Sectors

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2017. The model's allocation to Australia has proven to be quite volatile as evidenced by the large increase to Australia this month to 7% from 1.7% in last month. As a result, the other commodity country, Canada, is now back to underweight from neutral last month. There are no significant large adjustments in other countries, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 80 bps in December as the model was underweight the U.K. versus EMU, yet the U.K. was the best performer in the month while EMU underperformed. Since going live in January 2016, the overall model has outperformed the benchmark by 47 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 265 bps. The Level 1 model outperformed the MSCI World benchmark by 19 bps. Table 2Performance (Total Returns In USD) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 2, 2018. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates The model has turned more bullish on global growth as seen by a 2% increase in aggregate cyclical overweight. However, the model continues to reduce its overweight in the resources-based sectors, and has upgraded financials to overweight on the back of improving momentum. Finally, both utilities and telecom stocks have been moved further into underweight territory. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com.

Dear Client, We are sending you this last issue of the year, a lighter fare than usual, highlighting 10 charts we find important. The first two charts tackle two of the key economic questions of the day: U.S. inflation and Chinese construction. The next seven charts are displays of technical action that has captured our attention for key currency pairs. The last chart tackles the topic du jour, bitcoin. We will resume regular publishing on January 5th, 2018. Finally, the Foreign Exchange Strategy team would like to thank you for your continued readership, and wishes you and your families a joyful holiday season as well as a healthy, happy and prosperous 2018. Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) U.S. Inflation Chart I-1AU.S. Inflation Is On Its Merry Way (I) U.S. Inflation Is On Its Merry Way (I) U.S. Inflation Is On Its Merry Way (I) Chart I-1BU.S. Inflation Is On Its Merry Way (II) U.S. Inflation Is On Its Merry Way (II) U.S. Inflation Is On Its Merry Way (II) U.S. inflation has been moribund in 2017, dismaying believers of the Philips curve, the Federal Reserve included. A few factors have been at play. The Fed sigma models show that the negative impact of a dollar rally on U.S. inflation is at its strongest with a two-year lag. Additionally, the fall in capacity utilization that happened following the industrial recession in late 2015/early 2016 continued to affect inflation negatively this year. These headwinds are passing. As the left panel of Chart I-1 illustrates, the easing in U.S. financial conditions this past year is likely to continue and become most salient for inflation in 2018. Meanwhile, the right panel of the chart shows that as the deceleration in money velocity growth forecasted the weakness in core inflation in 2017, its recent re-acceleration points to a pick-up in inflation next year. The Fed might be able to achieve its interest rate forecast of 3.1% in 2020 after all. 2) Chinese Housing Chart I-2AFrosty Outlook For Chinese Construction (I) Frosty Outlook For Chinese Construction (I) Frosty Outlook For Chinese Construction (I) Chart I-2BFrosty Outlook For Chinese Construction (II) Frosty Outlook For Chinese Construction (II) Frosty Outlook For Chinese Construction (II) Chinese monetary conditions have been tightened in 2017, fiscal expansion has been curtailed, and the growth of the M3 broad money supply has fallen to 8.8%. So far, the Chinese economy is hanging in, still benefiting from the fact that real interest rates have collapsed since November 2015 as producer price inflation rebounded from a 6% contraction to a 6% expansion today. This increase in producer prices has also helped industrial profits, which are expanding at a 23% pace, helping put a floor under industrial production. However, the outlook for residential investment needs to be monitored. Construction contributed 17% of GDP growth during the past two years. Chinese construction also contributed to 20% and 32% of the global consumption of refined copper and steel, respectively. This means that Chinese construction was a key driver of metal prices. Yet our leading indicator for Chinese house prices points toward a marked deceleration in the coming quarters. As the right panel of Chart I-2 shows, this could get translated into additional downside for iron ore. 3) EUR/USD Chart I-3The Euro Is At A Key Threshold The Euro Is At A Key Threshold The Euro Is At A Key Threshold 1.20 continues to represent a big hurdle to cross for EUR/USD. For the euro to punch above this mark, U.S. inflation will have to remain moribund in 2018. The rally in EUR/USD tracked an improvement in market estimates of the European Central Bank's terminal policy rate relative to the Fed's. Yet this improvement did not reflect an upgrade of the ECB's terminal rate itself, but rather a major downgrade of the Fed's, as U.S. inflation disappointed. If U.S. inflation rebounds as BCA anticipates, the dollar should be able to rally toward 1.10, especially as euro area inflation is unlikely to follow suit, as euro area financial conditions have tightened massively relative to the U.S. If U.S. inflation does not rebound, a move toward 1.30 is possible. Glimpsing at Chart I-3, it should also be obvious that any strength in the dollar next year is likely to prove a long-term buying opportunity for the euro. The EUR/USD has only traded below current levels when the U.S. dollar has been in the thralls of a major bubble. Additionally, global portfolios are deeply underweight euro area assets, therefore, a long-term rebalancing of portfolios toward euro area assets will support the euro down the road. Finally, when the next recession hits, the ECB is likely to have less room to stimulate its economy than the Fed will have. This means that during the next recession, the euro could behave like the yen has over the past 20 years: because the ECB will be impotent to fight deflationary pressures, falling euro area inflation will result in rising euro area real interest rates, especially against the U.S. This helped the yen then, and it could help the euro in the future, especially as the euro area's net international investment position is set to move into positive territory over the next 24 months. 4) EUR/GBP Chart I-4Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now EUR/GBP is at an interesting juncture. EUR/GBP has rarely traded above current levels (Chart I-4). On one hand, Brexit would suggest that EUR/GBP could actually rise. The uncertainty around the U.K. leaving the EU has caused the U.K. economy to be among the rare ones to not accelerate in unison with global growth this year, despite the stimulative effect of a lower pound. This suggests that the hands of the Bank of England will remain tied, limiting its capacity to increase the cash rate. Moreover, U.K. politics continue to take an increasingly populist tone, and the growing popularity of Jeremy Corbyn suggests that the discontent is present on all sides of the political spectrum. Populist policies are rarely good for a currency. On the other hand, the GBP is trading at such a discount to its fair value against both the USD and the EUR that historically, buying the pound at current levels has generated gains for investors with investment horizons measured in years. Moreover, if the EUR weakens in the first half of 2018, historical antecedents argue that EUR/GBP would also weaken in this context. When taken altogether, these factors suggest that EUR/GBP is likely to remain stuck in its post-Brexit trading range for as long as political uncertainty remains, especially as it is unlikely that the U.K. will receive a sweetheart FTA deal from the EU. Thus, while we expect EUR/GBP to retest 0.84 over the course of the next three to six months, at these levels we would buy EUR/GBP with a target of 0.90. 5) EUR/SEK Chart I-5EUR/SEK Will Fall From 10 To 9 EUR/SEK Will Fall From 10 To 9 EUR/SEK Will Fall From 10 To 9 EUR/SEK flirted with 10 this month. As Chart I-5 illustrates, this only happened during the financial crisis. Sweden is a much more pro-cyclical economy than the euro area, hence EUR/SEK exhibits very strong counter-cyclical behavior. It only trades above 10 when global growth is in tatters, and below 9 when it is booming. The recent spate of strength in EUR/SEK is thus perplexing, since global growth has been very robust and broad-based this year. The very easy policy of the Riksbank has been the main culprit. Timing a reversal in EUR/SEK is tricky, as it remains a function of the rhetoric of the Riksbank. But today, Swedish inflation is on the rise, with the CPIF, the inflation gauge targeted by the Swedish central bank, being at target. Thus, the days of super easy monetary policy in Sweden are numbered, especially as the output gap is a positive 1%, unemployment stands nearly 1% below equilibrium, and resource utilization measures have spiked up. Today, it makes sense to buy the SEK versus the euro. However, EUR/SEK is unlikely to move below 9, as the best of the global business cycle is probably behind us. 6) USD/JPY Chart I-6A Big Move In USD/JPY Is On Its Way A Big Move In USD/JPY Is On Its Way A Big Move In USD/JPY Is On Its Way USD/JPY is at an interesting technical juncture. This pair has been forming a very large tapering wedge in recent years (Chart I-6). This type of formation can be resolved in either a bullish fashion or a bearish one. Our current inclination is to bet on a bullish resolution for USD/JPY, as global bond yields seem to finally be regaining some vigor, which historically has been poison for the yen. Supporting our bias is the fact that we see more interest rate increases in the U.S. than are currently priced in, as we foresee a pick-up in inflation in 2018. The one thing that keeps us awake at night when thinking about our bullish disposition for USD/JPY is that EM carry trades have begun to weaken. Historically, this has led to a softening in global activity which foments further EM-carry-trade reversals and weakness in USD/JPY. Investors should keep an eye on this space. 7) AUD/USD Chart I-7AUD/USD At 0.8 Is A Line In The Sand AUD/USD At 0.8 Is A Line In The Sand AUD/USD At 0.8 Is A Line In The Sand The Australian dollar possesses the poorest outlook among the G10 currencies. The Australian economy continues to be plagued by large amounts of overcapacity, inflation is still absent, and Australia is the economy most exposed to a slowdown in Chinese construction activity as Australian terms-of-trade shocks follow metals prices. Additionally, China's push to fight pollution points to weakening coal prices, another key export of Australia. Moreover, Chart I-7 illustrates that the AUD rarely trades above 0.8. To do so, it needs an especially robust global economy, with China firing on all cylinders. We do not think China is about to crash, but it is not about to accelerate either, especially when it comes to demand for metals. Thus, with AUD/USD trading at 0.77, we see more downside for this pair than upside. In fact, when observed in a broader, longer-term context, the rally since 2016 in the AUD looks like a consolidation within a larger downtrend. 8) AUD/CAD Chart I-8AUD/CAD Will Breakdown AUD/CAD Will Breakdown AUD/CAD Will Breakdown AUD/CAD seems to have hit its natural ceiling this year. Only in the first half of the 1990s and when China was reflating its economy with all its might right after the financial crisis was AUD/CAD able to punch above 1.03 (Chart I-8). We do not see a repeat of this performance in the coming two years. First, as we mentioned, BCA does not anticipate any re-acceleration in Chinese investment or EM demand. Second, AUD/CAD is expensive, trading 9% above its fair value. Third, BCA remains more bullish on oil prices than metals prices. Fourth, a weakening AUD/USD tends to be associated with a weakening AUD/CAD. Finally, if these four factors cause AUD/CAD to weaken below 0.964, a key upward trend line that has supported AUD/CAD since late 2008 will be broken, which should prompt additional selling in this cross. 9) AUD/NZD Chart I-9AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD is likely to remain stuck in its trading range established since 2013 (Chart I-9). To begin with, the Australian dollar is trading at a 10% premium to the NZD. This has happened three times over the previous 17 years. Each of these instances were followed by vicious corrections in this cross. Additionally, while the AUD is very exposed to a slowing in Chinese construction and the associated problems for base metals prices, the NZD is not. In fact, the NZD may even benefit from the new economic objectives set by China's leadership. One of these new key objectives is to rebalance the economy toward the consumer. Moreover, Chinese consumer preferences have seen a switch toward higher quality foodstuffs.1 Higher quality foodstuffs, meat and dairy in particular, are exactly what New Zealand exports. Thus, a relative negative terms-of-trade shock is likely to come for AUD/NZD. The one big negative to our view is the political situation in New Zealand. The recent wave of populism points toward a fall in the potential growth rate, and thus a fall in the terminal policy rate of the Reserve Bank of New Zealand. The limit on foreign investment in Kiwi housing is another negative.2 Thus, we are not yet willing to bet on AUD/NZD falling below parity. 10) Bitcoins Chart I-10Groupthink Points To A Bitcoin Correction Toward 11,000 Groupthink Points To A Bitcoin Correction Toward 11,000 Groupthink Points To A Bitcoin Correction Toward 11,000 Valuing bitcoins is an arduous exercise. A lack of clearly defined fundamentals is the key difficulty. It is also why bitcoin prices can move so violently. We have already covered the technological elements behind Bitcoin and the blockchain,3 but to uncover what could be driving investors' imaginations, we have to move back to the realm of economics and finance. One theory tries to value bitcoin by linking it to a mode of payment. Using this method, Dhaval Joshi, who writes our BCA European Investment Strategy service, estimates a fair value for BTC/USD. Using the quantity of money theory, he shows that if the market assumes that bitcoins can support US$0.5 trillion of global GDP, and if the velocity of money historically averages 1.5 times, with 21 million potential bitcoins in issuance, a bitcoin should be worth US$17,000.4 Changing estimates for velocity or how much of global GDP will be transacted using bitcoins varies this estimate. Another approach has been to value bitcoins as an asset with a limited supply, like gold. Using this methodology, the global gold stock is worth approximately US$7 trillion, but cryptocurrencies, with their high volatility, are unlikely to steal the yellow metal's entire market share. Instead, they might be able to carve out 25% of gold's current total market capitalization. In this case, cryptos would be worth US$1.75 trillion. Bitcoin could represent half of this amount, which equates to a total market capitalization of US$875 billion. With a stock of 21 million bitcoins, the "fair value" would be around US$42,000. A third approach exists, and it is the simplest (Occam Razor's alert?). As Peter Berezin argues in BCA's Global Investment Strategy service, global governments extract seigniorage benefits from issuing currency.5 As an example, by printing cash, the U.S. government can buy services and good worth roughly US$90 billion per year, at a near zero cost. This is a very significant amount. Governments are unlikely to ever give up this source of funding. Since crypto currencies are a direct threat to this, they will likely be made illegal as a result. This would imply a fair value of BTC/USD of zero. The current fair value is likely to be a probability weighted average of all three scenarios. We assign a 10% probability for the first case (mode of payment), a 10% probability to the second case (store of value), and an 80% probability to the last case (zero value due to illegality). This would give a current fair value of roughly US$6,000. At the current juncture, bitcoin trading is exhibiting strong herd-like tendencies. When groupthink takes over a market, as is the case right now with crypto-currencies in general and bitcoin in particular, a trend reversal is likely to materialize. Today, bitcoin's "fractal dimension" has hit the 1.25 neighborhood, where such reversals have tended to happen (Chart I-10). As such, a correction is very likely. The average correction since 2016 has been around 35%. Following similarly parabolic moves as the one observed over the past month, pullbacks have been closer to 45%. A retracement toward BTC/USD of 11,000 is very probable over the coming quarters. That being said, it is too early to call the ultimate top for bitcoin. With the narrative among the bitcoin investing public increasingly switching to bitcoin being a store of value akin to gold, a move to the US$40,000 neighborhood is, in fact, not a tail event. However, this is a move to play at one's own peril, since fair value is likely to be well below these levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Atkinson, Simon. "Why are China instant noodle sales going off the boil?" BBC News, BBC, 20 Dec. 2017, www.bbc.com/news/business-42390058. He, Laura. "China's growing middle class lose appetite for instant noodles." South China Morning Post, 20 Aug. 2017, www.scmp.com/business/companies/article/2107540/chinas-growing-middle-class-lose-appetite-instant-noodles. 2 For a more detailed discussion of the political situation in New Zealand as well as its potential impact, please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How to Transform Gold into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "Blockchain And Cryptocurrencies" dated May 12, 2017, available at fes.bcaresearch.com 4 Please see European Investment Strategy Weekly Report, titled "Bitcoins And Fractals" dated December 21, 2017, available at eis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, titled "Don't Fear A Flatter Yield Curve" dated December 22, 2017, available gis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Housing starts increased by 1.3 million units, beating expectations, building permits also outperformed; Both the Philadelphia Fed Manufacturing Survey and Chicago Fed National Activity Index outperformed expectations; However, annualized Q3 GDP growth came in at 3.2%, less than the expected 3.3%; Growth in headline and core personal consumption deflators also failed to meet expectations, coming in at 1.5% and 1.3% respectively. Easier financial conditions are expected to slowly push the core PCE deflator back to the Fed's 2% target. This will allow Jerome Powell to continue in Janet Yellen's footsteps. As credit continues to grow, the large U.S. consumer sector will become an increasingly important tailwind to growth. The fiscal thrust from the new tax plan will could also accentuate growth and inflationary pressures. Therefore, investment and consumption activity are both likely to pick up next year. This will should support the Fed as well as the USD. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: German ZEW Current Situation increased to 89.3, outperforming expectations of 88.5; European ZEW Current Situation slightly underperformed expectations of 18, coming in at 17.4; Manufacturing and services PMIs for Germany and Europe as a whole both outperformed expectations; European trade balance decreased to EUR 19 bn from EUR 25 bn, and the current account also underperformed; European CPI was in line with expectations, contracting at a monthly pace, and growing at a 0.9% annual pace, under the expected 1% rate. On the Back of strong momentum in activity indicators, the ECB upgraded its growth and inflation forecasts for the upcoming years. However, since inflation is expected to remain under target for the whole forecast horizon, the ECB is likely to tighten policy at a much slower pace than the Fed. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Annual Import growth came in at 17.2%, surprising to the downside. Moreover, the All Industry Activity Index monthly growth also underperformed expectations, coming in at 0.3%. However, export annual growth surprised to the upside, coming in at 16.2%, an acceleration relative to last month's reading. On Wednesday, the Bank of Japan left its policy rate unchanged at -0.1%. Furthermore, the yield curve control policy, in which 10-year yields are kept around 0%, has been maintained. We stay bullish on USD/JPY, as we expect U.S. bond yields to rise when inflation picks up next year. However the yen could appreciate against commodity currencies if a risk-off period is triggered by tightening in China. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Gfk Consumer confidence underperformed expectations, coming in at -13. This measure also decline from the November reading. However, CBI industrial Trend Survey for orders, surprised to the upside, coming in at 17. Finally, public sector borrowing also surprised to the upside, coming in at 8.118 Billion pounds. The pound has been flat against the U.S. dollar this week. Overall we remain skeptical in the ability of the Bank of England to tighten much in the near future, given that real disposable income growth is very depressed, house price growth continues to be tepid, and uncertainty weighs on capex. Moreover, inflation will likely come down from present levels, as the pass through from the pound depreciation dissipates. All of these factors will limit any upside to cable in the next months. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The AUD rallied solidly in recent weeks thanks to buoyant data out of Australia and China. Last week's labor numbers were especially important in this regard. The growth in full-time employment has outperformed that of part-time since summer, while the underemployment rate has declined by 0.3% since 2017Q2.. Moreover, RBA officials identified further positives in the housing market: excessive price appreciation has slowed down considerably and household's balance sheets are improving. For now, the biggest risk to the Australian dollar remains the Chinese economy. Xi Jinping's commitment to clamp down on pollution, debt and inequalities is a bearish prospect for the AUD. Additionally, Chinese house prices could decline substantially - something which would have negative repercussions for the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: The current account surprised to the downside, coming in at -2.6% of GDP. However this number did improve from last quarter's -2.8% reading. However, both imports and exports outperformed expectations, coming in at 5.82 billion and 4.63 billion respectively. Moreover, GDP growth outperformed expectations, coming in at 2.7%. However, this number did decline from the 2.8% reading in Q2. NZD/USD was flat this week, even as the USD weakened. We continue to believe that carry currencies like the NZD, will be affected by tightening of financial conditions in China. However, the NZD has upside against the AUD, as the New Zealand dollar is cheaper than the AUD, and it is not as levered to the Chinese industrial cycle as the Australian dollar is. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was strong this week: Retail sales increased month-on-month by 1.5%, outperforming expectations by 0.8%; core retail sales also increased by a 0.8% monthly pace; Core inflation is at 1.3%, outperforming the expected 0.8%; Headline CPI is at 2.1%, above the expected 2%; The Canadian economy is growing in line with our expectations. A strong U.S. economy has allowed the export sector to flourish, while high demand for jobs has caused the labor market to tighten substantially. As labor shortages intensify, wages should gain traction in the near future, paving way for the BoC to tighten at least twice next year. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recently, the SNB released its 4th quarter quarterly bulletin. This report highlighted that the Swiss economy continues to recover, and GDP growth is expected to reach 2% in 2018, after a 1% expansion this year. Furthermore, the bulletin remarked that the labor market continues to tighten, with unemployment reaching 3% and employment growth finally hitting its long term average. The SNB also remarked that although the output gap continues to be negative, measures of capacity utilization are very close to reaching their long term average. However, the SNB continues to be unapologetically committed to its dovish bias and to intervention in currency markets, as inflation in Switzerland continues to be too weak for the SNB to change its stance. Thus, the CHF is likely to continue depreciating. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has appreciated by nearly 1.5% since last week, even as Brent has rallied by more than 2.5%. This dynamic highlights the fact that USD/NOK continues to be more correlated to interest rate differentials between Norway and the U.S. than to oil prices. Inflationary pressures and economic activity continue to be too tepid for the Norges to adopt a much more hawkish tone than it did last week. Meanwhile, the Fed is likely to surprise the market next year, by following up on its "dot plot". These dynamics will continue to put upward pressure on USD/NOK. Nevertheless, foreign exchange investors can still use the krone to bet on higher oil prices resulting from the extension of the OPEC supply cuts. The way to do so is by shorting EUR/NOK, which is more correlated with oil prices. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data has bounced back considerably: Headline CPI increased by 1.9% annually and CPIF grew by 2% annually; The unemployment rate dropped substantially from 6.3% to 5.8%, while the seasonally adjusted figure dropped from 6.7% to 6.4%. This week, the Riksbank announced a formal end to additional bond purchases by the end of December. However, reinvestments will continue until the middle of 2019, which means that the Bank's holdings of government bonds will actually increase into 2019. Additionally, the Swedish central bank also forecasts the repo rate to begin gradually increasing in the middle of 2018. This makes sense as the Swedish economy is running beyond capacity conditions. Given Sweden's stellar growth period, an appreciation in the SEK is long-awaited, but this will have to wait until Governor Ingves convinces markets that his perennial dovish-bias is ebbing. At that point, any hint of hawkishness will cause a sharp appreciation in the SEK, especially against the euro. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights As bitcoin has developed into a fledgling form of money, the best valuation framework for it is the quantity theory of money. This states that the bitcoin money supply (in dollars) times bitcoin's velocity of circulation = the amount of world GDP carried out in bitcoin. In the short term, excessive herding signals a likely countertrend reversal, and implies that the bitcoin price will retest $12,750 at some point in the next 130 days. In the long term, the wholesale acceptance of cryptocurrencies in the global economy will be deflationary. Feature Bitcoin's near-vertical price ascent to $19,000 has left many commentators crying "bubble!" The problem with this is that you cannot define an asset bubble simply from the behaviour of a price. You need to assess fundamental value, and the extent of deviation above this fundamental value. Conceivably, bitcoin's near-vertical price ascent could be a correction from an "anti-bubble", in which the price was a long way below its fundamental value and rapidly corrected upwards. Which begs the question: what is the best way to assess the fundamental value of bitcoin and other cryptocurrencies? Chart of the WeekCryptocurrencies Will Prevent Inflation, Just Like The Gold Standard Cryptocurrencies Will Prevent Inflation, Just Like The Gold Standard Cryptocurrencies Will Prevent Inflation, Just Like The Gold Standard A Valuation Framework For Bitcoin As bitcoin has developed into a fledgling form of money, one potential valuation framework is the quantity theory of money. This states that the money supply times its velocity of circulation equals nominal GDP. Given that the supply of bitcoin will not exceed an upper limit of 21 million coins, we can say that the bitcoin money supply (in dollars) is the bitcoin price times 21 million. We can then use the quantity theory to deduce: Bitcoin price times 21 million times bitcoin's velocity of circulation = Amount of world GDP carried out in bitcoin. If we additionally assume that bitcoin's velocity is similar to that of the stock of broad fiat money, 1.5, then we can rearrange and simplify the equation to approximately: Bitcoin price = Amount of world GDP carried out in bitcoin divided by 30 million So if the market was discounting that $0.5 trillion of world GDP would be carried out in bitcoin, then its price should be $16,700. Given the purported nefarious uses of cryptocurrencies at the moment, and an estimated size of the world's shadow economy at around $16 trillion, an assumption of $0.5 trillion of bitcoin use in the world economy does not seem excessive. On the other hand, nefarious use might make bitcoin's velocity of circulation a lot higher than conventional money. Which would pull bitcoin's fair price much lower. Suffice to say, the above assumptions are broad-brush and open to challenge. Nevertheless, despite the many caveats, the above framework is probably the most valid for valuing a cryptocurrency once it gains acceptance as a fledgling form of money. Putting Bitcoin Through Fractal Analysis The behaviour of price alone cannot gauge an asset bubble. But the behaviour of price alone can gauge a shortage of liquidity in the asset which implies a potential countertrend reversal. Liquidity is plentiful when the market is split between short-term momentum traders and longer-term value investors. This is because the two herds generally disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity and little movement in price. This raises an obvious question. Can there really be any value investors in cryptocurrencies? The answer is potentially yes, if these investors believe that cryptocurrency acceptance will increase over time. And if they apply the aforementioned valuation framework from the quantity theory of money. Still, liquidity will periodically evaporate if too many value investors join the short-term momentum herd. Instead of dispassionately investing on the basis of a valuation framework, value investors get lured into participating in a strong rally, and their buy orders add fuel to the rally. A tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, fractal analysis measures whether the herding behaviour in any financial instrument has reached its tipping point, signalling a likely end of its price trend. Today, the 130-day herding indicator for bitcoin is at a level which has indicated three previous countertrend reversals of at least one fifth of the preceding 130-day move (Chart I-2, Chart I-3, Chart I-4). Chart I-2Bitcoin: The 130 Day Fractal Dimension Signalled A Reversal In 2015 Bitcoin: The 130 Day Fractal Dimension Signalled A Reversal In 2015 Bitcoin: The 130 Day Fractal Dimension Signalled A Reversal In 2015 Chart I-3Bitcoin: The 130 Day Fractal Dimension Signalled Two Reversals In 2017 Bitcoin: The 130 Day Fractal Dimension Signalled Two Reversals In 2017 Bitcoin: The 130 Day Fractal Dimension Signalled Two Reversals In 2017 Chart I-4Bitcoin: The 65 Day Fractal Dimension Also Signalled Two Previous Reversals Bitcoin: The 65 Day Fractal Dimension Also Signalled Two Previous Reversals Bitcoin: The 65 Day Fractal Dimension Also Signalled Two Previous Reversals If this herding indicator signals a fourth countertrend reversal, it implies that the bitcoin price will retest $12,750 at some point in the next 130 days. Are Cryptocurrencies Inflationary Or Deflationary? On the face of it, the emergence of cryptocurrencies sounds inflationary. After all, if the general acceptance of cryptocurrencies for commercial transactions increases, there will be new money supply. And this new money supply will increase the nominal demand for goods and services. However, the truth is more nuanced. Unlike fiat money supply - which can expand without limit - each cryptocurrency has a defined limit to its supply. Although new cryptocurrencies can emerge, there seems to be a limit to the aggregate amount of cryptocurrency supply. The limiting factor is that it takes energy to create cryptocurrency through so-called 'mining'. Miners must compete to validate transactions that occur in a cryptocurrency. The competition takes the form of solving a mathematical problem - for example, finding the prime factors of a very large number. And the computational demands are energy sapping. Furthermore, the computational demands - known as 'proof of work' - get progressively more difficult for each additional new coin mined. Given that the computational resources in the world are finite and growing at a gentle and predictable rate, the implication is that the growth in the total amount of cryptocurrency is also limited. So while the emergence of cryptocurrencies does increase the money supply in the near-term (Chart I-5), a large-scale rejection of fiat money would make it impossible for uncouth policymakers to spike the overall money supply over the longer-term. Chart I-5Cryptocurrencies: Market Cap Is Now Non-Trivial Bitcoins And Fractals Bitcoins And Fractals Here's a further thought. Imagine if the proof of work computations, instead of being random mathematical calculations, solved useful problems that expanded the envelope of knowledge. This could boost real productivity, which is ultimately just a function of the stock of human ingenuity. In which case, any increase in money supply would be matched by an increase in potential real output. Interestingly, a recent paper from the Bank of Canada proposes that a wholesale acceptance of cryptocurrencies in the global economy could act as a new gold standard, whose effect would be mildly deflationary1 (Chart of the Week) and Table I-1). We fully agree with the Bank of Canada analysis. Table I-1No Persistent Inflation For 700 Years! Bitcoins And Fractals Bitcoins And Fractals The sting in the tail is that the analysis describes prices denominated in cryptocurrency terms. In fiat currency terms, the quantity theory of money implies that prices would rise2 - unless central banks reacted to the emergence of cryptocurrencies by shrinking the supply of fiat money. Would they? Very likely yes. If they didn't, the demise of fiat money would accelerate as people voted with their wallets and switched to superior stores of purchasing power. Nevertheless, we suspect that any central bank response would just delay the inevitable. As Larry Summers puts it: I am much more confident that the world of payments will look very different 20 years from now than I am about how it will look. And with that observation, I am signing off for 2017. I do hope you have enjoyed our provocative and counterintuitive insights this year. In the vast majority of cases, these insights have led to highly profitable investment recommendations. We promise to continue the success in 2018! Early next year, we will also unveil a major enhancement to our proprietary fractal trading strategy. So stay tuned. It just remains for me to wish you all a very enjoyable Festive Season and a prosperous 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Bank of Canada Staff Working Paper, A Bitcoin Standard: Lessons from the Gold Standard https://www.bankofcanada.ca/2016/03/staff-working-paper-2016-14/ 2 Please see the Global Investment Strategy Special Report titled "Bitcoin's Macro Impact", dated September 15, 2017 available at gis.bcaresearch.com and Technology Sector Strategy Special Report titled "Cyber Currencies: Actual Currencies Or Just Speculative Assets?", dated December 12, 2017 available at tech.bcaresearch.com. Fractal Trading Model* As discussed in the main body of this report, this week's trade is to expect a countertrend reversal in bitcoin. Go short with a profit target at $12750 and stop-loss at $28000. In other trades, long silver has had a strong 1-week bounce while long U.K. personal products / short U.K. food and beverages reached the end of its 65 day maximum holding period and closed with a small profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-6 Long Silver Long Silver The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The financial system / banks cannot and do not lend out or intermediate national or households "savings". In any economy, new money/new purchasing power is originated by commercial banks "out of thin air". The term "savings" in macroeconomics denotes an increase in the economy's capital stock, not deposits at the banks. The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. Hence, the narrative that justifies China's money, credit and property market excesses by high national and household "savings" is incorrect. The maneuvering room for China is diminishing as inflationary pressures are rising, productivity is slowing and speculative leverage is high. Feature The debate on China's macro outlook continues to linger both within and outside BCA. The focal point of the debate centers on the role of national "savings" in China in spurring credit origination and debt formation. Many of my colleagues at BCA and the majority of commentators outside BCA argue that China's high "savings" rate, or so-called "excess savings", has been an important contributor to its exponential credit and money growth. Contrary to this narrative, we within BCA's Emerging Markets Strategy team maintain that the dramatic surge in credit and money in China has been the result of speculative behavior by banks and debtors. As such, the boom in money and credit growth has produced large imbalances and excesses, if not outright bubbles (Chart I-1). Chart I-1An Unprecedented Credit ##br##And Money Boom In China An Unprecedented Credit And Money Boom In China An Unprecedented Credit And Money Boom In China Every financial bubble in history has had its justifications. Last decade, the common narrative about U.S. real estate was that nationwide, U.S. house prices had historically never deflated in nominal terms. In the late 1990s, the tech bubble was vindicated by the "new productivity" era. In the meantime, in the 1980s in Japan and the mid-1990s in Hong Kong, sky high property prices were rationalized by limited amounts of land, given that these are islands. Despite these validations, all of these bubbles ultimately burst. We feel that vindicating China's enormous credit, money and property market excesses - which are all interrelated - by the nation's high "savings" is another attempt to endorse overextended and unsustainable macro imbalances. This report is a continuation of our series discussing these issues in great depth.1 The objective of this piece is to illuminate on the confusion between national "savings" and credit / deposits / money. Intuitively, many investors and commentators use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not about deposits or money in the banking system at all. The term "savings" in macroeconomics denotes an increase in the economy's capital stock. Therefore, the financial system in general, and banks in particular, cannot and do not lend out or intermediate national or households "savings." The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. In an economy where banks exist, "savings" and financing are very different things. Commercial banks (hereafter referred to as banks) provide financing by expanding their balance sheets - creating deposits "out of thin air" as and when they originate loans. We previously elaborated on this money creation process,2 but given its importance to the topic of this report, we revisit it here. Banks Create New Purchasing Power "Out Of Thin Air" When a bank originates a loan, it simultaneously creates a deposit, or new money. Importantly, this does not represent a transfer of an existing deposit to the new borrower. This is a new deposit - new purchasing power - that did not previously exist (Figure 1). Figure I-1Credit / Money Creation Process The True Meaning Of China's Great 'Savings' Wall The True Meaning Of China's Great 'Savings' Wall The borrower can immediately use this new deposit to purchase goods and services or buy assets. At the same time, all owners of existing deposits at the bank still have their deposits too, and can use them as, when, and how they prefer. Thereby, the bank has created new purchasing power "out of nothing" when it originated a loan. Traditional macroeconomic theory presumes that for a person or company to invest in productive capacity, another person/unit must save. This assumption is true for a barter economy with no banks and money - where some entities produce but do not consume, so that others can acquire their output (goods) and in turn use them as investment. Nevertheless, in an economy with banks, one does not need to save in the form of a deposit in a bank in order for the latter to lend money to another entity. When a bank grants a loan or acquires an asset, it simultaneously creates new deposit/money - which is de facto new purchasing power originated by the bank "out of thin air." We use the terms deposit and money interchangeably because broad money supply is computed as the sum of all deposits in the commercial banks. Let's consider an example of how a bank loan leads to new income creation. A company borrows from a bank to build a bridge, it then pays its suppliers and contractors for their work. As a result, the suppliers and contractors, and consequently their employees and shareholders, earn income. Without this loan, the bridge would not have been built, and the suppliers, their employees and business owners would not have received income. In short, the loan comes first, then the investment - and only after the investment is carried out do employees and business owners earn income. Thereafter, they can consume, acquire assets and save in forms of bank deposits. Critically, this income is realized because the bank originated a loan / new purchasing power "out of nothing." Chart I-2 illustrates that the Chinese banking system has created RMB 140 trillion of broad money/deposits since January 2009. This is equivalent to US$21 trillion at today's exchange rate. This is twice as much as aggregate broad money - equivalent to $10.5 trillion - generated by commercial and central banks in the U.S., the euro area and Japan combined since early 2009 - even amid their respective QE programs. Chart I-2Helicopter Money In China Helicopter Money In China Helicopter Money In China The unprecedented new purchasing power of Chinese companies and households has been primarily due to this enormous balance sheet expansion by mainland commercial banks (Chart I-3). Chart I-3China: Commercial Banks ##br##Assets And Money Multiplier China: Commercial Banks Assets And Money Multiplier China: Commercial Banks Assets And Money Multiplier Bank Versus Financial Intermediaries Banks perform a unique function in the economy and financial system. There are considerable differences between a bank lending money or buying assets and a non-bank doing the same. This is unfortunately not reflected in mainstream economic theory and macro models. Unlike banks, non-banks - such as pension funds, insurance companies, households, businesses and all other non-bank entities - do not create new money/new purchasing power when they grant a loan or acquire an asset. The act of lending by non-banks simply constitutes a transfer of an existing deposit from a creditor to a borrower. Banks are not intermediaries of deposits into loans as the Loanable Funds Theory (LFT) alleges. They create deposits themselves by making loans and acquiring assets. The LFT, nonetheless, applies to non-bank lenders - the latter are indeed financial intermediaries, i.e., they channel existing deposits into loans or other assets. The institutional and legal differences that make commercial banks unique and allow them to create money are discussed in detail in "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?," Werner (2014b).3 The theory of fractional banking is not applicable to modern banking as well.4 It is the theory of money creation by banks that we subscribe to and present here that accurately describes the process of money creation. Bottom Line: Banks differ vastly from non-bank financial institutions, and are unique in their ability to create money/new purchasing power by originating loans or acquiring assets. Money Versus Credit Remarkably, there is also an important analytical distinction between credit/leverage and money. New money matters when one is attempting to gauge the (nominal) growth outlook because it represents new purchasing power. New money can only be originated by banks, including the central bank. Central banks can create broad money in circulation (i.e. beyond central bank reserves) when they buy financial assets from or lend to non-bank entities. Doing so creates a deposit in the commercial banking system. By contrast, the degree of credit/leverage is critical when evaluating the risk of financial distress in both the economy and the financial system. Credit can be extended not only by banks but also by non-banks. Hence, lending or buying corporate bonds by non-banks creates leverage/credit but not new money. The banking system is the only one capable of originating new money, and in turn, new purchasing power. In China, the outstanding stock of total non-financial debt (private plus public) is close to the amount of money supply (Chart I-4). Even though non-bank credit growth has risen in importance since 2010, it seems that without banks' money creation, non-bank credit would not have expanded. Chart I-4China: Money Versus Credit/Debt China: Money Versus Credit/Debt China: Money Versus Credit/Debt On another note, household propensity to save alters the velocity of money, not the amount of money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system. As an example, a person who gets paid $1000 might spend $800 of her income and decide to save the remaining $200. The amount of deposits in the banking system does not change; $800 will be transferred to another bank account as she pays for her purchases, while the remaining $200 stays in her existing bank account. Hence, there is no change in the amount of deposits and money supply in the banking system in this scenario. On the whole, the amount of deposits, and hence, broad money supply, in any banking system is equal to the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings." The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. Interestingly, changes in household propensity to save are reflected not in money supply but in the velocity of money. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. Bottom Line: Money is distinct from credit and leverage. Changes in the propensity to save alter the velocity of money, but not the amount of deposits/money supply in the banking system. True Meaning Of "Savings" In Macroeconomics What is the true meaning of "savings"5 in macroeconomics, given the amount of deposits in the banking system has no bearing on "savings?" The confusion between national "savings" and deposit/money creation is dealt with nicely by Fabian Lindner. Having modelled it, Lindner6 argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy. Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving (emphasis is added). Thus, saving and investment are equivalent in the aggregate... The equivalence of investment and saving however does not mean - as claimed by LFT - that household saving (or the sum of household and government saving) is equal to total saving and thus to investment. No matter how high one group's financial saving is, the financial dis-saving of the rest of the economy has to be just as high. The only thing remaining is the creation of tangible assets." (Lindner 2015) In another paper,7 Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock." (Lindner 2012) Bottom Line: For a country to raise its domestic "savings" rate, it needs to build its capital stock by using domestically produced investment goods and raw materials. Thereby, domestic "savings" have nothing to do with the absolute level or changes in amount of deposits/money in the banking system. China's Great Wall Of "Savings" China has been investing tremendous amounts for many years, and its capital stock has been mushrooming (Chart I-5, top panel). Yet, the incremental capital-to-output ratio (ICOR) has surged and, its inverse, the output-to-capital ratio has plunged since 2010 (Chart I-5, middle and bottom panels). These developments signify deteriorating efficiency in the Chinese economy and worsening capital allocation. They also entail that companies might have difficulties servicing their debt. When its export machine faltered in 2008 due to the Global Financial Crisis, China offset it by boosting its domestic investments. These investments - incremental additions to the nation's capital stock - defined by macroeconomics as domestic "savings"- offset the decline in external "savings." As such, the composition of national "savings" has changed dramatically since 2008: the share of external "savings" (net exports) have declined while the share of domestic "savings" has risen (Chart I-6). Chart I-5China: Capital Stocks Has Surged China: Capital Stocks Has Surged China: Capital Stocks Has Surged Chart I-6China: Domestic And External 'Savings' China: Domestic And External 'Savings' China: Domestic And External 'Savings' In China, the augmentation of its capital stock and, hence, its domestic "savings," have been largely financed by loans from Chinese banks. This may sound like nonsense, but only because we are using the term "savings" in a way used in macroeconomics. Yet, new purchasing power originated by the banking system is not in and of itself a sufficient condition to generate domestic "savings." The sufficient condition for having high domestic "savings" is the ability to produce domestic capital goods and raw materials that go into investment. If a country does not build its capacity to produce capital goods and raw materials, it would need to rely on imports - in other words it has to acquire foreign "savings" to invest. Encouraging domestic "savings" entails enhancing capacity to produce goods that are used in capital spending like raw materials, chemicals, steel, cement, machinery, and various equipment and instruments. This is what China has done exceptionally well over the past 20 years. The following points illustrate how China achieved very high "savings" and investment rates (Chart I-7): China devalued its currency in January 1994 by 32% and relied on a cheap currency to produce large trade surpluses (Chart I-8). It used the foreign currency proceeds to purchase foreign technologies and equipment to boost its capital stock. Chart I-7Savings And Investment Ratios Savings And Investment Ratios Savings And Investment Ratios Chart I-8China: The 1994 Currency ##br##Devaluation Started New Era China: The 1994 Currency Devaluation Started New Era China: The 1994 Currency Devaluation Started New Era It also attracted FDI to build its productive capacity both for consumer goods as well as capital goods. FDI inflows surged since China's acceptance into the WTO in 2001. Since 2009, however, China has been relying on new purchasing power created by banks to expand its industrial capacity to produce commodities, raw materials, industrial equipment and machinery. Meanwhile, mainland banks have been originating new loans, and hence deposits/money - new purchasing power - to finance real estate development and infrastructure construction, utilizing these domestically produced raw materials and machinery. This has allowed China to sustain high levels of domestic "savings." On the whole, China indeed has had "excess savings" as its economy has been suffering from excess industrial capacity. Initially, China invested to create such excess capacity. Then, its banking system originated enormous amount of money/new purchasing power to support and keep zombie companies alive in these industries with excess capacity. The banking system is still involved in this function up until today. While this is a reasonable economic policy in the short run, it is not a good growth strategy in the long term. The problem is that easy money and credit support inefficient enterprises and encourage unproductive investment. As a result, productivity growth will slow and potential growth will decelerate considerably. Bottom Line: The countries that produce a lot of goods and services for domestic investment are said to have high domestic "savings." By definition, the more excess industrial capacity a country has, the more "excess savings" that economy will carry. Yet, uncontrolled money/credit origination to support zombie enterprises in over-capacity sectors entails inefficient allocation of capital that necessarily slows productivity growth and hence economic growth potential in the long term. Limits On Money Creation A natural question that arise from all this is what are the limits on money creation? We list some of major ones here, but these issues have been addressed in our previous three reports,8 and we will address them again in forthcoming reports. Inflation and/or deprecation pressures on the currency that could lead to monetary tightening; Bank regulation and various regulatory ratios; Shareholders of banks - who are highly leveraged to non-performing assets/loans - might order reduced lending; Removing the implicit government "put" that encourage irresponsible borrowing and lending. Inflationary pressures are presently rising and more entrenched in China now than at any time in the past decade or so (Chart I-9). In the context of negative real interest rates (Chart I-10) and barring major growth slowdown, the authorities are unlikely to stimulate anytime soon. Chart I-9Beware Of Rising Inflation In China... Beware Of Rising Inflation In China... Beware Of Rising Inflation In China... Chart I-10...Making Interest Rates Negative ...Making Interest Rates Negative ...Making Interest Rates Negative Negative real local interest rates undermine Chinese households' willingness to hold the currency. China's foreign exchange reserves at $3 trillion, while high, are equal only to 10% broad money (M3) and 14% of official M2. This signifies how much money the banking system has created. At the moment, mainland banking regulations are being tightened. This as well as liquidity tightening by the People's Bank of China and the government's anti-corruption crackdown that is moving into the financial industry will further dampen money creation and leverage expansion. This triple tightening amid lingering money and credit excesses constitutes the main rationale behind our negative stance on China's growth and China-related plays in global financial markets. Policy tightening is especially dangerous amid the existing credit, money and property market imbalances and excesses. Downgrade Chinese Stocks From Overweight To Neutral The Chinese MSCI Investable equity index - which unlike H-shares includes mega-cap tech companies - has rallied massively and outperformed the EM benchmark (Chart I-11). Chart I-11Downgrade Chinese Investable Stocks ##br##From Overweight To Neutral Downgrade Chinese Investable Stocks From Overweight To Neutral Downgrade Chinese Investable Stocks From Overweight To Neutral Relative performance is overbought, and we recommend dedicated EM equity portfolios downgrade their allocation from overweight to neutral. Our overweight position was initiated on November 26, 2014, and has generated an 18.5% gain. The freed-up capital should be allocated proportionally to our remaining overweights, which are Taiwan, Thailand, Korean tech stocks, Russia and central Europe. We are contemplating upgrading Chile. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled "Misconceptions About China's Credit Excesses," dated October 16, 2016, available on available on ems.bcaresearch.com 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Werner, R. (2014a), "Can banks individually create money out of nothing? -- The theories and the empirical evidence", International Review of Financial Analysis, 36, 1-19. 5 We use "savings" in parenthesis because as this term does not really mean households' and companies' and governments' financial assets or deposits at the banks. "Savings" signifies the amount of goods and services produced but not consumed by an economy. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012. 8 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Overweight Last week saw some sad news as Hunter Harrison, the CEO of CSX and legendary railroad captain, passed away. While we are overweight the S&P railroads index, we did not upgrade when Mr. Harrison joined CSX and we will not change our rating as a result of his passing. Rather, we continue to focus on surging global trade volume (second panel) as the fundamental revenue driver. Our rail shipment commodity group diffusion indicator is sending a nearly unanimous message of rising volumes (third panel), which should correlate with continued overall industry volume gains. Further, industry pricing power is soaring while employment is declining (bottom panel) which, in conjunction with the previously noted volume growth, implies solid productivity improvements to come. This means margins have a powerful tailwind, irrespective of the operating leverage that topline growth should deliver. In sum, railroads remain a core industrial and transports holding; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Global Trade Keeps Rails On Track Global Trade Keeps Rails On Track

Highlights Portfolio Strategy The easy money has already been made in the liquidity-to-growth theme-levered long S&P energy/short global gold miners pair trade. Lock in profits and move to the sidelines, for now. Similarly, book gains in the long S&P materials/short S&P utilities market-neutral trade. A stealthy macro shift, at the margin, suggests that a more challenging phase lies ahead for this relative share price ratio. Recent Changes Book 18.3% profits in the long S&P energy/short global gold miners pair trade today. Take profits in excess of 8.6% in the long materials/short utilities pair trade today. Table 1 EPS And "Nothing Else Matters" EPS And "Nothing Else Matters" Feature Equities continued to defy gravity last week, vaulting to fresh all-time highs. Seasonality (or the pending Santa rally) appears to have trumped any "buy on rumor sell the tax news" jitters, at a time when macro data continue to surprise to the upside. Heading into 2018, easier fiscal policy will likely offset some of the uneasiness of the Fed's ongoing tightening cycle as we postulated in early October.1 Synchronized global economic and capex growth remain the key macro themes that dominate markets. The latest GDP revisions in the G3 confirm our global capex upcycle bias: U.S., euro area and, especially, Japanese gross fixed capital formation are on fire (Chart 1). Importantly, once the tax bill related dust settles, profits will come back to the forefront as a key stock market driver. In that regard, the news on the EPS front is ebullient and, along with the forward multiple, all that matters. Table 2 shows annual SPX returns going back to 1979, and breaks down the composition of the capital (not total) return into two components: forward earnings growth and the forward P/E multiple (January 1979 is the first IBES data point for forward EPS SPX estimates). Chart 1Synchronized Global Capex Synchronized Global Capex Synchronized Global Capex Table 2Disentangling SPX Returns EPS And "Nothing Else Matters" EPS And "Nothing Else Matters" Currently, sell side analysts expect 11% EPS growth for 2018, and our sense is that 8-12% EPS growth is achievable next year, a message that our SPX EPS macro model corroborates (Chart 2). Keep in mind that there is no tax cut penciled into our EPS model's numbers. Chart 2SPX EPS Macro Model Flashing Green SPX EPS Macro Model Flashing Green SPX EPS Macro Model Flashing Green What is interesting from the multiple/EPS analysis is that over the last four decades when forward profit growth was in this high single-digit / low double-digit range (ten iterations), the multiple expanded modestly (on average, adding 2.6 percentage points to the market's return) and EPS did the heavy lifting (explaining, on average, roughly 80% of the S&P 500's 12.9% average annual return, Table 3). If we consider periods when EPS growth was positive but below 8% (eleven iterations), SPX returns are close to 10%, on average, with EPS and the multiple contributing almost equally to the market's return. One caveat is that two recessionary years and the dot com bust are part of this segment skewing the results to the downside (Table 3).2 Table 3Disentangling SPX Returns Continued EPS And "Nothing Else Matters" EPS And "Nothing Else Matters" Nevertheless, if history at least rhymes, were EPS growth to stay positive next year and hit the 8-12% mark, then a profit driven low double-digit broad equity market return is likely. If profits disappoint and grow between 0-8%, barring recession, empirical evidence suggests that equity returns will still prove healthy. Adding it up, the path of least resistance is higher for equities on a cyclical 9-12 month horizon. Granted, since Brexit the SPX has rallied in a near straight line up and a healthy and temporary pause for breath is likely in Q1/2018. As a result, this week we are booking impressive gains in two tactical market-neutral trades we initiated in late-August and mildly de-risking our portfolio. Lock In Profits In The Long Energy/Short Gold Producers Trade In late-August we initiated a liquidity-to-growth handoff levered market-neutral trade: long S&P energy/short global gold miners. Over the past four months this trade is up 18.3%. It also sports a positive annual dividend carry of 200bps. With the equity market overshoot phase likely going on hiatus sometime in early 2018 is it still prudent to hold this high-octane intra-commodity and market-neutral trade? The short answer is no. Nothing in terms of macro data has changed to trip up this pair trade. If anything, the handoff of global liquidity to economic growth has gained steam in the past few months. Global GDP, IP, manufacturing PMIs, global trade (Chart 3) and gross capital formation are all growing simultaneously across all of the G7 and most of the EMs. Even China's economy seems to have stabilized. The Fed announced its plans to wind down its balance sheet as expected in September and the BoE and BoC have both tightened monetary policy. Even the ECB announced a halving of the size of its monthly purchases in late-October (but extended it for nine months). All these central bank (CB) moves suggest that, at the margin, the global liquidity injection is reversing, with CBs actually mopping up liquidity. This is de facto negative for the shiny metal and gold mining equities as interest rates are headed higher (Chart 4). Chart 3Brisk Global Growth... bca.uses_wr_2017_12_18_c3 bca.uses_wr_2017_12_18_c3 Chart 4...Higher Rates... ...Higher Rates... ...Higher Rates... Moreover, geopolitical uncertainty is steadily receding, especially now that the Senate also passed a tax bill, and a final bill will likely soon be signed into law.3 Historically in times of duress, safe haven assets are bid up and vice versa, and the current low policy uncertainty backdrop is conducive to additional gains in the relative share price ratio (policy uncertainty shown inverted, Chart 5). Meanwhile, on the relative operating front, energy stocks have the upper hand versus gold miners. The oil and gas rig count has resumed its advance and remains 150% clear of the lows hit during the depths of the global manufacturing recession of late-2015/early-2016. Anecdotes of global oil majors comfortably registering positive EPS, in the new era of $50/bbl oil, and reinstating stock buybacks and eliminating scrip dividends (RDS, BP & ENI) suggest that the worst is behind the industry. In contrast, safe haven asset demand is in retreat and will continue to weigh on global gold ETF flows. Anecdotally, the BITCOIN/ICO/cryptocurrency mania may also steal some of bullion's thunder, as this mania is capturing investor's imagination. Either a flare up in global geopolitical risk or a global growth scare could cause investors to start shifting capital into gold ETFs. Our relative EPS models do an excellent job in capturing this energy positive/gold negative backdrop and continue to suggest that energy profits will outpace gold mining EPS (Chart 6). Chart 5...And Diminishing Uncertainty##br## Still Bode Well For The Trade ...And Diminishing Uncertainty Still Bode Well For the Trade ...And Diminishing Uncertainty Still Bode Well For the Trade Chart 6But We Do Not Want To##br## Overstay Our Welcome But We Do Not Want To Overstay Our Welcome But We Do Not Want To Overstay Our Welcome If these different macro and operational forces all emit an unambiguously bullish signal for S&P energy shares compared with global gold miners, why book profits? Our sense is that there are high odds of a pullback in Q1/2018 and from a portfolio management and risk perspective it is prudent to lock in handsome profits in excess of 18.3% in a four month period. There are high odds that most of these key drivers are reflected in relative share prices versus late-August. Relative valuations are pricier today and technicals are also flashing yellow (bottom panel, Chart 4). We deem that the easy money has already been made in this market-neutral trade, despite the still favorable relative macro backdrop. This was a tactical three-to-six month pair trade that has mostly played out and we would not like to overstay our welcome. Were the broad market pullback to occur in the upcoming quarter, and the ratio to trade significantly lower, we would not hesitate to reinstate this pair trade. Our cyclical strategy is to "buy the broad market dip" and remain opportunistic on a tactical basis. Bottom Line: Lock in 18.3% profits in the long S&P energy/short global gold miners pair trade and move to the sidelines for now. Take Profits In Materials Vs. Utilities Similar to booking gains in the liquidity-to-growth levered market-neutral long S&P energy/short global gold miners pair trade, we also recommend taking profits in the reflation levered long S&P materials/short S&P utilities pair trade. Since its late-August inception this market-neutral trade has generated returns in excess of 8.6% and added alpha to our portfolio. While overall macro conditions continue to underpin the relative share price ratio, some cracks are appearing on the surface. Global reflation has matured and synchronized global growth is as good as it gets. The ISM manufacturing and services surveys have ticked down in sympathy recently, warning that the easy gains are behind this market neutral trade (Chart 7). Worrisomely, our relative sector Cyclical Macro Indicators are sniffing out this marginal shift in the macro backdrop and suggest that a more challenging phase lies ahead for the relative share price ratio (Chart 8). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018. This is one of our key themes for next year, and given that this trade typically moves in lockstep with interest rates, the path of least resistance is higher. Nevertheless, the fact that this ratio has not kept up with the slingshot recovery in the stock-to-bond (S/B) ratio is slightly disconcerting. The top panel of Chart 9 shows that the gap between the S/B and the materials/utilities ratios has widened further since late-August. Chart 7As Good As It Gets? As Good As It Gets? As Good As It Gets? Chart 8Fatigue Signs Fatigue Signs Fatigue Signs Chart 9More Balanced Backdrop=Move To The Sidelines More Balanced Backdrop=Move To The Sidelines More Balanced Backdrop=Move To The Sidelines On the operating front, our relative EPS models are also showing signs of fatigue. Materials profits cannot expand indefinitely at the breakneck pace observed since the 2016 trough, at a time when utilities EPS have stabilized. Currently, the relative earnings models suggest that materials are on an even keel with utilities (Chart 9). Tack on rising odds of a healthy broad market pullback in Q1/2018, and from a risk management perspective we would rather de-risk the portfolio a notch by locking in near double-digit gains since inception in this volatile pair trade. Bottom Line: Book gains of 8.6% in the long S&P materials/short S&P utilities pair trade. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 For reference and completion purposes Table 3 also tabulates the results during EPS contractions (nine iterations) and in profit boom times, i.e. forward EPS growth north of 12% (nine iterations). 3 Please see BCA U.S. Equity Strategy & Geopolitical Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Neutral Yesterday's news that Disney was buying key media content assets from Twenty-First Century Fox, including movie studios and some cable properties, came as a surprise to few following longstanding rumors the assets were for sale and Monday's announcement from Comcast that they were no longer a bidder. The market has thus far been cheering the deal, which is part of Disney's strategy to beef up its offering in advance of the launch of their own media streaming service. Investors have fretted over this launch, owing to the lack of media property breadth compared to established competitors like Netflix and Amazon; this deal should assuage some of those fears. Still, we think the structural decline in media-related consumer outlays and its impact on earnings (second panel) is the dominant investment theme, underpinning the historic divergence between consumer confidence and the index's performance this year (bottom panel). Net, while this deal boosts Disney's ability to compete long-term, earnings headwinds keep a ceiling on our optimism; stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB. A Blockbuster Deal With Mixed Reviews A Blockbuster Deal With Mixed Reviews

Recommended Allocation Quarterly - December 2017 Quarterly - December 2017 Highlights We are late cycle. Strong growth could turn in 2018 from a positive for risk assets into a negative. More risk-averse investors may thus want to turn cautious. But the last year of a bull run can be profitable, and we don't expect a recession until late 2019. For now, therefore, our recommendations remain pro-risk and pro-cyclical. We may turn more defensive in 2H 2018 if the Fed tightens above equilibrium. We expect inflation to pick up in 2018, which will lead the Fed to hike maybe four times. This will push long rates to 3%, and strengthen the U.S. dollar. Equities should outperform bonds in this environment. We prefer euro zone and Japanese equities over U.S., and remain underweight EM. Late-cycle sectors such as Financials and Industrials, should do well. We also favor corporate bonds and private equity. Feature Overview Fin de cycle Global economic growth in 2017 was robust for the first time since the Global Financial Crisis (Chart 1). Forecasts for 2018 put growth slightly lower, but are likely to be revised up. However, as the year rolls on, the strong economic momentum may turn from being a positive for risk assets into a negative. U.S. output is now above potential, according to IMF estimates. As Chart 2 shows, historically recessions - and consequently equity bear markets - have usually come within a year or two of the output gap turning positive. With the economy operating above capacity, inflation pressures force the Fed to tighten monetary policy, which eventually causes a slowdown. Chart 1Growth Finally On A Firm Footing Global Growth Has Accelerated Growth Finally On A Firm Footing Global Growth Has Accelerated Growth Finally On A Firm Footing Global Growth Has Accelerated Chart 2Recessions Follow Output Gap Closing Recessions Follow Output Gap Closing Recessions Follow Output Gap Closing That is exactly how BCA sees the next couple of years panning out, leading to a recession perhaps in the second half of 2019. U.S. inflation was soft in 2017, but underlying inflation pressures are picking up, with core CPI inflation having bottomed, and small companies saying they are raising prices (Chart 3). Add to that wage pressures (with unemployment heading below 4% in 2018), tax cuts (which might boost growth by 0.2-0.3% points in their first year) and a higher oil price (we expect Brent to average $67 a barrel during the year), and core PCE inflation is likely to rise to 2%, in line with the Fed's expectations. This means the market is too sanguine about the risk of monetary tightening in the U.S. It has priced in less than two rates hikes in 2018, compared to the Fed's three dots, and almost nothing after that (Chart 4). If inflation picks up as we expect, four rate hikes in 2018 could be on the cards. Chart 3Inflation Pressures Picking Up Inflation Pressures Picking Up Inflation Pressures Picking Up Chart 4Market Still Underpricing Fed Hikes Market Still Underpricing Fed Hikes Market Still Underpricing Fed Hikes The consequences of this are that bond yields are likely to rise. Despite a significant market repricing since September of Fed behavior, long-term rates have not risen much, leading to a flattening yield curve (Chart 5). The market has essentially priced in that inflation will not rebound and that, consequently, the Fed will be making a policy mistake by hiking further. If, therefore, we are correct that inflation does reach 2%, the yield curve would be likely to steepen over the next six months, with the 10-year U.S. Treasury yield reaching 3% by mid-year. Other developed economies, however, have less urgency to tighten monetary policy and we, therefore, see the U.S. dollar appreciating. The only other major economy with a positive output gap currently is Germany (Chart 6). However, the ECB will continue to set policy for the weaker members of the euro area, and output gaps in France (-1.8% of GDP), Italy (-1.6%) and Spain (-0.7%) remain significantly negative. In the absence of inflation pressures, the ECB won't raise rates until late 2019. Japan, too, continues to struggle to bring inflation up the BOJ's 2% target and the Yield Curve Control policy will therefore stay in place, meaning that a rise in global rates will weaken the yen. Chart 5Is Fed Making A Policy Mistake? Is Fed Making A Policy Mistake? Is Fed Making A Policy Mistake? Chart 6Still A Lot Of Negative Output Gaps Quarterly - December 2017 Quarterly - December 2017 This sort of late-cycle environment is a tricky one for investors. The catalysts for strong performance in equities that we foresaw a few months ago - U.S. tax cuts and upside surprises in earnings - have now largely played out. Global earnings will probably rise next year by around 10-12%, in line with analysts' forecasts. With multiples likely to slip a little as the Fed tightens, high single-digit performance is the best that investors should expect from equities. The macro environment which we expect, would be more negative for bonds than positive for equities. That argues for the stock-to-bond ratio to continue to rise until closer to the next recession (Chart 7). And, for now, none of the recession indicators we have been consistently monitoring over the past months is flashing a warning signal (Chart 8). Chart 7Stock-To-Bond Ratio Likely To Rise Further Stock-To-Bond Ratio Likely To Rise Further Stock-To-Bond Ratio Likely To Rise Further Chart 8Recession Warning Signals Still Not Flashing Recession Warning Signals Still Not Flashing Recession Warning Signals Still Not Flashing More risk-averse investors might chose to reduce their exposure to risk assets now, given how close we are to the end of the cycle. But this would be at the risk of leaving some money on the table, since the last year of a bull run can often be the most profitable (remember 1999?). We, therefore, maintain our recommendation for pro-cyclical and pro-risk tilts: overweight equities versus bonds, overweight credit, overweight higher-beta equity markets and sectors, and a preference towards riskier alternative assets. We may move towards a more defensive stance in mid to late 2018, when we see clearer signs that the Fed has tightened above equilibrium or that the risk of recession is rising. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Be The Impact Of The U.S. Tax Cuts? It is not a done deal, but it still seems likely (notwithstanding the Democratic victory in Alabama) that the U.S. House and Senate will agree a joint tax bill to pass before the end of the year. Since the two current bills have only minor differences, it is possible to make some estimates of the macro and sector impacts of the tax reform. The Joint Committee on Taxation estimates that the cuts will reduce government revenue by $1.4 trillion over 10 years - or $1 trillion (5% of GDP) once positive effects on growth are accounted for. The Treasury argues that tax reform (plus deregulation and infrastructure development) will push GDP growth to 2.9% and therefore government revenues will increase by $300 billion. BCA's estimate is that GDP growth will be boosted by 0.2-0.3% in 2018 and 2019.1 For businesses, the key tax changes are: 1) a reduction in the headline corporate rate from 35% to 21%; 2) immediate expensing of capital investment; 3) a limit to deduction of interest expenses to 30% of taxable income; 4) a move to a territorial tax system from a worldwide one, with a 10% tax on repatriation of past profits held overseas; 5) curbs for some deductions, such as R&D, domestic production and tax-loss carry-forwards. Corporate tax cuts will give a one-off boost to earnings, since the effective tax rate is currently over 25% (Chart 9, panel 1), with telecoms, utilities and industrials likely to be the biggest beneficiaries. This is not fully priced into stocks, since companies with high tax rates have seen their stock prices rise only moderately (Chart 9, panel 2). BCA's sector strategists expect that capex will especially be boosted: they estimate that the one-year depreciation increases net present value by 14% (Table 1).2 This should be positive for the Industrials sector (supplying the capital goods) and for Financials (which will see increased demand for loans). We are overweight both. Chart 9Tax Cuts Should Boost Earnings Tax Cuts Should Boost Earnings Tax Cuts Should Boost Earnings Table 1 Quarterly - December 2017 Quarterly - December 2017 Is Bitcoin A Bubble, And What Happens When It Bursts? The recent surge in prices (Chart 10) of virtual currencies has pushed Bitcoin and aggregate cryptocurrency market cap to $275 billion and $500 billion respectively. The recent violent run-up certainly bears a close resemblance to classic bubbles, but the impact of a sharp correction should be minimal on the real economy and traditional capital markets. As mentioned above, the market cap of cryptocurrencies has reached $500 billion. Globally, there is about $6 trillion in currency3 outstanding, so the value of virtual currencies is now 8% that of traditional fiat currency. Additionally, an estimated 1000 people own about 40% of the world's total bitcoin, for an average of about $105 million per person. At the moment, the macro impact has been constrained by the fact that most people are buying bitcoins as a store of value (Chart 11) or vehicle for speculation, rather than as a medium of exchange. However, when the public begins to regard them as legitimate substitutes for traditional fiat currencies, their impact will be felt on the real economy. Chart 10A Classic Bubble A Classic Bubble A Classic Bubble Chart 11Bitcoin Trading Volume By Top Three Currencies Quarterly - December 2017 Quarterly - December 2017 That would raise the issue of regulation. The U.S. government generates close to $70 billion per year as "seigniorage revenue." Governments across the world have no intention of losing this revenue, and would most likely introduce their own competitors to bitcoin. Until then, the biggest potential impact of these private currencies might be to spur inflation in the fiat currencies in which their prices are measured. That would be bad for government bonds, but potentially good for stocks. A further risk - and a similarity with the real estate bubble of 2007 - is the use of leverage. The news of a Tokyo-based exchange (BitFyler) offering up to 15x leverage for the purchase of bitcoins has spooked investors. However, the U.S. housing market is valued at $29.6 trillion, almost 60 times that of cryptocurrencies. Finally, the 19th century free banking era in the U.S., which at one point saw 8000 different currencies in circulation, experienced multiple banking crises. A world with myriad private currencies all competing with one another would be similarly unstable. Why Did The U.S. Dollar Weaken In 2017, And Where Will It Go In 2018? Chart 12Positioning And Relative Rates Supportive For USD Positioning And Relative Rates Supportive For USD Positioning And Relative Rates Supportive For USD We were wrong to be bullish on U.S. dollar at the start of 2017. We think the dollar weakness during most of the year can be attributed to the fact that investors were massively long the dollar at the end of 2016 (Chart 12, panel 2), which made the market particularly vulnerable to surprises. Several surprises did come: inflation softened in the U.S. but strengthened in the euro area. There were also positive geopolitical surprises in Europe - for example the victory of Emmanuel Macron in the French presidential election - while the failure to repeal Obamacare in the U.S. raised investors' concerns on the administration's ability to undertake fiscal stimulus. As a result, the U.S. dollar depreciated against euro despite widening interest rate differentials (Chart 12 panel 4) in 2017. Chart 13late Cycle Outperformance late Cycle Outperformance late Cycle Outperformance Since investors are now aggressively short the dollar, the hurdle for the greenback to deliver positive surprises is much lower than a year ago. Since the Senate passed the Republican tax bill in early December, we have already seen some recovery in the dollar (Chart 12, panel 1). As the labor market continues to firm, with GDP running above potential, U.S. inflation should finally start to pick up in 2018, which will allow the Fed to hike rates, possibly as many as four times during the year. This will contrast with the macro situation overseas: Japan and Europe are likely to continue loose monetary policy to maintain the momentum in their economies. All this should be supportive of the dollar. Are Convertible Bonds Attractive Over The Next 12 Months? With valuations for traditional assets expensive and investors' thirst for yield continuing, the market is in need of alternative sources of return. Convertible bonds offer a hybrid credit/equity exposure, giving investors the option to participate in rising equity markets but with less risk. An allocation to convertibles could prove attractive for the following reasons: Convertible bonds typically outperform high-yield debt in the late stages of bull markets, because of their relatively lower exposure to credit spreads. Junk spreads have a history of starting to widen before equity bear markets begin. Fifty percent of the convertibles index comprises issuance from small-cap and mid-cap firms. Although equity valuations are expensive, prices should continue to rise as long as inflation stays low. Additionally, our U.S. Investment Strategy service thinks that small-cap equities will outperform large caps in the coming months, partly because the likely cuts in U.S. corporate taxes will disproportionately benefit smaller companies. Convertible bonds do appear somewhat cheap relative to equities (Chart 13, panel 3) but, on balance, there is not a strong valuation case for the asset class. Equities appear fairly valued relative to junk bonds, and convertibles are trading at an elevated investment premium. However, valuation is not likely to be a significant headwind to the typical late-cycle outperformance of convertibles versus high yield. biggest near-term risk for convertibles relative to high yield stems from the technology sector, which makes up 35% of the convertibles index. Technology convertible bonds have strongly outperformed their high-yield counterparts in recent months (Chart 13, panel 4), and are possibly due for a period of underperformance. We recommend investors stay cautious on technology convertibles. Other Than U.S. Tips, What Other Inflation-Linked Bonds Do You Like? Our research shows that inflation-linked bonds (ILBs) are a good inflation hedge in a rising inflationary environment.4 With our house view of rising inflation in 2018, we have been overweight U.S. Tips over nominal Treasury bonds as the U.S. is the most liquid market for inflation-linked bonds, with a market cap of over US$ 1.2 trillion. Outside the U.S., we favor ILBs in Japan and Australia, while we suggest investors to avoid ILBs in the U.K. and Germany (even though the U.K. linkers' market is the second largest after the U.S.), for the following two key reasons: First, even though inflation is below target in Japan, Australia and the euro area, while above target in the U.K., in all of these markets, inflation has bottomed, as shown in Chart 14. Second, our breakeven fair-value models, which are based on trade-weighted currencies, the Brent oil price in local currencies, and stock-to-bond total-return ratios, indicate that ILBs are undervalued in Japan and Australia, while overvalued in the U.K. and Germany, as shown in Chart 15. Chart 14Inflation Dynamics Inflation Dynamics Inflation Dynamics Chart 15Where to Buy Inflation? Quarterly - December 2017 Quarterly - December 2017 The shorter duration (in real terms) of ILBs are an added bonus which fits well with our overall underweight duration positioning in the government bond universe. Global Economy Overview: Growth in developed economies remains strong and there is little in the data to suggest it will slow. This is likely to push up inflation and interest rates, especially in the U.S., over the next six to 12 months. Prospects for emerging markets, however, are less encouraging given that China is likely to slow moderately as it pushes ahead with reforms. U.S.: U.S. growth momentum remains very strong. GDP growth in the past two quarters has come in over 3%, and NowCasts for Q4 point to 2.9-3.9%. The Citigroup Economic Surprise Index (Chart 16, panel 1) has surged since June, and the Manufacturing ISM is at 53.9 and the Non-Manufacturing at 57.4 (panel 2). The worst that can be said is that momentum will be unable to continue at this rate but, with business confidence high, wage growth likely to pick up in 2018, and some positive impacts from tax cuts, no significant slowdown is in sight. Euro Area: Given its stronger cyclicality and ties to the global trade cycle, euro zone growth has surprised on the upside even more strongly than in the U.S. The Manufacturing PMI reached 60.6 in December (its highest level since 2000), and GDP growth in Q3 accelerated to 2.6% QoQ annualized. The euro's strength in 2017 seems to have done little to dent growth, and even weaker members of the euro zone such as Italy have seen improving GDP growth (1.7% in Q3). With the ECB reining back monetary easing only slightly, and banking problems shelved for now, growth should remain resilient in early 2018. Japan: Retail sales saw some weakness in October (-0.2% YoY), probably because of bad weather, but elsewhere data looks robust. Q3 GDP came in at 1.3% QoQ annualized and export growth remains strong at 14% YoY. There are even some signs of life in the domestic economy, with wages finally picking up a little (+0.9% YoY), driven by labor shortages among part-time workers, and consumer confidence at a four-year high. Inflation has been slow to rise, but at least core core inflation (the Bank of Japan's favorite measure) is now in positive territory at +0.2%. Emerging Markets: Chinese credit and monetary series, historically good lead indicators for the real economy, continue to decline (M2 growth in October of 8.8% was the lowest since data started in 1996). But, for now, economic growth has held up, with the Manufacturing and Non-Manufacturing PMIs both stably above 50 (Chart 17, panel 3). Key will be how much the government's moves to deleverage the financial system and implement structural reform in 2018 will slow growth. Elsewhere in emerging markets, economic growth remains sluggish, with GDP growth in Brazil barely rebounding to 1.4% YoY, Russia to 1.8%, and India slowing to 6.3% (down from over 9% in early 2016). Chart 16Growth Momentum Very Strong Growth Momentum Very Strong Growth Momentum Very Strong Chart 17Will China And EM Slow in 2018? Will China And EM Slow in 2018? Will China And EM Slow in 2018? Interest rates: We expect U.S. inflation to pick up in 2018, as the lagged effects of 2017's stronger growth and the weak dollar start to come through, amid higher oil prices and rising wages. We, along with the Fed, expect core PCE inflation to rise to 2% during the year. This means the Fed is likely to raise rates four times, compared to market expectations of twice. Consequently, we see the 10-year Treasury yield over 3% by mid-year. In the euro zone, the still-large output gap means inflation is less likely to surprise on the upside, allowing the ECB to keep negative rates until well into 2019. The Bank of Japan is unlikely to alter its Yield Curve Control, given the signal this would send to the market when inflation expectations are still well below its 2% target (Chart 17, panel 4). Chart 18Equities: Priced for Perfection Equities: Priced for Perfection Equities: Priced for Perfection Global Equities Still Cautiously Optimistic: Our pro-cyclical equity positioning in 2017 worked very well in terms of country allocation (overweight euro zone and Japan in the DM universe) and global sector allocation (favoring cyclicals vs defensives). The two calls that did not pan out were underweight EM equities vs. DM equities, which was partially offset by our positive stance on China within the EM universe, and the overweight of Energy, which was the worst performing sector of the year. The stellar equity performance in 2017 was largely driven by strong earnings growth. Margins improved in both DM and EM; earnings grew in all sectors, and analysts remained upbeat (Chart 18). Another important contributor to 2017 performance was the extraordinary performance of the Tech sector, especially in China: globally, tech returned 41.9%, outperforming the MSCI all country index by 18.9%. GAA's philosophy is to take risk where it is mostly likely be rewarded. In July, we took profits in our Tech overweight and used the funds to upgrade Financials to overweight from neutral. Then in October we started to reduce tracking risk by scaling down our active country bets, closing our overweight in the U.S. to reduce the underweight in EM. BCA's house view is for synchronized global growth to continue in 2018, but a possible recession in late 2019. We are a little concerned that equity markets are priced for perfection, given that our earnings model indicates a deceleration in the coming months mostly due to a base effect. As such, our combination of "close to shore" country allocation and "pro-cyclical" sector allocation is appropriate for the next 9-12 months. Country Allocation: Still Favor DM Over EM Chart 19China: From Tailwind to Headwind for EM ? China: From Tailwind to Headwind for EM ? China: From Tailwind to Headwind for EM ? Our longstanding call of underweight EM vs. DM since December 2013 was gradually reduced in scale, first in March 2016 (to -5 percentage points from -9) and then in October 2017 (further to -2 points). Going forward, investors should continue to maintain this slight underweight position in EM vs. DM. First, our positive stance on China proved to be timely as shown in Chart 19, panel 4, with China outperforming EM by 54.1% since March 2016, and by 18.8% in 2017. Back then our positive stance on China was supported by attractive valuations (bottom panel) and our view that Chinese politics would be supportive for global growth in the run up to the 19th Party Congress. Now BCA's Geopolitical Strategists think that "China politics are shifting from a tailwind to a headwind for global growth and EM assets".5 In addition, Chinese equities are no longer valued at a discount to the EM average (bottom panel). Second, BCA's currency view is for continued strength in the USD, especially against emerging market currencies. This does not bode well for EM/DM performance in US dollar terms (Chart 19, panel 1). Third, EM money growth leads profit growth by about three months (Chart 19, panel 2). The rolling over in money growth indicates that the currently strong earnings growth may lose steam going forward, while relative valuation is in the fair-value zone (Chart 19, panel 3). Sector Allocation: Stay Overweight Energy Our pro-cyclical sector positioning has worked well in aggregate as the market-cap-weighted cyclical index significantly outperformed the defensive index in 2017. This positioning is also in line with BCA's house view of synchronized global growth and higher inflation expectations, which translates into two major sector themes: capex recovery and rising interest rates. (Please see detailed sector positioning on page 24.) Within the cyclical space, however, the Energy sector did not perform as expected in 2017 (Chart 20). It returned only 3.4%, underperforming the global aggregate by 19.6%. For the next 9-12 months, we recommend investors to stay overweight this underdog of 2017. Chart 20Energy Stocks Lagging Oil Price Energy Stocks Lagging Oil Price Energy Stocks Lagging Oil Price First, the energy sector is a major beneficiary from a capex recovery. There are already signs of a recovery in basic resources investment in the U.S.6 Second, the energy sector's relative return lagged oil price performance in 2017. Given the generally close correlation between earnings and the oil price, and between analyst earnings revisions and OECD oil inventory growth, earnings in the sector should outpace the broad market. Third, based on price-to-cash earnings, the energy sector is still trading at about a 30% discount to the broad market, and offers a much higher dividend yield (about 1.2 points higher) than the broad market. Even though these discounts are in line with historical averages, they are still supportive of an overweight. Government Bonds Maintain Slight Underweight Duration. One important theme for 2018 will be a resumption of the cyclical uptrend in inflation.7 The implications are that both nominal bond yields and break-even inflation rates will be higher in 2018. We have been underweight duration in government bonds since July 2016. Now with the U.S. 10-year Treasury yield at 2.35%, much lower than its fair value of 2.81%, there is considerable upside risk for global bond yields from current low levels. Investors should continue to underweight duration in global government bonds Maintain Overweight Tips Vs. Treasuries. The base-case forecast from our U.S. bond strategists is that the Tips breakeven rate will rise to 2.4-2.5% as U.S. core PCE reaches the Fed's 2% target, probably sometime in the middle of 2018. Compared to the current level of 1.87%, 10-yr Tips would have upside of 33-38 bps, an important source of return in the low-return fixed-income space (Chart 21, bottom panel). In terms of relative value, Tips are now slightly cheaper than nominal bonds, also supportive of the overweight stance. Underweight Canadian Government Bonds. BCA's Global Fixed Income Strategy has taken profits in their short Canada vs. U.S. and U.K. tactical position, as the market has become too aggressive in pricing in more rate hikes in Canada. Strategically, however, the underweight of Canada (Chart 22) in a hedged global portfolio is still appropriate because: 1) the output gap has closed in Canada, according to Bank of Canada estimates, and so any additional growth will translate into higher inflation; and 2) the rising CAD will not deter the BoC from more rate hikes if the oil prices remain strong. Chart 21U.S. Bond Yields Have Further To Rise U.S. Bond Yields Have Further To Rise U.S. Bond Yields Have Further To Rise Chart 22Strategic Underweight Canadian Bonds Strategic Underweight Canadian Bonds Strategic Underweight Canadian Bonds Corporate Bonds Our overweights through most of 2017 on spread product worked well: U.S. investment grade (IG) bonds returned around 290 bps over Treasuries in the year to end-November, and high-yield bonds almost 600 bps. Returns over the next 12 months are unlikely to be as attractive. Spreads (Chart 24) are now close to historic lows: the U.S. IG bond spread, at 90 bps, is only about 30 bps above its all-time record. High-yield valuations look a little more attractive: based on our model of probable defaults over the next 12 months, the default-adjusted spread over U.S. Treasuries is likely to be around 240 bps (Chart 25). In both cases, however, investors should expect little further spread contraction, meaning that credit is now no more than a carry trade. However, in an environment where rates remain fairly low and investors continue to stretch for yield, that pick-up will remain attractive in the absence of a significant turn-down in the economic cycle. The key to watch is the shape of the yield curve. An inverted yield curve in history has been an excellent indictor of the end of the credit cycle. We expect the yield curve to steepen somewhat in H1 2018, before flattening again and then inverting late in the year. Spread product is likely, therefore, to produce decent returns until that point. Thereafter, however, the deterioration of U.S. corporate health over the past three years (Chart 23) could mean a sharp sell-off in corporate bonds. This might be exacerbated by the recent popularity of open-ended mutual funds and ETFs: a small widening of spreads could be magnified by a panicked sell-off in such funds. Chart 23Rising Leverage May Worsen Sell-Off Rising Leverage May Worsen Sell-Off Rising Leverage May Worsen Sell-Off Chart 24Credit Spreads Close To Record Lows Credit Spreads Close To Record Lows Credit Spreads Close To Record Lows Chart 25But Default - Adjusted, Junk Still Looks Attractive But Default - Adjusted, Junk Still Looks Attractive But Default - Adjusted, Junk Still Looks Attractive Commodities Energy: Bullish Energy prices performed strongly in H2 2017, and we expect bullish sentiment to continue. OPEC 2.0 is likely to maintain production discipline, and will maintain its promised 1.8mm b/d production cuts through the end of 2018. Our estimates for global demand growth are higher than those of other forecasters. This, along with potential unplanned production outages in Iraq, Libya and Venezuela (together accounting for 7.4mm b/d of production at present), drives our above-consensus price forecast of $67 a barrel for Brent crude during 2018. Industrial Metals: Neutral Since China accounts for more than 50% of world base-metal consumption, prices will continue to be highly dependent on developments there. (Chart 26, panel 4). Since the government is trying to accelerate environmental and supply-side reforms, domestic production capacity for base metals will shrink, which will be a positive for global metals prices. However, a focus on deleveraging in the financial sector and restructuring certain industries could slow Chinese GDP growth, reducing base-metal demand. Precious Metals: Neutral Gold has risen by 12% in 2017, supported by an uncertain geopolitical environment coupled with low interest rates. We believe that geopolitical uncertainties will persist and may even intensify, and that inflation may rise in the U.S., which would be positives for gold (Chart 26, panel 3). Based on BCA's view that stock market could be at risk from the middle of 2018,8 a moderate gold holding is warranted as a safe-haven asset. However, rising interest rate and a potentially stronger U.S. dollar are likely to limit the upside for gold. Currencies USD: The currency is down over 6% on a trade-weighted basis over the past 12 months (Chart 27). Looking into 2018, the USD is likely to perform well in the first half. U.S. inflation should gather steam in the first two to three quarters, and the Fed will be able at least to follow its dot plot - something interest rate markets are not ready for. As investors remain short the USD, upside risk to U.S. interest rates should result in a higher dollar. Chart 26Bullish Oil, Neutral Metals Bullish Oil, Neutral Metals Bullish Oil, Neutral Metals Chart 27Dollar Likely To Appreciate Dollar Likely To Appreciate Dollar Likely To Appreciate EM/JPY: Carry trades are a key mechanism for redistributing global liquidity, and they have recently begun to lose steam. A crucial reason for this has been the policy tightening in China which has been the key driver of growth in EM economies. Additionally, Japanese flows have been chasing momentum into EM assets. Further tightening in EM could reverse the flows and initiate a flight to safety, favoring the yen relative to EM currencies. CHF: The currency continues to trade at a 5% premium to its PPP fair value against the euro. However, after considering Switzerland's net international investment position at 130% of GDP, the trade-weighted CHF trades in line with fair value. The CHF will continue to behave as a risk-off currency, and so long as global volatility remains well contained, EUR/CHF will experience appreciating pressure. GBP: Sterling continues to look cheap, trading at an 18% discount to PPP against the USD. However, Brexit remains a key problem. If future immigration is limited, the U.K. will see lower trend growth relative to its neighbors, forcing its equilibrium real neutral rate downward. Consequently, it will be more difficult to finance the current account deficit of 5% of GDP. Until negotiations with the EU come closer to completion, the pound will continue to offer limited reward and plenty of volatility. Alternatives Chart 28Favor Private Equity and Farmland Favor Private Equity and Farmland Favor Private Equity and Farmland Alternative assets under management (AUM) have reached a record $7.7 trillion in 2017. Lower fees and a broader range of investment types have helped attract more capital. Private equity remains the most popular choice,9 driven by its strong performance and transparency. Many investors have also shifted part of their allocations toward potentially higher-return private debt programs. Return Enhancers: Favor Private Equity Vs. Hedge Funds In 2017 so far, private equity has returned 12.1%, whereas hedge funds have managed only a 5.9% return (Chart 28). We expect private-equity fund-raising to continue into 2018, but with a larger focus on niche strategies with more favorable valuations. Additionally, deploying capital gradually not only provides for vintage-year diversification, but also creates opportunities for investors to benefit from potential market corrections. We continue to favor private equity over hedge funds outside of recessions. During a recession, we recommend investors take shelter in hedge funds with a macro mandate. Inflation Hedges: Favor Direct Real Estate Vs. Commodity Futures In 2017 to date, direct real estate has returned 5.1%, whereas commodity futures are down over 3.7%. Direct real estate as an asset class continues to provide valuable diversification, lower volatility, steady yields and an illiquidity premium. However, a slowdown in U.S. commercial real estate (CRE) has made us more cautious on the overall asset class. With regards to the commodity complex, the long-term transition of the global economy to a more renewables-focused energy base will continue the structural decline in commodity demand. We continue to stress the structural and long-term nature of our negative recommendation on commodities. Volatility Dampeners: Favor Farmland & Timberland Vs. Structured Products In 2017 to date, farmland and timberland have returned 3.2% and 2.1% respectively, whereas structured products are up 3.7%. Farmland continues to outperform timberland. The slow U.S. housing recovery has added downward pressure to timberland returns. Investors can reduce the volatility of a traditional multi-asset portfolio with inclusion of farm and timber assets. For structured products, low spreads in an environment of tightening commercial real estate lending standards and falling CRE loan demand, warrant an underweight. Risks To Our View We think upside and downside risks to our central scenario for 2018 - slowing but robust economic growth, and continuing moderate outperformance of risk assets - are roughly evenly balanced. On the negative side, perhaps the biggest risk is China, where the slowdown already suggested in the monetary data (Chart 29) could be exacerbated if the government pushes ahead aggressively with structural reforms. Geopolitical risks, which the market over-emphasized in 2017, seem under-estimated now.10 U.S. trade policy, Italian elections, and North Korea all have potential to derail markets. Also, when the U.S. yield curve is as flat as it is currently, small risks can be blown up into big sell-offs. This is particularly so given over-stretched valuations for almost all asset classes. Chart 29China Monetary Conditions Suggest A Slowdown China Monetary Conditions Suggest A Slowdown China Monetary Conditions Suggest A Slowdown Table 2How Will Trump Try To Influence The Fed? Quarterly - December 2017 Quarterly - December 2017 The most likely positive surprise could come from a dovish Fed. New Fed chair Jay Powell is something of an unknown quantity, and the White House could use the three remaining Fed vacancies to push the Fed to keep rates low, so as not to offset the positive effect of the tax cuts. Without these new appointees, the Fed would have a slightly more hawkish bias in 2018 (Table 2). The intellectual argument for hiking only slowly would be, as Janet Yellen said last month: "It can be quite dangerous to allow inflation to drift down and not to achieve over time a central bank's inflation target." The Fed has missed its 2% target for five years. It is possible to imagine a situation where the Fed increasingly makes excuses to keep monetary policy easy (encouraged, for example, by a short-lived sell-off in markets or a slowdown in China) and this causes a late-cycle blow-out, similar to 1999. 1 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017 available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Insight Report, "Tax Cuts Are Here - Sector Implications," dated December 12, 2017, available at uses.bcaresearch.com. 3 CBNK Survey: Monetary Base, Currency in Circulation. Source: IMF - International Financial Statistics. 4 Please see Global Investment Strategy Special Report, "Two Virtuous Dollar Circles," dated October 28, 2016, available at gis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 6 Please see U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 7 Please see The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com. 8 Please see The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 9 Source: BNY Mellon - The Race For Assets; Alternative Investments Surge Ahead. 10 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. GAA Asset Allocation

Overweight Anecdotal evidence of a strong recovery in holiday shopping, not least of which is Amazon's guidance of 28-38% growth in the December quarter, should see retailers in festive moods. However, with online sales set to overtake in-store for the first time this year, a round of intense discounting is the most likely outcome. While this points to an uncertain margin result for retailers, consumer finance stocks are unambiguous beneficiaries. Household net worth has been surging this year and now easily exceeds pre-GFC levels (second panel). This has led to steady acceleration in consumer finance sales expectations and sustained low delinquencies (third panel). Tack on rising interest rates (as a reminder, BCA's bond view calls for higher rates in 2018) and the stage is set for well above average earnings growth. Only some of the good news is reflected in the index's valuation, which has returned to average levels, trading at a normal premium to the broad market (bottom panel). We think the superior earnings tailwind justifies a more aggressive valuation; stay overweight. The ticker symbols for the stocks in the S&P consumer finance index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. A Happy Holiday Season For Consumer Finance A Happy Holiday Season For Consumer Finance

Highlights Overweighting Eurostoxx50 versus S&P500 is just a sector play - you must believe that banks are going to outperform technology. It is categorically not a relative economic growth or relative valuation play. The best expression of euro area economic outperformance - as we believe is likely - is not through mainstream equity indexes. It is through the euro. Could Spain in 2014-17 be Italy in 2018-21? If so, the cleanest play is through Italian bonds: long Italian BTPs versus French OATs. Play the lottery for free: when the price gap between the second and first month VIX future is greater than that between the first month and VIX spot - as it is now - it signals a potentially free lottery ticket. Feature Don't Play The Euro Area Economy Through The Stock Market The fallacy of division is a logical fallacy. It occurs when somebody falsely infers that what is true for the whole is also true for the parts that make up the whole. For example, somebody might see that their computer screen appears purple, and infer that the pixels that make up the screen are also purple. In fact, pixels are never purple. They are either red or blue. The fallacy of division is that the property of the whole - purpleness - does not translate to the property of the parts - redness or blueness. Chart of the WeekEuro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology Euro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology Euro Area Vs. U.S. Equities Is Just A Sector Play: Banks Vs. Technology The fallacy of division also affects investors. Since global equities are a play on the global economy, some investors infer that major equity indexes such as the Eurostoxx50 are relative plays on their regional economies. In fact, this is a fallacy of division: the property of the equity market as a global aggregate does not translate to the relative property of an equity market as a regional or national part. Through the past three years, the euro area economy has comfortably outperformed the U.S. economy1 (Chart I-2). Yet the Eurostoxx50 has substantially underperformed the S&P500 (Chart I-3). Why? Because the Eurostoxx50 has a major 14% weighting to banks and a minor 7% weighting to technology. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 24% weighting to technology. Chart I-2The Euro Area Economy ##br##Has Outperformed... The Euro Area Economy Has Outperformed... The Euro Area Economy Has Outperformed... Chart I-3...But The Eurostoxx50 ##br##Has Underperformed ...But The Eurostoxx50 Has Underperformed ...But The Eurostoxx50 Has Underperformed Hence, for the Eurostoxx50 the distinguishing property is 'bank'; for the S&P500 it is 'technology'. And as banks have underperformed technology, the Eurostoxx50 has underperformed the S&P500. This large difference in sector exposure also means that a head-to-head comparison of equity market valuation is misleading. The euro area, trading on a forward price to earnings (PE) multiple of 15, appears considerably cheaper than the U.S., trading on a forward PE of 19. But this head-to-head difference just reflects the forward PEs of banks at 11 and technology at 19. As banks will likely generate less long-term growth than technology, banks are rightfully cheaper than technology and the Eurostoxx50 is rightfully cheaper than the S&P500. Some people suggest sector-adjusting stock market valuations to allow for the sector biases. The problem is that this suggestion cannot avoid the inescapable end-result. The bank-heavy Eurostoxx50 versus the tech-heavy S&P500 relative performance will still depend on banks versus technology (Chart of the Week). Remarkably, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. This means that relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,2 or vice-versa (Chart I-4). Chart I-4Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Eurostoxx50 Vs. S&P500 Reduces To: Santander, BNP & ING Vs. Apple, Microsoft & Google Everything else is largely irrelevant. Hence, the counterintuitive conclusion is that overweight Eurostoxx50 versus S&P500 is actually a sector play. You must hold the view that banks are going to outperform technology. At the moment, we are agnostic on this view. The best expression of euro area economic outperformance - as we believe is likely - is not through mainstream equity indexes. It is through bond yield spread compression and through exchange rates. Our preferred expression is structurally long EUR/USD. Could Spain In 2014-17 Be Italy In 2018-21? In 2013, Spain seemed to be on its knees. The economy had slumped by almost 10%, unemployment stood at 27%, and the stock of bank loans which were non-performing exceeded 13%. Doomsayers abounded. Standard and Poor's downgraded Spain's sovereign credit rating to BBB-, one notch above junk, and esteemed Wall Street strategists predicted the unemployment rate would remain above 25% for the rest of the decade. But the esteemed strategists were completely wrong. Through 2014-17, Spanish real GDP per head has grown by almost 15% (Chart I-5) - making it one of the top performing developed economies; unemployment has plunged by 10% (Chart I-6); and non-performing loans have declined sharply. What suddenly transformed Spain from zero to hero? The answer is that Spain recapitalised its banks. Chart I-5Through 2014-17 Spanish Real GDP ##br##Per Head Is Up Almost 15%... Through 2014-17 Spanish Real GDP Per Head Is Up Almost 15%... Through 2014-17 Spanish Real GDP Per Head Is Up Almost 15%... Chart I-6...And Unemployment##br## Is Down 10% ...And Unemployment Is Down 10% ...And Unemployment Is Down 10% After a financial crisis, the golden rule of recovery is to repair the banking system as soon as possible. In the aftermath of housing-related banking crises in 2008, the U.S. and U.K. quickly recapitalised their damaged banking systems; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as soon as the banks' aggressive deleveraging ended. Which brings us to Italy. Many people claim that Italy's long-standing economic underperformance is due to deep-seated structural problems. We do not dispute that such problems exist, but they cannot be the main cause of the economic underperformance. After all, through 1999-2007, Italian real GDP per head performed more or less in line with the U.S., Canada and France (Chart I-7), even without a private sector credit boom which the other economies had. Italy's underperformance really started after the 2008 financial crisis. And the most plausible explanation is that its dysfunctional banking system has been left broken for so long. Italy has procrastinated because its government is more indebted than other sovereigns and its banking problems have not caused an outright crisis - yet. But now policymakers in Rome, Brussels and Frankfurt realise that a hamstrung economy carries risks of a populist backlash against the European project. Finally, Italian banks' equity capital is rising, their solvency is improving and the share of non-performing loans appears to have peaked at the same level as in Spain in 2013 (Chart I-8). Chart I-7Through 1999-2007 Italy Performed In##br## Line With Other Major Economies Through 1999-2007 Italy Performed In Line With Other Major Economies Through 1999-2007 Italy Performed In Line With Other Major Economies Chart I-8Spanish NPLs Peaked In 2013, ##br##Italian NPLs Are Peaking Now Spanish NPLs Peaked In 2013, Italian NPLs Are Peaking Now Spanish NPLs Peaked In 2013, Italian NPLs Are Peaking Now So could Spain in 2014-17 be Italy in 2018-21? Once again, doomsayers abound and the counterintuitive thought could pay off. The cleanest way to play this is through Italian bonds: long Italian BTPs versus French OATs. Play The Lottery For Free As everybody knows, playing the lottery is not a good investment strategy. Most of the time your Lotto ticket brings zero reward, though occasionally you do win a prize. In fact, the U.K. National Lottery has said that the expected win per £1 played averages £0.47. Meaning the long-term return on this strategy is -53%. In the financial markets, the equivalent of a Lotto ticket is to buy volatility. In practice, this means buying a future on a volatility index such as the VIX. The problem is that the VIX futures curve usually slopes upwards. So if the curve doesn't change, a future bought above the spot price loses value when it expires at the spot price (Chart I-9). The upshot is that most of the time, the future 'rolls down the curve', and you lose money, though occasionally when volatility spikes you win. But counterintuitively, sometimes you can play the lottery for free. Look at the VIX futures curve: when the price gap between the second and first month is greater than that between the first month and spot - as it is now (Chart I-10) - it signals a potentially free lottery ticket. Chart I-9VIX Futures "Roll Down The Curve" VIX Futures "Roll Down The Curve" VIX Futures "Roll Down The Curve" Chart I-10Spotting A Free Lottery Ticket Spotting A Free Lottery Ticket Spotting A Free Lottery Ticket Under these circumstances, the strategy is to go long the first month future and short the second month future. If the futures curve stays broadly as it is - and both futures contracts roll down the curve - the loss on the first month long position will be made up by the gain on the second month short position. Effectively, the combined position becomes costless. Yet this potentially costless position is still playing the lottery. Because if volatility does spike, the volatility futures curve tends to invert sharply (go into backwardation). Hence, the gain on the first month long position substantially outweighs the loss on the second month short position. Now might be a good time to play the lottery for free. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 On a real GDP per capita basis. 2 Listed as Alphabet. Fractal Trading Model* Silver's 65-day fractal dimension is at a level which has previously indicated four tradeable trend reversals. Go long silver with a profit target / stop-loss of 4.5% In other trades, we are pleased to report that short basic materials versus market and short copper / long tin both hit their respective profit targets. This leaves us with six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long Silver Long Silver The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations