative to metal and mining equities (Chart 24). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "2018 Key Views, Part I: Five Black Swans," dated December 6, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 On June 14, James Hodkinson, a left-wing activist, attacked Republican members of Congress while practicing baseball for the annual Congressional Baseball Game for Charity. 6 A very sophisticated client in New York asked us whether we believed that National Guard units, who are staffed from the neighborhoods they would have to pacify in case of unrest, would remain loyal to the federal government in case of impeachment-related unrest. Our high-conviction view is that they would. First, the U.S. has a highly professionalized military with a strong history of robust civil-military relations. Second, if the Alabama National Guard remained loyal to President Kennedy in the 1963 University of Alabama integration protests - the so-called "Stand in the Schoolhouse Door" incident - then we certainly would expect "Red State" National Guard units to remain loyal to their chain-of-command in 2017. That said, the very fact that we do not consider the premise of the question to be ludicrous suggests that we are in a genuine paradigm shift. 7 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 8 The "Saturday Night Massacre," which escalated the crisis in the White House, occurred in October, the same month that OPEC launched an oil embargo and caused the oil shock. The U.S. economy was already sliding into recession, which technically began in November. 9 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017, available at gis.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, and Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 16 For instance, the decision to stack the country's chief bank regulator (the CBRC) with some of the country's toughest anti-corruption officials is significant and will bode ill not only for corrupt regulators but also for banks that have benefited from cozy relationships with them. This is not a neutral development with regard to bank lending. Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 18 Note that these eco-reforms will reduce supply, which could offset - at least in part - the lower demand from within China. Please see BCA Commodity & Energy Strategy Weekly Report, "Shifting Gears In China: The Impact On Base Metals," dated November 9, 2017, available at ces.bcaresearch.com. The status of China's supply-side reforms suggests that steel, coking coal, and iron ore prices are most likely to decline from current levels; please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com, and China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 21 It is primarily credit excesses that a reform-oriented government would seek to rein in, while fiscal spending may have to increase to try to compensate for slower credit growth. 22 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Brewing Tensions In The South China Sea: Implications," dated June 13, 2012, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Commodity & Energy Strategy, "Key Themes For Energy Markets In 2018," dated December 7, 2017, available at ces.bcaresearch.com.

Highlights Investors should expect little policy initiative out of the U.S. Congress after tax cuts; Polarization is likely to rise substantively in 2018, gridlocking Congress; Chinese policymakers are experimenting with growth-constraining reforms; Global growth has peaked; underweight emerging markets in 2018; Go long energy stocks relative to metal and mining equities. Feature Last week we published Part I of our 2018 Key Views.1 In it, we presented our five "Black Swans" for 2018: Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran - throwing the Middle East into chaos - and protectionism against China. A Coup In North Korea: Chinese economic pressure overshoots its mark and throws Pyongyang into a crisis. Kim Jong-un is replaced, but markets struggle to ascertain whether the successor is a moderate or a hawk. Prime Minister Jeremy Corbyn: Markets cheer the higher probability of "Bremain" and then remember that Corbyn is a genuine socialist. Italian Election Troubles: Markets are fully pricing in the sanguine scenario of "much ado about nothing," which is our view as well. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM? Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked. These are not our core views. As black swans, they are low-probability events that may disturb markets in 2018. Our core view remains that geopolitical risks were overstated in 2017 and will be understated in 2018 (Charts 1 & 2). Most importantly, U.S. politics will be a tailwind to global growth while Chinese politics will be a headwind to global growth. While the overall effect may be neutral, the combination will be bullish for the U.S. dollar and bearish for emerging markets.2 Chart 12018 Will See Risks Dominate... 2018 Will See Risks Dominate... 2018 Will See Risks Dominate... Chart 2...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge This week, we turn to the three questions that we believe will define the year for investors: Is A Civil War Coming To America? Is The Ghost Of Deng Xiaoping Haunting China? Will Geopolitical Risk Shift To The Middle East? Is A Civil War Coming To America? On a recent visit to Boston and New York we were caught off guard by how alarmed several large institutional clients were about the risk of severe social unrest in the U.S. We share this concern about the level of polarization in the U.S. and expect social instability to rise over the coming years (Chart 3).3 When roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being," we have entered a new paradigm (Chart 4). Chart 3Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 4"A Threat To The Nation's Well-Being?" Really?! Three Questions For 2018 Three Questions For 2018 Where we differ from some of our clients is in assessing the likely trigger for the unrest and its investment implications over the next 12 months. If the Democrats take the House of Representatives in the November 6 midterm election, as is our low-conviction view at this early point, then we would expect them eventually to impeach President Trump in 2019.4 Even then, it is not clear that the Senate would have the necessary 67 votes to convict Trump of the articles of impeachment (whatever they prove to be) and hence remove him from power. Republicans are likely to increase their majority in the Senate, even if they lose the House, because more Democratic senators are up for re-election in 2018. Therefore well over a dozen Republican senators would have to vote to remove a Republican president from power. For that to happen, Trump's popularity with Republican voters would have to go into a free fall, diving well below 60% (Chart 5). Meanwhile, we do not buy the argument that hordes of gun-wielding "deplorables" would descend upon the liberal coasts in case of impeachment. There may well be significant acts of domestic terrorism, particularly in the wake of any removal of Trump from office, but they would likely be isolated and unable to galvanize broader support. Our clients should remember, however, that ultra-right-wing militant groups are not the only perpetrators of domestic terrorism.5 Any acts of violence or social unrest are likely to draw press coverage and analytical hyperbole. But our left-leaning clients in the Northeast are likely overstating the sincerity of support for President Trump. President Trump won 44.9% of the Republican primary votes, but he averaged only 35% of the vote in the early days when the races were the most competitive. Given that only 25% of Americans identify as Republicans (Chart 6), it is fair to say that only about a third of that figure - 8%-10% of all U.S. voters - are Trump loyalists. Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). Of that small percentage of genuine Trump fans, it is highly unlikely that a large share would seriously contemplate taking arms against the state in order to keep their leader in power against the constitutional impeachment process. Especially given that President Trump would be replaced by a genuine conservative, Vice President Mike Pence.6 Chart 5We Are A Long Way Away##BR##From Trump's Demise Three Questions For 2018 Three Questions For 2018 Chart 6Party Identifications##BR##Are Shrinking Party Identifications Are Shrinking Party Identifications Are Shrinking As such, we believe that it is premature to speak of a total breakdown of social order in America. It is notable that such a conversation is taking place, but other forms of polarization and social unrest are far more likely to be relevant at the moment. In terms of policy, we would expect gridlock in Congress if Democrats take the House and begin focusing on impeachment. In fact, gridlock may already be upon us, as we see little agreement between the Trump administration, its loyalists in Congress, and establishment Republican Senators like Dan Sullivan (R, Alaska), Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), Ben Sasse (R, Nebraska), and Thom Tillis (R, North Carolina). These six Senators are all facing reelection in 2020 and are likely to evolve into Democrats-in-all-but-name. If President Trump's overall popularity continues to decline, we would not be surprised if one or two (starting with Collins) even take the dramatic step of leaving the Republican Party for the 2020 election. Essentially, establishment Republicans will become effective Democrats ahead of the midterms. Post-midterm election, with Democrats potentially taking over the House, the legislative process will grind to a complete halt. Government shutdowns, debt ceiling fights, failure of proactive policymaking to deal with crises and natural disasters, will all rise in probability. As President Trump faces greater constraints in Congress, we can see him becoming increasingly reliant on his executive authority to create policy. He would not be unique in this way, as President Obama did the same. While Trump's executive policy will be pro-business, unlike Obama's, uncertainty will rise regardless. The business community will not be able to take White House policies seriously amidst impeachment and a potential Democratic wave-election in 2020. Whatever executive orders Trump signs into power over the next three years, chances are that they will be immediately reversed in 2020. What about the markets? The Mueller investigation and heightened level of polarization could create drawdowns in equity markets throughout the year. However, impeachment proceedings are not likely to begin in 2018 and have never carried more weight with investors than market fundamentals (Chart 7).7 True, the Watergate scandal under President Richard Nixon triggered a spike in volatility and a fall in equities. However, the scandal alone did not cause the correction, rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, massive insurance fraud, recession, and a global oil shock.8 Chart 7AFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets Chart 7BFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets What about the impact on the U.S. dollar? Does Trump-related political instability threaten the dollar's status as the chief global reserve currency and a major financial safe haven? The data suggest not. We put together a list of events in 2017 that could be categorized as "unorthodox, Trump-related, political risk" (Table 1). We specifically left out geopolitical events, such as the North Korean nuclear crisis, so as not to dilute our dataset's focus on domestic intrigue. As Chart 8 illustrates, the U.S. dollar rose slightly, on average, a week after each event relative to its average weekly return prior to the crisis. While this may not be a resounding vote of confidence for the greenback (gold performed better), there is no evidence that investors are betting on a paradigm shift away from the dollar as the global reserve currency. Table 1An Eventful Year 1 Of Trump Presidency Three Questions For 2018 Three Questions For 2018 Chart 8Trump Is Not A U.S. Dollar Paradigm Shift Three Questions For 2018 Three Questions For 2018 If investors should not worry about investment-relevant social strife in the U.S. in 2018, then when should they worry? Well, if Trump is actually removed from office, a first in U.S. history, at a time of extreme polarization, and in a country with easy access to arms and at least a strain of domestic terrorism, then 2019-20 will at least be a time for concern. Even without Trump's removal, we worry about unrest beyond 2018. We expect the ideological pendulum to shift to the left by the 2020 election. If our sister service - BCA's Global Investment Strategy - is correct, then a recession is likely to begin in late 2019.9 A combination of low popularity, market turbulence, and economic recession would doom Trump's chances of returning to the White House. But they would also be toxic for the candidacy of a moderate Democrat and would possibly propel a left-wing candidate to the presidency. Four years under a left-wing, socially progressive firebrand may be too much for many far-right voters to tolerate. Given America's demographic trends (Chart 9), these voters will realize that the writing is on the wall, that the window of opportunity to lock in their preferred policies has been firmly shut. The international context teaches us that disenchanted groups contemplate "exit" when the strategy of "voice" no longer works. How this will look in the U.S. is unclear at this point. Bottom Line: Investors should continue to fade impeachment-related, and Mueller investigation-related, pullbacks in the markets or the U.S. dollar in 2018. Our fears of U.S. social instability are mostly for the medium and long term. Fundamentals drive the markets and U.S. fundamentals remain solid for now. As our colleague Peter Berezin has pointed out, there is no imminent risk of a U.S. recession (Chart 10) and the cyclical picture remains bright (Chart 11).10 Chart 9A Changing America A Changing America A Changing America Chart 10No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession Chart 11U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright Where BCA's Geopolitical Strategy diverges from the BCA House View, however, is in terms of the global growth picture. While we recognize that there are no imminent risks of a global recession, we do believe that the policy trajectory in China is being obfuscated by positive global economic projections. To this risk we now turn. Is The Ghost Of Deng Xiaoping Haunting China? Our view that Chinese President Xi Jinping would reboot his reform agenda after the nineteenth National Party Congress this October is beginning to bear fruit. Investors are starting to realize that the policy tightening of 2017 was not a one-off event but a harbinger of what to expect in 2018. China's economic activity is slowing down and the policy outlook is getting less accommodative (Chart 12).11 To be clear, we never bought into the 2013 Third Plenum "reform" hype, which sought to resurrect the ghost of Deng Xiaoping and his decision to open China's economy at the Third Plenum in 1978.12 Nor will we buy into any similar hype around the upcoming Third Plenum in 2018. Instead, we focus on policymaker constraints. And it seems to us that the constraints to reform in China have fallen since 2013. The severity of China's financial and economic imbalances, the positive external economic backdrop, the desire to avoid confrontation with Trump, and the Xi administration's advantageous moment in the Chinese domestic political cycle, all suggest to us that Xi will be driven to accelerate his agenda in 2018. Broadly, this agenda consists of revitalizing the Communist Party regime at home and elevating China's national power and prestige abroad. More specifically it entails: Re-centralizing power after a perceived lack of leadership from roughly 2004-12; Improving governance, to rebuild the legitimacy and popular support of the single-party state, namely by fighting corruption; Restructuring the economy to phase out the existing growth model, which relies excessively on resource-intensive investment while suppressing private consumption (Chart 13). Chart 12China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming Chart 13Excess Investment Is A Real Problem Excess Investment Is A Real Problem Excess Investment Is A Real Problem The October party congress showed that this framework remains intact.13 First, Xi was elevated to Mao Zedong's status in the party constitution, which makes it much riskier for vested interests to flout his policies. Second, he declared the creation of a "National Supervision Commission," which will expand the anti-corruption campaign from the Communist Party to the administrative bureaucracy at all levels. Third, he recommitted to his economic agenda of improving the quality of economic growth at the expense of its pace and capital intensity. What does this mean for the economy in 2018? We expect government policy to become a headwind, after having been a tailwind in 2016-17. As Xi and the top-decision-making Politburo officially stated on December 9, the coming year will be a "crucial year" for advancing the most difficult aspects of the agenda: Financial risk: Financial regulation will continue to tighten, not only on banks and shadow lenders but also on the property sector, which Chinese officials claim will see a new "long-term regulatory mechanism" begin to be enacted (perhaps a nationwide property tax) (Chart 14). Local governments will face greater central discipline over bad investments, excessive debt, and corruption. The new leadership of the People's Bank of China, and of the just-created "Financial Stability and Development Commission," will attempt to establish their credibility in the face of banks that will be clamoring for less readily available liquidity.14 Green industrial restructuring: State-owned enterprises (SOEs) will continue to face stricter environmental regulations and cuts to overcapacity. This is in addition to tighter financial conditions, SOE restructuring initiatives, and an anti-corruption campaign that puts top managers under the microscope. SOEs that have not been identified as national champions, or otherwise as leading firms, will get squeezed.15 What are the market implications? First and foremost, the status quo in China is shifting, which is at least marginally negative for China's GDP growth, fixed investment, capital spending, import volumes, and resource-intensity. Real GDP should fall to around 6%, if not below, rather than today's 7%, while the Li Keqiang index should fall beneath the 2013-14 average rate of 7.3%. Second, a smooth and seamless conclusion of the 2016-17 upcycle cannot be assumed. The government's heightened effectiveness in economic policy will stem in part from an increase in political risk: the expansion of the anti-corruption campaign and Xi Jinping's personal power.16 The linking of anti-corruption probes with general policy enforcement means that any lack of compliance could result in top officials being ostracized, imprisoned, or even executed. Xi's measures will have sharper teeth than the market currently expects. Local economic actors (small banks, shadow lenders, local governments, provincial SOEs) will behave more cautiously. This will create negative growth surprises not currently being predicted by leading economic indicators (Chart 15). Chart 14Property Tightening##BR##Continues Property Tightening Continues Property Tightening Continues Chart 15Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Chinese economic policy uncertainty, credit default swaps, and equity volatility should trend upward, as investors become accustomed to sectors disrupted by government scrutiny and a government with a higher tolerance for economic pain (Chart 16). How should investors play this scenario? Despite the volatility, we still expect Chinese equities, particularly H-shares, to outperform the EM benchmark, assuming the economy does not spiral out of control and cause a global rout. Reforms will improve China's long-term potential even as they weigh on EM exports, currencies, corporate profits and share prices. On a sectoral basis, BCA's China Investment Strategy has shown that China's health care, tech, and consumer staples sectors (and arguably energy) all outperformed China's other sectors in the wake of the party congress, as one would expect of a reinvigorated reform agenda (Chart 17). These sectors should continue to outperform. Going long the MSCI Environmental, Social, and Governance (ESG) Leaders index, relative to the broad market, is one way to bet on more sustainable growth.17 Chart 16Stability Continues##BR##After Party Congress? Stability Continues After Party Congress? Stability Continues After Party Congress? Chart 17China's Reforms Will Create##BR##Some Winners And Losers China's Reforms Will Create Some Winners And Losers China's Reforms Will Create Some Winners And Losers More broadly, investors should prefer DM over EM equities, since emerging markets (especially Latin America) will suffer from a slower-growing and less commodity-hungry China (Chart 18). Within the commodities complex, investors should expect crosswinds, with energy diverging upward from base metals that are weighed down by China.18 Chart 18Who Is Exposed To China? Three Questions For 2018 Three Questions For 2018 What are the risks to this view? How and when will we find out if we are wrong? Chart 19All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead First, the best leading indicators of China's economy are indicators of money and credit, as BCA's Emerging Markets Strategy and China Investment Strategy have shown.19 The credit and broad money (M3) impulses have finally begun to tick back up after a deep dip, suggesting that in six-to-nine months the economy, which has only just begun to slow, will receive some necessary relief (Chart 19). The question is how much relief? Strong spikes in these impulses, or in the monetary conditions index or housing prices, would indicate that stimulus is still taking precedence over reform. Second, our checklist for a reform reboot, which we have maintained since April and is so far on track, offers some critical political signposts for H1 2018 (Table 2).20 For instance, if China is serious about deleveraging, then authorities will restrain bank lending at the beginning of the year. A sharp increase in credit growth in Q1 would greatly undermine our thesis (while likely encouraging exuberance globally).21 Also, in March, the National People's Congress (NPC), China's rubber-stamp parliament, will hold its annual meeting. NPC sessions can serve to launch new reform initiatives (as in 1998 and 2008) or new stimulus efforts (as in 2009 and 2016). This year's legislative session is more important than usual because it will formally launch Xi Jinping's second term. The event should provide more detail on at least a few concrete reform initiatives. If the only solid takeaways are short-term growth measures and more infrastructure investment, then the status quo will prevail. Table 2China Reform Checklist Three Questions For 2018 Three Questions For 2018 By the end of May, an assessment of the concrete NPC initiatives and the post-NPC economic data should indicate whether China's threshold for economic pain has truly gone up. If not, then any reforms that the Xi administration takes will have limited effect. It is important to note that our view does not hinge on China's refraining from stimulus altogether. We do not expect Beijing to self-impose a recession. Rather, we expect stimulus to be of a smaller magnitude than in 2015-16. We also expect the complexion of fiscal spending to continue to become less capital intensive as it is directed toward building a social safety net (Chart 20). Massive old-style stimulus