Currencies

Highlights Global growth will remain strong in 2018, but the composition of that growth will shift in favour of the U.S. The surprise results of the Alabama Senate election are unlikely to scuttle the Republicans' tax plans. We expect a bill to be finalized by the end of the year. The Fed is poised to raise rates four times next year, two more hikes than the market is pricing in. The dollar should stage a modest rebound in 2018. China's economy will decelerate over the coming months, but merely from an above-trend pace. Near-term concerns about Chinese debt levels are overblown. Stay cyclically overweight global risk assets at least for the next six months. Feature Tax Cut Or Not, U.S. Growth Is Likely To Stay Strong In 2018 We expect global growth to remain strong in 2018. However, the composition of that growth is likely to shift back towards the United States. The weakening of the dollar this year should boost net exports, while dwindling spare capacity and faster wage growth should spur business investment and consumer spending. A looser fiscal policy will also help buoy the U.S. economy, but as we have discussed in recent reports, the contribution to growth from lower tax rates is likely to be fairly modest.1 We estimate that the final bill will lift real GDP growth by about 0.2%-0.3% in 2018 and 2019. The effects will diminish thereafter, eventually turning negative as larger budget deficits crowd out the savings that are necessary to finance private-sector investment. Democrat Doug Jones' surprise victory in the Alabama Senate election has thrown a wrench into the legislative process. Outgoing Senator Bob Corker voted against the original bill. If the reconciled House and Senate bill is not passed by the time Jones is seated in January, the Republicans may not have enough votes to get it through the chamber. Our geopolitical strategists expect the bill to pass by the end of the year, but this will likely require that Congressional Republicans acquiesce to Senator Collins' demand that Congress adopt legislation to help health insurers deal with the proposed abolition of the individual mandate. It may also require that Republican dealmakers ditch their last-minute effort to cut the marginal personal tax rate to 37% (the House version of the bill penciled in a top rate of 39.6%, while the Senate version envisioned a rate of 38.5%). The Fed Keeps On Hiking The Federal Reserve hiked rates again this week, taking the fed funds target range up to 1.25%-1.50%. The Fed's determination to tighten monetary policy at a time when inflation is still below target has many investors fretting. We are not particularly concerned. Inflation is a highly lagging indicator. The New York Fed's Underlying Inflation Gauge, which includes various forward-looking inflation components such as producer prices and the ISM prices paid index, has accelerated to a cycle high of 3.0% (Chart 1). The unemployment rate is likely to fall to 3.5% by the end of next year. This would leave it more than one full point below NAIRU and 0.4 points below the median dot in the Summary Of Economic Projections released on Wednesday. Auxiliary measures of labor market slack, such as the U-6 rate and the share of the working-age population that is out of the labor force but wants a job, have also fallen back to pre-recession levels (Chart 2). Chart 1U.S. Inflationary Pressures Starting To Brew Chart 2Labor Market Slack Has Largely Vanished If U.S. growth surprises on the upside next year, as we expect, the Fed is likely to raise rates four times in 2018. This is roughly two more hikes than the market is currently pricing in. We recommended shorting the December 2018 fed funds futures contract on September 7th. The trade is up 48 basis points since then, but we think there is still scope for further gains. Modestly Slower Growth Elsewhere Outside the U.S., growth is likely to come down a notch in 2018. Japanese growth should cool somewhat from the heady pace of 2.7% seen over the past two quarters. Euro area growth is also likely to tick lower, as the impact of a stronger euro begins to bite. Financial conditions in the U.S. have loosened significantly relative to those in the euro area since the start of 2017. If history is any guide, this will cause euro area inflation to rise less than U.S. inflation over the coming year (Chart 3). This, in turn, will keep the ECB's forward guidance on the dovish side. This week's ECB meeting reinforced the message that the central bank is unlikely to raise rates at least until the summer of 2019. Chart 3Diverging Financial Conditions Will Have Inflationary Consequences Chart 4 shows that the euro has strengthened more against the dollar since the beginning of this year than can be accounted for by changes in interest rate expectations. We expect EUR/USD to fall back to 1.11 by the end of 2018. Chart 4AEUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials Chart 4BEUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials The Chinese Wildcard The biggest question mark over growth surrounds China. Real-time measures of industrial activity such as electricity generation, freight traffic, and excavator sales have slowed since the start of the year (Chart 5). The Caixin manufacturing PMI has also dipped, signaling weaker growth prospects among the country's small-to-medium sized private enterprises. Monetary conditions have tightened (Chart 6). How worried should investors be? So far, there is no reason to panic. Growth has weakened, but from an above-trend pace. Nominal GDP growth reached 11.2% year-over-year in Q3 2017, up from 6.4% in Q4 2015. Producer price inflation rose to 6.9% in October before backing off to 5.8% in November. Some cooling in the economy was both inevitable and desirable (Chart 7). Chart 5Growth Has Ticked Down ##br##Modestly In China Chart 6Monetary Conditions Have##br## Tightened In China Chart 7Chinese Growth Has Merely Weakened##br## From An Above-Trend Pace A more ominous slowdown cannot be ruled out, but that would require a substantial policy error. Such errors have occurred in the past. In 2015, the government undertook measures to reduce credit growth and cool the property market just as the global manufacturing sector was entering a recession on the heels of a sudden decline in energy sector capex. The Chinese authorities amplified the problem by trying to tippy-toe over the question of whether to devalue the currency, even as other EM currencies were sinking. This led to large capital outflows, thereby exacerbating the tightening in Chinese financial conditions. The circumstances today are quite different from 2015. While the authorities have clearly stepped up the pace of reforms following the Party Congress, the global and domestic backdrop is a lot more favorable. Global growth is much stronger. The yuan is also a lot cheaper - down 8.8% in real trade-weighted terms since its peak in 2015 (Chart 8). Chart 8The Yuan Has Cheapened Since 2015 Domestic demand remains on a firm footing. The service sector PMI ticked up further in November, an important development considering that China's service sector is now larger than its manufacturing sector (Chart 9). Alibaba reported sales of over U.S. $25 billion on its platform on "Singles Day" last month, up 39% from last year, and greater than U.S. online sales on Black Friday and Cyber Monday combined. The Chinese government is unlikely to take measures that allow growth to fall significantly below trend. Indeed, if anything, the recent evidence suggests that the authorities are tentatively easing their foot off the brake. Bond yields and credit spreads have come off their recent highs. New loans to the real economy clocked in at RMB 1.12 trillion in November, well above consensus estimates of RMB 800 billion. While the year-over-year change in M2 growth remains close to historic lows, the three-month change has hooked up (Chart 10). Chart 9It's Not All About Manufacturing In China Chart 10China: Money Growth Starting To Accelerate Higher core inflation has pushed real deposit rates into negative territory, making it increasingly painful for households to hold cash. This should cause the velocity of money to speed up, allowing nominal GDP growth to exceed money growth. Don't Bet On A Chinese Debt Crisis... Yet What about the longer-term debt issues haunting China? Here, there is both good and bad news. The bad news is that China's need to keep piling on debt may be an even more vexing problem than typically assumed. Pundits often claim that the government simply needs to bite the bullet and take the painful measures that are necessary to curb debt growth. The problem with this argument is that it sidesteps the question of what will offset the loss in spending from slower debt accumulation. Chinese households are massive net savers (Chart 11). As a matter of arithmetic, these savings must either be transformed into domestic investment or exported abroad via a current account surplus. China used to emphasize the latter. Its current account surplus reached 10% of GDP in 2007, mainly due to a widening trade surplus. It would be economically and politically impossible to pursue such a beggar-thy-neighbour strategy today. Economically, China is simply too big. Its economy has more than doubled relative to the rest of the world over the past decade (Chart 12). Politically, no major economy these days is prepared to tolerate a massive trade deficit with China - certainly not the U.S. Chart 11Mattresses Are ##br##Thicker In China Chart 12China's Size Limits Its Ability To Export Its ##br##Way Out Of Its Problems This means that China must now recycle excess savings internally. One way that Chinese households have done this is by purchasing real estate. In many respects, the Chinese property market has served as a piggy bank of sorts for much of the population. Large amounts of savings have also been placed into bank deposits and, increasingly, so-called wealth management products. These funds have then been used to satisfy the borrowing needs of local governments and business enterprises. It is no surprise that credit growth in China began to accelerate in 2009, just as the current account surplus was starting to narrow (Chart 13). In practice, the distinction between fiscal and corporate spending in China is rather blurry. Chart 14 shows China's official general government budget deficit as well as an augmented version constructed by the IMF which includes various off-balance sheet expenses. The former stands at a reasonably slim 3.7% of GDP, while the latter weighs in at a hefty 12.6% of GDP. Chart 13Credit Growth Took Off As ##br##Current Account Surplus Shrunk Chart 14China's "Secret" ##br##Budget Deficit A large chunk of these off-balance sheet items consist of losses incurred by China's state-owned enterprises. In many respects, these companies are the equivalent of Japan's fabled "bridges to nowhere": They exist to prop up demand in an economy where there is too much savings. Rather than making the economy more efficient, the risk is that structural reforms, if undertaken too rapidly, will simply depress growth. The most misallocated resource is a worker who wants a job but cannot find one. The troubling implication is that deleveraging may be difficult to achieve without causing significant economic distress. On The Bright Side... Fortunately, a number of factors mitigate the risks of a Chinese debt crisis. As Japan's experience shows, as long as a country has ample domestic savings and borrows primarily in its own currency, debt can increase to levels that many people might have thought impossible. Moreover, most of China's debt mountain consists of loans made by state-owned banks to SOEs and local governments. These loans often carry implicit guarantees from the central government. While this exacerbates the moral hazard problem, it does limit the potential of "leveraged losses" to lead to a massive credit crunch of the sort experienced during the Global Financial Crisis. China also has reasonably good long-term growth prospects. Output-per-worker is only a quarter of U.S. levels. Likewise, capital-per-worker is a fraction of what it is among advanced economies (Chart 15). Even with its bleak demographics, China would need to grow by around 6% per year over the coming decade if it were to remain on course to catch up to South Korea in output-per-worker by 2050 (Chart 16). Chart 15China Has More Catching Up To Do (1) Chart 16China Has More Catching Up To Do (2) Given China's well-educated labor force, it is likely that productivity levels will continue to converge with richer economies in the years ahead (Chart 17). Rapid growth, in turn, will allow China to outgrow some its debt and overcapacity problems more easily than would be the case for slower growing economies. Chart 17A Well-Educated Labor Force Bodes Well For China's Development Lastly, not all credit creation in China represents the intermediation of savings into productive investment. A lot of it is simply driven by speculative activities that contribute little to growth. Curbing the ability of individuals and companies to use extreme amounts of leverage to supercharge financial returns would enhance economic stability. To its credit, the government is actively addressing this issue. The bottom line is that Chinese growth is likely to slow modestly next year, but not by enough to imperil the global economy. Investors should remain cyclically overweight global equities and other risk assets at least for the next six months. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017; and Weekly Report, "Fiscal Follies," dated November 17, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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

Highlights Growth in the Taiwanese economy has trended sideways this year, but a budding turnaround in weak domestic demand suggests that growth should improve in 2018. The appreciation of the TWD from its 2016 low reflects investor inflows rather than bullish fundamentals. The risk of a protectionist backlash means that monetary authorities are reluctant to intervene aggressively to limit the rise. We recommend that investors stick with our existing long MSCI China / short Taiwan trade, for now. A breakout in relative Taiwanese tech sector performance coupled with a weakening TWD would likely be a sufficient basis to close the trade at a healthy profit. Feature We last wrote about Taiwan in February of this year,1 when the risk of protectionist action from the Trump administration loomed large. While there have been no negative trade actions levied against Taiwan this year, macro factors, particularly the strength of the currency, continue to argue for an underweight stance within the greater China bourses (China, Hong Kong, and Taiwan). Our long MSCI China / short Taiwan trade has generated an impressive 19% return since its inception in February. The trade has become significantly overbought, but we recommend that investors stick with it, for now. A material easing in pressure on Taiwan's trade-weighted exchange rate appears to be the most likely catalyst to close the trade and to upgrade Taiwan within a portfolio of greater China equities. The Taiwanese Economy In 2017: What Has Changed? Real GDP growth in Taiwan has generally trended sideways in 2017, decelerating in the first half of the year and then recovering in the third quarter (Chart 1). While these fluctuations in its growth profile have been somewhat muted, overall GDP growth has masked a sizeable divergence between domestic demand and export growth. Taiwan is a highly trade-oriented economy, with exports of goods & services accounting for nearly 65% for its GDP, and a recent acceleration in real export volume has positively contributed to overall growth. Over 50% of Taiwan's exports are tech-based, and Chart 1 panel 2 highlights the close link between global semiconductor sales (which have risen sharply over the past year) and Taiwanese nominal exports. But as Chart 1 panel 3 shows, growth in real domestic demand has fallen back into contractionary territory, driven largely by a sharp decline in gross fixed capital formation. This decline in investment is somewhat surprising, given the close historical relationship between Taiwan's real exports and investment (Chart 2, panel 1). But the sharp drop may have been a lagged response to the export shock that occurred during the synchronized global growth slowdown in 2015, as it led to a non-trivial accumulation of inventory (Chart 2, panel 2). The recent acceleration of export growth and a renewed draw in inventories suggests that the severe pullback in investment is likely to reverse in the coming year. Chart 1A Divergence Between Domestic Demand##br## And Exports Chart 2Investment Likely To Rebound Over ##br##The Coming Year The evolution of Taiwanese capital goods imports is likely to provide an important confirming signal about the trend in real investment, given the close historical correlation between the two series. For now, the growth in capital goods imports is rebounding from negative territory (Chart 3), which is consistent with the view that investment is set to recover. Finally, while real consumer spending growth also decelerated in the first half of the year, the acceleration in Q3 has brought consumption back to its 5-year moving average. More importantly, Chart 4 highlights that the consumer confidence index in Taiwan is closely correlated with real spending, with the former heralding a rise in the latter over the coming months. Chart 3Capital Goods Signal An Investment Recovery Chart 4Consumption Also Set To Improve Bottom Line: Growth in the Taiwanese economy has trended sideways this year, but a budding turnaround in weak domestic demand suggests that growth should improve in 2018. The Taiwanese Dollar: Driven By Flows, Not Fundamentals Taiwanese stock prices have underperformed Greater China bourses since the beginning of the year (Chart 5), despite the recent improvement in real export growth and signs of an impending improvement in domestic demand. To us, this underperformance has been largely caused by the strength in the Taiwanese currency. The Taiwanese dollar has appreciated since early-2016, both against the U.S. dollar and in trade-weighted terms (Chart 6). Although the currency retreated from May to August of this year, it has since resumed its uptrend and currently stands between 8-9% higher than last year's low in trade-weighted terms. Chart 5Significant Underperformance Of ##br##Taiwan Vs Greater China Chart 6Material Currency Appreciation##br## Since Early-2016 Crucially, Chart 7 highlights that the rise in the TWD cannot be explained by relative monetary policy or by an improvement in the terms of trade. The chart shows how the USD/TWD began to decouple from the relative 2-year swap rate spread in early-2016, and how the trend in Taiwan's export price index has been negatively correlated with the trade-weighted exchange rate. The best explanation for the recent strength in Taiwan's currency appears to be a surge in capital inflows oriented towards Taiwan's equity market (Chart 8). Foreign ownership of Taiwanese stocks has increased significantly over the past few years and is currently at a record high of 43%. Given that Taiwan's equity market is enormously tech-focused, it appears that global investors have been attracted to Taiwanese stocks as part of a play on the global tech rally. As we will discuss below, this has become somewhat of a self-defeating strategy, at least in terms of Taiwan's relative performance vs Greater China bourses. While it is possible that monetary authorities will attempt to combat the appreciation of the Taiwanese dollar, Chart 9 highlights that there is little room to maneuver. First, Taiwan's policy rate of 1.375% is already extremely low, and is only 12.5 bps above the level that prevailed during the worst of the global financial crisis. Second, panels 2 and 3 suggests that while past central bank intervention was successful at depreciating the TWD, monetary authorities also seem reluctant to allow Taiwan to be labeled as a currency manipulator. Our proxy for central bank intervention is the rolling 3-month average daily depreciation in TWD/USD in the first 30 minutes of aftermarket trading, a period that the central bank has historically used to intervene in the foreign exchange market. The chart shows that periods of intervention have been associated with a subsequent decline in TWD/USD, but that intervention durably ended once Taiwan was added to the U.S. Treasury's watch list of potential currency manipulators (first vertical line). Taiwan was removed from the watch list in October of this year (second vertical line), after central bank intervention ceased. Chart 7Currency Strength Not Supported ##br##By Fundamentals Chart 8Equity-Oriented Capital Inflows##br## Are Pushing Up The TWD Chart 9Little Room For Policy ##br##To Push Down The Exchange Rate Bottom Line: The appreciation of the TWD from its 2016 low reflects investor inflows rather than bullish fundamentals. While there is scope for further central bank intervention to help depreciate the currency, the risk of a protectionist backlash means that monetary authorities are reluctant to act. The Relative Outlook For Taiwanese Equities Table 1 presents a simple performance attribution analysis for Taiwan's year-to-date stock returns relative to Greater China bourses,2 in an attempt to answer the following question: Has Taiwan underperformed because it is underweight sectors that have outperformed, or because its highly-weighted sectors underperformed? To test this question we calculate a "hypothetical" return for the Taiwanese stock market, which shows what would have occurred if Taiwan's tech and ex-tech sectors had earned the benchmark return instead of their own. Table 1Taiwan's Poor Performance This Year Is Due To Its Tech Sector The table clearly shows that Taiwan would have substantially outperformed Greater China in this hypothetical scenario, underscoring that its sector weighting is not the source of the underperformance. While both Taiwan's tech and ex-tech indexes underperformed those of Greater China, it is apparent that most of the gap in performance can be linked to Taiwan's tech sector. Tech accounts for roughly 60% of Taiwan's equity market capitalization, and the sector significantly underperformed Greater China tech this year. Chart 10 highlights that Taiwan's tech sector underperformance is significantly explained by the rise in Taiwan's trade-weighted currency. Panels 2 & 3 of the chart shows Taiwan's rolling 1-year tech sector beta and alpha vs Greater China tech, both compared with the (inverted) year-over-year percent change in the trade-weighted exchange rate. Here, we define alpha using Jensen's measure, which is the difference between Taiwan's tech sector price return and what would have been expected given its beta and Greater China's tech sector performance. The chart clearly shows that the sharp rise in Taiwan's trade-weighted exchange rate caused both a decline in Taiwan's tech sector beta (from a historical average of about 1) as well as a significantly negative alpha over the past year. Chart 10, in combination with the currency-driven downtrend in Taiwan's export prices shown in Chart 7, suggests that Taiwan's equity market has suffered in relative terms due to the outsized appreciation in its currency. This is somewhat ironic, as we noted above that the currency appreciation itself appears to be caused by capital inflow oriented towards Taiwan's tech sector, meaning that global investors have inadvertently contributed to Taiwan's equity market underperformance relative to Greater China bourses. Looking forward, there are cross-currents affecting the outlook for Taiwanese stock prices. Chart 11 shows that technical conditions and relative valuation argue against maintaining an underweight stance; Taiwanese stocks are heavily oversold vs Greater China, and have de-rated in relative terms since the beginning of the year. Taiwanese tech in particular is quite cheap in relative terms. In addition, panel 1 of Chart 10 suggests that Taiwanese tech (in relative terms) may have undershot the appreciation in the currency. Chart 10Taiwan's Tech Underperformance Is Explained By Currency Appreciation Chart 11Taiwan Vs China: Oversold, And Cheaper Than Usual However, Taiwan's tech sector is mostly made up of the semiconductors & semiconductor equipment industry group, and there are signs that the growth rate in global semiconductor sales is in the process of peaking. Chart 12 illustrates the close correlation between the growth of global semi sales and Taiwan's absolute 12-month forward earnings per share, with the recent gap likely having occurred due to the currency impact noted above. The chart suggests that earnings expectations for Taiwan are highly unlikely to accelerate if semi sales growth slows, meaning that Taiwanese stocks, particularly the tech sector, currently lack a catalyst to re-rate. Chart12Taiwan Is Lacking A Re-Rating Catalyst From our perspective, a lasting depreciation in the currency appears to be the most likely catalyst for a re-rating, as it would increase the odds that the relationship shown in Chart 10 would durably recouple. Until then, any exogenous rebound in relative tech sector performance is likely to be met with a self-limiting TWD appreciation. Bottom Line: We recommend that investors, for now, stick with our existing long MSCI China / short Taiwan trade. However, a breakout in relative Taiwanese tech sector performance coupled with a weakening TWD would likely cause us to close the trade, and upgrade Taiwanese stocks to at least neutral within a greater China equity portfolio. Stay tuned. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Assistant linx@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Taiwan's 'Trump' Risk", dated February 2, 2017, available at cis.bcaresearch.com. 2 We use MSCI's Golden Dragon index to represent Greater China, which includes China investable, Hong Kong, and Taiwanese stocks. Cyclical Investment Stance Equity Sector Recommendations

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

Special Report

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

Highlights Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This points to a major top in EM share prices. In Brazil, falling inflation has led to a relapse in nominal GDP growth. This has endangered the already-bad public debt dynamics. Without the social security reforms, the country needs to boost nominal growth to stabilize public debt dynamics. Currency depreciation will likely be required to achieve this. When the Brazilian currency sells off, the nation's financial markets perform poorly. Feature Deteriorating EM Equity Breadth Breadth within EM equity markets has been deteriorating, especially in relative terms, versus DM stock markets. This heralds a major downleg in EM versus DM relative share prices, at a minimum, and a relapse in EM share prices in absolute terms as well. Chart I-1 demonstrates that the relative performance of EM equal-weighted stock index versus the DM equal-weighted share price index has decoupled from the relative performance of EM versus DM market cap-weighted equity benchmarks. Such a gap has emerged for the first time since 1999, when MSCI's equal-weighted equity data became available. Chart I-1EM Equity Outperformance Narrowly Based Versus DM... Each stock has the same weight in the equal-weighted index, while the regular indexes are market-cap weighted. Hence, an equal-weighted index reflects performance of an average stock while the market cap-weighted ones are skewed by the performances of large-cap stocks. This confirms what many investors already know: that in 2017, EM outperformance versus DM has been largely due to the surge in four large-cap technology stocks in Asia. Comparing EM against the U.S. only on similar measures, the message is identical (Chart I-2). Chart I-3 illustrates the absolute performance of MSCI EM market cap-weighted and MSCI EM equal-weighted equity indexes. It appears that the EM equal-weighted stock index has failed to make new cyclical highs lately. Thereby, it has not confirmed the new high in the EM market-cap weighted equity benchmark (Chart I-3). Chart I-2...And U.S. Chart I-3EM Equal-Weighted Index Did Not ##br##Confirm EM Market-Cap Recent Highs Similarly, the rally in share prices of EM banks - an important macro-driven sector of the EM equity universe - has lately paused. As such, it has also not confirmed the new high in the overall EM equity benchmark (Chart I-4). Given EM tech stocks (29% of MSCI benchmark index) are extremely overbought, the EM equity rally can be sustained if leadership rotates to EM financials and commodities stocks, which account for 23% and 14% of market cap, respectively. The failure of both EM financials and commodities stocks to make new cyclical highs of late suggests the EM equity rally is wearing off. The advance-decline line for EM stocks has lately dropped below the 50 line (Chart I-5, top panel). By contrast, the DM measure is still above 50 (Chart I-5, bottom panel). This signals a major bout of EM underperformance versus DM, as well as downside risks to EM's absolute performance. Chart I-4EM Banks Also Did Not Confirm ##br##EM Market-Cap Recent Highs Chart I-5Poor Advance-Decline Line In EM Equities The weak technical profile for EM equities is consistent with our fundamental assessment that the main risks to global growth and share prices stem from EM/China rather than DM economies. Therefore, EM/China plays will be the first to roll over, while DM stocks will lag. Investors looking for signs of reversal in the rally in global risk assets should monitor EM/China plays. Finally, EM small cap stocks' relative performance against their DM counterparts has not confirmed the EM outperformance based on an aggregate index (Chart I-6). This is a negative signal as well, and heralds new lows in relative performance. This also corroborates that, outside those EM large-cap tech stocks that have gone exponential, the EM equity rally has been much less exuberant and vigorous. More importantly, the EM rally has recently shown signs of fatigue. Bottom Line: Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This implies that a major downturn in EM share prices as well as EM risk assets generally is approaching. Investors should stay put/underweight EM risk assets. Brazil: A Political Economy Dilemma The Nominal Impediment We are aware that the pace of economic activity in Brazil is presently gathering speed. Manufacturing, retail sales and hiring are all recovering (Chart I-7). Even capital spending that has been shrinking until recently is now starting to show signs of life. Chart I-6EM Small Caps Have Not Confirmed ##br##EM Large Cap Outperformance Chart I-7Brazil: Economic Activity Is Recovering Nevertheless, Brazil's public debt dynamics remain unsustainable. Nominal GDP growth has declined to its 2015 low - as falling inflation has more than offset the revival in real output (Chart I-8). Besides, real interest rates remain elevated and nominal GDP growth is well below the government's borrowing costs (Chart I-9). Chart I-8Brazil: Real Growth Is Recovering ##br##While Nominal Growth Is Relapsing Chart I-9Brazil: Borrowing Costs Are Still High Therefore, without full-fledged social security reforms and/or lowering ex-ante real interest rates substantially, the public debt trajectory will likely spin out of control. Interest rates in real terms are also elevated for the private sector. This suggests that credit stress among companies and households might not recede quickly, and high real interest rates might cap the recovery in loan growth (Chart I-10). Interestingly, Chart I-11 demonstrates that private banks' NPLs (non-performing loans) inversely correlate with nominal GDP growth (nominal GDP is inverted on the chart). This entails that the amelioration in Brazil's NPL cycle is at least due for a pause. Chart I-10Brazil: Bank Loan Growth Is Stabilizing Chart I-11Brazil: Nominal GDP & Bank NPLs In short, to stabilize public and private debt dynamics, higher nominal GDP growth and much lower borrowing costs in real terms are vital. The latter means an unexpected rise in inflation is required. Chart I-12Brazil In the Late 1990s To boost nominal growth considerably and finance government at lower real interest rates, a combination of quantitative easing (QE) and currency depreciation will be needed. This is not a forecast that the Brazilian central bank will certainly implement QE. Rather, our point is that without extensive social security reforms - which are politically unfeasible now (more on this below) - a meaningful currency depreciation and/or public debt monetization by the central bank will be necessary to stabilize public debt dynamics and put the economy on a sustainable expansion path. Remarkably, in the late 1990s, faced with low inflation and weak nominal growth, the Brazilian government opted for large currency devaluation, which boosted nominal GDP growth (Chart I-12). Notably, the currency was devalued despite the large share of public foreign currency debt. This ratio is now very low. Hence, currency depreciation will be less painful now than it was in 1998. A Political Economy Dilemma: Growth Versus Creditors Brazil's elected politicians (congressmen and senators) are facing a political economy dilemma: (a) Should they satisfy interests of government creditors (including foreign investors) - i.e., pursue painful fiscal reforms to make public debt sustainable? Or (b) Should they gratify the electorate - i.e., avoid austerity and stimulate the still-beleaguered economy? To put this in perspective, the economy is just exiting one of the worst recessions of the past century, and the unemployment rate is still at a decade high. Over the next several months, the government of President Michel Temer will try to pass a diluted version of the pension reform bill. The government is desperate to enact this bill to keep financial markets buoyant and preserve the ongoing economic recovery heading into the elections. Being already very unpopular, government officials realize this is the only way their candidate has a chance to get elected in the presidential elections next year. However, the diluted version will not be enough to ensure debt sustainability. Chart I-13Brazil's Median Voter Favors ##br##Anti-Government Candidates Moreover, many of the government's coalition partners have different incentives. Going into the general elections in October 2018, odds favor that the majority of congressmen and senators will likely vote for avoiding austerity. As a result, the pension reforms draft - even in its diluted form - will likely fail. The median voter in Brazil remains on the left. Chart I-13 reveals that according to the latest polls, 60% of voters support anti-market candidates. Hence, any politician who wants to be elected needs to heed to the electorate. Worsening Fiscal Dynamics Public debt sustainability has been worsening: The primary and overall deficits have lately widened to 2.9% and 9.3% of GDP, respectively (Chart I-14). Public debt sustainability necessitates that the primary fiscal balance swings into a surplus, and borrowing costs drop below nominal GDP. None of these requirements have been satisfied or are likely to be anytime soon. Meanwhile, central government total revenue growth has dwindled (Chart I-15, top panel). In turn, central government net revenue - i.e. excluding transfers to local governments - are mildly contracting due to the increase in revenue transfers to the latter (Chart I-15, bottom panel). Chart I-14Brazil: Fiscal Deficit Has Not Improved Chart I-15Central Government Revenues Are Very Weak Furthermore, the overall fiscal deficit excluding social security is at 6% of GDP and has widened over the past year (Chart I-14, bottom panel). Interest payments account for 32% of government spending and 6.4% of GDP. On the whole, without a large fiscal retrenchment and with real interest rates close to current levels, the gross public debt-to-GDP ratio will likely reach 85% by the end of 2018 and 92% in two years' time - even if nominal GDP growth recovers to 6-6.5%. This puts the impetus solely on the central bank to reflate nominal growth aggressively and/or bring down real interest rates. This can be achieved via currency depreciation or public debt monetization. The outcome of the latter will necessarily be a major drop in the currency's value. This, along with our negative view on commodities prices in general and iron ore prices in particular, prompts us to retain our bearish stance on the Brazilian real. Chart I-16 demonstrates that the currency is highly correlated with iron ore prices, and has no correlation with the level of and changes in the interest rate differential between Brazil and the U.S. Investment Implications The path of least resistance for the Brazilian real is down - it will depreciate more than 2% and 4% that are implied by 6- and 12-month forwards, respectively. Stay short. When the Brazilian currency sells off, the nation's financial markets perform poorly. In particular, Brazil's sovereign and corporate credit spreads are very narrow, and will widen as investors begin doubting public debt sustainability. In turn, currency depreciation will raise the cost of foreign currency debt for the private sector. Dedicated EM investors should underweight Brazilian sovereign and corporate credit relative to their benchmarks. The relapse in narrow money (M1) growth presages downside risk in share prices (Chart I-17). Chart I-16Driver Of BRL: Commodities Not Interest Rates Chart I-17Brazil: M1 Growth And Share Prices The broad stock market is not particularly cheap, given the magnitude of the rally that has considerably exceeded the EPS recovery. Finally, in the local fixed-income market we continue recommending a bet on yield curve flattening that typically happens when the currency sells off. Foreign investors should wait for currency depreciation to play out before going long local currency government bonds. Local investors should overweight local bonds versus stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Dear Client, I'm on the road this week teaching the BCA Academy in Chicago. Instead of our regular Weekly Report, we are sending you a Special Report written by my colleague Juan Manuel Correa. His piece, "Riding the Wave: Momentum Strategies in Foreign Exchange Markets," focuses on the application of momentum strategies in the FX space. More specifically, Juan lays out the case that momentum is now pointing to upside in the U.S. dollar. I trust you find his report both informative and enjoyable. Best regards, Mathieu Savary, Vice President, Foreign Exchange Strategy Feature Merchant: In this chaos of opinions, which is the most prudent? Shareholder: To go in the direction of the waves, and not fight against powerful currents - Confusion de Confusiones, Joseph de la Vega, 1688. Since the invention of financial markets, momentum has captivated the minds of investors, economists and general speculators. As early as 1688, the Spanish merchant Jose de la Vega became the first market observer to document the powerful forces of momentum in the primitive financial markets of Amsterdam.1 Since then, a number of academic studies have confirmed that momentum strategies deliver significant excess returns, even when traditional risk factors are taken into account.2 Because the success of momentum flies in the face of the Efficient Market Hypotheses, academia has tried to understand this phenomenon. Transaction costs, short-selling constraints and unsophisticated market participants have been among some of the explanations advanced and more widely accepted. However, there is still no real consensus as to why momentum strategies work. Foreign exchange markets present themselves as a fascinating space to study momentum, given that FX markets are:3 a) Very liquid, and possess very low transaction costs; b) Include no short selling constraints; c) Are populated by very sophisticated investors. So how successful are momentum strategies in foreign exchange markets? More specifically: In what time frame does momentum work best? In which currencies or crosses are momentum strategies more effective? Are there any macroeconomic factors that influence the success of a momentum strategy? Generally, momentum in financial markets is defined as the positive correlation between past and future returns. Momentum can either refer to time series momentum (buy/sell a currency which has had positive/negative returns) or cross-sectional momentum (buy the best-performing currencies and sell the worst-performing currencies). In this report, we will focus on time-series momentum. We use moving average crossovers to generate signals. We chose this technique as it is commonly used by practitioners, and it provides an easy and flexible buy/sell signal. When a short-term moving average crosses a long-term one from below, we buy the cross. Conversely, when it crosses it from above, we short the cross. While it is true that this technique does not follow the strict definition of momentum, it is a close enough proxy, as it takes into account the relative acceleration of the price. Furthermore, we tested 15 different combinations of moving averages on all 45 crosses in the G10, on a sample of nearly 29 years. By doing this we do not bias our analysis to dollar pairs or to any particular strategy. For more details on the methodology, please see Appendix A. Wave Watching: Observations On Historical Returns Our strategies consist of 15 different combinations of 1-month, 2-month, 3-month, 6-month, 12-month and 24-month moving averages. On average, momentum strategies had an annualized spot return of 0.5% and a carry return of 0.9% from when our sample period started in January 1989 to its end in October 2017 (Chart I-1). Furthermore, most strategies provided positive returns on average (see Appendix B) while substantially decreasing drawdowns (see Appendix D, Table 1). Chart I-1Momentum Across History However, some strategies performed better than others. On average, we found that momentum strategies based on the "medium-term" - i.e. when the slower of the two moving averages necessary to generate the crossovers was either 130-days (6-months) or 260-days (12-months) - tended to perform best. In terms of nomenclature in our comparative study, we named each strategy by summing the number of days in the faster moving average and the slower one. The resulting number is the total amount of days considered by the strategy. This way shorter term-focused strategies have lower numbers while longer-term focused strategies have higher numbers (Appendix A, Table 1). We found that risk-adjusted returns for strategies focused on the short term tend to be low: they rise as strategies become more focused on medium-term horizons, and then they drop again when longer term moving-average crossovers are used, following a "hump" pattern (Chart I-2). This pattern holds across the majority of FX crosses (see Appendix C). Our results are consistent with the literature on momentum on other assets classes. Generally, short-term returns tend to be reverting: if an asset's return last month was positive it will likely be negative the following month. The reversal effect tends to also be present in the long-term: if an asset experienced strong positive returns on a multi-year horizon, it is likely to offer negative returns in the subsequent time period. On the other hand, positive return auto correlation, the staple of traditional momentum strategies, tends to be strongest in medium-term time frames.4 Next, we examined the carry component of the strategies. On average, momentum strategies are long carry currencies slightly more often than not, and vice versa with funding currencies. As a result, momentum strategies tend to generate a positive carry (Chart I-3). Chart I-2Medium Term Focused Strategies ##br##Perform Best Chart I-3Momentum Strategies Favor ##br##Carry Currencies... This result is robust across strategies and across currency pairs (see Appendix B & C). Of the 675 different return indexes generated by our various moving average crossover signals, only 108 had a negative carry. So, are momentum strategies and carry strategies one and the same? Not quite. When we tested the correlation between the returns of our G10 carry strategy Index and the returns of all 15 of our momentum indexes, we found it to be nearly zero. Furthermore, we found that the spot returns of momentum strategies tended to increase in periods of increasing G10 implied volatility (Chart I-4). This stands in stark contrast to carry strategies, which are allergic to any increase in volatility.5 Chart I-4...But Momentum Also Likes Volatility We also tested for which crosses momentum strategies worked best. We found that commodity crosses tend to be the worst performers, with the least reliable and least rewarding signals. Meanwhile, pairs involving the yen or the U.S. dollar in one of the legs tended to perform the best by a wide margin, in both spot terms and carry terms (Chart I-5). Chart I-5AMomentum Winners: ##br##USD And JPY Crosses Chart I-5BMomentum Winners: ##br##USD And JPY Crosses Bottom Line: Historically, momentum strategies have provided positive returns. However, medium term-focused strategies tend to perform best. Momentum strategies also tend to produce positive carry, even though their spot return rises along with volatility. Finally, crosses involving a USD or JPY leg tend to provide the best momentum returns. Characteristics Of Momentum: Wave Patterns And Surfing Lessons We opted to take an unconventional approach from the plethora of academic research trying to understand momentum. However, to do so, we needed to momentarily step away from financial markets and instead dive in another field where riding waves is paramount: surfing. Diagram 1Oceanic Wave Patters Oceanic waves are produced by the wind. When wind blows across the surface of the ocean, the force is transferred to the water and generates swell, which is a group of travelling waves.6 However not all swell is created equally. There are two main types of swell: groundswell and windswell. Groundswell is the result of powerful winds or storms thousands of miles away from shore. These strong storm systems far away in the ocean tend to generate smooth and infrequent waves. These are the best waves for surfing, as these waves create enough power for a surfer to gain great balance and thus, ride the wave for a long period of time (Diagram 1 - Top Panel). On the other hand, windswell refers to swell created by local winds. These local winds tend to generate smaller waves and choppy waters, which makes for lower-quality surfing (Diagram 1 - Bottom Panel). This insight from surfing can be translated to financial markets. Much like a surfer at the beach, a momentum player would prefer smooth waves in the currencies he or she trades, as these types of waves can provide consistent signals that he or she can take advantage of. We therefore tested whether currencies that behave like groundswell tend to have higher risk-adjusted momentum returns than currencies that behave like windswell. How can we test this numerically? We found that volatility is not the right measure to capture this particular wave pattern, as it does not account for smoothness (see Appendix D). Instead, we measured smoothness by calculating a cross's average 1-year fractal dimension,7 a modification of an indicator championed by BCA's European Investment Strategy's Dhaval Joshi. A low average fractal dimension over that 1-year window indicates that more often than not a cross has been following a smooth trend, while an elevated fractal dimension indicates a cross that has been range-bound.8 We invert this number, giving higher numbers to smoother, trending crosses and lower numbers to jagged, noisy crosses. We call this the "Wave Smoothness Indicator," and it turns out to be highly correlated to risk-adjusted momentum returns for crosses in the G10, particularly if we take out managed crosses like EUR/CHF, EUR/SEK, and EUR/NOK (Chart I-6). To further illustrate this point, we sorted all crosses by their median risk-adjusted returns across all the moving-average crossover strategies we tested. We then looked at the five crosses where our momentum strategies delivered the higher risk-adjusted returns against the five crosses where the strategies fared the worst (Chart I-7A & Chart I-7B). The best currencies to execute momentum strategies have long and smooth cycles, while the worst ones exhibit much more noise. Chart I-6Wave Dynamics And Momentum Returns Chart I-7AGroundswell: Paradise For Momentum Surfers Chart I-7BWindswell: No Wave Riding In Choppy Waters As a result, it is apparent that smoothness is a crucial factor behind successful momentum trading, at least in the FX space. For example, while AUD/NZD displays long cycles, these gyrations are not smooth. Consequently, moving-average crossover strategies work badly for this cross, as it is too noisy to provide reliable buy/sell signals. Bottom Line: Analogous to the dynamic between surfers and oceanic waves, currencies that have long and smooth cycles (groundswell) tend to provide better returns than currencies which have small and noisy cycles (windswell). Storm Warning: Macro Determinants Of Momentum What factors make a currency behave more like groundswell as opposed to windswell? In order to gain some understanding, let's look at the crosses where momentum strategies worked best in our sample: the USD crosses and the JPY crosses. The yen and the dollar experience such strong and broad-based trends that for any cross, simply being correlated to the trade-weighted dollar and the trade-weighted yen makes for a good predictor of whether this currency pair will experience strong momentum-continuation behavior. Moreover, in line with our results above, crosses with a high correlation to these currencies also tend to exhibit stronger groundswell patterns (Chart I-8). What is so special about the dollar and the yen? The oceanic waves once again offer a clue. Recall that groundswell is generated by powerful oceanic storms. Similarly, the trade-weighted dollar and yen are ultra-sensitive to two of the most powerful forces in the global economy: global trade dynamics and global risk aversion (Chart I-9). Chart I-8JPY And USD Determine Wave ##br##Patterns In Currency Markets Chart I-9The Powerful Winds Of ##br##The Global Economy Global trade and risk aversion generate strong and well-defined waves, which makes any cross that is highly correlated to them fertile ground for implementing momentum strategies. Moreover, due to their sheer strength, these economic forces are subject to extremely strong feedback loops that reinforce the groundswell pattern present in "momentum" currencies. How exactly do these feedback loops work? Let's begin with the USD. The U.S. economy has a low beta to global growth, as it is a relatively closed economy where manufacturing represents a small share of both employment and gross value-added. Thus, when global trade accelerates, the U.S. economy does not benefit as much as other large blocs, and the dollar depreciates (Chart I-10). However, a fall in the dollar also helps global trade, as the world economy, particularly EM economies, carry large liabilities in U.S. dollars. Thus, when the dollar falls, the cost of financing global trade decreases, which in turn generates more trade, more investment, and more growth. This is a very powerful feedback loop. Although related, the yen cycle is slightly different, as it is more related to risk aversion and liquidity, given that the yen is the funding currency of choice for carry traders. When global economic activity is strong, carry trades distribute funds from places where liquidity is plentiful like Japan to places that offer high-return at the cost of higher risk (Chart I-11). So long as returns are elevated in the nations sporting high-carry currencies, more liquidity flows into these economies, supporting additional growth and returns. However, this virtuous cycle can become a vicious one when volatility rises, as liquidity can be quickly drained when Japanese investors repatriate home funds from abroad, and carry traders close their positions, selling the high-carry currency and covering their shorts in the funding ones. This not only appreciates the yen relatively to riskier currencies but also worsens the economic outlook and return profile of the carry currencies.9 Chart I-10The U.S. Economy Is Less ##br##Sensitive To Global Growth Chart I-11Japan Is The World's ##br##Provider Of Liquidity These dynamics also explain why momentum strategies tend to be more frequently long-carry currencies than funding ones. Simply put, risk-on cycles tend to be longer than risk-off ones. Chart I-12 shows how momentum strategies tend to overweight funding currencies on the rare occasions when volatility spikes, which makes their spot returns higher than their carry returns during those instances. On the other hand, when volatility is low, momentum strategies buy carry currencies, adding an additional benefit beyond their spot returns. Chart I-12Momentum Overweighs Carry More Often, ##br##Because Greed Is More Common Than Fear Meanwhile, risk-off cycles may be short-lived but they tend to be very intense. Thus, buying the funding currencies as they start generating higher momentum can deliver very quick, very powerful gains. This also helps elucidate the seeming paradox whereby momentum trades in the FX space see an accelerating pace of gains when volatility rises. This makes momentum strategies more agile than carry strategies. Importantly, understanding the link between momentum and the exposure to global factors like global trade as well as risk aversion explains why pairs where both legs of the cross are commodity currencies perform so badly as momentum plays. Much like windswell is generated by local winds, crosses from commodity producers like AUD/NOK or AUD/NZD have a diminished sensitivity to global factors, and instead are mostly driven by relative commodity dynamics or even relative domestic dynamics - forces akin to a localized wind system. With all of the above considered, we conclude the following: In the G10 currency space, momentum strategies will provide high profits on crosses that are driven by powerful systematic forces, and will provide lower returns from crosses driven by more idiosyncratic forces. It thus seems that an investor profiting from momentum in the FX space is not exploiting a market inefficiency, in the strictest academic terms, but rather a fundamental trait of each currency. Finally, we are not suggesting moving-average crossovers are the only mean to generate momentum-based buy and sell signals for currencies. But MA crossovers are a simple yet powerful indicator that provides timing signals in the foreign exchange market. Bottom Line: Currencies that are driven by powerful systematic forces will provide better momentum returns than currencies driven by weak idiosyncratic forces. Global forces like trade dynamics and risk aversion will generate groundswell-like wave patterns that are optimal for momentum strategies. Investment Implications Based on the observations made in this report, we have created a list of five rules of thumb for investors to consider when using momentum in currency markets: When using moving averages to assess momentum, the slower of the two moving averages should have a rolling window between 6-months and 12-months in order to generate superior signals. This gives credence to the commonly used 200-day moving average. Meanwhile, the faster of the moving averages should not exceed 3-months. Currencies that have long, powerful and smooth cycles (groundswell) will tend to provide better returns that currencies that have short, choppy and weak cycles (windswell). Moreover, currencies with a groundswell pattern will tend to be driven by powerful systematic factors, while currencies with a windswell pattern will be driven by weaker idiosyncratic factors. More specifically, investors should try to capture momentum in global risk aversion and global trade. The currencies that best follow these criteria are the JPY and USD crosses. What is momentum telling us now? The financial world continues to be in a risk-on mood. As glee rather than fear has taken hold of investors, momentum continues to point to further downside in the yen (Chart I-13). Chart I-13Plentiful Liquidity Is Supporting Momentum##br## In This Risk-On Environment... Chart I-14...But Global Growth Is##br## Starting To Peak On the other hand, momentum seems to be favoring the dollar right now. Global trade is very strong, but signs are accumulating that it may begin to slow after a spectacular couple of years. The faster moving 1-month/6-month moving-average crossover signals that the dollar is a buy, while the 1-month/200-day is also relatively close (Chart I-14). This means that at the very least, investors should be reducing their short dollar exposures. Juan Manuel Correa, Research Analyst juanc@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Gray, Wesley R., and Jack R. Vogel. "Quantitative Momentum a Practitioner's Guide to Building a Momentum-Based Stock Selection System." Quantitative Momentum a Practitioner's Guide to Building a Momentum-Based Stock Selection System, Wiley, 2016. 2 Jegadeesh, Narasimhan and Sheridan Titman, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency" Journal of Finance, 48(1): 65-91 (1993) 3 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies" (2011) 4 Gray, Wesley R., and Jack R. Vogel. "Quantitative Momentum a Practitioner's Guide to Building a Momentum-Based Stock Selection System." Quantitative Momentum a Practitioner's Guide to Building a Momentum-Based Stock Selection System, Wiley, 2016. 5 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 6 "Wave Energy, Decay and Direction." Surfline.com, 2017, www.surfline.com/surfology/surfology_forecast_index.cfm. 7 Bruno, R. and Raspa, G. (1989). Geostatistical characterization of fractal models of surfaces. In Geostatistics, Vol. 1 (M. Armstrong, ed.) 77-89. Kluwer, Dordrecht. 8 For more insights into application of fractals in finance please see European Investment Strategy Special Report, titled "Fractal Dimension And Market Turning Points", dated July 24, 2014, available at eis.bcaresearch.com 9 For a more detailed discussion of how carry trades generate virtuous and vicious circles in the economies of high-carry currencies, please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at fes.bcaresearch.com Appendix A: Methodology Appendix AFormula 1 Table 1Days Used By Each Strategy Appendix B: Momentum By Strategy Chart II-1A1-Month/2-Month Momentum Strategy Chart II-1B1-Month/2-Month Momentum Strategy Chart II-2A1-Month/3-Month Momentum Strategy Chart II-2B1-Month/3-Month Momentum Strategy Chart II-3A1-Month/6-Month Momentum Strategy Chart II-3B1-Month/6-Month Momentum Strategy Chart II-4A1-Month/12-Month Momentum Strategy Chart II-4B1-Month/12-Month Momentum Strategy Chart II-5A1-Month/24-Month Momentum Strategy Chart 5B1-Month/24-Month Momentum Strategy Chart II-6A2-Month/3-Month Momentum Strategy Chart II-6B2-Month/3-Month Momentum Strategy Chart II-7A2-Month/6-Month Momentum Strategy Chart II-7B2-Month/6-Month Momentum Strategy Chart II-8A2-Month/12-Month Momentum Strategy Chart II-8B2-Month/12-Month Momentum Strategy Chart II-9A2-Month/24-Month Momentum Strategy Chart II-9B2-Month/24-Month Momentum Strategy Chart II-10A3-Month/6-Month Momentum Strategy Chart II-10B3-Month/6-Month Momentum Strategy Chart II-11A3-Month/12-Month Momentum Strategy Chart II-11B3-Month/12-Month Momentum Strategy Chart II-12A3-Month/24-Month Momentum Strategy Chart II-12B3-Month/24-Month Momentum Strategy Chart I-13A6-Month/12-Month Momentum Strategy Chart II-13B6-Month/12-Month Momentum Strategy Chart II-14A6-Month/24-Month Momentum Strategy Chart II-14B6-Month/24-Month Momentum Strategy Chart 15A12-Month/24-Month Momentum Strategy Chart II-15B12-Month/24-Month Momentum Strategy Appendix C: Momentum By Currency Legs Chart III-1 Chart III-2 Chart III-3 Chart III-4 Chart III-5 Chart III-6 Chart III-7 Chart III-8 Chart III-9 Chart III-10 Appendix D: Other Data Chart IV-1Volatility Does Not Fully Explain ##br##Momentum Returns Chart IV-2Volatility Does Not Fully Explain ##br## Momentum Returns Table 1Worst Sample 1-Month Return Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We are putting the Indonesian stock market on an upgrade watch list. Indonesia's financial markets' beta relative to EM peers has been declining. As such, Indonesian markets will likely outperform the EM benchmark in a sell-off. Inflation in Mexico is peaking and will drift lower. The Mexican peso is particularly attractive relative to the South African rand and the Brazilian real. However, we still recommend that investors maintain a neutral stance on Mexican assets relative to EM peers until more clarity emerges from the NAFTA negotiations. Feature Indonesia: Putting On Upgrade Watch List Indonesian share prices have considerably underperformed the EM benchmark since February 2016 (Chart I-1). This has occurred despite exports growing at an annual rate of 18% in U.S. dollar terms in 2017. The surge in Indonesian exports has been largely driven by soaring prices for thermal coal, palm oil and copper. Export prices have soared by 24% for coal and copper and 11% for palm oil from their lows in early 2016. Nevertheless, their export volumes have been rather stagnant (Chart I-2). These commodities are large drivers of Indonesia's exports. Thermal coal and palm oil account for around 20% of total exports, while copper accounts for around 4%, in value terms. Chart I-1Indonesian Stock Prices: Relative & Absolute Chart I-2Indonesian Exports: Volume Vs. Prices We expect coal1 and base metals prices to drop considerably in 2018 due to China's meaningful growth slowdown. Having this backdrop in mind, we discuss the outlook for Indonesia's stock market in both absolute and relative terms. We continue recommending a neutral allocation to Indonesian stocks within an EM equity portfolio for now, but are putting this bourse on an upgrade watch list and will wait for the following triggers to go overweight: Chart I-3Chinese & Indonesian Equities: ##br##A Rotating Dance The first trigger is when Chinese H-shares and large-cap tech stocks begin underperforming the EM overall equity index. Interestingly, the relative performance of Indonesian equities and Chinese stocks has been negatively correlated (Chart I-3). Indonesia's stock market's underperformance relative to the EM benchmark can be also partially explained by the manic rise in a small number of EM large-cap tech stocks. Tech stocks are absent from Indonesia's stock exchange and when tech stocks' relative performance does turn south, it will be easier for the Indonesian bourse to outperform the EM benchmark. The second trigger for upgrading Indonesian stocks is when the initial phase of decline in commodities prices (10-15%) occurs. This phase could be the most painful for commodities plays like Indonesia, as nervous investors bail out. In short, we are waiting for the momentum of Indonesia's relative performance to turn up before overweighting the bourse. Domestic Demand And Exports: Parting Ways? The Indonesian economy and its financial markets have historically been highly correlated with commodities prices and exports: a positive external shock would trigger an export boom and foreign inflows would ensue. These inflows would in turn lead to currency appreciation and a subsequent fall in interest rates. The end result was the overheating of the economy and financial markets. Recently, however, Indonesia's economy and financial markets have been slowly disconnecting from exports in general and commodities prices in particular. The top panel of Chart I-4 shows that while exports used to be extremely correlated with the rupiah, these correlations have been breaking down since early 2016. Similarly, a disconnect is occurring between exports and other domestic macro variables like bank loans (Chart I-4, bottom panel). What is also noteworthy is the absence of a notable pickup in domestic demand growth amid the strong recovery in global trade. Chart I-5 shows that car and motorcycle sales are still anemic. Chart I-4Disconnect Between Indonesian ##br##Exports Vs. Rupiah & Bank Loans Chart I-5Indonesia's Domestic Sector Remains Sluggish Below are some of the reasons that help shed light as to why this divergence between exports and domestic demand has been taking place: First, the ratio of Indonesia's commodities' exports to total has fallen more sharply than in other commodities-producing EM nations (Chart I-6). Exports have also become generally less important for the overall Indonesian economy post the global financial crisis. Chart I-7 shows that private non-financial debt as a whole has risen, while exports have fallen as a share of GDP. Chart I-6Indonesia's Commodities ##br##Exports Ratio Has Plunged Chart I-7Private Debt Is A Bigger Driver Of ##br##Indonesia's Economy Than Exports The government has been following cautious and prudent policies. This is another reason why domestic demand growth has been mediocre amid robust exports. Chart I-8 signifies that growth in government expenditures has stalled in nominal terms and contracted in real terms. Indeed, the impulse in the banking system's net domestic assets (the combined aggregate of the central bank and commercial banks) remains negative, albeit improving on a rate of change basis (Chart I-9). Net domestic assets (NDA) measure the banking system's2 credit to the domestic sector - i.e. the government and the private sector. Chart I-8Indonesia's Government ##br##Has Been Prudent Chart I-9Banking System's Net Domestic ##br##Assets & Fiscal Deposit Drain The NDA impulse has been negative because the government has borrowed less from the banking system. In addition, the government has been shifting deposits from commercial banks to the central bank (Chart I-9, bottom panel). This has drained liquidity in the system and has slowed broad money growth and capped commercial banks' reserves at Bank Indonesia. As the potential negative term-of-trade shock transpires, the government will have enough of a buffer to spend by deploying its deposits from the central bank and by borrowing and spending more. That will in turn provide support for the economy when commodities prices fall and the external sector suffers. Chart I-10Central Bank Has Been Building FX Firepower As for the currency, the central bank has recently accumulated plenty of foreign exchange assets, creating commercial bank reserves in the process (Chart I-10). The central bank now has plenty of room to defend the currency by selling foreign assets when the rupiah comes under selling pressure. Bank Indonesia will also have more leeway managing a reasonable balance between a depreciating currency and rising local interbank rates. Bottom Line: Indonesia's domestic demand has been mediocre, despite the surge in exports and commodities prices. Meanwhile, the central bank and the government have used the positive global environment to accumulate firepower. This puts them in a position to act as shock absorbers when the external environment turns hostile. As a result, the Indonesian financial markets' beta to their EM peers will decline. We therefore recommend putting the Indonesian stock market on an upgrade watch list. Consistently, the potential downside in the currency and a sell-off in the domestic bond markets will be smaller than we previously anticipated. While still advocating a cautious/neutral stance on this market, we will be looking to upgrade it to overweight versus its EM peers after the first phase of a potential EM and commodities sell-off transpires. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Mexico: Waiting For A Better Entry Point In Mexico, inflation has very likely peaked and will drift lower as the central bank maintains a tight monetary policy stance: A large part of the rise in inflation in 2017 was caused by depreciation in the peso. The firmness in the peso this year entails that inflation will roll over soon (Chart II-1). Consumer spending and capital expenditure are set to contract as the impact of higher interest rates continue to filter through the economy (Chart II-2). In fact, domestic vehicles sales are shrinking sharply. Chart II-1Mexico: Peso & Inflation Chart II-2Higher Interest Rates Are ##br##Slowing Domestic Spending Furthermore, weak real wage growth will continue to weigh on consumer spending (Chart II-3). In addition, contracting fiscal non-interest expenditures will remain a headwind on economic growth (Chart II-4). Chart II-3Lower Real Wages = Lower Inflation Chart II-4Belt-Tightening By The Government Finally, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of last year - will subside as the base effect of these price increases abates. The inflation rate will in turn moderate. Despite all this, Banxico will continue to keep monetary policy tight due to lingering uncertainty related to NAFTA negotiations. Within the EM currency universe, the Mexican peso is particularly attractive relative to the South African rand and the Brazilian real. We will be looking to reinstate long positions in the MXN versus both the ZAR and the BRL for the following reasons: Relative trade balance dynamics will continue to favor Mexico relative to South Africa and Brazil. Mexican exports are likely to remain robust due to strong U.S. growth (Chart II-5), while South African and Brazilian exports will slow down as China's growth and imports falter (Chart II-6). Chart II-5Mexican Exports Will Remain ##br##Robust Due To Strong U.S. Growth Chart II-6South African & Brazilian Exports ##br##Will Take A Hit As China Slows Furthermore, metals prices will be affected more negatively than oil prices due to China's growth slump. China's share of world consumption in base and industrial metals at 50-55% is much larger than oil (12.5%). This will leave Mexican exports less negatively affected than those of Brazil and South Africa. Mexico does not suffer from rapidly rising public debt like Brazil and South Africa (Chart II-7). Large fiscal deficits and rising public debt burdens in Brazil and South Africa require a higher risk premium in their respective financial markets, leaving further room for the MXN to outperform both the BRL and the ZAR. While Mexico has already gone through some structural reforms, Brazil and South Africa have yet to deliver any substantial efforts on that front. This leaves Mexico in a much better position to attract long-term capital inflows compared to Brazil and South Africa. Finally, on a real effective exchange rate basis, the peso remains cheap relative to the rand and the real (Chart II-8). Chart II-7Public & Private Debt Is Lower In Mexico Chart II-8The Mexican Peso Is Still Cheap We closed our long MXN/BRL and long MXN/ZAR trades on October 25th because at present there is too much uncertainty with respect to NAFTA negotiations that could have a negative impact on the peso. However, with regards to the national general elections, uncertainty in South Africa and Brazil is even greater than in Mexico. In Mexico, the anti-establishment candidate Andres Manuel Lopez Obrador is currently leading the polls, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress. Investment Conclusions We recommend that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA3 negotiations before going overweight the country's currency and fixed-income markets relative to their EM peers. Mexican stocks have been selling off sharply in absolute terms and have substantially underperformed the EM benchmark. This poor performance is mainly attributed to financials and consumer discretionary stocks. While these two sectors only account for 20% of the total MSCI market cap, the retrenchment in their share price has been large enough to bring the whole market down. We have the following observations on these two equity sectors: The consumer discretionary sector has been underperforming due to disappointing earnings. Our bias is that it is still too early to call a bottom in the consumer cycle in Mexico. With regards to banks, we believe that tight monetary policy will continue to weigh on their share prices. More importantly, the yield curve remains inverted, and until we see it steepen, it will be hard for banks to rally. All in all, we continue recommending a neutral weighting in Mexican stocks within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, the link is available on page 15. 2 Banking system is the sum of the central bank and commercial banks. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights EM/JPY carry trades represent an important "canary in the coal mine" for the global economy that investors need to monitor very closely. They are currently sitting at a key resistance. A breakout above these levels would suggest that global growth will only strengthen, a move down would point to a deceleration in EM and global industrial activity. If EM/JPY carry trades indeed suffer, the key reasons are likely to be the combined onslaught of Chinese policy tightening and DM removal of monetary accommodation. While still not a base case, this breakdown would affect commodity currencies, the AUD in particular, most severely. Scandies would also suffer but the JPY and CHF would be much stronger than we currently anticipate. The ECB is unlikely to match the Fed next year, thus rate differentials will move against EUR/USD. GBP is still stuck in its post-Brexit range. It is likely to weaken anew toward its lower bound once the upper bound is hit during the coming weeks. Feature Chart I-1EM/JPY Carry Trades: ##br##A Canary To Monitor A "canary in the coal mine" for the global economy, EM / JPY crosses, have hit what has been their ceiling for the past ten years, and have begun to roll over (Chart I-1). We believe that carry trades are a key component to global liquidity that historically provide important signals for global industrial activity and EM assets. The weakness in EM/JPY carry trades is in the early innings, but further deterioration would raise dark flags heading into 2018. On the other hand, if EM/JPY carry trades manage to break out of their historical ceiling, the likelihood that the global industrial cycle accelerates further and EM assets strengthen will only grow. Therefore, EM/JPY carry trades need to be both monitored and understood. In this report, we examine one of the two key dynamics affecting these EM carry trade returns: Chinese policy and EM growth dynamics. In another report later this month, we will examine the other key factor: changes in DM monetary policy. Why Do Carry Trades Matter? In a carry trade, funds are borrowed from nations where they are plentiful and cheap - countries like Japan, with high current account surpluses, plenty of foreign assets and low interest rates. Then, these funds are lent to countries experiencing savings shortfalls, but where prospective returns are perceived to be high. These countries tend to have higher growth, current account deficits and higher interest rates. Through this activity, the funding currencies depreciate, and the high-carry currencies appreciate. Chart I-2After Carry Trades Lose Momentum, ##br##Global IP Weakens This transfer of funds supports global economic activity, as it facilitates a more efficient allocation of capital: Carry trades distribute liquidity to the faster-growing corners of the global economy where investment opportunities are plentiful. In the process, this liquidity further supports economic activity, profit growth and asset returns in those attractive markets. A virtuous loop ensues: As asset and currency returns in the high-carry nations remain elevated, further liquidity finds its way into these economies, which supports additional economic and profit growth. All that said, the virtuous loop can quickly mutate into a vicious downward spiral. If returns in the economies that need the borrowed foreign liquidity disappoint, liquidity can quickly find its way out of these nations. This outflow of funds not only hurts the exchange rate of the high-returns economies, it creates a dearth of liquidity in their domestic markets, which hurts domestic asset returns, profits and growth. This invites further outflows, further currency depreciation, and further economic pain. As Chart I-2 illustrates, when EM carry currencies outperform the yen, this tends to support global industrial activity. However, when EM carry currencies weaken relative to the yen, this tends to lead to a sharp deceleration in global growth by an average of three months. What is surprising is the reliability of the signals, especially when picking episodes of decelerating growth. We posit that this relationship works because of three factors. On one hand, EM are where most of the global capex happens (Chart I-3). Capital goods are the key driver of both global industrial production and global trade. Moreover, EM excluding China still needs foreign capital, as they are expected to run a combined current account deficit of US$300 billion in 2018. Thus, industrial activity is greatly influenced by the cost of financing of EM economies. On the other hand, Japan is still the greatest creditor nation in the world, with a net international investment position (NIIP) of US$3 trillion (Chart I-4). Chart I-3EM Are Where Capex Happens Chart I-4Japan Is The World's Biggest Creditor As a result of these dynamics, when EM currencies underperform the yen, it is a symptom that a key source of liquidity is leaving EM economies, and that global industrial activity is set to suffer. Chart I-5EMU PMIs Follow The EM/JPY Carry Trade Unsurprisingly, the performance of EM currencies vis-à-vis the yen also tends to lead dynamics for euro area industrial growth. As Chart I-5 illustrates, the euro area manufacturing PMI is a function of the performance of this supercharged carry trade. The European economy and its manufacturing sector in particular are very exposed to the EM business cycle. This relationship is a confirmation of the validity of the link between EM carry trades and global growth. Bottom Line: EM/JPY carry trades provide a reliable leading signal on global industrial activity. It is because carry trades are a key mechanism of redistributing global liquidity - taking savings from countries where they are oversupplied, and bringing them to countries where they are needed. EM countries are where the marginal capex in the global economy takes place today. Hence, a deterioration in carry trades' returns signals a deterioration of liquidity conditions in the economies that matter most for the global industrial cycle. It is noteworthy that EM/JPY carry trades have recently begun to lose steam. What Lies behind the Weakness in EM/JPY carry Trades? Chinese Policy! What could explains the recent slowdown in EM carry trades? The yen does not seem to be the culprit, as USD/JPY continues to follow the path charted by U.S 10-year yields this year. Instead, we posit that the source of the weakness is Chinese dynamics, the other key driver of EM returns beyond global liquidity conditions. Chinese policymakers have been curtailing their support to the domestic economy this year. Fiscal spending had decelerated massively, and Chinese monetary conditions have been on a tightening path since the end of 2016 (Chart I-6). Moreover, the administrative and regulatory tightening of the shadow banking system is also beginning to leave its mark. Small financial institutions have not been borrowing as aggressively as in recent years. Historically, this leads to a slowdown in the Chinese credit impulse (Chart I-6, bottom panel). Chart I-6Key Risk To Chinese Credit Growth Chinese##br## Policy Has Been Tightened Chart I-7The Chinese Economy Depends On Policy##br## Because Excess Savings Are Deflationary This is especially important as China is very reliant on policy support. As Chart I-7 shows, fiscal spending and credit creation contributed nearly twice as much to Chinese GDP as exports. This is because the Chinese economy's private savings exceed investments by 5% of GDP. If government spending or the lending machine slows, these excess savings are not used, creating deficient demand which imparts a deep deflationary influence on China and the global economy. We are already seeing early signs that the removal of stimulus is beginning to bite. The diffusion index of Chinese house prices, a key leading indicator of prices themselves, has fallen below the 50% line. Since Chinese real estate construction tends to lag prices, a slowdown in this sector is likely to emerge (Chart 8). Additionally, the slowdown in the leading economic indicator also highlights the risks to China's industrial activity as measured by the Keqiang Index (Chart I-8, bottom panel). The implications for EM are straightforward. EM economies outside of China have exhibited little domestic momentum, with poor credit growth of 5.5% and retail sales growth of 1.1%. Thus, a slowdown in Chinese monetary conditions could do what it historically does: lead to a slowdown in EM industrial production that will reverberate throughout the world (Chart I-9). Chart I-8Policy Is ##br##Biting Chart I-9EM Economies Don't Respond ##br##Well When China Tightens Bottom Line: The crucial factor that could explain why our favorite canary in the coal mine has begun to lose momentum is most likely to be tightening Chinese policy. China is dependent on policy actions to allocate its vast amount of savings. The tightening that began this year is already causing some symptoms to pop up in the Chinese economy. Since China has been the key driver of growth in other EM economies, these dynamics could begin to weigh on EM returns. EM/JPY carry trades will be the canary in the coal mine to judge whether or not these risks begin to weigh on global growth. Other Considerations And Some Implications Positioning considerations could exacerbate the negative impulse emanating from Chinese policy. To begin with, investors are not positioned for this. Not only are risk reversals in EM currencies still pricing in a very benign outcome, short interest in popular EM bond plays remain very low. Thus, the risk of a sharp repositioning in EM plays is high; in fact, it is much higher than for much-maligned assets like the supposedly over-loved S&P 500 (Chart I-10). Japanese investors have been heavily investing outside of their country, and since 2016, EM markets have been the recipients of these portfolio flows. But as Chart I-11 shows, these Japanese flows seem to have been chasing momentum into EM. Thus, if EM assets begin to suffer from a tightening of policy in China, the Japanese flows could reverse, causing a drying out of liquidity conditions in EM and exacerbating the pain already induced by China. Chart I-10Investors Are Oblivious ##br##To EM Risks Chart I-11Japanese Investors Are ##br##Chasing EM Momentum DM monetary policy and inflation dynamics also can play a key role. Carry trades have historically been a play on low volatility in capital markets. An environment of improving growth, low inflation surprises, and easy monetary policy has been key to support this low-volatility state. However, BCA believes that U.S. inflation is set to surprise to the upside, which will contribute to a tighter Federal Reserve. The European Central Bank will begin tapering its asset purchases and the Bank of Japan has ramped up its hawkishness despite the absence of inflation in Japan. This is likely to contribute to an increase in volatility that should prove especially harmful for carry trades in the FX space. This should tighten global liquidity conditions, especially in emerging markets. We will explore this angle in more detail in an upcoming report. Chart I-12EM/JPY Carry Informs EUR/USD In terms of investment implications, if EM carry trades were to break down in the near future, this would represent a major risk to the views espoused in the BCA Outlook and the investment recommendations associated with it. Most obviously, it would have an immediate negative impact on commodity currencies, since it would point to tightening liquidity and financial conditions in EM economies that will impact global industrial activity. The expensive AUD would be the currency most likely to suffer in this environment. The Scandinavian currencies would also suffer against the euro. Scandinavian economies have been highly levered to EM growth, and historically the SEK and the NOK have been greatly affected by EM spreads and commodity prices.1 The dovish bend of the Norges Bank and the Riksbank would only strengthen these negative impulses. EUR/USD would also likely suffer. As we argued two weeks ago, in the past 12 months, the euro has not behaved as a risk-off currency. In fact, quite the contrary, the euro has rallied alongside traditional EM plays, as the euro area has benefited from the positive economic impulse emanating from EM economies.2 Moreover, historically, EUR/USD has weakened when EM/JPY canaries have depreciated (Chart I-12). Finally, the yen would obviously enjoy such an unwinding of carry trades. We are currently negative the yen on U.S. bond yield dynamics. However, an underperformance of carry trades would prompt much short covering in the JPY as well as repatriation flows into Japan. If the EM canaries weaken further. We will be forced to change our stance on the JPY. Bottom Line: Investors are not positioned for any meaningful weakness in EM/JPY carries, and Japanese flows could move in reverse in a heartbeat. DM policy too is becoming a risk for these carry plays. China's tightening is thus coming at a terrible time for these carry trades. If canaries were to weaken, the AUD would bear the brunt of the pain among G10 currencies. The NOK and the SEK would also underperform a euro that would be falling against the USD. The yen would likely be able to rally in this environment. EUR/USD: Focus On The Western Shores Of The Atlantic Last week, data from Europe once again confirmed that growth in the euro area is stellar. Meanwhile, rate expectations declined in the U.S. as the Fed minutes displayed an FOMC increasingly concerned with the conundrum of a very tight labor market and weak inflation. EUR/USD rallied by 1%. But what really drove the rally in EUR/USD this year? It first and foremost reflected a massive repricing in relative rate expectations between the euro area and the U.S. However, most of this repricing was caused by a decline in the U.S. terminal rate, not an upward adjustment in the European policy end-point (Chart I-13). Chart I-13EUR/USD: All About Falling ##br##U.S. Terminal Rates Chart I-14Most Major Euro Area Economies Experienced##br## Little Inflationary Pressures In 2017 U.S terminal rates have fallen because the market doesn't believe the Fed's interest rate forecast, as core PCE has collapsed by nearly 45 basis points despite a U.S. economy at full employment. Meanwhile, long-term rate expectations in the euro area have remained flat because core inflation did not move much in the major euro area economies (Chart I-14). Going forward, the U.S. terminal rate is likely to move higher against that of the euro area. U.S. inflation is set to accelerate versus the euro area as financial conditions in Europe have tightened massively versus the U.S. since early 2016, a factor we have highlighted in the past.3 The strength in the U.S. economy is also considerable, and would argue that since the U.S. is more advanced in the business cycle than the euro area, this strength is more likely to generate inflationary pressures in the U.S. than in the euro area (Chart I-15). Moreover, U.S. tax cuts are looking increasingly likely in 2018, which will only add fuel to the U.S. fire. We continue to expect the Fed to follow its "dots," generating a policy outcome well in excess of what is currently priced into the OIS curve. If our base-case scenario for the Fed unfolds, for interest rate differentials to stay constant, the EONIA rate would need to be at 1% by the end of 2020 (Chart I-16). In our view, this is highly unlikely, and we expect rate differentials to move in favor of the USD. Chart I-15Europe Is Strong, ##br##But So Is The U.S. Chart I-16Fed Funds Rate Scenarios ECB Rates Will Have To ##br##Rise Much More To Match What The Fed Will Deliver An EONIA rate of 1% by the end of 2020 will not only defy what the ECB is currently forecasting, it will also be the highest rates since Trichet committed his infamous 2011 policy mistake of hiking rates. In order for European rates to be that high by that date, global growth will have to still be stellar. If this is the case, U.S. rates are likely to be even higher than what the Fed dots are currently implying. This means that based on our expectations for global growth, U.S. inflation and European inflation, the most likely path for rate differentials is that they widen in favor of the U.S. as the Fed still is in a better position to increase rates than the ECB. This expected widening in spreads between the U.S. and the euro area will favor a move in EUR/USD toward 1.10 by the middle of 2018. An adverse move in EM liquidity conditions only adds credence to these dynamics as it will affect European growth more than it will affect U.S. growth. Moreover, safe-haven flows associated with EM weakness would only add to global demand for the USD. Bottom Line: EUR/USD rallied in line with changes in relative terminal rates in 2018. However, this did not reflect an upgrade to the expected terminal rate in the euro area; it mostly reflected a downgrade to the U.S. terminal rate. We do anticipate this downgrade in the expected U.S. terminal rate to reverse course, especially when compared to the euro area. U.S. growth will accelerate further and U.S. inflation will outpace that of the euro area. In an environment where the Fed hikes in line with its "dots," the EONIA rate will not be able to follow, which will put downward pressure on EUR/USD. GBP/USD: Divorce-Bill Rally? This week, the U.K. agreed that its share of liabilities to the EU is around EUR100 billion, which would mean a net payment of around EUR50 billion. The GBP rallied massively in response to this news as markets interpreted this as a sign that negotiations on future trade relationships would start. The pound is very cheap on a PPP basis, and is likely to generate attractive returns on a long-term time horizon. However, Brexit is far from being over. Nagging questions regarding the Irish border remain, and the EU clearly has the upper hand in the negotiations. Moreover, Brexit would hurt both British trade and British potential growth. While abandoning Brexit down the road would help the GBP, this would happen around much political turmoil and result in a likely Corbyn government. When we compare all these positives and negatives, at the current juncture, it is highly unlikely that GBP/USD and EUR/GBP will escape their post-June 2016 trading range. In the short term, EUR/GBP is likely to hit 0.84, and cable, 1.37. We would use moves to such levels to sell the pound on a tactical basis. A move below the post Brexit lows is also highly unlikely as long as the stalemate continues. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Euro: Risk On Or Risk Off?", dated November 17, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Best Of Possible Worlds?", dated October 6, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was positive this week: Annualized GDP growth came in at 3.3%, above the expected 3.2%; The PCE price deflator grew at a 1.6% annual rate, above the expected 1.5%, while the core PCE deflator stayed in line with expectations at 1.4%; Initial jobless claims were lower than expected at 238,000; However, the dollar was only up against the CAD and the NZD, while down against all other G10 currencies as the nomination of Marvin Goodfriend as a member of the FOMC was interpreted as a potential dovish move by the markets. The U.S. 10-year yield was up 4 basis points on higher inflation expectations. U.S. growth is now beginning to outperform Germany's 3.2% annualized GDP growth which should help translate into higher inflation relative to the euro area next year, which will shift upside risk in the favor of the dollar. Report Links: The Xs And The Currency Market - November 24, 2017 It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: German CPI was strong, with the headline measure growing at 1.8%, and the harmonized index also at 1.8%; German retail sales contracted at an annual rate of 1.4%; The number of unemployed people in Germany declined by 18,000 yet the unemployment rate stayed flat at 5.6%; European unemployment decreased to 8.8% from 8.9%; Euro area inflation increased by less than expected at 1.5% on an annual basis. Despite this mixed data, the euro was up 0.6% against the dollar on Thursday. Certain European metrics such as Industrial Confidence are also at all-time highs, levels at which a reversal is increasingly likely. Robust U.S. growth and higher inflation could serve as an indicator that the tide is about to turn in the favor of the greenback as the Fed resumes its hiking cycle. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Nikkei Manufacturing PMI outperformed expectations, coming in at 53.8. Meanwhile, large retailers sales growth also outperformed expectations, coming at -0.7%. Nevertheless, this was a decline from last month's 1.9% expansion. Industrial production growth surprised to the downside, coming in at 5.9%. Finally housing starts also underperformed expectations, coming in at -4.8% and declining even more from last month's -2.9% reading. On Sunday, the BoJ unexpectedly shifted to a less dovish stance, as they hinted that their yield curve control program might be watered down next year. This change in rhetoric could limit the JPY's downside. In fact, the risk growing risk that EM carry trades could begin to crack down even raises the probability that a yen rally unfolds. In this environment trades like short AUD/JPY and short NZD/JPY would benefit greatly. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative Consumer credit underperformed expectations, coming in at 1.451 billion pounds, and declining from the previous month's number. Moreover, mortgage approvals also underperformed expectations, coming in at 64,575. This number was also decline from last month's reading. GBP/USD has appreciated by almost 1% this week, as the United Kingdom and the European Union seem to have agreed that the cost to the U.K. for leaving the EU will be 50 billion euro. Overall, it is unclear whether this breakthrough in the negotiations will be positive or negative for the pound, as many details are yet to be defined. We continue to be negative on cable on the short term, as we expect rate differentials to favor the U.S. over the U.K. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data for Australia was mixed: Private sector credit grew at a 5.3% annual pace, albeit slower than the previous 5.4% figure; Building permits increased sharply by 18.4% annually; Private capital expenditure grew in line with expectations at 1%; Chinese Manufacturing PMI was strong, coming in at 51.8 - stronger than the previous 51.6 and the expected 51.4; Stronger Chinese data buoyed the AUD, however, the Aussie is still weighed down by low wages and a dovish RBA stance. The recent outperformance of the yen versus high carry currencies could be foreshadowing a growth-negative event, especially as Chinese authorities are tightening policy. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday, the RBNZ announced that they will ease mortgage lending restrictions, as it expects policies by the new government to dampen the housing market. After January 1st, banks will be allowed to provide more low-deposit home loans to owner occupiers. Moreover the down payment required to obtain a mortgage will also decline. This announcement by the RBNZ goes in line with our view that the new populist government, will curb immigration, and thus curb pressures in the kiwi economy. Overall we remain bearish on the NZD against the U.S. dollar and against the yen, as we expect global growth to slow down momentarily by the end of the year, as China continues to tighten monetary policy. However, we remain bearish on AUD/NZD as the AUD would suffer more than the NZD in this environment. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was decent: Industrial product prices are growing at a 1% monthly pace, higher than the expected 0.5% pace; Raw materials Index increased by 3.8% in October, higher than the previous 0.2% contraction, pointing to higher inflation; The current account deficit grew to CAD -19.53 bn, better than the expected CAD -19.50 bn. However, the CAD has displayed some weakness recently following Governor Poloz's comments about financial stability within the economy. These fragilities mostly involve household debt and the housing market, which continue to be carefully monitored by the BoC. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Gross domestic Product growth outperformed expectations, coming in at 1.2%. This measure also increased form a growth rate of 0.5% the previous quarter. Moreover, the KOF leading indicator also surprised to the upside, coming in at 110.3. Industrial production yearly growth also continued to increase, coming in at 5.5% However real retail sales growth underperformed expectations substantially, contracting at a 3% pace, after a 0.5% growth in September. EUR/CHF has appreciated by nearly 0.8% this week. Overall we continue to believe that Swiss inflation is still too weak for the SNB to stop intervening in the franc. We will continue to monitor the Swiss economy and global economy for inflationary pressures, to get an idea when the SNB might shift its monetary stance. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover Norway's credit indicator also underperformed coming in at 5.7%. USD/NOK has rallied by roughly 2% this week, as the NOK has experienced a dramatic sell off across the board. This sell off has been caused by the decline in oil prices that we have experienced this week. This is partly because positioning in oil seems to be over stretched, thus a tactical correction in oil prices is expected. Overall, regardless of the outlook for oil prices, we continue to be bullish on USD/NOK, as this cross will mostly trade on rate differentials between Norway and the U.S. rather than on oil prices. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden was disappointing: Retail sales growth slowed to 0.1% monthly and 2.6% annually, compared to the expected 0.2% and 3.4% rates, respectively; The trade balance went into negative territory, coming in at SEK -3.1 bn, compared to the previous SEK 3.2 bn; Annual GDP growth in Q3 was only 2.9% compared to the expected 3.5%. The Q2 data point was also revised downwards from 4% to 2.7%. While quarterly growth was in line with expectations at 0.8%, it still weakened from the previous quarterly growth of 1.2% - which was also revised down from 1.7%. The Riksbank will take these data points into account in their next meeting in two weeks and is likely to stay dovish especially as Stefan Ingves has been re-appointed as governor, adding downward pressure on the krona against the dollar. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades