Protectionism/Competitive devaluation

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

Highlights Nothing in Trump's congressional address changes our outlook from November; Trump has reaffirmed his commitment to mercantilism; Investors should continue to favor small caps over large caps; We expect Trump to get his way on more spending, and a tax reform plan to pass by the end of the year; The Dutch election is a red herring, Le Pen's chances of winning are falling, but Italy remains a risk, especially in 2018; North Korea has evolved from a red herring into a black swan, stay short KRW/THB. Feature President Donald J. Trump delivered a reassuring speech last week. Sporting a magnanimous tone (and a new tie!) the president shocked the media by invoking a "new surge of optimism." Gone were the diatribes about "American carnage." Instead, President Trump implored Congress to work together to bring forth a major infrastructure program that would rival that of Eisenhower's interstate highway system, adopt a merit-based immigration system akin to Canada, and reform Obamacare in a way that would retain all its popular pillars. Trump concluded the speech by stating that "everything that is broken in our country can be fixed" and warning the polarized Congress that "true love for our people requires us to find common ground." After the speech, a narrative emerged in the media and financial press saying that Trump was a changed man. Should investors believe it? Not at all! There was simply nothing in the Trump speech that changes our outlook in November: that President Trump was elected on a populist platform and that he will be unconstrained on blowing out the U.S. budget and pursuing a mercantilist agenda.1 On everything else - from immigration reform to Obamacare - Trump may pursue a pragmatic set of policies. Or he may not. But what investors really care about is whether the Trump administration and Congress will: Get sweeping tax cut legislation done in 2017; Pass some infrastructure spending in 2017; Pursue protectionist policies. On all three counts, we believe that the answer is yes. Trump will get his way on both his pro-growth - anti-fiscal discipline - and mercantilist agendas. The timing is difficult to gauge, but we believe that we will see all three policy avenues aggressively pursued throughout the year and passed into law by the year's end. Trump's speech has only reinforced this view. Who Is Trump? Tax Cuts As we discussed in a recent report detailing the border adjustment tax (BAT) proposal, newly elected presidents rarely fumble on tax reform.2 Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In addition, the GOP knows that it must move fast if it wants to pass any tax cuts in 2017. President Trump is now the most unpopular president since polling began tracking the question (Chart 1). Chart 1Does President Trump Lack Political Capital? Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was However, Republican voters continue to support him at 88%. This means that the House Republicans are vulnerable both to a Democrat/Independent backlash against Trump in the midterm elections and a Trump supporter backlash in the Republican primaries. They need to pass major legislation that satisfies middle class concerns and ensure that they do not incur the wrath of the Trump voters in primary races. While it is unlikely that the Democrats could significantly eat into Republican majorities in the House of Representatives and the Senate, stranger things have happened.3 Adding fire under the GOP are two special Congressional Elections, in Georgia's sixth district and for Montana's "at large" seat, to be held in April and May respectively.4 Both were easily won in November by Republicans. A slippage by the Republicans in either would send shockwaves through Congress. There is therefore little time to waste. The Republicans know that they must strike while the iron is hot. We suspect that most representatives will abandon their demand for revenue-neutral tax reform to get any tax reform. That may mean adjusting House Speaker Paul Ryan's favorite revenue-raising proposal - the border adjustment tax (BAT) - so that it brings less revenue by exempting whole categories of imports from punitive corporate taxes. "Dynamic scoring" - an accounting method that considers the holistic impact of budget measures on revenues and thus deficits - will be used to make the "math" work and satisfy the procedural demand for budget responsibility.5 What about Obamacare? A narrative has emerged in the media that Republicans cannot work on tax reform while the issue of "repealing and replacing" the Affordable Care Act looms over their heads. We disagree. There are plenty of examples of the White House and Congress cooperating on multiple policy agendas at the same time. For example, the Obama White House used its majorities in Congress to push through a major fiscal stimulus, financial reform, and the controversial health care plan. Ronald Reagan also managed to enact comprehensive immigration and tax reform in 1986. Trump's congressional address made only one mention of government debt. But he did emphasize that his tax plan would provide "massive tax relief for the middle class." This implies that the election campaign's individual income tax proposals may have to be altered. Trump's and the GOP's plans from last year agreed that the individual income tax should be reduced from seven to three brackets, with the marginal rates at 12%, 25%, and 33%. This would have cut the top marginal rate from 39.6% to 33%, but would also have left a significant number of Americans with an increase, or no change, to their marginal tax rate.6 It is likely that this will have to change, potentially creating an even greater impact on the deficit. Bottom Line: We expect both corporate and individual tax reform by the end of 2017. We do not have clarity on how legislators will go from here to there, but we suspect that to get both passed, Republicans in Congress will err on the side of greater deficits. As such, investors should expect exemptions on many imports under the final BAT (weakening any USD spike) and likely greater middle class tax cuts than are currently priced in the market. Infrastructure Spending Trump's congressional address ended several weeks of silence from the Trump administration on infrastructure spending. Not only did Trump reference the Eisenhower interstate highway system as a model to emulate, but he also promised a considerable increase in military spending and the completion of the wall on the border with Mexico ahead of schedule. Trump referred back to the original $1 trillion price tag that he announced in the heat of the electoral campaign. This figure was revised down by Trump's transition team to a modest $550 billion, though the difference may only be due to time frame. Whatever the case, Trump is using the bigger number now. We continue to believe that GOP representatives will not obstruct Trump's spending priorities. First, "dynamic scoring" can be applied to both tax cuts and infrastructure spending to make anything look close to revenue neutral. Second, voters want infrastructure spending (Chart 2). It is in fact the only issue other than combating drug addiction that Republicans and Democrats deeply agree on (Chart 3). Chart 2Everyone Loves Infrastructure Spending Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 3Infrastructure Is Not A Partisan Issue Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Third, history is not on the side of deficit hawks. True, the national debt is higher today at $20 trillion than it has been for previous Republican administrations. However, it is not only an arithmetic fact that Republican administrations run large deficits (Chart 4), it is also a fact that they tend to get more than they ask from Congress. Chart 5 shows, with astonishing consistency, that Congress is only a check on Democratic presidents when it comes to the final size of appropriation bills, whereas Republican presidents always managed to get Congress to approve more funding than they asked for. Chart 4Fact: Republicans Run##br## Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Chart 5Budgets: Republican Presidents ##br##Get What They Want Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Bottom Line: It remains difficult to gauge the actual size or economic impact of Trump's government spending proposals. However, we expect that President Trump will get his way on more spending not only for defense, veterans, and the wall, but also for infrastructure. While the impact will be minimal in 2017, investors should see greater fiscal thrust in 2018. Mercantilism While the media focused on the magnanimous tone of Trump's speech last week, we saw little change in his commitment to mercantilism. We continue to believe that Trump is a populist protectionist and that he is serious about enacting mercantilist policies.7 Recent government appointments (Table 2) and statements from the Trump administration (Table 3) suggest that we are correct. Table 2Government Appointments That Certify That Trump Is A Protectionist Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In his speech, Trump invoked President Abraham Lincoln's words that "abandonment of the protective policy by the American Government [will] produce want and ruin among our people."8 He went on to call for "fair trade," contrasted explicitly with "free trade," and to suggest that he would support changing the U.S. corporate tax system to make U.S. exports more competitive. Trump also said on February 24, in a Reuters interview, that he thought that the border adjustment tax would boost exports and help keep jobs in the U.S.9 This should end the speculation - prompted by an early comment from Trump on the BAT - that the president and congressional GOP are irreconcilably at odds over the BAT. Table 3Protectionist Statements From The Trump Administration Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was While Trump has yet to endorse Ryan's BAT proposal officially, he does not oppose its protectionist aspects. As a reminder, the BAT is protectionist because of two key elements: The BAT would give a "rebate" on exports (implicitly or explicitly) that could be higher than the amount of tax due on foreign profits (Diagram 1). For all intents and purposes, this is a dirigiste government subsidy for export-oriented industries. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was The BAT would allow companies to write off wages and salaries as costs, just like under the current corporate income tax system. But under the value-added tax systems of the rest of the world wages are not deductible. In addition, Trump still retains a bevy of traditional tools like tariffs with which to go after potential trade rivals. As we have pointed out since November, there are few constraints on a U.S. president when imposing protectionist measures.10 Bottom Line: Donald Trump remains committed to a mercantilist agenda. Investors should expect him to live up to the hype at some point in 2017. Investment Implications If markets have been cheering Trump's pro-growth policies, in addition to improving global growth data, we suspect the stock-market party will continue. Investors can take from President Trump's March 1 speech a renewed commitment to a populist agenda that should cause government spending to increase, regulations to be cut, corporate and individual tax rates to fall, and the budget deficit to widen. Won't this pursuit of nominal GDP growth at any cost create conditions for inflation and eventually a recession? Yes, but the timing is difficult to gauge and much will depend on whether Donald Trump replaces the doves on the Fed governing board with hawks, as current conventional wisdom has it. We highly doubt that he would chose hawks, or policymakers committed to rules-based central banking, given his singular focus on reviving economic growth. But even a dovish Fed may move to raise interest rates aggressively given the slate of pro-growth policies being undertaken so late in the economic cycle. In the meantime, on a cyclical horizon, the party will continue and stocks will go higher. As we posited two weeks ago, many of our clients are cautious and tactically bearish, expecting a correction, but we cannot find a single structural bear. In this environment, where everyone expects to "buy on dips" following the correction that never seems to happen, it is hard for a correction to happen. But isn't protectionism and a trade war between the U.S. and China, or even the rest of the world, a risk to the rally? Not necessarily. First, the timing is uncertain. Second, the impact on economic growth is even more uncertain. Third, aside from any knee-jerk selloffs, protectionism will split sectors and stocks into winners and losers. Those with a greater share of revenues abroad will suffer due to potential retaliation from America's trade partners. Furthermore, much of Trump's policies will be dollar bullish - including tax cuts, greater government spending, and likely the BAT. As such, export-oriented sectors and companies will stand to suffer. We continue to believe that an overweight position in small caps will be a way to play the "Trump effect" on a strategic basis. Europe - Election Update Europe's election season is heating up, with the Dutch election just a week away and the first round of the French presidential election in just over a month. Here is a quick update on the key developments: The Netherlands According to the latest polls from the Netherlands, the Euroskeptic Party for Freedom (PVV) appears to be slipping (Chart 6). Just two months ago, the PVV was projected to capture around 35 seats, a number that has now fallen to around 25. Given that the Dutch parliament has 150 seats and that the PVV has no potential allies amongst the other 13 competitive parties, this election is largely a red herring. Should investors be worried about the Netherlands' role in European integration in the future? We don't think so. Support for the euro and the EU has not slipped in the Netherlands, at least not according to the data we have presented in these pages before.11 Instead, the PVV's support has risen due to the recent migration crisis. In fact, the number of asylum seekers has correlated almost perfectly with the PVV's support level since mid-2015 when the influx began (Chart 7). Given that the migration crisis is over (and we do not expect it to restart any time soon), we suspect that the PVV's support will moderate over the next electoral cycle. Chart 6Dutch Euroskeptics Are##br## An Overstated Threat Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 7Dutch Populists Are A##br## Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis France The French election continues to grab headlines in Europe. However, almost all the news is bad news for Marine Le Pen. First, François Bayrou, a notable centrist who captured 9.3% of the vote in the first round of the 2012 election and 18.6% in 2007, has decided not to contest the election and instead support Emmanuel Macron. Non-French media have not picked up on the significance of the endorsement. It is more important than Bayrou's 3-5% level of support in the polls suggests. While Bayrou is a centrist, he once belonged to the center-right, conservative movement and was a cabinet minister during Jacques Chirac's reign. As such, his endorsement will give Macron, a former Socialist Party minister, even more "cross-over appeal" for center-right voters in the second round against Le Pen. Chart 8Le Pen Is Facing Resistance Le Pen Is Facing Resistance Le Pen Is Facing Resistance Second, the rumored alliance between the far-left Jean-Luc Mélenchon and the left-wing candidate of the ruling Socialist Party, Benoît Hamon, has failed to materialize. Their potential alliance was one of the main concerns that many of our clients brought to us in recent meetings. Given current polling, such a marriage could have produced a singular left-wing candidacy that would have propelled either Mélenchon or Hamon into the second round. However, the alliance was always a long shot, as anyone who has followed French politics knows, given Mélenchon's staunch commitment to running on his own platform. And furthermore, arithmetically combining the polling of the two candidates makes no sense given that a singular platform would have forced compromises that would have led to serious defections by voters to other candidates. As such, the combined ticket's support level was always just a theoretical exercise. Third, the latest polls suggest that Le Pen's mini-rally has been arrested (Chart 8). She has failed to consistently break through the 40% percentile mark for the second round. Against Macron, her most likely opponent, she continues to trail by a 25-30% margin. The second-round election is on May 7, just two months away. Two months from November 8, Donald Trump trailed Hillary Clinton by just 5%. Italy Our main political concern in Europe remains Italy. Polls continue to show that Euroskeptics are gaining on the centrist parties (Chart 9). Most worryingly, Italians continue to gain confidence in life outside the EU. According to a poll that asks respondents whether they think "their country could better face the future outside of the EU," Italians are the most optimistic, next to the Brits and the historically Euroskeptic Austrians, about life outside the bloc (Chart 10). Chart 9Italian Establishment##br## Is Collapsing Italian Establishment Is Collapsing Italian Establishment Is Collapsing Chart 10AItalians Are Now The Only People In ##br##The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Chart 10BItalians Are Now The Only People In##br## The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits We therefore find the market's sanguine view on Italy to be myopic. Yes, the probability of an election in 2017 is declining. The ruling Democratic Party (PD) has set its leadership race for April 30, which rules out an election this summer, and former Prime Minister Matteo Renzi appears to have agreed to an election in February 2018.12 On a cyclical time horizon of 12 months, Italy is therefore not a major risk. However, once the election does take place, it could be source of considerable market volatility. At that point, investors would have to ask whether the election would take place under a new electoral law. If not, then the probability of a hung parliament would be considerable. Unless, that is, the Euroskeptic parties could form a coalition based solely on holding a referendum to leave the euro area. We doubt that the left-wing Five Star Movement (M5S) would be able to cooperate with the more staunchly Euroskeptic and right-wing Northern League and Brothers of Italy on this matter. Particularly since M5S has already begun to moderate on the issue of Euroskepticism. There is no point in speculating on an outcome of an election a year from now given that we are not even certain what electoral rules the contest would use. However, we do not think that investors should be sanguine because the likeliest outcome is governmental dysfunction. Chart 11SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent The one thing that may help Italy in 2018 is the outcome of the German election in September. The radically Europhile chancellor-candidate of the Social Democratic Party (SPD), Martin Schulz, has continued to do well in the polls against Angela Merkel (Chart 11). On a recent tour of highly sophisticated clients in New York we were surprised that only a handful were aware of Schulz's platform and background. Even if Schulz does not win, a renewed Grand Coalition between Merkel's Christian Democratic Union and the SPD would have to take into consideration his meteoric rise. The price for a renewed Grand Coalition could be the abandonment of Merkel's reticent leadership of the euro area. Investment Implications For now, our view that the markets will climb the wall of worry in Europe in 2017 is holding up. We suspect that investors will quickly refocus their attention on Italy once the French election is out of the way. One of the best gauges of euro area breakup risk has been the performance of French bonds versus German bonds relative to the performance of Spanish and Italian bonds versus German bonds. In our view, every time French spreads have correlated highly with Spanish and Italian spreads, the euro area faced existential threats. The shaded sections of Chart 12 largely conform to the political context in Europe over the past five years. In particular, it is interesting that French yields have decoupled from their Mediterranean peers ever since the ECB's "whatever it takes" announcement. Chart 12French Spreads Are Overstated French Spreads Are Overstated French Spreads Are Overstated Until right now, that is. We think the bond market is making a mistake. France is not a risk and euro area breakup risk over the next 12 months is essentially near zero. However, the probability of a major economy leaving the euro area over the next five years is going up. This is both because of the political situation in Italy and because Euroskeptics like Marine Le Pen could take over the mantle of the "official opposition" to the "centrist consensus" running Europe. If a country like Italy exits the euro area, would the currency union be doomed? It depends, largely on how that economy were to perform post-exit. In the ceteris paribus world of macroeconomics, a massive currency devaluation post-exit would be a clear and definitive positive. However, BCA's Geopolitical Strategy was created specifically to go beyond ceteris paribus analysis. And we doubt that the euro area exit would be undertaken by pragmatic policymakers capable of taking advantage of currency devaluation while reassuring both markets and EU member states that they would pursue orthodox economic policies. As a guide for what we think would happen to Italy, we would suggest our clients read our January 2016 report on the Greek future post euro area.13 In this think piece, we argue that Greece would not become a "land of milk and honey" after exiting, largely because the political context of exit would be turbulent and lead to populist policies that would devastate the economy. As such, we would stress that while the probability of an individual member state leaving the euro area is climbing - even one as important as Italy - it does not necessarily mean that the probability of euro area dissolution is climbing at the same rate. North Korea: No Longer A Red Herring A brief word about the Korean peninsula is in order after the four North Korean missile tests on March 6 and our report last week recommending that clients steer clear of South Korean assets.14 Simply put, the Korean peninsula is a source of real geopolitical risk right now, contrary to the status quo in which North Korea was largely a red herring. We have narrated this transition since last year,15 but it boils down to the following points: North Korea is finally "arriving" at the nuclear club: It is coming upon that horizon foreseen long ago in which it possesses the ability strike the United States with a nuclear missile, however crude. The American and Japanese defense establishments are becoming more concerned, and their public opinion can follow on command.16 Trump's policy looks to be more assertive, though that is not certain. U.S.-China relations have gone sour: The worsening of Sino-American tensions makes these two more suspicious of each other's motives and simultaneously increases economic and political pressure on both Koreas. Ironically, China is currently sanctioning both North and South Korea, the latter because it is hosting the U.S. THAAD missile defense system (Chart 13). The U.S., for its part, has been rushing THAAD, which it is just now rapidly deploying after the latest North Korean launches. North Korean internal stability is overrated: It is hard to argue that Kim Jong Un has not consolidated power impressively. But this consolidation has coincided with some loosening of internal economic control to help compensate for slower Chinese growth and worse Chinese relations. Gradual marketization threatens to undermine the regime from within, yet the standard playbook of belligerence threatens to provoke sanctions with real teeth from without, like China's proposed coal import ban for the rest of this year.17 Chart 13China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles Adding to the volatile mix, South Korea's right-of-center ruling party is collapsing, which affects the behavior of all the interested parties. The Constitutional Court is set to decide whether to uphold the president's impeachment as early as this week. Where is it all going? In the short term, markets will respond to the court case and elections. A ruling is expected immediately, but could take until June. A ruling ejecting the president would be positive for South Korean risk assets, as it would reduce the current extreme uncertainty. As to the long-term outlook, if everything were to happen according to the region's familiar patterns of rising and falling tensions, China's sanctions would force North Korea to offer de-escalation, a new left-wing government in South Korea would launch a bold new "Sunshine Policy" of engagement with the North, and the alignment of these three in favor of new diplomatic negotiations would drive Japan and the United States to give peace another chance despite their skepticism about the outcome. By 2018, a revival of something like the Six Party Talks, discontinued in 2009, would be on the horizon or even underway. The problem is that the usual cycle is less assured because of the North's improving capabilities and other factors above. Thus, until we see China verifiably enforce sanctions, North Korea step back from its provocations, and the Trump administration take a non-aggressive posture (with Japan following suit), the Korean peninsula will be at a heightened risk of producing geopolitical "black swan" events. Bottom Line: North Korea is shifting from a red herring to a potential black swan, at least until U.S.-China relations improve and lend some stability to the situation. Stay short KRW/THB. Marko Papic, Senior Vice President marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 3 For example, the 2010 "Tea Party" revolution reversed the Democrat's majority in the House with one of the most sweeping victories merely 24 months following President Obama's 2008 victory, which itself was a lot more convincing than Trump's victory over Clinton. 4 Republican Ryan Zinke won the Montana seat but left it to become Trump's Secretary of Interior; Republican Tom Price won the Georgia seat but left it to become Secretary of Health and Human Services. 5 Dynamic-scoring, also known as macroeconomic modeling, is a favorite tool of Republican legislators when passing tax cut legislation. It allows policymakers to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. The same method could be used to pass "revenue-neutral" infrastructure spending, given that it too would produce higher economic growth and thus presumably higher government revenues. 6 Several income brackets would see no substantial tax cuts under the original tax cut plan proposed by the Trump campaign. Those making $15,000-$19,000 would see their tax rate increase from 10% to 12%. Those making $52,500-101,500 would see their rate stay the same at 25%, while those making $127,500-$200,500 would see their rate rise substantively, from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 President Trump failed to mention that the U.S. was - when Lincoln made the statement in 1846 - a developing economy. Nor did he mention that Lincoln made the statements not as a president but a representative. 9 Please see Holland, Steve, Reuters, "Exclusive: Trump says Republican border tax could boost U.S. jobs," dated February 24, 2017, available at reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 12 Renzi said on February 26 that "The elections are envisaged in February 2018. Fullstop." Please see Reuters, "Decision on early Italian elections up to PM Gentiloni: Renzi," dated February 26, 2017, available at reuters.com. 13 Please see BCA Geopolitical Strategy Special Report, "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, and "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 16 Please see Mark Landler, "North Korea Nuclear Threat Cited by James Clapper, Intelligence Chief," New York Times, February 9, 2016; Siegfried S. Hecker, "The U.S. Must Talk To North Korea," New York Times, January 12, 2017, available at www.nytimes.com. See also Jeff Seldin, "N. Korea Capable of Nuclear Strike at US, Military Leader Says," Voice of America, April 7, 2015, available at www.voanews.com. In 2013, Chairman of the Joint Chiefs of Staff General Martin Dempsey said that "in the absence of concrete evidence to the contrary, we have to assume the worst case, and that's ... why we're postured as we are today," quoted in "Hagel: North Korea Near 'Red Line,'" UPI, April 10, 2013, available at www.upi.com. 17 Enforcement is as yet unclear. Please see Leo Byrne, "North Korean cargo ship moves between Chinese, DPRK coal facilities," dated March 6, 2017, available at www.nknews.org.

Highlights The supply of U.S. dollar outside America has been curtailed, yet there is large pent-up demand for dollars. This warrants another upleg in the greenback. The Trump administration's desire to shrink America's current account deficit will be very deflationary for the rest of the world, and mildly inflationary for the U.S. Such policies, if adopted, will exaggerate the paucity of U.S. dollars beyond America's borders and lead to notable dollar appreciation. The RMB is at risk because Chinese banks have created too many yuan, and deposit rates in real terms have turned negative as inflation has risen. Our negative view on EM has been and continues to be driven by our outlook on EM/China domestic demand, commodities prices and the U.S. dollar - not growth in advanced economies. Feature In recent weeks we met with clients in Asia and Australia. This week's report addresses some of the more common questions that we were asked to address. Question: You have written about "global U.S. dollar liquidity shortages." Why have these "global dollar shortages" occurred given the Fed expanded its balance sheet enormously from 2008 until 2014? How does one measure "global dollar shortages," and what does it mean for financial markets? By "global U.S. dollar shortages," we refer to deficiency in U.S. dollars outside the U.S., where U.S. dollar supply growth has fallen short of growth in demand for the greenback. We have the following pertinent observations on this issue: U.S. dollar shortages in the global banking system (eurodollar market) can be represented by U.S. banks' and other financial firms' claims on foreigners. This measure has been shrinking since early 2015 (Chart I-1). This corroborates the fact that U.S. banks, prime money market funds and other financial institutions have been unable/unwilling to supply dollars to the eurodollar market. This is consistent with rising LIBOR rates, which still continue to climb. U.S. non-financial entities' foreign assets have also fallen in the past year and a half but they are much smaller than banks and other financial institutions claims. As to U.S. banks' and other financial firms' claims on EM, they have also been shrinking since early 2015 (Chart I-2). Chart I-1Weak Supply Of U.S. Dollars To Rest ##br##Of World By U.S. Financial Institutions Weak Supply Of U.S. Dollars To Rest Of World By U.S. Financial Institutions Weak Supply Of U.S. Dollars To Rest Of World By U.S. Financial Institutions Chart I-2Shrinking Supply Of U.S. Dollars ##br##To EM By U.S. Financial Institutions Shrinking Supply Of U.S. Dollars To EM By U.S. Financial Institutions Shrinking Supply Of U.S. Dollars To EM By U.S. Financial Institutions Another way that the U.S. emits dollars to the rest of the world is by running a current account deficit. The U.S. current account deficit as a share of global GDP is now much smaller now than it was before the Great Recession (Chart I-3). This also means a smaller U.S. dollar supply relative to the size of the world economy. On the demand side, the widening in cross currency basis swaps indicates structural demand for U.S. dollar funding among euro area and Japanese investors (Chart I-4). Chart I-3The U.S. Emits Less ##br##Dollars To World Via Trade The U.S. Emits Less Dollars To World Via Trade The U.S. Emits Less Dollars To World Via Trade Chart I-4Pent-Up Demand For Dollars From Japanese ##br##And European Fixed-Income Investors Pent-Up Demand For Dollars From Japanese And European Fixed-Income Investors Pent-Up Demand For Dollars From Japanese And European Fixed-Income Investors These investors have been opting for exposure to dollar assets due to the higher yield on U.S. dollar fixed-income instruments - but they have been reluctant to take on exchange rate risk. In brief, they have avoided getting long exposure to the U.S. dollar. The reluctance to accept the exchange rate risk by European and Japanese investors means they are not bullish on the dollar. This goes against the widespread opinion among investors that the overwhelming majority of global investors are bullish on the U.S. currency. By hedging the exchange rate risk - in this case the risk of potential greenback depreciation - these investors are giving up a considerable portion of higher yield that they obtain in U.S. fixed-income market. In fact, if these basis swaps continue to widen or remain wide it might make sense for European and Japanese fixed-income investors to buy U.S. fixed-income securities and not hedge the currency risk. If and when these investors stop hedging their exchange rate risk, the U.S. dollar will appreciate versus the euro and the yen. Provided European and Japanese fixed-income investors are sizable players in global fixed income and hence currency markets, they have the potential to make a difference in exchange rate markets. In short, there is potential pent-up demand for U.S. dollars from these European and Japanese institutions. Such a widening in basis swaps is also consistent with the above observations that U.S. banks have been reluctant to take the other side of this trade - i.e., offer U.S. dollars to European and Japanese investors - even though it is a very profitable opportunity. Finally, the drop in EM central banks' foreign exchange reserves reflects demand for U.S. dollars in their economies, primarily in China (Chart I-5). The Chinese central bank has sold U.S. securities to meet mushrooming demand for U.S. dollars from Chinese households and companies. This entails there has been and remains considerable pent-up demand for dollars by mainland companies and households. With respect to the supply of currency, it is important to note that it is up to commercial banks - not the central bank - to create money. Central banks provide liquidity for commercial banks, but it is the latter that creates money.1 In a nutshell, by undertaking QE, the Fed provided reserves for U.S. commercial banks (Chart I-6), yet the latter have been reluctant to create too much money. Banks create money by originating loans and other types of claims. Chart I-5China: Selling U.S. Securities To ##br##Meet Domestic Demand For Dollars China: Selling U.S. Securities To Meet Domestic Demand For Dollars China: Selling U.S. Securities To Meet Domestic Demand For Dollars Chart I-6The Fed's Balance ##br##Sheet In Perspective The Fed's Balance Sheet In Perspective The Fed's Balance Sheet In Perspective U.S. banks have been very conservative in money creation especially outside America. In the U.S., banks shrunk their balance sheets and loans in the 2009-2011 period. That is why the Fed's QE programs have not led to inflation. Notably, U.S. banks' total assets - including bank loans - and broad money (M2) growth have lately rolled over (Chart I-7). This worsens the lingering dollar scarcity outside the U.S., which should in turn prop up the value of the dollar. The reasons why U.S. banks and financial institutions have been conservative is due to their own deleveraging objectives and because of regulatory changes in the financial industry. In regard to interest rates, U.S. nominal and real (inflation-adjusted) interest rates are very low yet they are high relative to European and Japanese real rates (Chart I-8). Given a relatively tight labor market, odds are that U.S. interest rate expectations will rise further in both absolute and relative terms. This will cause the dollar to appreciate. Chart I-7U.S. Banks Control ##br##The Supply Of U.S. Dollars U.S. Banks Control The Supply Of U.S. Dollars U.S. Banks Control The Supply Of U.S. Dollars Chart I-8U.S. And German ##br##Inflation-Adjusted Interest Rates U.S. And German Inflation-Adjusted Interest Rates U.S. And German Inflation-Adjusted Interest Rates Bottom Line: The pace of supply of dollars beyond the U.S. is falling short of growth in demand for this currency. Typically, this warrants greenback appreciation. Question: What about the U.S. administration's preference for a weaker dollar to improve America's trade position? Won't the greenback depreciate as the Trump administration expresses its desire for a weaker currency? Certainly U.S. officials can verbally influence the exchange rate and drive markets for a (short) period of time. Yet fundamentals and flows will re-assert themselves and the greenback will ultimately appreciate even if its rally is delayed by policymakers. The new U.S. administration intends to run mercantilist policies to create jobs in America and doing so will shrink the current account deficit. Nevertheless, a narrowing U.S. current account deficit ultimately entails diminishing flows of U.S. dollars to the rest of the world, which is bullish for the greenback. In brief, the U.S. administration can delay the dollar rally, but it will not be able to prevent it if and when it shrinks the U.S. current account deficit. This will be enormously deflationary for the rest of the world and ultimately for the global economy. The supply of dollars outside U.S. borders will become even more dearth. As their exports tumble, manufacturing-heavy Asian and European economies will have to run even more stimulative policies - reduce their real interest rates further - to offset such a deflationary shock to their economies. In the case where the Trump administration successfully manages to weaken the U.S. dollar, the ensuing boost to U.S. manufacturing and employment will be mildly inflationary given the already relatively tight labor market. Thereby, trade protectionism or policy-driven currency depreciation, if these occur, will lift U.S. inflation and U.S. interest rates will go up. Rising U.S. interest rates and lower interest rates throughout the rest of the world will propel the dollar's value higher. On the whole, in the case of U.S. trade restrictions, the exchange rates have to adjust to mitigate deflation in the rest of world and cap inflation in America. This ultimately entails a stronger U.S. dollar and weaker currencies abroad. A final note on exchange rates valuation. Based on unit labor costs, the U.S. dollar is not yet expensive (Chart I-9A). The same measure for other currencies is also shown in Chart I-9A and Chart I-9B. Chart I-9AReal Effective Exchange ##br##Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Chart I-9BReal Effective Exchange ##br##Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Financial markets tend to overshoot and undershoot before a major trend reversal. We believe the U.S. dollar is in a genuine bull market and will likely become more expensive before topping out. Bottom Line: The U.S.'s desire to shrink its current account deficit is very deflationary for the rest of the world. Such policies, if adopted in the U.S., will exaggerate the scarcity of U.S. dollars beyond America's borders and lead to notable dollar appreciation. Question: The RMB/USD exchange rate has been stable lately. Does this mean the authorities have reasserted their control over the exchange rate and will not allow it to depreciate? The authorities in China have partial and temporary control over the exchange rate. Ultimately, it will be Chinese households and companies that drive the exchange rate, barring full-out government controls over all export/import transactions, money transfers as well as financial and capital account flows. If mainland households and companies opt to convert a small portion of their liquid savings (deposits at banks) into foreign currency, there is little the authorities can do to defend the RMB, barring a complete closing of balance-of-payments transactions to companies and households. The primary risk to the yuan exchange rate is not currency valuation but an overflow of yuan in the system - i.e., excess supply of RMBs is the main factor that will cause currency depreciation. Unlike U.S. banks, Chinese banks have created too many yuan. Broad money (M2) in China has risen from RMB 48 trillion as of December 2008 to RMB 158 trillion currently - i.e., it has surged by 3-fold. M2 has risen from 150% to 210% of GDP in the past eight years (Chart I-10). In the meantime, the ratio of foreign exchange reserves to M2 has dropped to 14% (Chart I-11). Chart I-10Chinese Banks Have ##br##Created Too Many Yuan Chinese Banks Have Created Too Many Yuan Chinese Banks Have Created Too Many Yuan Chart I-11China: Foreign Reserves Are ##br##Small Relative To Money Supply China: Foreign Reserves Are Small Relative To Money Supply China: Foreign Reserves Are Small Relative To Money Supply The latter ratio implies that if Chinese companies and households decide to convert 14% of their deposits at banks into foreign currencies and the People's Bank of China (PBoC) sells its international reserves to offset it, the latter will simply evaporate. We are not suggesting this will actually happen. The point to emphasize is that mainland banks have created so much money that even the country's US$ 3 trillion foreign exchange reserves are not sufficient to back those deposits up. Chinese households and companies may already be sensing there is too much in the way of RMBs floating around, and intuitively may not trust the currency. They have paid astronomical multiples for real assets like property in China, and have recently been willing to shift assets into foreign currencies/assets. Importantly, the one-year deposit rate at banks is 1.5% in nominal terms but in real terms it has now become negative as inflation has picked up. Chart I-12 (top panel) demonstrates that the deposit rate deflated by core inflation is negative for the first time in the past 10 years. The bottom panel of Chart I-12 shows that the deposit rate deflated by headline CPI inflation is also negative. Interestingly, any time the real deposit rate turned negative in the past, the central bank hiked interest rates. It is impossible to know whether the latest pick up in China's inflation represents a temporary spike or is the beginning of a major and lasting uptrend (Chart I-13). We are surprised by how fast and sharply inflation has risen lately, given the growth improvement has so far been modest. Chart I-12China: Real Deposit ##br##Rates Have Turned Negative China: Real Deposit Rates Have Turned Negative China: Real Deposit Rates Have Turned Negative Chart I-13China: Inflation ##br##Is Rising, For Now China: Inflation Is Rising, For Now China: Inflation Is Rising, For Now The trillion- dollar question is what is the true output gap in China and, correspondingly, whether the latest rise in inflation is genuine and lasting or simply a statistical aberration. No one including Chinese policymakers knows the answers to these very essential questions. What type of adjustment China embarks on depends on monetary policy and banks in China. As and if Chinese banks slow down money creation, economic growth will tumble and deflationary tendencies will resurface. This scenario is good for creditors - households and companies with large amounts of deposits - because deposit rates in real terms will rise again. Yet this is a bad outcome for indebted companies, capital spending and employment. If mainland banks continue to create money at a double-digit pace as they have been doing, inflation will likely become persistent and durable. These dynamics are positive for debtors as real borrowing costs will drop further/stay negative, and growth will hold up. However, in such a case, negative real rates will buttress capital outflows and pressure the value of the RMB. By and large, the Chinese authorities are facing a profound choice: Policymakers can choose to help debtors (indebted companies) by accommodating continuous money supply expansion by banks, i.e., opt for negative real interest rates. The outcome will be much stronger downward pressure on the RMB. The latter will depreciate at a double-digit pace annually in the next several years. They can opt to force the banking system to slow down the pace of money/credit creation. This will lead to some sort of debt deflation. Money growth and inflation will drop and the currency will not be at a risk of major depreciation. Yet, economic growth/profits/employment will tumble. A third choice for the authorities is to resort to full-out government controls over all trade, transfers as well as financial and capital account transactions - i.e., take the country back to socialism. Only in such a case can the authorities control the exchange rate and interest rates simultaneously - i.e., they can inflate the credit bubble away while preventing households from converting their liquid savings into foreign currency. In brief, this entails financial repression, and it will erode the real value of Chinese deposits. It is not clear to us whether this is a politically more viable option than allowing some bankruptcies/layoffs and debt deflation. Besides, this will devastate China's vibrant private sector as businessmen and high-income employees become reluctant to invest and expand as they observe the real value of their savings/wealth decline. Chart I-14U.S. Dollar And Commodities ##br##Prices Unusual Decoupling U.S. Dollar And Commodities Prices Unusual Decoupling U.S. Dollar And Commodities Prices Unusual Decoupling As if there were not enough domestic challenges, Chinese policymakers are also facing a hawkish Trump administration on the issue of trade and the exchange rate. Putting it all together, we conclude it will be extremely difficult for the Chinese authorities to navigate through these challenges. One area where we disagree with many investors is that the Chinese authorities have a viable plan and strategy. Given the above constraints, there are no easy choices and it is hard to know which route the Chinese government will take. The latest bout of stability in the RMB has been due to a notable shutdown in outflows. Yet this is a temporary solution. The inability to convert liquid savings into foreign currency will only make households and companies more set on converting their yuan. Odds are that capital outflows will skyrocket on any relaxation of recent harsh restrictions. Bottom Line: In any country, the monetary authorities cannot simultaneously control the price of money (interest rates), the quantity of money, and thereby the exchange rate. This will prove to be true in China too. We continue betting on further RMB depreciation. Question: Why do you not think this commodities rally has further to go, given supply has been curtailed and demand is picking up as global growth improves? The strength in commodities prices in recent months when the U.S. dollar has been firm is a major departure from historical correlations (Chart I-14). Remarkably, oil forward prices have recently dropped and global energy share prices have relapsed in absolute terms, even though the spot price has held up (Chart I-15). This foretells that the marketplace does not believe in the sustainability of the current spot price level of crude. As to industrial metals, our hunch is that Chinese demand will weaken again as the nation's credit and fiscal impulse relapses (Chart I-16). Besides, the recent resilience in copper has been due to supply disruptions that may be temporary. Chart I-15Has Sell Off In Oil Market Begun? Has Sell Off In Oil Market Begun? Has Sell Off In Oil Market Begun? Chart I-16China's Growth To Peak Later This Year China's Growth To Peak Later This Year China's Growth To Peak Later This Year Notably, hopes that U.S. infrastructure spending - even if such spending turns out to be considerable - will boost demand for industrial metals are misplaced, because the U.S. is a small consumer of metals. China consumes six to seven times more copper, nickel, zinc, aluminum, tin and lead than the U.S. Hence, we view industrial metals as a pure play on China's capital spending. Bottom Line: We expect a combination of a stronger dollar, weaker Chinese growth and elevated oil inventories to produce a major reversal in industrial metals and oil prices. Chart I-17EM Stocks And U.S. ##br##TIPS Yields: Negative Correlation EM Stocks And U.S. TIPS Yields: Negative Correlation EM Stocks And U.S. TIPS Yields: Negative Correlation Question: Is your negative stance on EM contingent on weakness in DM growth? No, our negative stance on EM is not contingent on a relapse in DM growth. Some combination of the following key factors will trigger and drive weakness in EM risk assets: Higher U.S. real rates or a stronger U.S. dollar. Chart I-17 demonstrates the strong negative correlation between higher U.S. TIPS yields and EM share prices in the recent years. Lower commodities prices. Renewed weakness in China's economy. Our negative view on EM has and continues to be driven by our views on EM/China domestic demand/credit cycles, commodities and the U.S. dollar. Investment Conclusions Chart I-18EM/China Plays Are At Critical Juncture EM/China Plays Are At Critical Juncture EM/China Plays Are At Critical Juncture Exchange rates have been critical to financial market dynamics in recent years. This is unlikely to change. Odds favor another upleg in the U.S. dollar and a weaker RMB. As such, the outlook for EM risk assets is poor. EM currencies will be driven by a stronger dollar, a weaker RMB and lower commodities prices. EM share prices as well as global mining, and machinery stocks are at a critical juncture (Chart I-18). China-plays may soon start reacting to the PBoC's recent modest tightening as well as regulatory credit curtailment and begin to sell off in anticipation of weaker growth later this year. Global equity portfolios should continue underweighting EM stocks. Similarly, global credit (corporate bonds) portfolios should underweight EM sovereign and corporate credit. Finally, the outlook for weaker currencies does not bode well for EM local currency bonds. However, for fixed income investors we have several swap rate trades, relative value recommendations and yield curve positions that are published regularly in our Open Position Table on page 16. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to Trilogy of Special Reports on money/loan creation, savings and investment, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and "China's Money Creation Redux And The RMB," dated November 23, 2016, links available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Tensions are still high between the U.S. and China; China's neighbors are in the line of fire; Korea and Taiwan stand to suffer; We are bullish Thailand, Vietnam, and the Philippines; We are bearish Indonesia and Malaysia. Feature Over the past two weeks we have taken clients on a tour through Europe, where we think political and geopolitical risks are generally overstated in the short term. This provides ample room for European financial assets to outperform this year.1 This week we turn to Asia Pacific, where the situation is quite different. We see this region as the chief source of geopolitical "Black Swans," mainly due to rising U.S.-China tensions, which we have highlighted since 2012.2 While U.S. President Donald Trump and Chinese President Xi Jinping have recently reassured the world that relations will be cooperative and stable, it is far too soon to declare that the two have resolved anything substantial. While we have addressed U.S.-China relations before, it is essential to watch the rest of EM Asia, where proxy battles between the U.S. and China continue to play out.3 If the Philippines shocked the world in 2016 by pivoting away from the U.S. and toward China, South Korea is the country that will do the same in 2017. In this report, we review the opportunities and risks afforded by this regional dynamic. I. Will Trump And Xi Cool Their Heels? Fundamentally, geopolitical risk in Asia Pacific is driven by the "Thucydides Trap," a struggle between the established regional and global power (the United States), and an emerging power that seeks to rewrite the region's geopolitical order (China).4 This dynamic emerged well before President Donald Trump's election.5 Trump is an unpredictable agent thrown into a structural dynamic. His election on an avowed platform of protectionism, his comments singling out China as a U.S. threat, and his break with the U.S. foreign policy establishment all suggest that the secular rise in Sino-U.S. tensions is about to get worse.6 Yet, since taking office, Trump has sent mixed signals. On the one hand, he threatens a policy of isolationism that would see the U.S. withdraw from its global security commitments. On the other hand, he has threatened to escalate geopolitical conflicts in order to get what he wants on business and trade. Table 1Market Implications Of ##br##Trump's Options Toward China How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia As Table 1 illustrates, it is extremely important for investors which of these foreign policies Trump ultimately pursues - nationalist or isolationist - and whether he combines it with the trade protectionism (or mercantilism) that he has threatened. In the short term, the most bullish combination would be the economic status quo with a scaled-down U.S. presence. The most bearish would be mercantilism combined with nationalist foreign policy. Trump's recent interchanges with Xi were notable because for once he adhered to diplomatic protocol. He and Xi gave some initial - and we would add tentative - assurances to the world that Sino-U.S. relations will not explode in a ball of flames this year: Taiwan - Trump reaffirmed the One China Policy, i.e., that Taiwan has no claim to independence from the mainland. Trump's phone call with the Taiwanese President Tsai Ing-wen in December, and subsequent comments, had put this principle in doubt, raising the prospect of a new Cold War or actual war. North Korea - China has offered to enforce a stringent new set of economic sanctions on North Korea, namely barring coal imports for 2017. This is significant, given the short duration of China's previous punitive measures against the North and the hit that North Korean exports have already suffered from China's slowing economic growth (Chart 1). The Obama administration had begun sanctioning China as a result of its unwillingness to enforce, so with enforcement may come the Trump administration's deactivation of such threats for a time. The RMB - Trump did not accuse China of currency manipulation on "day one" of his administration as he had promised during his campaign, though he has informally called the Chinese the "grand champions" of manipulation.7 This strongly suggests that he will allow the Treasury Department's semi-annual foreign exchange review process to run its course (Diagram 1). On that time frame, the U.S. would issue a warning in the April report and then begin negotiations that legally should take a year. Of course, China does not qualify by the usual measures. Since 2015 it has been propping up its currency rather than suppressing it (Chart 2), and its current account surplus has dropped sharply from 10% to 2% of GDP over the past ten years (though still massive in absolute terms). Diagram 1Calling China A Currency Manipulator: The Process How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia The Trans-Pacific Partnership (TPP) - Trump yanked the U.S. out of the major multilateral trade initiative of the Obama administration, which was an advanced trade deal that excluded China and primarily benefited smaller Chinese competitors like Vietnam and Malaysia. Though Trump acted unilaterally - and therefore cannot have gotten any real concessions from China in exchange for killing an "anti-China" trade deal - he avoided the frictions with China that would have resulted over the coming years from implementing the deal. Chart 1Will China Cut Imports From Here? Will China Cut Imports From Here? Will China Cut Imports From Here? Chart 2The 'Grand Champions' Of Currency Manipulation The 'Grand Champions' Of Currency Manipulation The 'Grand Champions' Of Currency Manipulation In addition, the Trump administration is already embroiled in domestic politics with a number of its early actions. Thus it would not surprise us if Trump - exactly like Ronald Reagan, Bill Clinton, Barack Obama, and George W. Bush - needed to pacify relations with China despite his early tough talk. Meanwhile President Xi wants stability even more than usual this year as the Communist Party holds its "midterm" five-year National Party Congress. We will return to the party congress in an upcoming report, but for now we will simply reiterate that stability means neither excessive stimulus nor excessive reform (Chart 3). Chinese policymakers could trigger unintended consequences with their financial tightening, but that's why we think they will be exceedingly cautious.8 If Trump does not try to sabotage this politically sensitive year, China should be relatively stable. Chart 3China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress So have U.S.-China ties become bullish all of a sudden? No. At least, not yet. Consider the following: South China Sea still a powder keg - On both sides, the idea of excluding "access" to the sea is being openly discussed, if disavowed.9 While there is conceivably a path for both sides to de-escalate, it will take very tough negotiations, and we are not there yet. Trade fight hasn't even begun - Though previous presidents got sidetracked, Trump was the first to campaign aggressively on a protectionist, anti-China platform, and to put a team in place to pursue that platform.10 We think he will get tough. We also think he will endorse the House Republicans' plan of a Border Adjustment Tax - a tax on imports - which would hurt China most of all as the country with the biggest trade surplus with the U.S.11 Japan is proactive - Japan has virtually no domestic political constraints and has an incentive to play up security threats. Why? Because Prime Minister Abe wants a nationwide popular referendum on revising the constitution to legitimize the Japanese Self-Defense Forces.12 And this is not even to mention that Taiwan and the Koreas are still major risks. Structurally, we still see Sino-U.S. tensions as the chief source of geopolitical risk and "Black Swan" events this year that could rattle markets in a very big way. Bottom Line: A modus vivendi between Trump and Xi is conceivable, but the U.S. and China are not out of the woods yet. II. What About The Neighbors? Short of the formidable "left-tail" risk of direct U.S.-China conflict, China's periphery is the chief battlefield and source of risk for investors. Asian EM economies have the most to risk from the reversal of the past decade's trade globalization (Chart 4). Investors also tend to underrate the fact that they are in the thick of the geopolitical risk arising from Sino-U.S. tensions and global "multipolarity" more broadly.13 A look across the region suggests that most Asian EM economies are shifting their policy to become more accommodative with China. This should reduce their geopolitical risk in the short term, though it is too soon to sound the "all clear." We remain strategically short EM stocks relative to DM. Within the EM space, we are bullish on Thailand, less so on the Philippines and Vietnam, and neutral-to-bearish on Taiwan, South Korea, Malaysia, and Indonesia. Chart 4De-Globalization Hurts Asia Pacific Most Of All How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Koreas - Here Comes The Sunshine Policy South Korea is at the center of the U.S.-China struggle as it faces a domestic political crisis, economic pressure from China, rising North Korean nuclear and missile capabilities, and a likely clash with the new U.S. administration. First, the Constitutional Court must decide the fate of impeached President Park Geun-hye. The market has rallied since the ruling Saenuri Party turned against her in early December, paving the way for her December 9 impeachment in the assembly. However, the politics of the court makes her removal from office less likely than the market expects, especially if the court does not rule by March 13, when a second judge this year retires from the bench.14 If the impeachment falters, it will lock South Korea into greater political instability throughout the year, at least until the scheduled election on December 20. Chart 5Leftward Policy Shift In South Korea ... How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia However, it is virtually impossible for the Saenuri Party candidate, Acting President Hwang Kyo-Anh, to win the election, despite his fairly strong polling (Chart 5). His party has been discredited and split, and there are now calls for his impeachment as he defends Park from further investigation. The leading contenders are all left-of-center. They are contending in a primary election over how to redistribute wealth, crack down on the Chaebol (corporate conglomerates), engage North Korea, and improve relations with China. These policies are receiving a tailwind because Korean society has seen the economic system shocked by the end of the debt supercycle in the United States and the slowdown in China. Moreover, inequality has been rising in Korea (Chart 6). As in neighboring Taiwanese elections last year, the election is shaping up to be a backlash against the pro-trade and globalization policies of the preceding decade. Korea's share of global exports has increased, and its tech companies are profitable, but the government has engaged in conservative fiscal policies, its workers are overworked and underpaid, and its social safety net is non-existent (Chart 7). Redistribution and reforming the Chaebol could bring serious benefits over the long run, but both will negatively affect corporate profits on the margin. Internationally, improving relations with North Korea and China will mean that the new South Korean government, in H2 of this year or H1 of next, could be on a collision course with the United States and especially Japan. We expect Korea to go its own way for a time, giving the impression globally that another American ally is "pivoting to China" (after the Philippines in 2016).15 While this may seem bullish for Korea, as it did for the Philippines due to the fact that China is a growing economy, Korean exports to the U.S. and Japan are still a significant portion of its total exports (Chart 8). Korea is also constrained by the fact that China is increasingly a trade competitor, and Korea's exports to China mainly consist of goods that China wants to make itself: high-end electronic manufacturing, cars, and car parts. Thus, China will welcome greater ties as it looks for substitutes for the increasingly protectionist West in acquiring technology and expertise, but Korea's new government will see rising fears of economic "absorption" as it attempts to improve access to Chinese markets. Chart 6... As Inequality Has Risen Sharply How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Chart 7Workers Want More Largesse Workers Want More Largesse Workers Want More Largesse Chart 8Korea's Balancing Act Korea's Balancing Act Korea's Balancing Act What are the market implications? South Korea is in a decent place in the short run. Global growth, exports, and corporate earnings are improving, and stock valuations have come down, especially relative to EM. Over the long run, however, we are turning bearish. Korean labor productivity is in a downtrend (Chart 9), its population is not growing, and there is no reservoir of young people left to tap. There are three basic options for securing future growth. First, Korea could become a net investor nation like Japan (Chart 10). However, it is not yet wealthy enough to do so, and needs to build the aforementioned social safety net. Second, South Korea could reunify with the North, which would alleviate its labor force problems, though the costs of reunification would be extreme (Chart 11). Chart 9Reforms On Hold Until New Government Sits Reforms On Hold Until New Government Sits Reforms On Hold Until New Government Sits Chart 10Korea's Japanese Dream Korea's Japanese Dream Korea's Japanese Dream Chart 11Reunification Would Increase Labor Force How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Third, it could continue on its current path of trying to secure large markets like the U.S. and China, while conducting a balancing act between them as geopolitical tensions rise. The problem right now is that the first two options are not ready and the balancing act is getting too hard, too soon. The South stands to suffer from both protectionism and multipolarity, i.e., being sandwiched between resurgent Sino-U.S. and Sino-Japanese tensions. Furthermore, the Trump administration has not yet decided whether its North Korea policy will be one of engagement, aggression, or continued neglect. Yet the U.S. defense and intelligence establishment's threat assessment is reaching a level that will cause greater public concern and more demand for action. Until Trump's policy is clear, South Korea's attempts to launch a new "Sunshine Policy" toward eventual reunification will be extremely vulnerable. Over time, North Korea is likely to become more of a black swan than the red herring it has been in the past (Chart 12). Chart 12North Korean Incidents: Mostly Red Herrings North Korean Incidents: Mostly Red Herrings North Korean Incidents: Mostly Red Herrings Bottom Line: Now is ostensibly a good entry point for Korean stocks relative to EM stocks, but we remain reluctant due to the political and geopolitical factors. Also, the path of least resistance for the Korean won is down, so we recommend going long THB/KRW, discussed further below. Taiwan - "One China" Or More? Our prediction that China-Taiwan relations would deteriorate dramatically, and that Taiwan could be one of five "Black Swans" of 2016, has essentially played out.16 The two sides cut off formal contact, Trump accepted a phone call from the Taiwanese president in a sharp break with U.S.-China convention, and the Taiwanese navy accidentally fired a missile toward the mainland during a drill on the Chinese Communist Party's 95th birthday on July 1. Despite the tensions, hard data coming out of Taiwan have been strong. Its export-oriented economy is buoyed by strong global growth. Both its equities and currency are the few bright spots in the EM universe and investors have been responding positively to the strong data (Chart 13). Yet Taiwan remains highly vulnerable to geopolitical tensions, as its economy is "too open," especially to China. China has imposed discrete economic sanctions, as we expected. The number of mainland tourists to Taiwan have dropped by 50% (Chart 14). This trend will continue, hurting consumer sentiment. While Trump has backed away from his threat to break the One China Policy, a move markets view as very reassuring, he cannot unsay his words and China will not forget them. Moreover, his administration will attempt to shore up the U.S.