should only return if the economy starts to collapse, or closer to the sensitive 2020-21 economic targets timed to coincide with the anniversary of the Communist Party.22 Chart 20China's Fiscal Spending Is Becoming Less Capital Intensive Three Questions For 2018 Three Questions For 2018 Bottom Line: The Xi administration has identified financial instability, environmental degradation, and poverty as persistent threats to the regime and is moving to address them. The consequences are, on the whole, likely to be negative for growth in the short term but positive in the long term. We expect China to see greater volatility but to benefit from better long-term prospects. Meanwhile China-exposed, commodity-reliant EMs will suffer negative side-effects. Will Geopolitical Risk Shift To The Middle East? The U.S. geopolitical "pivot to Asia" has been a central theme of our service since its launch in 2012.23 The decision to geopolitically deleverage from the Middle East and shift to Asia was undertaken by the Obama administration (Chart 21). Not because President Obama was a dove with no stomach to fight it out in the Middle East, but because the U.S. defense and intelligence establishment sees containing China as America's premier twenty-first century challenge. Chart 21U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East The grand strategy of containing China has underpinned several crucial decisions by the U.S. since 2011. First, the U.S. has become a lot more aggressive about challenging China's military expansion in the South China Sea. Second, the U.S. has begun to reposition military hardware into East Asia. Third, Washington concluded a nuclear deal with Tehran in 2015 - referred to as the Joint Comprehensive Plan of Action (JCPA) - in order to extricate itself from the Middle East and focus on China.24 President Trump, however, while maintaining the pivot, has re-focused his rhetoric back on the Middle East. The decision to move the U.S. embassy to Jerusalem, while largely accepting a fait accompli, is an unorthodox move that suggests that this administration's threshold for accepting chaos in the Middle East is a lot lower. Our concern is that the Trump administration may set its sights on Iran next. President Trump appears to believe that the U.S. can contain China, coerce North Korea into nuclear negotiations, and reverse Iranian gains in the Middle East at the same time. In our view, he cannot. The U.S. military is stretched, public war weariness remains a political constraint, regional allies are weak, and without ground-troop commitments to the Middle East Trump is unlikely to change the balance of power against Iran. All that the abrogation of the JCPA would do is provoke Iran, which could lash out across the Middle East, particularly in Iraq where Tehran-supported Shia militias remain entrenched. Investors should carefully watch whether Trump approves another six-month waiver for the Iran Freedom and Counter-Proliferation Act (IFCA) of 2012. This act imposes sanctions against all entities - whether U.S., Iranian, or others - doing business with the country (Table 3). In essence, IFCA is the congressional act that imposed sanctions against Iran. The original 2015 nuclear deal did not abrogate IFCA. Instead, Obama simply waived its provisions every six months, as provided under the original act. Table 3U.S. Sanctions Have Global Reach Three Questions For 2018 Three Questions For 2018 BCA's Commodity & Energy Strategy remains overweight oil. As our energy strategists point out, the last two years have been remarkably benign regarding unplanned production outages. Iran, Libya, and Nigeria all returned production to near-full potential, adding over 1.5 million b/d of supply back to the world markets (Chart 22). This supply increase is unlikely to repeat itself in 2018, particularly as geopolitical risks are likely to return in Iraq, Libya, and Nigeria, and already have in Venezuela (Chart 23). Chart 22Unplanned Production Outages Are At The Lowest Level In Years Three Questions For 2018 Three Questions For 2018 Nigeria is on the map once again with the Niger Delta Avengers vowing to renew hostilities with the government. Nigeria's production has been recovering since pipeline saboteurs knocked it down to 1.4 million b/d in the period from May 2016 to June 2017, but rising tensions could threaten output anew. And Venezuela remains in a state of near-collapse.25 Iraq is key, and three risks loom large. First, as we have pointed out since early 2016, the destruction of the Islamic State is exposing fault lines between the Kurds - who have benefited the most from the vacuum created by the Islamic State's defeat - and their Arab neighbors.26 Second, remnants of the Islamic State may turn into saboteurs since their dream of controlling a Caliphate is dead. Third, investors need to watch renewed tensions between the U.S. and Iran. Shia-Sunni tensions could reignite if Tehran decides to retaliate against any re-imposition of economic sanctions by Washington. Not only could Tehran retaliate against Sunnis in Iraq, throwing the country into another civil war, but it could even go back to its favorite tactic from 2011: threatening to close the Straits of Hormuz. Another critical issue to consider is how the rest of the world would respond to the re-imposition of sanctions against Iran. Under IFCA, the Trump administration would be able to sanction any bank, shipping, or energy company that does business with the country, including companies belonging to European and Asian allies. If the administration pursued such policy, however, we would expect a major break between the U.S. and Europe. It took Obama four years of cajoling, threatening, and strategizing to convince Europe, China, India, Russia, and Asian allies to impose sanctions against Iran. For many economies this was a tough decision given reliance on Iran for energy supplies. A move by the U.S. to re-open the front against Iran, with no evidence that Tehran has failed to uphold the nuclear deal itself, would throw U.S. alliances into a flux. The implications of such a decision could therefore go beyond merely increasing the geopolitical risk premium. Chart 23Iraq, Libya, And Venezuela Are##BR##At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Chart 24Buy Energy,##BR##Short Metals Buy Energy, Short Metals Buy Energy, Short Metals Bottom Line: BCA's Commodity & Energy Strategy has set the average oil price forecast at $67 per barrel for 2018.27 We believe that the upside risk to this view is considerable. As a way to parlay our relatively bearish view on the Chinese economy with the bullish oil view of our commodity colleagues, we would recommend that our clients go long global energy stocks relative to metal and mining equities (Chart 24). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "2018 Key Views, Part I: Five Black Swans," dated December 6, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 On June 14, James Hodkinson, a left-wing activist, attacked Republican members of Congress while practicing baseball for the annual Congressional Baseball Game for Charity. 6 A very sophisticated client in New York asked us whether we believed that National Guard units, who are staffed from the neighborhoods they would have to pacify in case of unrest, would remain loyal to the federal government in case of impeachment-related unrest. Our high-conviction view is that they would. First, the U.S. has a highly professionalized military with a strong history of robust civil-military relations. Second, if the Alabama National Guard remained loyal to President Kennedy in the 1963 University of Alabama integration protests - the so-called "Stand in the Schoolhouse Door" incident - then we certainly would expect "Red State" National Guard units to remain loyal to their chain-of-command in 2017. That said, the very fact that we do not consider the premise of the question to be ludicrous suggests that we are in a genuine paradigm shift. 7 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 8 The "Saturday Night Massacre," which escalated the crisis in the White House, occurred in October, the same month that OPEC launched an oil embargo and caused the oil shock. The U.S. economy was already sliding into recession, which technically began in November. 9 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017, available at gis.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, and Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 16 For instance, the decision to stack the country's chief bank regulator (the CBRC) with some of the country's toughest anti-corruption officials is significant and will bode ill not only for corrupt regulators but also for banks that have benefited from cozy relationships with them. This is not a neutral development with regard to bank lending. Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 18 Note that these eco-reforms will reduce supply, which could offset - at least in part - the lower demand from within China. Please see BCA Commodity & Energy Strategy Weekly Report, "Shifting Gears In China: The Impact On Base Metals," dated November 9, 2017, available at ces.bcaresearch.com. The status of China's supply-side reforms suggests that steel, coking coal, and iron ore prices are most likely to decline from current levels; please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com, and China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 21 It is primarily credit excesses that a reform-oriented government would seek to rein in, while fiscal spending may have to increase to try to compensate for slower credit growth. 22 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Brewing Tensions In The South China Sea: Implications," dated June 13, 2012, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Commodity & Energy Strategy, "Key Themes For Energy Markets In 2018," dated December 7, 2017, available at ces.bcaresearch.com.

Highlights China stands out as the most likely candidate to send negative shock waves through EM and commodities in 2018. Granted the ongoing policy tightening in China will likely dampen money growth further, the only way mainland nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. Assigning equal probabilities to various scenarios of velocity of money, the outcome is as follows: one-third probability of robust nominal growth (continuation of the rally in China-related plays) and two-third odds of a non-trivial slowdown in nominal growth with negative ramifications for China-related plays. Hence, we reiterate our negative stance on EM risk assets Feature The key question for emerging markets (EM) in 2018 is whether a slowdown in Chinese money growth will translate into a meaningful growth deceleration in this economy, and in turn produce a reversal in EM risk assets. This week we address the above question in detail elaborating on what could make China's business cycle defy the slowdown in its monetary aggregates and how investors should approach such uncertainty. Before this, we review the status of financial markets going into 2018. Priced To Perfection Or A New Paradigm? Several financial markets are at extremes. Our chart on the history of financial market manias reveals that some parts of technology/new concept stocks may be entering uncharted territory (Chart I-1). Tencent's share price, for instance, has surged 11-fold since January 2010. Chart I-1History Of Financial Markets Manias: They Lasted A Decade History Of Financial Markets Manias: They Lasted A Decade History Of Financial Markets Manias: They Lasted A Decade This is roughly on par with the prior manias' average 10-year gains. As this chart indicates, the manias of previous decades run wild until the turn of the decade. It is impossible to know whether technology/new concept stocks will peak in 2018 or run for another two years. Regardless whether or not the mania in tech/new concept stocks endures up until 2020, some sort of mean reversion in their share prices is likely next year. This has relevance to EM because the magnitude of the EM equity rally in 2017 has been enormously boosted by four large tech/concept stocks in Asia. Our measure of the cyclically-adjusted P/E (CAPE) ratio for the U.S. market suggests that equity valuations are reaching their 2000 overvaluation levels (Chart I-2, top panel). The difference between our measure and Shiller's measure of CAPE is that Shiller's CAPE is derived by dividing share prices by the 10-year moving average of EPS in real terms (deflated by consumer price inflation). Our measure is calculated by dividing equity prices by the time trend in real EPS (Chart I-2, bottom panel). Our CAPE measure assumes that in the long run, U.S. EPS in real terms will revert to its time trend. Meanwhile, the Shiller CAPE is based on the assumption that real EPS will revert to its 10-year mean. Hence, the assumptions behind our CAPE model are quite reasonable if not preferable to those of Shiller's P/E. Remarkably, the U.S. (Wilshire 5000) market cap-to-GDP ratio is close to its 2000 peak (Chart I-3). With respect to EM equity valuations, the non-financial P/E ratio is at its highest level in the past 15 years (Chart I-4). EM banks have low multiples and seem "cheap" because many of them have not provisioned for NPLs. Hence, their profits and book values are artificially inflated. In short, excluding financials, EM stocks are not cheap at all, neither in absolute terms nor relative to DM bourses. Chart I-2A Perspective On U.S. Equity Valuation A Perspective On U.S. Equity Valuation A Perspective On U.S. Equity Valuation Chart I-3The U.S. Market Cap-To-GDP ##br##Ratio Is Close To 2000 Peak The U.S. Market Cap-To-GDP Ratio Is Close To 2000 Peak The U.S. Market Cap-To-GDP Ratio Is Close To 2000 Peak Chart I-4EM Non-Financial Equities Are Not Cheap EM Non-Financial Equities Are Not Cheap EM Non-Financial Equities Are Not Cheap Such elevated DM & EM stock market valuations might be justified by currently low global long-term bond yields. Yet, if and when long-term bond yields rise, multiples will likely shrink. The latter will overpower the profit growth impact on share prices, as multiples are disproportionately and negatively linked to interest rates - especially when interest rates are low - but are proportionately and positively linked to EPS.1 As a result, a small rise in long-term bond yields will lead to a meaningful P/E de-rating. Despite very high equity valuations, U.S. advisors and traders are extremely bullish on American stocks. Their sentiment measures are at all time and 11-year highs, respectively. So are copper traders on red metal prices (Chart I-5). The mirror image of the strong and steady rally in global stocks is record-low implied volatility. The aggregate financial markets' implied volatility index is at a multi-year low (Chart I-6). Finally, yields on junk (high-yield) EM corporate and sovereign bonds are at all-time lows (Chart I-7). They are priced for perfection. Chart I-5Bullish Sentiment On Copper Is Very Elevated Bullish Sentiment On Copper Is Very Elevated Bullish Sentiment On Copper Is Very Elevated Chart I-6Aggregate Global Financial Markets ##br##Implied VOL Is At Record Low Aggregate Global Financial Markets Implied VOL Is At Record Low Aggregate Global Financial Markets Implied VOL Is At Record Low Chart I-7EM Junk Bond Yields Are At Record Low EM Junk Bond Yields Are At Record Low EM Junk Bond Yields Are At Record Low Are we in a new paradigm, or are we witnessing financial market extremes that are unsustainable? In regard to the timing, can these dynamics last throughout 2018 or at least the first half of next year, or will they reverse in the coming months? We have less conviction on the durability of the U.S. equity rally, but our bet is that EM risk assets will roll over in absolute terms and begin underperforming their DM peers very soon. What could cause such a reversal in EM risk assets? China stands out as the most likely candidate to send negative shock waves through emerging markets and commodities. China: "Financial Stability" Priority Entails Tighter Policy The Chinese authorities are facing unprecedented challenges: The outstanding value of broad money in China (measured in U.S. dollars) is now larger than the combined U.S. and euro area broad money supply (Chart I-8, top panel). Chart I-8Beware Of Money Excesses In China Beware Of Money Excesses In China Beware Of Money Excesses In China As a share of its own GDP, broad money in China is much higher compared to any other nation in history (Chart I-8, bottom panel). In brief, there is too much money in China and most of it - $21 trillion out of $29 trillion - has been created by the banking system since early 2009. We maintain that the enormous overhang of money and credit in China represents major excess/imbalances and has nothing to do with the nation's high savings rate.2 Rather, it is an outcome of animal spirits running wild among bankers and borrowers over the past nine years. Easy money often flows into real estate and China has not been an exception. Needless to say, property prices are hyped and expensive relative to household income. Policy tightening amid lingering excesses and imbalances makes us negative on China's growth outlook. In a nutshell, we place more weight on tightening when there are excesses in the system, and downplay the importance of tightening in a healthy system without excesses. Importantly, excessive money creation seems to finally be pushing inflation higher. Consumer price services and core consumer price inflation rates are on a rising trajectory (Chart I-9, top and middle panels). As a result, banks' deposit rates in real terms (deflated by core CPI) have plunged into negative territory for the first time in the past 12 years (Chart I-9, bottom panel). Remarkably, the People's Bank of China's existing $3 trillion of international reserves is sufficient to "back up" only 13% and 11% of official M2 and our measure of M3, respectively (Chart I-10). If Chinese households and companies decide to convert 10-15% of their deposits into foreign currency and the PBoC takes the other side of the trade, its reserves will be exhausted. Chart I-9China: Inflation Is Rising And ##br##Real Deposit Rate Is Negative China: Inflation Is Rising And Real Deposit Rate Is Negative China: Inflation Is Rising And Real Deposit Rate Is Negative Chart I-10China: Low Coverage Of ##br##Money Supply By FX Reserves bca.ems_wr_2017_11_29_s1_c10 bca.ems_wr_2017_11_29_s1_c10 Therefore, reining money and credit expansion is of paramount importance to China's long-term financial and economic stability. "Financial stability" has become the key policy priority. "Financial stability" is policymakers' code word for containing and curbing financial imbalances and bubbles. Having experienced the equity bubble bust in 2015, policymakers are determined to preclude another bubble formation and its subsequent bust. Consequently, the ongoing tightening campaign will not be reversed in the near term unless damage to the economy becomes substantial and visible. By the time the authorities and investors are able to identify such damage in the real economy, China-related plays in financial markets will be down substantially. Chart I-11China: Corporate Bond Yields And Yield Curve China: Corporate Bond Yields And Yield Curve China: Corporate Bond Yields And Yield Curve Faced with significant excesses in money, leverage and property markets, the Chinese authorities have been tightening - and have reinforced their policy stance following the Party's Congress in October. There is triple tightening currently ongoing in China: 1. Liquidity tightening: Money market rates have climbed, and onshore corporate bond yields are rising (Chart I-11, top panel). Remarkably, the yield curve is flat, pointing to weaker growth ahead (Chart I-11, bottom panel). 2. Regulatory tightening: The China Banking Regulatory Commission (CBRC) is forcing banks to bring off-balance-sheet assets onto their balance sheets, and is reining banks' involvement in shadow banking activities. In addition, financial regulators are trying to remove the government's implicit "put" from the financial system, and thereby curb speculative and irresponsible investment behavior. Finally, many local governments are tightening investors' participation in the real estate market. 3. Anti-corruption campaign is embracing the financial institutions: The powerful anti-corruption commission is planning to dispatch groups of inspectors to examine financial institutions' activities. This could dampen animal spirits among bankers and shadow banking organizations. The Outlook: The "Knowns"... In China, broad money growth has already slumped to an all-time low (Chart I-12). The money as well as the credit plus fiscal spending impulses both point to a considerable slowdown in the mainland's industrial cycle and overall economic activity (Chart I-13). Chart I-12China: Broad Money ##br##Growth Is At All-Time Low bca.ems_wr_2017_11_29_s1_c12 bca.ems_wr_2017_11_29_s1_c12 Chart I-13China: Money And Credit & ##br##Fiscal Impulses Are Negative bca.ems_wr_2017_11_29_s1_c13 bca.ems_wr_2017_11_29_s1_c13 The slowdown is not limited to money growth; there are a few real business cycle indicators that are already weakening. For example, the growth rate of property floor space sold and started has slumped to zero (Chart I-14). Electricity output and aggregate freight volume growth have both decisively rolled over (Chart I-15). Chart I-14China: Property Starts Are Set To Contract Again China: Property Starts Are Set To Contract Again China: Property Starts Are Set To Contract Again Chart I-15China: A Few Signs Of Slowdown China: A Few Signs Of Slowdown China: A Few Signs Of Slowdown That said, based on the past correlation between money and credit impulses on the one hand and the business cycle on the other, China's economy should have slowed much more, and its negative impact on the rest of the world should have already been felt (Chart I-13, on page 9). This has been the key pillar of our view on EM, but it has not yet transpired. Is it possible that the relationship between money/credit impulses and the business cycle has broken down? If so, why? And how should investors handle such uncertainty? Bottom Line: China's ongoing policy tightening will ensure that money and credit impulses remain negative for some time. Can the country's industrial sectors de-couple from its past tight correlation with money and credit? ...And The "Unknowns" By definition, the only way to sustain nominal economic growth in the face of a decelerating money supply is if the velocity of money increases. This is true for any economy. Nominal GDP = Money Supply x Velocity of Money Provided China's policy tightening will likely further dampen money growth, the only way nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. This is the main risk to our view and strategy. Chart I-16 portrays all three variables. Chart I-16China: Money, Nominal GDP ##br##And Velocity Of Money China: Money, Nominal GDP And Velocity Of Money China: Money, Nominal GDP And Velocity Of Money Even though the velocity of money has fallen structurally over the past nine years (Chart I-16, bottom panel), it has risen marginally in 2017, allowing the mainland's nominal economic growth to hold up despite a considerable relapse in money supply growth. Notably, this has been the reason why our view has not worked this year. What is the velocity of money, and how can we forecast its fluctuations and, importantly, the magnitude of its variations? The velocity of money is one of the least understood concepts in economic theory. The velocity of money is anything but stable. In our opinion, the velocity of money reflects animal spirits of households and businesses as well as government spending decisions. Forecasting animal spirits and the magnitude of their variations is not very a reliable exercise. In a nutshell, the banking system (commercial banks and the central bank) creates money via expanding its balance sheet - making loans to or acquiring assets from non-banks. However, commercial banks have little direct influence on the velocity of money. The latter is shaped by non-banks' decisions to spend or not (i.e., save). Significantly, non-banks' spending and saving decisions do not alter the amount of money in the system. Yet they directly impact the velocity of money. The banking system creates money, and non-banks churn money (make it circulate). At any level of money supply, a rising number of transactions will boost nominal output, and vice versa. Further, there is a great deal of complexity in the interaction between money supply and its velocity. Both are sometimes independent, i.e. they do not influence one another, but in some other cases one affects the other. For example, with the ongoing triple tightening in China and less money being originated by the banking system, will households and businesses increase or decrease their spending? Our bias is that they will not increase spending. This is especially true for the corporate sector, which has record-high leverage and where access to funding has been tightening. It is also possible that rising velocity will lead to more money creation as more spending leads to higher loan demand and banks accommodate it - i.e., originating more loans/money. These examples corroborate that money supply and the velocity of money are not always independent of each other. On the whole, it is almost impossible to reliably forecast the magnitude of changes in velocity of money. In the same vein, it is difficult to forecast animal spirit dynamics in any economy. Chart I-17U.S.: The Rise In Velocity Of Money ##br##Overwhelmed Slowdown In Money U.S.: The Rise In Velocity Of Money Overwhelmed Slowdown In Money U.S.: The Rise In Velocity Of Money Overwhelmed Slowdown In Money One recent example where nominal GDP has decoupled from broad money growth is the U.S. Chart I-17 demonstrates that in the past 12 months, U.S. nominal GDP growth has firmed up even though broad money (M2) growth has slumped. This decoupling can only be explained by a spike in the velocity of M2. In other words, soaring confidence and animal spirits among U.S. households and businesses have boosted their willingness to spend, even as the banking system has created less money and credit growth has slowed considerably over the past 12 months. Going back to China, how should investors consider such uncertainty in changes in the velocity of money? Investing is about the future, which is inherently uncertain. Hence, an investment process is about assigning probabilities to various scenarios. Provided the velocity of money is impossible to forecast, we assign equal probabilities to each of the following scenarios for China in 2018 (Figure I-1): One-third odds that the velocity of money rises more than the decline in broad money growth, producing robust nominal GDP growth; One-third probability that the velocity of money stays broadly flat - the outcome being meaningful deceleration in nominal GDP growth; A one-third chance that the velocity of money declines - the result being a severe growth slump. Figure I-1How Investors Can Consider Uncertainty Related To Velocity Of Money Questions For Emerging Markets Questions For Emerging Markets In short, a positive outcome on China-related plays has a one-third probability of playing out, while a negative outcome carries a two-thirds chance. This is why we continue to maintain our negative view on EM and commodities. Commodities Our view on commodities and commodity plays is by and large shaped by our view on China's capital spending. Given the credit plus fiscal spending impulse is already very weak, the path of least resistance for capital expenditures is down. Besides, the government is clamping down on local governments' off-balance-sheet borrowing and spending (via Local Government Financing Vehicles). A deceleration in capital expenditures in general and construction (both infrastructure and property development) in particular is bearish for industrial metals (Chart I-18). Money and credit impulses herald a major downturn in Chinese imports values and volumes (Chart I-19). Chart I-18Industrial Metals / Copper Are At Risk bca.ems_wr_2017_11_29_s1_c18 bca.ems_wr_2017_11_29_s1_c18 Chart I-19China Will Be A Drag On Its Suppliers bca.ems_wr_2017_11_29_s1_c19 bca.ems_wr_2017_11_29_s1_c19 As to China's commodities output reductions, last week we published a Special Report3 on China's "de-capacity" reforms in steel and coal. The report concludes the following: The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. Importantly, the mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity in order to replace almost entirely obsolete capacity. The combination of demand slowdown and modest production recovery will weigh on non-oil raw materials. As for oil, the picture is much more complicated. Oil prices have been climbing in reaction to declining OECD inventories as well as on expectations of an extension to oil output cuts into 2018. One essential piece of missing information in the bullish oil narrative is China's oil inventories. In recent years, China has been importing more crude oil than its consumption trend justifies. Specifically, the sum of its net imports and domestic output of crude oil has exceeded the amount of refined processed oil. This difference between the sum of net imports and production of crude oil and processed crude oil constitutes our proxy for the net change of crude oil inventories. Chart I-20 shows that our proxy for mainland crude oil inventories has risen sharply in recent years. This includes both the nation's strategic oil reserves as well as commercial inventories. There is no reliable data on the former. Therefore, it is impossible to estimate the country's commercial crude oil inventories. Chart I-20China: Beware Of High Chinese Oil Inventories China: Beware Of High Chinese Oil Inventories China: Beware Of High Chinese Oil Inventories Nevertheless, whether crude oil inventories have risen due to a build-up of strategic petroleum reserves or commercial reserves, the fact remains that crude oil inventories in China have surged and appear to be reaching the size of OECD total crude and liquid inventories (Chart I-20). In short, China has been a stabilizing force for the oil market over the past three years by buying more than it consumes. Without such excess purchases from China, oil prices would likely have been much weaker. Going forward, the pace of Chinese purchases of crude oil will likely slow due to several factors: (a) China prefers buying commodities on dips, especially when it is for strategic inventory building. With crude oil prices having rallied to around $60, the authorities might reduce their purchases temporarily, creating an air pocket for prices, and then accelerate their purchases at lower prices; (b) Commercial purchases of oil will likely decelerate due to tighter money/credit, possibly high inventories and a general slowdown in industrial demand for fuel. Bottom Line: Raw materials and oil prices4 are at risk from China and overly bullish investor sentiment. Beyond Commodities The slowdown in China will impact not only commodities but also non-commodity shipments to the mainland (Chart I-21). In fact, 47% of the nation's imports are commodities and raw materials and 45% are industrial/capital goods - i.e., China's imports are heavily exposed to investment expenditures, not consumer spending. This is why money/credit impulses correlate so well with this country's imports. Consistently, China's broad money (M3) impulse leads EM corporate profit growth by 12 months - and currently heralds a major EPS downtrend (Chart I-22). In addition, aggregate EM narrow money (M1) growth also points to a material slump in EM EPS (Chart I-23). Chart I-21China Is A Risk To ##br##Non-Commodity Economies Too bca.ems_wr_2017_11_29_s1_c21 bca.ems_wr_2017_11_29_s1_c21 Chart I-22Downside Risk To EM EPS bca.ems_wr_2017_11_29_s1_c22 bca.ems_wr_2017_11_29_s1_c22 The only EM countries that are not materially exposed to China and commodities are Turkey and India. The former is a basket case on its own. Indian stocks are expensive and will have a difficult time rallying in absolute terms when the EM equity benchmark relapses. As for Korea and Taiwan, their largest export destination is not advanced economies but China. China accounts for 25% of Korea's exports and 28% of Taiwan's. This compares to a combined 22% of total Korean exports and 20% of total Taiwanese exports going to the U.S. and EU combined Can robust growth in the U.S. and EU derail the growth slowdown in China when capital spending slows? This is very unlikely, in our view. Chart I-24 portends that China's shipments to the U.S. and EU account for only 6.6% of Chinese GDP, while capital spending and credit origination constitute 45% and 25% of GDP, respectively. Chart I-23EM M1 And EM EPS EM M1 And EM EPS EM M1 And EM EPS Chart I-24What Drives Chinese Growth? What Drives Chinese Growth? What Drives Chinese Growth? A final word on tech stocks. EM's four large-cap tech stocks (Tencent, Ali-Baba, Samsung and TSMC) have gone exponential and are extremely overbought. At this juncture, any strong opinion on tech stocks is not warranted because they can sell off or continue advancing for no fundamental reason. We have been recommending an overweight position in tech stocks, and continue recommending overweighting them, especially Korean and Taiwanese semiconductor companies. As for Tencent and Alibaba, these are concept stocks, and as a top-down house we have little expertise to judge whether or not they are expensive. These are bottom-up calls. Investment Strategy EM Stocks: Asset allocators should continue to underweight EM versus DM, and absolute-return investors should stay put. Our overweights are Taiwan, China, Korean tech stocks, Thailand, Russia and central Europe. Our underweights are Turkey, South Africa, Brazil, Peru and Malaysia. Chart I-25EM Currencies: A Canary In ##br##Coal Mine For EM Credit? EM Currencies: A Canary In Coal Mine For EM Credit? EM Currencies: A Canary In Coal Mine For EM Credit? Stay short a basket of the following EM currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. For traders who prefer a market neutral currency portfolio, our recommended longs (or our currency overweights) are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Continue underweighting EM sovereign and corporate credit relative to U.S. investment grade bonds. The mix of weaker EM/China growth, lower commodities prices and EM currency depreciation bode ill for already very tight EM credit spreads (Chart I-25). Within the sovereign credit space, our underweights are Brazil, Venezuela, South Africa and Malaysia and our overweights are Russia, Argentina and low beta defensive credits. The main risk to EM local currency bonds is EM currency depreciation. With foreign ownership of EM domestic bonds at all-time highs, exchange rate depreciation could trigger non-trivial selling pressure. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, China, India, Argentina and Central Europe. Other high-conviction market-neutral recommendations: Long U.S. banks / short EM banks. Long U.S. homebuilders / short Chinese property developers. Long the Russian ruble / short oil. Long the Chilean peso / short copper. Long Big Five state-owned Chinese banks / short small- and medium-sized banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 For example, given that interest rates are in the denominator of the Gordon Growth model, a one percentage point change in interest rates from a low level can have a significant impact on the fair value P/E ratio. 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, link available on page 22. 4 This is the Emerging Markets Strategy team's view and is different from BCA's house view on commodities. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights When it meets in Vienna at the end of this month, OPEC 2.0 will look through the pipeline leaks in South Dakota, which are expected to take some 500k b/d of Canadian crude shipments to the U.S. off the market until repairs are done at the end of November. While this will provide an unexpected assist in draining U.S. inventories, it truly is a transitory event (no pun intended). The larger issue for prices is gauging market expectations going into the OPEC 2.0 meeting at the end of this month. We believe the market is giving high odds to the coalition extending its 1.8mm b/d production cut to cover all of 2018 at its Vienna meeting. This is without doubt the result of the synchronized messaging coming from the leaders of OPEC 2.0, the Kingdom of Saudi Arabia (KSA) and Russia. Based on our balances models, an extension of the cuts to end-June - our base case - will draw OECD stocks down below their five-year average by mid-2018 (Chart of the Week). An executed extension to end-December 2018 would produce even sharper draws. This leaves the only material risk to prices a failure to extend the cuts on Nov. 30, or a reduction in the cuts themselves. Of the two, a failure to extend the cuts is the only material downside risk we see going into the Vienna meetings. Should OPEC 2.0 fail to extend its production cuts at month-end, and cause the markets to sell, we would view it as a buying opportunity: a Mar/18 expiry runs counter to OPEC 2.0's strategy. Energy: Overweight. Our Brent and WTI call spreads in May, July and December 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 41.4%, since they were recommended in September and October. Our long Jul/18 WTI vs. short Dec/18 WTI trade initiated November 2, 2017 in expectation of steepening backwardation is up 27.7%. Base Metals: Neutral. A weaker USD is providing a tailwind for copper, which is up ~ 2% over the past week. Our U.S. Bond Strategy desk expects the Fed to remain behind the inflation curve, which will translate into lower real rates and continue to support base metals.1 Precious Metals: Neutral. Gold continues to trade on either side of $1,280/oz, hardly budging following the upheaval in KSA. U.S. financial conditions - particularly a weaker USD - are driving gold. Our long gold portfolio hedge is up 4.2% since inception May 4, 2017. Ags/Softs: Neutral. Updated projections of record-high yields from U.S. corn farmers is behind the upward revision to 2017/2018 corn ending stocks in the November WASDE. This led to a massive increase - by 7.56mm MT - in U.S. corn output, which was partially offset by an increase in expected world demand and a downward adjustment to global beginning stocks. Corn prices were down more than 3% in the week following the revisions, but have since regained 2.5%. Feature Markets appear to be pricing in an extension of OPEC 2.0's production cuts to end-2018 when the producer group meets in Vienna at the end of the month around OPEC's regularly scheduled meeting. Our updated balances suggest a sharp sell-off triggered by market disappointment in OPEC 2.0 would represent a buying opportunity, particularly in 2H18. We continue to expect Brent to average $65/bbl next year in our base case (OPEC 2.0 cuts extended to end-June), with WTI trading $2/bbl under that. An extension of OPEC 2.0's cuts to end-December could lift our 2018 Brent forecast as much as $5/bbl, although the Brent-WTI spread likely would widen to $4 to $5/bbl, if this occurs. We do not believe additional cuts are in the offing. Nor do we expect an even-more-dramatic announcement of cuts being extended beyond 2018. We are deliberately keeping our base case more conservative than the apparent market expectation of an extension to end-2018. This suggests markets will be disappointed with anything less than an extension of the OPEC 2.0 cuts to end-June. Given our balances modeling, we believe any disappointment in the market's expectation that leads to a sell-off would represent a buying opportunity, since a Mar/18 expiry – the current terminus of the OPEC 2.0 production cuts, defeats the coalition's strategy of reducing OECD inventories. Under our base case, inventories draw to their five-year average levels by mid-year 2018 (Chart of the Week). In our updated balances model, we have a 100k b/d downward revision in expected U.S. oil-shale output for 2018 tightening the supply side for next year. The U.S. EIA has repeatedly revised its historical estimated shale production lower in recent months, and late-2017 rig counts have deteriorated slightly, which have shifted our historical production curve lower as well. On the demand side, we expect growth of ~ 1.65mm b/d on average in 2017 - 18. These assumptions give an upward bias to our 2018 price forecasts for Brent and WTI crude oil (Chart 2). Chart of the WeekSupply-Demand Balances##BR##Point Toward Tight Markets Supply-Demand Balances Point Toward Tight Markets Supply-Demand Balances Point Toward Tight Markets Chart 2Balances Are Tightening,##BR##Giving An Upward Bias To Prices Balances Are Tightening, Giving An Upward Bias To Prices Balances Are Tightening, Giving An Upward Bias To Prices Inventory Draw Could Be Sharper Chart 3Extending OPEC 2.0 Cuts To End-December##BR##Will Result In Sharper Draws Extending OPEC 2.0 Cuts To End-December Will Result In Sharper Draws Extending OPEC 2.0 Cuts To End-December Will Result In Sharper Draws An extension of the OPEC 2.0 cuts to end-Dec/18 would translate to a deeper storage draw than our end-June base case expectation (Chart 3). The Keystone pipeline leaks referenced above also provide an unanticipated assist in drawing down inventories, by temporarily removing ~ 500k b/d from the market in the 2H of November. While we have modeled price-induced additions to U.S. shale-oil output next year in our base case, an extension of OPEC 2.0's cuts to end-December likely will accelerate this production increase as additional production is added in 2H18. This will tend to temper price hikes, but not arrest them, given the differential storage draws we expect of 127 mm bbls. As we have noted, an extension of the OPEC 2.0 production cuts to the end of 2018 could lift Brent and WTI prices by as much as $5/bbl. However, given the still-insufficient pipeline take-away in the U.S. shale basins, we would expect higher production would widen the Brent - WTI price spread to $4 to $5/bbl next year. Practically, if the extension of the production cuts pushes Brent to $70/bbl, we're more inclined to expect WTI prices to average ~ $65/bbl next year. EM Continues To Lead Growth In Oil Demand EM oil demand strength continues to be the dominant feature of the oil market this year, and, we expect, into next year. We are modeling a 1.13mm b/d and 1.22mm b/d increase in EM demand this year and next, respectively. This accounts for 75% and 77% percent of global growth in 2017 and 2018 (Table 1). DM demand, which we proxy with OECD oil consumption, is expected to average 47.5mm b/d over the two-year interval, an average gain of 490k b/d over the interval, vs. 1.18 mm b/d gain in EM oil demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices China and India account for slightly more than one-third of the 52mm b/d of consumption we are modeling for non-OECD demand over this period, and ~50% of the non-OECD demand growth from 2016 to 2018. The indicators we use to confirm or refute the demand trends we see - EM imports and global PMIs - continue to support the global-growth theme we've noted throughout the year, particularly in the EM markets (Charts 4 and 5). Chart 4EM Trade Volumes Remain Strong,##BR##Supporting The Global Growth Hypothesis EM Trade Volumes Remain Strong, Supporting The Global Growth Hypothesis EM Trade Volumes Remain Strong, Supporting The Global Growth Hypothesis Chart 5Global Manufacturing Activity##BR##Remains Robust Global Manufacturing Activity Remains Robust Global Manufacturing Activity Remains Robust Continue Watching The Fed EM oil demand and import volumes are highly dependent on Fed policy, which is of particular concern now, because the U.S. central bank is trying to carry out its rate-normalization policy (Chart 6). Still, as our colleagues on the U.S. Bond Strategy desk note, "To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve." This will be bullish for trade, since as we've shown in the past, U.S. monetary policy has a huge effect on trade.2 For the near term - into 1H18 - fundamentals will dominate the evolution of price: Supply, demand and inventories will matter more than U.S. monetary policy effects on the USD and real rates. Nonetheless, should the hawks in the Fed carry the day, we would expect a strengthening of the USD, which, all else equal, would act as a headwind to oil prices next year. For the time being, a weaker USD is reinforcing stronger prices brought about by tighter fundamentals, particularly in the Brent market (Chart 7). Chart 6Continue Watching The Fed Continue Watching The Fed Continue Watching The Fed Chart 7A Weaker USD Provides A Slight Tailwind A Weaker USD Provides A Slight Tailwind A Weaker USD Provides A Slight Tailwind Bottom Line: Markets are expecting OPEC 2.0 to extend its 1.8mm b/d production cut to end-2018. We are deliberately using a more conservative extension to end-June in our balances modeling, which produce 2018 Brent and WTI prices forecasts of $65/bbl and $63/bbl. An executed extension of the OPEC 2.0 cuts to end-December 2018 likely would add as much as $5/bbl to Brent prices, and perhaps $2/bbl to WTI prices, which would widen the Brent - WTI spread to $4 to $5/bbl on average next year. Fundamentals will continue to dominate the evolution of prices into 2018 - supply growth (falling), demand growth (rising), and inventories (falling) will drive prices. For the moment a weaker USD is supportive for commodities generally, particularly oil and copper. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see "The Fed Will Fall Behind The Curve," published October 24, 2017, by BCA Research's U.S. Bond Strategy. It is available at usbs.bcaresearch.com. 2 Please see footnote 1 above. U.S. monetary policy effects on EM oil demand and trade volumes, and the feedback loop back to the key indicators used by the Fed, have been a recurrent theme in our research. Please see, e.g., "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. Our line of research recently found support in IMF research published earlier this month; please see "Global Trade and the Dollar," published by the IMF November 13, 2017. The IMF research is available at http://www.imf.org/en/Publications/WP/Issues/2017/11/13/Global-Trade-and-the-Dollar-45336?cid=em-COM-123-36197 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Oil Balances Continue To Point To Higher Prices Oil Balances Continue To Point To Higher Prices Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months BCA Expects The Curve To Steepen In The Next 12 Months BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed October CPI Provides Cover For The Fed October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession Spreads Would Need To Widen Significantly More To Signal A Recession Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries HY Credit Still Outperforming Treasuries HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Time To Worry? Time To Worry? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Spread Widening, Recessions, S&P 500 And Vol Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Lessons From Periods Of Rising Oil Prices Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve Lessons From Periods Of A Steepening Yield Curve Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings Time To Worry? Time To Worry? The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Market Remains Skeptical That Tax Package Will Pass Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.

Highlights The Arabic title of this Special Report is "Against Wasta." Wasta roughly translates as reciprocity in formal and informal dealings. It "indicates that there is a middleman or 'connection' between somebody who wants a job, a license or government service and somebody who is in a position to provide it."1 While it has been helpful, it also has led to profound corruption. Feature The political sandstorm ripping through the Kingdom of Saudi Arabia (KSA) - visible in the lifting of the ban on women driving cars earlier this year, and, most recently in the consolidation of military and political power by Crown Prince Mohammed bin Salman (often referred to as "MBS") over the past few weeks - must be seen as prelude to implementing Vision 2030, which will feature an ongoing battle against wasta in KSA. If successful, this could transform a feudal desert kingdom into a modern nation-state.2 When the storm passes, MBS will hold the military and political reins of power in the Kingdom. This will allow the Sudairi branch of the Saud family, led by MBS's father, King Salman, to execute on its Vision 2030 agenda to wean itself from an almost-complete dependence on oil-export revenues. To do so, the Kingdom's leadership must successfully navigate OPEC 2.0's production-cutting deal in the short term, and the IPO of Saudi Aramco in the long term.3 KSA's Leadership Is On A Mission Chart of the WeekMarkets Take KSA News In Stride Markets Take KSA News In Stride Markets Take KSA News In Stride It's fairly obvious KSA's leadership and Russian President Vladimir Putin are on the same page re extending OPEC 2.0's 1.8mm b/d production-cutting deal to end-2018, given the public statements of MBS and Putin supporting such a measure. While markets have been responsive to this messaging, Russian Energy Minister Alexander Novak is restraining a full-throttled embrace of this expectation, saying a decision to extend the deal might not come at OPEC's November 30 meeting, given the amount of data to be analyzed.4 Markets appear to be taking the recent news - particularly the headlines out of KSA - in stride, as the major safe-haven assets have been remarkably well-behaved (Chart of the Week). In our base case, we continue to expect the OPEC 2.0 deal to be extended to end-June, which will lift Brent and WTI prices to $65 and $63/bbl next year. If we do get an extension of the OPEC 2.0 deal to end-December - and the odds of this appear very high - our 2018 Brent and WTI average-price forecasts could increase by as much as $5/bbl.5 KSA, Russia Have A Transactional Relationship, Not An Alliance The public alignment of the views of the Saudi and Russian leaderships are important over the short term. However, this does not necessarily mean both states have achieved a general alignment of views on everything of common concern to them. The OPEC 2.0 coalition led by KSA and Russia - the two largest oil exporters in the world - is a transactional relationship, not an alliance. The coalition members negotiated a deal to remove 1.8mm b/d of oil from the market in order to drain global inventories, particularly in the OECD. This deal was negotiated under duress - Brent prices threatened to fall through the $20/bbl level at the beginning of 2016 in the wake of the market-share war declared by OPEC at the end of 2014.6 Such an outcome would have imperiled the very survival of the member states (Chart 2). The success of OPEC 2.0 has taken many by surprise: The overwhelming market consensus in the lead-up to the deal getting done was the coalition would never come about, and, if it did, it would never be able to maintain the discipline necessary to follow through on its goal to return OECD inventories to their five-year average. BCA was outside this consensus from the get-go.7 And we continue to expect OPEC 2.0's production discipline to be maintained into next year, with KSA and Russia leading by example (Chart 3). Chart 2Oil-Price Collapse Clobbered Reserves Oil-Price Collapse Clobbered Reserves Oil-Price Collapse Clobbered Reserves Chart 3OPEC 2.0 Production Discipline Holds OPEC 2.0 Production Discipline Holds OPEC 2.0 Production Discipline Holds As important as the management of OPEC 2.0 is to KSA, Russia and the oil markets, the Kingdom's leadership has a laser focus on its chief long-term goal: the Saudi Aramco IPO. In light of its Vision 2030 agenda, the most important decision the Kingdom's leadership will make will be whether to IPO Aramco on a Western bourse - e.g., the NY Stock Exchange - or whether the initial offering of KSA's crown jewel is placed directly with China's sovereign wealth fund (SWF) and two of that country's largest oil companies. KSA controls this evolution. Decisions made by its leaders will resound in the oil markets for years, if not decades, to come. KSA's Anti-Corruption Campaign And The Aramco Offering The recent arrest of Saudi royals and consolidation of power by the Sudairi branch of the Saud royal family - led by King Salman and his son, MBS - appear to be part and parcel of an anti-corruption campaign laid out in the Vision 2030 document last year. This campaign, like the formation of OPEC 2.0, is being undertaken to support the IPO of Saudi Aramco next year. Proceeds from the IPO will support KSA's diversification away from being almost wholly dependent on oil exports.8 King Salman, MBS and their closest advisors have concluded they must reform the system of wasta if the Kingdom is to offer anything resembling a prosperous future full of opportunity to its restive population, most of which - more than 50% - are members of MBS's 30-something demographic cohort (Chart 4). Chart 4KSA's Under-30 Cohort Needs Jobs KSA's Under-30 Cohort Needs Jobs KSA's Under-30 Cohort Needs Jobs The wasta system in the Middle East - like the "old-boy" networks in the West - can be positive, in that it can "lower transaction costs and reduce the problem of asymmetric information if, for example, the use of such connections can place disadvantaged groups or individuals into the workforce who might otherwise not have the same opportunity as others," according to Prof. Ramady. However, such a system can, and has, become corrosive to the evolution of society, and can stunt the evolution toward an innovative, dynamic society and economy. Prof. Ramady notes, "Fighting negative wasta is important for the countries that seek to truly implement a more equal opportunity and entrepreneurial knowledge-based economic base." This discontent with the status quo post-Arab Spring was apparent in 2016, when BCA's Geopolitical Strategy noted KSA was in the early stages of such reforms.9 From everything King Salman and MBS have said and done to date, this appears to be the agenda that is being enacted. The lifting of the ban on women driving in KSA to take effect next year; hosting investors and entrepreneurs in Riyadh in September - the so-called Davos in the Desert presentations; even the recent mass arrests and consolidation of power are part and parcel of this reform.10 Early indications of this agenda could be seen in April 2015, when KSA lowered the value of projects requiring approval by the Council of Ministers to SR100 million from SR300 million ($27 million from $80 million). The collapse in oil prices from more than $100/bbl in 2014 likely drove this decision, but, as Prof. Ramady notes, "the intention of the Saudi government was clear: that even 'small' projects (by Saudi standards) could now be scrutinised to avoid 'hidden costs' and corruption." Following the April 2015 reforms, King Salman told the Kingdom's Anti-Corruption Committee "that his government would have zero tolerance for corruption in the country and that he and other members of the royal family are not above the law and that any citizen can file a lawsuit against the king, crown prince or other members of the royal family. These were some of the strongest statements to be made by a Saudi monarch on the issue of combating corruption and nepotism." (Emphasis added.)11 The Aramco IPO The way KSA monetizes its crown jewel will have a profound effect on the evolution of the country's institutions and the oil markets. MBS's implementation of the anti-corruption campaign laid out by his father, King Salman, suggests an IPO on a western bourse is in the offing. Such a listing would impose regulatory and transparency requirements on Aramco that are fully consistent with the royal family's words and deeds since King Salman took power in January 2015. Monetizing 5% of what could potentially be the largest oil-producing and -refining enterprise in the world - the only asset capable of funding the transformation of an entire country of 32mm people - on a bourse that requires even a minimal level of transparency for investors means the government of KSA could demand similar transparency from every other firm and individual in the Kingdom. It gives the government license, so to speak, to develop and enforce the rule of law, consistent with King Salman's remarks to the Anti-Corruption Committee. This will resonate with the younger KSA elites, many of whom are tech-savvy, educated in the West and in MBS's 30-something cohort. This would be a huge gamble on the future and the Kingdom's ability to transform itself into an open monarchy. Success would transform a feudal kingdom into a modern nation-state with an enfranchised population that can advance based on entrepreneurial innovation and merit. The rule of law and transparency in business and governmental dealings would replace wasta, privilege and corruption. It also could expose the royal family to a palace coup, as Marko Papic, BCA's Chief Geopolitical strategist, notes in his most recent report "The Middle East: Separating The Signal From The Noise," which we cite above. The stakes couldn't be higher. Listing on a Western bourse also would position Saudi Aramco squarely in the market and central to it, executing on its plan to become the dominant global oil refiner, and funding the Kingdom's diversification away from near-total dependence on oil exports. Lastly, it would allow KSA to retain its geopolitical optionality - playing competing global interests off each other when negotiating alliances and commercial deals. Implications Of An Aramco Private Placement If the Aramco shares are privately placed with China's SWF and the country's two largest oil companies, the pressure to reform likely would be lessened, as the Chinese government typically does not make reform demands on governments of resource-rich countries in which it is investing.12 Assuming China's SWF and/or the oil companies participating in its bidding consortium received a seat(s) on the Aramco board, China certainly would gain greater assurance over its crude oil and refined product supplies going forward. This is a critical concern with domestic production falling and demand for crude oil increasing (Chart 5). And it would give China an eventual interest in using military power to protect its investments in KSA, thus advancing and supporting its long-term evolution as a superpower.13 It also would, in all likelihood, expand the membership of the club trading oil in yuan, which now includes Russia and Iran, to KSA and its GCC allies and Iraq by 2020, if not sooner. This would represent ~ 39mm b/d of production (Chart 6), and 23mm b/d of exports. BP estimates just over 42mm b/d of crude oil are traded globally, meaning this petro-yuan producing coalition would account for 55% of total exports.14 Chart 5China Needs To Offset Declining Production China Needs To Offset Declining Production China Needs To Offset Declining Production Chart 6A Petro-yuan Would Be Formidable A Petro-yuan Would Be Formidable A Petro-yuan Would Be Formidable At some 9mm b/d, China accounts for ~ 21% of global crude oil imports. The combination of OPEC 2.0's crude production and exports with China's import volumes could make the OPEC 2.0 + 1 - the "+1" being China - the most potent force in the oil trading markets, if such a coalition can find a way to balance the competing interests of the world's largest exporters (KSA and Russia) with those of the world's largest importer (China). It also would put the petro-yuan bloc firmly in China's geopolitical orbit, allowing it to expand its sphere of influence deeply into the Persian Gulf, and the global oil market. Bottom Line: The recent turmoil in KSA must be seen as the opening moves in the transformation of a feudal desert kingdom into a modern nation-state. The evolution of the transformation is critically dependent on decisions made by KSA's leadership. How this breaks will profoundly affect the global oil markets and the Kingdom itself particularly in regard to how oil is priced - USD vs. yuan - and the effect new trading blocs have on market structure. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Ramady, Mohamed A., ed. (2016), "The Political Economy of Wasta: Use and Abuse of Social Capital Networking," Springer International Publishing Switzerland. Ramady is a professor of Finance and Economics at King Fahd in Dhahran, Saudi Arabia. The introduction of the book starts by quoting the proverb: To accept a benefit is to sell one's freedom. 2 Please see "The Middle East: Separating The Signal From The Noise," published November 15, 2017, in BCA Research's Geopolitical Strategy, for a full analysis of these issues. 3 OPEC 2.0 is our moniker for the OPEC and non-OPEC coalition of oil producers led by KSA and Russia, which agreed to remove 1.8mm b/d of oil production from the market at the end of last year. 4 Please see "Russia's Novak: Oil cut pact extension decision not necessarily at Nov meeting," published November 2, 2017, by reuters.com. Elevating the level of uncertainty as to when the OPEC 2.0 pact will be unwound is exactly the sort of forward guidance OPEC 2.0 leaders would need to convey to markets in order to backwardate the forward oil-price curve - i.e., keep longer-dated prices below prompt prices. A backwardated forward curve means U.S. shale producers realize lower prices on longer-dated hedges, which restrains the number of rigs they can deploy in the field. On Wednesday, Reuters also reported as spokesman for Rosneft, Russia's largest oil company, foresees difficulty in the wind-down of OPEC 2.0's production cuts - and the return to unrestrained production. Mikhail Leontyev said, "Speaking about the company's concerns, first of all it was about how to prepare for suspending measures to restrict production. This is a serious question. Sooner or later, of course, these measures will be lifted," Leontyev said. "Now or later, that's a separate question. It's a serious challenge, for which one needs to prepare." Roseneft is responsible for 40% of Russia's oil output; it is 50% owned by the Russian government. Please see "Russia's Rosneft says managing exit from OPEC+ deal is a serious challenge," published by reuters.com on November 15, 2017. 5 Please see "Oil Forecast Lifted As Markets Tighten," published by BCA Research's Commodity & Energy Strategy, October 19, 2017. It is available at ces.bcaresearch.com. Worth noting is the fact that should OPEC 2.0 not extend the expiry of the production-cutting deal markets likely would sell off quickly. This is because the leadership of the coalition - MBS and President Putin - have publicly embraced such a move; not doing so would be a disappointment to markets. Our modelling in the article cited here indicates the cuts have to be extended at least to end-June 2018, if the OPEC 2.0 goal of reducing OECD commercial oil inventories to their 5-year average levels is to be achieved. Also worth noting, if we do see the OPEC 2.0 cuts extended to end-2018, we likely will be widening our implied Brent vs. WTI spread to $4/bbl, given the transportation bottlenecks that are likely to emerge in the event of a further lift in U.S. prices: Pipeline infrastructure in the most productive shales, particularly the Permian Basin, cannot get oil to export facilities as quickly as it is produced. Please see "Transportation constraints and export costs widen the Brent-WTI price spread," published in the U.S. EIA's This Week in Petroleum series November 8, 2017. 6 We discuss this at length in our 2017 outlook. Please see "2017 Commodity Outlook: Energy," published by BCA Research's Commodity & Energy Strategy December 8, 2016. See also our "2016 Commodity Outlook: Neutral Across the Board," published December 17, 2016, for a detailed discussion of pricing dynamics as this time. Both are available at ces.bcaresearch.com. 7 Please see the 2017 Outlook referenced above in footnote 6. 8 KSA officials believe the company is worth $2 trillion, based on their expectation a 5% IPO of the company would generate $100 billion. 9 Please see "Saudi Arabia's Choice: Modernity Or Bust," the May 2016 issue of BCA Research's Geopolitical Strategy. It is available at gps.bacresearch.com. 10 Please see "Saudi Arabia plans to build futuristic city for innovators," published October 24, 2017, by phys.org. 11 Please see footnote 1, p. ix. 12 Please see "Exclusive - China offers to buy 5 percent of Saudi Aramco directly: sources," published by reuters.com October 16, 2017. 13 We examined this in depth in our report entitled "OPEC 2.0: Fear and Loathing in Oil Markets," published by BCA Research's Commodity & Energy Strategy on April 27, 2017. It is available at ces.bcaresearch.com. 14 Please see https://www.bp.com/en/global/corporate/energy-economics/statistical-review-of-world-energy/oil/oil-trade-movements.html. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades ضد الواسطة ضد الواسطة Commodity Prices and Plays Reference Table ضد الواسطة ضد الواسطة Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Middle Eastern geopolitics will add upside risk to our bullish oil view, but not cause a drastic supply shock; Saudi Arabia is at last converting from a feudal monarchy to a modern nation-state; The greatest risk is domestic upheaval, motivating Saudi internal reforms and power consolidation; Abroad, the Saudis are constrained by military weakness, relatively low oil prices, and U.S. foreign policy; Geopolitical risk premia are seeping back into oil prices, but OPEC 2.0 and the Saudi-Iranian détente are still intact. Feature Geopolitical and political turbulence in Saudi Arabia kicked into high gear in November, with Crown Prince Mohammad bin Salman apparently turning the Riyadh Ritz-Carlton into a luxury prison for members of the royal family.1 At the same time, rumors are swirling that the bizarre resignation of Lebanese Prime Minister Saad Hariri, allegedly orchestrated by Saudi Arabia, is a potential casus belli. In this scenario, Lebanon would become a proxy war for a confrontation between Sunni Gulf monarchies led by Saudi Arabia (aided by Israel) and their Shia rivals, led by Iran and its proxy Hezbollah. To our clients around the world we say, "please take a deep breath." In this report, we intend to separate the signal from the noise. The Middle East has been a theater of paradigm shifts since at least 2011.2 Not all of them are investment relevant. In this report, we conclude that: Changes under way in the Middle East are the product of impersonal, structural forces that have been in place since the U.S. pulled out of Iraq in 2011; Saudi Arabia is engaged in belated, European-style nation-building, a volatile process that will raise tensions in the country and the region; Saudi Arabia remains constrained by a lack of resources and military capabilities, and unclear alliance structures. Iran, meanwhile, benefits from the status quo. As such, no major war with Iran is likely in the short term, although proxy wars could intensify. In the short term, we agree that the moves by Saudi leadership will increase tensions domestically and in the region. However, over the long term, the evolution of Saudi Arabia from the world's last feudal monarchy into a modern nation-state should improve the predictability of Middle East politics. Regardless of our view, one thing is clear: Saudi Arabia has an incentive to keep oil prices at the current $64 per barrel, or higher, as domestic and regional instability looms. As such, we believe that risks to oil prices are to the upside, but a global growth-constraining geopolitical shock to oil supply is unlikely. The Paradigm Shift: Multipolarity "Tikrit is a prime example of what we are worried about ... Iran is taking over [Iraq]."3 -- Prince Saud al-Faisal, Saudi Foreign Minister, to U.S. Secretary of State John Kerry, March 5, 2015 Pundits, journalists, investors, and Middle East experts all make the same mistake when analyzing the region: they assume it exists on "Planet Middle East." It does not. The Middle East is part of a global system and its internal mechanic is not sui generis. Its actors are bit players in a much bigger game, which involves nuclear powers like the U.S., China, and Russia. Yes, the whims and designs of Middle East leaders do matter, but only within the global constraints that they are subject to. The greatest such constraint has been the objective and observable withdrawal of the U.S. from the Middle East, emblematized by a dramatic reduction of U.S. troops in the region (Chart 1). The U.S. went from stationing 250,000 troops in 2007 to mere 36,000 in 2017. The withdrawal was not merely a manifestation of President Barack Obama's dovish foreign policy. Rather, it was motivated by U.S. grand strategy, specifically the need to "pivot to Asia" and challenge China's rising geopolitical prowess head on (Chart 2). Chart 1U.S. Geopolitical Deleveraging U.S. Geopolitical Deleveraging U.S. Geopolitical Deleveraging Chart 2China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. As we expected, President Donald Trump has not materially increased the U.S. presence in the region since taking office.4 His efforts to eradicate the Islamic State have largely built on those of his predecessor. While he has rhetorically changed policy towards Iran, and taken steps to imperil the nuclear deal by decertifying it, he has not abrogated the deal. The U.S. president can withdraw from the nuclear deal without congressional approval, yet President Trump has merely passed the buck to Congress, which has until the end of the year to decide whether to re-impose sanctions. For Saudi Arabia, U.S. rhetoric and half measures do not change the fact that Iraq is now devoid of American troops and largely in the Iranian sphere of influence. Following the 1991 Gulf War, Saudi Arabia enjoyed the best of both worlds for two decades: a Sunni-dominated but weakened Iraq serving the role of an impregnable buffer between itself and the much more militarily capable Iran. Since Iraq's paradigm shift in the wake of American invasion, the buffer has not only vanished but has been replaced by a Shia-dominated, Iranian-influenced Iraqi state (albeit still relatively weak). Unsurprisingly, Saudi military spending as a share of GDP nearly doubled from the 2011 U.S. withdrawal to 2015, and in absolute terms has risen from $48.5 billion in 2011 to $63.7 billion in 2016, revealing a deep concern in Riyadh that its northern border has become nearly indefensible (Chart 3). Chart 3Saudis React To U.S. Withdrawal The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Meanwhile, Baghdad's heavy-handed political and military tactics produced an immediate reaction from the Sunni population.5 Militant Sunni insurgent groups, with material support from unofficial (and probably official) channels in Saudi Arabia and wider Gulf monarchies, began to fight back. Violence escalated and soon melded with the emerging civil war in Syria, which by early 2013 had taken on a sectarian cast as well. This led to the emergence of the Islamic State, which grew out of the earlier Sunni insurgence against the U.S. in the Al Anbar governorate. The military success of the Islamic State in 2014 against the inexperienced and demoralized Iraqi Army forced Baghdad to lean even more heavily on domestic Shia militias, and Iran, for survival. Islamic State militants reached the outskirts of Baghdad in September 2014 and were only beaten back by a combination of hardline Shia militias and Iranian advisers and irregular troops. From the Saudi perspective, this direct intervention by the Iranian military in Iraq was the final straw. Most jarring to the Saudis was the fact that the Americans acquiesced to the Iranian presence in Iraq and even collaborated with Iran. In fact, the overt presence of Iranian military personnel in Syria and Iraq drew no rebuke from the U.S. Some American officials even seemed to praise the Iranian contribution to the global effort against the Islamic State. Meanwhile, the nuclear negotiations continued undisturbed, right down to their successful conclusion in July 2015. Bottom Line: Global multipolarity and the rise of China has forced America's hand, and the dramatic withdrawal of military assets from the Middle East is the direct consequence. Saudi Arabia has suffered a dramatic reversal of geopolitical fortunes, with its crucial geographic buffer, Iraq, now dominated by its strategic rival, Iran. Saudi Arabia "Goes It Alone," And Fails Miserably "Saudi Arabia will go it alone."6 -- Mohammed bin Nawwaf Bin Abdulaziz Al Saud, Saudi ambassador to the U.K., December 17, 2013 To counter growing Iranian influence across the region and its strategic isolation, Saudi Arabia relied on five general strategies, all of which have failed: Map 1Saudi Arabia's Shia-Populated Eastern Province Is A Crucial Piece Of Real Estate The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Asymmetric warfare: Saudi Arabia has explicitly and implicitly supported radical-Islamist Sunni militant groups around the region. Some of these groups were either directly linked to, or vestiges of, al-Qaeda. The Islamic State, which received implicit support from Saudi Arabia in its early days of fighting president Bashar al-Assad in Syria, eventually turned against Saudi Arabia itself. Its agents claimed multiple mosque attacks in the Shia-populated Eastern Provinces (Map 1), attacks intended to incite sectarian violence in this key oil-producing Saudi area. Saudi officials also became alarmed at a large number of Saudi youth who went to fight with Islamic State fighters across the region, some of whom are now back in the country (Chart 4). "Sunni NATO": Talk of a broad, Sunni alliance against Iran has not materialized. Despite the Saudis' best efforts, the main Sunni military powers - Egypt and Pakistan - have remained aloof of its regional efforts to isolate Iran. The best example is the paltry contribution of its Sunni peers to the ongoing war in Yemen, where anti-government Houthi rebels are nominally allied with Iran. Pakistan contemplated sending a brigade of 3,000 troops to the Saudi-Yemen border earlier this year, but has refused to join the fight directly. Egypt sent under 1,000 troops early in the war, but none since. Talk of a 40,000 Egyptian deployment to the Yemen conflict earlier this year has not materialized. If Pakistan and Egypt are unwilling to help Saudi Arabia against the Houthis, why would they be interested in directly confronting a formidable military power like Iran? Direct warfare: When supporting militants and spending money on allies did not work, Saudi Arabia decided to try its hand at direct warfare. In February 2015, it began airstrikes against the Houthi rebels in Yemen. The war, which costs Saudi Arabia over $70 billion a year, has gone badly for Saudi Arabia.7 Despite two years of intensive involvement by Saudi Arabia and its GCC allies, the capital Sanaa remains in Houthi hands. As far as we are aware, there has been no real Saudi ground troop commitment to the conflict. K-street: Despite its best efforts, and the vast resources spent on lobbyists in Washington, Saudi Arabia could not prevent the U.S. détente with Iran. What the Saudis failed to appreciate was multipolarity, i.e. how the U.S. pivot to Asia would affect Washington's policy toward the Middle East.8 Oil prices: At the fateful November 2014 OPEC meeting, Saudi Arabia refused to cut oil production in the face of falling prices, instead increasing production (Chart 5). Since late 2016, however, Saudi Arabia has reversed this aggressive bid for market share and orchestrated oil production cuts with Russia and OPEC states. Chart 4The Islamic State Movement Threatens Saudi Arabia The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Chart 5Saudis Surged Production Into Falling Prices Saudis Surged Production Into Falling Prices Saudis Surged Production Into Falling Prices Each and every one of the above strategies has failed. The last one is the most spectacular: Saudi Arabia was forced to backtrack from its oil production surge and negotiate with long-time geopolitical rival Russia, which was courting the Saudis to relieve its budget pressures from low oil prices. Saudi Arabia not only accepted the need to work with Russia, but also acquiesced to Russia's geopolitical demands for détente in the ongoing Syrian Civil War. The latter will force Saudi Arabia at least tacitly to accept the continued leadership of President al-Assad in Syria. Furthermore, Saudi intervention in Yemen has gone nowhere. Pundits who claim that the Saudis are on the verge of a major military engagement in ______ (insert Middle East country), should carefully study the effectiveness of the Saudi military in Yemen. After over two years of Saudi bombardment, the Houthis are further entrenched in the country. Meanwhile, Saudi Arabia's Sunni allies have not committed many ground troops to the effort, save for Sudan, which is impoverished and has no choice but to curry favor with its largest foreign donor. Bottom Line: The past six years have taught the Saudi leadership a series of hard lessons. Saudi Arabia cannot "go at it alone." On the contrary, the rise of the Islamic State - a messianic political entity claiming religious superiority to the Saudi kingdom - has alarmed the Saudi leadership and awoken it to a truly existential risk: domestic upheaval. Nation-Building, Saudi Style "What happened in the last 30 years is not Saudi Arabia. What happened in the region in the last 30 years is not the Middle East. After the Iranian revolution in 1979, people wanted to copy this model in different countries, one of them is Saudi Arabia. We didn't know how to deal with it. And the problem spread all over the world. Now is the time to get rid of it."9 -- Saudi Crown Prince Mohammed bin Salman, October 24, 2017 European nation-states developed over the course of five hundred years, from roughly the end of the Hundred Years' War between England and France to the unification of Italy and Germany in the mid-nineteenth century. Fundamentally, these efforts were about centralizing state power under a single authority by evolving the governance system away from feudal monarchy toward a constitutional, bureaucratic, and national system. The defining feature of feudalism was the separation of feudal society into three "estates": the clergy, the nobility, and the peasantry. The first two estates - the clergy and the nobility - had considerable rights and privileges. The king, who was above all three estates, nonetheless had to curry favor with both in order to raise taxes and wage wars. The state was weak and often susceptible to foreign influence via interference in all three estates. Saudi Arabia is one of the world's last feudal monarchies and it does not have five hundred years to evolve. Still, the best model for what is going on inside Saudi Arabia today is the European nation-building of the past. In brief, recent Saudi policies - from foreign policy assertiveness to domestic reforms - are intended to centralize power and evolve Saudi Arabia into a modern nation-state. Three parallel efforts, modeled on European history from the last millennia, are under way: Curbing the "first estate": Saudi Arabia has begun to curb the power of the religious establishment. In April 2016, it severely curbed the powers of the hai'a - the country's religious police. They no longer have the power to arrest. Instead, they have to report violations of Islamic law to the secular police; and they are only allowed to work during office hours.10 The state has even arrested a prominent cleric who opposed the change in hai'a powers, and has dismissed many other conservative clerics since King Salman came to power. Curbing the "second estate": The detention of members of the Saudi royal family at the Ritz Carlton is part of an ongoing effort to curb the powers of the "landed aristocracy" and bring it under the control of the ruling Sudairi branch of the royal family.11 This is not just palace intrigue, but a necessary step in harnessing the financial resources of the state, which are currently dispersed amongst roughly 2,000 members of the "second estate." Rallying the "third estate": Nationalism was used by European leaders of the nineteenth century to rally the plebs behind the state-building efforts of the time. Similarly, King Salman and his son, Crown Prince Mohammad bin Salman, are building a Saudi national identity. To do so, they are appealing to the youth, which makes up 57% of the country's population (Chart 6), as well as emphasizing the existential threat that Iran poses to the kingdom. Chart 6Still A Young Country Still A Young Country Still A Young Country We do not see these efforts as merely the reckless agenda of an impulsive thirty year-old, as Crown Prince Mohammad bin Salman is often derisively portrayed by his opponents. We see genuine strategy in every policy that has been initiated by Saudi leadership since King Salman took over in January 2015. Several efforts are particularly notable. Vision 2030: A Major Salvo Against The "First Estate" As we indicated in May 2016, we consider the Saudi "Vision 2030" reform blueprint to be a serious document.12 While its plan to address Saudi economic constraints is overly ambitious and vague, there are nonetheless several prominent themes that reveal the preferences of Saudi leaders: Education: The document emphasizes the link between education and economic development. Notably, there is no mention of religion. Gender Equality: Elevating the role of women in the economy will require relaxing many strict social and religious rules that impede gender equality. As if on cue, the Saudi leadership announced that it would soon end its policy of forbidding women to drive. Corruption: A new emphasis on government transparency and reducing corruption will undermine many powerful vested interests, including the religious elites. We were right to emphasize these three themes back in May 2016 as it is now obvious that King Salman and his son Mohammad bin Salman are following the prescriptions of their Vision 2030. What explains their reformist zeal? Over half of the Saudi population of almost 30 million is below 35 years of age. The youth population is facing difficulty entering the labor force, with unemployment above 30% (Chart 7). This rising angst is often expressed online, where the Saudi population is as interconnected as its peers in emerging markets (Chart 8). Saudi citizens have an average of seven social media accounts and the country ranks seventh globally in terms of the absolute number of social media accounts. Between a quarter and a fifth of the population uses Facebook, a quarter of all Saudi teenagers use Snapchat,13 and Twitter has the highest level of penetration in Saudi Arabia of any other country in the region.14 Chart 7A Potential National Security Risk A Potential National Security Risk A Potential National Security Risk Chart 8Saudi Youth Is As Internet Savvy As Others Saudi Youth Is As Internet Savvy As Others Saudi Youth Is As Internet Savvy As Others The idea that the royal family can take on the religious establishment on behalf of the youth seems far-fetched. Skeptics point out that the conservative Sunni Wahhabi religious movement lies at the foundation of the Saudi state. However, commentators who take this mid-eighteenth-century alliance as a key feature of modern Saudi Arabia often overstate its nature and influence. Not only is the Wahhabi hold on power potentially overstated, but Westerners may even overstate the country's religiosity as a whole. According to the World Values Survey, Saudi Arabia is less religious than Egypt and is on par with Morocco.15 Although Saudi Arabia has not appeared in the survey since 2004, it is fair to assume that, with the proliferation of social media and rise in the youth population, the country has not become more religious over the past decade (Chart 9). In addition, Saudis identify with values of self-expression over values of survival (as much as moderate Muslim Malaysians, for example), which is a sign of a relatively wealthy, industrial society. Chart 9Saudi Arabia: More Modern Than You Think The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise The Weekend At The Ritz: The "Second Estate" Is Put On Notice The ongoing effort to curb the power of the Saudi "second estate" is not just about court intrigue and political maneuvering. Without harnessing the economic resources of the wider Saudi aristocracy, the state would succumb to debilitating capital outflows. If the Saudi "second estate" decided to "vote" against King Salman and his son with their "deposits" - and flee the country - the all-important currency peg would collapse. Despite a pickup in oil prices, Saudi Arabia's currency reserves are falling rapidly and could soon dip below the total amount of local-currency broad money (Chart 10). Beneath that point, confidence among locals and foreigners in the currency peg could shatter, leading to massive capital flight, which was clearly a very serious problem as of end-2016 (Chart 11). Chart 10KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting Chart 11KSA: Capital Outflows Persist KSA: Capital Outflows Persist KSA: Capital Outflows Persist The peg of the Saudi riyal to the U.S. dollar is not just an economic tool. It is a crucial social stability anchor for an economy that imports nearly all of its basic necessities. De-pegging would lead to a massive increase in import costs and thus a potential political and social crisis. The Saudi Arabian Monetary Agency (SAMA) has at its disposal considerable resources for the next two years. However, this is only the case if capital outflows do not pick up and oil prices continue to stabilize. The Russia-OPEC deal is in place to ensure the latter. The "weekend at the Ritz" is meant to ensure the former. But doesn't the crackdown against the wealth of 2,000 royal family members represent appropriation of private property? Not in the minds of King Salman and his reformist son. In fact, if the financial wealth of the royal family is used to fill the coffers of the Saudi sovereign wealth fund, there is no reason why members of the Saudi "second estate" cannot benefit from its future investment returns and essentially "clip coupons" for a living. In fact, prior to the anti-corruption crackdown against the "second estate," Saudi officials hosted a completely different event at the Ritz Carlton: a gathering of top international investors for a conference called "Davos in the Desert." Judging by the conversations we had with a number of participants at that event, the point was not to encourage investments in Saudi Arabia. Rather, it was to secure the services of top international managers as Saudi Arabia ramps up the investment activities of its Public Investment Fund (PIF). Investors should therefore consider the first weekend at the Ritz as the launch of a new international investment vehicle by Saudi officials and the second weekend at the Ritz as its capitalization by the wider "second estate." We expect that fighting corruption will remain a major domestic policy thrust going forward. A recent academic study, for example, takes on the difficult job of eradicating wasta - the concept that each favor or privilege in Saudi society flows through middlemen or connections.16 The volume has been edited by Mohamed A. Ramady, professor of Finance and Economics at King Fahd University in Dhahran, Saudi Arabia, and is undoubtedly supported by the royal family. Moreover, King Salman and his son have the example of Chinese President Xi Jinping's impressive power consolidation via anti-corruption campaign right in front of them and are unlikely to have embarked on this course with the expectation that it would be a short process. Iran As An Existential Threat: Harnessing The "Third Estate" Real reform is always and everywhere difficult, otherwise the desired end-state would already be the form. For the Saudi leadership, attacking both the first and second estate presents considerable risks. It is appropriate, therefore, to believe that a palace coup may be attempted against King Salman and his son.17 International tensions with Iran are a particularly useful strategy to distract the opposition and paint all domestic dissent as treasonous. This is not to say that Saudi Arabia does not face considerable strategic challenges from Iran. As mentioned, Iranian influence in Iraq is particularly threatening to Saudi Arabia as it gives Tehran influence over a key strategic buffer that also produces 4.4 million barrels of crude per day. Furthermore, Iran supported the 2011 uprising in Shia-majority Bahrain against the Saudi-allied al-Khalifa monarchy; it at least nominally supports the Houthi rebels in Yemen; it has directly intervened in Syria on behalf of President al-Assad; and it continues to support Hezbollah in Lebanon. It is safe to say that, since 2011, Iran has been ascendant in the Middle East and has surrounded Saudi Arabia with strategic threats on all points of the compass. But to what extent is the Saudi rhetoric on Lebanon, Bahrain, Yemen, and Qatar a real threat to the stability in the Middle East? We turn to this question in our next section. Bottom Line: Saudi Arabia's domestic intrigue is far more logical than pundits and the media make it out to be. King Salman and his son, Crown Prince Mohammad bin Salman, are trying to build a modern nation state from what is today the world's last feudal monarchy. To do so, they have to enlist the support of the third estate - the country's large youth population - and curb the powers of its first and second estates - the religious establishment and the landed aristocracy. The process will be filled with risks and volatility, but is ultimately necessary for the long-term stability of the kingdom. Regional Risk Of War Is Overstated "[I am] positive there will be no implications coming out of this dramatic situation at all."18 -- Secretary of Defense James Mattis, asked about the Qatar crisis and the fight against ISIS, June 5, 2017 As this report goes to publication Saudi Arabia has accused Iranian-allied Hezbollah of forcing Lebanese Prime Minister Saad Hariri to run for his life. Hariri resigned while visiting Saudi Arabia. Although he claims that he is not being held against his will by Saudi authorities, his resignation is highly suspect. Saudi officials have also called a failed missile attack on Riyadh's airport, allegedly launched by Houthi rebels in Yemen, as a possible "act of war" by Iran. Meanwhile, Bahrain's Saudi-allied government has accused Iran of destroying an oil pipeline via terrorist action. The region's rumor mill - one of the most productive in the world - is in overdrive. What are the chances of increased proxy warfare between Saudi Arabia and Iran? We think that there is a good chance that Saudi Arabia will step up its military activity in the ancillary parts of the Middle East. In particular, we could see renewed Saudi military campaigns in Yemen and Bahrain. In isolation, these campaigns would add a temporary risk premium to oil prices. But given that Iran has no intention to become directly involved in either, we would expect Saudi moves to be largely for show. Over the long term, we do not see a direct confrontation between Iran and Saudi Arabia for three reasons. First, Saudi military capabilities are paltry and the kingdom has failed to secure the support of the wider Sunni world for its "Sunni NATO." We have already mentioned Saudi military failures in Yemen. Anyone who thinks that Saudi Arabia is ready to directly confront Iran must answer two questions. First, how does the Saudi military confront a formidable foe like Iran when it cannot dislodge Houthis from Yemen? Second, if Saudi Arabia is itching for a real conflict with Iran, why is it not saber-rattling in Iraq, a far more strategic piece of real estate for Saudi Arabia than any of the other countries where it accuses Iran of meddling? Chart 12Correlation Between Oil Prices And Military Disputes The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Second, oil prices remain a constraint to war. The reality is that there is a well-known relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart 12). Political science research shows that the relationship is not spurious. Chart 13 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes when oil prices are higher.19 While oil prices have recovered from their doldrums from two years ago, they are also a far cry from their pre-2014 highs. In fact, by our calculation, oil prices are still below the Saudi budget break-even price of oil, despite its best efforts to implement austerity (Chart 14). Chart 13More Oil Revenue = More Aggression The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Chart 14Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Third, Saudi Arabia has failed to secure a clear security commitment from the U.S. While the Trump administration is far more open to supporting Saudi Arabia than the Obama administration, it still criticized the Saudi decision to ostracize Qatar. Secretary of Defense James Mattis made a visit to Qatar in September to offer American support. In a shocking reversal to over half-a-century of geopolitics, King Salman went to Moscow this October to deepen geopolitical relations with Russia.20 The visit included several business deals in the realm of energy and a significant promise by Saudi Arabia to purchase Russian arms in the future, including the powerful S-400 SAM system. Saudi Arabia is the world's third-largest arms importer and uses purchases as a tool of diplomacy, but has never purchased weapons from Russia in a significant way in the past. While many pundits have pointed to the Saudi-Russian détente as a sign of strength, we see it as a sign of weakness. It illustrates that Saudi Arabia is diversifying its security portfolio away from the U.S. It is doing so because it has to, not because it wants to. As U.S. petroleum imports continue to decline due to domestic shale production, Saudi Arabia is compelled to find new allies (Chart 15). The plan to hold an initial public offering for Aramco, and to target sovereign Chinese entities as major bidders for Aramco assets, fits this pattern as well. Chart 15Saudi Arabia Has To Diversify Its Security ##br##Portfolio As U.S. Oil Imports Decline Saudi Arabia Has To Diversify Its Security Portfolio As U.S. Oil Imports Decline Saudi Arabia Has To Diversify Its Security Portfolio As U.S. Oil Imports Decline However, diversifying the geopolitical security portfolio to include Russia and China will not mean that Saudi Arabia will have a blank check to wage direct war against Iran. Both Russia and China have considerable diplomatic and economic interests in Iran and are as likely to restrain as to enable Saudi ambition. Finally, talk of a Saudi-Israeli alliance against Hezbollah in Lebanon is as far-fetched as a direct Saudi-Iranian confrontation. Israel won the 2006 war against Hezbollah, but at a high cost of 157 soldiers killed and 860 wounded.21 The Israeli public grew tired of the one month campaign, showing political limits to offensive war. Furthermore, twelve years later, Hezbollah is even more deeply entrenched in Lebanon. Unless Saudi Arabia is willing to provide ground troops for the effort (see Yemen discussion above), it is unclear why Israel would want to enter the morass of Lebanese ground combat on behalf of Riyadh. Bottom Line: Constraints to Saudi offensive military action remain considerable: paltry military capability, fiscal constraints imposed by low oil prices, and a lack of clear support from the U.S. While rhetorical attacks on Iran serve the strategic goal of nation-building, we do not expect a major war between oil-producing states that would significantly raise oil prices over the medium term. The rhetoric and posturing will increase volatility and temporarily push up prices from time to time. Investment Implications Of Saudi Nation-Building First, on the question of OPEC 2.0, our baseline case is for the 1.8 million barrel-per-day production cuts to be extended through June 2018, drawing OECD inventories down toward their five-year average and creating the conditions for Brent and WTI prices to average $65 per barrel and $63 per barrel respectively next year.22 Moreover, both Crown Prince Mohammad bin Salman and Russian President Vladimir Putin have endorsed extensions through end-2018. These comments add bullish upside risk to prices, though they also alter perceptions and thus raise the short-term downside risk if no extension is agreed this month (which we think is the least likely scenario). Second, as to broader geopolitical risks in the Middle East, we believe they are rising yet again in the short and medium term, after the relative calm of 2017.23 We could see Saudi officials decide to ramp up military operations in Yemen or revive them in neighboring Bahrain. However, we do not see much of a chance of serious conflict in Lebanon or Qatar. The former would require an Israeli military intervention, which is unlikely given the outcome of the 2006 war. The latter would require American acquiescence, which is unlikely given the vital U.S. strategic presence in the country's Al Udeid military base. Nonetheless, even temporary military operations in any of these locales could add a geopolitical risk premium to oil markets. For example, the 2006 Lebanon-Israel War, which had no impact on oil production, generated a significant jump in oil prices (Chart 16). Chart 16Even The 2006 Israel-Lebanon War Produced A Risk Premium... Even The 2006 Israel-Lebanon War Produced A Risk Premium... Even The 2006 Israel-Lebanon War Produced A Risk Premium... Over the long term, how should investors make sense of the complicated Middle East geopolitical theater? Our rule of thumb is always to seek out the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. For a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications, we would need to see it have an impact on at least two of the following three factors: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni versus Shia. When we consider the security dilemma between Iran and Saudi Arabia, Iraq and the Eastern Province in Saudi Arabia are two regions critical to global oil supply. Tellingly, neither has played a role in the recent spate of tensions between the two countries. Saudi Arabia has been very careful not to increase tensions with Iran in Iraq. In fact, the Saudi leadership has reached out to Iraqi Prime Minister Haider al-Abadi, who was received by King Salman in October in the presence of U.S. Secretary of State Rex Tillerson. How should investors price domestic political intrigue in Saudi Arabia? In the long term, any failure of King Salman and his son to reform the country would be negative for internal stability, with risks to oil production if social unrest were to increase. In the short and medium term, however, even a palace coup would likely have no lasting impact on oil prices as it would be highly unlikely that an alternative leadership would imperil the kingdom's oil exports. On the contrary, a coup against King Salman could lead to lower oil prices if the new leadership in Riyadh decided to renege on their oil production cuts with Russia. The bottom line is that the geopolitical risk premium is likely to rise. The evolution of Saudi Arabia away from a feudal monarchy requires the suppression of the kingdom's first and second estates, a dangerous business that will likely be smoothed by nationalism and saber-rattling. Risks to oil prices, therefore, are to the upside. However, given the considerable constraints on Saudi Arabia's military and foreign policy capabilities, we do not foresee global growth-constraining oil supply risks in the Middle East. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The latest news from Riyadh is that the nearby Courtyard by Marriott Hotel may have been enlisted by the Saudi authorities for the crackdown, in addition to the Ritz Carlton. If true, we can only imagine the horrors that the prisoners are subject to! 2 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, and BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 3 Please see "Iran 'taking over' Iraq, Saudis warn, blaming U.S. refusal to send troops against ISIS," The National Post, dated March 5, 2015, available at nationalpost.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 5 Iran's influence in Iraq grew almost immediately following the American military withdrawal. Iraq's Shia Prime Minister, Nouri al-Maliki, wasted no time revealing his allegiance to Iran or his sectarian preferences. Baghdad issued an arrest warrant for the Sunni Vice President Tariq al-Hashimi literally the day after the last American troops withdrew from the country, signaling to the Sunni establishment that compromise was not a priority. Persecution of the wider Sunni population soon followed, with counter-insurgency operations in Sunni populated Al Anbar and Nineveh governorates. 6 Please see Mohammed bin Nawwaf bin Abdulaziz al Saud, "Saudi Arabia Will Go It Alone," New York Times, dated December 17, 2013, available at nytimes.com. 7 Please see Bruce Riedel, "Saudi Arabia's Mounting Security Challenges," Al Monitor, dated December 2015, available at al-monitor.com. 8 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 9 Please see Martin Chulov, "I will return Saudi Arabia to moderate Islam, says crown prince," The Guardian, dated October 24, 2017, available at www.theguardian.com. 10 Something tells us that most violations of Islamic law are likely to be committed after hours! 11 The Sudairi branch of the Saud dynasty refers to the issue of Saudi Arabia's founder Abdulaziz Ibn Saud with Hassa bint Ahmed Al Sudairi, one of Ibn Saud's wives and a member of the powerful Al Sudairis clan. The union produced seven sons, the largest faction out of the 45 sons that Ibn Saud fathered. As the largest grouping, the sons - often referred to as the "Sudairi Seven" - were able to consolidate power and unite against the other brothers. In addition to the current King Salman, the other member of the Sudairi faction who became a king was Fahd, ruling from 1982 to 2005. 12 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 2016, available at gps.bcaresearch.com. 13 The app is used to transmit photos and videos between users that disappear from the device after being viewed in 10 seconds. It is highly unlikely to be used for religious education. It is highly likely to be used by teenagers for ... well, use your imagination. 14 Please see "Social Media In Saudi Arabia - Statistics And Trends," TFE Times, dated January 12, 2017, available at tfetimes.com; "Saudi social media users ranked 7th in the world," Arab News, November 14, 2015, available at arabnews.com. 15 The World Values Survey is used in academic political science research to track changes in global social and political values. Ronald Inglehart and Christian Welzel have summarized the key findings in Modernization, Cultural Change, and Democracy (Cambridge: Cambridge UP, 2005). For more information, please see http://worldvaluessurvey.org. 16 Please see Mohamed A. Ramady, ed., The Political Economy Of Wasta: Use and Abuse of Social Capital Networking (New York: Springer, 2016). 17 It would not be the first such coup in Saudi history. King Saud was deposed in 1962 by his brother, King Faisal. 18 Please see Nahal Toosi and Madeline Conway, "Tillerson: Dispute Between Gulf States And Qatar Won't Affect Counterterrorism," dated June 5, 2017, available at www.politico.com. 19 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 20 Please see BCA Energy Sector Strategy and Geopolitical Strategy Special Report, "King Salman Goes To Moscow, Bolsters OPEC 2.0," dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see "Mideast War, By The Numbers," Associated Press, August 17, 2006, available at www.washingtonpost.com. 22 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," dated October 19, 2017, available at ces.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com.

Highlights The macro environment remains positive for risk assets. Nonetheless, the shadow of the '87 stock market crash is a reminder that major market corrections can occur even when the earnings and economic growth backdrop is upbeat. Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of easier financial conditions and the likelihood of some fiscal stimulus next year. Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should overweight Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments). High-yield relative value is decent after accounting for the favorable default outlook. It is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late cycle phase. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. The risk of disappointment is therefore elevated. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons and provide dry powder to boost exposure after the correction. Feature The October anniversary of the '87 stock market crash was a reminder to investors that major market corrections can arrive out of the blue. With hindsight, there were some warning signs evident before the crash. Nonetheless, the speed and viciousness of the correction caught the vast majority of investors by surprise, in large part because the economy was performing well (outside of some yawning imbalances such as the U.S. current account deficit). Many worried that the 20% drop in the S&P 500 would trigger a recession, but the economy did not skip a beat and it was not long before the equity market recouped the losses. We view the '87 crash as a correction rather than a bear market. BCA's definition of a bear market is a combination of magnitude (at least a 15% decline) and duration (lasting at least for six months). Bear markets are usually associated with economic recessions. Corrections tend to be short-lived because they are not associated with an economic downturn. None of our forward-looking indicators suggest that a recession is in the cards in the near term for any of the major economies. Even the risk of a financial accident or economic pothole in China has diminished in our view. As discussed below, the global economy is firing on almost all cylinders. Chart I-1Valuation Today Is Very Stretched Vs. 1987 Valuation Today Is Very Stretched Vs. 1987 Valuation Today Is Very Stretched Vs. 1987 Nonetheless, there are some parallels today with the mid-1980s. A Special Report sent to all BCA clients in October provides a retrospective on the '87 crash.1 One concern is that the proliferation of financial computer algorithms and derivatives is a parallel to the popularity of portfolio insurance in the 1980s, which was blamed for turbocharging the selling pressure when the market downturn gathered pace in October. My colleague Doug Peta downplays the risks inherent in the ETF market in the Special Report, but argues that automatic selling will again reinforce the fall in prices once it starts. It is also worrying that equity valuation is much more stretched than was the case in the summer of 1987 based on the cyclically-adjusted P/E ratio (CAPE, Chart I-1). The CAPE is currently at levels only previously reached ahead of the 1929 and 2000 peaks. In contrast, the CAPE was close to its long-term average in 1987. Quantitative easing and extremely low interest rates have pulled forward much of the bond and stock markets' future returns. It has also contributed to today's extremely low readings on implied volatility. The fact that the Fed is slowly taking away the punchbowl and that the ECB is dialing back its asset purchase program only add to the risk of a sharp correction. The Good News For now though, investors are focusing on the improving global growth backdrop and the still-solid earnings picture. While the S&P 500 again made new highs in October, it was the Nikkei that stole the show among the major countries. Impressively, the surge in the Japanese stock market was not on the back of a significantly weaker yen. As we highlighted last month, risk assets are being supported by the three legged stool of robust earnings growth, low volatility and yield levels in government bonds, and the view that inflation will remain quiescent for the foreseeable future. The fact that the global growth impulse is broadly-based is icing on the cake because it reduces lingering fears of secular stagnation. Even emerging economies have joined the growth party, while a weak U.S. dollar has tempered fears of a financial accident in this space. Our forward-looking growth indicators are upbeat (Chart I-2). Our demand indicators in the major economies remain quite bullish, especially for capital spending (not shown). Animal spirits are beginning to stir. Moreover, financial conditions remain growth-friendly, especially in the U.S., and subdued inflation is allowing central banks to proceed cautiously for those that are tightening or tapering. The global PMI broke to a new high in October, and the economic surprise index for the major economies has surged in recent months. Our global LEI remains in a strong uptrend and its diffusion index shifted back into positive territory, having experiencing a worrisome dip into negative territory earlier this year. We expect the global growth upturn will persist for at least the next year. The U.S. will be the first major economy to enter the next recession, although this should not occur until 2019. It is thus too early to expect the equity market to begin to anticipate the associated downturn in profit growth. Earnings: Japan A Star Performer It is still early days in the Q3 earnings season, but the mini cyclical rebound from the 2015/16 profit recession in the major economies is still playing out. The bright spots at the global level outside of energy are industrials, materials, technology and consumer staples (Chart I-3). All four are benefitting from strengthening top line growth and rising operating margins. Chart I-2Upbeat Global Economic Indicators Upbeat Global Economic Indicators Upbeat Global Economic Indicators Chart I-3Global Earnings By Sector Global Earnings By Sector Global Earnings By Sector The U.S. is further advanced in the mini-cycle and EPS growth is near its peak on a 4-quarter moving total basis. The expected topping out in profit growth is more a reflection of challenging year-on-year comparisons than a deterioration in the underlying fundamentals. The hurricanes will take a bite out of third quarter earnings, but this effect will be temporary. Moreover, oil prices are turbocharging earnings in the energy patch and we expect this to continue. Our commodity strategists recently lifted their 2018 target price for both Brent and WTI to $65/bbl and $63/bbl, respectively. The global uptick in GDP growth, along with continued production discipline from OPEC 2.0 are the principal drivers of our revised outlook. We expect the fortuitous combination of fundamentals to accelerate the drawdown in oil inventories globally, which also will be supportive for prices. While U.S. financials stocks have cheered the prospects that Congress may pass a tax bill sometime in early 2018, sell-side analysts have been brutally downgrading financial sector EPS estimates. This has dealt a blow to net earnings revisions in the sector. Expected hurricane-related losses are probably the main culprit, especially in the insurance sector. Nonetheless, our equity sector strategists argue that such indiscriminate downgrades are unwarranted, and we would lean against such pessimism.2 Recent profit results corroborate our positive sector bias, although we are still early in the earnings season. European profits will suffer to some extent in the third quarter due to the lagged effects of previous euro strength. The same will be true in the fourth quarter, although we expect this headwind to diminish early in 2018. That leaves Japan as the star profit performer among the majors in the near term. The recent surge in foreign flows into the Japanese market suggests that global investors are beginning to embrace the upbeat EPS story. Abe's election win in October means that the current monetary stance will remain in place. The ruling LDP's shift away from austerity (e.g. abandoning the primary balance target) may also be lifting growth expectations. A Return To The Great Moderation? Chart I-4Market Correlation And The ERP bca.bca_mp_2017_11_01_s1_c4 bca.bca_mp_2017_11_01_s1_c4 A lot of the good news is already discounted in equity prices. The depressed level of the VIX and the drop in risk asset correlations this year signal significant complacency. Large institutional investors are reportedly selling volatility and thus dampening vol across asset classes. But there is surely more to it. It appears that investors believe we have returned to the pre-Lehman period between 1995 and 2006 when the Great Moderation in macro volatility contributed to low correlations among stocks within the equity market (Chart I-4). The idea is that low perceived macroeconomic volatility during that period had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. Of course, the Great Recession and financial market crisis brought the Great Moderation to a crashing end. Correlations rocketed up and investors demanded a higher equity risk premium to hold stocks. Today, dispersion in the outlooks for growth and interest rates have fallen back to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart I-5). Some of this can be justified by fundamentals. The onset of a broadly-based global expansion phase has likely calmed lingering fears that the global economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has moderated as well (bottom panel). Historically, implied volatility tended to fall during previous periods when global industrial production was strong and global earnings were rising across a broad swath of countries (Chart I-6). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to fall as earnings fundamentals become more important performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. Similarly, the VIX can fluctuate at low levels for an extended period when global growth is broadly based. Chart I-5A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? Chart I-6Broad-Based Growth Lower Implied Volatility Broad-Based Growth Lower Implied Volatility Broad-Based Growth Lower Implied Volatility Still, current levels of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table I-1 shows the drop in the S&P 500 index during non-recession periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during the nine episodes, with a range of -3.6 to -18.1%. Table I-1Episodes When VIX Spiked November 2017 November 2017 The Equity Risk Premium Chart I-7Still Some Value In High-Yield Still Some Value In High-Yield Still Some Value In High-Yield On a positive note, the equity risk premium (ERP) is not overly depressed. There are many ways to define the ERP, but we present it as the 12-month forward earnings yield minus the 10-year Treasury yield in Chart I-4. It has fallen from about 760 basis points in 2011 to 310 basis points today. We do not believe that the ERP can return to the extremely low levels of 1990-2000. At best, the ERP may converge with the level that prevailed during the last equity bull market, from 2003-2007 (about 200 basis points). The current forward earnings yield is 550 basis points and the 10-year Treasury yield is 2.4%. The ERP would need to fall by 110 basis points to get back to the 2% equilibrium. This convergence can occur through some combination of a lower earnings yield or higher bond yield. If the 10-year yield is assumed to peak in this cycle at about 3% (our base case), then this leaves room for the earnings yield to fall by 50 basis points. This would boost the forward earnings multiple from 18 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We are not betting on any further multiple expansion but the point is that stocks at least have some padding in the event that bond yields adjust higher in a gradual way. It is the same story for speculative-grade bonds, which are not as expensive as they seem on the surface. The average index OAS is currently 326 bps, only about 100 bps above its all-time low. However, junk value appears much more attractive once the low default rate is taken into account. Chart I-7 presents the ex-post default-adjusted spreads, along with our forecast based on unchanged spreads and our projection for net default losses over the next year. The spread padding offered by the high-yield sector is actually reasonably good by historical standards, assuming there is no recession over the next year. We are not banking on much spread tightening from here, which means that high-yield is largely a carry trade now. Nonetheless, given a forecast for the default and recovery rate, we expect U.S. high-yield excess returns to be in the range of 2% and 5% (annualized) over the next 6-12 months. The bottom line is that the positive growth backdrop does not rule out a correction in risk assets, especially given rich valuations. But at least the profit, default and growth figures will remain a tailwind in the near term. The main risk is a breakout in inflation, which financial markets are not priced for. Inflation And Hidden Slack The September CPI report did little to buttress the FOMC's view that this year's inflation pullback is temporary. The report disappointed expectations again with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. The inflation debate continues to rage inside and outside the Fed as to whether the previous relationship between inflation and growth have permanently changed, whether low inflation simply reflects long lags, or whether it will require tighter labor markets in this business cycle to fuel wage and price pressures. We back the latter two of these three explanations but, admittedly, predicting exactly when inflation will pick up is extremely difficult and we must keep an open mind. A Special Report in the October IMF World Economic Outlook sheds some light on this vexing issue.3 Their work suggests that the deceleration in wage growth in the post-Lehman period in the OECD countries can largely be explained by traditional macro factors: weak productivity growth, lower inflation expectations and labor market slack. The disappointing productivity figures alone account for two-thirds of the drop in wage growth. However, a key point of the research is that the headline unemployment figures are not as good a measure of labor market slack as they once were. This is because declining unemployment rates partly reflect workers that have been forced into part-time jobs, referred to as involuntary part-time employment (IPT). The rise in IPT employment could be associated with automation, the growing importance of the service sector, and a diminished and more uncertain growth outlook that is keeping firms cautious. The IMF's statistical analysis suggests that the number of involuntary part-time workers as a share of total employment (IPT ratio) is an important measure of slack that adds information when explaining the decline in wage growth. Historically, each one percentage point rise in the IPT ratio trimmed wage growth by 0.3 percentage points. Chart I-8 and Chart I-9 compare the unemployment rate gap (unemployment rate less the full-employment estimate) with the deviation in the IPT ratio from its 2007 level. The fact that the IPT ratio has had an upward trend since 2000 in many countries makes it difficult to identify a level that is consistent with full employment. Nonetheless, the change in this ratio since 2007 provides a sense of how much "hidden slack" the Great Recession generated due to forced part-time employment. Chart I-8Measures Of Labor Market Slack (I) Measures Of Labor Market Slack (I) Measures Of Labor Market Slack (I) Chart I-9Measures Of Labor Market Slack (II) Measures Of Labor Market Slack (II) Measures Of Labor Market Slack (II) For the OECD as a whole, labor market slack has been fully absorbed based on the unemployment gap. However, the IPT ratio was still elevated at the end of 2016 (latest data available), helping to explain why wage growth has remained so depressed across most countries. The IPT ratio is still above its 2007 level in three-quarters of the OECD countries. Of course, there is dispersion across countries. Japan has no labor market slack by either measure. In the U.S., the unemployment gap has fallen into negative territory, but only about half of the post-2007 rise in the IPT ratio has been unwound. For the Eurozone, the U.K. and Canada, the unemployment gap is close to zero (or well into negative territory in the U.K.). Nonetheless, little of the under-employment problem in these economies has been absorbed based on the IPT ratio. Our discussion in last month's report highlighted the importance of the global output gap in driving inflation in individual countries. Consistent with this, the IMF finds that there have been important spillover effects related to labor market slack, especially since 2007. This means that wage growth can be held down even in countries where slack has disappeared because of the existence of a surplus of available labor in their trading partners. Phillips Curve Is Not Dead That said, we still believe that the U.S. is at a point in the cycle when inflationary pressures should begin to build, even in the face of persisting labor market slack at the global level. Chart I-10 shows the ECI and the Atlanta Fed wage tracker, which are the best measures of wages because they are less affected by composition effects. Both have moved higher along with measures of labor market tightness. Wage and consumer price inflation have ebbed this year, but when we step back and look at it over a longer timeframe, the Phillips curve still appears to be broadly operating. Moreover, inflation is a lagging indicator. Table I-2 splits the post-war U.S. business cycles into short, medium, and long buckets based on the length of the expansion phase. It presents the number of months from when full employment was reached to the turning point for consumer price inflation in each expansion. There was a wide variation in this lag in the short- and medium-length expansions, but the lags were short on average. Chart I-10Phillips Curve Still (Weakly) Operating Phillips Curve Still (Weakly) Operating Phillips Curve Still (Weakly) Operating Table I-2Inflation Reacts With A Lag November 2017 November 2017 It is a different story for long expansions, where the lag averaged more than two years. We have pointed out in the past that it takes longer for inflation pressures to reveal themselves when the economy approaches full employment gradually, in contrast to shorter expansions when momentum is so strong the demand crashes into supply constraints. The fact that U.S. unemployment rate has only been below the estimate of full employment for eight months in this expansion suggests that perhaps we and the Fed are just being too impatient in waiting for the inflection point. Turning to Europe, the IPT ratio confirms the ECB's view that there is an abundance of under-employment, despite the relatively low unemployment rate. This suggests that the Eurozone remains behind the U.S. in the economic cycle. As expected, the ECB announced a tapering in its asset purchase program to take place next year. While policymakers are backing away from QE in the face of healthy growth and a shrinking pool of bonds to purchase, they will continue to emphasize that rate hikes are a long way off in order to avoid a surge in the euro and an associated tightening in financial conditions. U.S./Eurozone bond yield spreads are still quite wide by historical standards and thus it is popular to bet on spread narrowing and a stronger euro/weaker dollar. However, some narrowing in short-term rate spreads is already discounted based on the OIS forward curve (Chart I-11). The real 5-year, 5-year forward OIS spread - the market's expectation of how much higher U.S. real 5-year rates will be in five years' time relative to the euro area - stands at about 70 basis points. This spread is not wide by historical standards, and thus has room to widen again if market expectations for the fed funds rate moves up toward the Fed's 'dot plot' over the next 6-12 months. While market pricing for the ECB policy rate path appears about right in our view, market expectations for rate hikes in the U.S. are too complacent. This implies that long-term spreads could widen in favor of the U.S. dollar over the coming months, especially if U.S. growth accelerates while euro area growth cools off a bit. The fact the U.S. economic surprise index has turned positive is early evidence that this process may have already begun. Moreover, the starting point is that the dollar has been weaker than interest rate differentials warrant, such that there is some room for the dollar to 'catch up', even if interest rate differentials do not move (Chart I-12). We see EUR/USD falling to 1.15 by the end of the year. Chart I-11Room For U.S./Eurozone Spreads To Widen... Room For U.S./Eurozone Spreads To Widen... Room For U.S./Eurozone Spreads To Widen... Chart I-12...Giving The Dollar A Lift ...Giving The Dollar A Lift ...Giving The Dollar A Lift A New Fed Chair? Our forecast for yield spreads and currencies is not overly affected by the choice of Fed Chair for next year. President Trump's meeting with academic John Taylor reportedly went well, but we think the President will prefer someone with a less hawkish bent. Keeping Chair Yellen is an option, but she has strong views on financial sector regulation that Trump does not like. The prevailing wisdom is that Jerome Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. In any event, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. As discussed above, uncertainty is elevated, but our base case sees inflation rising enough in the coming months for the Fed to maintain their 'dot plot' forecast. The market and the Fed are correct to 'look through' the near-term growth hit from the hurricanes, to the rebound that always follows the destruction. The U.S. housing sector is a little more worrying because some softness was evident even before the hurricanes hit. Since the early 1960s, a crest in housing led the broader economic downturn by an average of seven quarters. Nonetheless, we continue to expect that the housing soft patch does not represent a peak for this cycle. Residential investment should provide fuel to the economy for at least the next two years as pent up demand is worked off, related to depressed household formation since the 2008 financial crisis. Affordability will still be favorable even if mortgage rates were to rise by another 100 basis points (Chart I-13). Robust sentiment in the homebuilder sector in October confirms that the hurricane setback in housing starts is temporary. China And Base Metals Turning to China, economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at double-digit rates, albeit down from recent peak levels (Chart I-14). Various price indexes also reveal a fairly broadly-based inflation pickup to levels that will unnerve the authorities. Growth will likely slow in 2018 as policymakers continue to pare back stimulus. We do not foresee a substantial growth dip next year, but it could be hard on base metals prices. Chart I-13Housing Affordability Outlook Housing ##br##Affordability Under Various Rate Assumptions Housing Affordability Outlook Housing Affordability Under Various Rate Assumptions Housing Affordability Outlook Housing Affordability Under Various Rate Assumptions Chart I-14China: Healthy ##br##Growth Indicators China: Healthy Growth Indicators China: Healthy Growth Indicators Policy shifts discussed in Chinese President Xi's speech in October to the Party Congress are also negative for metals prices in the medium term. The speech provided a broad outline of goals to be followed by concrete policy initiatives at the National People's Congress (NPC) in March 2018. He emphasized that policy will tackle inequality, high debt levels, overcapacity and pollution. Globalization will also remain a priority of the government. The supply side reforms required to meet these goals will be positive in the long run, but negative for growth in the short run. Restructuring industry, deleveraging the financial sector and fighting smog will all have growth ramifications. The government could use fiscal stimulus to offset the short-term hit to growth. However, while overall growth may not slow much, the shift away from an investment-heavy, deeply polluting growth model, will undermine the demand for base metals. Our commodity strategists also highlight the supply backdrop for most base metals is not supportive of an extended rally in prices. The implication is that investors who are long base metals should treat it as a trade rather than a strategic position. Despite our expectation that policy will continue to tighten, we believe that investors should overweight Chinese stocks relative to other EM markets. Investment Conclusions: Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of the easing in U.S. financial conditions that has taken place this year and the likelihood of some fiscal stimulus next year. The U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to reach President Donald Trump's desk by the end of the first quarter of next year. Surveys show that investors have all but given up on the prospect of tax cuts, which means that it will be a positive surprise if it finally arrives (as we expect). Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should favor Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments) in the major developed fixed-income markets. Our base-case outlook implies that it is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late-cycle phase. Calm macro readings and still-easy monetary policy have generated signs of froth. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Upside inflation surprises would destabilize the three-legged stool supporting risk assets, especially at a time when the Fed is shrinking its balance sheet. Black Monday is a reminder that major market pullbacks can occur even when the economic outlook is bright. Thus, investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons, and to ensure that they have dry powder to exploit them when they materialize. Mark McClellan Senior Vice President The Bank Credit Analyst October 26, 2017 Next Report: November 20, 2017 1 Please see BCA Special Report, "Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis," October 19, 2017, available at bca.bcaresearch.com 2 Please see BCA U.S. Equity Strategy Weekly Report, "Banks Hold The Key," October 24, 2017, available at uses.bcaresearch.com 3 Recent Wage Dynamics In Advanced Economies: Drivers And Implications. Chapter 2, IMF World Economic Outlook. October 2017. II. Three Demographic Megatrends Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Our Aging World Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Savings Over The Life Cycle Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult November 2017 November 2017 Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The Ratio Of Workers To Consumers Has Peaked The Ratio Of Workers To Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders November 2017 November 2017 Chart II-6Immigration Versus Income Distribution Immigration Versus Income Distribution Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe November 2017 November 2017 Chart II-8Immigration Is Straining Generous ##br##European Welfare States November 2017 November 2017 All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind November 2017 November 2017 Chart II-10Worries About Immigrant Assimilation November 2017 November 2017 Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population The Projected Expansion In Sub-Saharan Population The Projected Expansion In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart November 2017 November 2017 Chart II-13The Erosion Of Trust In Media November 2017 November 2017 It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? November 2017 November 2017 Chart II-15People Versus Companies November 2017 November 2017 The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? November 2017 November 2017 Table II-2Crime Rates Are Creeping Higher In Europe November 2017 November 2017 Chart II-17Homicides And Inflation Homicides And Inflation Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy November 2017 November 2017 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). III. Indicators And Reference Charts Global equity markets partied in October on solid earnings and economic growth figures, and the rising chances of a tax cut in the U.S. among other bullish developments. The Nikkei has been particularly strong in local currency terms following the re-election of Abe. Our equity indicators remain upbeat on the whole, although the rally is looking stretched by some measures. The BCA monetary indicator is hovering at a benign level. Implied equity volatility is very low, investor sentiment is frothy and our Speculation Indicator is elevated. These suggest that a lot of good news is already discounted. Our valuation indicator is also closing in on the threshold of overvaluation at one standard deviation. Our technical indicator is rolling over, although it needs to fall below the zero line to send a 'sell' signal. On a constructive note, the solid rise in earnings-per-share is likely to continue in the near term, based on positive earnings surprises and the net revisions ratio. Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in September for the third consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and European WTPs rose in October after a brief sideways move in previous months, suggesting that equity flows have turned more constructive. But the Japanese WTP is outshining the others. Given that the Japanese WTP is rising from a low level, it suggests that there is more 'dry powder' available to purchase Japanese stocks, especially relative to the U.S. market. We favor Japanese stocks relative to the other two markets in local currency terms, as highlighted in the Overview section. Oversold conditions for the U.S. dollar have now been absorbed based on our technical indicator, but there is plenty of upside for the currency before technical headwinds begin to bite. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys has moved above the zero line, but has not reached oversold territory. Bond valuation is close to fair value based on our long-standing valuation model. These factors suggest that yields have more upside potential before meeting resistance. Other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still about 20 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

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

Highlights Global "Low-flation" Vs. Oil Reflation: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Fed Tightening Vs. Trump Easing: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018 Strong Growth Vs. Modest Inflation In Europe: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Feature The bull market in global risk assets continued last week, with the S&P 500 hitting yet another all-time record and other major bourses in both Developed Markets and Emerging Markets hitting multi-year highs. This is a sensible reflection of the strength and persistence of the current coordinated global economic upturn, which is boosting corporate profit growth worldwide. At the same time, the health of the current expansion has dampened risk-aversion among investors. This is helping to keep market volatility at depressed levels with only modest changes expected for both inflation and monetary policy. Yet there are storms brewing on the horizon that have the potential to shake up this low-volatility, risk-seeking backdrop. Specifically, a potentially less stable outlook for global inflation, amidst uncertainty over the direction of fiscal policy in the U.S. and monetary policy at the Fed and European Central Bank (ECB), could pose a threat to the current Goldilocks environment for risk assets (Chart of the Week). In this Weekly Report, we discuss some macroeconomic "trade-offs" that investors will have to grapple with over the next 6-12 months, and how to position bond portfolios accordingly. Chart of the WeekMarkets Not Worried About The Fed Or ECB Markets Not Worried About The Fed Or ECB Markets Not Worried About The Fed Or ECB Trade-Off #1: "Low-flation" Vs. Rising Oil Prices Chart 2Global Inflation Pressures Are Slowly Building Global Inflation Pressures Are Slowly Building Global Inflation Pressures Are Slowly Building Realized inflation data across the major developed economies is showing no imminent threat of breaching, or even just reaching, central bank targets. This is occurring despite a robust, coordinated global economic expansion that is generating some of the fastest growth rates seen since the Great Recession. With nearly ¾ of the countries in the OECD now with unemployment rates below the estimates of the full employment NAIRU, subdued inflation readings remain a puzzle for both investors and policymakers (Chart 2). The term "low-flation" has been used to describe this backdrop of inflation rates remaining low seemingly regardless of what is happening with growth. Bond investors have reacted to this by keeping market-based inflation expectations at levels below central bank inflation targets, suggesting a potential problem with the credibility of policymakers. Yet a fresh challenge to the low-flation thesis will soon come from the global oil markets. Last week, our colleagues at BCA Commodity & Energy Strategy upgraded their oil price targets for the fourth quarter of 2017 and all of 2018.1 Their estimates for global oil demand were revised upward based on the improving economic momentum, as evidenced by the IMF recently boosting its own forecasts for world GDP growth to 3.6% for all of 2017 and 3.7% for 2018. Combined with continued discipline on output from the so-called "OPEC 2.0" coalition of Russia & Saudi Arabia - currently responsible for 22% of the world's oil production - the global oil market is expected to see demand exceeding supply until late 2018 (Chart 3). The positive demand/supply balance should lead the Brent oil price benchmark to average just over $65/bbl in 2018 (Table 1), which would be a 13% increase from current levels. This is a move that global bond markets are likely to notice, given the strong correlation that still exists between market-based inflation expectations and oil prices in the developed economies. Chart 3A Positive Fundamental Backdrop For Oil A Positive Fundamental Backdrop For Oil A Positive Fundamental Backdrop For Oil Table 1Upgrading The BCA Oil Price Forecasts How To Trade The Trade-Offs How To Trade The Trade-Offs In Charts 4 & 5, we show the market-based pricing on inflation expectations at the 10-year maturity for the U.S. (using TIPS breakevens), the U.K., Germany, Japan, Canada and Australia (using CPI swaps). For each country, we also show the Brent oil price denominated in local currency terms. We add one additional data point to the charts, shown as an asterisk, incorporating the 2018 average Brent oil price expectation converted at current exchange rates versus the U.S. dollar. As can be seen, the higher oil price that our commodity strategists are expecting should act to put upward pressure on the inflation expectations component of government bond yields in the major developed markets. Chart 4Upward Pressure On Inflation Expectations ... Upward Pressure On Inflation Expectations... Upward Pressure On Inflation Expectations... Chart 5... From Higher Oil Prices In 2018 ...From Higher Oil Prices In 2018 ...From Higher Oil Prices In 2018 Of course, the unchanged currency assumption made in Charts 4 & 5 is unrealistic. Yet given the significant increase in oil prices that we are expecting next year (+13%), it is also unrealistic to expect enough currency appreciation in any country to fully offset the inflationary impact from oil. In fact, given the BCA view that the U.S. dollar should enjoy one last cyclical boost next year as the Fed delivers more rate hikes than the market is currently discounting, inflation expectations may actually rise by more than we are showing in our charts in non-U.S. countries (given that oil is priced in U.S. dollars). In Table 2, we show the forecast for the local-currency Brent oil price for 2018 and the date that oil prices were last at that level in each country (all in 2015 after the cyclical peak in oil prices that began in 2014). We also present the data on 10-year government bond yields, the 2-year/10-year slope of yield curves, market-based inflation expectations, and realized headline and core inflation rates for the major developed economies. We show the current levels for all those variables, plus the levels that prevailed the last time oil was at the levels we are forecasting. The major differences that stand out are: Table 2Bond Markets Now Vs. The Last Time Oil Prices Were In The Mid-$60s How To Trade The Trade-Offs How To Trade The Trade-Offs Yield levels are not dramatically different than where they were in 2015 in the U.S., Canada and Australia, but are lower now in the U.K., Euro Area and Japan thanks to central bank asset purchase programs. Yield curves are much flatter now in the U.S., U.K., Canada and Japan, but are steeper in the Euro Area and Australia. Market-based inflation expectations now are very close to the levels that prevailed in 2015, except in Japan where they are much lower. Headline inflation rates are much higher now everywhere except Australia, while core inflation rates are a lot higher in the U.K., a touch higher in the U.S. and Euro Area, and lower everywhere else. The conclusion from Table 2 is that there is potential for bond yields to rise as oil prices head higher in the U.S., U.K. and Euro Area given that inflation expectations are at the same levels as 2015 but realized inflation rates are higher. This would suggest that owning inflation protection in these countries is a sensible way to play the "low-flation vs. oil reflation" trade-off - trades that we already have in place in our Tactical Trade Overlay by being long Euro Area CPI swaps and owning U.S. TIPS versus nominal U.S. Treasuries and (see table on page 16). We are reluctant to add U.K. inflation protection to this list, however, and may even look to go the other way given the likelihood that the currency-fueled surge in U.K. inflation is in the process of peaking out. In sum, bond markets will be unable to ignore a combination of strong global growth (still called for by rising global leading economic indicators), tightening labor markets and rising oil prices in 2018. As investors come to grips with oil trading with a 60-handle for the first time since 2015, inflation expectations should widen out in all developed market countries that are at, or beyond, full employment. This should put upward pressure on nominal bond yields as well, and potentially trigger bear-steepening of yield curves if central banks do not respond to higher oil-driven inflation with a faster tightening of monetary policy. Bottom Line: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Trade-Off #2: Fed Tightening Vs. Trump Easing Last Friday, the U.S. Senate passed President Trump's budget plan by the slimmest of margins (51 to 49), allowing for an increase in federal deficits of up to $1.5 trillion over the next decade. Trump immediately put pressure on the U.S. House of Representatives to also pass the Senate plan, and the initial comments from House Republican leadership was that they would also endorse the Senate budget proposal which included significant tax cuts for corporations and some households. This is unsurprising given that the Republicans need a major, economy-boosting legislative victory to present to voters in next year's U.S. Midterm elections. The U.S. Treasury market responded to this news on Friday in a fashion that we believe to be sensible - the curve bear-steepened, with the 2-year/30-year spread widening 4bps on the day. We have written about the interaction between budget deficits, Fed policy and the slope of the Treasury curve in past Weekly Reports this year, most recently at the beginning of this month.2 Chart 6 is taken from that most recent report, and we feel that it is important to go through our logic once again after last week's events. Chart 6UST Curve: Bear-Steepener First, Bear-Flattener Later UST Curve: Bear-Steepener First, Bear-Flattener Later UST Curve: Bear-Steepener First, Bear-Flattener Later The Treasury curve typically steepens during periods when the U.S. federal budget deficit is widening (top panel). The Treasury curve is typically negatively correlated to the real fed funds rate, steepening when the real rate is falling and vice versa. Budget deficits usually are widening during periods of soft economic growth, when tax receipts are slowing and counter-cyclical fiscal spending is increasing. This is also typically correlated to periods when spare capacity in the U.S. economy is opening up and inflation pressures are diminishing (middle panel), hence giving the Fed cover to lower interest rates and putting steepening pressure on the Treasury curve. The current backdrop is atypical, as a fiscal stimulus is being proposed at a time when the economy is already at full employment with little sign of slowing. At the same time, the Fed is in a tightening cycle - albeit a slow one because of relatively subdued inflation - which usually does not occur during periods of widening budget deficits. This represents another difficult "trade-off" for investors to process. A so-called "full employment" fiscal stimulus should be inflationary at the margin, by definition, if it boosts economic growth to an above-potential pace. That would steepen the Treasury curve as longer-term inflation expectations rise, until the Fed steps in with rate hikes to offset the impact of the fiscal stimulus. If the Fed felt that the greater fiscal deficit was becoming a problem for medium-term inflation stability, then there could be a faster pace of rate hikes that would boost the real funds rate and put flattening pressure on the Treasury curve. A more straightforward way to describe that would be a scenario where the Trump tax cuts end up boosting U.S. real GDP growth to something close to 3% next year, which results in the U.S. unemployment rate falling to a "3-handle". This would likely put upward pressure on U.S. realized inflation and steepen the Treasury curve as the market prices in higher inflation - IF the Fed is slow to respond to that inflation pickup. When inflation rises by enough to threaten the Fed's 2% inflation target, perhaps even rising above that level, then the Fed would step in with more rate hikes. The result: a higher real fed funds rate and a flatter Treasury curve. That scenario is how we envision the next year playing out. Various FOMC members have already noted that they cannot account for any fiscal stimulus in their economic projections until they see the details. Furthermore, many members of the FOMC are expressing concern that the downdraft in inflation was enough of a surprise to raise questions about the Fed's understanding of the underlying inflation process. This suggests that the Fed will want to see inflation, both realized and expected, rise first before increasing the pace of rate hikes beyond current projections. Net-net, we see the Trump fiscal stimulus steepening the Treasury curve in 2018 before the Fed flattens it with tighter monetary policy. One caveat for the latter is the upcoming decision on the next Fed Chair. President Trump, ever the reality game show host, noted last week that the finalists for this season's episode for "The Apprentice: FOMC" are now down to Jerome Powell, John Taylor and current Chair Janet Yellen. Both Powell and, of course, Yellen would represent a continuation of the current cautious FOMC framework, while Taylor would likely be more hawkish given his public comments on Fed policy decisions (and the output of his own Taylor Rule!). If Taylor were to be appointed by Trump as the new Fed Chair, the Treasury curve may not steepen much on the back of fiscal easing if the markets begin to discount a more aggressive Fed. Bottom Line: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018. Trade-Off #3: Strong European Growth Vs. Mild Inflation The ECB meets later this week, and is expected to make a decision on the size and scope of its asset purchase program for next year and beyond. The latest Bloomberg survey of economists is calling for a cut in the monthly pace of asset purchases from €60bn/month to €30bn/month, but with an extension of the program until September 2018.3 The same survey calls for the ECB to deliver a hike in the deposit rate in Q1/2019, with a hike in the benchmark interest rate in Q2/2019. We agree with the former, although we think there will be no rate hikes of any kind until the 4th quarter of 2019, at the earliest. Chart 7Why Would The ECB NOT Taper? Why Would The ECB NOT Taper? Why Would The ECB NOT Taper? The trade-off between robust European growth and still modest rates of core inflation are the reason we expect the ECB to be very late to begin hiking policy rates after the asset purchase program is completed. It is clear from a variety of data, from almost all countries in the Euro Area, that the economy is expanding at a robust, above-potential pace (Chart 7). Headline inflation has increased steadily off the 2015 lows and now sits at 1.5%, still below the ECB's target of "just below 2%". The ECB has played down this pickup in inflation, given that is has largely been driven by the rise in oil prices since the 2015 lows. There is certainly a strong correlation between the annual change of oil prices (denominated in euros) and Euro Area headline inflation (middle panel), and the ECB expects fading oil price momentum to result in Euro Area headline inflation drifting back to 1% in early 2018. Yet the oil price increase that our commodity strategists are calling for next year would boost the year-over-year growth rate to a pace around 40%, which has in the past been consistent with 2% headline inflation outcomes. A rising euro would help mitigate the impact from oil, but as mentioned earlier, we see more potential for some modest depreciation of the euro versus the U.S. dollar after the run-up seen in 2017. Despite the pickup in headline inflation already underway, core inflation in Europe remains benign at 1.1%. Our measure of the "breadth" of the rise in core inflation across 75 individual subsectors - the Euro Area core inflation diffusion index - sits right around the "50 line" suggesting that just as many components of Euro Area core inflation are rising as are falling. Yet with broad Euro Area unemployment approaching 8%, and with some measures of wage inflation starting to awake as a result, the odds are increasing that continued strong growth will result in additional upward momentum in core inflation. The ECB is already forecasting a return of core inflation to 1.9% in 2019, which is why some reduction in the pace of asset purchases will be announced this week. The entire asset purchase program was only put in place in 2015 to fight a deflation threat after oil prices collapsed in 2014, and that has now passed with inflation steadily grinding higher. So the "trade-off" for investors in Europe, between strong growth and moderate inflation, will be resolved by the ECB shifting to a less-accommodative monetary policy stance. In terms of the impact on Euro Area bond yields, however, the change in the pace of bond buying matters even more than the size of the asset purchases. In Chart 8, we show the ECB's monetary base and three scenarios for how it will evolve through asset purchases until the end of 2018: Base Case: The ECB slows the pace of bond buying to €30bn/month starting in January 2018 until September 2018, then cuts that down to €15bn/month for the remainder of 2018 and stops the program completely at year-end. Dovish Scenario: The pace of bond buying is maintained at €60bn/month until the end of 2018, with no commitment to end the program then. Hawkish Scenario: The ECB tapers its purchases by €10bn/month for the first six months of next year, then ends the program in July 2018. In the bottom two panels of Chart 8, we show the year-over-year growth rate of the ECB's balance sheet, with those three scenarios, and compare them to the benchmark 10-year German Bund yield and our estimate of the German term premium. In all three scenarios, even the dovish one where the ECB keeps on buying at the current pace, the growth rate of the monetary base will decelerate in 2018. As can be seen in the chart, that growth rate has been highly correlated to yields and the term premium during the life of the ECB's asset purchase program. The conclusion here is that central bank asset purchase programs need to increase in size versus previous years to maintain the same impact on bond yields over time. Put another way, asset purchases represent a signaling mechanism ("forward guidance") from a central bank to the markets about future changes in interest rates when they are already at the zero bound. Increasing the size of the purchases sends a more powerful message than simply keeping the pace of buying unchanged. This is especially true if the underlying economy is growing and inflation is rising, which would typically cause investors to price in a higher expected path of interest rates into the government bond yield curve. So, unless the ECB takes the highly unlikely step of increasing the size of its asset purchases for next year, then there are no outcomes from this week's ECB meeting that should be expected to be sustainably bullish for longer-dated European government bonds. At the same time, there will be no signals given on future changes in short-term interest rates, as the ECB has maintained for some time that rates will not be touched until "some time" after the asset purchase program has ended (Q4/2019, in our view). Hence, Euro Area yield curves are likely to eventually see some bear-steepening pressure on the back of this week's ECB meeting. The story is similar for Peripheral European government bonds and Euro Area investment grade corporate credit. In Chart 9, we show the same growth rates of the ECB monetary base with our scenario projections versus the 10-year Italy-Germany spread, 10-year Spain-Germany spread, 10-year Portugal-Germany spread and the Barclays Bloomberg Euro Area Investment Grade corporate spread. While the correlations are not as clear as that for German yields, a slower pace of ECB asset purchases would be consistent with some spread widening in Peripheral European and in corporate credit. Chart 8ECB Bond Buying:##BR##Watch The Pace, Not The Level ECB Bond Buying: Watch The Pace, Not The Level ECB Bond Buying: Watch The Pace, Not The Level Chart 9European Credit Spreads##BR##Set To Widen Post-ECB? European Credit Spreads Set To Widen Post-ECB? European Credit Spreads Set To Widen Post-ECB? Bottom Line: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten", dated October 19th 2017, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "The Case For Steeper Yield Curves", dated October 3rd 2017, available at gfis.bcaresearch.com. 3 https://www.bloomberg.com/news/articles/2017-10-22/draghi-seen-going-for-ecb-bond-buying-limit-in-qe-s-last-hurrah The GFIS Recommended Portfolio Vs. The Custom Benchmark Index How To Trade The Trade-Offs How To Trade The Trade-Offs Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns