Regulation

Highlights BCA's view is that while a major trade war is unlikely, trade tensions will persist. The Fed, not protectionism, will end the cycle. There have been five episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policy were all aligned to boost the U.S. economy. The March Beige Book keeps the Fed on track to hike four times this year. Feature The Trump Administration's announcement last week to slap hefty tariffs on steel and aluminum runs the risk of provoking a "tit-for-tat" trade war. This proposed levy follows a similar move earlier this year to impose tariffs on washers and solar panels. The EU has retaliated with a threat to introduce tariffs on Harley Davidson motorcycles and Levi's jeans. Even if a trade war develops, our Global Investment Strategy team notes1 that the U.S. would suffer less in a trade war than other nations, and that higher tariffs may lead to more domestic demand, a more aggressive Fed and a stronger dollar. Certainly, the tariff issue does not signal the end of the U.S. economic expansion or equity bull market. BCA's view is that while a major trade war is unlikely, trade tensions will persist. Our Geopolitical Strategy service states2 that investors should closely monitor bellwether factors for trade policies, including Trump's position on NAFTA, exemptions granted on the steel and aluminum tariffs to countries (such as Mexico and Canada) and most importantly, the treatment of intellectual property trade with China. Bottom Line: The end of the equity bull market will probably be due to an overheated U.S. economy and rising financial imbalances, and not escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Policy Panacea The backdrop for U.S. economic growth remains solid. Consensus global GDP projections for 2018 and 2019 have perked up, in contrast with prior years when forecasters issued relentless lower GDP estimates (Chart 1). Moreover, global exports growth is in a persistent uptrend since the earlier part of 2016 (Chart 2). Chart 1U.S. & Global Growth Expectations Are Still Accelerating U.S. & Global Growth Expectations Are Still Accelerating U.S. & Global Growth Expectations Are Still Accelerating The surge in global growth occurs even as China's economy is poised to slow. Among the components of BCA's Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang), all six series are in a downtrend, and five fell in January (the growth in M2 was the exception).3 Although China's economy is decelerating, BCA's view is that a repeat of the late 2015/early 2016 shock is unlikely (Chart 3). Chart 2Global Exports##BR##Are Booming... Global Exports Are Booming... Global Exports Are Booming... Chart 3Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth In China bca.usis_wr_2018_03_12_c3 bca.usis_wr_2018_03_12_c3 The U.S. economy and financial markets will benefit from the uptick in global growth, a large dose of fiscal policy, still accommodative monetary policy, and a decline in regulation. Table 1 and Chart 4 show that there have been four other junctures in the past 35 years when these factors all pulled in the same direction to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. All four previous periods occurred closer to the start and not the end of a business cycle; BCA's stance is that the U.S. economy is in the late stages of an economic expansion that began in 2009. These phases lasted, on average, for just under two years. The current phase is entering its third year. The longest was in the early 2000s (2002-2004), while the shortest was a 14-month interval in the first year of the 1991-2001 economic expansion. Three of the prior four periods ended as fiscal policy turned restrictive. In the early 1980s' chapter, a reversal in global IP signaled the end of the growth sweet spot. Performance Of U.S. Financial Assets, Gold, Oil And Earnings When Global Growth Is Increasing Alongside Stimulative Monetary, Fiscal And Regulatory Policy .... Policy Line Up Policy Line Up Chart 4Global Growth, Fiscal, Monetary And Regulatory Policy##BR##All Pulling In The Same Direction Global Growth, Fiscal, Monetary And Regulatory Policy All Pulling In The Same Direction Global Growth, Fiscal, Monetary And Regulatory Policy All Pulling In The Same Direction Not surprisingly, risk assets perform well during these "tailwind" points (Table 1 again and Chart 5). The S&P 500 rose in the previous four periods and again in the current one. However, BCA's stock-to-bond ratio fell in the early 1990s and early 2000s. Credit tends to outperform Treasuries when monetary, fiscal and regulatory policy are synchronized, and small caps outperform large. This is the case in the current episode that began in January 2016. Gold and oil also perform well when global growth is surging, fiscal and monetary policy is stimulative and regulations are on the wane. However, on average, the dollar falls during these intervals as demonstrated in the early 2000s and early 2010s. S&P 500 earnings growth is solid and well above average during these phases. Chart 5U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push Table 2 shows that U.S. risk assets tend to struggle in the year after these legs end, but the economy keeps flourishing. Stocks underperformed bonds a year after the end of two of the four periods, but none of those periods coincided with a recession. Investment-grade and high-yield credit underperforms Treasuries in the ensuing 12 months, while small caps struggle to keep up with large. Gold performs well in three of the four periods, but oil posts a mixed performance. The dollar rises and S&P 500 earnings per share increase in the year after stretches of synchronous policy, but at a much slower pace than when the stimulative fiscal policy, deregulation and easy monetary policy are all in place. Table 2... What Happens In The 12 Months After These Episodes End... Policy Line Up Policy Line Up Tighter Fed policy will end the current era of pro-growth policies. BCA's stance is that the Fed will raise rates four times this year and another three or four times next year, pushing monetary policy into restrictive territory. U.S. fiscal policy will likely add to growth into the next year, thanks to tax cuts and the lifting of spending caps, and Trump will continue to look for deregulation opportunities. Bottom Line: Fed tightening will end the latest era of deregulation, easy monetary policy and stimulative fiscal policy, but not until early next year. Until then, a favorable backdrop will persist for stocks over bonds, credit, S&P 500 earnings and oil. Stay long stocks and credit, and underweight duration. This forecast assumes that the trade spat does not degenerate into a trade war. If that occurs, we would recommend reducing our overweight to risk assets sooner than early next year. Beige Book: More Tailwinds Fed Chair Powell's February 27 testimony to Congress noted that "some of the headwinds the U.S. economy faced in previous years have turned into tailwinds."4 The Beige Book released on March 7 highlights many of those tailwinds, keeps the Fed on track to boost rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach5 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market. Furthermore, the disconnect between the Beige Book's view of inflation and the market's stance has eased. Moreover, references to a stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and Trump's assault on regulation. The latest Beige Book ran from mid-January to February 26 and, therefore, did not capture the business community's reaction to the tariff announcement in early March. Chart 6, panel 1 shows that at 67% in March, BCA's Beige Book Monitor stayed near its cycle highs, which reconfirms that the underlying economy was upbeat in early 2018. The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 15 mentions of the tax bill in the March Beige Book, up from 12 in January and only 3 in November 2017 (not shown). The tax bill was cast in a positive light in 87% of the remarks in March versus 75% in January. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Chart 6Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation And Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy Based on the minimal references to a robust dollar in the past six Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018. This sharply contrasts with 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6, panel 4). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. Business uncertainty over government policy (fiscal, regulatory and health) multiplied in the past few Beige Books as Congress debated the tax bill. However, in general, these comments have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 6, panel 5). However, the controversy associated with the tariffs on steel and aluminum will add to business unease in the coming months unless Trump reverses his position. The disagreement between the Fed and the market on inflation narrowed in the March edition of the Beige Book (Chart 6, panel 3). The number of inflation words in the Beige Book rose to an 8 month high in March, reflecting the abrupt change in sentiment on inflation in early 2018 both in the business community and the market. In the past year, inflation words in the Beige Book climbed as the readings on CPI and PCE rolled over. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The March Beige Book supports BCA's view that the U.S. economy is poised to expand above its long-term potential in the first half of 2018. Moreover, the elevated soundings on inflation in the Beige Book in recent years have again proved prescience, as price measures are poised to turn higher. While the first few Beige Books in 2018 showed that the business and financial communities welcomed tax cut legislation, the next edition will likely reflect elevated concern over the nation's trade policies. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Trump's Tariffs: A Q&A", published March 9, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Client Note "Market Reprices Odds Of A Global Trade War", published March 6, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation", published March 7, 2018. Available at cis.bcaresearch.com. 4 https://www.federalreserve.gov/newsevents/testimony/powell20180226a.htm 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," published April 17, 2017. Available at usis.bcaresearch.com.

Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Rising U.S. Inflation Expectations Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Fiscal Policy Gets Expansive Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Populism Will Fuel Fiscal Spending Beyond The U.S. Populism Will Fuel Fiscal Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Chart 6Lots Of Bonds Hitting The Private Market Lots Of Bonds Hitting The Private Market Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Democrats Have Lost Some Steam Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years U.S. Polarization Has Risen For 60 Years U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming EM Economies Underperforming EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress Yen Carry Trades Signal Distress Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Li Keqiang Index Surprises Downward Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... China's Economy Weakens... China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates ...While Policy Drives Up Interbank Rates ...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... January Credit Growth Disappoints... January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Crackdown On Shadow Lending Has Teeth Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Market Expects No Political Volatility Yet Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? Has China Halted Its Version Of The VIX? Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Monetary Policy May Not Tighten From Here Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Tighter-Fisted China Will Hit EM Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Weak Inflation And Dollar Drove EM Assets Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma Market Likes Ramaphosa, Unlike Zuma Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chronic Youth Unemployment Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population Few Gains In Middle Class Population Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity A Distant Laggard In Productivity A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Twin Deficits A Structural Weakness Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.

Highlights While bullish sentiment for copper remains high, concerns that policymakers' attempts at a managed slowdown in China this year goes too far will weigh on the market. Fundamentally, support for copper prices from potential supply shortfalls at both the mining and refining levels will be offset by a stronger USD and slower growth in China this year (Chart of the Week). Despite our expectation a slight physical supply deficit will emerge this year, we remain neutral copper. We do not believe this will be enough to rally prices in a meaningful way. Energy: Overweight. Ministers from Saudi Arabia and Russia confirmed OPEC 2.0 - the oil-producer coalition led by these states - will survive beyond the expiry of their production-management deal at the end of this year. What and how they will manage the production of coalition members, however, remains unknown. Base Metals: Neutral. Positive fundamentals for copper are at risk if the USD rallies on the back of Fed tightening this year or China's managed economic slowdown is too severe (see below). Precious Metals: Neutral. Gold prices remained well bid, despite expectations for three or four Fed rate hikes this year, suggesting the market is pricing in either fewer rate hikes and lower real rates, or geopolitical risk - most prominently in Venezuela or North Korea. We remain long gold as a strategic portfolio hedge. Ags/Softs: Underweight. Soybean has been gaining ground on concerns about yield damage due to droughts in parts of Argentina. Expectations of a bumper year for Brazil will mitigate the impact on global supply. Feature Bullish copper sentiment is at a multi-year high, with four bulls for every bear in the market (Chart 2). The strong global economy, weak USD, and elevated risk of further supply-side disruptions - at mines as well as at the refining level - are feeding into buyers' optimism. Chart of the WeekChina Fears Weighing##BR##On Copper Prices China Fears Weighing On Copper Prices China Fears Weighing On Copper Prices Chart 2Bullish Sentiment Remains##BR##At Multi-Year Highs Bullish Sentiment Remains At Multi-Year Highs Bullish Sentiment Remains At Multi-Year Highs Our outlook for 2018 calls for another, albeit smaller, refined copper deficit (Chart 3). This will come on the back of escalated risks from supply side disruptions at mines in Chile and Peru, and potential constraints on primary and secondary refined output from China, the largest refined copper producer (Table 1). Chart 3A (Smaller) Deficit##BR##In 2018 A (Smaller) Deficit In 2018 A (Smaller) Deficit In 2018 Table 1China Is Significant For##BR##Copper Supply And Demand Stronger USD, Slower China Growth Threaten Copper Stronger USD, Slower China Growth Threaten Copper China also is the world's largest refined-copper consumer, which makes the risk of a more severe downturn in China arising from too much policy-driven restraint in the metal's top consumer acute. In the following sections, we present our expectations for the fundamentals: copper mine output, refined copper production, and refined copper consumption. Industrial Action Will Threaten Mine Output Again In 2018 Copper had an exceptional year in 2017. The synchronized global upturn and weak USD set the stage for a memorable performance. On the supply-side, disruptions at some of the world's largest mines pushed prices up 8% in 1H17. Although the risk of further production shocks had subsided by 2H17, copper gained another 22% on the back of restrictive Chinese scrap import policies and better than expected demand fundamentals. Last year, the copper market registered a physical deficit, mainly on the back of a decline in copper mine supply. A 0.3% yoy fall in copper ores and concentrate output in the first eleven months of the year kept production broadly unchanged compared to the same period last year. In fact, this was the first yoy decline for that period since 2002, and contrasts with an average 5% expansion in ore and concentrate output for that period since 2012 (Chart 4). The most notable supply side disruptions last year were: Chart 4Supply Disruptions Put##BR##Copper In Deficit Last Year Supply Disruptions Put Copper In Deficit Last Year Supply Disruptions Put Copper In Deficit Last Year A 9% yoy decline in output from top producer Chile in 1H17. Chile accounts for more than a quarter of global ore & concentrate supply. The decline is a result of strikes at the Escondida mine as well as lower output from Codelco mines. The Indonesian government's ban on exports of copper ores in the first four months of the year led to a 6% yoy decline in production in the first eleven months. U.S. output, which accounts for~7% of global copper ores & concentrates supply is down 12% yoy in the first eleven months of 2017. In fact, the last time the U.S. recorded a positive yoy growth rate was in October 2016. The decline in U.S. output came mainly on the back of lower grade ores, a fall in mining rates, and poor weather conditions. The majority of these disruptions occurred in 1H17 - the first five months of the year witnessed a 1.6% yoy fall in output, while the Jun-Oct period experienced a 0.7% yoy increase. Nonetheless, the ramp up in second part of the year is significantly slower than the 6% yoy and 5% yoy increases in the same period in 2015 and 2016. Global supply was partially supported by Peruvian and European production. Peruvian output grew 3.6% yoy in the first eleven months of the year. However this rate is dwarfed in comparison to previous years. Output grew almost 40% yoy in 2016 and 23% yoy in 2015. Similarly, European output - which accounts for 8% of global supply - seems to be continuing its uptrend. It expanded by 2.4% in the first eleven months of 2017 to record the highest level of output for that period. In fact, growth in output is above the average 0.8% yoy pace in the same period in 2014-2016. We expect a small rebound in mine production in 2018. According to the International Copper Study Group, temporarily shut down capacity in the Democratic Republic of Congo (DRC) and Zambia will resume operations, supporting mine supply this year. Supply-side disruptions pose a significant risk to mine supply again this year. An estimated more than 30 labor contracts, representing ~5mm MT of mined copper - a quarter of global production - will expire this year.1 While surely not all of these negotiations will result in strikes and supply disruptions, the figure is noteworthy as it is significantly above the average 1.7mm MT worth of annual copper supply at risk from contract renewal between 2011 and 2016. The most significant of these renewals is that which was most damaging last year. The 44-day strike at BHP Billiton's Escondida mine in Chile last year, which resulted in a 7.8% yoy fall at the world's most productive copper mine, ended without agreement. Although the contracts were extended, they are due for renegotiation in June. In fact, one of the unions at Escondida held a day long "warning strike" in November, an indication that they do not intend to back down from their demands. Unless management gives in, this implies a heightened risk of disruptions. Bottom Line: Supply disruptions negatively impacted mine supply in some of the world's top producers in 1H17. Although European and Peruvian supply has been somewhat supportive, global supply stagnated in 2017. Industrial action remains the major risk to mined copper this year. 5mm MT worth of copper ores and concentrates are at risk of supply side disruptions in 2018 - the highest figure since 2010. Environmental Reforms Limit Refined Production From China Chart 5China's Scrap Imports Cushion##BR##Against High Prices China's Scrap Imports Cushion Against High Prices China's Scrap Imports Cushion Against High Prices World refined production grew 1.3% yoy in the first eleven months of 2017, the slowest growth rate for that period since 2009. This reflects significant declines in refined copper production in Chile and the U.S. Supply disruptions at mines in Chile - the world's second-largest producer of refined copper - led to a 182k MT fall in refined output in the first eleven months of 2017, compared to the same period in 2016. Refined output from the U.S. fell by 91.4k MT in that period. However, the downside pressure on refined output from lower ore production was mitigated by increased secondary production from scrap, which accounts for ~20% of global refined copper production. Chinese copper producers took advantage of the oversupply in global scrap and ramped up their production. According to the ICSG global secondary output expanded by almost 10% yoy in the first ten months of last year. China's copper scrap imports increased 9% yoy in the first eleven months of last year, following four years of declines (Chart 5). China makes up less than 10% of global mined copper, but it is the largest producer of refined copper in the world, accounting for 36% of the global production. China is expected to remain the main contributor to world refined production growth (Chart 6). However, Beijing's environmental reforms, and measures to curb the imports of "foreign trash" will limit secondary refined production. Chart 6China Remains Most Significant Factor In Refined Production Growth Stronger USD, Slower China Growth Threaten Copper Stronger USD, Slower China Growth Threaten Copper New policies affecting refined output in China are supportive of copper prices this year: 1. In relation to scrap copper, Beijing recently imposed two policy changes, in line with its environmental reforms. First, since the start of 2018, only copper scrap end-users and processors will be granted import licenses. Second, a proposal to limit the hazardous impurity levels in scrap copper imports to 1% by March. Both these policies will curtail China's scrap copper imports. China imports an estimated 3mm MT of scrap copper annually, accounting for roughly half of its total scrap copper supply. Such limitations would severely dent China's scrap supply. Furthermore, scrap copper imports play a significant role in China. They act as a buffer against high prices, soaring during periods of high prices and dwindling when prices are low - as they were between 2013 and 2016. If China does in fact go through with the tighter regulations on scrap imports, Chinese copper consumers would not be able to fall back on the secondary metal when prices rise - as they have been over the past year - leading to greater demand for imports of primary products, chasing prices higher. However, over the long term, we are likely to see Chinese scrap traders move their businesses offshore, notably in Southeast Asia, where they will process the scrap until it meets the regulations necessary to be imported by China.2 In fact, this has already started to happen in the case of the category 7 scrap - derived from end-of-life electronics, households, cars and industrial products - which is widely believed will be banned by year-end. Nevertheless, these recycling plants do not yet exist. Thus, the transition cannot occur overnight, and we expect the tighter policies on scrap imports to support prices in the interim as China increases its imports of ores and refined copper in order to fill the supply gap. 2. China's environmental reforms also pose a risk on refined supply this year. Smelters and refiners risk being shut down if they do not comply with tighter pollution controls. This could limit copper output this year. Similar to the winter production cuts occurring at steel and aluminum producers, China's second largest copper smelter - Tongling Nonferrous Metals Group - announced plans to reduce its smelter capacity by up to 30% during the winter.3 In addition, late last month, China's largest smelter - Jiangxi Copper Co. - was forced to curb output while local pollution levels were assessed.4 The extent to which these measures are adopted by other producers will interrupt refined output this year. Given the more elevated pollution levels during the winter months, this risk is most notable in the November to March period. Bottom Line: The major risk to refined copper supply is China's environmental reforms which will likely constrain copper scrap imports, and could lead to temporary shutdowns of polluting smelters and refineries. If Beijing tightens these regulations, we are likely to witness disruptions in both primary and secondary refined output, while the copper supply chain readjusts to be able to comply with these policies. Slowdown In China Would Temper Copper World refined copper consumption grew 0.8% yoy in the first eleven months of 2017. Weaker consumption was mainly in the 1H17, during which global consumption fell 1.8% yoy, whereas consumption in the July-to-November period accelerated by 3.9% yoy. Weaker demand in the first half of the year came on the back of weaker demand from China, which accounts for half of global consumption. China recorded a 7.7% yoy fall in consumption of refined copper in the January-to-April period. However, Chinese copper demand subsequently strengthened, accelerating by 7.4% yoy in the May-to-November period. While demand from the rest of the world muted the impact of weaker Chinese consumption in the first half of the year, it weakened in the second half of the year, falling 3.3% yoy in the May-to-October period. This fall in copper demand was driven by a 5.5% yoy fall in the U.S., and to a lesser extent, a 2.0% yoy fall in demand in Japan in the May-to-November period. According to China Customs data, China's refined copper imports fell 5.1% in 2017 after growing 3.7% in 2016 (Chart 7). However, what is noteworthy is that while imports fell 18.3% yoy in H1, they picked up in H2, increasing by 11.3% yoy, mainly on the back of strong demand in Q3. This is in line with strong economic performance in China in 2H17 - an upside surprise which supported copper prices. Going into 2018, we expect a managed deceleration in China - and in China's demand for copper - to be mitigated by stronger demand from the rest of the world. In fact, the IMF revised up its 2018 and 2019 global growth forecasts in the latest WEO Update earlier this week (Table 2). Global growth is now forecast to reach 3.9% in 2018, up from the estimated 3.7% last year. Chart 7China's Q4 Imports Were Strong China's Q4 Imports Were Strong China's Q4 Imports Were Strong Table 2Upward Revisions To IMF Growth Projections Stronger USD, Slower China Growth Threaten Copper Stronger USD, Slower China Growth Threaten Copper Chart 8Speed Bump Ahead For China? Speed Bump Ahead For China? Speed Bump Ahead For China? That said, our China construction Indicator - which includes several variables measuring construction activity in China - shows strong growth in the main end-user for copper (Chart 8). Given that building construction accounts for 43% of copper end-use in China, this indicates demand for copper should remain healthy in the near term. Furthermore, despite concerns of a slowdown, China's manufacturing PMI still points to a healthy economy. Even so, a decline in the Li Keqiang Index, which tracks industrial activity, warrants caution and could be signaling trouble ahead for the Chinese economy. In addition, government spending has decelerated significantly from its mid-2017 peak. Against these risks, the global economy is expected to remain strong. Thus the biggest risk to our assessment is a pronounced deceleration in China which would hit demand for the red metal. Bottom Line: The major risk to refined copper demand this year is a slowdown from China. Downside Risk From A Stronger USD In addition to the fundamental variables highlighted above, U.S. monetary policy - and its effect on the USD - will also be an important driver of the copper market. We expect the Fed to embark on its interest rate normalization process more aggressively this year, hiking its policy rate up to four times. This would see copper prices weaken as the red metal becomes more expensive in USD terms. The USD is significant because a weaker dollar means that dollar-based commodities are cheaper for foreign buyers. Thus, foreigners tend to buy dollar-denominated commodities when the USD is weak, and sell when the USD is strong, in order to also benefit from exchange rate differentials. Continued weakness of the USD has been supportive of copper prices since the beginning of 2017. A risk to our outlook is an unexpectedly dovish Fed, which would keep the dollar muted and be favorable to copper. Bottom Line: We expect the copper market to record a small physical deficit this year. A stronger USD and deceleration in China will prevent a repeat of 2017's performance. However supply side disruptions at the mine and refined levels will provide opportunities for some upside in the market. Synchronized global demand will be a tailwind throughout the year. In the near term, we expect copper to continue gyrating around its current level of $3.10/lb. Absent a marked slowdown in China, we expect a rally into mid-year as contract renegotiations get underway. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see "Copper soars to 4-year high as funds bet on shortages," dated December 28, 2017, available at reuters.com. 2 Please see "As China restricts scrap metal companies look to process copper abroad," dated January 8, 2018, available at reuters.com. 3 Please see "Chinese Copper Smelter Halts Capacity to Ease Winter Pollution," dated December 7, 2017, available at Bloomberg.com. 4 Please see "Copper Rallies to Three-Year High as China Plant Halts Output," dated December 26, 2017, available at Bloomberg.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Stronger USD, Slower China Growth Threaten Copper Stronger USD, Slower China Growth Threaten Copper Trades Closed in 2018 Summary of Trades Closed in 2017 Stronger USD, Slower China Growth Threaten Copper Stronger USD, Slower China Growth Threaten Copper

Highlights Controversial gaffes aside, President Trump has started 2018 by moving to the middle; This comes at a time when animal spirits are reawakening thanks to tax cuts; And the path of least resistance for fiscal policy points towards more profligacy; Meanwhile, Chinese growth is imperiled by structural reform efforts; With money growth and import data showing signs of stress; The combination of upside growth risks in the U.S. and downside growth risks in the rest of the world should revive the U.S. dollar and threaten EM performance in 2018. Feature In just the first two weeks of 2018, U.S. President Donald Trump has: Hosted a meeting on immigration policy with Republican and Democratic leaders during which he said that the upcoming legislation should be a "bill of love," while encouraging congressional leaders to think big and pursue comprehensive immigration reform; Claimed that he has a "very good relationship" with Kim Jong-Un, while refusing to deny that he has already spoken privately with the North Korean leader; Supported bringing back "earmarks" in order to grease the wheels of bipartisanship in Congress - i.e., new spending that allocates funds to specific projects; Extended sanction relief to Iran, albeit with the caveat that it would be the last time he does so without demanding modifications to the Joint Comprehensive Plan of Action (the Iran nuclear deal); Broken with his former chief political strategist Steve Bannon - dubbing him "Sloppy Steve" in the process - while disparaging Bannon's penchant for scorched-earth tactics.1 On the whole, Trump's actions in January suggest a move towards the political center. Meanwhile, the media and political opponents continue to dwell on Trump's alleged comments where he disparaged immigrants from certain countries, obscuring the subtle shift in political strategy. What would be the reason for a Trump shift to the middle? As we wrote last week, the Pocketbook Voter Theory in political science suggests that Trump's Republican Party should be benefiting from a surge in popular support amid strong economic data and record-setting market performance.2 However, the 2018 generic congressional ballot still points to a very challenging midterm election for the Republican Party (Chart 1). Trump has two choices. First, he can ignore the poor GOP polling, as well as his own (Chart 2) in the face of stellar economic performance, and plow into an electoral disaster. This would make him the earliest "lame duck" president in recent U.S. history. As we wrote in December, this choice is a serious market risk for investors.3 Lame duck presidents have often sought relevancy abroad, given the lack of constitutional constraints to executive action in the foreign policy realm. In the case of Trump, we could think of three avenues by which he might increase geopolitical risk premiums: Protectionist policies towards China, the abrogation of NAFTA, or military tensions with Iran. Chart 1History Favors The Opposition History Favors The Opposition History Favors The Opposition Chart 2Trump Is Extraordinarily Unpopular Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China The second option for President Trump is to move to the middle ahead of the midterms. This would be unexpected in every way other than that Trump is the master of the unexpected. We happen to agree with his supporters that he is a political genius. Unless, that is, he continues to waste an extraordinary bull market, strong economy, and soaring consumer/business confidence by refusing to woo the median voter. What would a shift towards the center mean for the equity market? First, the already low probability that domestic political intrigue will upend the ongoing rally would get even lower in a world where Trump moves to the center. Second, the risk of market-moving geopolitical risks prompted by White House policy would decline as Trump would presumably seek and follow the advice of his establishment advisers. In other words, it would be pure nectar for the already buoyant markets. This is not to say that there would not still be reason for a pullback in U.S. equities. The bull-bear ratio is dangerously high (Chart 3), and consumer confidence is ominously stretched (Chart 4). Chart 3Investor Bullishness Is At Record High... Investor Bullishness Is At Record High... Investor Bullishness Is At Record High... Chart 4...And So Is Consumer Confidence ...And So Is Consumer Confidence ...And So Is Consumer Confidence U.S.: Business Owners Are Republican While some of our clients in the financial community may fret about Trump's unorthodoxy, our clients in the corporate world clearly do not. This is not merely an offhand observation, it is an empirical fact (Chart 5). America's business leaders have given President Trump the benefit of the doubt since he was elected. Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business (NFIB), which publishes the Small Business Optimism survey, went on to comment this month: "we've been doing this research for nearly half a century ... and I've never seen anything like 2017 ... The 2016 election was like a dam breaking."4 It is dangerous, therefore, to be overly mathematical about U.S. growth prospects in 2017. While we agree with our colleague Peter Berezin that, on face value, the strict growth impact of the tax cuts may merely add 0.3% of GDP growth in 2018, the qualitative impact of unleashing animal spirits is incalculable.5 The risk to growth in the U.S. is therefore very much tilted to the upside. First, as we discussed in a Special Report published with our U.S. Equity Strategy colleague Chris Bowes, a crucial, yet under-reported change in the corporate tax bill allows the immediate expensing of capital investment.6 Most market observers have overlooked this part of the legislation as it is simply a shift in the "time value of money." The IRS already allows significantly accelerated depreciation of capex; this reform merely brings it forward. Our analysis, however, suggests that the impact of bringing it forward could, at the margin, change spending behavior for firms and drive the next upleg in capex. This comes at a time when the prospects for business investment are already positive (Chart 6).7 Chart 5Business Owners Are Depressed When##br## Democrats Control The White House Business Owners Are Depressed When Democrats Control The White House Business Owners Are Depressed When Democrats Control The White House Chart 6Animal Spirits Will ##br##Spur CAPEX Animal Spirits Will Spur CAPEX Animal Spirits Will Spur CAPEX Second, investors are underestimating the probability that the current budget impasse - which could lead to a government shutdown in late January - gets resolved through more, not less, federal spending. Trump surprised legislators during a meeting on immigration when he offered his support for "earmarks" - i.e., legislative tags that direct funding to special interests in representatives' home districts. Earmarks were done away with in 2011 by the GOP following the Tea Party-inspired 2010 midterm victory, but they have crept back into the discussion through different guises (Chart 7). Chart 7Pork-Barrel Prohibition Is Ending Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China The timing of Trump's statement on earmarks is interesting as the House Rules Committee is holding public hearings on the originally GOP-instituted earmark ban. In fact, the 115th Congress (the current one) almost reinstated earmarks at the beginning of 2017, only to be held back by House Speaker Paul Ryan and the newly elected White House. In January 2017, Ryan and the White House agreed that it would be unseemly to approve "pork barreling" so quickly after the election of a man who promised to "drain the swamp." Apparently, a year later, the appropriate amount of time has passed to make the move okay! What about the fears that the budget deficit is unsustainable? Investors may be fretting about a problem that does not exist (at least not yet). Chart 8 shows that budget deficits have decreased in almost every case ahead of a recession by 1.16% on average in the eight quarters before a downturn. This is because revenues are very important in determining deficit dynamics. Only just before the recession hits, as growth slows, does the deficit start to flatline or expand. If the risk to the U.S. economy is to the upside, as we believe it is, then deficits will come down regardless of tax or spending policy. Chart 8The Deficit Is Not A Problem... Yet The Deficit Is Not A Problem... Yet The Deficit Is Not A Problem... Yet Fiscal policy rhetoric may alone be far more important to the equity, bond, and currency markets than the market is currently pricing. Talk of draconian spending cuts - remember the May 2017 White House budget? Anyone? - could very quickly be replaced with an appropriation bill in late January that combines higher defense spending with higher discretionary spending. Given the current low levels of discretionary spending (Chart 9), the move towards greater spending could be sizeable and surprising. And if earmarks make a comeback, look out! Chart 9Government Spending Is Bottoming Government Spending Is Bottoming Government Spending Is Bottoming Chart 10Global Economy Is Firing On All Cylinders Global Economy Is Firing On All Cylinders Global Economy Is Firing On All Cylinders This fiscal fuel is coming when the fire of the U.S. economy is already well lit. Yes, global growth is strong (Chart 10), but U.S. growth is likely to beat it in 2018 (Chart 11). The global and U.S. economy may diverge just as the BCA's two-factor 10-year Treasury yield model is showing that U.S. long-dated bonds are expensive (Chart 12), while dollar bearishness is overcrowded (Chart 13). Chart 11U.S. May Outperform Global Growth U.S. May Outperform Global Growth U.S. May Outperform Global Growth Chart 12More Room For Yields To Rise More Room For Yields To Rise More Room For Yields To Rise Chart 13The Dollar Will Be Great Again The Dollar Will Be Great Again The Dollar Will Be Great Again Bottom Line: Tax cuts will unleash animal spirits in the U.S. in 2018. Meanwhile, the political path of least resistance on fiscal policy is towards profligacy. Fade any talk of austerity or entitlement reform, earmarks are back! A combination of easy fiscal policy and tax cuts should be good for equity markets, bad for Treasuries, and good for the greenback in 2018. Technical indicators flag some near-term risks to the dollar, but over the course of the year, our assessment is that it will hold at current levels or rally. China: Reform Reboot Is Growth-Constraining Unlike the U.S. economy, where risks lie to the upside, China is our top candidate for growth disappointments in 2018. Premier Li Keqiang has announced that China's GDP grew by 6.9% in 2017, slightly above expectations at the beginning of the year. However, growth momentum is already slowing due to cyclical factors, the waning of fiscal and credit stimulus, and the government's financial tightening measures that were implemented over the past year (Chart 14). Chinese imports are what really matter from a global macro perspective, and the latest import data suggest that the domestic economy is slowing more abruptly than expected. Import growth fell sharply to 5% year-on-year in December and 0.46% month-on-month. Import volume growth fell from 27.1% in early 2017 to 9.3% in December (Chart 15). Chart 14Chinese Economy: Weakness Ahead Chinese Economy: Weakness Ahead Chinese Economy: Weakness Ahead Chart 15What Happens In China, Does Not Stay In China What Happens In China, Does Not Stay In China What Happens In China, Does Not Stay In China Policy changes are highly likely to add to this slowdown. There can no longer be much doubt about the reformist turn in government policy that we highlighted last year.8 All of the policy announcements that came out of the nineteenth National Party Congress in October so far have had a reformist bent. The market agrees, as the sectors of the equity market most likely to benefit from reforms - health care, IT, energy and consumer staples - have outperformed the broad market significantly since President Xi's five-year policy speech on October 18, 2017 (Chart 16). Two separate news items that caused market jitters over the past week reflect the reformist turn. First came unconfirmed rumors that China would make its exchange rate more flexible by abandoning a "counter-cyclical factor" in its daily fixing rate; second came a "fake news" report that China planned to diversify its foreign exchange reserves away from U.S. Treasuries (Chart 17). The rumors were not significant in themselves, at least not without more information, but they were significant in suggesting that debates on major macro policies are intensifying.9 The question is how much resolve will China's central government have in executing its renewed reform agenda? President Xi obviously does not want to self-impose a recession, yet meaningful reform will constrain credit, investment, and growth. For instance, the current financial regulatory crackdown has caused a precipitous drop in the growth of wealth management products (WMPs), which are investment products that make up about 60% of the burgeoning non-bank credit flows; non-bank credit, for its part, makes up 28% of total credit (total social financing). And regulators have gone on to tackle entrusted loans, corporate bonds, and other innovative financial products as well (Chart 18). The impact could be material over the course of this year. Chart 16Markets Believe In China Reforms Markets Believe In China Reforms Markets Believe In China Reforms Chart 17Chinese Treasury Reserves Can Be Weaponized Chinese Treasury Reserves Can Be Weaponized Chinese Treasury Reserves Can Be Weaponized Chart 18China's Dodd-Frank Moment China's Dodd-Frank Moment China's Dodd-Frank Moment We strongly urge clients to fade the narrative that China is already "easing up" on reforms. In the three months since China's party congress we have seen a handful of false media narratives about how the government is backtracking on its policy agenda. For instance, both The Wall Street Journal and The New York Times declared that the outcome of the major annual economic policymaking meeting - the Central Economic Work Conference - included a turn away from deleveraging. This was not only a misreading of the high-level policy priorities but also a mistranslation of the Economic Work Conference documents, which argued that deleveraging remains a key policy focus.10 It would be humiliating for President Xi - who, not incidentally, has achieved Mao-like authority within the Communist Party - to backtrack on his second-term economic agenda before he has even officially been elected to his second term. Xi will be re-elected in March and he is looking at 2020-21 deadlines for progress on key reforms according to the thirteenth Five Year Plan (2015-20) and his own three-year plan to fight the "Three Battles" of systemic financial risk, poverty, and pollution. The only way to meet these deadlines while ensuring that the country is strong and stable for the 100th anniversary of the Communist Party in 2021 is to frontload the reform push in 2018-19.11 In Table 1 we update our "Reform Reboot Checklist" to reflect the reality that the Central Economic Work Conference produced a strikingly reform-oriented outcome. This is significant because it was billed as the first major statement of economic policy under "Xi Jinping Thought on Socialism with Chinese Characteristics for the New Era." Table 1How Do We Know China Is Reforming? Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China The money growth (M2) target for 2018, for instance, is rumored to be the lowest in China's history after that meeting (supposedly it will be 9%, down from the low- to mid-teens seen in previous years). Now all we need to confirm that serious reforms are afoot is slower bank loan growth (which will likely be tipped in January numbers due in early February), or substantially tighter interbank rates, plus the announcement of significant reform initiatives at the annual "Two Sessions" in early March. It is very common in China for central government decrees to be too draconian initially and then to be modified after an outcry from industry. This year, however, we would advise clients to avoid confusing the inevitable back-and-forth between the central and local governments for a lack of resolve from the central government.12 China's bark will have bite this time around because the political and macroeconomic constraints to the core leadership are lower than they have been at any point in the past ten years. Table 2 shows the issues that we are watching to gauge the reform process and its impact on growth. In light of the above initiatives, we give a 30% subjective probability that China's policymakers will overtighten this year, which could lead to a global risk-off move in financial assets. Table 2China Is Rebooting Economic Reforms Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China Even in our baseline case - China slows abruptly but remains stable - we believe financial markets have yet to understand the shift in Chinese policymaker thinking, which means that China is the prime candidate for negative surprises in a year in which markets are priced for perfection. Chart 19China's Trade Surplus Is A Geopolitical Risk China's Trade Surplus Is A Geopolitical Risk China's Trade Surplus Is A Geopolitical Risk Finally, China is still a major geopolitical risk this year. It scored the largest trade surplus ever with the U.S. in 2017 (Chart 19) and several key U.S. trade rulings are looming that could trigger a tit-for-tat conflict. This was, of course, the real reason behind the rumors about halting U.S. Treasury purchases. We will discuss the trade and geopolitical tensions in a forthcoming report. Bottom Line: China's reform reboot is gaining steam. It will threaten to constrain growth via the anti-corruption campaign, financial and regulatory tightening, corporate and industrial restructuring, and local government scrutiny. In combination with a stronger U.S. economy, China's downward-sloping business cycle and reform-capable political cycle spell disappointments for global markets this year. Investment Implications A faster growing U.S. economy and a slower growing China is beneficial for DM versus EM, the USD versus the RMB and other EM and commodity-linked currencies, U.S. stocks relative to DM stocks (because China's slower growth will weigh on Japanese and European earnings), and Chinese stocks relative to EM. It is bearish for China/EM corporate bonds. It will have varying impacts on commodity prices, depending on the role of Chinese supply-side reforms, but in the long term - as overcapacity cuts are priced in - it should be marginally bearish base metals as a result of China's desired switch of the growth model to a less investment-intensive model.13 Could stronger U.S. growth compensate for slower Chinese growth? We doubt it very much. China is alone expected to make up a third of all global economic growth in 2018, with China-leveraged EM making up the other 45%, according to the latest IMF World Economic Outlook (Chart 20). It is unfathomable to see how the U.S., which is expected to contribute just 10% of all growth, can compensate for slower growth in developing nations. Even if U.S. growth massively surprised to the upside, the U.S. economy is far too domestically driven to make a genuine difference through higher imports. Chart 20Chinese Growth Outweighs U.S. Globally Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China As for the U.S. economy and markets, a global slowdown may be precisely what the doctor ordered. With stretched valuations, a foreign-induced correction may be healthy from a valuation perspective while having no impact on domestic economic fundamentals. Meanwhile, a dollar rally combined with some market volatility later in the year may be enough to give the Fed just enough pause to slow down the pace of hikes. Technical indicators are flagging some near-term risks to the dollar, but over the course of the year our assessment is that it will hold at current levels or rally. While this is not our base case, it would be the type of event that could prolong the current economic cycle. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 In his official statement on the break with Mr. Bannon, President Trump concluded with an important paragraph: "We have many great Republican members of Congress and candidates who are very supportive of the Make America Great Again agenda. Like me, they love the United States of America and are helping to finally take our country back and build it up, rather than simply seeking to burn it all down." The statement was important as it aligned President Trump firmly with Congressional Republicans in their opposition to the Bannon/Breitbart Clique. 2 Please see BCA Geopolitical Strategy Weekly Report, "The American Pocketbook Voter," dated January 10, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 Please see NFIB, "December 2017 Report: Small Business Optimism Index," dated December 12, 2017, available at www.nfib.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at gps.bcaresearch.com. 7 The biggest pushback against our view comes from the oft-repeated anecdote of a meeting between Gary Cohn, the Director of the National Economic Council, and American business leaders. Apparently, when Cohn asked the attendees how many would invest if their corporate taxes were cut, only one executive raised their hand. We have now heard this anecdote repeated to us so many times by clients that it has become clear that it is essentially the only evidence that U.S. corporations have no intention of increasing capex. Needless to say, we do not base our analysis on a single anecdote! 8 For this theme, please see BCA Geopolitical Strategy Weekly Report, "China Down, India Up?" dated March 15, 2017, available at gps.bcaresearch.com. 9 The change to the RMB fixing method is not confirmed, while the rumor of a change in the forex reserve portfolio management came from an unreliable media report that was denied by China's State Administration of Foreign Exchange (SAFE). China's purchases of U.S. Treasuries peaked in 2011; China would harm itself if it sold its Treasuries rapidly. However, it may want to highlight this threat in response to U.S. President Donald Trump's threats of broad tariffs on Chinese imports. 10 The official communique from the 2017 Central Economic Work Conference did not specifically use the term "deleveraging," as in the 2015 and 2016 statements. This omission triggered U.S. news reports claiming that Beijing was backing off its deleveraging goal. However, the 2017 communique clearly emphasized preventing financial risk, including the first of the administration's "three battles" for the next three years. It also indirectly referred to "deleveraging" by citing the "Three De's, One Lower, and One Make Up," which is shorthand for the policy phrase "De-capacity, de-stocking, deleveraging, lowering costs and making up for weaknesses," which has been a fixture in rhetoric on China's supply-side reforms. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 For instance, the central government is facing pushback on new asset management regulations that are set to be fully in force by June 2019. While there may be some compromise, we do not expect the regulations themselves to be watered down too much. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com; and BCA Emerging Markets Strategy Special Report "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com.

Highlights Environmental reforms in China continue to reduce steelmaking capacity. The shuttering of illegal induction facilities in China also is tightening markets. Although official Chinese steel output is higher, this likely reflects the fact that output from illegal induction mills went unreported - and thus uncounted - while production from legal mills is increasing to fill the gap left by closures. Steelmakers' profits are surging, which means demand for iron ore in China will remain stout at least through 1H18. Copper has been well bid since June 2017, following supply disruptions and strong demand growth driven by the global economic upturn. We expect it will get an additional lift in 1H18, as wiring and plumbing in construction projects now absorbing steel in China get underway. Later, global growth will make up for any slowdown in China. Our analysis indicates the global steel market will be tightening in 1H18, as it already is doing in China. Consistent with this, we are opening a tactical long position in Mar/18 steel rebar futures on the Shanghai Futures Exchange, which are quoted in RMB/ton. We are including a 10% stop loss on this recommendation. Energy: Overweight. Our once-out-of-consensus oil view is now the consensus, so we are taking profits on Brent and WTI $55 vs. $60/bbl call spreads on May- and July-delivery oil at tonight's close. These positions were up 109.2% and 123.5% at Tuesday's close. Any sell-offs will present an opportunity to re-establish length along these forward curves. Base Metals: Neutral. Copper will remain well bid this year as the global economic recovery rolls on. A large number of contract renegotiations at mines is an additional upside risk to copper prices this year. Precious Metals: Neutral. Given our expectation of four rate hikes by the Fed, it is difficult to get too bullish gold. However, any indication the central bank is tilting dovish - particularly if we fail to see higher inflation this year - will rally the metal. Ags/Softs: Underweight. Markets will tread water until Friday's USDA WASDE. We remain underweight, except for corn. Feature Chart of the WeekIron Ore And Steel Prices Diverged In 2017 Iron Ore And Steel Prices Diverged In 2017 Iron Ore And Steel Prices Diverged In 2017 China's environmental policy actions have reduced world steel-making capacity by 100 mm MT between 1H16 and 1H18. This is most visible in Chinese steel prices, which gained more than 30% in 2017, following an almost 80% increase in 2016. The total gain in steel prices since the start of Beijing's focus on steel-market reforms is a resounding 135%. Iron ore prices posted similar gains to steel in 2016 but diverged sharply in 2017, slumping more than 40% between mid-March and mid-June - ending almost 8% lower year-on-year (yoy) (Chart of the week). Soaring steel prices pushed profit margins at Chinese mills higher, which, of course, fed through to demand for iron ore, the critical steel-making ingredient in China, toward year-end: Iron ore prices were up 20% in the last two months of 2017. How Did We Get Here? A Recap Of China's Steel Sector Reforms As part of its reforms aimed at reducing air pollution by eliminating outdated, excess industrial capacity, Beijing pledged to eliminate 100-150 mm MT of steel capacity over the 2016-2020 period. To date it has shuttered an estimated 100 mm MT of capacity. In addition to these reforms Beijing pledged to shut down smaller induction furnaces in China, which melt scrap steel, and produce steel of shoddy quality. These induction furnaces are estimated to account for 80-120 mm MT worth of annual capacity, although their actual output is far less: They produced an estimated 30-50 mm MT in 2016, according to S&P Global Platts.1 This is less than 7% of China's total crude-steel output. Production cuts from induction mills are not evident in official data - China's crude steel production figures have continued to rise amid these cuts, as we discussed in previous research (Chart 2).2 Data from the International Iron and Steel Institute shows global steel output was at a record high for the first 11 months of 2017, increasing by more than 5% yoy. Likewise, crude steel output from China - which accounts for 50% of global output - peaked in August: Output over the same period was the highest on record, increasing by 5.28% compared to the same period in 2016. This production paradox can be put down to the fact that many Chinese induction furnaces are illegal, and, as a result their output is not accounted for in official production data. As legal steelmakers ramped up their output to offset declines from the closed down induction furnaces, official crude production figures climbed. In fact, further examination of Chinese steel data makes it clear that China's steel market is in fact tighter than what can be inferred from the crude production figures (Chart 3). The following observations point to a strained market: While China's crude steel production has been paving new record highs, China Stat Info data reveals a contradictory picture about steel products. Output of steel products in the March to November period of 2017 came in 3.46% lower yoy, marking the first yoy decline for that period since 1995! While crude steel produced by induction furnaces would not be included in official crude steel figures, the metal would eventually be used to manufacture steel products - wires, rods, rails and bars, and are represented in this data. Thus the decline in steel products indicates that lower crude supply has weighed down on the output of steel products. China's steel exports have been on a downtrend. In theory, this can be due to either an increase in domestic demand or a decrease in foreign demand. Given the healthy state of the global economy, and what we know about steel production in China, we are believers in the former theory. China's exports of steel products are down 30% yoy in the first 11 months of 2017. Aside from the 3.04% yoy decline in 2016, these mark the first annual declines in exports since 2009. In face of lower domestic supply, China has likely reduced its exports in order to satisfy demand from local steel users. China's scrap steel imports fell in 2H17. Unlike blast furnaces which use iron ore as the main input in steelmaking, the shuttered illegal steelmakers use scrap steel which they melt in an induction furnace. Coincident with the elimination of these furnaces, China's imports of scrap steel fell 14.35% yoy in 2H17. This is further evidence of reduced demand for the scrap steel from these furnaces. China steel inventories are falling. In fact steel product inventories in major industrial cities are at record lows (Chart 4). This is a symptom of a tight market with demand outpacing supply, contradicting China's crude steel production figures. Chart 2Record Chinese Production Of Crude Steel##BR##Amid Falling Steel Products Output Record Chinese Production Of Crude Steel Amid Falling Steel Products Output Record Chinese Production Of Crude Steel Amid Falling Steel Products Output Chart 3China Trade Data Evidence##BR##Of Tight Market China Trade Data Evidence Of Tight Market China Trade Data Evidence Of Tight Market Chart 4Steel Inventories##BR##In China Are Falling Steel Inventories In China Are Falling Steel Inventories In China Are Falling Furthermore, according to World Steel Association (WSA), capacity utilization in the 66 countries for which they collect data increased by 3.12 percentage points yoy for the July to November 2017 period to average 72.64%, up from the 69.52% average in the same period of 2016. These observations are evidence that despite the increase in official crude steel production figures, the actual output has in fact fallen and supply is tighter. Whether steel prices will remain buoyed by tight supply hinges on whether China is successful in permanently shuttering excess capacity and shoddy steel producers, or if induction furnace operators are able to circumvent these policies and bring illegal steel back to the market. China's Reforms To Dominate Steel Market, At Least This Winter Following the conclusion of the mid-December Central Economic Work Conference, Chinese authorities announced the "three tough battles" for the next three years, which they see as crucial for future economic prosperity. These battles are summarized as (1) preventing major risks, (2) targeted poverty alleviation, and (3) pollution control. The International Energy Agency (IEA) estimates that air pollution has led to ~1 million premature deaths while household air pollution caused an additional 1.2 million premature deaths in China annually.3 Because of this, improving China's air quality is a chief social and health target for China. Chart 5Lower Chinese Steel Production##BR##Will Impact Global Output Lower Chinese Steel Production Will Impact Global Output Lower Chinese Steel Production Will Impact Global Output This will mean that measures to reduce pollution and clear China's skies will be critically important to the steel sector. According to the Ministry of Environmental Protection, China has pledged a 15% yoy reduction in the concentration of airborne particles smaller than 2.5 microns in diameter - known as PM2.5 - in 28 smog-prone northern cities. The steel industry, which is mostly concentrated in the northern China region of Beijing-Tianjin-Hebei, is one of the top sources of air polluting emissions in that region. In fact, industrial emissions - most notably from the steel and cement sectors - are reportedly responsible for 40-50% of these small airborne particles. China's winter smog "battle plan" will target these polluting industries by mandating cuts on steel, cement, and aluminum production during the smog-prone mid-November to mid-March months, as well as restricting household coal use, diesel trucks and construction projects. Steel production cuts target a range between 30-50%, which, according to Platts estimates, will take 33 mm MT of steel production - equivalent to ~3.9% of China's projected 2017 crude steel output - offline during the winter. In fact, according to China's environment minister, Li Ganjie, "these special campaigns are not a one-off, instead it is an exploration of long-term mechanisms."4 Thus, these cuts may become a recurring event in China's steel sector. China's official crude steel figures are beginning to show the impact of these cuts with November crude production falling 8.6% month-on-month (mom) and growing by just 2.2% yoy - significantly slower than the 7.6% yoy average experienced since July. As a consequence, although crude production in the rest of the world grew in line with previous months, global steel output fell almost 6% month-on-month in November, while yoy production grew 3.7% – a significant deceleration from the average 6.6% yoy rate witnessed since the beginning of 2H17 (Chart 5). Risks to this outlook come from weak compliance with these cuts. There are recent reports of evasions by aluminum and steel producers in Shandong. Nonetheless, given China's focus on these reforms, we do not foresee widespread violations. Another risk comes from the demand side. As part of its environmental agenda, Beijing announced plans put off the construction of major public projects in the city - road and water projects - until springtime. The suspension is not intended to impact "major livelihood projects" such as railways, airports, and affordable housing. Construction is the largest end user for steel - according to WSA more than half of global steel is used for buildings and infrastructure - a slowdown in the construction sector would weigh on steel demand.5 If other major construction zones adopt a similar policy, the impact of lower steel supply will be offset by weak demand, muting the overall effect on the steel market. Bottom Line: We expect to see lower steel production and exports from China in the coming months. Given Xi Jinping's resolve to improve air quality, we expect compliance to environmental reforms among steelmakers to be strong this winter. This, along with lower output from induction furnaces in China, indicates the market could be tighter than is commonly supposed at least in 1H18. The likelihood the global economic recovery and expansion persists through 2018 suggests steel markets could remain well bid in 2H18, particularly if, as we expect, growth ex-China picks up the slack resulting from any slowdown in China. However, we will need to see what the actual reforms for the industry look like following the National People's Congress in March 2018.6 Steel Profit Margins Spur Iron Ore Demand Given steel's exceptional price gains over the past two years, and iron ore's lackluster performance in 2017, profit margins at China's steel producers reached multi-year highs (Chart 6). Ordinarily, this would normally encourage steel production, which would flood the market with supply and push prices down. However, China's environmental reforms will cap output from the country's most productive steelmaking region in coming months. Consequently, unless there are mass policy violations by steel producers this winter, we do not anticipate a swift price adjustment lower. Instead, steel producers are preparing to run on all cylinders when production restrictions are lifted in the spring. As such, they are filling iron ore inventories and taking advantage of weaker iron ore prices, before the iron ore market catches up with steel. China's iron ore imports reached an all-time record in September, while the latest data shows a 19% month-on-month (mom) jump in imports, corresponding with a 2.8% yoy increase (Chart 7). Chart 6Healthy Steel##BR##Profit Margins Healthy Steel Profit Margins Healthy Steel Profit Margins Chart 7Steel Producers Stocking Up On Iron Ore##BR##In Preparation For Spring Steel Producers Stocking Up On Iron Ore In Preparation For Spring Steel Producers Stocking Up On Iron Ore In Preparation For Spring This runs counter to what we expect during a period of muted steel production. Especially in an environment of healthy iron ore inventories, as China is in currently. Although Chinese inventories came down from mid-year peaks, they resumed their upward trend in 4Q17. This coincides with the steel winter capacity cuts, and is likely due to reduced demand for the ore from steel mills. There are two theories to explain this phenomenon: 1. Chinese steelmakers are taking advantage of lower iron ore prices and locking in higher profit margins, in anticipation of higher iron ore prices once steel production picks up again in the spring. 2. Amid the winter cuts, China's steelmakers are demanding high-grade iron ore, imported from Brazil and Australia. This will help them ensure that they are able to maximize their output without violating environmental policies. Environmental Consciousness Widens Iron Ore Spreads A consequence of the steel winter capacity cuts is stronger demand for higher grade raw materials to cut down on the most polluting phases of steel production. Higher-grade iron ore, which is defined by its purity or iron content, is more efficient for blast furnaces to use, allowing them to produce more steel from each tonne of iron ore they consume, maximizing output and profit. This is especially true in a tight steel market, with healthy profit margins: Steelmakers are able to afford the higher grades and are favoring productive efficiency. The discount for lower grade iron ore fines - 58% iron content - as well as the premium for higher grade 65% iron content have widened (Chart 8). This is because mills have found a way to legally circumvent the winter environmental restrictions, and still remain compliant. Furthermore, purer ores are less polluting, which helps serve China's environmental agenda. In addition, the premiums for iron ore pellets and iron ore lumps have also widened. Unlike lumps and pellets which can be fed directly into blast furnaces, fines require a sintering process which is highly polluting. Thus, China's environmental reforms have increased demand for higher grade, less polluting ores. An additional factor that could be driving up spreads is higher metallurgical coke prices (Chart 6). Higher grade iron ore contains less silica and thus requires less met coke to purify the ores. According to anecdotal evidence from China, Carajas fines from Brazil - which have the highest iron ore content and lowest silica content- are reportedly in high demand.7 Furthermore, China's imports show a decline in iron ore from India - which is of the lower grades. In the July to October period, imports fell 11.26% yoy with October imports falling almost 25% yoy and 30% mom. This is consistent with the theory that steel makers are shunning lower grade ores. On the other hand, imports from Brazil and Australia are expected to remain strong (Chart 9). The latest Australian Resources and Energy Quarterly forecasts Australian and Brazilian iron ore exports to grow 5.4% and 4.2% respectively in 2018, while Indian exports are projected to fall 57.5% yoy. Chart 8Wide Iron Ore##BR##Price Spreads Wide Iron Ore Price Spreads Wide Iron Ore Price Spreads Chart 9Environmental Concerns Will Support##BR##Demand For High Grade Iron Ore Environmental Concerns Will Support Demand For High Grade Iron Ore Environmental Concerns Will Support Demand For High Grade Iron Ore Bottom Line: In an effort to keep production high and profit from strong steel prices in face of the winter production cuts, steel producers are turning to higher-grade iron ore, pushing up the spread between high vs. low grade ores. The extent to which steel producers are able to successfully keep production going on the back of higher-grade ores will dampen the impact of the winter production cuts on the steel sector. Given that China's environmental focus is a long term plan, we expect these spreads to remain wide, rather than reverting back to their historic average. Steel Prices And Copper Markets Chart 10Steel Consumption Helps##BR##Predict Copper Prices Steel Consumption Helps Predict Copper Prices Steel Consumption Helps Predict Copper Prices The copper market had a roller coaster fourth quarter. Prices for the red metal were on a general uptrend since May, and first peaked in early September at $3.13/lb before bottoming at $2.91/lb by the second half of that month. Shortly thereafter, copper prices peaked at a new high of $3.22/lb by mid October - their highest in more than three years. Fears of a slowdown in China following messaging from the 19th Communist Party Congress caused the metal to lose almost 10% of its value, when it bottomed for the second time in early December. In fact, this coincided with a 4.65% decline in the price on December 5. While there is no clear justification for this fall, it can be put down to a mix of factors including a ~10 th MT increase in LME inventories, worries about a China slowdown, as well as a liquidation of positions ahead of the new year. Nonetheless, copper has since regained these losses to end the year at $3.28/lb. In our modelling of copper, we find that steel consumption is significant in forecasting future copper price behavior. More specifically, China's steel consumption has a significant positive relationship with copper prices 6 months into the future (Chart 10). This can be explained by the importance of the construction sector as an end user of both materials. However, each metal goes into the construction site at different time frames. While steel products are used in the construction of the structures, and thus are needed at the beginning of the project, copper is used in the electrical wiring and plumbing, and is thus needed later (6 months or so) in the project. This is in line with our findings that steel is most significant with a six-month lag - reflecting the average time period between which the structure is built and the plumbing and wiring are needed. Steel consumption in China is a useful leading indicator of copper markets when demand side fundamentals are dominating steel and copper markets. Government stimulus and a solid construction sector boosted China's steel demand in 2017. However, according to the WSA Short Range Outlook, demand for steel will moderate this year on the back of reflation in China, partially offset by strong global growth. WSA notes that the closure of induction furnaces skewed up steel demand growth figures to 12.4% yoy, and instead cite a more reasonable estimate along the lines of 3% yoy steel demand growth from China in 2017, bringing the global steel demand growth rate to 2.8%. While steel demand outside of China grew by an estimated 2.6% in 2017, they foresee it reaching 3% in 2018. In contrast, they expect flat demand from China in 2018, bringing world steel demand growth to 1.6% in 2018 (Table 1). Table 1Steel Demand (yoy Growth Rates) China's Environmental Reforms Drive Steel & Iron Ore China's Environmental Reforms Drive Steel & Iron Ore Moderating demand from China and the stability (or lack thereof) of the supply-side will dominate the copper market this year. On the demand side, China's steel market offers insight about the future direction of the red metal. Bottom Line: Given China's appetite for steel has remained healthy to date and is projected to maintain its 2017 level this year, we do not expect a demand-induced plunge in copper prices in the 6 month horizon. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "Will China's induction furnace steel whac-a-mole finally come to an end?" published by S&P Global Platts March 6, 2017. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," published September 7, 2017, available at ces.bcaresearch.com. 3 Please see IEA World Energy Outlook 2016 Special Report titled "Energy and Air Pollution," available at iea.org. 4 Please see "Provincial China officials used fake data to evade aluminium, steel capacity curbs - China Youth Daily," published on December 26, 2017, available at reuters.com. 5 Please see "Steel Markets" at worldsteel.org. 6 For additional discussion, please see "Shifting Gears in China: The Impact On Base Metals," in the November 9, 2017, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 Please see "High-medium grade iron ore fines spread widens to all-time high of $23.55/dmt," published August 22, 2017, available at platts.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table China's Environmental Reforms Drive Steel & Iron Ore China's Environmental Reforms Drive Steel & Iron Ore Trades Closed in 2017

Highlights Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. The good news on global growth continue to roll in. Real GDP growth is accelerating in the major advanced economies, driven in part by a surge in capital spending. Nonetheless, record low volatility and a flat yield curve in the U.S. highlight our major theme for 2018; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. We expect inflation to finally begin moving higher in the U.S. and some of the other advanced economies. This will challenge the consensus view that "inflation is dead forever", and that central banks will respond quickly to any turbulence in financial markets with an easier policy stance. The S&P 500 would suffer only a 3-5% correction if the VIX were to simply mean-revert. But the pain would likely be more intense if there is a complete unwinding of 'low-vol' trading strategies. We will be watching inflation expectations and our S&P Scorecard for signs to de-risk. Government yield curves should bear steepen, before flattening again later in 2018. Stay below benchmark in duration for now and favor bonds in Japan, Italy, the U.K. and Australia versus the U.S. and Canada (currency hedged). Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. The intensity of forthcoming Chinese reforms will have to be monitored carefully for signs they have reached an economic 'pain threshold'. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex. Bitcoin is not a systemic threat to global financial markets. Feature Chart I-1Policy Collision Course? Policy Collision Course? Policy Collision Course? Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. Ominously, though, a flatter U.S. yield curve and extraordinarily low measures of volatility hover like dark clouds over the equity bull market (Chart I-1). The flatter curve could be a sign that the Fed is at risk of tightening too far, which seems incompatible with depressed asset market volatility. This combination underscores the major theme of the BCA Outlook 2018 that was sent to clients in November; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. Analysts are debating how much of the decline in volatility is due to technical factors and how much can be pinned on the macro backdrop. For us, they are two sides of the same coin. Betting that volatility will remain depressed has reportedly become a yield play, via technical trading strategies and ETFs. Trading models encourage more risk taking as volatility declines, such that lower volatility enters a self-reinforcing feedback loop. The danger is that this virtuous circle turns vicious. On the macro front, many investors appear to believe that the structure of the advanced economies has changed in a fundamental and permanent way. Deflationary forces, such as Uber, Amazon and robotics are so strong that inflation cannot rise even if labor becomes very scarce. If true, this implies that central banks will proceed slowly in tightening, and that the peak in rates is not far away. Moreover, below-target inflation allows central banks to respond to any economic weakness or unwanted tightening in financial conditions by adopting a more accommodative policy stance. In other words, investors appear to believe in the "Fed Put". Implied volatility is a mean-reverting series. It can remain at depressed levels for extended periods, especially when global growth is robust and synchronized. Nonetheless, we believe that the "outdated Phillips curve" and the "Fed Put" consensus views will be challenged later in 2018, leading to an unwinding of low-vol yield plays. For now, though, it is too early to scale back on risk assets. Global Growth Shifts Up A Gear... The good news on global growth continue to roll in. Easy financial conditions and the end of fiscal austerity provide a supportive growth backdrop. A measure of fiscal thrust for the G20 advanced economies shifted from a headwind to a slight tailwind in 2016 (Chart I-2). Our short-term models for real GDP growth in the major countries continue to rise, in line with extremely elevated purchasing managers' survey data (Chart I-3). The major exception is the U.K., where our GDP growth model is rolling over as the Brexit negotiations take a toll. Chart I-2Fiscal Austerity Is Over Fiscal Austerity Is Over Fiscal Austerity Is Over Chart I-3GDP Growth Models Are Upbeat GDP Growth Models Are Upbeat GDP Growth Models Are Upbeat Much of the acceleration in our GDP models is driven by the capital spending components. Animal spirits appear to be taking off and it is a theme across most of the advanced economies. G3 capital goods orders pulled back a bit in late 2017, but this is more likely due to noise in the data than to a peak in the capex cycle (Chart I-4). Industrial production, the PMI diffusion index and advanced-economy capital goods imports confirm strong underlying momentum in investment spending. Chart I-4Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth In the U.S., tax cuts will give business outlays and overall U.S. GDP growth a modest lift in 2018. The House and Senate hammered out a compromise on tax cuts that is similar to the original Senate version. The new legislation will cut individual taxes by about $680 billion over ten years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability that the tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. Any infrastructure program would also augment the fiscal stimulus. The total impact is difficult to estimate given the lack of details, but it is clearly growth-positive. ...But The U.S. Yield Curve Flattens... Bond investors are unimpressed so far with the upbeat global economic data. It appears that long-term yields are almost impervious as long as inflation is stuck at low levels. In the U.S., a rising 2-year yield and a range-trading 10-year yield have resulted in a substantial flattening of the 2/10 yield slope (although some of the flattening has unwound as we go to press). Investors view a flattening yield curve with trepidation because it smells of a Fed policy mistake. It appears that the bond market is discounting that the Fed can only deliver another few rate hikes before the economy starts to struggle, at which point inflation will still be below target according to market expectations. We would not be as dismissive of an inverted yield curve as Fed Chair Yellen was during her December press conference. There are indeed reasons for the curve to be structurally flatter today than in the past, suggesting that it will invert more easily. Nonetheless, the fact that the yield curve has called all of the last seven recessions is impressive (with one false positive). The good news is that, in the seven episodes in which the curve correctly called a recession, the signal was confirmed by warning signs from our Global Leading Economic Indicator and our monetary conditions index. At the moment, these confirming indicators are not even flashing yellow.1 Our fixed-income strategists believe that the curve is more likely to steepen than invert over the next six months. If inflation edges higher as we expect, then long-term yields will finally break out to the upside and the curve will steepen until the Fed's tightening cycle is further advanced. If we are wrong and inflation remains stuck near current levels or declines, then the FOMC will have to revise the 'dot plot' lower and the curve will bull-steepen. In other words, we do not think the FOMC will make a policy mistake by sticking to the dot plot if inflation remains quiescent. Rising inflation is a larger risk for stocks and bonds than a policy mistake. A clear uptrend in inflation would shake investors' confidence in the "Fed Put" and thereby trigger an unwinding of the low-vol investment strategies. A sharp selloff at the long end of the curve in the major markets would send a chill through the investment world because it would suggest that the Phillips curve is not dead, and that central banks might have fallen behind the curve. ...As Inflation Languishes For now there is little evidence of building inflation pressure in either the CPI or the Fed's preferred measure, the core PCE price index. The latter edged up a little in October to 1.4% year-over-year, but the November core CPI rate slipped slightly to 1.7%. For perspective, core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE index. The Fed has made no progress in returning inflation to target since the FOMC started the tightening cycle. A risk to our view is that the expected inflation upturn takes longer to materialize. The annual core CPI inflation rate fell from 2.3 in January 2017 to 1.7 in November, a total decline of 0.55 percentage points. The drop was mostly accounted for by negative contributions from rent of shelter (-0.31), medical care services (-0.13) and wireless telephone services (-0.1). These categories are not closely related to the amount of slack in the economy, and thus might continue to depress the headline inflation rate in the coming months even as the labor market tightens further. Recent regulatory changes, for example, suggest that there is more downside potential in health care services inflation. We have highlighted in past research that it is not unusual for inflation to respond to a tight labor market with an extended lag, especially at the end of extremely long expansion phases. Chart I-5 updates the four indicators that heralded inflection points in inflation at the end of the 1980s and 1990s. All four leading inflation indicators are on the rise, as is the New York Fed's Underlying Inflation Indicator (not shown). Importantly, economic slack is disappearing at the global level. The OECD as a group will be operating above potential in 2018 for the first time since the Great Recession (Chart I-6). Finally, oil prices have further upside potential. Higher energy prices will add to headline inflation and boost inflation expectations in the U.S. and the other major economies. Chart I-5U.S. Inflation: Indicators Point Up U.S. Inflation: Indicators Point Up U.S. Inflation: Indicators Point Up Chart I-6Vanishing Economic Slack Vanishing Economic Slack Vanishing Economic Slack The bottom line is that we are sticking with the view that U.S. inflation will grind higher in the coming months, allowing the FOMC to deliver the three rate hikes implied by the 'dot plot' for 2018. In December, the FOMC revised up its economic growth forecast to 2.5% in 2018, up from 2.1%. The projections for 2019 and 2020 were also revised higher. Growth is seen remaining above the 1.8% trend rate for the next three years. The FOMC expects that the jobless rate will dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. With the estimate for long-run unemployment unchanged at 4.6%, this means that the labor market is expected to shift even further into 'excess demand' territory. If anything, these forecasts look too conservative. It is unreasonable to expect the unemployment rate to stabilize in 2019 and tick up in 2020 if the economy is growing above-trend. This forecast highlights the risk that the FOMC will suddenly feel 'behind the curve' if inflation re-bounds more quickly than expected, at a time when the labor market is so deep in 'excess demand' territory. The consensus among investors would also be caught off guard in this scenario, resulting in a rise in bond volatility from rock-bottom levels. How Vulnerable Are Stocks? How large a correction in risk assets should we expect? One way to gauge this risk is to estimate the historical 'beta' of risk asset prices to mean-reversions in the VIX. The VIX is currently a long way below its median. Major spikes to well above the median are associated with recessions and/or financial crises. However, as a starting point, we are interested in the downside potential for risk asset prices if the VIX simply moves back to the median. Table I-1 presents data corresponding to periods since 1990 when the VIX mean-reverted from a low level over a short period of time. We chose periods in which the VIX surged at least to its median level (17.2) from a starting point that was below 13. The choice of 13 as the lower threshold is arbitrary, but this level filters out insignificant noise in the data and still provides a reasonable number of episodes to analyze.2 Table I-1Episodes Of VIX 'Mean Reversion' January 2018 January 2018 The episodes are presented in ascending order with respect to the starting point for the 12-month forward P/E ratio. This was done to see whether the valuation starting point matters for the size of the equity correction. The "VIX Beta" column shows the ratio of the percent decline in the S&P 500 to the change in the VIX. The average beta over the 15 episodes suggests that stocks fall by almost a half of a percent for every one percent increase in the VIX. Today, the VIX would have to rise by about 7½% to reach the median value, implying that the S&P 500 would correct by roughly 3½%. Investment- and speculative-grade corporate bonds would underperform Treasurys by 22 and 46 basis points, respectively, in this scenario. Interestingly, the equity market reaction to a given jump in the VIX does not appear to intensify when stocks are expensive heading into the shock. The implication is that a shock that simply returns the VIX to "normal" would not be devastating for risk assets. The shock would have to be worse. Chart I-7Market Reaction To 1994 Fed Shock Market Reaction To 1994 Fed Stock Market Reaction To 1994 Fed Stock The episodes of VIX "mean reversion" shown in Table I-1 are a mixture of those caused by financial crises and by monetary tightening (and sometimes both). The U.S. 1994 bond market blood bath is a good example of a pure monetary policy shock. It was partly responsible for the "tequila crisis", but that did not occur until late that year. Chart I-7 highlights that the U.S. equity market reacted more violently to Fed rate hikes in 1994 than the average VIX beta would suggest. The VIX jumped by about 14% early in the year, coinciding with a 9% correction in the S&P 500. Investors had misread the Fed's intension in late 1993, expecting little in the way of rate hikes over the subsequent year. A dramatic re-rating of the Fed outlook caused a violent bond selloff that unnerved equity investors. We are not expecting a replay of the 1994 bond market turmoil because the Fed is far more transparent today. Nonetheless, the equity correction could be quite painful to the extent that the VIX overshoots the median as the large volume of low-volatility trades are unwound. A 10% equity correction in the U.S. this year would not be a surprise given the late stage of the bull market and current market positioning. Yield Curves To Bear Steepen Upward pressure on inflation, bond yields and volatility will not only come from the U.S. We expect inflation to edge higher in the Eurozone, Canada, and even Japan, given tight labor markets and diminished levels of global spare capacity. The European economy has been a star performer this year and this should continue through 2018. Even the periphery countries are participating. The key driving factors include the end of the fiscal squeeze in the periphery and the recapitalization of troubled banks. The latter has opened the door to bank lending, the weakness of which has been a major growth headwind in this expansion. Taken at face value, recent survey data are consistent with about 3% GDP growth (Chart I-3). We would dis-count that a bit, but even continued 2.0-2.5% GDP growth in the euro area would compare well to the 1% potential growth rate. This means that the output gap is shrinking and the labor market will continue tightening. Despite impressive economic momentum, the ECB is sticking to the policy path it laid out in October. Starting in January, asset purchases will continue at a reduced rate of €30bn per month until September 2018 or beyond. Meanwhile, interest rates will remain steady "for an extended period of time, and well past the horizon of the net asset purchases." If asset purchases come to an end next September, then the first rate hike may not come until 2019 Q1 at the earliest. Thus, rate hikes are a long way off, but the deceleration of growth in the Eurozone monetary base will likely place upward pressure on the long end of the bund curve (shown inverted in Chart I-8). Chart I-8ECB Tapering Will Be Bond-Bearish ECB Tapering Will Be Bond-Bearish ECB Tapering Will Be Bond-Bearish Canada is another economy with ultra-low interest rates and rapidly diminishing labor market slack. The Bank of Canada will be forced to follow the Fed in hiking rates in the coming quarters. In Japan, strong PMI and capital goods orders are hopeful signs that domestic capital spending is picking up, consistent with our upbeat real GDP model (Chart I-3). Recent data on industrial production and retail sales were weak, but this was likely due to heavy storm activity; we expect those readings to bounce back. Nonetheless, it is still not clear that the Japanese economy has moved away from a complete dependency on the global growth engine. We would like to see stronger wage gains to signal that the economy is finally transitioning to a more self-reinforcing stage. It is hopeful that various measures of core inflation are slightly positive, but this is tentative at best. That said, the BoJ may be forced to alter its current "yield curve control" strategy by modestly lifting the target on longer-term JGB yields later in 2018, in response to pressures from robust growth and rising global bond yields. Thus, the pressure for higher bond yields should rotate away from the U.S. in the latter half of 2018 towards Europe, Canada and possibly Japan. This could eventually see the U.S. dollar head lower, but we still foresee a window in the first half of 2018 in which the dollar will appreciate on the back of widening interest rate differentials. We are less bullish than we were in mid-2017, expecting only about a 5% dollar appreciation. China: Long-Term Gain Or Short-Term Pain? The Chinese cyclical outlook remains a key risk to our upbeat view on risk assets. Significant structural reforms are on the way, now that President Xi has amassed significant political support for his reform agenda. These include deleveraging in the financial sector, a more intense anti-corruption campaign focused on the shadow-banking sector, and an ongoing restructuring in the industrial sector. The reforms will likely be positive for long-term growth, but only to the extent that they are accompanied by economic reforms. This month's Special Report, beginning on page 19, highlights that 2018 will be pivotal for China's long-term investment outlook. In the short term, reforms could be a net negative for growth depending on how deftly the authorities handle the monetary and fiscal policy dials. We witnessed this tension between growth and reform in the early years of President Xi's term, when the drive to curtail excessive credit growth and overcapacity caused an abrupt slowdown in 2015. Managing the tradeoff means that China's economy will evolve in a series of growth mini cycles. China is in the down-phase of a mini cycle at the moment, as highlighted by the Li Keqiang Index (LKI; Chart I-9). The LKI is a good proxy for the business cycle. BCA's China Strategy service recently combined the data with the best leading properties for the LKI into a single indicator.3 This indicator suggests that the LKI will end up retracing about 50% of its late 2015 to early 2017 rise before the current slowdown is complete. The good news is that broad money growth, which is a part of the LKI leading indicator, has re-accelerated in recent months. This suggests that the current economic slowdown phase will not be protracted, consistent with our 'soft landing' view. The intensity of forthcoming reforms will have to be monitored carefully for signs they have reached an economic pain threshold. We will be watching our LKI leading indicator and a basket of relevant equity sectors for warning signs. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex (Chart I-10). Chart I-9China: Where Is The Bottom? China: Where Is the Bottom? China: Where Is the Bottom? Chart I-10Metals At Risk Of China Soft Landing Metals At Risk Of China Soft Landing Metals At Risk Of China Soft Landing Equity Country Allocation For now we continue to recommend overweight positions in stocks versus bonds and cash within balanced portfolios. We also still prefer Japanese stocks to the U.S., reflecting our expectation for rising bond yields in the latter and an earnings outlook that favors the former. Chart I-11 updates our earnings-per-share growth forecast for the U.S., Japan and the Eurozone. We expect U.S. EPS growth to decelerate more quickly in 2018 than in Japan, since the U.S. is further ahead in the earning cycle and is more exposed to wage and margin pressure. European earnings growth will also be solid in 2018, but this year's euro appreciation will be a headwind for Q4 2017 and Q1 2018 earnings. European and Japanese stocks are also a little on the cheap side versus the U.S., although not by enough to justify overweight positions on valuation grounds alone. We have extended our valuation work to a broader range of countries, shown in Chart I-12. All are expressed relative to the U.S. market. These metric exclude the Financials sector, and adjust for both differing sector weights and structural shifts in relative valuation. Mexico is the only one that is more than one standard deviation cheap relative to the U.S. Nonetheless, our EM team is reluctant to recommend this market given uncertainty regarding the NAFTA negotiations. Russia is not as cheap, but is in the early stages of recovery. Our EM team is overweight. Chart I-11Top-Down EPS Projection Top-Down EPS Projection Top-Down EPS Projection Chart I-12Valuation Ranking Of Nonfinancial Equity Markets Relative To The U.S. January 2018 January 2018 A Note On Bitcoin Finally, we have received a lot of client questions regarding bitcoin. The incredible surge in the price of the cryptocurrency dwarfs previous asset price bubbles by a wide margin (Chart I-13). As is usually the case with bubble, supporters argue that "this time is different." We doubt it. Chart I-13Bitcoin Bubble Dwarfs All The Rest January 2018 January 2018 BCA's Technology Sector Strategy weighed into this debate in a recent Special Report.4 In theory, blockchain technology, including cyber currencies, can be used as a highly secure, low cost, means of transfer value from one person to the next without an intermediary. However, the report highlights that bitcoin is highly subject to fraud and manipulation because it is unregulated. Liquidity and accurate market quotes are questionable on the "fly by night" exchanges. Its use as a medium of exchange is very limited, and governments are bound to regulate it because cryptocurrencies are a tool for money laundering, tax evasion and other criminal activities. Another fact to keep in mind is that, although the supply of new bitcoins is restricted, the creation of other cryptocurrencies is unlimited. Would the bursting of the bitcoin bubble represent a risk to the economy? The market cap of all cryptocurrencies is estimated to be roughly US$400 billion (US$250 billion for bitcoin alone). This is tiny compared to global GDP or the market cap of the main asset classes such as stocks and bonds. The amount of leverage associated with bitcoin is unknown, but it is hard to see that it would be large enough to generate a significant wealth effect on spending and/or a marked impact on overall credit conditions. The links to other financial markets appear limited. Investment Conclusions Our recommended asset allocation is "steady as she goes" as we move into 2018. The policy and corporate earnings backdrop will remain supportive of risk assets at least for the first half of the year. In the U.S., the recently passed tax reform package will boost after-tax corporate cash flows by roughly 3-5%. Cyclical stocks should outperform defensives in the near term. Nonetheless, we expect 2018 to be a transition year. Stretched valuations and extremely low volatility imply that risk assets are vulnerable to the consensus macro view that central banks will not be able to reach their inflation targets even in the long term. The consensus could be in for a rude awakening. We expect equity markets to begin discounting the next U.S. recession sometime in early 2019, but markets will be vulnerable in 2018 to a bond bear phase and escalating uncertainty regarding the economic outlook. If risk assets have indeed entered the late innings, then we must watch closely for signs to de-risk. One item to watch is the 10-year U.S. CPI swap rate; a shift above 2.3% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We will also use our S&P Scorecard Indicator to help time the exit from our overweight equity position (Chart I-14). The Scorecard is based on seven indicators that have a good track record of heralding equity bear markets.5 These include measures of monetary conditions, financial conditions, value, momentum, and economic activity. The more of these indicators in "bullish" territory, the higher the score. Currently, four of the indicators are flashing a bullish signal (financial conditions, U.S. unemployment claims, ISM new orders minus inventories, and momentum). We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in the subsequent months. A drop below three this year would signal the time to de-risk. Our thoughts on the risks facing equities carry over to the corporate bonds space. Our Global Fixed Income Strategy service notes that uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart I-15).6 Elevated leverage in the corporate sector adds to the risk of a re-rating of implied volatility. For now, however, investors should continue to favor corporate bonds relative to governments for the (albeit modest) yield pickup. Chart I-14Watch Our Scorecard To Time The Exit Watch Our Scorecard To Time The Exit Watch Our Scorecard To Time The Exit Chart I-15Higher Uncertainty & ##br##Vol To Hit Corporate Bonds Higher Uncertainty & Vol To Hit Corporate Bonds Higher Uncertainty & Vol To Hit Corporate Bonds Overall bond portfolio duration should be kept short of benchmark. We may recommend taking profits and switching to benchmark duration after global yields have increased and are beginning to negatively affect risk assets. While yields are rising, investors should favor bonds in Japan, Italy, the U.K. and Australia within fixed-income portfolios (on a currency-hedged basis). Underweight the U.S. and Canada. German and French bonds should be close to benchmark. Yield curves should steepen, before flattening later in the year. Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Finally, investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. Mark McClellan Senior Vice President The Bank Credit Analyst December 28, 2017 Next Report: January 25, 2018 1 Please see BCA Global ETF Strategy service, "A Guide to Spotting And Weathering Bear Markets," August 16, 2017, available at etf.bcaresearch.com 2 Note that we are not saying that a rise in the VIX "causes" stocks to correct. Rather, we are assuming that a shock occurs that causes stocks to correct and the VIX to rise simultaneously. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," November 30, 2017, available at cis.bcaresearch.com 4 Please see BCA Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" December 12, 2017, available at tech.bcaresearch.com 5 Market Timing: Holy Grail Or Fool's Gold? The Bank Credit Analyst, May 26, 2016. 6 Please see BCA Global Fixed Income Strategy service, "Our Model Bond Portfolio Allocation In 2018: A Tail Of Two Halves," December 19, 2017, available at gfis.bcaresearch.com II. A Long View Of China 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal The New Normal The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? January 2018 January 2018 Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign China's Slowdown So Far Benign China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Urban Income Targets At Risk Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship January 2018 January 2018 This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others January 2018 January 2018 China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Inequality: A Severe Problem In China Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility January 2018 January 2018 "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense January 2018 January 2018 In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart II-14Chinese Public Grievances January 2018 January 2018 Chart II-15Anti-Corruption Is Popular January 2018 January 2018 Chart II-16Productivity Requires Institutional Change Productivity Requires Institutional Change Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... January 2018 January 2018 Chart II-17B...But There's A Long Way To Go January 2018 January 2018 Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind January 2018 January 2018 Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time January 2018 January 2018 Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. III. Indicators And Reference Charts Global equity indexes remained on a tear heading into year-end on the back of robust earnings growth in the major countries and U.S. tax cuts. There are some dark clouds hanging over this rally, as discussed in the Overview section. The technicals are stretched, but none of our fundamental indicators are warning of a market top. Implied equity volatility is very low, which can be interpreted in a contrary fashion. Investor sentiment is frothy and our Speculation Indicator is very elevated. Moreover, our equity valuation indicator has finally reached one standard deviation, which is our threshold of overvaluation. Valuation does not tell us anything about timing, but it does highlight the downside risks. Our monetary indicator also deteriorated a little more in December, although not by enough on its own to justify downgrading risk assets. On a positive note, earnings surprises and the net revisions ratio are not sending any warning signs for profit growth (although net revisions have edged lower recently). Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in November for the fifth consecutive month. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The small dip in the Japanese WTP in December is a little worrying, but we need to see more weakness to confirm that flows no longer favor Japanese equities. In contrast, Europe's WTP rose sharply in December, suggesting that investors are allocating more to their European equity holdings. We are overweight both Europe and (especially) Japan relative to the U.S. (currency hedged). U.S. Treasury valuation is still very close to neutral, even following December's backup in yields. There is plenty of upside potential for yields before they hit "inexpensive" territory. Similarly, our technical bond indicator suggests that technical factors will not be headwind to a further bond selloff in 2018. Little has change for the dollar. The technicals are neutral. Value is expensive based on PPP, but less so by other valuation metrics. We see modest upside for the greenback in 2018. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart II-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart II-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart II-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart II-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart II-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart II-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart II-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart II-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart II-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart II-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart II-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart II-20Euro Technicals Euro Technicals Euro Technicals Chart II-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart II-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart II-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart II-24Commodity Prices Commodity Prices Commodity Prices Chart II-25Commodity Prices Commodity Prices Commodity Prices Chart II-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart II-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart II-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart II-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart II-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart II-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart II-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart II-33U.S. Consumption U.S. Consumption U.S. Consumption Chart II-34U.S. Housing U.S. Housing U.S. Housing Chart II-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart II-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart II-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart II-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2017. We will resume our regular publishing schedule on January 4, 2018 with a brief market update. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights 2017 served as a prime example of the periodic oscillation of Chinese economic policy between pursuing painful reforms and stimulating demand. While policymakers are merely attempting to control the private sector debt-to-GDP ratio, the risk of a tightening overshoot should not be discounted. Recent economic activity in China appears to have been driven by highly-polluting industries, in the context of strong public demand for an improvement in air quality. This raises the risk that environmental reforms over the coming few years could seriously curtail growth. The incredible returns from Chinese stocks this year means that investable equities are no longer "exceptionally cheap". Still, the range of valuation among Chinese investable sectors has increased, suggesting increased opportunity for alpha generation over the coming 6-12 months. Feature Following the publication of our special year end Outlook report for 2018,1 BCA's China Investment Strategy service recently expanded on our global view by outlining our three key themes for China over the coming year.2 As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their longer-term implications. China's Mini Cycle In Requiem, From A Bigger Picture Perspective Chart 1Some Modest Deleveraging Achieved ##br##In The Corporate Sector Some Modest Deleveraging Achieved In The Corporate Sector Some Modest Deleveraging Achieved In The Corporate Sector 2017 saw the growth momentum of China's recent "mini cycle" peak, following a tightening in monetary conditions that began late last year. Part of the tightening in monetary conditions reflected normal countercyclical actions by the PBOC, but it also signified a strong desire on the part of policymakers to avoid significant further leveraging of the economy. As such, 2017 served as a prime example of the periodic oscillation of Chinese economic policy between promoting painful supply-side reforms and pushing demand-side countercyclical policies. Chart 1 highlights that policymakers did manage to achieve some modest outright deleveraging in the non-financial corporate sector in the first two quarters of the year, but at least half of this gain occurred because nominal GDP growth accelerated (i.e. the denominator of the debt-to-GDP ratio improved). No such deleveraging occurred in the household sector, which continued to see year-over-year debt growth of 24%. The struggling of Chinese policymakers to control the pace of credit growth reflects the inherent difficulty of China's new de-facto growth model, which shifted significantly in 2010. Chart 2 presents a stylized timeline of China's economic history over the past 15 years; rather than painting the rise in China's debt-to-GDP ratio in a sinister light, it underscores the unenviable lose-lose position facing Chinese policymakers in 2010. The chart describes how China's extremely rapid growth phase from 2002-2008 was followed by the global financial crisis and a normal rise in the debt-to-GDP ratio. This rise occurred due to a significant deceleration in nominal GDP growth, and standard counter-cyclical economic policy during an extremely challenging time for the global economy. However, following the onset of the economic recovery in 2009, it became clear that China's export-enabled catchup growth phase was durably over, and policymakers were faced with a hard choice: Either replace exports as a growth driver with debt-fueled domestic demand in order to buy the economy time to move up the value-added chain and to transition to a services-led economy (the "reflate" path), or allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity (the "stagnate" path). Chart 2A Stylized Timeline Of China's Recent Economic History Legacies Of 2017 Legacies Of 2017 The well-known legacy of China's choice to pursue the "reflation" path is the significant and persistent gap between the growth rates of private non-financial credit and nominal GDP since 2010 (Chart 3). It is significant that this gap almost entirely closed in the first half of 2017, but a further deceleration in credit growth will be necessary to keep it closed given that nominal GDP growth is likely to decline over in the coming year. Chart 3No Overall Deleveraging,##br## But A Halt To Rising Leverage No Overall Deleveraging, But A Halt To Rising Leverage No Overall Deleveraging, But A Halt To Rising Leverage Table 1 underscores the lasting economic impact of the "sudden stop" experienced by China's external sector, even given the choice to pursue the "reflate" path, by presenting the contribution to real GDP growth by broad expenditure categories. Relative to the 2002-2008 average, the largest negative contributor to growth during the global financial crisis and its aftermath was from net exports, made up by a stimulus-induced acceleration in investment. However, over the following five years most of the deceleration in growth came from gross capital formation, as private producers adjusted to the new export environment by rapidly slowing their additions to new capacity. Absent new investment from China's state-owned sector (which occurred as part of the reflation plan), Table 1 strongly suggests that gross capital formation in China would have slowed much more aggressively than it did had policymakers not chosen to reflate the economy. Given this, many investors have a sanguine view on the risks posed by China's massive increase in debt-to-GDP, and are likely to view policymaker efforts to durably close this gap as a policy mistake. According to this perspective, global investors would be far less concerned if the post-2010 rise in debt had occurred explicitly on the government's balance sheet, and since most of the rise in non-financial corporate debt is attributable to the state-owned sector, it is quasi-sovereign in nature and thus not likely to be the source of a financial crisis. Table 1The Global Financial Crisis Caused A Lasting Economic Impact, ##br##Even Given China's Choice To Reflate Legacies Of 2017 Legacies Of 2017 Chinese policymakers would argue that their goal is simply to control China's debt-to-GDP ratio and to stop continued leveraging, not to put the financial system on an active deleveraging path that would risk destabilizing the economy. But even within this policymaker framework, there are two clear potential risks, both of which will need to be tracked over the coming year. The first is that the monetary tightening that has already occurred (and is still underway) causes debt service payments to become unbearable for state-owned firms, which forces a crisis that inflicts considerable short-term pain on the economy. The second is that other reform initiatives, those intended to pare back heavy-polluting industry (see below), to hasten the transition of China's economy to "consumer-led" growth, and to continue to crack down on corruption and graft end up negatively impacting the economy in a way that policymakers did not intend. Both of these risks will need to be monitored closely in 2018 and beyond. Bottom Line: 2017 served as a prime example of the periodic oscillation of Chinese economic policy between promoting painful supply-side reforms and pushing demand-side countercyclical policies. While policymakers are merely attempting to control the private sector debt-to-GDP ratio and are not pushing for active deleveraging, the risk of a tightening overshoot should not be discounted. Bumping Up Against The Environmental "Red Line" Another legacy of 2017 is the environmental impact of the recent economic mini cycle, and the lasting effect that poor air quality is likely to have on the country's reform agenda. Chart 4 presents one commonly used measure of air quality, termed PM2.5. It represents the concentration of airborne particulate matter that is 2.5 microns in size or smaller (smaller particles are more of a health risk), rescaled into an index. When using this measure, a value less than 50 is deemed to be good, whereas values above 50 are not ideal. At an index value of 150, PM2.5 concentrations become unhealthy for the entire population, not just sensitive groups. Chart 4Chinese Air Quality Deteriorated During ##br##This Growth Mini Cycle Chinese Air Quality Deteriorated During This Growth Mini Cycle Chinese Air Quality Deteriorated During This Growth Mini Cycle The chart shows the rolling 3-month average PM2.5 index for Beijing since 2010, along with the year-over-year change in the index. Three points are noteworthy: Over the past 8 years, Beijing's air quality has never been ranked as "good" for any significant period of time, and has typically contained moderate amounts of harmful particulate matter. Interestingly, at the onset of the recent growth mini-cycle in 2015, China's air quality deteriorated rapidly, nearly into unhealthy territory. This occurred again earlier in 2017, suggesting that the type of economic activity associated with growth over the past two years has been particularly negative for the environment. The slowdown in the Li Keqiang index over the past 6-9 months has corresponded with the largest year-over-year decline in Beijing's PM2.5 concentration since early-2015, when economic activity in China was slowing sharply. Given this, it is not surprising that President Xi's speech during the Party Congress in October emphasized the need to scale back highly-polluting heavy industry over the coming years. But if recent economic activity in China has been driven by these industries, this raises an obvious risk that environmental reforms over the coming few years could seriously curtail growth. This is especially true given that the Chinese public appears to be willing to sacrifice growth for an improvement in air quality (Chart 5). When outlining our key themes for 2018,3 we noted that next year's reform announcements will be highly significant not just because of the "what", but also the "how". We expect to see more details emerge in the lead up to the National People's Congress in March, but for now we are playing this theme by being long China's investable environmental, social, and governance (ESG) leaders index and short the investable benchmark (Chart 6). This trade is up 2% since we initiated it on November 16, and we expect further gains in 2018 if environmental reform remains a key priority for Chinese policymakers. Chart 5The Public Is Willing To Sacrifice Growth ##br##To Improve The Environment Legacies Of 2017 Legacies Of 2017 Chart 6Further Gains Likely##br## If The Environment Remains A Priority Further Gains Likely If The Environment Remains A Priority Further Gains Likely If The Environment Remains A Priority Bottom Line: Recent economic activity in China appears to have been driven by highly-polluting industries, in the context of strong public demand for an improvement in air quality. This raises the risk that environmental reforms over the coming few years could seriously curtail growth. A Year Of Spectacular Returns From Chinese Stocks. Now What? As of December 19, Chinese investable stocks (in US$) earned just over 50% in total return terms this year. Chart 7 shows that this ranks as the third largest annual gain among all major equity markets since 2010, behind only Russia and Brazil's commodity-fueled performance in 2016 (which was the mirror image of their spectacular losses in 2014/2015). Chart 7A Red Letter Year For Chinese Stocks Legacies Of 2017 Legacies Of 2017 There are two implications from China's amazing year-to-date equity market performance. First, it serves as a testament to the importance of tracking and playing economic mini cycles in China. BCA's China Investment Strategy service highlighted in February of this year that the economy would remain buoyant in the near term,4 and that investors should be overweight Chinese investable equities over the coming 6-12 months. Clearly this recommendation has panned out well. Second, it implies that Chinese stocks have re-rated significantly, and are no longer "exceptionally cheap". This means that the job of earning outsized returns from Chinese equities over the coming years will become more difficult, with investors possibly at some point needing to be selective in their allocation. The good news is that the range of valuation within China's investable market has increased, which implies more potential for alpha generation. In fact, Chart 8 highlights that this a global phenomenon, which appears to be at least somewhat related to the decline in intra-equity market correlation (panel 2). We plan on following up on the issue of sector-based alpha in the New Year, but for now there are no signs of a turnaround in the significant underperformance of investable value vs growth stocks (Chart 9). But given that the style dividend yield gap has grown to an elevated level (Chart 10), going long Chinese investable value / short investable growth is one of several potential trade ideas that we will be evaluating in the coming months. Stay tuned. Chart 8Lower Correlation Means Higher Valuation Dispersion Lower Correlation Means Higher Valuation Dispersion Lower Correlation Means Higher Valuation Dispersion Chart 9Chinese Value Stocks May Soon Attract Attentio Chinese Value Stocks May Soon Attract Attentio Chinese Value Stocks May Soon Attract Attentio Chart 10Value Is Now Particularly Valuable Value Is Now Particularly Valuable Value Is Now Particularly Valuable Bottom Line: The incredible returns from Chinese stocks this year means that investable equities are no longer "exceptionally cheap". Still, the range of valuation among Chinese investable sectors has increased, suggesting increased opportunity for alpha generation over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

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