South Korea

Highlights Chinese capex and EM domestic demand will falter again in the second half of this year. This is not contingent on a growth slowdown in the advanced economies, but due to a further slowdown in bank lending in EM and lower commodities prices. The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. India's deleveraging cycle is well advanced, especially when compared with other EM economies. Maintain an overweight position in Indian equities within the EM universe. Continue betting on yield curve steepening. Stay long the Czech koruna versus the euro. Feature EM/China growth will relapse in the second half of this year. Share prices, presuming they are forward-looking, will roll over beforehand. Chinese interest rates have risen, which typically heralds a downtrend in the mainland's credit impulse and business cycle (Chart I-1). Chinese interest rates are shown as an annual percentage change, inverted and advanced. This is a typical relationship between interest rates and credit cycles, and there is currently no reason why it will play out any differently in China. Given the mainland has a lingering credit bubble, rising borrowing costs and regulatory tightening of banks and the shadow banking system are guaranteed to lead to a relapse in credit origination, and in turn economic growth. China's yield curve has been flattening in recent months. This often precedes a selloff in both EM share prices and industrial metals (Chart I-2). Chart I-1China: Interest Rates ##br##And Credit/Business Cycles China: Interest Rates And Credit/Business Cycles China: Interest Rates And Credit/Business Cycles Chart I-2A Flattening Yield Curve In China Is ##br##A Bad Omen For EM And Commodities A Flattening Yield Curve In China Is A Bad Omen For EM And Commodities A Flattening Yield Curve In China Is A Bad Omen For EM And Commodities The Chinese yield curve has been experiencing bear flattening - front-end rates have risen more than long-term rates. Bear flattening in yield curves typically occurs before a major top in growth, when current conditions are still robust but the fixed-income market begins to question growth sustainability going forward. A flattening yield curve is consistent with our assessment: a lack of follow-through from last year's stimulus combined with the recent policy tightening will cause growth to downshift materially very soon. EM narrow (M1) money growth has rolled over decisively, and historically it has been a good leading indicator for EM earnings per share (EPS) (Chart I-3). The former has historically led the latter by about nine months. Chart I-3EM EPS To Roll Over In the Second Half 2017 EM EPS To Roll Over In the Second Half 2017 EM EPS To Roll Over In the Second Half 2017 The same is true in the case of China - the M1 impulse (the second derivative of M1) leads industrial profits by about six months and heralds an imminent reversal (Chart I-4). Chart I-4China's Industrial Profit Growth Recovery Is At A Risk China's Industrial Profit Growth Recovery Is At A Risk China's Industrial Profit Growth Recovery Is At A Risk The commodities currency index (an equally weighted average of AUD, NZD and CAD) has relapsed against the greenback. This index points to global growth deceleration in the second half of this year (Chart I-5). Similarly, these commodities currencies also lead commodities prices, and presently signal a top in the commodities complex (Chart I-6). Chart I-5Commodities Currencies Signify Weakness In Global Trade Commodities Currencies Signify Weakness In Global Trade Commodities Currencies Signify Weakness In Global Trade Chart I-6Commodities Currencies Point To Relapse In Commodities Prices Commodities Currencies Point To Relapse In Commodities Prices Commodities Currencies Point To Relapse In Commodities Prices In EM ex-China, Korea and Taiwan, bank loan growth has still been decelerating despite the global growth recovery of the past 12 months (Chart I-7, top panel). Besides, retail sales volume growth in EM ex-China, Korea and Taiwan has not ameliorated yet (Chart I-7, bottom panel). All of these economic aggregates are equity market cap-weighted. Similarly, auto sales in EM ex-China, Korea and Taiwan have been stabilizing at very low levels but have not recovered at all (Chart I-8). Hence, we infer that domestic demand in EM ex-China has stabilized, but it has not recovered. For example, manufacturing production in Brazil, Russia, South Africa and Indonesia has been rather subdued (Chart I-9). Chart I-7EM Ex-China, Korea And Taiwan: ##br##Domestic Demand Has Not Recovered EM Ex-China, Korea And Taiwan: Domestic Demand Has Not Recovered EM Ex-China, Korea And Taiwan: Domestic Demand Has Not Recovered Chart I-8EM Ex-China, Korea And Taiwan: ##br##Auto Sales Are Stabilizing At Low levels EM Ex-China, Korea And Taiwan: Auto Sales Are Stabilizing At Low levels EM Ex-China, Korea And Taiwan: Auto Sales Are Stabilizing At Low levels Chart I-9Synchronized Global Recovery? Synchronized Global Recovery? Synchronized Global Recovery? As EM ex-China credit growth decelerates further due to the lingering credit excesses and poor banking system health, their domestic demand will disappoint. This is a major risk to the EM profit outlook. Bottom Line: Chinese and EM domestic demand and by extension corporate earnings will falter again in the second half of this year. This view is not contingent on a growth slowdown in the advanced economies but will be the outcome of further slowdown in bank lending in EM and lower commodities prices. A reversal in Chinese imports from other EM is the link that explains how a relapse in the mainland's growth in the second half this year will hurt the rest of the world in general, and EM in particular. Profits Hold The Key Chart I-10Profits, Not Valuations, Hold The Key Profits, Not Valuations, Hold The Key Profits, Not Valuations, Hold The Key Emerging markets' relative performance versus the S&P 500 has historically been driven by EPS (Chart I-10). In the past 12 months, EM EPS has improved modestly but has not outperformed U.S. EPS in U.S. dollar terms. Consistently, EM stocks have failed to outperform the S&P 500 in common currency terms; they have been flat at low levels in the past 12 months. An important message from this chart is that equity valuations are not critical to EM versus U.S. relative equity performance. It is all about corporate profit cycles. The widely held view within the investment community is that EM stocks are cheaper than those in the U.S., and therefore will outperform based on more attractive valuations. The fact that EM stocks are indeed cheaper versus the S&P 500 only reflects the fact that U.S. equity valuations are expensive and EM equity valuations are neutral in absolute terms. Equity valuations may affect the degree of out- and underperformance, but they do not determine the direction of relative performance as vividly illustrated by Chart I-10. The same can be said about EM stocks' absolute performance. Equity valuations do not determine the direction of share prices; the latter rise when profits expand, and fall when EPS contracts. However, valuations affect the magnitude of the move in equity prices: cheap valuations and growing EPS will produce a larger rally compared to neutral equity valuations and identical growth in EPS. We discussed EM equity valuations at great length in our Weekly Report published two weeks ago.1 In absolute terms, EM equity valuations are presently neutral. Therefore, they have no bearing on the direction of share prices. If EM EPS expands, stocks will continue to rally. If EPS growth stalls or turns negative, EM stocks will stumble. As Charts I-3 and I-4 on page 3 illustrate, EM EPS will soon relapse. In addition, U.S. return on equity (RoE) remains well above EM's RoE (Chart I-11), reflecting better equity capital utilization in the U.S. versus the EM. Looking forward, one variable that has had a reasonably good track record in gauging relative performance of EM versus U.S. share prices is the ratio of industrial metals to U.S. lumber prices (Chart I-12). Industrial metals prices are a proxy for economic growth in China/EM, while U.S. lumber prices are indicative of America's business cycle. Industrial metals prices (the LMEX index) have lately underperformed U.S. lumber prices, pointing to renewed EM underperformance versus the S&P 500. Chart I-11EM RoE Is Below U.S. RoE EM RoE Is Below U.S. RoE EM RoE Is Below U.S. RoE Chart I-12EM Stocks To Underperform The S&P 500 EM Stocks To Underperform The S&P 500 EM Stocks To Underperform The S&P 500 Our view is that EM EPS growth will contract again within a cyclical investment horizon (over the next 12 months). While not all sectors' earnings are set to shrink, our view is that banks' profits will decline driven by credit growth deceleration and a rise in non-performing loans in a number of countries. Besides, commodities producers' EPS will drop anew if, as we expect, commodities prices head south again. Table I-1 illustrates the weights of each EM equity sector within total EM-listed companies' profits. Financials account for 24%, while energy and materials comprise 7.5% each of the aggregate EM equity market cap, respectively. In aggregate, these sectors make up 50% of EM EPS and 40% of the stock index. Table I-1EM Sectors: Equity Market Caps ##br##And EPS's Share Of Total EPS Signs Of An EM/China Growth Reversal Signs Of An EM/China Growth Reversal We remain positive on the technology/internet sector's growth outlook. While this sector's weight in terms of both market cap and EPS is very large, it is not yet sufficient to lift the overall EM equity index if other large sectors falter. In fact, technology/internet stocks have already rallied dramatically and are presently overbought. They will likely correct along with the rest of the universe. Nevertheless, we continue to recommend an overweight stance in technology stocks within the EM benchmark. Bottom Line: The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. Consistently, we maintain our long-standing strategy of being short EM / long the S&P 500. Taking Profits On Short Korean Auto Stocks Initiated on July 3, 2013, this recommendation has generated a 35% gain (Chart I-13, top panel). Notably, Korean auto stocks have failed to rally in the past 12 months. Furthermore, Korean auto stocks have underperformed the overall EM equity index by a whopping 22% since our recommendation (Chart I-13, bottom panel). For dedicated investors, we recommend lifting the allocation to this sector from underweight to neutral. In regard to allocation to the KOSPI overall, we maintain our overweight stance within an EM equity portfolio for now. Geopolitical volatility could create near-term disturbance but the primary trend in Korea's relative performance against the EM benchmark is up (Chart I-14). Within the KOSPI, we continue to overweight technology stocks, companies with exposure to DM growth and domestic industries. Meanwhile, companies with exposure to China's capital spending should be avoided. Chart I-13Take Profits On Short ##br##Korean Stocks Recommendation Take Profits On Short Korean Stocks Recommendation Take Profits On Short Korean Stocks Recommendation Chart I-14Korean Equities ##br##Relative To EM Overall Korean Equities Relative To EM Overall Korean Equities Relative To EM Overall Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Equity Valuations Revisited", dated March 29, 2017, link available on page 21. India: Beyond De-Monetization The growth-dampening effects from India's de-monetization program are beginning to dissipate. Both services and manufacturing PMIs are recovering (Chart II-1). As more cash is injected back into the system, consumer sector growth will improve. Beyond the recovery in consumption, however, capital spending - the key driver of productivity and non-inflationary growth - is still anemic because of structural reasons that began well before de-monetization was announced (Chart II-2). Chart II-1PMIs Are Recovering PMIs Are Recovering PMIs Are Recovering Chart II-2Capital Spending Is Depressed Capital Spending Is Depressed Capital Spending Is Depressed Public Banks: Is Deleveraging Advanced? The Indian authorities appear serious about restructuring their public banks, and the banking downturn cycle is likely approaching its final stages (Chart II-3). As and when India's public banks find themselves on more solid footing, industrial credit growth will pick up meaningfully and capital expenditures will follow. The previous credit boom that occurred in the infrastructure, mining, and materials sectors left a large number of failed and stalled projects. Chart II-4 shows the number of stalled projects remains stubbornly high and is not yet declining. These mal-investments have ended up as non-performing loans primarily on public banks' balance sheets: Non-performing loans (NPLs) currently amount to 11.8% and distressed assets (DRA) stand at around 4% of total loans on Indian public banks' balance sheets. This has forced public banks to curtail credit growth to the industrial sector (Chart II-5). Chart II-3Bank Credit Growth Is At All Time Low Bank Credit Growth Is At All Time Low Bank Credit Growth Is At All Time Low Chart II-4Plenty Of Projects Stalled Plenty Of Projects Stalled Plenty Of Projects Stalled Chart II-5Bank Credit Growth To Industries Is Contracting Bank Credit Growth To Industries Is Contracting Bank Credit Growth To Industries Is Contracting Public banks' NPLs and DRAs have spiked because the Reserve Bank of India (RBI) is forcing commercial banks to acknowledge and provision for these bad loans via the central bank's Asset Quality Review (AQR) program. This is eroding public banks' capital and constraining their ability to grow their loan book. However, the program is bullish for India's economy in the long run and stands in stark contrast to other EM countries where authorities are turning a blind eye on banks attempting to window dress their NPLs. India's government and the RBI are currently working with commercial banks and proposing measures to recover loans from defaulters. The government is also injecting capital into public banks. It has announced 100 billion INR in capital injections for this fiscal year and will inject more if needed. It is also forcing banks to raise more capital by ridding their books of non-core businesses. We have performed a scenario analysis on public banks (presented in Table II-1) to gauge their stock valuations. In all scenarios, we assume that DRAs will be constant at 5% of total loans, and also assume a 70% recovery rate on DRAs. We examine various scenarios for NPLs - the latter vary from 12-15% of total loans (the current actual NPL rate is 11.8%). Equity valuations are very sensitive to the recovery rate on NPLs. We stress test for recovery rates of 30%, 40%, 50% and 60%. If one assumes a 12% NPL ratio and a recovery rate of 60%, public bank stocks would be 30% cheap - their adjusted (post provisions, capital impairment, and recapitalization) price-to-book value (PBV) ratio will be 0.7, which is 30% less than its historical mean PBV ratio for public banks of 1.0. By contrast, assuming a 15% NPL ratio and a 30% recovery rate, banks' equity valuations would be 50% expensive - their adjusted (post provisions, capital impairment, and recapitalization) PBV ratio would be 1.5. Table II-1Under/Overvaluation (In %) Of Public Banks Stocks For A Given NPL Ratio And Recovery Ratio* Signs Of An EM/China Growth Reversal Signs Of An EM/China Growth Reversal Our bias is to believe that the NPL ratio is somewhere between 14-15% and the recovery rate near 40%. In such a case, public bank stocks would presently be 10-20% expensive. This does not offer a great buying opportunity at current levels, but suggests the downside is probably smaller than in other EM bank stocks. Overall, India is much more advanced in terms of recognizing and provisioning for NPLs as well as re-capitalization of its banking system than many other EM countries. Therefore, we believe India's deleveraging cycle is well advanced, especially when compared with other EM economies. Due to this and the fact that this economy is not exposed to China/commodities prices, we still recommend an overweight position in Indian equities within the EM universe. Inflation And Fixed-Income Strategy While headline inflation is easing due to temporarily lower food prices, core inflation remains sticky. The central government's overall and current expenditures - which often drive inflation - are rising rapidly (Chart II-6). Likewise, state governments' current expenditures are also booming and state development loans - borrowing by state governments - are growing at an extremely fast pace. In addition, in June 2016, the Indian central government announced it will raise salaries, allowances and pensions of government employees by 23%. The central government also raised the minimum wage for non-agriculture laborers by 42% in August 2016, and the Ministry of Labor followed by doubling the minimum wage of agricultural workers in March 2017. All of this will entail accumulating inflationary pressures, even if oil and food prices remain tame. The central bank hiked the reverse repo rate last week to absorb excess liquidity from the banking system. Even though it cited service sector inflation as a concern, we believe it will lag behind accumulating inflationary pressures. This warrants a steeper yield curve. Investors should continue to bet on yield curve steepening by paying 10-year swaps / receiving 1-year swap rates (Chart II-7). Chart II-6Government Expenditures Are Rising Government Expenditures Are Rising Government Expenditures Are Rising Chart II-7Bet On A Yield Curve Steepening Bet On A Yield Curve Steepening Bet On A Yield Curve Steepening Rising inflationary pressures and higher bond yields could weigh on Indian stocks in absolute terms, but will likely not preclude them outperforming the EM equity benchmark. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Stay Long Czech Koruna Versus Euro On September 28th 2016, we recommended going long CZK / short EUR on the back of expectations that the Czech National Bank (CNB) would abandon its currency peg. Last week, the CNB has floated the koruna. We expect this currency to appreciate versus the euro further and suggest keeping this position. Inflationary pressures in the Czech economy are genuine and heightening. The 1.5% appreciation in the koruna versus the euro since last week will not tighten monetary conditions enough to cap inflation. As such, we expect the CNB to eventually start raising interest rates, leading to further koruna appreciation versus the euro (Chart III-1). The output gap is turning positive, which historically has led to a rise in core inflation (Chart III-2). Chart III-1The Czech Koruna Has More Catch-Up To Do The Czech Koruna Has More Catch-Up To Do The Czech Koruna Has More Catch-Up To Do Chart III-2Output Gap And Inflation Output Gap And Inflation Output Gap And Inflation The labor market is tight - the Czech unemployment rate is the lowest in Europe. Both wages and until labor costs growth are robust and trimmed-mean consumer price inflation is accelerating (Chart III-3). The CNB's foreign exchange reserve accumulation has generated an overflow of liquidity in the Czech financial/banking system (Chart III-4). Chart III-3Inflationary Pressures Are Broad-Based Inflationary Pressures Are Broad-Based Inflationary Pressures Are Broad-Based Chart III-4Money And Credit Growth Are Very Strong Money And Credit Growth Are Very Strong Money And Credit Growth Are Very Strong The rapid expansion of liquidity has led to strong credit growth (Chart III-4, bottom panel), and a rapid appreciation in real estate prices. This warrants higher interest rates to prevent the formation of a bubble. Furthermore, the Czech economy has been benefiting from the recovery in European economic growth in general and manufacturing in particular. Tourist arrivals have also been robust. Notably, the nation's current account surplus stands at 1% of GDP. Chart III-5The Koruna Is Mildly Cheap The Koruna Is Mildly Cheap The Koruna Is Mildly Cheap With regards to currency valuations, the koruna is silently cheap and as such has further room to appreciate (Chart III-5). Either the koruna will gradually appreciate over the next few months, tightening monetary conditions to an extent where the CNB does not need to hike interest rates, or the CNB is eventually forced to hike rates considerably. The latter will push up the value of the Czech currency. We suspect that the CNB is still intervening in the forex market in order to prevent a dramatic appreciation in the koruna. The central bank has stated in its last press conference that it stands ready to intervene to mitigate exchange rate fluctuations if needed. However, in an economy with open capital account, the central bank cannot target the exchange rate and interest rates simultaneously. If the CNB desires to cap inflation, it has to hike interest rates or allow the currency to appreciate considerably. If it chooses the former, the koruna will still rally dramatically. Bottom Line: Stay long the Czech koruna versus the euro. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof bca.gps_so_2016_12_14_c3 bca.gps_so_2016_12_14_c3 Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand bca.gps_so_2016_12_14_c4 bca.gps_so_2016_12_14_c4 At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... bca.gps_so_2016_12_14_c5 bca.gps_so_2016_12_14_c5 Chart 6And Now China ##br##Is Exporting Deflation bca.gps_so_2016_12_14_c6 bca.gps_so_2016_12_14_c6 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 8Sino-American ##br##Symbiosis Is Over bca.gps_so_2016_12_14_c8 bca.gps_so_2016_12_14_c8 Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Globalization: A Deflationary Shock Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Europe's Economy Is Holding Up Europe's Economy Is Holding Up Chart 19 "Mainstream Media" Is A Dirty Word For Many "Mainstream Media" Is A Dirty Word For Many We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 21The Internet Has Killed Journalism Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Get Used To Tail-Risk Events Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Support For The Euro Remains Stable Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 26The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating bca.gps_so_2016_12_14_c30 bca.gps_so_2016_12_14_c30 Chart 31There Is A Lot Of Daylight... bca.gps_so_2016_12_14_c31 bca.gps_so_2016_12_14_c31 The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's bca.gps_so_2016_12_14_c32 bca.gps_so_2016_12_14_c32 Chart 33Italy Lags Peers On Euro Support bca.gps_so_2016_12_14_c33 bca.gps_so_2016_12_14_c33 Chart 34Italy's Next Election Is Too Close To Call bca.gps_so_2016_12_14_c34 bca.gps_so_2016_12_14_c34 Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? bca.gps_so_2016_12_14_c35 bca.gps_so_2016_12_14_c35 Chart 36Italy Has Learned To Live With Its Debt Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe bca.gps_so_2016_12_14_c37 bca.gps_so_2016_12_14_c37 Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 40Iraq Is The Big, And Cheap, Hope bca.gps_so_2016_12_14_c40 bca.gps_so_2016_12_14_c40 This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 42Oil Supply Glut Is Gone In 2017 bca.gps_so_2016_12_14_c42 bca.gps_so_2016_12_14_c42 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 44Asia Sells, America Rules bca.gps_so_2016_12_14_c44 bca.gps_so_2016_12_14_c44 It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike bca.gps_so_2016_12_14_c45 bca.gps_so_2016_12_14_c45 Chart 46China Backing Away From U.S. Treasuries bca.gps_so_2016_12_14_c46 bca.gps_so_2016_12_14_c46 There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade bca.gps_so_2016_12_14_c47 bca.gps_so_2016_12_14_c47 Chart 48China Is De-Globalizing bca.gps_so_2016_12_14_c48 bca.gps_so_2016_12_14_c48 That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone bca.gps_so_2016_12_14_c49 bca.gps_so_2016_12_14_c49 The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses bca.gps_so_2016_12_14_c50 bca.gps_so_2016_12_14_c50 What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Sweden Yield Curve: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. Swedish Rates: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. NZ Rates: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Korea vs. Japan: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Feature The surprising U.S. election victory of President-elect Trump, on a policy platform that is both reflationary and protectionist, has shaken up the global macro landscape. The shock has been even more acute for small, open and export-oriented economies like Sweden, New Zealand and Korea. This triggers a necessary re-assessment of our positions. In this Weekly Report, we revisit three previously recommended trades included in our "Overlay Trades Portfolio" that are most exposed to the changing global backdrop. Sweden: Closing Our Flattener Trade... Last year, we were of the view that the Riksbank would shift to a more hawkish policy stance during 2016.1 Fast forward to today, and this has not panned out as we expected with the Riksbank persistently sticking with its dovish bias. We are no longer comfortable facing the stiff resolve of the Riksbank and, therefore, we are closing our recommended Swedish 5-year/10-year yield curve flattener trade (Chart 1). Chart 1Closing Our Sweden Flattener Closing Our Sweden Flattener Closing Our Sweden Flattener Chart 2The Dovish Rhetoric Is Paying Off The Dovish Rhetoric Is Paying Off The Dovish Rhetoric Is Paying Off The message has been clear - Sweden's central bank will stay accommodative as long as it takes to get inflation back on a sustainable upward trajectory. In a unified fashion, the most senior Riksbank officials have communicated the following: 2 Monetary policy is set to escape low inflation as fast as possible. Currency intervention to weaken the Krona cannot be ruled out. There is no problem in extending the Riksbank's asset purchase program, since it has worked well so far in keeping government bond yields at accommodative levels and helping depress the Krona. The exchange rate is now notably weaker throughout the entire Riksbank forecast period than previously assumed, but this has not been sufficient to counteract the lower underlying inflationary pressures in Sweden.3 In a nutshell, the Riksbank wants to bring about higher inflation through a depreciation of the currency. The strategy has started to work of late (Chart 2). A very accommodative monetary policy, combined with rising inflation pressures from a cheapening Krona, now points to a prolonged period of low real policy rates that will keep the Swedish yield curve under steepening pressure. Aside from the monetary policy rhetoric, the global political landscape is no longer favorable for a yield curve flattening trade either, even in Sweden. In June, when Brexit surprised the planet, our Sweden flattener trade performed well, as global uncertainty spiked and a risk-off environment supported lower longer-term bond yields. Donald Trump's upset election earlier this month had the exact opposite effect, however, triggering a massive curve steepening in most bond markets, including Sweden (Chart 3).4 Going forward, if the effects of Trump's proposed policies - such as a decent fiscal impulse and protectionist trade measures - linger, as we expect, a Swedish flattener will likely underperform. Global bond markets will continue to be heavily influenced by a steepening U.S. Treasury curve. Moreover, our optimism on Swedish growth has dimmed recently, with certain parts of the economy slowing down. At the business level, weakening new orders data signal lower industrial production growth ahead. In addition, exporter order books have rolled over, resulting in a build-up of inventories (Chart 4). Chart 3Same Populism, Different Outcome A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades Chart 4Dimming Optimism Dimming Optimism Dimming Optimism In turn, Swedish households are feeling the pinch. Slower wages and employment growth are reducing consumption. Growth in retail sales and car registrations has decelerated and private bankruptcies have started to rise (Chart 5). Since household consumption is a vital part of Sweden's economy, the recent robust expansion will moderate in the next few quarters. Consequently, the gap between the Riksbank's dovish monetary stance and the economic backdrop can no longer be deemed unsustainable, as we have described it in the past. This reality has been well depicted in the latest Riksbank Monetary Policy Report (MPR), where 2016 GDP growth is now forecasted to be only 1.8%. This seems reasonable considering the decline in actual demand - observable through the slowing growth of Swedish imports - and the Riksbank's own forward-looking economic activity index (Chart 6). The Riksbank is now projecting only a modest growth rebound to 2.5% in 2017, but this implies a meaningful reacceleration in growth to an above-trend pace later on in the year. Chart 5Swedish Households: Feeling The Pinch Swedish Households: Feeling The Pinch Swedish Households: Feeling The Pinch Chart 6Swedish GDP Growth Will Slow Further Swedish GDP Growth Will Slow Further Swedish GDP Growth Will Slow Further Bottom Line: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. ...And Placing A New Bet On Rising Swedish Inflation Currently, the Swedish Overnight Index Swap (OIS) curve is expecting monetary policy stability in the first half of next year, pricing in only a 10% probability of a rate cut and a mere 2% chance of a rate hike by July 2017. Of the two, a rate hike is most likely, in our view, given the growing risks of upside inflation surprises stemming from a weaker Krona and rising energy prices. With such a low probability of a hike currently priced into the curve, the risk/reward potential for a trade is compelling. Today, we enter into a new position: paying 18-month Swedish OIS rates (Chart 7). Chart 7Pay 18-Month Sweden OIS Rates Pay 18-Month Sweden OIS Rates Pay 18-Month Sweden OIS Rates Chart 8Energy Prices Are Crucial For Swedish Inflation A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades In the Riksbank's October MPR, the first rate increase was pushed forward from the second quarter of 2017 to the first quarter of 2018.5 At that point, the central bank's forecast becomes slightly lower than the interest rate expectation now priced in the OIS market. Even with our more sober view of the Swedish economy, the next rate hike is now expected to occur too far into the future. It will likely happen beforehand as upside surprises on inflation will force the Riksbank to begin tightening sooner than planned. Sweden's inflation path is mainly influenced by two factors: the Krona and energy prices. If the Krona's weakness accelerates and energy prices resume their uptrend, inflation will jump. In turn, if inflation reaches its target earlier, the central bank will start normalizing rates sooner than expected. Chart 9Can Sweden Still Overheat? Can Sweden Still Overheat? Can Sweden Still Overheat? As stated above, the Riksbank members' dovish rhetoric has been successful in pushing the Krona lower. Much to our astonishment, they seem ready to continue moving in that direction, despite the potential negative spillovers. The bubbly Swedish housing market - fueled by low interest rates and lacking the macro-prudential measures to stop its expansion - does not appear to be a major concern of the Riskbank for the time being. In addition to the exchange rate, the path of energy prices is crucial for inflation; it represents the bulk of the deflationary pressure over the last few years (Chart 8). Although this situation has changed recently, with a positive contribution to inflation in the last four months, energy prices will need to appreciate again to keep consumer price advances on track. This is likely to happen. Our Commodity strategists believe that the markets are understating the odds of Brent exceeding $50/bbl by the end of this year, given their expectation that Saudi Arabia and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30th in Vienna.6 If such meaningful production cuts come to fruition, energy prices will rise and add to Sweden's inflationary pressure. Moreover, the bigger structural picture in Sweden remains very inflationary, despite the short term cyclical weakness stated earlier. GDP, employment and hours worked are all expanding faster than the Riksbank's assessment of the long-run trend growth rates. Plus, according to the Economic Tendency Survey, companies are reporting labor shortages in all major business sectors.7 In sum, with resource utilization already stretched, keeping real interest rates low for longer can only prolong the steadfast Swedish credit expansion, potentially overheating the economy and creating additional inflation surprises (Chart 9). This will set the stage for an eventual shift by the Riksbank to a more hawkish posture. Bottom Line: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. New Zealand: Inflation To Re-Surface Here, As Well Chart 10Global Output Gaps Have Narrowed Global Output Gaps Have Narrowed Global Output Gaps Have Narrowed On November 9th, the Reserve Bank of New Zealand (RBNZ) cut its overnight rate to 1.75% and signaled that it would probably be on hold for the foreseeable future. From here, things could go both ways; another rate cut is not inconceivable in 2017. Yet the market is expecting a stable rate backdrop, pricing in only a 5% chance of a rate cut and a 6% probability of a rate hike by June 2017. Such an "undecided" market is not surprising. On one hand, inflation remains below target. On the other hand, the economy has been humming along with no signs of any major slowdown on the horizon. In our view, monetary policy risks are tilted towards rate hikes. Similar to Sweden's case, inflation has the potential to surprise on the upside in 2017. Several factors have contributed to the current stubbornly low inflation environment. However, going forward, those forces will abate and push inflation and, eventually, short term interest rates higher. 1.A more inflationary global backdrop New Zealand's low inflation problem comes from the tradable components. Simply put, because of the global deflationary environment of the last few years, and because of the Kiwi's strength, New Zealand has imported lower prices from abroad. But this phenomenon will move in the other direction going forward. The global inflationary backdrop has slowly changed. As noted by our Chief Global Investment Strategist, Peter Berezin, spare capacity within the developed economies has shrunk substantially over the last few years (Chart 10).8 Unemployment rates are lower than the non-accelerating inflation rates of unemployment (NAIRU) in most major countries, with the exception of France and Italy. Looking ahead, the current cyclical upswing in global growth, coming at a time of narrowing output gaps and increasing supply-side constraints, will put upward pressure on global inflation. This will eventually trigger a rise in New Zealand's import price inflation, although the impact might not be felt in the very short term. 2.A continued boost from China Closer to home for New Zealand, China's backdrop has become less deflationary. As we pointed out in a recent Special Report, China has turned into a cyclical tailwind for the global economy, putting upward pressure on inflation and bond yields in the near-term.9 Our "GFIS China Check List", composed of our favored indicators, highlights that China is in the expansionary phase of its economic cycle (Table 1). Table 1The GFIS China Checklist A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades Most striking is that Chinese final goods producer prices have turned positive. This could prove to be a major development for New Zealand tradable goods prices, if it lasts; the correlation between Chinese PPI inflation and the tradable goods contribution to New Zealand's headline CPI has historically been elevated (Chart 11). 3.A weaker kiwi dollar Donald Trump's U.S. election victory could help raise New Zealand inflation through the exchange rate. If his ambitious fiscal plan and protectionist inclinations gain traction, the Fed might have to raise rates more aggressively than expected, putting upward pressure on the U.S. dollar. Under such a scenario, the Kiwi will re-price lower, potentially reversing the prior dampening effect on import prices from a strengthening currency. This would relieve policymakers on the RBNZ, who have consistently pointed to the currency's strength as the main reason inflation has missed the target (Chart 12). Chart 11China: A New Tailwind For Prices China: A New Tailwind For Prices China: A New Tailwind For Prices Chart 12The Kiwi Is Problematic The Kiwi Is Problematic The Kiwi Is Problematic 4.A stronger dairy sector Over the past couple of years, the Achilles heel for New Zealand has been its dairy sector, with plunging prices eroding confidence throughout the economy. Fortunately, this bad predicament is about to change as well. The exogenous factors depressing dairy prices are abating and prices are surging anew (Chart 13). The Global Dairy Trade price index has advanced in seven out of the last eight dairy auctions.10 If this impulse is prolonged, both New Zealand's export prices and domestic wages will begin to reflate. 5.A reversal of migration inflows The massive flow of migration into New Zealand since 2013 has been the main factor capping wage growth by increasing the supply of labor (Chart 14). The bulk of this inflow has been composed of young workers, aged between 15 & 29 years old.11 It is unclear if this migration will become permanent or prove to be transitory. Chart 13NZ Dairy Prices Have Rebounded NZ Dairy Prices Have Rebounded NZ Dairy Prices Have Rebounded Chart 14NZ Inward Migration To Stabilize... NZ Inward Migration To Stabilize... NZ Inward Migration To Stabilize... Much of this inflow can be explained by the weakness in the Australian economy, which has triggered migration back into New Zealand from those who left for work in Australia. As such, if the Aussie economy improves, the migration flow could conceivably reverse, at least to some extent. As a result, the domestic supply of workers would recede and the invisible ceiling on New Zealand wages would progressively disappear. This scenario is highly plausible. The latest surge in Australia's terms of trade could be an early signal of a commodity sector revival. Much of this is due to China's growth upturn this year. However, the wave of optimism towards a potential fiscal stimulus in the U.S. - especially through longer-term infrastructure projects - is a possible boost to demand that could support higher global commodity prices higher over the next few years.12 If this proves correct, New Zealand migration towards Australia could be renewed, shrinking the domestic pool of skilled labor, and pushing wages higher (Chart 15). An unwind of these disinflationary forces would coincide with improving cyclical growth prospects. A mix of strong credit growth, decent construction sector activity and robust corporate earnings should support job creation and wages in the short term (Chart 16). In this environment, consumption will accelerate. Since the output gap is already closed, faster spending will cause inflationary pressures to build (Chart 17). Chart 15...If Australian Mining Revives ...If Australian Mining Revives ...If Australian Mining Revives Chart 16An Inflationary Backdrop An Inflationary Backdrop An Inflationary Backdrop Chart 17Inflation Surprises Ahead Inflation Surprises Ahead Inflation Surprises Ahead Traders can benefit from a turnaround in New Zealand inflation prospects by playing the Overnight Index Swap market. Since April 12th of this year, we have recommended payer positions in 6-month New Zealand Overnight Index Swap (OIS) rates.13 This trade has not worked as planned, due to the stubbornly low trend of New Zealand inflation, and today we are closing that trade recommendation at a loss of -30bps. The market is currently pricing in a 23% chance of a rate hike by the September 28, 2017 RBNZ meeting. Due to the inflation risks cited above, the probability should be higher than that, in our view. As such, we are entering a 12-month OIS payer. This trade offers modest downside risk versus for a decent potential gain, i.e. a risk/reward ratio of about 3:1. Bottom Line: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Closing Our Japan/Korea Relative Value Trade This week, we are unwinding our Japan/Korea relative value trade, where we were long 5-year Korean government bonds versus 5-year Japanese Government Bonds (JGBs) on a currency-unhedged basis. While the currency leg did allow for a profitable trade, the Korea/Japan yield differential widened by +52bps. Several unpredictable events have negatively impacted Korean bonds since the trade was initiated. Chart 18Political Scandal = Higher Risk Premium Political Scandal = Higher Risk Premium Political Scandal = Higher Risk Premium Chart 19Trump: Catastrophic For Korean Bonds Too Trump: Catastrophic For Korean Bonds Too Trump: Catastrophic For Korean Bonds Too First, a scandal surrounding the Korean president, a.k.a. Choi-Gate, has erupted. As more details of the affair have been revealed, the president's approval rating has plunged - standing now at 5% - and the Government has become dysfunctional (Chart 18). In the near future, the geopolitical risks surrounding Korean assets should remain elevated as the prosecutors will continue the process of investigating the president and her associates; the risk premium on Korean bond yields might increase further. Chart 20The Korea 5-Year Bond Model The Korea 5-Year Bond Model The Korea 5-Year Bond Model Second, Trump's victory has been catastrophic for bond markets across the globe, including those related to open and export-oriented economies linked to the emerging markets, like Korea (Chart 19). Yet the impact on JGBs has been more contained since the Bank of Japan (BoJ) moved to a yield curve targeting framework back in September. The BoJ surprised many by adopting that policy of anchoring longer-term JGB yields. This has substantially reduced the volatility of JGBs, even during the recent backup in global yields. In turn, this has lowered the payoff potential of shorting JGBs, both in absolute terms and versus Korean bonds. Finally, the appeal of our Korea vs Japan trade has decreased from a valuation perspective. A simple model that we have developed for the Korean 5-year government bond yield now points towards rising yields in 2017 (Chart 20).14 With all of these factors now working against our trade, we are choosing to close it out. The trade has generated a profit from the currency exposure, which we decided not to hedge. However, when events move against the original reasons for putting on a trade, the prudent strategy is to unwind that position and look for other opportunities. Bottom Line: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Riksbank: Close To An Inflection Point", dated September 22, 2015, available at gfis.bcaresearch.com 2 Source: Bloomberg Finance L.P. NSN OG2NHA6JIJUO GO. NSN OGD9GRSYF01S GO. NSN OGFQO26S972O GO 3 http://www.riksbank.se/Documents/Protokoll/Penningpolitiskt/2016/pro_penningpolitiskt_161026_eng.pdf 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 For details, please see http://www.riksbank.se/en/Press-and-published/Published-from-the-Riksbank/Monetary-policy/Monetary-Policy-Report/ 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut", dated November 3, 2016, available at ces.bcaresearch.com 7 Private services, retail trade, construction and manufacturing 8 Please see BCA Global Investment Strategy Weekly Report, "Slack Around The World", dated November 4, 2016, available at gis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Special Report, "How To Assess The 'China Factor' For Global Bonds", dated November 8, 2016, available at gfis.bcaresearch.com 10 https://www.globaldairytrade.info/en/product-results/ 11 For details, please see "Understanding low inflation in New Zealand", Dr, John McDermott, October 11, 2016 available at http://www.rbnz.govt.nz/news/2016/10/understanding-low-inflation-in-new-zealand 12 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2017, available at gps.bcaresearch.com 13 Please see BCA Global Fixed Income Strategy Special Report, "New Zealand: More Than Just Dairy", dated April 12, 2016, available at gfis.bcaresearch.com 14 This model is based upon a regression of Korean yields on U.S. 5-year treasury yield, Korean Trade-weighted currency, Brent crude price in USD, and Korea's headline CPI. Forecasts are based on financial market futures data and the ministry of finance's inflation forecast. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Dear Client, The growth of the electric-vehicle market, particularly re its implications for hydrocarbons as the primary transportation fuel in the world, will remain a key issue for energy markets, particularly oil. The IEA estimates transportation accounted for 64.5% of oil demand in 2014, the latest data available, compared to natural gas's 7% share and electricity's 1.5% share.1 Last week, Fitch Ratings published a report concluding, "Widespread adoption of battery-powered vehicles is a serious threat to the oil industry." For example, the agency contends that "in an extreme scenario, where electric cars gained a 50 per cent market share over 10 years about a quarter of European gasoline demand could disappear." This is not a widespread view in the energy markets. IHS Energy published a report in 2014 finding, "Past energy transitions took decades to unfold and were driven by a combination of market factors: cost, scarcity of supply, utility and flexibility, technology development, geopolitical developments, consumer trends, and policy.2" While our view is more aligned with IHS's, it is undeniable electric vehicles are a growing market. For this reason, we are publishing an analysis by BCA Research's EM Equity Sector Strategy written by our colleague Oleg Babanov, which explores the lithium-battery supply chain and how investors can gain exposure to this critical element of the fast-growing global electric-vehicle market. Separately, we are downgrading our strategic zinc view from neutral to bearish, and recommending a Dec/17 short if it rallies. Robert P. Ryan Senior Vice President, Commodity & Energy Strategy Lithium is a rare metal with a costly production process and a high concentration in a small number of countries. Difficulty in production is comparable to deep-sea oil drilling. Lithium is the key element in lithium-ion batteries. Demand is rapidly increasing as more countries adopt environment-protection policies and electric-car production is on the rise. We recommend an overweight on the lithium battery supply chain (Table 1), on a long-term perspective (one year plus). We estimate demand for the raw material to rise by approximately 30% over the coming years, driven by the main electric vehicle production clusters in Asia and the U.S. Table 1Single Stock Statistics For Companies##br## In The Lithium Battery Supply Chain (Oct 2016)* The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market What Is Powering Your Battery? Being a relatively rare and difficult to produce metal, lithium demand is rapidly increasing due to the metal's unique physical characteristics, which are utilized in long-life or rechargeable batteries. Rapidly rising demand from portable electronics manufacturers, and the push of the auto industry to develop new fuel-efficient technology, backed by the widespread support of many governments to reduce transportation costs and improve CO2 emissions, are driving prices for the metal higher. We believe that companies in the electric vehicle (EV) supply chain, from miners to battery producers and down to EV manufacturers, will benefit from the change in environmental policies and the growing need for more portable devices with larger energy storage. As the focus of the wider investment community remains tilted towards the U.S. (and Tesla in particular), many companies in the lithium battery supply chain, as well as EV producers, remain overlooked and undervalued. EV Production Expected To Surge We expect a continuation of the push towards energy-saving vehicles among car manufacturers, driven by government incentives and new tougher regulations (EU regulations for CO2 emissions in 2020 will be the strictest so far). Over one million EV vehicles of different types were sold in 2015. In countries such as Norway, the penetration of PEVs is reaching up to 23% (Chart 1). Based on the current growth rates (Chart 2), the compound annual growth rate of EV production is estimated at 30% to 35% over the next 10 years. Japan will remain in top spot in EV penetration (the current HEV rate is around 20% of the overall market). Japan's market (controlled by Toyota and Honda) is dominated by the HEV type of vehicles, and we expect it to remain this way. Chart 1PEV Penetration By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 2EV Sales By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market We expect the largest boost in market share gains to happen on the European market, based on very stringent CO2 emissions regulation (Chart 3) and ambitious EV targets set by the larger countries. EV market share is set to reach 20% (from the current 5%) in the coming seven to 10 years. The EU is closely followed by South Korea. The Ministry of Trade, Industry and Energy (MOTIE) has developed an ambitious plan of growth, by which EV market share should reach 20% by 2020 and 30% by 2025. New EVs will receive special license plates, fuel incentives, and new charging stations. MOTIE wants the auto industry to be able to produce 920,000 NEVs per year, of which 70% should be exported. Among other large markets, the U.S. and China will remain the two countries with lowest EV penetration rates, although growth rates will be impressive. This will be due to low incentives from the government and cheap traditional fuel supply (in the U.S.), or a low base, some subsidy cuts, and infrastructure constraints (in China). Especially in China's case, the numbers remain striking (Chart 4). According to statistics published by the China Association of Automobile Manufacturers (CAAM), EV sales in 2015 grew 450% YOY. The market is estimated to grow at an average rate of 25% over the next 10 years. Chart 3EU CO2 Emission Targets bca.ces_wr_2016_10_27_c3 bca.ces_wr_2016_10_27_c3 Chart 4Monthly NEV Sales China Monthly NEV Sales China Monthly NEV Sales China In this report we will highlight companies from the raw material production stage: Albermarle (ALB US), Gangfeng Lithium (002460 CH), Tianqi Lithium Industries (002466 CH), and Orocobre (ORE AU); to added-value battery producers: BYD (1211 HK), LG Chem (051910 KS), and Samsung SDI (006400 KS); down to some electric vehicle companies: Geely Automobile Holdings (175 HK) and Zhengzhou Yutong Bus Company (600066 CH). The Supply Side Driven by demand from China and the U.S., the raw material base for lithium has shifted in the past 20 years from subsurface brines to more production-intensive hard-rock ores. Brine operations are mostly found in the so-called LatAm "triangle" - Argentina, Chile and Bolivia - while China and Australia produce lithium from spodumene (a mineral consisting of lithium aluminium inosilicate) and other minerals. The U.S. Geological Survey estimates world reserves at 14 million tonnes in 2015, with Bolivia and Chile on top of the table (Chart 5). The main lithium producing countries, according to the U.S. Geological Survey, are Australia, Chile, and Argentina (Chart 6). Chart 5Lithium Reserves Concentrated In LatAm The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 6Lithium Production Dynamics By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The lithium mining process starts with pumping lithium-containing brine to subsurface reservoirs and leaving the water to evaporate (from 12 to 24 months) until the brine reaches a 6% lithium content. From here there are three ways to process the concentrate, or the hard-rock in mineral form: Treatment with sulfuric acid (acidic method) Sintering with CaO or CaCO3 (alkali method) Treatment with K2SO4 (salt method) Further, lithium carbonate (Li2CO3), a poorly soluble solution, is isolated from the received concentrate and transferred into lithium chloride, which is purified in a vacuum distillation process. Storage is also difficult: as lithium is highly corrosive and can damage the mucous membrane, it is most commonly stored in a mineral oil lubricant. Due to the rare nature of the metal, lithium comes mainly as a by-product of other metals and comprises only a small part of the production portfolio. This is the reason why the underlying metal price and the share prices of the largest producers of lithium have low correlation (Chart 7). Albermarle, SQM, and FMC Corp currently control as much as three-quarters of global lithium production, but price performance is not keeping up with the price of the underlying metal. For best exposure to the metal, we concentrate on companies with a large degree of dedication to mining lithium and close ties to the end-users. We recommend one established market leader (by volume) - Albermarle (ALB US); one company that just started operations - Orocobre (ORE AU), whose assets are concentrated in Argentina; and two lithium miners from China - Jiangxi Ganfeng Lithium (002460 CH) and Tianqi Lithium (002466 CH). These companies display much higher correlation to the metal price (Chart 8). Chart 7FMC Corp., SQM And ##br##Albermarle Vs. Lithium Price bca.ces_wr_2016_10_27_c7 bca.ces_wr_2016_10_27_c7 Chart 8Orocorbe, Jiangxi Ganfeng And##br## Tianqi Lithium Vs. Lithium Price bca.ces_wr_2016_10_27_c8 bca.ces_wr_2016_10_27_c8 Albermarle (ALB US): U.S. company with EM exposure (Chart 9). After the acquisition of Rockwood Holdings in 2015, Albermarle became one of the largest producers of lithium and lithium derivatives. Lithium accounts for more than 35% of the company's revenue stream (+20% YOY), which compares favourably to the 20% of the Chilean producer SQM and the 8% of another large US producer FMC Corp. Chile comprises 31% of global production. Albermarle's 2Q16 results on 3 August came broadly in line with market expectations. Some deviation from expectations occurred because of discontinued operations in the Surface Treatment segment. Group sales contracted by 7%, due to divestures started in previous quarters (Chemetal). Positively, lithium sales grew 10% YOY due to both better pricing and higher volumes, and EBITDA in the segment improved by 20%. Group EBITDA (adjusted) grew by 5% YOY and the bottom-line (adjusted) expanded by 11% YOY. Management appears confident about FY16 operations, guiding 1% improvement in EBITDA, as well as 3% in FY EPS and aims to maintain EBITDA margins in the lithium segment at over 40%. We see high growth potential due to Albermarle's portfolio composition. The market is currently expecting an EPS CAGR of 9% over the next four years. Albermarle is trading at a forward P/E of 23.1x. Orocobre (ORE AU): An Australian company mining in Argentina (Chart 10). Orocobre is an Australian resource company, based in Brisbane. As in the case with Albermarle, the majority of operations are located in EM, so we see it as appropriate to include the company into our portfolio. Chart 9Performance Since October 2015: ##br##Albermarle vs MXEF Index bca.ces_wr_2016_10_27_c9 bca.ces_wr_2016_10_27_c9 Chart 10Performance Since October 2015: ##br##Orocobre vs MXEF Index bca.ces_wr_2016_10_27_c10 bca.ces_wr_2016_10_27_c10 Orocobre is at an initial stage in the lithium production process. The only division working at full capacity is Borax Argentina (acquired from Rio Tinto in 2012), an open-pit borate mining operation (producing 40 kilotonnes per annum (ktpa)). The flagship project (65% share), launched in a JV with Toyota Tsusho Corp, is the Olaroz lithium facility, a salt lake with an estimated 6.5 million tonnes of lithium carbonate (LCE) reserves. The planned capacity is at 17.5 ktpa. Due to the geological structure, it comes with one of the lowest operational costs ($3500 per tonne). The production ramp-up to 2,971 tonnes of lithium, reported on 19 July together with the 4Q16 results, came a notch below market expectations. The management lowered the production guidance, delaying full operational capacity by two months until November (realistically it might take even longer). Positive points in guidance included an LCE price exceeding $10,000/tonne in the upcoming quarter and confirmation that the company turned cash flow positive in the first half of this year.3 Orocobre is already planning capacity expansion at the Olaroz facility to 25 ktpa, with diversification into lithium hydroxide. Further exploration drilling is underway in the Cauchari facility, just south of Olaroz. The market forecasts the company to produce a positive bottom-line in FY17 and grow EPS by a CAGR of 25% for the next four years. Orocobre is currently trading at a forward P/E of 36.1x. Jiangxi Ganfeng Lithium (002460 CH): one of the largest lithium producers in China (Chart 11). Gangfeng is a unique company in the lithium space in the sense that it is a raw material producer with added processing capabilities. The main trigger for our OW recommendation was the acquisition of a 43% stake in the Mt Marion project in Australia. From 3Q16 onwards the bottleneck in raw material supply will be removed and the company can count on approximately 20 thousand tonnes (kt) of lithium spodumene. On the back of this news, the company announced a production expansion into lithium hydroxide (20 kt) from which 15 kt will be battery grade and 5 kt industry grade. This has the potential to lift Ganfeng to one of the top five producers in the world. Ganfeng reported stellar 2Q16 results on 22 August. The top-line grew two times YOY, while operating profit increased by 7.8x. Operating margin jumped from 9.8% to 35.9%, and the bottom-line expanded five-fold YOY. The profit margin also improved from 8.55% to 25.3%. We expect less strong, but still robust, YOY growth for the upcoming quarters. Market projects EPS CAGR of over 50% during the next four years, as the production run-up will continue. The company is currently trading at a forward P/E of 36.8x. Tianqi Lithium Industries (002466 CH): Making the move (Chart 12). Tianqi is the third largest producer in the world (18% of global capacity). Recently the company got into the news on rumors of its attempted expansion by taking a controlling stake in the world's largest lithium producer, Chile's SQM. Chart 11Performance Since October 2015:##br## Jiangxi Ganfeng Lithium vs MXEF Index bca.ces_wr_2016_10_27_c11 bca.ces_wr_2016_10_27_c11 Chart 12Performance Since October 2015: ##br##Tianqi Lithium vs MXEF Index bca.ces_wr_2016_10_27_c12 bca.ces_wr_2016_10_27_c12 SQM has an intricate shareholding structure, with the involvement of the Chilean government and a rule that no shareholder is currently allowed to own more than a 32% stake in the company (this rule can be changed only through an extraordinary shareholder meeting). At the moment the largest shareholder is Mr. Ponce Lerou (son-in-law of former President Augusto Pinochet), who owns just under 30% and has a strategic agreement with a Japanese company, Kowa, which makes the combined holding 32%. During the last week of September Tianqi acquired a 2% stake (for USD209 m) from US-based fund SailtingStone Capital Partners, which held a 9% stake, with the option to buy the remaining 7%. In a further step, Tianqi is trying to negotiate a deal with one of Mr. Ponce Lerou's companies which holds a 23% stake. It is said that Mr. Ponce Lerou has got into a political stalemate with the Chilean government on a production increase at one of its deposits and is looking to exit the company. Tianqi reported strong Q2 results on 22 August. Revenues grew by 2.4x YOY, and operating profit improved by 3.9x YOY. Operating margin grew from 42.99% in 2015 to 69.35% in 2Q16, and bottom-line increased twofold QOQ as production ramp-up continued. At the same time profit margin reached 48.9%, up from 2.8% a year ago. The company is currently trading at a forward P/E of 23.4x, and the market is forecasting an EPS CAGR of 13% over the next three years. The Demand Side4 Lithium is used in a wide range of products, from electronics to aluminium production and special alloys, down to ceramics and glass. But battery production takes the largest share of utilization (Charts 13A & 13B). Chart 13ALithium Usage The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 13BLithium Batteries Most Widely Used The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market As confirmed by import statistics (from the U.S. Geological Survey), demand in many Asian countries, as well as the U.S., has been constantly rising. Among the main importers, South Korea is in fourth place with the largest number of new lithium-related projects started. In top position is the U.S., where we expect a strong demand increase, once the Tesla battery mega-factory in Nevada is completed, followed by Japan, which has the highest penetration of electric vehicles (EV), and China (Chart 14). Chart 14Composition Of Lithium Imports By Country The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Because of its low atomic mass, lithium has a high charge and power-to-mass ratio (a lithium battery generates up to 3V per cell, compared to 2.1V for lead-acid or 1.5V for zinc-carbon), which makes it the metal-of-choice for battery electrolytes and electrodes, and makes it difficult to replace with other metals, due to its unique physical features. Lithium is used in both disposable batteries (as an anode) and re-chargeable ones (Li-ion or LIB batteries, where lithium is used as an intercalated compound). Li-ion batteries are used in: Portable electronics, such as mobile phones (lithium cobalt oxide based); Power tools / household appliances (lithium iron phosphate or lithium manganese oxide); EVs (lithium nickel manganese cobalt oxide or NMC). The most produced battery is the cylindrical 18650 battery. Tesla's Model S uses over 7000 of these type of batteries for its 85 kWh battery pack (the largest on the market until mid-August, when Tesla announced a 100 kWh battery pack). The amount of lithium used in a battery pack depends on the kW output. Rockwood Lithium (now Albermarle), estimated in one of its annual presentations that: A hybrid electric vehicle (HEV) uses approximately 1.6kg of lithium A plug-in hybrid (PHEV) uses 12kg An electric vehicle (EV) uses more than 20kg (but all depends on make, model, and technology). An average car battery (PHEV/EV) would use over 10kg of lithium, assuming 450g per kWh (please note that real-life calculations suggest a usage of up to 800g per kWh of lithium. We have used the lower end of the range for our estimates), with Tesla's battery consuming around 70kg of lithium. Simple math suggests that with the completion of the mega-factory (estimated production of 35 GWh or 500k batteries p.a.), Tesla alone will be consuming at least half of world lithium production by 2020, and create a large overhang in demand. Among car battery producers, we like global players with dominant market positions and strong ties to end-users, such as LG Chem, Samsung SDI in Korea, and BYD in China. Those three companies together control more than half of global battery production (Chart 15) and will most likely maintain market share in the foreseeable future, as barriers to entry are high due the amount of investment required into technology and production facilities, and the end-product is difficult to differentiate on the market. BYD Corp (1211 HK): Build Your Dreams, it's in the name (Chart 16). Founded in 1995 and based in Shenzhen, BYD covers the whole value chain, from R&D and production of batteries (phone and car batteries) to automobile production and energy storage solutions. It is currently the largest battery and PHEV producer in China. The total revenues stream consists of 55% from auto and auto components sales, 33% portable electronics battery, and 12% car battery sales. Chart 15Largest Lithium ##br##Battery Producers The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Chart 16Performance Since October 2015: ##br##BYD Corp vs MXEF Index bca.ces_wr_2016_10_27_c16 bca.ces_wr_2016_10_27_c16 We believe the company is best positioned to reap multi-year rewards from the recent drive of the Chinese government to promote new electronic vehicle (NEV) growth through subsidies, support of charging infrastructure, and changes in legislation. The introduction of carbon trading in August (carbon credit will be measured on the number of gasoline-powered vehicles in the producer's fleet) will give BYD a benefit over other car manufacturers. BYD's model pipeline and battery manufacturing capacity (expected to reach 20 GWh by FY17), as well as favourable pricing ($200 kWh compared to over $400 kWh for Tesla) put the company into a leadership position. BYD reported 2Q16 results on 28 August, which came out very strong. Revenues grew by 52.5% YOY and 384% on a semi-annual perspective, driven by all three business segments and especially strong in EV sales (+29% YOY). This came with a significant beat of consensus estimates and later we saw a 68% upwards adjustment. As a result operating margin and profit margin improved from 3.8% and 2.2% in 2Q15 to 8.5% and 5.8% in 2Q16. Bottom-line was up 4x YOY. The market is currently pricing in an EPS CAGR of 12% over the next three years. BYD is trading at a forward P/E of 23.9x. LG Chem (051910 KS): Catering for the US market (Chart 17). LG Chem is the largest chemical company in South Korea, operating in three different divisions: petrochemicals (from basic distillates to polymers), which account for 71% of total revenues, information technology and electronics (displays, toners etc.), which represent 13% of total revenues, and energy solutions, 16% of total revenues. LG Chem is the third largest battery producer in the world, manufacturing a pallet from small watch and mobile phone batteries down to auto-packs. LG's North American operations in Holland, Michigan produce battery packs for the whole range of GM (Chevrolet, Cadillac) EVs (including the most popular Volt range), as well as for the Ford Focus. In Europe, customers include Renault; in Asia, LG is working with Hyundai, SAIC, and Chery. The company reported better-than-expected 2Q16 results on 21 July. Revenues grew by 3% YOY and operating profit by 8.5% YOY, driven solely by the petrochem division (up 10% YOY). Bottom-line expanded by a healthy 8% YOY. LG Chem trades at deeply discounted levels (forward P/E of 11.6x) due to the remaining negative profitability in the battery segment (partly due to licensing issues in China, which represents 32% of total revenues), but we estimate that the trend will turn in the following quarters, as Chevrolet is ramping up demand with new product lines and management is guiding for a resolution in China. Furthermore, plans released by the Korean government in June/July (renewable energy plan and EV expansion plan) will increase demand for batteries by more than 30% CAGR in the next five years. The market is forecasting an EPS CAGR of 9% over the upcoming four years. Samsung SDI (006400 KS): Investing into the future (Chart 18). In contrast to LG Chem, Samsung SDI is fully focused on Li-ion battery production, with 66.5% of total revenues coming from this division (BMW and Fiat among clients). The company also produces semiconductors and LCD displays, which account for 35.5% of total revenue. Chart 17Performance Since October 2015: ##br##LG Chem vs MXEF Index bca.ces_wr_2016_10_27_c17 bca.ces_wr_2016_10_27_c17 Chart 18Performance Since October 2015: ##br##Samsung SDI vs MXEF Index bca.ces_wr_2016_10_27_c18 bca.ces_wr_2016_10_27_c18 Samsung SDI is currently in a reorganization phase, as the company is spinning off "Samsung SDI Chemicals" and has announced it will invest $2.5 bn into further development of its car battery business. The proceeds from the sale of Samsung SDI Chemicals (taken over by Lotte Chemicals in April for around $2.6 bn) will also be directed towards the car battery segment. Samsung SDI reported weak 2Q16 results on 28 July, as expected. Revenues continued to contract on a YOY basis, although the rate of decline slowed compared to Q1 and even registered 2% QOQ growth. The bottom-line was positive due to a one-off gain (the sale of the chemical business). The main headwinds came from delays in licensing Chinese factory production and a strong Japanese yen. On the positive side, Li-ion batteries in portable devices performed well, due to better than expected Galaxy S7 sales, as well as OLED sales, due to increased demand and capacity constraints in the mobile phone and large panel spaces. Due to the high concentration of EV battery-related revenues in its portfolio, we believe that Samsung SDI will be the largest beneficiary of government's renewable energy and EV expansion plans. The company is also ideally positioned to take advantage of the fast-growing Chinese market (35% of revenues coming from China), once the issue with licensing is resolved (which management guided will happen in Q3). The recent problems with overheating or exploding batteries, reported by users of the new Samsung phones, have sent the share price lower. We believe that this offers an excellent entry point, as ultimately the company will replace/improve the technology, and, at the same time, there are no alternatives which could threaten Samsung SDI's leadership in the portable battery space. The temporary issue in China has weighted on valuations, as Samsung SDI is trading at a forward P/E of 27.7x, while the market expects EPS to increase fivefold in the coming four years. Accessing The Chinese EV Market Best access to the fast growing Chinese market is through local car manufacturers, such as Geely (Chart 19). The subsidy schemes, put in place by the National Development and Reform Commission (NDRC), currently cover only domestic-made models (except the BMW i3). Furthermore, import duties are making foreign-made vehicles uncompetitive in terms of price. We recommend to overweight Geely (0175 HK) and electric bus producer Yutong Bus (600066 CH) on the 30% NEV rule for public transport procurement. Chart 19Accessing The Chinese EV Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market The Lithium Battery Supply Chain: Efficient Exposure To Electric-Vehicle Market Geely ("Lucky" in Mandarin) Automobile Holdings (175 HK): A company with large ambitions (Chart 20). Probably best known for its two foreign car holdings, Volvo and the London Taxi Company, Geely grew from a small appliances manufacturer to the second largest EV producer in China, with an ambitious goal to manufacture 2 mn units by 2020. We see the main positive driver in Geely's big push into the EV market. The goal set by management is to have 90% of its fleet powered by electricity by 2020. The so called "Blue Geely" initiative is based on a revamp of Geely's current fleet into HEVs/PHEVs (65% as per plan) and EVs (35%). In May the company raised $400 mn in "green bonds" in a first for a Chinese car company, to support its R&D and manufacturing project, Ansty, to produce the first zero-emission TX5 black cabs in the U.K. The company reported strong 1H16 results on 18 August. Revenues were up 30% YOY, driven by higher production volume (up 10% YOY) and a sales price hike of around 15% YOY. The co-operation with Volvo seems to be working well (Volvo's design, Geely's production capabilities). The average waiting time for new models in China is approximately two months. The bottom-line expanded by 37.5% YOY despite a high density of new model launches, and we expect to see some margin improvement in the coming quarters. The market forecasts an EPS growth CAGR of 25% over the coming four years. Geely is currently trading at a forward P/E of 15.6x. Zhengzhou Yutong Bus Company (600066 CH): An unusual bus manufacturer (Chart 21). Yutong Bus Company is the world's largest, and technologically most advanced, producer of medium and large-sized buses (over 75k units produced in FY15, 10% global market share), with its own R&D and servicing capabilities. Even more important, Yutong is one of the largest producers of electric-powered buses in China and globally. Chart 20Performance Since October 2015: ##br##Geely Automobile Holdings vs MXEF Index bca.ces_wr_2016_10_27_c20 bca.ces_wr_2016_10_27_c20 Chart 21Performance Since October 2015:##br## Yutong Bus Company vs MXEF Index bca.ces_wr_2016_10_27_c21 bca.ces_wr_2016_10_27_c21 Due to the 30% EV procurement rule for local governments, the number of electric buses produced in 2015 soared 15 times to 90,000, a quarter of which were produced by Yutong. We expect this number to grow further with the introduction of the new carbon emission trading scheme. We see Yutong as best positioned in the bus manufacturers' space to take advantage of the new trading rules. Yutong reported 2Q16 results on 23 August, which came in broadly in line with market expectations. Revenue expanded by 34% YOY, driven by volume growth (7400 NEV units sold, +100% YOY). The push into EVs came with higher cost-of-sales (warranty and servicing). This did not affect gross margin (up 1% to 25%). Bottom-line grew by 50% YOY. Management maintained an upbeat outlook, guiding 25,000 units of NEV sales in FY16, with an average sales price increase due to higher sales in the large-bus segment. Management also expects to receive the national subsidy for FY15 in 3Q16 and for 2016 in 1Q17. The market currently factors in an EPS CAGR growth of 8% over the next four years. Yutong is trading at a forward P/E of 12.3x. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of four mining companies, three car battery pack producers, and two EV manufacturers. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Albermarle (ALB US), Gangfeng Lithium (002460 CH), Orocobre (ORE AU), Tianqi Lithium Industries (002466 CH), BYD (1211 HK), LG Chem (051910 KS), Samsung SDI (006400 KS), Geely Automobile Holdings (175 HK), Zhengzhou Yutong Bus Company (600066 CH). ETFs: Global X Lithium ETF (LIT US) Funds: There are currently no funds available, which invest directly into lithium or lithium-related stocks. Please note that the trade recommendation is long-term (1Y+) and based on an OW call. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). Trades can also be implemented through our recommendation versus MXEF index either directly through equities in the recommended list or through ETFs. For convenience, the performance of both the ETFs and market cap-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the broad diversification, we see our portfolio exposed to idiosyncratic risk factors, which could affect single-stock performance, as well as the following macro factors: Mining: Falling lithium prices due to lower demand or a ramp-up in production on some of the Australian projects, could hurt profitability or delay new projects (especially in case of Orocobre). We also see some political risk stemming from the region of operations (Argentina, Chile), especially taking into account the weak performance of Chile's own lithium producer SQM and its role in a Brazil-like political scandal. Battery and EV production. We identify the main risk in drastic changes to governments' environmental and subsidy policies, which would hit the whole supply chain. A slowdown in economic development can make green or power-saving initiatives too expensive and governments will have to rethink their subsidy policies or production/penetration goals. This will hurt profitability through either a negative impact on sales or through smaller subsidies, which producers and end-users are receiving from their governments. One further risk is the dramatic increase in demand for lithium after the completion of Tesla's factory in Nevada, but may also come from other large players such as BYD. We currently see this risk as muted. As with all large Tesla initiatives, you have to take them with a pinch of salt, as the exact end numbers and the time the factory will be working at full capacity are unclear. Furthermore, Tesla, unlike many Chinese competitors, has no supply of lithium of its own, so there is little chance that it can protect supply or control prices. In any case, we see the overall portfolio as balanced, as the mining companies' performance should compensate for a negative impact on the end producers. Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk BASE METALS China Commodity Focus: Base Metals Zinc: Downgrade To Strategically Bearish We downgrade our strategic zinc view from neutral to bearish. We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Tactically, we still remain neutral on zinc prices as we believe the market will remain in supply deficit over the near term. Chinese zinc ore production will recover in 2017, while the country's zinc demand growth will slow. China is the world's biggest zinc ore miner, refined zinc producer, and zinc consumer. We recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Zinc has been the best-performing metal in the base-metals complex, beating copper, aluminum and nickel this year. After bottoming at $1,456.50/MT on January 12, zinc prices have rallied 64.7% to $2,399/MT on October 3 (Chart 22, panel 1). The Rally The rally was supercharged by a widening supply deficit, which was mainly due to a record shortage of zinc ores globally (Chart 22, panels 2, 3 and 4). Late last October our research showed the output loss from the closure of Australia's Century mine, the closure of Ireland's Lisheen mine and Glencore's production cuts would reduce global zinc supply by 970 - 1,020 KT in 2016, which would be equivalent to a 7.1 - 7.5% drop in global zinc ore output.5 Moreover, a 16% price decline during the November-January period spurred additional production cut worldwide. According to the WBMS data, for the first seven months of 2016, global zinc ore production declined 11.9% versus the same period of last year, a reduction never before seen in the zinc market. In comparison, there was no decline in global zinc demand (Chart 22, panel 4). As a result, the global supply deficit reached 152-thousand-metric-tons (kt) for the first seven months of 2016, versus the 230kt supply surplus during the same period last year. What Now? Tactically, We Remain Neutral. On the supply side, we do not see much new ore supply coming on stream over the next three months. On the demand side, both monetary and fiscal stimulus in China has pushed Chinese zinc demand higher. For the first seven months of 2016, the country's zinc consumption increased 209 kt, the biggest consumption gain worldwide. Because of China, global zinc demand did not fall this year. China will continue lifting global zinc demand as its auto production, highway infrastructure investment, and overseas demand for galvanized steel sheet will likely remain elevated over the near term (Chart 23, panels 1, 2 and 3). Inventories at the LME are still hovering around the lowest level since August 2009, while SHFE inventories also have been falling (Chart 23, bottom panel). Speculators seem to be running out of steam, as the open interest has dropped from the multi-year high on futures exchanges. Chart 22Zinc: Strategically Bearish, Tactically Neutral bca.ces_wr_2016_10_27_c22 bca.ces_wr_2016_10_27_c22 Chart 23Positive Factors In The Near Term bca.ces_wr_2016_10_27_c23 bca.ces_wr_2016_10_27_c23 The aforementioned factors militate against zinc prices dropping sharply in the near term. However, with prices near the 2014 and 2015 highs, and facing strong technical resistance, we do not see much upside. Strategically, We Downgrade Our Strategic Zinc View From Neutral To Bearish We believe zinc supply (both ore and refined) will rise in response to current high prices, resulting in a 10-15% decline in zinc prices over next 9-12 months. Chart 24High Prices Will Boost Supply In 2017 bca.ces_wr_2016_10_27_c24 bca.ces_wr_2016_10_27_c24 Zinc prices at both LME and China's SHFE markets are high (Chart 24, panel 1). Last year, many miners and producers cut their ore and refined production due to extremely low prices. If zinc prices stay high over next three to six months, we expect to see an increasing amount of news stories on either production cutbacks coming back or new supply being added to the market, which will clearly be negative to zinc prices (Chart 24, panels 2 and 3). So far, even though Glencore, the world's biggest ore producing company, is still sticking firmly to its output reduction plan, there have been some news reports about other producers raising their output, all of which will increase zinc ore supply in 2017. The CEO of the Peruvian Antamina mine said on October 10 the mine operator will aim to double its zinc output in 2017 to 340 - 350 kt, up from an estimated 170 kt - 180 kt this year, as the open pit operation transitions into richer zinc areas. This alone will add 170 kt - 180 kt new zinc supply to the market. Vedanta said last week that its zinc ore output from its Hindustan Zinc mine located in India will be significantly higher over next two quarters versus the last two quarters. Nyrstar announced in late September that it is reactivating its Middle Tennessee mines in the U.S., expecting ore production to resume during 2017Q1 and to reach full capacity of 50 kt per year of zinc in concentrate by November 2017. Red River Resource is also restarting its Thalanga zinc project in Australia, and expects to resume producing ore in early 2017. Glencore may not produce more than its 2016 zinc production guidance over next three months. But it will likely set its 2017 guidance higher, if zinc prices stay elevated. After all, the company has massive mothballed zinc mines, which are available to bring back to the market quickly. In comparison to the high probability of more supply coming on stream, global demand growth is likely to stay anemic in 2017, as the stimulus in China, which was implemented in 2016H1, will eventually run out of steam. How Will China Affect The Global Zinc Market? Chart 25Look To Short Dec/17 Zinc bca.ces_wr_2016_10_27_c25 bca.ces_wr_2016_10_27_c25 China is the world's largest zinc ore producing country, the world's largest refined zinc producing country, and the world's largest zinc consuming country. Last year, the country produced 35.9% of global zinc ore, 43.8% of global refined zinc, and consumed 46.7% of global zinc. Over the near term, China is a positive factor to global zinc prices. Domestic refiners are currently willing to refining zinc ores as domestic zinc prices are near their highest levels since February 2011. With inventories running low and domestic ore output falling 7.8% during the first seven months of 2016, the country may increase its zinc ore imports in the near term, further tightening global zinc ore supply. Domestic zinc demand and overseas galvanized steel demand are likely to stay strong in the near term. However, over the longer term, China will become a negative factor to global zinc prices. China's ore output the first seven months of 2016 was 221 kt lower than the same period of last year as low prices in January-March forced widespread mine closures. The country's mine output may not increase much, as the government shut 26 lead and zinc mines in August in Hunan province (the 3rd largest zinc-producing province in China) due to safety and environmental concerns. The ban will be in place until June 2017. Looking forward, elevated zinc prices and a removal of the ban will boost Chinese zinc ore output in 2017. Regarding demand, we expect much weaker Chinese zinc demand growth next year as this year's stimulus should run out of steam by then. Risks If global zinc ore supply does not increase as much as we expect, or global demand still have a robust growth next year, global zinc supply-demand balance may be more tightened, resulting in further zinc price rallies. If Chinese authorities resume their reflationary policies next year during the lead-up to the 19th National Congress of the Communist Party of China in the fall, which may increase Chinese and global zinc demand considerably, we will re-evaluate our bearish strategic zinc view. Investment Ideas As we are strategically bearish zinc, we recommend selling Dec/17 zinc if it rises to $2,400/MT (current: $2,373.5/MT) (Chart 25). If the sell order gets filled, put on a stop-loss level at $2,500/MT. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see p. 32 of the 2016 edition of the International Energy Agency's "Key World Energy Statistics." The IEA reckons global oil demand in 2014 averaged just over 93mm b/d. 2 Please see the Financial Times, p. 12, "Warning on electric vehicle threat to oil industry," in the October 9, 2016, re the Fitch Ratings report, and IHS Energy's Special Report, "Deflating the 'Carbon Bubble,' Reality of oil and gas company valuation," published in September 2014. 3 Because of the early stage of the project, a conventional equity analysis is not yet applicable. 4 Please see Technology Sector Strategy Special Report "Electric Vehicle Batteries", dated September 20, 2016, available at tech.bcaresearch.com 5 Please see Commodity & Energy Strategy Weekly Report for Base Metal section, "Global Oil Market Rebalancing Faster Than Expected", dated October 22, 2015, available at ces.bcaresearch.com Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

This week, we are reviewing all of our active trades discussed in the last twelve months, which are intended to be an overlay to our recommended fixed income portfolio.

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

The fiscal spending impulse in China is still positive but receding. The nation's productivity and potential GDP growth are bound to decline due to a rising role of government in capital and resource allocation. Hence, cyclical stabilization could well be overwhelmed by a structural slowdown. Another bubble is forming in China, this time in the corporate bond market. The amelioration in Korean and Taiwanese exports is due to the technology sector/semiconductors, and does not reflect broad-based improvement in global trade.

A number of divergences have emerged in global financial markets. These gaps are unsustainable. The recent improvement in Asian trade/manufacturing has been largely due to firming demand for electronics/semiconductors. Meanwhile, demand/output for industrial goods and basic materials - the areas leveraged to Chinese capital spending - remain weak. Fixed-income traders should bet on yield curve steepening in India: receive 1-year/pay 10-year swap rates.

Risks to global growth remain to the downside. Selling pressure in cyclical markets and assets will escalate. EM currencies will make new lows versus the U.S. dollar, the euro and yen. Take profits on our long JPY/short KRW and long JPY/short SGD trades. Short KRW versus an equal-weighted basket of the U.S. dollar, yen and euro. Continue underweighting Peruvian equities.