-Taiwan alliance in traditional ways, including with new arms sales that will provoke angrier responses than in the past from Beijing (Chart 15). Chart 13Investors Do Not Fear Independence Talk Yet Investors Do Not Fear Independence Talk Yet Investors Do Not Fear Independence Talk Yet Chart 14China's Silent Sanctions China's Silent Sanctions China's Silent Sanctions Chart 15Plenty More To Come How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Crucially, Taiwan's domestic politics are not a major constraint on its actions, which heightens the risks of a cross-strait "incident." The Democratic Progressive Party (DPP) is in control at almost every level of government on the island. President Tsai Ing-wen and the DPP swept to power on a popular mandate to stall and roll back trade liberalization with China, which the public felt had gone too far under the previous Kuomintang government. Perhaps if Trump had never entered the picture, Taiwan and China would have found a new equilibrium in which Taiwan distanced itself while assuring the mainland it did not seek independence. Now, however, the odds of that solution are declining. Taipei may become overly aggressive if it believes Trump has its back, and this dynamic will ensure continuous Chinese pressures and sanctions, all negative for Taiwanese assets. Bottom Line: Despite the fact that Taiwan's economy has some bright spots (exports, capital formation), we are sticking with our "One China Policy" trade of going long Chinese equities / short Taiwanese and Hong Kong equities. BCA's China Investment Strategy agrees with this call and is shorting Taiwanese stocks relative to its mainland counterparts.17 We expect China to penalize these territories for expressing the desire for greater autonomy. We also suggest going short the Taiwanese dollar versus the Philippine peso, to be discussed further below. Thailand - The Junta's Persistence Is Bullish For most of the past fifteen years, the death of Thailand's King Bhumibol Adulyadej, which occurred on October 13 of last year, was feared as a catalyst for a total breakdown of law and order due to the deep socio-political and regional division in Thai politics that has pitted an urban royalist faction against a rural populist faction. But the 2014 coup was intended to preempt the king's death and ensure that the royalist, pro-military faction held firm control over the country during the risky succession period. The market responded positively during the coup in 2014 and upon the king's death last year (Chart 16). We recommended going long Thai stocks and THB last October, in a joint report with BCA's Emerging Markets Strategy, and both trades are in the black.18 Chart 16Thailand: Investors Cheered The Succession Crisis Thailand: Investors Cheered The Succession Crisis Thailand: Investors Cheered The Succession Crisis The junta's strategy has been to root out the leaders of the populist movement and rewrite the constitution to legitimize its ability to intervene in the future. The new monarch has cooperated with the military so far, upholding the status quo, but if at any point he favors the populists to the detriment of the military, political uncertainty will spike from its current historically low levels (Chart 17). The junta is fully in charge for the time being. It has pushed back elections to February 2018 or later, delaying the re-introduction of political instability into the Thai market. It is also surging public spending and transfers to the rural poor to ensure social stability. Historically, strong public capital investment and global exports coincide with strong Thai manufacturing output (Chart 18). Favorable domestic and external macro environments should be bullish for Thai equities, creating a near-term buying opportunity in the Thai market. Chart 17Junta Keeps A Lid On Politics... Junta Keeps A Lid On Politics... Junta Keeps A Lid On Politics... Chart 18... And Buys Friends With Public Money ... And Buys Friends With Public Money ... And Buys Friends With Public Money Thailand is distant from China's quarrels with its neighbors over the South China Sea. It was the first of the U.S. allies to hedge against President Obama's pivot and seek better relations with China instead, a strategy that has paid off. Thailand, like many regional actors, may be forced to choose between China and U.S. at some point, but for now it enjoys the best of both worlds. With a fundamentally strong macro-backdrop, including a large current account surplus of 12% of GDP, we are bullish on Thai assets relative to EM. Bottom Line: Thailand is the most attractive Asian EM economy right now from an investment-oriented geopolitical point of view. It is not too late to go long THB/KRW or long Thai stocks relative to EM. Philippines - The War On Drugs Is A Headwind The Philippines continues to display strong macro-fundamentals and market momentum in the EM universe. However, domestic political risks are significant and prevent us from returning to an overweight stance relative to EM.19 The inauguration of populist southerner Rodrigo Duterte as president of the Philippines in July of last year led the country into a bloodbath that has since claimed over 7,000 lives in a "war on drugs." Only recently has it shown any sign of abating, and it is not clear that it will. The political backlash is gradually building. Duterte's policy preferences are left-leaning and mark a partial reversal of the pro-market, reform orientation of the preceding Aquino government.20 As a result, foreign investment has dropped off from its sharp rise, though it remains elevated (Chart 19). The Philippines may also fall victim to its own success. Due to the booming economy under the Aquino presidency, bank loans and deposits have enjoyed strong growth in recent years. However, the loan-to-deposit ratio is getting overextended and the economy is showing signs of heating up with inflation creeping above 2% in 2016 (Chart 20). Populist policies and the advanced cyclical expansion may add more heat. Thus, it is becoming more likely that monetary policy will tighten as the economy moves into the advanced stage of its cyclical expansion. Duterte could create a problem if at any point he decides to interfere with the central bank or technocratic management of the economy more broadly. In terms of geopolitical risk, Duterte is engineering a pivot away from the United States toward Russia and China, aggravating relations with the former, its chief ally (Chart 21). As relations with China improve, they will bring some investment in infrastructure and a calming of the near seas. Chart 19Duterte Marked The Top Duterte Marked The Top Duterte Marked The Top Chart 20Credit Is Strong, Inflation Creeping Back Credit Is Strong, Inflation Creeping Back Credit Is Strong, Inflation Creeping Back Chart 21Duterte's 'Pivot' To Asia Duterte's 'Pivot' To Asia Duterte's 'Pivot' To Asia Ultimately, however, we view this calming as temporary, since China's assertiveness is a long-term phenomenon. We also think that the fundamental U.S.-Philippine alliance will survive any major disagreements of the Duterte era. Duterte is constrained by his weakness in the Philippine Senate and the popularity of the United States among Filipinos, which is among the highest in the world. In essence, the public is not anti-American but "anti-colonialist" - many feared that the U.S. "Pivot to Asia" of the Obama and Aquino administrations would put the Philippines into a subordinate "colonial" role highly vulnerable to Chinese aggression. Like other U.S. allies in the region, the Philippines wants to be a partner of the U.S. and not just a naval base. Thus, for now, we see the Philippines in a gray area of frictions with the U.S. yet disappointing hopes with regard to China. Until Duterte removes the headline risk to internal stability from his belligerent law and order policies - and compromises on his more anti-market economic stances - we are at best open to tactical possibilities. Bottom Line: Considering its strong macro-fundamentals, advanced cyclical expansion, and politically driven uncertainty, we are only willing to entertain short-term, tactical opportunities in the Philippines. Now is a decent entry point for equities relative to EM. Also, our colleagues at BCA's Foreign Exchange Strategy point out that the peso is currently trading at a 10% discount.21 We recommend going long the peso versus the Taiwanese dollar to capitalize on the dynamics outlined for both countries above. Indonesia - A Dream Deferred Indonesia outperformed our expectations throughout 2016.22 President Joko Widodo ("Jokowi") managed to corral his party behind him despite an internal leadership struggle. And the large bureaucratic party, Golkar, joined his coalition in parliament, creating a strong legislative majority. These were our two preconditions for a more effective government; Jokowi has also found allies within the military, as we surmised. As a result, he managed to make some progress on his tax-raising, union-restraining, and infrastructure-building initiatives. Nevertheless, the market has sniffed out the difference between a pro-reform government and the enormous difficulties of pulling off reform in Indonesia. Long-term investment has fallen even as short-term portfolio investment has rallied on the back of the EM reflation trade (Chart 22). While Jokowi reduced the size of costly domestic fuel subsidies in his first year, it was easy to do so amid the oil-price collapse in 2014. Since then, Indonesian retail gasoline prices have remained subdued, indicating that subsidies are still significant. As the global oil prices continue increasing, so will the subsidy (Chart 23), adding to the country's budget deficit. Jokowi also put forth minimum-wage reforms in 2015, introducing a formula which requires the minimum wage to be adjusted every year based on inflation and economic growth (rather than ad hoc negotiations with local unions and governments). Predictably, wages have skyrocketed since the indexing policy was implemented, which is negative for profit margins (Chart 24). Chart 22Investors Skeptical Of Jokowi's Reforms Investors Skeptical Of Jokowi's Reforms Investors Skeptical Of Jokowi's Reforms Chart 23Fuel Subsidies Still In Effect Fuel Subsidies Still In Effect Fuel Subsidies Still In Effect Chart 24No Wage Rationalization Yet No Wage Rationalization Yet No Wage Rationalization Yet Indonesia is on the outskirts of China's claims in the South China Sea and has a domestically driven economy that should suffer less than that of its neighbors in a context of de-globalization. In that sense, we are inclined to view it favorably. However, its currency is at risk from twin deficits - current account and budgetary reforms have stalled, and the credit impulse is weakening. If Jokowi's favored candidate wins the heavily contested gubernatorial run-off in Jakarta in April, it will not be very bullish, but a loss would be bearish for Jokowi's reform agenda ahead of the 2019 elections. Bottom Line: We are still short Indonesia within the EM space - its underperformance since the second half of last year can persist. Vietnam - No American Guarantee Vietnam is highly vulnerable to a geopolitical conflict with China which would impact markets. Unlike the Philippines and Thailand, it cannot count on an underlying bedrock of American defense to anchor its pivot toward China - and yet, it has the greatest historical and territorial conflicts with China of all the Southeast Asian states. Chart 25Fighting In The Teeth Of The Dragon Fighting In The Teeth Of The Dragon Fighting In The Teeth Of The Dragon Nevertheless, in the short term, geopolitical risks are abating. Relations have improved since a recent low point in 2014.23 And Vietnamese leaders, having invested heavily in the TPP as the trade pact's biggest potential beneficiaries, are trying to make amends with China now that it is canceled. Thus, we remain long Vietnamese equities relative to EM. This is mostly due to the country's strong domestic demand and export competitiveness (Chart 25), attractive environment for foreign investment, and ability to capitalize on diversification away from China. The country's reforms are not perfect, but it has at least recognized NPLs and begun privatizing some SOEs. Bottom Line: We are sticking with long Vietnamese equities versus EM, though downgrading it to a tactical trade due to our wariness of a turn for the worse in China relations or the broader trade environment. Malaysia - Going To The Pawnshop Malaysia, with Vietnam, was to be the top beneficiary of the TPP. It, too, has lost greater access to the U.S. market that the deal would have provided and must now make amends with China. The latter process has already begun, as Malaysia's government has turned to China for a $33 billion deal in exchange for energy assets and valuable land in the state of Johor. The general election of 2013 and the economic slowdown have catalyzed domestic political divisions, especially ethnic and religious ones, igniting a drastic push over the past two years to have Prime Minister Najib Razak ousted for his alleged embezzlement of funds from the state-owned 1MDB corporation. Najib chose to crack down on the opposition and ride out the storm, which he has managed so far, causing unprecedented political instability. Najib's decision to sell land to the Chinese will not sit well with much of the Malay population. Many will see it as undignified; and historically, there is much animosity toward the local Chinese. Najib already faces an intense political struggle due to the exodus of high-ranking politicians from his ruling United Malay National Organization (UMNO). Former strongman leader Mahathir Mohammad and ex-Deputy Prime Minister Muhyiddin Yassin are leading the defectors to form a new Malay party that will pose a serious challenge in the 2018 elections. Recent flirtation between the ruling UMNO and the Islamist Pan-Malaysia Islamic Party (PAS) also injected new uncertainty into the already turbulent domestic political environment. In essence, the one-party state that investors once knew (and loved) is forming new factions that will contest the upcoming elections with abandon. Chart 26Growth Slowing, Credit Drying Up Growth Slowing, Credit Drying Up Growth Slowing, Credit Drying Up This struggle over the 2018 election promises to be emphatically unfriendly to investors. And until Najib gets a new mandate, he can do very little to arrest the economic breakdown. As long as the support and continuity of Najib's policies are in question, it is difficult to take a directional view of Malaysian assets. A victorious UMNO does not mean that investors should be bullish, but it will resolve the question of "Who is in charge?" At that point, we can reassess the market attractiveness based on the higher "certainty" of the policy preferences of the country. Meanwhile the constraints to Malaysia's economy are clear from a host of weak data, from domestic trade to the property market to the current account and the currency, along with a rise in NPLs that will undermine the inadequately provisioned banks' willingness to lend (Chart 26). While palm oil and petroleum prices have recovered, which is positive for Malaysian markets, this is not enough to outweigh the negative factors. Bottom Line: We are bearish on Malaysian assets and currency. Matt Gertken, Associate Editor mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, and BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Special Report, "The Looming Conflict In The South China Sea," dated May 29, 2012, available at gis.bcaresearch.com, and BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see BCA China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 9 In the short time since Trump's and Xi's phone call, the U.S. has announced that it intends to intensify the Freedom of Navigation Operations around the rocks in the South China Sea to assert its rights of navigation and overflight. Meanwhile Chinese lawmakers have revealed that they want to pass a new maritime law by 2020 that would encourage maritime security forces to bar foreign ships from passing through Chinese "sovereign" waters if they are ill-intentioned. 10 Trump's Treasury Secretary Steve Mnuchin was only just confirmed by the Senate and could not have taken any significant action yet. His appointees, notably Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer, are China hawks. If not currency, Trump's team will rotate the negotiations to focus on China's capital controls and failure to liberalize the capital account, its lackadaisical cuts to industrial overcapacity, and the negative business environment for U.S. firms. 11 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com, and Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 12 The first nationwide evacuation drill in the event of a North Korean missile attack will take place sometime in March of this year. 13 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 14 Bringing the total number of judges from nine to seven, and thus reducing the threshold for a vote in favor of retaining Park in office from four to two, for constitutional reasons. All but one of the judges were appointed by Park or her party's predecessor. 15 For instance, if the new administration reverses the deployment of the U.S. Terminal High Altitude Area Defense (THAAD) system, it will provoke a crisis with the U.S., but if it does not, China will continue its underhanded economic sanctions on the South, and the new South Korean president's North Korean policy will be stillborn. 16 Please see BCA Geopolitical Strategy Special Reports, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Taiwan's 'Trump' Risk," dated February 2, 2017, available at cis.bcaresearch.com. 18 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW," in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, available at ems.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 For instance, he is imposing controls on the mining sector that will scare away investors, in an echo of Indonesia's mining fiasco implemented since 2013, and he is working on eliminating a "contract worker" system that enables employers to avoid the costs of full-time hiring. Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 21 Please see BCA Foreign Exchange Strategy Special Report, "Updating Our Long-Term FX Value Models," dated February 17, 2017, available at fes.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Stick To Long Modi / Short Jokowi," dated November 23, 2015, available at gps.bcaresearch.com. 23 Vietnam has moved toward better crisis management with China since the HYSY-981 incident in 2014, when a clash broke out over a mobile Chinese oil rig in the South China Sea. Significantly, the Vietnamese Communist Party's leaders removed former Prime Minister Nguyen Tan Dung, the highest-ranked China hawk and pro-market reformer on the Politburo, in the January 2016 leadership reshuffle.

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Long Expansion Comparison (I) Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) Long Expansion Comparison (II) Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat March 2017 March 2017 But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds March 2017 March 2017 Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Chart I-11Gilts To Underperform Gilts To Underperform Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. 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. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. 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-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global 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-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights Fears that the Trump Administration will brow-beat America's trading partners into strengthening their currencies have pushed down the dollar in recent weeks. The likelihood of another Plaza-type accord remains extremely low, however. History suggests that such agreements only work when currency interventions are aligned with the underlying macroeconomic fundamentals. With the Fed eager to hike rates, that is not the case today. The only situation where a multilateral agreement to weaken the dollar could be reached is one where the dollar ascends so high that major financial stresses begin to form, particularly in emerging markets. We are not there yet. The real trade-weighted dollar is likely to rise 5%-to-10% by the end of the year. A stronger greenback will hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. Feature Dollar Under Pressure Chart 1The Recent Dollar Dip Is Not ##br##Reflected In Interest Rate Spreads The Recent Dollar Dip Is Not Reflected In Interest Rate Spreads The Recent Dollar Dip Is Not Reflected In Interest Rate Spreads After rallying sharply following the U.S. presidential election, the greenback has given up some of its gains. Since peaking in late December, the trade-weighted dollar has fallen by around 2.5%. Notably, the dollar's swoon has not been accompanied by a narrowing of 2-year real interest rate differentials between the U.S. and its trading partners (Chart 1). This suggests that shifts in relative growth expectations have played a relatively minor role during this latest dollar selloff. In our view, the more important factor has been the "weak dollar" rhetoric coming out of the Trump administration. Historically, U.S. officials have at least given lip service to America's "strong dollar policy." As with many other political customs, Trump has thrown this one out the window. Peter Navarro, head of Trump's National Trade Council, made headlines last week by calling Germany a "currency manipulator" - even though, strictly speaking, Germany does not have a currency to manipulate. This came on the heels of Trump's comments to The Wall Street Journal earlier in January where he lamented that "our currency is too strong... it's killing us." The President reiterated that sentiment last week, telling a group of pharmaceutical company executives: "You look at what China's doing, you look at what Japan has done over the years ... they play the devaluation market and we sit there like a bunch of dummies." A Deal That Worked The Trump administration's efforts to talk down the dollar have raised the question of whether another Plaza Accord is on the horizon. The original agreement was concluded at The Plaza Hotel in 1985. As fate would have it, Trump ended up buying the landmark property three years later. It would go on to be the setting for such historically momentous events as Trump's wedding to Marla Maples and his Oscar-worthy cameo in Home Alone 2: Lost In New York. The Plaza Accord prescribed that G5 nations - the U.S., Japan, Germany, the U.K., and France - intervene in currency markets with the aim of driving down the value of the dollar. At least in this respect, the Accord was a smashing success. Between early 1985 - when rumors of a deal began to swirl - and January 1987, the dollar fell by 54% against both the yen and the mark, 49% against the franc, and 44% against the pound. In fact, so effective was the Plaza Accord that it necessitated the Louvre Accord two years later, an agreement that was drawn up in order to halt the dollar's slide. Chart 2A Widening Current Account ##br##Deficit Sowed The Seeds For The Plaza Accord A Widening Current Account Deficit Sowed The Seeds For The Plaza Accord A Widening Current Account Deficit Sowed The Seeds For The Plaza Accord Then And Now: Some Similarities... There are some clear similarities between 1985 and the present. Just like today, the greenback strengthened significantly in the years leading up to the Accord. At first, the Reagan administration was content to let the dollar appreciate, seeing this as validation of its pro-growth policies. The Fed was also happy to go along with a stronger dollar since lower import prices helped to dampen inflation. As time wore on, however, the damage from an overvalued dollar became increasingly apparent: The current account balance swung from a modest surplus at the start of the 1980s to a deficit of 2.7% of GDP by the end of 1985 (Chart 2). The Big Three automakers, along with companies such as Caterpillar, IBM, and Motorola, began to lobby the U.S. government for trade sanctions against foreign competitors. With Reagan's appointment of James Baker to the post of Treasury Secretary in February 1985, U.S. trade policy moved away from being governed by a doctrinaire free market philosophy and took on a more pragmatic tone. Fearing further protectionist measures, the Japanese and Europeans agreed to take action to strengthen their currencies. ...But Some Notable Differences Despite the clear parallels between 1985 and the present, there are also a number of critical differences. First, there is the issue of magnitude. By early 1985, the greenback was entering the seventh year of a massive bull market - one that had lifted the real broad trade-weighted dollar up 53% from its lows in October 1978 (Chart 3). In contrast, the current dollar bull market is a mere 2.5 years old and has seen the dollar strengthen by "only" 20% since July 2014. Moreover, the current bull market began from a point where the dollar was highly undervalued. As a consequence, as of today, the real trade-weighted dollar remains 21% below its 1985 peak and 11% below its 2002 peak. Second, one of the reasons the Plaza Accord worked so well was because policymakers ensured that their currency interventions were consistent with the macroeconomic fundamentals. The combination of tight monetary policy and loose fiscal policy created a fertile backdrop for the dollar's ascent in the early 1980s. By 1984, however, those bullish dollar fundamentals started to break down. Chart 4 shows that the dollar continued to appreciate into 1985, even though U.S. interest rates were declining relative to other G5 economies. The dollar, in other words, had entered a full-fledged bubble - one that was ripe for a pricking. Chart 3The Dollar Is ##br##Below Past Peaks The Dollar Is Below Past Peaks The Dollar Is Below Past Peaks Chart 4A Full-Fledged Dollar ##br##Bubble Preceded The Plaza Accord A Full-Fledged Dollar Bubble Preceded The Plaza Accord A Full-Fledged Dollar Bubble Preceded The Plaza Accord Once the dollar bubble burst, monetary policy amplified the downward pressure on the greenback. Most notably, the Federal Reserve continued cutting interest rates, ultimately taking the effective Fed funds rate down from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year nominal interest rate differential shrank by 454 basis points against Japan over this period. For the U.K., the interest rate differential fell by 630 basis points, while for Germany it declined by 407 basis points. In contrast to the mid-1980s, the Fed is unlikely to lean into dollar weakness this time around. The output gap in the U.S. has been nearly eliminated and the economy continues to grow at an above-trend pace. This suggests that the Federal Reserve will keep raising rates. We expect the Fed to hike rates three times this year, one more than the market is pricing in. Most other central banks are nowhere near the point where they can start tightening monetary policy. As such, the interest rate differential between the U.S. and its trading partners is likely to widen further. In a world where foreign exchange trading now exceeds $5 trillion per day, any currency intervention - unless it is backed by an underlying shift in the economic fundamentals - is bound to backfire. A Political Reality Check Chart 5China's Weight Matters Plaza Accord 2.0: Unnecessary, Unfeasible, And Unlikely Plaza Accord 2.0: Unnecessary, Unfeasible, And Unlikely Political considerations also render another Plaza Accord highly improbable. In the 1980s, West Germany and Japan were politically subservient to the U.S. That is less the case today. China's role in the global economy has also expanded. The RMB now accounts for 22% of the Fed's broad trade-weighted dollar basket, the largest weight of any country (Chart 5). China's government will fiercely resist negotiating any agreement that is not in the country's best interests. The economic circumstances facing most of America's trading partners could also scuttle any hopes for a deal to weaken the dollar. Inflation expectations in Japan have risen over the past six months, but still remain well below the BoJ's 2% target. A stronger yen would undermine efforts to reflate the economy. The German economy is certainly benefiting from an undervalued exchange rate. However, a continued weak currency is necessary for Southern Europe, where unemployment is still very high. Moreover, it is not clear that Germany could stomach a much stronger euro. The German unemployment rate is at a 25-year low, but that is because the country is running a massive 9% of GDP current account surplus. Take away Germany's ability to export its excess savings abroad, and the German economy would look a lot like Japan's. The only scenario in which a new multilateral accord would be seriously entertained is if a rising dollar began to wreak havoc on the global economy. A modestly stronger dollar would boost global growth to the extent that it redistributed demand from the U.S. to economies such as Europe and Japan with greater levels of economic slack. However, if the greenback were to ascend into bubble territory, this could instigate a vicious circle where an appreciating dollar increases the local-currency value of EM dollar-denominated debt, leading to a wave of bankruptcies and defaults, and, in the process, generating even further selling pressure on EM currencies. That said, the dollar would probably need to appreciate by another 15% or so before a crisis occurred. And even if a meltdown seemed imminent, the bar for currency intervention would remain quite high. No emerging market wants to go cap-in-hand to the IMF or the U.S. Treasury. This is particularly true for China, which would likely shun any offers of assistance, even if capital were flooding out of the country. In any case, if a deal were reached, it would likely seek to prevent the dollar from rising further, rather than falling in value. That is a critical distinction. Trump, Trade, And The Fed The discussion above suggests that a new Plaza-style accord is not in the cards, at least not unless the dollar strengthens substantially from current levels. Where does that leave Trump's pledge to bring manufacturing jobs back to the U.S.? We see two possible ways that Trump could try to square this circle. First, Trump could lean on the Fed to maintain a highly accommodative monetary stance. Since inflation expectations are likely to rise further as the economy begins to overheat, it is possible that real rates would actually decline unless the Fed raised rates fast enough, pushing down the dollar in the process. The problem with this theory is that Trump's public pronouncements on monetary policy have generally been on the hawkish side. He criticized Janet Yellen on the campaign trail, accusing her of trying to goose the economy in order to help the Democrats at the polls. Granted, Trump's views on the hard money/easy money debate may have changed now that he is President and poised to benefit politically from a more stimulative monetary policy. Nevertheless, it will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans are likely to resist efforts to pack the FOMC with doves. As long as the economy is doing well, our guess is that Trump will accede to Republican demands that he nominate members to the FOMC with a somewhat hawkish disposition. This should keep the dollar uptrend intact. If a policy U-turn does occur, it will happen towards the end of the decade, by which time the economy will be due for another recession. With another presidential election looming at that point, Trump might end up taking a page out of the old Nixon playbook and browbeat the Fed chair into pursuing a massively expansionary monetary policy.1 This could set the stage for a stagflationary episode, a prediction we discussed at length in our latest Strategy Outlook.2 In the meantime, Trump will try to mitigate the effects of a stronger dollar on U.S. manufacturing by pursuing a more protectionist trade agenda. This is likely to entail expanding the use of countervailing duties which target foreign industries that are alleged to be engaging in unfair trade practices - similar to what Obama did when he slapped an extra 35% duty onto Chinese tires in 2009. Trump is also likely to continue "twitter shaming" companies that have moved, or are contemplating moving, production abroad. On the whole, however, a radical departure from existing trade policy is unlikely as long as the economy continues to expand. Nevertheless, as with his approach to Fed policy, Trump could break with all established traditions if unemployment starts rising and his poll numbers begin tumbling. In other words, a major trade war is coming, just not yet. Investment Conclusions Chart 6The Dollar Can Climb Amid ##br##Bullish Sentiment The Dollar Can Climb Amid Bullish Sentiment The Dollar Can Climb Amid Bullish Sentiment In politics, as in life, preferences are not the only things that matter. Constraints are as important, if not more so. Just as in the early 1980s, the U.S. is pursing a policy of fiscal easing and monetary tightening. As was the case back then, this has led to a stronger dollar. It would be easy to say that Trump could badger other countries into tightening monetary policy in order to keep the dollar from appreciating. Even if we ignore the political implausibility of such a strategy, it still would not work. If a country needs a low interest rate to keep growth from stalling, then raising rates is unlikely to boost that country's currency. The market will realize in short order that the central bank will eventually have to reverse course and cut rates to keep deflationary forces from setting in. The point is that trying to influence exchange rates without changing the economic fundamentals is destined to fail. We expect the real trade-weighted dollar to rise 5%-to-10% by the end of the year. Granted, bullish dollar sentiment is widespread these days (Chart 6). However, dollar bulls were around in even greater numbers in the second half of the 1990s, and this did not prevent the greenback from scaling to new highs. If the dollar resumes its ascent, as we expect, this could hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. A stronger greenback would also weigh on commodity prices, with metals being the most vulnerable. The risks to our dollar view are fairly symmetric. On the downside, the failure of the Trump administration to loosen fiscal policy could prevent the Fed from hiking rates as much as planned. The risk here is not so much that the tax cuts will be scuttled, but rather that Congressional Republicans succeed in pushing through big spending cuts as part of any budget deal. On the upside, the passage of a Border Adjustment Tax - something to which we assign 50% odds - would lift the dollar.3 Rising stress in emerging markets could also push money into safe haven markets such as U.S. Treasurys, similar to what happened during the late 1990s. This could cause the dollar to appreciate more than our baseline forecast implies. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Burton A. Abrams, "How Richard Nixon Pressured Arthur Burns: Evidence From The Nixon Tapes," The Journal of Economic Perspectives, Vol. 20, no. 4 (2006), pp.177-188. 2 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Global competitiveness equalisation occurs: For Germany, at EUR/USD = 1.35 For the Euro area, at EUR/USD = 1.20 For Spain, at EUR/USD = 1.17 For France, at EUR/USD = 1.15 For Italy, at EUR/USD = 1.10 But today EUR/USD = 1.07. The main culprit for the over-competitive euro is the ECB. Feature President Trump is right about one thing. The ECB's own analysis - available at https://www.ecb.europa.eu/stats - shows that the trade-weighted euro needs to appreciate by 10% to cancel the euro area's competitive advantage versus its major trading partners including the United States. To cancel Germany's competitive advantage, the ECB calculates that the euro needs to appreciate by 25% (Chart I-1). Chart I-1ECB Analysis Supports President Trump: ##br##The Euro Is Over-Competitive ECB Analysis Supports President Trump: The Euro Is Over-Competitive ECB Analysis Supports President Trump: The Euro Is Over-Competitive Even more controversially, the central bank's own analysis shows that the ECB itself is to blame for the euro area's significant competitive advantage. Prior to the ECB's extreme and unprecedented policy easing, the euro area's competitiveness was exactly in line with its trading partners (Chart I-2). The ECB says that it does not target the exchange rate, but it is fully aware that negative interest rates and trillions of euros of asset purchases carry major ramifications for the euro's value. Chart I-2The ECB Caused The Over-Competitive Euro The ECB Caused The Over-Competitive Euro The ECB Caused The Over-Competitive Euro The ECB's Ultra-Looseness Is Counterproductive The ECB could be forgiven for its ultra-looseness if the euro area were on the edge of a deflationary abyss. But as we showed in Fake News In Europe1 euro area inflation and inflation expectations are little different to those in other major economies when compared on an apples for apples basis. Chart I-3Emergency Monetary Policy##br## Not Needed Emergency Monetary Policy Not Needed Emergency Monetary Policy Not Needed Furthermore, the euro area is among the world's top-performing major economies through the past three years (well before ECB easing started), and the percentage of the working age population in employment is at an all-time high. These are hardly the hallmarks of an imminent deflationary threat which warrants emergency monetary policy (Chart I-3). Perhaps the ECB's ultra-looseness is trying to quell a flare-up of ever-present political risk. If so, the strategy is becoming counterproductive. As well as irking President Trump, the extreme policy is riling Germany's Finance Minister, Wolfgang Schäuble, who has blamed Mario Draghi for "50 per cent" of the success of the populist right-wing Alternativ Für Deutschland. And by frustrating voters worried about the low interest rates on their hard-earned savings, the ECB is also playing right into the hands of Marine Le Pen's Front Nationale. Admittedly, the euro area's current economic 'mini-upswing' is likely approaching its end. But as we showed last week in Slowdown: How And When?,2 a deceleration is likely to be even more pronounced outside the euro area. Even the ECB acknowledges that "the risks surrounding the euro area growth outlook relate predominantly to global factors" rather than domestic factors. If the ECB is right, the extent of anticipated monetary tightening outside the euro area is overdone. If the ECB is wrong, then the extent of anticipated monetary tightening inside the euro area is underdone (Chart I-4 and Chart I-5). Either way, the investment conclusion is the same. Chart I-4Expected Divergence In Monetary Policy Drives##br## Relative Bond Market Performance... Expected Divergence In Monetary Policy Drives Relative Bond Market Performance... Expected Divergence In Monetary Policy Drives Relative Bond Market Performance... Chart I-5... And ##br##The Euro ... And The Euro ... And The Euro Stay underweight German bunds versus U.S. Treasuries. Stay long the euro, with our preferred crosses being euro/pound in the near term and euro/yuan in the long term. And given that euro/pound (inversely) drives relative stock market performance, stay underweight Eurostoxx600 versus FTSE100. The Great Currency Manipulation Manipulation: (noun) - the controlling or influencing of a situation cleverly. The creation of the euro in 1999 was arguably the greatest currency manipulation of modern times. To be absolutely clear, this is not a criticism, just a statement of fact. In 1999, when European policymakers killed national currencies such as the deutschemark, franc, lira and peseta and replaced them with the new-born euro, the action clearly fitted the dictionary definition of manipulation. Our preceding analysis about the euro area's competitive advantage today assumes that the euro started its life at the right value. The evidence suggests that this assumption is correct. In 1999, the euro area' external trade was in balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. Likewise the evidence suggests that national currencies such as the deutschemark, franc, lira and peseta converted to the euro at the right exchange rates. The euro area's constituent economies had much in common in 1999 and were broadly in balance with each other. Surprising as it now seems, in 1999 Germany and Italy scored identically on exports as a share of GDP (Chart I-6) and on total debt as a share of GDP (Chart I-7). And German wages had been rising in lockstep with productivity (Chart I-8). Chart I-6After The Euro, Germany's ##br##Exports Soared After The Euro, Germany's Exports Soared After The Euro, Germany's Exports Soared Chart I-7After The Euro,##br## Italy's Debt Soared After The Euro, Italy's Debt Soared After The Euro, Italy's Debt Soared Chart I-8After The Euro, German Wages##br## Lagged Productivity After The Euro, German Wages Lagged Productivity After The Euro, German Wages Lagged Productivity It was only in the decade after 1999 that the euro area developed its major internal imbalances. Germany depressed its wages relative to productivity and used the resulting ultra-competitiveness to build an export-driven business model. In the seven years before 1999, net exports had made zero contribution to Germany's economic growth (Chart I-9), but in the seven years after 1999, net exports accounted for all of Germany's economic growth (Chart I-10). Chart I-9Germany Pre Euro: Net Exports ##br##Contributed Nothing To Growth Germany Pre Euro: Net Exports Contributed Nothing To Growth Germany Pre Euro: Net Exports Contributed Nothing To Growth Chart I-10Germany Post Euro: Net Exports Contributed ##br##Everything To Growth Germany Post Euro: Net Exports Contributed Everything To Growth Germany Post Euro: Net Exports Contributed Everything To Growth Prior to the one-size-fits-all exchange rate, a rising deutschemark would have largely snuffed out the increased competitiveness from wage depression and thereby thwarted the export-driven business model. However, once locked in the euro, Germany's exchange rate could no longer rise sufficiently to choke off external demand. Meanwhile, Italy and Spain could suddenly rely on a debt-driven business model - especially given that their strong national cultures of homeownership provided the perfect collateral for borrowing. Prior to the one-size-fits-all interest rate, higher domestic interest rates would have thwarted this business model. But once locked in the monetary union, their interest rates could no longer rise sufficiently to choke off borrowing. By 2010, the imbalances had become monsters. Germany, through its wage depression, had become 20% over-competitive versus its major trading partners. Spain and Italy, through their reliance on debt-fuelled growth, had become 20% under-competitive. Understand that this is not a morality tale of good versus bad, as many commentators portray. The mirror-image imbalances were just the opposite sides of the same (euro) coin. Spain Is The Star-Performer Today, the good news is that the euro area's internal imbalances have narrowed sharply, as the under-competitive economies have taken draconian corrective measures. External competitiveness has also been boosted by a substantially weaker euro. The bad news is that Germany's over-competitiveness versus the world remains excessive. But as Wolfgang Schäuble correctly argues, it is extremely difficult for Germany to rebalance its global competitiveness when it is swimming against the tide of the ECB's extreme easing and resulting depression of the euro. The award for the most spectacular rebalancing goes to Spain. Eight years ago, Spain was 15% less competitive than France on the ECB's harmonised competitiveness indicator based on unit labour costs. Today, on the same measure Spain is 2% more competitive than France. This makes it very difficult to justify any yield premium on Spanish Bonos versus French OATs. The yield premium is a compensation for perceived redenomination risk. The expected annual loss of owning a Bono versus an OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. But if Spain is now as competitive as France, a new peseta ultimately should be as valuable as a new franc. The second item of the multiplication would be zero (Chart I-11). So irrespective of the probability of euro breakup, the yield premium should also be zero. Yet today, Spanish 10-year Bonos are still trading at a substantial 65 bps yield premium over French 10-year OATs (Chart I-12). Chart I-11Spain Is As Competitive ##br##As France... Spain Is As Competitive As France... Spain Is As Competitive As France... Chart I-12... Bonos Should Not Have A ##br##Yield Premium Over OATs ... Bonos Should Not Have A Yield Premium Over OATs ... Bonos Should Not Have A Yield Premium Over OATs Stay long Spanish Bonos versus French OATs. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 and available at eis.bcaresearch.com 2 Published on February 2, 2017 and available at eis.bcaresearch.com Fractal Trading Model* A tactically short position in equities is warranted. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Short MSCI AC World Short MSCI AC World * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The U.S. Border Adjustment Tax is likely to pass; Yet the political pieces are not in place; Trump himself will be the decisive factor; Trade retaliation would detract from trade benefits of the tax; Stay long volatility; small caps versus large caps; and long USD versus EM currencies. Remain short China-exposed S&P 500 stocks, and German exporters versus consumer services. Feature Donald Trump is a trend-setter. After winning the U.S. election on a protectionist platform that played well to voters in the Midwest, Trump has established an anti-globalization brand of politics. His success has revealed the preferences of the American "median voter."1 Other U.S. politicians are taking notice. The "Border Adjustment Tax" (BAT) is part of this new political trend, though it did not originate with Trump. The House GOP leadership has presented it as a response to economic dislocation in the American heartland, which propelled Trump to the White House. Is it protectionism? Yes, and in this analysis we explain why. The rest of the world is highly unlikely to treat the BAT as a standard Value Added Tax (VAT). It will therefore spark trade retaliation unless Congress addresses outstanding issues. So far President Trump is on the fence, and his support is necessary for passage. We think he will ultimately go with the proposal. The prospect of turning the tables on the U.S.'s trade partners, while spurring domestic investment and capital spending, speaks to his core promises to his voters. Trump's support for the plan should be read as a headwind for markets in the short term due to the uncertainties of implementation and trade disputes. If he should oppose the plan, it would be bullish for U.S. stocks in the short term, since it would mean cutting the corporate tax without radically altering the global status quo. It would signal that he is more interested in economic growth and corporate profits than changing the world or balancing the U.S. budget. Why Reform The Corporate Tax System? American policymakers have long struggled with the country's corporate income tax system. Leaving aside party politics, there are three main complaints:2 Corporate tax revenues are weak: Revenues have disappointed as companies have shifted profits to tax havens and used deductions and loopholes to avoid paying the 35% statutory rate. This erosion of the tax base has contributed to budget deficits as well as public dissatisfaction with governing institutions (Chart 1). U.S. companies have lost competitiveness: American businesses are overtaxed relative to their developed-market peers, taking a toll on competitiveness both at home and abroad (Chart 2). The middle class is losing out: U.S. workers are not as well compensated as their developed-market peers and have lost their share of American wealth in recent decades (Chart 3). The corporate tax contributes to this because companies foist the tax onto workers. Chart 1Over-Taxation Is In##br## The Eye Of The Beholder Over-Taxation Is In The Eye Of The Beholder Over-Taxation Is In The Eye Of The Beholder Chart 2U.S. Competitiveness##br## Has Suffered U.S. Competitiveness Has Suffered U.S. Competitiveness Has Suffered Chart 3Labor Suffers From##br## High Corporate Tax Rates Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? The Republican Party examined fundamental tax reform in 2005 but could not make progress on it - instead it settled for the Bush tax cuts, which focused primarily on cutting household tax rates.3 Now that the Republicans have control of all three branches of government again, its leaders are attempting broad tax reform anew. The GOP is primarily concerned with corporate competitiveness, but they also need to appease the middle class - the source of the populist angst that supported both Obama and Trump (the former being the Republicans' arch-nemesis, the latter a strange bedfellow). The GOP also wants to raise some revenue to make their desired tax rate cuts "revenue neutral," i.e. somewhat fiscally defensible, at least enough to pass the bill. Enter Paul Ryan, Speaker of the House, and Kevin Brady, Chairman of the Ways and Means Committee, and their "Better Way" tax plan, which proposes a sweeping overhaul of the U.S. tax system.4 The core idea is to pay for tax cuts by transforming the current corporate income tax system into a "destination-based cash-flow tax" (DBCFT) with border adjustability ("border adjustment tax" or BAT for short).5 We will get to the definition of that, but first, what is the ultimate point? The plan would purportedly drive corporate investment and economic growth by allowing companies to write off the expense of new investments immediately, the first year, rather than gradually through depreciation. (Depreciation schedules often mean that the tax write-off barely covers the cost of investment, thereby causing companies to err on the side of risk-aversion.) The plan would also remove the preferential treatment of corporate debt over equity, which is built into the current tax code through the deduction of interest - this change would discourage corporate indebtedness and encourage equity financing. Finally the plan would not allow U.S. companies to write off the expense of imported goods, as currently, and as such is essentially a tax on the U.S. trade deficit. Roughly, it could yield about $108 billion in revenue (assuming a 20% rate on the $538 billion deficit). The BAT is the chief tax uncertainty today for investors. That is because there are few constraints on the GOP passing some kind of corporate tax cut this year. Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. There is every reason to think it will happen fast. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? In other words, Trump and his party would need to have a train wreck to fail to pass something this year. That is not beyond belief! But the overriding question is whether the tax reform will be focused on cutting rates, or transforming the system. Currently, the market seems to think the BAT will go through. A basket of stocks based on potential winners and losers suggests that investors believe it will pass (Chart 4). Meanwhile, however, the share prices of high-tax companies (who should benefit the most if taxes are cut) have fallen back from the pop after Trump's election. This could signal the opposite expectation, or that that investors recognize that many high-tax sectors stand to lose from a tax on imports (Chart 5). There is considerable uncertainty in this measure. We think the Trump administration will ultimately accept the House GOP's BAT proposal. But the road between here and there will be tortuous, as past attempts at tax reform show. We expect dollar volatility, which is relatively restrained at present, to rise as the BAT debate intensifies, given that the proposal is bullish for the greenback (Chart 6). Chart 4Exporters Think Border##br## Adjustment Tax Will Pass Exporters Think Border Adjustment Tax Will Pass Exporters Think Border Adjustment Tax Will Pass Chart 5High-Tax Companies##br## Fear Policy Disappointments High-Tax Companies Fear Policy Disappointments High-Tax Companies Fear Policy Disappointments Chart 6No Border Adjustment##br## Tax Effect On The Dollar Yet No Border Adjustment Tax Effect On The Dollar Yet No Border Adjustment Tax Effect On The Dollar Yet Bottom Line: The Trump administration and GOP would have to be unusually incompetent to fail to achieve tax reform this year. The question is whether it will be mere rate cuts or a radical reform to the tax system as a whole. This is critical to the U.S. and global economy - especially given that the passage of a BAT will intensify trade disputes with the U.S. Why Is A Border Adjustment Tax "Protectionist"? Diagram 1 provides a simple illustration of how the current U.S. corporate tax works compared to the proposed BAT. The current system is a "worldwide" corporate income tax. The U.S. government taxes American companies based on their global profits (global revenues minus global costs). No matter where they incur costs, they can write them off, and no matter where they make profits, they must pay tax on them, at least in principle. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? The new system, by contrast, would be a "destination-based" tax in which the government taxes companies only on domestic profits (domestic revenues minus domestic costs). This means that revenues earned abroad from exports or sales in foreign jurisdictions would be free from tax. However - and here is the tricky part - it also means that costs incurred abroad, imports or purchases in foreign jurisdictions, would be ignored by the tax authority, i.e. they could not be written off like domestic costs. As the "rebate" in the Diagram shows, the BAT is effectively a tax on imports and subsidy to exports. This is not as egregiously protectionist as it sounds at first, because it is very similar to a Value-Added Tax (VAT), which is the dominant tax system across the world. The U.S. is a massive outlier for not having a VAT. But notice that the amount of the rebate to the exporting company in the diagram is higher (at $40) than the amount of tax that would be due if it paid a tax on its foreign profits, since ($200 - $100) x 20% = $20. The WTO may rule against the law if it believes major U.S. exporters will pay net negative taxes as a result of the rebate. Moreover, the BAT has certain differences from a VAT that ensure that the world will see it as a protectionist affront. The BAT is a combination of a VAT, which is a tax on consumption, and an income tax, which is the current system. However, the BAT would allow companies to write off wages and salaries as costs, just like under the current system. Under VAT systems, this is not possible because wages are not consumption and therefore not deductible.6 If the GOP proposal becomes law without addressing this difference - that is, without denying corporates the wage deduction, or taxing them in some other way to compensate - it will likely prompt global trade retaliation. While the World Trade Organization may deem the BAT legal by interpreting it as a VAT, it will not do so if U.S. companies cannot show that they are not getting a leg up on their international rivals by retaining the wage deduction from the former corporate income tax code. Wages are obviously a very large part of a company's expenses. They make up about 68-72% of U.S. companies' costs (Chart 7), and have grown at about 2-4% each year for the export-oriented sector (Chart 8). If U.S. companies can write off the wage expense in their exported goods, then foreign countries will have to adjust, possibly by imposing duties to counteract the share of taxes avoided by that write-off. Chart 7Wages Make For A Large Tax Deduction Wages Make For A Large Tax Deduction Wages Make For A Large Tax Deduction Chart 8Exporters Face Strong Growth In Wages Exporters Face Strong Growth In Wages Exporters Face Strong Growth In Wages Bottom Line: The BAT is a hybrid of tax systems. It is likely that the WTO and U.S. trading partners will object to it as an import tax and export subsidy, particularly because of the wage deduction. The House GOP could adjust the proposal ahead of time or afterwards to avoid this conflict, but that has not happened yet. In addition, corporate lobbying against removing wage deductions would be severe. Will A BAT Get Passed Into Law? Currently, the House GOP leaders face a rising wave of criticism about the BAT proposal and have begun to signal greater flexibility in drafting the law so as to win over various stakeholders. A salient point to remember about U.S. tax legislation is that it is very rare in recent decades for a ruling party to bungle it. Only eight pieces of tax legislation have been vetoed by presidents since 1975, only two of which were serious bills, and in both cases the president vetoed the legislation pushed by an opposition-controlled Congress (Table 2). By the time a serious tax bill makes it to the president's desk, a veto is unlikely, especially if the president and Congress belong to the same party. Table 2Major Tax Legislation Is Set Up For Success Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Even more salient, only 23 pieces of tax legislation since 1975 have been struck down in either of the two houses. Of these, seven were attempts to amend the constitution (not likely to pass), nine were attempts to amend the internal revenue code for highly specific things (spirits, cigars, the holding of conventions on cruise ships). Only seven were major bills, and in only one of these cases did the Senate strike down the bill, which was a case of a Republican Senate defending a Republican president from an opposition Congress. In only one case did the ruling party in the House kill a serious tax bill proposed by one of its own members, but it is not comparable to the tax reform in question today.7 What this means is that the BAT is highly likely to be passed into law if the House remains loyal to its leader Paul Ryan, and to the Ways and Means Committee chair Kevin Brady, the two authors of the BAT proposal. However, Trump could derail Ryan's best laid plans. Trump seemed to throw a wrench in the gears when he cast doubt on border adjustment tax, saying that it was too complicated. However, the Trump administration has recently made comments favorable to the BAT. Peter Navarro, chief of the new National Trade Council, highlighted it as a way to bring manufacturing supply chains back into the U.S. (note the protectionist angle of the comment). Meanwhile Sean Spicer, Trump's spokesman, said it would be a good way to make Mexico pay for the infamous wall to be constructed on the border (again, note that the angle is protectionist and populist, not about balancing the budget).8 In each case, the Trump team has gone to pains to emphasize that the BAT is only one option among many. Yet the fact that they have repeatedly brought it up as a solution to their own populist promises is suggestive. We think Trump will ultimately hew to the Republican Party leadership on tax reform.9 Why? Time's a'wastin': Party control of all three branches is a fleeting boon and 2018 mid-term campaigning would make the BAT harder to pass because it could hike the prices of consumer goods. Republicans have a plan ready to go, the House ultimately controls the purse, and Trump wants to move fast on tax cuts and boosting the economy. Furthermore, Republicans remember how short-lived the Democrats' control of Congress was after 2008. Trump wants to be transformative, not merely transactional:10 Trump was elected in a populist revolution and has vowed to improve American manufacturing and trade. His protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT: remove the "tax" on corporate investment to improve U.S. capital stock and productivity, and remove incentives to locate, operate, and stash profits offshore. There is at least some positive correlation between higher VAT rates and positive trade balances, and the law is simultaneously supposed to boost productivity (Charts 9 and 10). Chart 9Higher Investment Helps Productivity Higher Investment Helps Productivity Higher Investment Helps Productivity Chart 10Some (Not Much) Correlation Between Value-Added Tax Rates And Trade Surpluses Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Trump needs domestic and international "legitimacy": His protectionist platform will stand on firmer ground if he adopts policy that is at least debatable at the WTO, as opposed to imposing tariffs willy-nilly through bare executive power, which is eventually vulnerable to congressional and judicial oversight. Domestic courts have already shown an inclination to halt Trump's controversial executive orders.11 By contrast, they would almost certainly defer to Congress even on the most radical tax reforms. Trump needs a tradeoff for infrastructure spending: Unpopular presidents cannot set the legislative agenda.12 But Trump may be able to trade GOP-style corporate tax reform - which offsets tax cuts with new revenue provisions, such as the BAT - in return for infrastructure spending, which the GOP is reluctant to embrace. Trump is willing to lead a crusade against the WTO: This may be a necessary prerequisite for the passage of this bill, and Trump is heaven-sent to play the role. He would be to the WTO what George W. Bush was to the United Nations. It would be disastrous for the U.S.-built international liberal order, but it would give Trump the ability to pursue protectionism while rallying the public around the flag against America's "globalist" enemies. (Sovereignty over taxation is a cause that is hard to beat in the U.S.)13 BAT allows Trump to save face on the "Wall" with Mexico: As the White House spokesman hinted, Trump may use creative accounting to satisfy his promise that Mexico would pay for the wall. Moreover, if Trump comes out in support of the BAT, it will likely get passed: Chart 11Conservatives Agree With Trump Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Precedent: President John F. Kennedy's and Jimmy Carter's efforts at tax reform failed because Congress was not supportive, which is not a problem today; whereas Ronald Reagan's personal support for the 1986 tax reform - despite his reservations about the attempt to transform the system and broaden the base - proved critical in helping the bill move through Congress.14 Political science: The political context is a better determinant of presidential success than individual talents, and rising political polarization in the U.S. has created an environment in which "majority presidents," those whose party has a majority in Congress, are even more likely to be successful, while "minority presidents" are more likely to fail on key initiatives. The relevant factors of political context are the party's grip on Congress, the extent of polarization, and, somewhat less significantly, whether the president is in his "honeymoon period" and enjoys public support.15 Of these factors, Trump is only weak on public support, though not among conservatives (Chart 11), who could vote their representatives out of office if they defy Trump on tax reform. The Senate could still cause a serious hang-up. But if Trump and the House GOP stand behind the legislation then Senate Republicans would have to be suicidal to oppose it.16 What about the corporate lobbies that oppose the BAT? Certainly it is highly controversial at home. The tax could hurt import-heavy U.S. businesses and punish citizens with a high propensity to consume - i.e. the poor and elderly, both constituents that make up an important part of Trump's base. But that suggests that there will be carve-outs or phased implementation for key imports like food, fuel, and clothing. Such compromises will be messy, and will mitigate any dollar appreciation and reduce the tax revenues to be gained, but would probably enable the bill to get passed. The opposition of retailers like Wal-Mart and Target is overrated in terms of their power as a lobby. Importers form a slightly larger lobby than exporters, which makes sense given that the U.S. is a net importing economy, but neither of them comprises a large share of total lobbying (Chart 12). The sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart 13). The opposition of the Koch brothers is also overrated, given their unhelpful attitude toward Trump's candidacy for president! Chart 12'Import Lobby' Not A Giant Lobby Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Chart 13Cuts In Tax Rates Mitigate A New Import Tax Somewhat Will Congress Pass The Border Adjustment Tax? Will Congress Pass The Border Adjustment Tax? Bottom Line: The BAT is a radical plan to spur corporate investment and production in the United States, and that goal matches Trump's vision. Trump will be hard pressed to find a more effective, structural way of achieving his goals. And the two-year window with assured GOP control of government will close faster than one might think. Risks To The View A major risk to the BAT is that Trump will fear the repercussions on his political base of higher consumer prices, as hinted above. Consumer pain is a necessary consequence of his mercantilist vision of rebalancing the U.S. from consumption to investment and bringing down the U.S. trade deficit, so Trump will have to decide whether he means what he says. Moreover, if the dollar rises sharply as a result of the BAT, as expected, it would cause pain for the economy and S&P 500 companies, which source 44% of earnings outside the U.S. According to BCA's Global Investment Strategy, the impact of a much stronger dollar on U.S. assets denominated in foreign currencies could amount to a loss worth of 13% of U.S. GDP! (Not to mention Trump's personal wealth from overseas.) Given the huge uncertainties of a totally new tax system, and potential disruption to the economy, it would be perfectly understandable if Trump refused to hitch his fate as president to this wonkish grand experiment. Further, it is not as if there is no alternative to the BAT. Since Republicans will be humiliated if they fail to deliver on tax cuts, Trump's opposition to the BAT would force the House GOP to go back to good ol' fashioned tax cuts without significant revenue raising measures, and specific add-ons to deal with concerns like corporate inversions. Trump would still likely get the repatriation of overseas earnings, a political win, and the economy would experience an increase in investment from tax rate cuts without the uncertain consequences of deeper change. Ronald Reagan's administration offers a precedent for this sequencing, since he began his term with simple tax cuts in 1981 and only later attempted the dramatic tax overhaul of 1986. There is also a risk that the business lobby against the BAT proves stronger than expected and gains traction in the media and popular opinion as a result of the feared consequences on consumer prices. Tax reform is never going to be easy and will always hang in a precarious balance. These are serious risks, but we think Trump and the GOP will move now rather than make any assumptions about their ability to win subsequent elections and enact massive tax reform. The fact that the GOP controls all three branches of government, the BAT plan is well in the making, and Trump is looking to reshape the American economy in ways that align with the BAT, make the odds of passage higher than 50%. Unfortunately, this also means the world should brace for a sharp spike in trade disputes. Bottom Line: There are plenty of reasons to think the BAT plan could collapse of its own weight. The path of least resistance is certainly not the BAT. But we think the preponderance of power in GOP hands in Washington favors radical change, even if it ends up being a policy mistake. Investment Implications: Trade War The WTO is supposed to presume innocence with a country's laws, and it might also approve the BAT on the basis that proponents argue: the U.S. imposing the BAT is not much different from a VAT country increasing its VAT rate while simultaneously slashing the payroll tax (as France has done under President Hollande's administration). This view is misguided. The WTO will rule on the statute and international trade treaties, not the special pleading of the advocates. It may or may not accept that the BAT is equivalent to a VAT; it may or may not object to the wage deduction as a holdover from the "direct" tax on income. The GOP has not yet introduced a draft law, but given the express intention - in the Ryan plan, not even to mention Trump - to put "America first" with a "pro-America approach for global competitiveness," it seems likely that a clash of interests is in the making. In other words, American proponents of the tax are not even hiding its overt protectionist intentions. The WTO will probably discover a subsidy for U.S. exporters and a violation of the principle of trade neutrality with respect to imports. WTO litigation will take years. When the European Union sued the U.S. over its use of Foreign Sales Corporations, a comparable dispute, the proceedings began in 1999 and the WTO ruled against the U.S. in 2002. Ultimately, the U.S. Congress amended the law to avoid retaliation in 2004.17 Trump and the GOP would be less likely to amend their pet project in the current environment, especially if the litigant is the EU at the WTO! Trump, as mentioned, would be inclined to take the fight to the WTO - he has even threatened to withdraw the United States from it. His support group feeds on conflict with supra-national bodies and he may see foreign retaliation as a convenient reason to impose tariffs of his own. The trade environment would deteriorate in the meantime. In 2002, it was assumed that the U.S. and EU could work out an agreement without punitive measures, but that assumption does not hold today. And it would not only be the EU leveling complaints. In short, the U.S. would face foreign retaliation, during the proceedings and likely as a consequence of the WTO ruling. The Trump administration would attempt to mitigate the blowback through a series of bilateral deals, and perhaps the U.S. law would ultimately be modified, but the entire saga would have a negative impact on global trade. Financial markets had many factors to contend with during this period (like the dot-com bubble), and they will similarly respond to large currents in the coming years aside from any BAT. Nevertheless, the tax would reinforce our themes of global multipolarity, mercantilism, and protectionism - and thus reinforce several of our existing trades: We continue to favor small caps over large caps. Small caps are insulated from global trade, will benefit most from the cut in tax rates, and will suffer least from any appreciation of the dollar. Long volatility - Long VIX 20-25 call spread for expiration in March; Long USD versus short EM currencies; Short China-exposed S&P stocks; Short German exporters versus long consumer services. If Trump comes out in opposition to the BAT, he would send a bullish signal for markets in the short term. It would mean, first, that the U.S. will have corporate tax cuts without the broader uncertainties of the BAT; and second, that Trump is actually a pragmatist who eschews radical change if he thinks it will cause too much trouble for U.S. consumers or economic growth. However, it would not necessarily mean that the U.S. would avoid a trade conflict, given Trump's executive powers.18 Of course, the BAT's failure - which is not our baseline - would also be worse for the deficit and debt, as the GOP tax cuts would have no offsetting revenue increases but would rely purely on creative accounting, "dynamic scoring," to appear fiscally acceptable. This legislation would also likely fail to simplify the tax code as much as the BAT would. Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 2 Please see Alan J. Auerbach, "A Modern Corporate Tax," Center for American Progress, dated December 2010, available at www.americanprogress.org. 3 Please see President's Advisory Panel on Federal Tax Reform, "Final Report," dated November 1, 2005, available at govinfo.library.unt.edu. 4 Please see "A Better Way: Our Vision For A Confident America: Tax," dated June 24, 2016, available at abetterway.speaker.gov. 5 Our colleagues at BCA's Global Investment Strategy have recently provided a very helpful Q&A on the border adjustment tax (BAT), and we would refer readers to that report for a detailed discussion. Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 6 Please see Reuven S. Avi-Yonah, "Back To 1913?: The Ryan Blueprint And Its Problems," Tax Notes 153: 11 (2016), 1367-47, reprinted by University of Michigan, available at www.repository.law.umich.edu. 7 Amo Houghton, a liberal-leaning Republican from New York, proposed the Taxpayer Protection and IRS Accountability Act of 2002, a bill to streamline IRS administration. It failed in the Republican Congress under President Bush. 8 Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017, available at www.ft.com, and Bob Bryan, "Trump press secretary says the administration is considering a 20% border tax on Mexican imports to help pay for the wall," Business Insider, January 26, 2017, available at www.businessinsider.com. National Economic Council Director Gary Cohn has also indicated that the BAT is an option but not yet decided upon, see CNBC, "Squawk on the Street," February 3, 2017, available at www.cnbc.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 11 The U.S. Ninth Circuit Court of Appeals has already issued a temporary injunction against President Trump's executive orders on immigration. Please see "State of Washington & State of Minnesota v. Trump," available at www.ca9.uscourts.gov. 12 Please see John Lovett, Shaun Bevan, and Frank R. Baumgartner, "Popular Presidents Can Affect Congressional Attention, For A Little While," Policy Studies Journal 43: 1 (2015), 22-44, available at www.unc.edu. 13 Please see BCA Geopolitical Strategy Weekly Reports, "The Trump Doctrine," dated February 1, 2017, and "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 14 Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 15 Jeffrey E. Cohen, Jon R. Bond, and Richard Fleisher, "Placing Presidential-Congressional Relations In Context: A Comparison Of Barack Obama And His Predecessors," Polity 45:1 (2013), 105-126. 16 The Senate Financial Services Committee's support will be critical. Chairman Orrin Hatch has criticized but not yet declared against the BAT. Even if he does, it would not necessarily kill the deal. One of his predecessors, Senator Bob Packwood, initially opposed the Tax Reform Act in 1986 but was ultimately persuaded to support it. If Hatch and the Finance Committee support the initiative, it will pass the Senate. First, the tax overhaul can be accomplished by "reconciliation," a congressional trick that will enable the GOP to avoid a Senate filibuster and pass the tax reform with a simple majority. Second, the Republicans today have almost exactly the proportion of seats in the Senate as the average in previous examples of successful tax reform (see Table 1). So there would have to be a higher share of Republican defectors than in the past to overturn the bill. This is possible but unlikely if Trump and the House GOP are behind the bill. 17 Please see Congressional Research Service, "A History of the Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC) Export Tax-Benefit Controversy," dated September 22, 2006, available at digital.library.unt.edu. 18 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com.

Highlights Signing executive orders and memoranda post-Inauguration is a common tactic for new presidents. Unfortunately for investors, political rhetoric has caused uncertainty to surge, while actions affecting profitability have been minimal. The potential for radical changes to trade policy changes should not be underestimated. However, details about timing and contours are too vague to be of any support to potential industry-specific beneficiaries. Fed policymakers will focus primarily now on wage and price inflation to guide them on the appropriate pace of rate hikes. Policymakers increasingly believe the economy is operating at full employment. Feature Chart 1Policy Uncertainty Surge Policy Uncertainty Surge Policy Uncertainty Surge It has been a confusing two weeks in Washington. Since taking oath, President Trump has signed eighteen executive orders and presidential memoranda.1 This is not uncommon: Barack Obama signed an equal amount during his first week of his first presidential term, and executive orders are a frequent tactic used by new presidents to quickly deliver on campaign promises. Unfortunately for investors, Trump's signature has not yet found its way to policies that alter the profitability of U.S. businesses and/or clearly lower the risk premium for financial assets (although at the time of writing, there are rumors about an order that will affect Dodd-Frank). Instead, there has been a tremendous amount of rhetoric that has caused political uncertainty to spike higher (Chart 1). We have warned in past weekly reports that it would be difficult for equity prices to sustain gains built on the premise that a new American government will succeed in implementing a pro-business strategy while simultaneously avoiding any negative shocks from trade reform and foreign policy blunders. Actions under the new administration so far support this view. On Trade: Trade is the area of most confusion thus far in the Trump presidency. As our Geopolitical team highlighted in a recent report,2 the new White House seems focused on bringing the U.S. current account deficit down and will attempt to do so by using three primary tools: Protectionism, possibly in the form of a "destination-based border adjustment tax," as discussed in our Special Report two weeks ago.3 Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. and has insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption, though details are scant. Structural Demands: Trump and team appear ready to lob threats at other countries with trade surpluses, such as China - by charging the country with currency manipulation. Note that the above tools are in the White House's toolbox, but are yet to be employed. In terms of concrete action to date, President Trump has signed orders to pull out of the Trans Pacific Partnership (TPP). But this was a non-event since the TPP was never ratified by Congress. Takeaway: The potential for radical changes to trade policy should not be underestimated. However, details about timing and contours are too vague to be of any support to potential industry-specific beneficiaries. On the flipside, confusing and vague rhetoric should not (yet) form the basis of a negative economic and profit outlook. On Infrastructure: Trump signed an executive order to expedite environmental reviews for high-profile infrastructure projects. This executive order may expedite already approved projects, but any new spending requires approval from Congress. The budget will be announced only in mid- to late- April. Moreover, it is still an open question as to whether Congressional Republicans will try to axe government spending. Senior members of Trump's transition team have proposed a plan to cut federal spending by $10.5 trillion over the next 10 years! That would amount to a severe fiscal drag, rather than the much hoped-for fiscal thrust expected from infrastructure spending and tax cuts. Takeaway: As we have argued in the past, infrastructure spending could provide a fillip to U.S. growth, but at minimum, investors should not expect that to occur until late 2017 or 2018. On Taxes: None of the executive orders or memoranda directly address taxes. However, a majority of pundits believe that Trump's executive order on January 25 to Build The Wall with Mexico will be funded by U.S. taxpayers. Takeaway: Tax reform requires congressional approval. There has been no step forward as yet for a more market-friendly tax backdrop. On Regulation: On January 30, President Trump signed an executive order stating that for every new regulation proposed, two existing ones would be repealed. On the surface, this seems like excellent news for businesses, especially smaller ones that consistently argue that "red tape" is a major problem for their companies (Chart 2). After all, the U.S. ranks very poorly among global peers on how easy it is to start a business (Table 1). Note that the World Bank assigns the U.S. a much higher overall score for ease of doing business (8th), but this is due to high scores in only two areas: access to credit and bankruptcy protection laws! Chart 2(Part II) Regulation Is A Problem (Part II) Regulation Is A Problem (Part II) Regulation Is A Problem Table 1(Part I) Regulation Is A Problem What "Great" Really Means: Reality Vs. Rhetoric What "Great" Really Means: Reality Vs. Rhetoric Unfortunately, the language of the executive order is sufficiently vague that it is not clear what impact there will actually be. First, it is impossible to know which agencies and branches of government the order applies to. Second, it is not clear that a President has the legal authority to mandate the number of regulations, i.e. this executive order may be impossible to uphold. The President also signed a memorandum to streamline and reduce the regulatory burden for manufacturers. Though there is no immediate impact on businesses, the memorandum opens a 60 day window for the secretary of commerce to consult stakeholders. Takeaway: The President is serious about deregulation, but if anything, the 2-for-1 regulation order only serves to underscore that unwinding the regulatory burden is a complicated process that is unlikely to be achieved in the first 100 days of office. The bottom line is that the new administration has been busy, but little of their work thus far has been of direct concern to financial markets and underlying profitability. Instead, policy uncertainty has risen: protectionism, de-regulation and tax reform are all high on their agenda, but details are scant. This has left investors with little visibility. Our view is that the underpinnings of a self-reinforcing recovery are in place and thus will fuel outperformance of stocks relative to bonds on an intermediate time horizon (see last week's Special Report and also below).4 However, the rise in policy uncertainty serves to solidify our conviction that at current prices, risk assets are vulnerable to a near-term correction. Indeed, although not uniformly bearish, equity technical readings are beginning to herald a more treacherous phase ahead. Equity Technicals: Mixed Messages We are monitoring technical indicators for warning of a near-term equity pullback within the context of a longer term bull market. So far, the message is mixed. For example, our composite technical indicator is in the middle of its range and is not heralding danger. However, sentiment readings are at a bullish extreme. Our composite sentiment indicator remains near historic highs, which tends to be a good contrarian indicator (Chart 3). Meanwhile, the number of stocks above their 30 week and 10 week averages has also shot higher. Importantly, insiders are taking advantage of the price rally to sell their stock. The insider sell/buy ratio has soared to levels that typically herald corrections. Somewhat curiously, the VIX index - a measure of the cost of insurance - remains at bargain basement levels. This suggests that investors may be complacent to a near-term correction. Overall, sentiment readings have become extreme as has price momentum. As highlighted above, we expect that the near term catalyst for a pullback will likely center around policy disappointment. A more encouraging intermediate term outlook is supported by stronger economic fundamentals and, at least for now, a go-slow Fed. Fed & Economy Last week's FOMC policy statement included only minor tweaks from the previous one. Policymakers were silent as to how they view the impact on growth and inflation from the new Administration. Data released since the December minutes - when it appeared that the committee was shifting to a less dovish stance - have supported the Fed's more optimistic outlook. For example, the ISM manufacturing is trending higher, while the non-manufacturing index continues to be strong (Chart 4). On the manufacturing side, the composite index rose again in January, as the sector recovers from an energy-led recession. New orders held onto earlier impressive gains. The new orders-to-inventories ratio ticked down, but remains elevated, suggesting that there is more upside for industrial production in the coming months. Chart 3Equity Technicals: Mixed Message Equity Technicals: Mixed Message Equity Technicals: Mixed Message Chart 4Positive Economic Momentum Positive Economic Momentum Positive Economic Momentum In addition, as highlighted in our January 16 Weekly Report, conditions are ripe for a rebound in consumer spending.5 As confidence in the employment backdrop rises, the likelihood for a lower savings rate improves. Indeed, the January employment report, released on Friday, surprised to the upside, as non-farm payrolls grew by 227 000 (Chart 5). Despite the strong payrolls growth, the unemployment rate ticked higher to 4.8% due to an increase in the participation rate and average hourly earnings increased by a meager 0.1% m/m. Still, we expect that wages will rise as the labor market steadily tightens and Fed policymakers will focus primarily now on wage and price inflation to guide them on the appropriate pace of rate hikes. To this end, more policymakers are making the case that the economy is at full employment. In a speech in mid-January, San Francisco Fed president Williams argued that the economy has achieved full employment and that the economy only needs to create about 80 000 jobs to keep up with labor force growth.6 The implication is that with an average monthly payroll of 180 000, job creation will quickly put downward pressure on the unemployment rate. The San Francisco Fed has introduced a new, "Non Employment Index"7 which attempts to correct for the structural decline in participation (Chart 6). To construct the index, researchers treat everybody in the population as potentially in the labor force and construct a broader unemployment rate-a "non-employment index." This measure incorporates the unemployed and nonparticipants alike, based on their respective tendency to find jobs. They argue that when one carefully accounts for the availability of nonparticipants this way, the resulting broad non-employment index is consistent with a labor market at full strength. As the top panel of Chart 6 shows, even accounting for participation in this way, the non-employment index gives a very similar message to the standard unemployment rate. Chart 5Solid Employment Fundamentals Solid Employment Fundamentals Solid Employment Fundamentals Chart 6Full Employment = Wage Pressures Full Employment = Wage Pressures Full Employment = Wage Pressures The bond market is currently priced for two rate hikes later this year. We agree with this assessment, though view any surprises to the upside. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The latter have less legal weight than an executive order but serve as guidelines for the priorities of government. 2 Please see BCA Geopolitical Strategy Weekly Report "The 'What Can You Do For Me' World?," dated January 25, 2017, available at gps.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 23, 2017, available at usis.bcaresearch.com 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017, available at usis.bcaresearch.com 5 Please see U.S. Investment Strategy Weekly Report "U.S. Consumer: The Comeback Kid," dated January 16, 2017, available at usis.bcaresearch.com 6 http://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2017/january/looking-back-looking-ahead economic-forecast/?utm_source=frbsf-home-president-speeches&utm_medium=frbsf&utm_campaign=president-speeches 7 https://www.richmondfed.org/research/national_economy/non_employment_index

Highlights The DXY correction has a bit more to run as G10 economic surprises are likely to roll over. EM-related plays like commodity currencies can rally for a few more months, but the outlook for 2017 is troublesome. China is at risk of a deceleration. Global liquidity is tightening. Protectionism is rising. Feature Dollar Correction: It Ain't Over 'til It's Over Can the dollar correction advance further, or is the dollar bull market about to resume? We prefer to position ourselves for additional dollar weakness in the coming months. Despite persistently high bond yields, the DXY is still softening. It is being dragged down by a euro supported by strong economic news such as this week's Belgian business confidence, our favorite bellwether for the euro area. The pound too continues to show some vigor, which is also a byproduct of economic data pointing toward better growth (Chart I-1). We expect the support for the greenback from higher Treasury yields to be temporary. Momentum in U.S. 10-year government bond yields is driven by G10 economic surprises (Chart I-2). Currently, economic surprises are flirting with the upper end of their distribution of the past 12 years. Chart I-1The British Economy Is Picking Up The British Economy Is Picking Up The British Economy Is Picking Up Chart I-2G10 Economic Surprises Drive Treasury Yields G10 Economic Surprises Drive Treasury Yields G10 Economic Surprises Drive Treasury Yields Accentuating the odds of a rollover in surprises are two factors: First, as bond yields and risk-asset prices attest, investors are revising their growth expectations upward, lifting the hurdle for data to surprise to the upside. Second, having expanded for 10 months, the global credit impulse has experienced its longest upswing in a decade. Yet, the increase in global borrowing costs, along with the widening in cross-currency basis swap spreads, points to tightening global liquidity conditions, a poison for the credit cycle (Chart I-3). As credit slows, the economy will deteriorate. Chart I-3The Credit Cycle Is Stretched The Credit Cycle Is Stretched The Credit Cycle Is Stretched This means that the key factor that has supported the stronger dollar in recent months - higher U.S. yields - will begin to dissipate, putting downward pressure on the USD. Finally, our dollar capitulation index, after hitting overbought conditions, is now falling. Moreover, it currently stands below its 13-week moving average, conditions under which the greenback has recorded an average 8.1% annualized weekly loss since 1994, and an average 5.3% annualized weekly loss since 2011 (Chart I-4). Chart I-4Negative Momentum For The Dollar Negative Momentum For The Dollar Negative Momentum For The Dollar We continue to play this correction by shorting USD/JPY. As we have pointed out before, USD/JPY remains a function of the level of global bond yields (Chart I-5). Additionally, a negative surprise in global growth is likely to hurt risk assets. To conclude with the favorable backdrop for the yen, the high degree of uncertainty created by the seemingly erratic policy changes of the new Trump administration suggests that equity implied volatility remains too low. After all, we do not know what changes will hit global tax regimes, what the Fed policy will look like, nor how protectionist Trump will really be. Imbedding a premium for these risks will require higher equity implied vols. A higher VIX tends to support the yen against the USD (Chart I-6). Chart I-5USD/JPY And G10 Bond Yields USD/JPY And G10 Bond Yields USD/JPY And G10 Bond Yields Chart I-6The Yen Likes Uncertainty The Yen Likes Uncertainty The Yen Likes Uncertainty Bottom Line: The correction in the dollar should continue, as bond yields still have downside on a one- to three-month basis. The yen remains the best-placed currency to take advantage of these dynamics, especially if risk assets experience a correction. Focus - Emerging Markets and Liquidity: A March To The Scaffold This week, we re-examine our bearish view on emerging markets, a key theme underpinning our bearish stance on commodity currencies. EM assets, and therefore commodity currencies, have outperformed our expectations, reflecting the percolation of previous positive economic surprises in EM relative to the U.S. (Chart I-7). EM and commodity currencies are priced for perfection, with the risk-reversals on EM currencies displaying elevated levels of optimism (Chart I-8). For EM and commodity currencies to rally further, EM economies need to continue to outperform durably. This requires the Chinese economy and the global liquidity backdrop to only improve further. Can this happen? Chart I-7Surprise Beat In EM Versus The U.S. Has ##br##Helped EM And Commodity Currencies Surprise Beat In EM Versus The U.S. Has Helped EM And Commodity Currencies Surprise Beat In EM Versus The U.S. Has Helped EM And Commodity Currencies Chart I-8EM And Commodity Currencies ##br##Priced For Perfection EM And Commodity Currencies Priced For Perfection EM And Commodity Currencies Priced For Perfection While the next month or two may continue to generate generous returns for EM-related plays, the rest of 2017 may not prove as kind. The China Syndrome Let's begin with China. The recent upsurge in metal prices has reflected an improvement in Chinese economic activity (Chart I-9). As we have pinpointed before, the Keqiang index is near cycle highs, and, Chinese railway freight volumes have been growing at their fastest pace since 2010. This situation is unlikely to continue much longer. The upsurge in Chinese commodity intake - metals in particular - has been fueled by a vigorous rebound in Chinese real estate construction. However, Chinese real estate price appreciation has hit dangerous levels, and the authorities are already leaning against it, with the PBoC increasing rates by 10 basis points this week. The roll-over in Chinese real estate activity should deepen Chart I-10), hurting commodity prices - particularly iron ore, steel and copper - and commodity currencies along the way. Chart I-9China's Rebound Explains ##br##The Metals Rally China's Rebound Explains The Metals Rally China's Rebound Explains The Metals Rally Chart I-10The Risk Of A China Real Estate ##br##Slowdown Is Growing The Risk Of A China Real Estate Slowdown Is Growing The Risk Of A China Real Estate Slowdown Is Growing Moreover, some of the upswing in Chinese economic activity was also related to large amounts of fiscal stimulus in that nation. In mid-2015, the Middle Kingdom was inching ever closer to a hard landing, prompting a panicked Beijing to boost fiscal support and to speed up the roll-out of US$1.2 trillion of infrastructure public-private partnerships. Today, this fiscal hand-out is fading (Chart I-11). This could once again cause industrial activity and investments to weaken as Chinese capacity utilization remains near recession troughs. The recent disappointing investment growth reading in the latest Chinese GDP release could be a harbinger of this reality. Finally, as we have highlighted last week, Chinese monetary conditions have massively improved as Chinese producer-price inflation rebounded, pushing down Chinese real rates in the process. However, with commodity price inflation set to slow - courtesy of a dissipating base effect and of last year's dollar rally - Chinese PPI should roll over, pulling up real rates and tightening monetary conditions (Chart I-12). A tightening in Chinese monetary conditions represents a big problem for EM as it portends a slowdown in economic activity (Chart I-13). This will ultimately lead to a big drag on DM commodity producers, as EM commodity intake decreases, pushing down the likes of the AUD, CAD, and NZD as their terms of trade suffer. Chart I-11Fading Chinese##br## Fiscal Stimulus Fading Chinese Fiscal Stimulus Fading Chinese Fiscal Stimulus Chart I-12Commodity Inflation Will Peak, ##br##So Will Chinese Inflation Commodity Inflation Will Peak, So Will Chinese Inflation Commodity Inflation Will Peak, So Will Chinese Inflation Chart I-13Tightening China Monetary Conditions##br## Will Hurt EM Economic Activity Tightening China Monetary Conditions Will Hurt EM Economic Activity Tightening China Monetary Conditions Will Hurt EM Economic Activity Bottom Line: In early 2016, global markets were not positioned for a rebound in Chinese economic activity. Yet, Chinese industrial activity improved, resulting in a rebound in EM assets, commodity prices, and commodity currencies. The crackdown on real estate activity, the removal of Chinese fiscal stimulus, and the expected tightening in Chinese monetary conditions should result in a reversal of these trends, hurting commodity producers and their currencies in the process. Global Liquidity In Retreat While China represents a problem for EM plays and commodity currencies, deteriorating global liquidity could prove an even stronger hurdle. Our tactical expectation of a lower dollar and lower rates may support EM plays temporarily, but the cyclical outlook remains grim. To begin with, EM economies are dependent on global liquidity as they run a current account deficit expected to hit US$140 billion in 2017, or US$400 billion if China is excluded. Moreover, they sport large external debts of US$4.8 trillion, excluding Taiwan and China. Especially worrisome are the large funding requirements of many EM countries, especially for Turkey, Malaysia, and Colombia. (Chart I-14). Chart I-14EM Debt Vulnerability Ranking Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism Why is this a problem? Two reasons: Global Interest rates and the dollar. Global Interest rates, driven by higher Treasury yields, are rising as the U.S.'s economic slack vanishes, suggesting that the current tightening campaign by the Fed will be durable (Chart I-15). Higher U.S. rates lift the U.S. dollar against EM currencies, tightening EM liquidity conditions. But an unrelated shock is also putting exogenous upward pressure on the dollar. This force is the widening in LIBOR spreads (Chart I-16). This is the result of the regulation-related 90% melt down in the asset under management of U.S. prime money-market funds, an important source of global dollar liquidity. Moreover, U.S. banks, with their balance sheets under pressure by the binding constraints of Basel III, have not been able to fill the gap. Chart I-15The Fed has A Green Light To Hike The Fed has A Green Light To Hike The Fed has A Green Light To Hike Chart I-16Stresses In The Libor Market Remain Stresses In The Libor Market Remain Stresses In The Libor Market Remain The end result has been a widening of cross-currency basis swap spreads, which usually tends to boost the dollar (Chart I-17). This phenomenon increases the hedging costs to foreign investors of holding U.S. dollar assets. These investors become increasingly tolerant of purchasing U.S. assets unhedged, pushing up the value of the dollar in the process. This is best illustrated by the fact that net portfolio investments in the U.S. moved from a deficit of US$300 billion in Q1 2015 to a surplus of more than US$550 billion. Yet, hedges put in place, as approximated by the BIS's volume of OTC FX derivatives, have flat-lined since 2013 (Chart I-18). Chart I-17Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Chart I-18Hedging Activity is Receding Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism A rising dollar and LIBOR stresses are tightening global dollar liquidity, creating a big problem for EM. Wider-than-normal cross-currency basis swap spreads have been associated with declining global trade (Chart I-19). The stronger dollar plays a role, as it hurts the price of globally-traded good prices. Also, higher borrowing costs result in a mild disintermediation of global trade flows. As physical exports are 26% of EM GDP versus 13% for the U.S., this represents a huge drag on EM currencies, especially versus the USD. As a corollary, it is also a problem for the small open commodity producing DM economies like Australia, Canada, or New Zealand. Furthermore, the strength in the dollar associated with LIBOR shocks further hurts EM domestic economies by impeding EM credit growth (Chart I-20). The combined assault of a stronger dollar and higher rates increases the cost of EM foreign debt. Also, according to the BIS, between 2002 and 2014, 55% of EM commodity producers' debt issuance has been in USD.1 When the dollar rises, they see both their borrowing costs rise and the prices of the products they sell fall. Altogether, these forces preempt capex and credit accumulation in EM nations. Chart I-19Tightening Global Liquidity##br##Is Bad For Trade Tightening Global Liquidity Is Bad For Trade Tightening Global Liquidity Is Bad For Trade Chart I-20A Stronger Dollar Will Hamper##br## EM Credit Growth A Stronger Dollar Will Hamper EM Credit Growth A Stronger Dollar Will Hamper EM Credit Growth Bottom Line: The global liquidity backdrop is deteriorating. DM rates are rising cyclically, which is lifting the dollar. Moreover, a global dollar shortage is also supporting the greenback, further hurting EM liquidity conditions. Thus, we expect EM growth to deteriorate, hurting EM assets and commodity currencies. Protectionism The final issue affecting EM economies is the rise of protectionism, especially in the United States. EM - Asia and China in particular - have been the main beneficiaries of globalization (Chart I-21). Currently, they are in the line of sight of President Trump. Thus, we expect that any potential trade war between the U.S. and the rest of the world will focus on EM economies and China. Chart I-21EM And Asia Are In Trump's Line Of Sight Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism EM are much more dependent on the U.S. than the other way around. As an example, China's exports to the U.S account for 3.5% of Chinese GDP, while U.S. exports to China account for less than 1% of U.S. GDP. EM economies have a lot more to lose from a trade war than the U.S. Because of this imbalance in relative trade-exposures, EM economies are at risk from the border-adjustment tax being discussed in the U.S. These taxes would be very deflationary for EM economies as they could force a downward adjustment in EM labor costs and further depress capex in these nations. To ease these adjustments, falling EM exchange rates would be required. Once again, commodity currencies would suffer from these developments. First, lower capex in EM hurts Australian, New Zealand, or Canadian terms of trade. Second, lower EM exchange rates means that that exports from the dollar bloc to EM would suffer. Finally, and most perversely, lower EM exchange rates will give EM commodity producers an advantage versus DM producers, in that a stronger U.S. dollar means their local-currency costs are falling. EM commodity producers would keep producing more than warranted, putting additional downward pressure on commodity prices and stealing market shares from the dollar bloc producers. This is not a pretty picture. Bottom Line: EM should bear the brunt of the pain of any rise in U.S. protectionism. The tight link between EM economies and DM commodity producers suggests that this pain should adversely affect the AUD, the CAD, and the NZD. Risks To Our View Chart I-22Chinese Tariffs Are Falling Chinese Tariffs Are Falling Chinese Tariffs Are Falling The biggest risk to our view is a redoubling of Chinese fiscal stimulus. The threat of U.S. tariffs and trade sanctions is obviously deflationary and negative for the Chinese economy. We know this, as do the relevant powers in Beijing. A tool to mitigate any of these negative repercussions on the Chinese economy might be for Beijing to press on the gas pedal once more. Additionally, as our colleague Yan Wang wrote in this week's China Investment Strategy, key members of the new U.S. administration have been on record saying that the threat of tariffs is not an end game, but rather a negotiating tool to extract concessions from U.S. trade partners, implying a potentially more pragmatic stance from the U.S. than current rhetoric suggests.2 Moreover, the Chinese side of the negotiation table is also more open minded than most observers fear. China has been cutting its own tariffs and could continue to do so (Chart I-22). Moreover, Premier Li Keqiang has made a new pledge to move faster toward opening and liberalizing Chinese markets for access by foreign companies. A deal may be less elusive than feared. Finally, regarding the global liquidity deterioration, the recent rebound in gold and silver prices may be a harbinger of improving liquidity conditions globally. We doubt that the economic situation will let this rally be durable, but it remains something to monitor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Bruno Valentina, and Hyun Song Shin, "Global Dollar Credit And Carry Trades: A Firm-level Analysis", BIS, Working Papers, August 205. 2 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard", dated January 6, 2017, available at cis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed this week. The labor market saw both continuing and initial jobless claims rise above expectations. However, the economy is still near full employment and the Fed will not respond to this news. Furthermore, the Beige Book, released last week, also highlights that the U.S. economy remains resilient with employment and pricing activity particularly strong. This week the DXY broke through the key 100 level, as the market continues to reprice capricious assumptions of Trump's policies. Nevertheless, it has rebounded since then. The dollar is unlikely to see any real movement until the administration releases concrete information about its policies. For the time being, the Fed also seems to be on the sidelines in anticipation of more information. Report Links: U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Although the euro area has seen a brighter economic environment as of late, this week's data has been mixed: German and overall euro area services and composite PMI underperformed, while manufacturing PMI outperformed consensus. The IFO Business Climate and Expectations both underperformed consensus, while the Current Assessment remained in line with consensus. All measures still remain over 100. Finally, Belgian Business Confidence accelerated sharply. The ECB is unlikely to change its dovish stance. The euro will therefore see little upside. The recent uptrend in EUR/USD is due to dollar weakness, but the recent downtrend in EUR/GBP and EUR/SEK indicate that the market is not necessarily hopeful that the ECB will reach its inflation target anytime soon. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data indicates that last year's sharp depreciation of the yen is helping the Japanese economy: Exports increased by 5.4% YoY, crushing expectations of 1.2% growth. Nikkei Manufacturing PMI reached 52.8, also beating expectations. In November machinery orders grew by more than 10% YoY. The BoJ will be more resolute on its radical monetary measures, as recent data shows that their approach is working. This will prove very bearish for the yen on a cyclical basis, given that the cap in Japanese rates will cause the rate differential between the U.S. and Japan to widen. In the short term, USD/JPY will resume its correction. We estimate that USD/JPY will cease to be attractive as a short opportunity at around 110. Report Links: Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 On Tuesday, the Supreme Court upheld the decision of the High Court, requiring a parliamentary vote to authorize the exit of the U.K. from the European Union. This news is an added boon for cable, which has surged by almost 5% after bottoming at 1.20 about 10 days ago. As political risks start to dissipate, and the currency trades more on economic fundamentals, the pound should become a more attractive buy, particularly against the euro, given that the U.K. economy should outperform the market's dismal expectations. Recent data supports this view: Average earning growth outperformed expectations in November. GDP growth was 2.2% YoY in Q4, also outperforming expectations. Furthermore, short-term technicals point to a stronger pound. EUR/GBP has broken through its 100-day moving average, which indicates that momentum should continue to drive this cross downwards for the time being. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Two weeks ago, we argued that the rally in AUD lacks fundamental domestic causes. This week, the momentum of the recent AUD rally, caused by rising iron ore and copper prices, has seemingly paused. Exacerbating this change of pace is recent data which indicates a weak economic backdrop: the RBA trimmed mean CPI, and the more common CPI measure, underperformed consensus at both a quarterly and yearly pace. This could be due to depressed consumer sentiment, as the labor market remains mired in a slump, with the unemployment rate increasing to 5.8%, and total hours worked falling. Given recent data, it is likely that markets reprice growth prospects in Australia. U.S. trade policies could also potentially curtail global trade, painting a bearish picture for AUD. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The Kiwi has appreciated 4.4% since the start of 2017. Although this rally might eventually be limited against the U.S. dollar, the NZD will likely have more upside against its crosses, particularly the AUD. Indeed it seems that low inflation, one of the only sore spots for the RBNZ in an otherwise stellar kiwi economy, has turned the corner, surging to 1.3% on the latest reading Wednesday. More importantly, not only did inflation beat expectations but it also surpassed 1% for the first time since 2014. This is a significant development, given that persistently low inflation in New Zealand was keeping the dovish bias of the RBNZ. With this hurdle gone, and an economy that continues to be the best performing in the G10, this dovish bias should disappear, which will ultimately lift the NZD against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Despite the dissipating oil slump, potential risks may weigh on Canada's future. These risks are likely to emanate from an international sphere. Key concerns revolve around U.S. policies: recent statements have increased yields and tightened financial conditions, but global trade worries are not fully priced in. Recent news indicates that Trump has no ill-intentions aimed at Canada, however, protectionist policies could hurt global trade, indirectly curtailing Canadian exports. A U.S. corporate tax cut can also deviate investment from Canada to the U.S. The recent appreciation in the CAD against major currencies can also hurt Canadian competitiveness going forward. As oil is likely to remain relatively stable in the near future, we may again see a disassociation of CAD with oil, and a continued tight relationship with interest rate spreads. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Yesterday, EUR/CHF fell below the crucial 1.07 level. As we have recommended many times, any time that this cross falls below this threshold, it becomes an excellent buying opportunity. The SNB has not been shy to intervene in the currency markets, and they have been very clear that they will not tolerate any currency strength past a certain threshold as it could add additional deflationary pressures to an economy that has not had a positive inflation rate since 2014. We have identified a level of 1.07 for EUR/CHF as this threshold. Moreover given that the euro is the currency of reference for interventions, the behavior of USD/CHF should roughly mirror the behavior of the dollar against the Euro. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The Norwegian Krone has rallied along other commodity currencies so far this year, in spite of the meek performance of oil over this timeframe. This surge might prove unsustainable in the short term, as USD/NOK is very close to oversold territory. In the long term, the outlook for the NOK is more positive, particularly against other commodity currencies. Rising oil prices resulting from the OPEC cuts should supercharge the already high inflationary pressures in the Norwegian economy. This factor will eventually push the Norges Bank off its dovish bias, and the NOK higher in the process. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Swedish economy seems to be finally benefitting from last year's weaker krona; PPI numbers came in at 2.1% MoM, and 6.5% YoY, higher than previous numbers. This will feed into CPI in the near future. Additionally, 1-year, 2-year, as well as the important 5-year Prospera Inflation Expectations have all picked up, with the 5-year at 2%, in line with the Riksbank's target. The bank is aware of the krona's recent strength against major currencies, and realizes that it is important that the appreciation slows. In the short term, the SEK could continue to rally on the back of the dollar's correction and the Swedish economic outperformance vis-à-vis the euro area. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades