Market Returns

Dear client, This week, we are sending you an abbreviated version of our weekly bulletin as we are also publishing a piece written by our colleague Peter Berezin, Senior Vice President for our Global Investment Strategy service. This report, titled “U.S. Border Adjustment Tax: A Potential Monster Issue For 2017”, deals in great details with the Republican tax plans. In this report, Peter analyses the economic and financial market implications of the plan and concludes it is likely to be an additional support to the dollar bull market if it gets implemented in full, but not one without repercussions. I trust you will find this report very interesting and relevant. Best regards, Mathieu Savary Feature After continuing to sell off, the dollar regained some composure toward the end of the week. Not only did an elevated CPI print for December contribute to this rally, but so did Fed Chair Janet Yellen's comment that the U.S. economy was getting closer to the FOMC objectives and that the Fed was now closer to being capable of raising rates multiple times a year between now and 2019. Chart 1Froth Had Dissipated##br## From Treasury Yields Additionally, we had been expecting a correction in the dollar as we worried that U.S. bond yields would retrace some of their ascent. The pullback materialized and U.S. bond yields traded in line with our fair value estimate earlier this week (Chart 1). This meant that much of the froth in the dollar had dissipated. Based on these developments, is it time to buy the dollar again? On a cyclical basis, the dollar will make new highs in 12-18 months. However, short-term considerations remain complex. There are two President Trump out there: "Good Trump" and "Bad Trump". Good Trump is a president that talks about deregulation and tax cuts as well as various stimulus measures. This is the president that turbo charged the dollar after the election on hopes of a stronger U.S. economy. Bad Trump is the campaign Trump, the populist president that wants to revive protectionism and that promotes acrimonious international relations between the U.S. and the rest of the world, China in particular. The markets had expected Good Trump to be the first Trump to emerge, yet, the new president seems to have elected to present his Bad Trump profile first. In a way, this makes sense. Trump is focusing on the more economically painful parts of his program, campaign promises wanted by his electorate. This way, Good Trump can swoosh in and save the day by helping the economy closer to the mid-term election in late 2018, in the aim of solidifying the Republican control of Congress. With the 10-year yield back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is not pricing in any flare up of tensions with China, nor any deflationary shock that could emanate from such tensions (Chart 2). Investors were hoping that the talks of stimulus and deregulation would come first, instead they are getting a president that bullies corporations and build up tensions in Asia. The deflationary nature of the tension comes from the reality that while the Chinese economy has improved, China remains handicapped by a large debt load and a low demand for credit. It is ill equipped to handle foreign shocks. Moreover, the easing in Chinese monetary conditions will soon lose steam. Chinese monetary conditions eased because Chinese real rates fell from nearly 12% to -2% on the back of a powerful rebound in the Chinese producer prices (PPI) (Chart 3). This improvement in PPI was itself a byproduct of a rebound in commodity inflation. However, this rebound is soon behind us. Commodity prices troughed in Q1 2016, and have recently slowed their pace of ascent. This means that in the coming months, Chinese PPI will rollover as well and Chinese real borrowing costs will rise again (Chart 4). Chart 2All Must ##br##Go Well Chart 3Can Chinese Monetary ##br##Conditions Improve Further? Chart 4The Commodity Rebound Was A Key Factor##br## Behind The Chinese PPI Rebound This could prove problematic for China where loan demand remains very tepid, pointing to a potential down leg in Chinese industrial activity (Chart 5). This also raises the specter of renewed devaluation pressures on the Chinese yuan, as this would create another valve to alleviate deflationary pressures in the Chinese economy (Chart 6). Further RMB weakness would be welcomed neither by Trump, nor by the markets. Chart 5Chinese Loan Demand ##br##Remains Moribund Chart 6The RMB Is Another Relief Value For##br## Chinese Deflationary Pressures Taking all these factors into account, we remain warry of betting on a strong dollar against the euro and the yen in the coming weeks, at least not until bonds become cheap on our fair value gauge, reflecting these Chinese deflationary risks and a higher geopolitical risk premium. Chart 7EUR/GBP Is Misaligned##br## With Fundamentals Also, this means that we could see a dichotomy emerge between the narrow dollar (DXY) and the broad dollar. While lower bond yields are supportive of the euro and the yen, they do very little for EM and commodity currencies. In fact, EM and commodity currencies are highly leveraged to the Chinese economy and will be vulnerable to any flare up of tensions between China and the U.S., especially after currencies like the AUD and the CAD had already rallied 5% and 4% respectively since the last week of 2016. Thus, we would recommend investors favor risk-off currencies like the euro, the Swiss franc, and the yen at the expense of the AUD, NZD, CAD, and NOK. For the GBP, last week, we published an optimistic take on the British economy. We are looking to short EUR/GBP as rate differentials are still widely bearish of that cross (Chart 7). However, we warned that in anticipation of the actual triggering of article 50 of the Lisbon treaty, the GBP could come under duress. A risk-off event would only strengthen this case. Thus, we remain confident in our preferred strategy to short EUR/GBP once it hits 0.93. Bottom Line: The dollar correction is advanced but is now likely to become more differentiated. Tensions created by a protectionist and bellicose Trump are likely to push bonds into expensive territory. While the attending bond rally could support the euro, the Swiss franc, and the yen against the dollar, these same tensions are likely to support the dollar against EM and commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights House Republicans are pushing for a radical overhaul of the existing tax code, including adding a "border adjustment" mechanism that would effectively subsidize exports and tax imports. Despite President Trump's apparent mixed feelings about border taxation, we see a 50% chance that some version of the proposal will be implemented. This is a higher probability than the market currently is discounting. The trade-weighted dollar will rally by another 5% even in the absence of any tax changes, but could rise by 15% if the border adjustment tax is introduced. If the latter were to happen, it would take some time for the dollar to rise to its new equilibrium level. This, in conjunction with sticky import and export prices, would likely lead to a temporary narrowing of the U.S. trade deficit. Such an outcome could prompt the Fed to raise rates more aggressively than it otherwise would. Investors should underweight U.S. bonds on a currency-hedged basis. A stronger dollar will push down commodity prices and hurt external borrowers with dollar-denominated loans. A protectionist backlash against the U.S. might ensue. We are closing our long Chinese banks trade for a gain of 32%, and our long RUB/USD trade for a gain of 20%. Feature Making The Tax Code Great Again? Republicans in Congress are proposing an ambitious revamp of the tax code. A central element of their plan is the replacement of the existing corporate income tax with a so-called "destination-based cash flow tax." Key features of this plan include: Cutting the current federal corporate tax from a top rate of 35% to 20%. Allowing businesses to depreciate capital expenditures immediately, rather than writing them off over many years. Disallowing businesses from deducting interest expenses when calculating their tax bills. Moving to a system of territorial taxation, meaning that taxes would only be assessed on the value added of goods consumed in the United States. Since not all goods that are produced in the U.S. are consumed in the U.S., and not all goods that are consumed in the U.S. are produced in the U.S., a destination-based system requires what is known as a "border adjustment." Such an adjustment would tax the value added of imports and rebate the value added of exports at an equivalent rate. While border adjustments are routinely used in other settings - most notably by countries that have VATs - their application to corporate income taxes is a novel idea. As such, it is not surprising that the proposal has generated significant confusion among investors. With that in mind, we offer our thoughts on the matter using a Q&A format. Q: How exactly would a border adjustment on corporate income taxes work? A: Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred in the U.S.). Table 1 offers a simplified example to illustrate this point. Consider three types of companies: 1) A purely domestic producer whose revenues and costs are realized at home; 2) An exporter whose revenues are entirely derived from abroad but whose costs are all incurred in the U.S.; 3) An importer whose revenues are completely generated in the U.S. but whose costs are all incurred abroad. Suppose that all three companies have revenues of $100 and costs of $60 - implying $40 in pre-tax profits - and face a corporate tax rate of 20%. Before the border adjustment, each company would pay a tax of $8 ($40 times 0.2). The border adjustment is zero for the domestic producer. However, it would impose an additional tax of $12 on the importer ($60 times 0.2), while giving the exporter a rebate of $20 ($100 times 0.2). In the end, the importer and exporter face final tax bills of $20 and -$12, respectively, while the domestic producer continues to pay $8. Note that this conforms with the tax paid on domestic revenues minus domestic costs (for the domestic producer, domestic revenue minus domestic cost is equal to $40; for the exporter it is equal to -$60; and for the importer, it is equal to $100). Q: A tax on imports and a subsidy on exports? Sounds like massive protectionism! A: That depends on the extent to which the dollar appreciates. As Table 1 shows, if the dollar appreciates by 1/(1-tax rate) = 1/(1-0.2) = 25%, there would be no impact on the trade balance or on the distribution of after-tax corporate profits in the economy. This is because the stronger dollar would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits to their original level. Q: This seems like splitting hairs. If a country imposes a 20% tax on imports, most people would still regard this as a protectionist act, even if a currency appreciation offsets the impact. A: That's why a corresponding export subsidy is necessary. That may sound strange since export subsidies are also seen as protectionist measures, but consider the following: Imagine that the government only taxes imports. A tax on imports would curb import demand, implying less demand for foreign currency. This would push up the value of the dollar, leading to lower import prices. How high would the dollar go? Suppose it rose so much that the decline in import prices exactly offset the tariff, thereby restoring import volumes (and importer profits) back to their original level. Is that a stable equilibrium? The answer is no because a stronger dollar would also reduce the demand for U.S. exports, causing the trade deficit to swell. Thus, for the trade balance to remain unchanged, the dollar would have to rise only part of the way, leaving importers worse off than before the tariff was introduced. Such a policy would be protectionist because it would favor U.S.-based companies that produce for the domestic market over foreign exporters. Only in the case where importers are subject to a tax and exporters receive a subsidy will the dollar strengthen to the point that neither exports nor imports change. Intuitively, this is because an export subsidy indirectly benefits importers by pushing up the value of the dollar, while directly benefiting exporters by offsetting the effect of a stronger dollar on profits. Q: If there is no change in the trade balance, what is the advantage of border-adjusting the corporate income tax? A: Contrary to Donald Trump's assertion that border adjustments are "too complicated," their chief advantage is their simplicity. Accurately assessing taxes on worldwide income is hard. Companies routinely engage in practices that purposely lower taxable profits. In particular, importers may overstate the value of their imports and exporters may understate the value of their exports. In a world where many companies have overseas subsidiaries, such "transfer pricing" machinations are easy to pull off. Border adjustments eliminate such incentives in one fell swoop. Recall that with a border adjustment, taxes are assessed on the difference between domestic revenues and domestic costs - both of which the IRS has the means to monitor. Yes, a U.S. company that overstates imports will be able to report a lower gross profit to the IRS, but now it will be on the hook for a higher import tax. What it puts in one pocket it takes from the other. Likewise, an exporter that understates its overseas sales will end up with a lower gross profit, but will now receive a smaller subsidy. Q: And I suppose that because the U.S. imports more than it exports, the border adjustment will end up raising additional revenues? A: That is correct. The annual U.S. trade deficit currently stands at $500 billion. A border adjustment tax rate of 20% would thus raise $100 billion in additional revenue. Given that the corporate income tax brings in about $350 billion, this would allow corporate taxes to be substantially cut without any loss in overall revenue. And this calculation excludes any indirect revenue that would accrue to the Treasury from reducing the incentive for U.S. companies to engage in profit-shifting behavior. Keep in mind, however, that the revenue boost from the border adjustment will decline if the U.S. trade deficit narrows over time. To the extent that the U.S. must finance its trade deficit through the sale of assets such as stocks, bonds, and property, it is possible that foreigners will one day decide to swap all these assets in exchange for U.S. goods. This would lead to an improvement in the U.S. trade balance. Indeed, to the extent that the U.S. is a net debtor to the rest of the world, it is possible that the average future U.S. trade balance will be positive. If that were to happen, the government would lose revenue from the border adjustment over the long haul. Meanwhile, a 25% appreciation in the greenback would reduce the dollar value of the assets that Americans hold abroad, without much of a corresponding decline in U.S. external liabilities. A reasonable estimate is that this would impose a paper loss on the U.S. of about 13% of GDP.1 Q: Ouch! But this assumes that a 20% border adjustment tax will lead to a 25% appreciation in the dollar. That is a mighty big can opener your fellow economists are assuming! What's to say this actually happens? A: Good point. Less than 10% of the turnover in the global foreign exchange market is directly related to the cross-border trade in goods and services. The rest represents financial market transactions. There are many things that can influence the value of the dollar beside trade flows. For example, suppose the government introduces a border adjustment tax, but the Federal Reserve fails to raise rates sufficiently fast in response to rising inflation stemming from a narrowing trade deficit. In that case, U.S. real rates could actually decline, leading to a weaker dollar. Our sense is that this won't happen, but the point is that there is no automatic link between a border tax and the dollar. Much depends on how the Fed responds and the underlying economic conditions. And even if the Fed does hike rates to keep the economy from overheating, two important forces will limit the extent of any dollar appreciation: First, questions about the timing and magnitude of the border adjustment tax - including the possibility that such a measure could be reversed by a future Congress - are likely to lead to only a partial appreciation in the dollar. Second, other central banks - particularly in emerging markets - are liable to take steps to limit the dollar's ascent so as not to place too great a burden on borrowers with dollar-denominated debt. Q: So what happens to countries with hard currency pegs to the dollar? Borrowers with dollar-denominated loans will be spared, but won't these countries end up suffering due to a sharp loss of competitiveness against other economies that have more flexible currencies? A: Correct. It is damned if you do, damned if you don't. Assuming that countries with exchange rate pegs to the dollar are strong enough to fend off a speculative attack, they will still need to engineer an equivalent real depreciation of their currencies via a decline in their nominal wages relative to U.S. wages - what economists call an "internal devaluation." That could impose a deflationary impulse on those economies. Q: You're losing me. A: Think about an extreme case - one where all countries have currency pegs to the dollar. How would the economic adjustment to a U.S. border tax work then? The answer is that initially, a tax on U.S. imports, combined with a subsidy on U.S. exports, would lead to a smaller trade deficit. This would cause the U.S. economy to overheat, putting upward pressure on prices and wages. By definition, an improving trade balance in the U.S. implies a worsening trade balance in the rest of the world. This would sap demand in other countries, putting downward pressure on prices and wages abroad. The adjustment will be complete only after relative wages have shifted enough to restore the U.S. trade balance to its original level. The important point is that in a world where some countries have flexible exchange rates while others have fixed exchange rates or dirty floats, the economic adjustment to a U.S. border tax will come through some combination of a stronger nominal dollar, higher U.S. inflation, and lower inflation abroad. Q: Bullish for the dollar, but bearish for U.S. bonds, correct? A: Precisely. The degree to which bond yields adjust around the world depends on the extent to which nominal exchange rates and domestic prices are sticky. If exchange rates are slow to change, more of the adjustment has to occur through higher inflation in the U.S. and lower inflation everywhere else. But even if nominal exchange rates adjust quickly, sticky goods prices would still push up U.S. bond yields. To see this point, consider what would happen if the dollar appreciated by 25% in response to the introduction of a border adjustment tax, but neither import prices nor export prices (expressed in U.S. dollars) changed. If that were to happen, the profit margins of U.S. importers would tumble because they would now have to pay an import tax but would not benefit from lower import prices. Meanwhile, the margins of U.S. exporters would soar as export prices stayed firm and they received a subsidy from the government. The result would be less imports and more exports, and hence, an improved trade balance. This would raise U.S. aggregate demand and put upward pressure on inflation and Treasury yields. Considering that 97% of U.S. exports and 93% of U.S. imports are denominated in dollars, such an outcome is hardly far-fetched. The bottom line is that in the "real world," the introduction of a border adjustment tax would cause Treasurys to sell off and the dollar to rally. Q: What sort of numbers are we talking about? A: Assuming a 20% border tax is introduced, a reasonable guess is that the trade-weighted dollar would rise by 10% over a 12-month period above and beyond our current forecast of a 5% gain. This would imply 15% upside from current levels. The 10-year Treasury yield would probably rise to about 3%. Q: It still puzzles me how you can claim that bond yields will rise if the dollar strengthens. Wouldn't a stronger dollar normally lead to lower bond yields? A: Your premise is wrong. It is not the stronger dollar that leads to higher bond yields. It is a third factor - namely the improvement in the trade balance arising from the decision to tax imports and subsidize exports - that causes both the dollar and bond yields to rise. This is similar to what happens when the government loosens fiscal policy. Mind you, at some point the positive correlation between the dollar and bond yields could break down. If the dollar rises too much, emerging markets will crumble under the stress. This will trigger safe-haven flows into the Treasury market, leading to a stronger dollar and lower yields. Such an outcome is not our base case, but it cannot be dismissed. Q: Got it. Presuming that the global economy holds up, it sounds like a border tax would be great news for Boeing, but bad news for Walmart? A: Yes, but there are two important qualifications to consider. First, it is possible that the dollar overshoots its new long-term equilibrium level, so that the pain to Boeing from the appreciation of the greenback ends up outweighing the benefits from the export subsidy it receives. Second, given the potential economic and financial dislocations from the shift to a destination-based tax system, there is likely to be some delay between when the tax bill is signed into law and when it is implemented. And even once implementation begins, the adjustment in tax rates may be phased in only gradually. Since the dollar will rise in anticipation of all this, it is possible that exporters will actually suffer initially, while importers receive a temporary boost to profits. Nevertheless, we think that investors will see through the near-term hit to exporter margins and focus on the medium-term gains. As such, equity investors should maintain a preference for exporting companies over those that heavily rely on imports (Chart 1). Q: This assumes that the market has not fully priced in this outcome already. What are the chances that this border adjustment tax proposal actually sees the light of day? A: The border tax idea originated in the House of Representatives and has its strongest support there. There might be more opposition in the Senate, but this could be overcome if enough Democrats with protectionist leanings can be found. President Trump panned the idea in an interview with the Wall Street Journal earlier this week.2 He noted that "Anytime I hear about border adjustment, I don't love it... because usually it means we're going to get adjusted into a bad deal. That's what happens." Trump's comments suggest he may not fully understand how border adjustments work. This implies that he might be persuaded to go along with the idea if Republican legislators are able to reach a "great deal" on adjustments in his eyes, whatever that means. Subjectively, we would assign 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. This might entail excluding certain types of imports from a border tax if they are consumed disproportionately by the poor or represent an important input for U.S. manufacturing firms. Apparel and energy products would probably be on that list. It might also entail reducing the border adjustment tax to a lower level, say 10%, as Tom Barrack, head of Donald Trump's inaugural committee, has suggested. It is hard to know how much of this is already reflected in asset prices. The dollar fell after the WSJ article was published, but that may have had less to do with border adjustments and more to do with Trump's comment that he prefers a weaker dollar - an unprecedented statement for a U.S. president. Goldman Sachs' securities group has constructed two baskets using firm-level data, one comprised of "destination tax winners" and the other of "destination tax losers."3 The loser basket actually outperformed in the immediate aftermath of the election. While the relative performance of the winner basket has recovered more recently, it still remains below where it was last April (Chart 2). The limited reaction to the prospect of a border adjustment tax has been echoed in the fact that market expectations of the future volatility of the dollar has not changed much since the election, despite the possibility that the coming legislative debate could lead to wild swings in the greenback (Chart 3). Chart 3Dollar Volatility Has Not Escalated On balance, we conclude that investors are understating the likelihood of even a watered down border adjustment tax being introduced as part of a comprehensive tax reform program. This is broadly consistent with our client discussions, which have revealed that most investors - with a few notable exceptions - are only vaguely aware of the issue. Q: Won't the WTO rule against a border adjustment tax? That could explain why investors are discounting it. A: Yes, it probably will. The WTO permits border adjustments in the case of "indirect" taxes such VATs, but not in the case of direct taxes such as income or corporate profit taxes. Granted, the U.S. has brushed off WTO decisions in the past, such as when it ignored the trade body's ruling that U.S. laws restricting internet gambling contravened the General Agreement on Trade in Services. Considering that Donald Trump threatened to pull the U.S. out of the WTO during the election campaign, such an outcome cannot be easily dismissed. Nevertheless, given the magnitude of the border tax issue, even the Trump administration is likely to think twice about running afoul of WTO rules. Nevertheless, it might be possible to modify the border adjustment proposal to make it WTO-compliant. The distinction between direct and indirect taxes is one of those things self-styled experts like to pretend is important, but is not. It does not really matter whether a tax is levied on the sale of a good or service, or whether it is levied on income. In the end, someone has to pay the tax - be it a worker or a shareholder. The adoption by the U.S. of a border-adjusted destination tax would move the global economy in the direction of greater harmonization, not away from it. As noted at the outset, most other countries border adjust their value-added taxes. They do this so that their VATs mirror a consumption tax, as Table 2 illustrates with a simple example. Conceptually, a corporate cash flow tax coupled with a payroll tax functions in much the same way as a VAT (bottom part of Table 2). The U.S. already has both a corporate income and a payroll tax, so it is not that far away from having a VAT. All that is missing is a few tweaks to depreciation rules and the addition of the border adjustment. Yes, the dollar would strengthen if that were to happen, but this would put the greenback on par with other currencies. Chart 4 shows that the U.S. has run a trade deficit with the rest of the G7 since 1990, despite the fact that the dollar has traded on average 9% below its Purchasing Power Parity (PPP) over this period. One of the reasons this has occurred is that other G7 economies have a VAT, whereas the U.S. does not (Chart 5). This has kept the dollar weaker than it otherwise would have been. Chart 4The Dollar Was Cheap For A Reason Q: Okay, let's wrap this up. What are the main investment implications I should take away from this? A: Our main takeaway is that investors are underestimating the likelihood that the U.S. adopts a destination-based tax system. This suggests that the risks to the dollar are to the upside, as are the risks to U.S. Treasury yields. Global investors should underweight U.S. bonds on a currency-hedged basis. The implications for global equities are more nuanced. It may take some time for the dollar to adjust to the border tax. This, combined with the fact that import and export prices tend to be sticky in the short run, implies that the U.S. trade deficit will decline, boosting U.S. aggregate demand in the process. While that is potentially good news for U.S. corporate profits, the benefits will be curtailed by the fact that the U.S. economy is approaching full employment. This means that any further stimulus could simply result in higher real wages for workers without any offsetting increase in unit sales for U.S. companies. A shrinking U.S. trade deficit will diminish America's role as "the global consumer of last resort." This is problematic for export-dependent emerging markets. While a border adjustment may be justifiable on economic grounds, politically, it could be seen as the first volley in a global trade war. This could sour sentiment towards EM stocks. To make matters worse, a stronger dollar would harm emerging markets with high levels of dollar-denominated debt such as Turkey, Malaysia, and Chile, while also weighing on commodity prices. We recommend that investors underweight EM stocks relative to their DM counterparts. With these considerations in mind, we are closing our long Chinese banks trade for a gain of 32% and our long RUB/USD trade for a gain of 20%. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 U.S. external assets amount to 133% of GDP, while foreign liabilities stand at 175% of GDP. About 68% of U.S. external assets are denominated in foreign currency, compared with only 16% of external liabilities. Thus, the paper loss to the U.S. from a 25% appreciation in the dollar would be (175*0.16-133*0.68)*(1-1/1.25) = 12.5% of GDP. 2 Please see "Donald Trump Warns On House Republican Tax Plan," The Wall Street Journal, dated January 16, 2017, available at www.wsj.com. 3 The Bloomberg tickers for these baskets are GSCBDTW1 and GSCBDTL1. For more information, please see "US Daily: What Policy Changes Is The Equity Market Expecting?" Goldman Sachs Economic Research, dated January 11, 2017.

Highlights China's supply-side structural reforms will focus mainly on its coal and steel markets this year. In addition, environmental policies will become stricter in 2017, as Beijing puts more weight on environmental protection than economic development. As as result, supply growth will slow, particularly in steel markets, which will be good news for global steel producers and bad news for iron ore exporters in Australia and Brazil. While we are more bearish on iron ore than steel due to supply-side reforms and stricter environmental policies, we remain cautious getting short iron ore, given the Dalian Commodity Exchange's iron-ore futures are backwardated (prompt prices exceed deferred prices). This indicates buyers are willing to pay more for prompt delivery (e.g., next week) than they are for deferred delivery (e.g., next year). Energy: Overweight. The Saudi-Russia production deal will slow the rate of growth in supply relative to demand, which will tighten physical markets. This will cause inventories to draw, and the backwardation in crude to deepen. Our long Dec/17 vs. short Dec/18 WTI recommendation is up 700%. We are long at +$0.04/bbl, and will risk the spread going to -$0.05/bbl. We will take profits at $0.50/bbl. Base Metals: Neutral. Supply-side reforms, coupled with environmental restrictions will slow the growth of steel production in China this year, benefiting producers ex-China. Precious Metals: Neutral. Gold markets will become increasing volatile, with the Fed likely to keep any rate-hike decision on hold until it has greater clarity re the incoming Trump administration's fiscal policy intentions. Ags/Softs: Underweight. The USDA's most recent supply-demand balances continue to paint a bearish picture for grains, with global ending stocks expected to grow. Feature China will continue its supply-side structural reforms this year, focusing mainly on its coal and steel markets. China environmental policies will become stricter in 2017. This year will mark the first time the central government puts more weight on environmental protection over economic development in evaluating officials' performance since 1949, when the People's Republic of China was established. Supply growth will be slower than last year due to continuing reforms, and stricter environmental policies in the country. Among base metals and bulks, the steel and iron ore markets will be most affected. This will be good news for global steel producers and bad news for global iron ore producers. We are more bearish on iron ore than steel strategically, due to these supply-side reforms, stricter environmental policies, scrap steel substitution, and rising global iron ore supply. That said, we remain cautious getting short iron ore, given the Dalian Commodity Exchange's iron-ore futures are backwardated (prompt prices exceed deferred prices). This indicates buyers are willing to pay more for prompt delivery (e.g., next week) than they are for deferred delivery (e.g., next year). We are downgrading nickel from bullish to neutral, both tactically and strategically. We also are downgrading our tactically bullish stance on aluminum to neutral, as the Indonesian government on January 12 unexpectedly allowed exports of nickel ore and bauxite under certain conditions. China's Supply-Side Reforms In 2017 In 2016, steel prices rallied more than 90% from year-end 2015 levels, but Chinese crude steel and steel products production rose a mere 0.4% and 1.3% yoy, respectively. Back in 2009, when steel prices rose about 30% from November 2008 to August 2009, production grew 12.9% and 17.8% yoy for Chinese crude steel and the output of steel products, respectively (Chart 1). Chart 1China: A Slower Steel Production##br## Recovery Than In 2009 One reason for these disparate performances can be found in the massive production cuts made in China last year to crude steel capacity. In February 2016, China's central government announced that it planned to cut 100 to 150 million metric tons (mmt) of crude steel capacity over the five-year period of 2016-2020. While the country aimed to cut 45 mmt in 2016, the actual reduction accelerated in 2016H2 making the full year decrease much larger. According to the China Iron and Steel Association (CISA), 70 mmt of crude steel capacity was taken off line last year, equivalent to 6.2% of total crude steel production capacity in China. This explains, in part, the much slower crude steel production recovery last year when compared to the post-Global Financial Crisis (GFC) recovery in 2009. How much crude steel production capacity will China cut in 2017? Even though last year's 70 mmt capacity cut means about half of the five-year 100-150 mmt capacity-cut target was already achieved, the Chinese government does not show any sign of moderating its desire to see additional cuts. The Chinese Central Economic Work Conference (December 14-16, 2016) emphasized that 2017 will be a year to deepen supply-side structural reforms. Although the central government still has not finalized its 2017 target, we believe a further 40-50 mmt cut in 2017 is possible. For example, China's largest steel producing province - Hebei - has already announced its 2017 crude steel capacity reduction target, which will be 14.39 mmt, similar to its 2016 target of 14.22 mmt. We would note here that the actual cut for the Hebei province in 2016 was 16.24 mmt, much higher than the target, indicating officials will seek to err on the high side when it comes to taking production off line. In December 2016, the country launched a nationwide crackdown on production of so-called shoddy steel, also known as ditiaogang in Chinese - low-quality crude steel made from scrap metal, which is commonly used to produce substandard construction steel products. This material accounts for about 4% of Chinese crude steel output. Last week, the Chinese government ordered a full ban on "shoddy steel" production to be completed before June 30, 2017. This month, 12 inspection groups were sent to major shoddy steel producing provinces to oversee the implementation of the directive. In 2017, the Chinese government also plans to: rein in new steel production capacity; scrutinize new projects; push for more mergers; and generally tighten supervision in the steel sector. In early January, China's top economic planner - the National Development and Reform Commission (NDRC) - toughened its tiered electricity pricing to limit availabilities to outdated steel producers, and to advance its goal of capacity cuts. According to the NRDC website, the new measures raised the price paid by "outdated" steelmakers by 66.7% to 0.5 yuan per kWh, effective on Jan. 1, 2017. Outdated steelmakers, in the government's reckoning, are those scheduled to be phased out - for example, those shoddy steel producers - most of which are privately owned small- or medium- scale mills. Bottom Line: A further capacity cut will limit Chinese steel production growth in 2017. China's Environmental Policies In 2017 In 2016, the Chinese government increased the frequency at which it sent environmental inspection teams to major metal-producing provinces and cities, to ensure the smelters and refiners comply with state environmental rules. Factories that failed to meet environmental standards were ordered to permanently or temporarily shut down, depending on the severity of their violations. This year, with persistent and intensifying smog becoming a greater threat to the health of China's population, environmental policies will only get stricter, resulting in more frequent supply disruptions, especially in its steel industry. In addition to plant-specific environmental measures, in late 2016, China rolled out rules to evaluate the "green" efforts of local governments. For the first time since 1949, when the People's Republic of China was established, the central government indicated it would put more weight on environmental protection than on economic development, as measured by GDP, in evaluating local government officials' performance. This likely will reduce the local governments' incentive to support unqualified or unprofitable steel/aluminum production. Bottom Line: China's stricter environmental policies will cause more supply disruptions and increase production costs for the Chinese metal sector, especially the steel industry. Our Views On Iron Ore And Steel In 2017 We are strategically neutral on steel prices and bearish on iron ore prices. Supply-side reforms and stricter environmental policies in China likely will result in zero growth or even a small contraction in Chinese steel production, which may well support steel prices while reducing iron ore demand. This will be good news for global steel producers ex-China, and bad news for global iron ore producers. China is determined to cull all "shoddy steel" production by the end of June, which will make considerable volumes of scrap steel available to be used in good-quality steel production. Chinese steel producers are currently willing to replace iron ore with scrap steel in their steel production, given scrap steel prices are cheap versus iron ore and steel product prices (Chart 2). In addition, using scrap as an input to produce crude steel will save steel producers money on coking coal, the price of which has surged over the past year. Chinese steel demand growth may remain robust in 2017H1. Last year's stimulus still has not run out of steam, and this year's fiscal and monetary policy will stay accommodative.1 Raw-material costs in the form of iron ore, coking coal and oil soared versus levels seen last year, which means the production costs of steel now are much higher than last year. This will support steel prices (Chart 3). Chart 2More Scrap Steel Will Replace##br## Iron Ore In Steel Production Chart 3Cost Push Will Support ##br##Steel Prices Steel product inventories at the major cities in China are still low; producers' inventory holdings have declined to levels last seen in 2014, which also will be supportive of steel prices (Chart 4). China's iron ore inventories are high, while domestic iron ore production is recovering (Chart 5, panels 1 and 2). With slowing domestic steel production, Chinese iron ore import growth likely will be subdued this year (Chart 5, panel 3). Global iron ore supplies are increasing. The "Big Three" producers - Vale, Rio Tinto, and BHP - all plan to boost production in response to profitable iron ore prices this year. Indeed, this month, Vale started its first iron-ore shipments from the giant new S11D mine. Chart 4Low Inventory Supports Steel Prices As Well Chart 5Limited Chinese Iron Ore Import Growth In 2017 Bottom Line: The outlook for steel prices this year is brighter relative to iron ore in 2017, although, the backwardation in the Dalian Commodity Exchange's iron-ore futures suggests markets may be pricing in tighter iron-ore supply in the near term. We will explore this in future research. Downgrading Our Nickel And Aluminum Views We are downgrading nickel from bullish to neutral, both tactically and strategically. Chart 6Downgrading Nickel And Aluminum View In November, we expected the global nickel supply deficit to widen on rising stainless steel demand and falling nickel ore supply. One major reason we were bullish nickel was that there was no sign Indonesia's export ban - imposed in January 2014 - would be removed. With elevated global nickel output, surging Chinese nickel pig iron (NPI) imports, and rebounding Indonesian nickel ore exports, Chinese NPI production will recover in 2017, which will reduce the country's need for refined nickel imports (Chart 6). Our long Dec/17 LME nickel contract versus Dec/17 LME zinc contract was stopped out for a 5.1% loss this week. We are no longer bullish nickel versus zinc. We also are downgrading our tactically bullish stance on aluminum to neutral, after the Indonesian government unexpectedly allowed exports of nickel ore and bauxite under certain conditions earlier this month. We are removing our buy limit order to go long Mar/17 aluminum contracts if it falls to $1,640/MT from our shopping list. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "China Commodity Focus: How China's Monetary And Fiscal Policy Will Affect Metal Markets," dated January 12, 2017, available at ces.bcaresearch.com Grains/Softs Global Grain Stocks Set To Rise Overall: Despite some positive developments in the U.S. - where corn supplies are falling faster than demand - we remain underweight grains. This is largely because of the continued growth of production relative to consumption globally, which looks like it will lift global stocks by the end of the 2016-17 crop year in September. While we do expect a slight decrease in output this year, it is difficult to upgrade our view at this point (Table 1). Table 1World Grains Estimates - January 2017 Wheat: Worldwide, output growth in Argentina, Russia and the EU added 1.3mm tons of production to global supplies. In the U.S., ending stocks are projected to reach levels not seen since the late 1980s, according to the USDA. Global consumption, meanwhile, is projected to increase a mere 100k tons, according to the USDA, which will lift ending stocks 1.2mm tons by the end of the crop year to a record 253.3mm tons. Corn: U.S. production is expected to fall, which, along with higher usage in the ethanol market, will contribute to lower stocks. However, on a global basis, production is set to outstrip consumption resulting in higher ending stocks at the end of the crop year. Soybeans: Same story here: Production growth outstripping consumption, leaving ending stocks higher by close to 7% yoy, based on the USDA's estimates. Rice: In relative terms, the rice market has the most bullish fundamentals - global production and consumption are roughly balanced, leaving expected ending stocks slightly above last year's level. We continue to favor rice over the other grains (save wheat) for this reason. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017

Highlights Duration: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. Fed Balance Sheet: The Fed could start to reduce the size of its balance sheet as early as the end of this year, but more likely in 2018. In any case, allowing securities to run off its portfolio will not have much of an impact on long-dated Treasury yields. MBS: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Feature As we pointed out in our December 6 report, the bond selloff had proceeded too far, too fast, and was due for a pause. The 10-year Treasury yield then peaked at 2.6% on December 16 and has now fallen back to 2.4% as we go to press. It is of note that all of the reversal has come from the real component of yields while the compensation for expected inflation has remained firm (Chart 1). Chart 1Bear Market On Pause In our end-of-year "Themes For 2017" Special Report 1 we explained why we believe Treasury yields will level-off in the near term before heading higher throughout most of 2017. Now that we have entered this first "consolidation phase" it is time to consider what factors would cause us to reinstate a below-benchmark duration stance. But first, let us quickly recap our bearish 6-12 month outlook for Treasuries. The Cyclical Outlook For Treasury Yields Many of the headwinds that held back economic growth last year - including fiscal policy, inventory drawdowns and the impact of a distressed energy sector on capital spending - are poised to abate in 2017. With stronger growth and an already tight labor market, core inflation will continue to gradually rise toward the Fed's target. We expect trailing 12-month core PCE inflation will reach the Fed's 2% target near the end of 2017. Consequently, the cost of inflation protection embedded in bond yields will also converge with levels that are consistent with the Fed's target (Chart 2). We judge this level to be in the range of 2.4% to 2.5% for long-dated TIPS breakevens. With the 5-year/5-year forward TIPS breakeven rate at 2.13% and the 10-year TIPS breakeven rate at 2%, long-dated Treasury yields have approximately 30-50 bps of upside from the inflation component alone. Chart 2Breakevens Still Too Low Chart 3Real Yields Also Biased Higher We are less certain about how much higher real yields might move during the next 12 months. However, the downside in real yields is surely limited. Chart 3 shows that changes in the 10-year real yield and changes in our 12-month Fed Funds Discounter2 are almost always positively correlated. At present, the reading from our discounter is 46 bps, meaning the market is priced for about 2 more rate hikes during the next 12 months. Given our positive economic outlook, 2 or 3 rate hikes in 2017 sounds reasonable. Is Now The Time To Trim Duration? Barring any major economic setbacks we will consider three factors when making this decision: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation When we last shifted from a below-benchmark to a benchmark duration stance on December 6 the 10-year Treasury yield traded 14 bps above the fair value reading from our 2-factor Global PMI Model. At present, the 10-year yield is only 9 bps cheap on this model (Chart 4). In other words, valuation is essentially neutral. But since global PMI is likely to trend higher over the course of the year, we would be comfortable cutting duration at current valuation levels should the other two factors on our checklist fall into place. Factor 2: Uncertainty We've been talking a lot about uncertainty recently, mostly in reference to the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index exhibits a strong inverse correlation with Treasury yields over time and has shot higher during the past couple of months without a corresponding decrease in yields. When we consider the uncertainty index alongside Global PMI and bullish sentiment toward the U.S. dollar in our 3-factor model of Treasury yields, we find that the 10-year Treasury yield now appears 38 bps cheap (Chart 5). Chart 4Close To Fair Value... Chart 5...But Uncertainty Remains Elevated What is particularly odd is that the uncertainty index has diverged so sharply from measures of both consumer and small business confidence (Chart 6). This epic split can mean only one of two things: Chart 6Excessive Optimism Or A False Reading From The Uncertainty Index? Businesses and consumers are excessively optimistic in the face of an increasingly uncertain back-drop, or The uncertainty index is unable to distinguish between policy shocks with positive and negative economic implications We turn to history in an attempt to determine whether the warning from the uncertainty index should be heeded. Specifically, we searched for other one-month periods when there was a one standard deviation increase in the uncertainty index alongside increases in both consumer and small business confidence. Since 1991, ten months meet these criteria (Table 1). Table 1Periods Displaying One Standard Deviation Increase In Global Economic Policy##br## Uncertainty Index* And Increase In Both Consumer Sentiment Index** ##br##And Small Business Confidence Index*** (1991 To Present) First we note that Treasury yields declined in 7 out of the 10 flagged periods, but in many of those episodes the scale of the positive confidence shocks was not very large. The two months that appear most similar to the present situation are September 2008 and December 2013. Chart 7Investors Still Bearish The Fed announced the tapering of its asset purchases in December 2013 amidst signs of an improving economy. The hawkish Fed announcement and improving economic outlook sent yields higher on the month, while the uncertainty index spiked as a large number of Fed-related news stories hit the papers.4 One thing that makes December 2013 an imperfect comparable to the present day is that the uncertainty shock was relatively small compared to the confidence shocks. In September 2008 the confidence shocks were not as large as the uncertainty shock, much like today, and the 10-year Treasury yield managed a 2 bps increase. However, it is definitely unfair to draw a conclusion based on the extremely volatile price movements that were witnessed at the height of the financial crisis in September 2008. Based on the example of December 2013, we cannot decisively rule out the possibility that the uncertainty index is simply giving a false signal. However, if that is the case we would expect the uncertainty index to mean revert in relatively short order. Given the strong historical relationship between the uncertainty index and Treasury yields, we will wait for some mean reversion in the uncertainty index before shifting back to a below-benchmark duration stance. Factor 3: Sentiment & Positioning When we shifted from a below-benchmark to a benchmark duration stance measures of investor sentiment and positioning were at bearish extremes, sending a decisive signal that the bond market was oversold. As of today, some of these indicators have started to reverse course while others have not (Chart 7). Our BCA Bond Sentiment Indicator, a composite of a survey of bullish sentiment toward bonds and the 13-week rate of change in bond yields is no longer at an oversold extreme. However, net speculative positions in the 10-year Treasury futures contract have moved even further into "net short" territory. The J.P. Morgan client survey shows that investors remain below benchmark duration in aggregate, although active traders are no longer net short. Although some capitulation of shorts has already taken place, we will await some further normalization of positioning - particularly in net speculative futures - before reinitiating a below-benchmark duration stance. Bottom Line: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. The Fed's Balance Sheet & The Shortage Of Bills The minutes from December's FOMC meeting revealed that: Several participants noted circumstances that might warrant changes to the path for the federal funds rate could also have implications for the reinvestment of proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities Since then, three different FOMC members have also spoken about the size of the Fed's balance sheet. Philadelphia Fed President Patrick Harker said that the Fed should consider shrinking its balance sheet once the fed funds rate reaches 1%.5 Boston Fed President Eric Rosengren made the case for more immediate action6 and St. Louis Fed President James Bullard said the Fed should consider shrinking its balance sheet in 2017.7 Clearly, talk of unwinding the Fed's balance sheet is heating up. The Fed's only official stated position on this topic is that it will keep its balance sheet level until normalization of the fed funds rate is "well under way", a statement we have long interpreted to mean "until the fed funds rate is 1%, or perhaps even higher". As such, we would not expect any action on winding down the Fed's balance sheet until late this year at the earliest, and more likely in 2018. The Impact On Treasury Yields In any case, as we detailed in a report published in August 2015,8 we do not think that the Fed allowing its balance sheet to shrink will itself have much of an impact on Treasury yields. The reason relates to the way in which maturing Treasury securities are currently rolled over at auction and the persistent shortage of T-bills in the market. Chart 8Fed Runoff Will Increase##br## Issuance To Public ... At the moment, balances of matured Treasury securities are added to upcoming note/bond auctions as non-competitive bids. In other words, as Treasury securities mature the Fed buys an equal amount at upcoming Treasury auctions. If the Fed were to cease this reinvestment, that amount would need to be added to the competitive portion of the auctions and would greatly increase the gross issuance of Treasury debt to the public. For a sense of scale, we calculate that Treasury issuance to the public would need to increase by $426 bn in 2018 and $378 bn in 2019 if the Fed were to cease the reinvestment of its portfolio at the end of this year (Chart 8). We contend, however, that a significant portion of this extra financing requirement will be met through increased T-bill issuance and will therefore not impact long-dated Treasury yields. The Treasury department has had a stated goal of increasing T-bill issuance since May 2015 and bill supply as a percentage of total Treasury debt remains near a multi-decade low (Chart 9). Further, T-bills are still in high demand as evidenced by the fact that they are trading at a substantial premium to other money market instruments (Chart 10). This premium exists despite the fact that the Fed has been soaking up a lot of T-bill demand through its Overnight Reverse Repo facility (Chart 10, bottom panel). If the Fed were to phase this program out alongside a reduction in the size of its balance sheet - which is its current stated exit strategy - the shortage of T-bills would be exacerbated. Chart 9... But Mostly Through T-Bills Chart 10T-Bills In High Demand Of course there is a new regime about to enter the White House and the Treasury department, and also a lot of uncertainty about how large the deficit will be going forward. If the deficit is increased substantially then it would likely be necessary for the Treasury department to increase the size of both bill and coupon issuance in the years ahead. Bottom Line: It is necessary to consider both fiscal policy and the Fed's balance sheet together when forecasting Treasury issuance. Further, whatever the government's financing requirement, a considerable portion of it will be addressed through increased T-bill issuance in the years ahead. This will limit the impact on long-dated Treasury yields. A Quick Note On MBS Chart 11MBS Spreads Are Too Low Any unwind of the Fed's balance sheet will have a much greater impact on MBS spreads than on Treasury yields since it will add directly to the supply of MBS available to the public, which tends to correlate with MBS option-adjusted spreads (Chart 11). Of course, other factors such as the rate of prepayments will determine how quickly the Fed's MBS holdings run off and the state of the housing market will determine how much new mortgage origination takes place. We hope to explore these issues in more depth in the coming weeks. Of more immediate concern for MBS spreads though is the recent divergence between nominal spreads, rate volatility and the slope of the yield curve (Chart 11, bottom two panels). MBS spreads have not widened in recent weeks despite curve steepening and rising rate vol. MBS spreads are already low compared to investment alternatives and have upside in the near term, especially if the yield curve continues to steepen, as we expect it will. Looking further out, the eventual wind down of the Fed's balance sheet is another risk the MBS market will have to face. Bottom Line: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 207", dated December 20, 2016, available at usbs.bcaresearch.com 2 Our 12-month discounter measures the expected change in the fed funds rate during the next 12 months as discounted in the overnight index swap curve. 3 www.policyuncertainty.com 4 The uncertainty index is in part based on an algorithm that scans newspapers for coverage of policy-related economic uncertainty. 5 http://www.reuters.com/article/us-usa-fed-harker-idUSKBN14W1W4 6 http://www.cnbc.com/2017/01/09/reuters-america-interview-rosengren-urges-more-rate-hikes-slimmer-balance-sheet.html 7 http://www.businessinsider.com/lets-shrink-the-balance-sheet-bullard-says-2016-12 8 Please see U.S. Bond Strategy Weekly Report, "Currencies: The Tail Wagging The Dog", dated August 18, 2015, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy The elevated ratio of market cap-to-GDP discounts strong growth far into the future, suggesting that a market validation phase may be lurking. Capital markets-sensitive stocks have had a good run, but the six month outlook is more mixed than bullish. Lift the packaged food group to neutral following the price plunge, because expectations have undershot. Recent Changes S&P Packaged Foods Index - Lift to neutral, locking in a profit of 3%. Table 1 Feature Equities are approaching their first fundamental test since the post-election surge. Fourth quarter earnings season will soon begin in earnest, with the strong U.S. dollar threatening to temper forward guidance, based on its tight inverse correlation with future net earnings revisions (Chart 1). The post-election stock market valuation expansion has been sentiment-driven: our Equity Sentiment Composite is at a bullish extreme, powering the advance in multiples. That echoes the massive growth forecast upgrade on the back of expectations of a more business friendly, reflationary fiscal policy. The NFIB survey of small business optimism has soared to levels typically reserved for a V-shaped rebound exiting recession (Chart 1). Soaring growth expectations mean that a volatile, equity validation phase is inevitable. The timing is difficult to pinpoint, however, because momentum can be a powerful and seductive force. In other words, performance anxiety and fear of missing out are overwhelming cyclical warning flags. For instance, the total market capitalization (MC) of the U.S. stock market is more than 120% of (nominal) GDP, more than double the 2008 trough (Chart 2). MC as a share of GDP has only been higher during the TMT bubble in the late-1990s. Since the 2008 low, central bank balance sheet expansion and the accrual of earnings to the corporate sector rather than to laborers have powered this remarkable surge. Low interest rates have also incented investors to bid up MC using leverage. Margin debt is now at previous peaks relative to GDP (Chart 2). It is possible that a repeat of TMT period could be unfolding, but betting on a multi-standard deviation event is high risk and low reward, especially given already elevated margin debt, and more recently, rising debt-servicing costs. MC to GDP has averaged 75% over the last forty five years. Even if nominal GDP boomed at 8% per annum for the next five years, market cap would still be over 80% of GDP, or well above the average. It may be too optimistic to expect market cap to stay above average over the next five years even if economic growth booms, because strong growth would imply a shift from interest rate normalization to restrictive settings, and wages would take an ever increasing share of corporate profits, removing two key valuation supports. What is clear is that subsequent long-term returns from current levels of MC/GDP have been poor. Chart 3 inverts and advances MC/GDP by 10-years, and plots that with 10-year rolling equity returns: long-term return potential looks paltry. Admittedly, this valuation gauge does little to forecast short-term market moves, but over the next 3-6 months, our concern is that economic euphoria will prove to have overshot reality. Chart 1Too Many Bulls? Chart 2Investors Already Fully Committed Chart 3Paltry Long-Term Returns Ahead The steady decline in total bank loan growth to nil and slide in federal income tax receipts to zero growth is worrying. The latter is an excellent confirming indicator for overall employment and economic growth (Chart 2, bottom panel). The current message does not confirm the budding economic boom currently discounted by the stock market. Consequently, we recommend a capital preservation mindset and a focus on controlling risk, as opposed to chasing short-term momentum driven returns. Against this backdrop, this week we highlight an undervalued consumer-dependent area and revisit the red-hot financials sector. Where To Next For Capital Markets? Anything financials-related surged after the election. A short covering rally morphed into optimism that the sector's regulatory burden will be loosened, ultimately allowing companies to earn a higher return on equity, thereby warranting increased valuations. In response, we upgraded our overall financial sector view in November, boosting our exposure to the previously lagging asset management & custody bank (AMCB) group to overweight and the capital markets group to neutral. The surge in equities relative to bonds has provided a catalyst for these groups to outperform (Chart 4), and that has the potential to become a longer-term asset preference shift amidst Fed tightening. That dynamic bodes well for a continued re-rating of the AMCB index. Does the same hold true for the higher beta capital markets group? The jury is still out. Capital markets stocks have historically gotten off to a slow start during Fed tightening cycles. Table 2 shows the average relative 6-, 12- and 24-month returns once the Fed begins hiking interest rates. Capital market stocks have underperformed during the first six months, regaining that in the subsequent 6 months, before finally accelerating meaningfully in year two. Using this as a guide (and the most recent hike as the true start to a Fed tightening cycle) would suggest that the initial relative performance surge is vulnerable to a pullback in the first half of this year. Meanwhile, the bull case for capital markets includes more than just higher rates and a steeper yield curve. The share price jump suggests that industry profit outperformance looms (Chart 5). A similar relative performance surge in 2013 was accompanied by a massive earnings surge. Chart 4Good News For Capital Markets... Chart 5... But Already Discounted? Table 2Capital Markets & Fed Tightening Cycles Earnings outperformance requires a sustained increase in capital formation, but we are reluctant to extrapolate the recent improvement in market and economic sentiment to an actual increase in demand for capital just yet. Typically, a rise in the stock-to-bond (S/B) ratio foretells of an increase in animal spirits. A rise in the S/B ratio signals that deflationary risks are receding, and points to a re-acceleration in new stock issuance (Chart 4), a plus for fee generation. But companies have already been taking advantage of cheap financing to issue equity and debt to fund M&A and buybacks, reflecting the lack of organic growth opportunities in recent years. Incremental equity raises will require a validation of growth-sponsored capital needs, rather than more financial engineering. As a share of GDP, M&A has already reached levels that coincided with previous peaks in speculative activity (Chart 6). At best, a period like 1999 could occur, when M&A stayed at a high level for two years, helping profits and share prices to outperform. But that period was a massive speculative asset bubble, and positioning for a replay is fraught with risk. Chart 6Already Past The Peak? Chart 7Limited New Capital Formation We are more concerned that capital formation might not live up to what is quickly becoming embedded in share prices. Chart 7 shows that the yield curve already appears to be peaking, suggesting that economic expectations have hit a ceiling. Moreover, bank loan growth has dropped to nil over the past three months, led by the commercial & industrial credit category (Chart 7). The sharp decline in C&I loan demand implies that business funding requirements are diminishing. This is corroborated by the plunge in corporate bond issuance, which has occurred within the context of narrowing corporate bond spreads and increase in risk appetites, ideal conditions for companies to issue debt (Chart 7). All of this is consistent with the message from the corporate sector financing gap, which is signaling that companies are no longer spending in excess of their cash flow (Chart 7). The corporate sector is not in a financial position to embark on a major expansion phase. Our Corporate Health Monitor remains in deteriorating health territory, underscoring limited balance sheet capacity for growth. That is consistent with a rising corporate bond default rate and more subdued M&A activity (Chart 8). Directionally, M&A activity has a critical influence on swings in capital markets return on equity, given generous profit margins for this vertical (Chart 8). Chart 8Hard To Envision A Continued M&A Boom Chart 9Firms Are Not Positioning For Growth Even the capital markets industry itself is not yet putting its money to work in anticipation of an upturn in business activity. Staff level changes are pro-cyclical. Companies hire to meet increase demand on their resources and are quick to slash when revenue opportunities diminish. As such, capital markets employment provides a good confirming indicator for earnings momentum. Chart 9 shows that capital markets hiring has dried up, similar to loan demand. The implication is that the expected upturn in relative forward earnings momentum may not materialize in the short run. Perhaps lags will eventually close these gaps, but with valuations now more dear than at any time since the Great Financial Crisis (Chart 9), prudence warrants patience before adopting a more optimistic positioning. Bottom Line: The S&P AMCB index continues to represent a more attractive risk-adjusted exposure to the improvement in market and economic sentiment than the capital markets group, because a meaningful increase in capital formation is still not assured. Stay overweight the former, and neutral on the latter. Time To Nibble On Packaged Foods Packaged foods stocks have been through the grinder in the last few months. We have been underweight this group, because it had not corrected alongside the rest of the consumer products complex (Chart 10), while leading revenue metrics had softened and employment costs had increased. However, the sharp share price decline means that difficult conditions are now being discounted. Chart 11 shows that the relative forward P/E ratio is well under the long-term average. Sales growth expectations have cratered, reflecting the negative impact of food price deflation and the strong U.S. dollar on this export-dependent industry. Chart 10Food Stocks Have Spoiled Chart 11Expectations Have Undershot We doubt conditions will worsen, especially relative to depressed expectations. In fact, previous drags are stabilizing, on the margin. For instance, the consumer price index for food products has troughed on a growth rate basis, suggesting that the de-rating in sales expectations has run its course (Chart 11). On the downside, capacity utilization rates are still low as a consequence of the previous retrenchment in food spending and increase in capacity. Indeed, the food production footprint has expanded over the last several years, which has been a contributing factor to the rise in labor costs and constraints on profitability. The good news is that industry wage inflation has crested and utilization rates appear to have troughed. Importantly, the U.S. dollar is not undermining growth prospects as much as dire forecasts suggest. Real exports of food and beverage products have surged in recent months (Chart 12). On the flipside, imports have declined, suggesting less fierce foreign competition. Chart 12The Strong Dollar Is Not A Death Knell... Chart 13... Especially If It Keeps Costs Down Total food demand growth has improved, as measured by the combination of export growth and real domestic food spending (Chart 12). Even the food shipments-to-inventories ratio has edged back into positive territory, a plus for future selling price increases. In addition, a strong U.S. dollar should continue to keep a lid on raw food prices (Chart 13). Low input commodity costs have helped propel our profit margin proxy to new cyclical highs, heralding ongoing margin expansion. The latter demonstrates impressive operating discipline amidst a tough sales backdrop. More recently, sales growth at food and beverage stores has reaccelerated (Chart 13), suggesting that factories will get busier, providing additional support to profit margins and reversing sagging return on equity. If ROE stabilizes, then the valuation compression will end. Bottom Line: Lift the S&P packaged food index to neutral, locking in a 3% profit since our underweight call in September 2015. A further upgrade is possible if utilization rates begin to improve, heralding an increase in pricing power. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Special Report

Highlights Argentina's structural reform story keeps getting better and the bull market in the nation's assets has further to go. Further interest rate cuts means a cyclical economic recovery is in the making. The South American nation will continue to attract, and retain, global capital. Stay with the long ARS / short BRL trade. Dedicated EM and FM investors should remain overweight Argentine equities, and stay with the long Argentina / short Brazil relative equity trade. Sovereign credit traders should stay overweight Argentine credit within EM credit portfolios. In addition, go overweight Argentine local currency government bonds versus the EM benchmark. A new trade: go long 7-year Argentine local currency government bonds, currency unhedged. Feature After taking a pause over the past few months, Argentine share prices have once again begun to climb (Chart 1), and rightfully so. Yet another round of reforms and needed policy adjustments by the all-star cabinet of President Mauricio Macri have been rolled out. In fact, the sheer volume and frequency of orthodox policy measures deployed so far has been so extensive that not a week has gone by when seemingly yet another price control has been lifted or incentive-distorting subsidy scrapped. This is also a sign of how many distortions were in place to begin with, but clearly the government's reform momentum remains in high gear. Chart 1The Bull Market In Argentine Equities Has More To Go With positive long-term reform, however, comes short-term pain, as we highlighted back in September.1 Unsurprisingly, Argentina's recession has been deep and prolonged. This is about to change. A strong disinflationary momentum is starting emerge, and will re-animate growth in the months to come as interest rates drop significantly. Ultimately, what matters for investors is the outlook for the economy's return on capital, and signs point towards a potentially multi-year and sustainable economic expansion in the making. The re-rating process has further to go. Stay long/overweight Argentine assets, including equities, sovereign and local credit, and the Argentine peso versus the Brazilian real. Full-Out Structural Transformation Continues 2017 has been kicked off with a full reform swing in Argentina, as the Macri administration has implemented another round of orthodox measures. Among them: Capital Markets Liberalization. Capital controls have been eliminated. The 120-day holding period for repatriating capital has been abolished. In addition, the central bank has done away the maximum monthly amount of foreign exchange purchases. Energy Reform. A major agreement with oil companies and oil unions has been announced regarding the nation's massive Vaca Muerta shale oil and gas basin. Competitiveness will be boosted via lower labor costs as unions have agreed to more flexible contracts and to limit benefits. In addition, firms have pledged to invest US$5 billion in 2017. Also, export taxes on crude oil and derivatives have been removed, and oil price subsidies will continue to be reduced. Telecom Reform. For the first time since 2001, the government is no longer intervening to block price increases, even for regulated services where tariffs had not increased since 2001. In addition, regulations in the telecommunications sector will be loosened in a bid to increase competition, boost investment and modernize the nation's internet service. On top of these recent reforms, the government is already beginning to implement an ambitious infrastructure plan while currently drafting a long-term strategy - its so-called 2020 Production Plan. The plan boasts eight main pillars, among them: developing and deepening local capital markets to attract more foreign investment; lowering the cost of capital for firms; working towards much needed tax reforms to lower the incredibly high tax burden on corporations; improving labor legislation; fostering innovation; increasing competition; reducing red tape; and boosting infrastructure. This continued supply-side reform push, coupled with a big pullback in the role of the state in the economy to crowd in investment, is exactly what this capital-starved economy needs (Chart 2). Startlingly, even among low savings/investment South American economies, at 14% of GDP, Argentina's capex-to-GDP is the lowest in the region, with Brazil now in a close second-to-last place (Chart 3). As a capex-boom materializes in Argentina, the potential upside for return-on-capital of such a mismanaged and underinvested economy is enormous. Chart 2Argentina: More Investment, Less Government? Chart 3Structural Reforms Will Improve Argentina's Abysmal Investment Rate A clear advantage is that the nation boasts an overall well-educated population, at least by South American standards. The country's tertiary educational enrollment rate, a quantity measure, currently stands at 80% - a high level both in absolute terms and relative to South American peers (Chart 4). And when looking at standardized test scores, a quality measure, Argentina stands close to the middle of the pack relative to other emerging market (EM) and frontier market (FM) economies, but near the top versus its Latin American peers (Chart 5). Overall, a supply-side reform bonanza, agile and orthodox policymaking and a relatively educated population means Argentina's overall return on capital and languishing labor productivity growth could experience a similar surge to the one seen during the 1990s (Chart 6). Chart 4Argentina Versus South America: ##br##Educational Attainment Chart 6Labor Productivity Is Set To Improve,##br##Significantly Bottom Line: Argentina's structural outlook is extremely positive. A Dollar Deluge... In Argentina? Argentina has been known much more for repelling capital (i.e. capital flight) than attracting it. However, its ongoing structural transformation means that foreign capital will continue to make its way back in. Attracting sufficient foreign capital is key to finance the Macri administration's ambitious capex-led growth plan. Yet at 15% of GDP, Argentina's domestic savings rate is low, also reflected by its current account deficit (Chart 7). Will the nation be able to attract sufficient capital to finance its current account deficit of 2.8% of GDP, or US$16 billion dollars? We believe so. If an economy offers a high return on capital, as is likely in Argentina at present for the reasons mentioned above, it will attract more than enough capital to finance its current account deficit - possibly even more than it requires. So far, this appears to be the case in Argentina. For instance: Portfolio inflows have gone vertical over the past year, reaching an astounding annualized level of US$29.1 billion dollars, a 20-year high (Chart 8, top panel). Chart 7Argentina's Domestic Savings Rate Is Low Chart 8Capital Will Likely Continue ##br##To Flood Into Argentina Moreover, cross-border M&A deals, a robust leading indicator for net FDI capital inflows, have surged (Chart 8, bottom panel). Chart 9Argentine Banks Are Flush With Dollars The first phase of a tax amnesty scheme that ran from May to last December has been a massive success. Roughly US$100 billion dollars' worth of assets were repatriated and/or declared, which generated ARS 108 billion, or 1.3% of GDP worth of tax revenues. The second round ends this March, and there may be much more to come. The Federal Reserve has suggested that due to decades of crises, Argentineans along with former Soviet countries have hoarded an enormous amount of (most likely undeclared) U.S. dollars.2 The result of repatriated or undeclared dollar financial assets as well as a boom in agricultural exports receipts, which followed from a more competitive currency and the elimination of almost all export taxes a year ago, has caused foreign currency deposits at commercial banks to soar to US$24 billion, or 20% of total deposits (Chart 9). Chart 10Argentina: Falling Foreign Lending Rates, ##br##Despite Rising U.S. LIBOR As foreign currency loans can only be made to exporters with revenue streams in U.S. dollars, the government has recently loosened regulations so that banks can use the equivalent of half the amount they lend out to exporters, currently US$9 billion in total, to underwrite dollar-denominated Treasury bonds. This means that at least US$4.5 billion worth of U.S. dollar sovereign debt will be able to be bought by local banks, something not possible since 2001. This will provide an additional source of demand for Argentine dollar-denominated debt in the event of any major global financial stress. Lastly, such an ample supply of foreign currency is being reflected in local dollar interest rates, which have been plummeting at a time when U.S. LIBOR rates have been rising fast (Chart 10). This will provide a cushion of cheaper U.S. financing for Argentine exporters as U.S. interest rates continue to rise.3 Importantly, the reason the Argentine peso has been relatively weak in the face of large capital inflows is largely due to the sizable pent-up demand for foreign capital (hard currency assets), following the removal of capital controls in place for so many years. Thus, it was natural there would be some sort of capital flight by households and firms. In addition, corporates that had been previously unable to repatriate profits abroad did so. However, we believe these were one-off's. Going forward the currency should stabilize and/or likely strengthen as the nation's robust macro policy framework boosts the country's return-on-capital, attracting further global capital. Bottom Line: Only a year ago Argentina was locked out of international debt markets and starved for foreign currency. Now, in the face of rising global interest rates, it is flush with foreign currency, with more on the way. A Disinflationary Boom Is On Its Way While the recession in Argentina will likely last a bit longer, there are already signs of an economic recovery in the making. Mainly: Not only has inflation begun to drop in earnest, but importantly inflation expectations are plunging (Chart 11). This is an incredibly significant development as inflation expectations tend to be "adaptive", meaning that they are set based on past experience rather than through some rational, forward-looking thought process. Therefore, such a dramatic fall in inflation expectations appears to be marking the end of Argentina's most recent battle with hyperinflation. Hoping to avoid a major policy mistake on its way toward implementing an inflation-targeting framework, the central bank has been relatively cautious. However, further rate cuts are on their way, which should re-ignite the credit cycle and boost economic activity (Chart 12 and 13). Chart 11Has Hyperinflation Finally Come To An End? Chart 12Much Lower Interest Rates Should Help Support Growth Chart 13Argentina's Credit Cycle Is About To Turn Up For their part, wages in real (inflation-adjusted) terms will be slow to recover (Chart 14), as dislocations to the labor market caused by the Macri government's shock therapy will take time to work themselves out. This is bullish for corporate profit margins and return on capital. In turn, high potential profitability will incentivize local and international companies to ramp up their capital spending in Argentina. Notably, capital goods imports are already rising, a sign that investment is recovering (Chart 15, top panel). As Argentine firms faced foreign currency restrictions for years, an increase in imported capital is bound to go a long way toward boosting productivity. Chart 14Incomes Will Take Time To Recover From Shock Therapy Chart 15Early Signs Of A Recovery In Investment? In addition, rising apparent consumption of cement suggests that the collapse in construction activity is in late stages (Chart 15, bottom panel). Lastly, as to external accounts, chances are the pros and cons will mostly balance out (Chart 16). Chart 16External Accounts Will Not Be A Drag ##br##On Growth Argentina's agribusiness exports will be aided by a competitive currency, and the current investment boom taking place in the sector. However, the country's single largest trading partner, Brazil, which consumes 15% of all its exports and most of its manufactured exports, has so far failed to even recover. Thus, gains from commodities exports will be offset by weak exports to Brazil, which at least will help keep the trade and current account balances in check as import demand recovers. Bottom Line: Aided by structural tailwinds, a cyclical economic recovery is in the making. Politics And Fiscal Policy Exactly one year ago the key risks we highlighted to our bullish Argentine view centered around the ability of the Macri administration to navigate the turbulent waters of shock therapy successfully.4 Specifically, history has shown the failure of Argentine center-right leaders to effectively balance meaningful economic reform with labor relations. In addition, the Macri administration and its alliance – made up mainly of Macri’s Republican Proposal (PRO), the Civic Coalition ARI (CC), the Radical Civic Union (UCR) parties – did not have a majority in either house of Congress, making restoring fiscal discipline challenging, given the deep hole dug by the previous government. While closing the fiscal deficit of 5% of GDP has indeed proved quite difficult in the midst of a recession and full-out structural transformation of the economy, as we expected, Macri's team has brilliantly managed all other risks. Now, as growth is set to recover, the deficit will be lifted by higher tax revenues in real (inflation-adjusted) terms. Chart 17Can Macri Walk On Water? Importantly, with US$19 billion, or 3.1% of GDP, in external debt service due this year (principal and interest), fixed-income markets have been jittery over the 2017 debt financing plan. However, the latest news is once again incredibly bullish for Argentine assets. Just last week the administration unveiled its 2017 debt plan and it has already secured an 18-month repo line with international banks worth US$6 billion. The country also plans on borrowing another US$4 billion from multilateral agencies, and will tap global capital markets with US$10 billion worth of sovereign paper. The government is front-loading the debt issues and tapping global capital before U.S. President-elect Donald Trump takes office on January 20 to hedge against possible market turbulence. External debt service requirements will also drop off considerably after this year - making tapping debt markets now an equally prudent move. To be sure, this year's legislative elections, to be held in October, will be important to monitor, as the balance of power in Congress may speed up or slow down the government's ambitious reform agenda. At present, we do not expect any major change. As a result, Macri's reform efforts will likely continue, particularly if the economy continues to recover. Besides, Macri's team has already proved not only incredibly capable of negotiating with labor unions, but also with politicians of diverse stripes, as was the case during last December's tax reform. To conclude, we warned investors last January that Macri would not "walk on water" when it came to suddenly reining in the fiscal accounts and engineering economic shock therapy. To his and his administration's credit, however, a year on and it appears they have managed to tip-toe on razor-thin ice rather successfully and even maintain a high approval rating to boot (Chart 17). Bottom Line: Argentina's fiscal situation seems poised to improve considerably, which is very bullish for Argentine fixed-income assets. Investment Recommendations Chart 18Stay Overweight Argentine Sovereign ##br##Debt Versus The EM Credit Benchmark Stay long ARS / short BRL. The Argentine peso is not expensive and structural reforms and orthodox macroeconomic policies will likely attract more than enough FDI to fund the nation's balance of payments. And while FDI inflows have also been strong in Brazil, we believe these FDI inflows are set to decelerate,5 in contrast to accelerating inflows in Argentina. Sovereign credit traders should stay overweight Argentine credit within EM credit portfolios (Chart 18), as the growth recovery will greatly improve the nation's fiscal metrics. Fiscal revenues in real (inflation-adjusted) will grow helping contain the fiscal deficit, and the recovery in economic activity will bring down the public debt-to-GDP ratio which currently stands at 57% of GDP. In addition, now that capital controls have been completely lifted, local fixed-income instruments yielding a 1400-basis-point spread above duration-matched U.S. Treasurys are incredibly attractive. Overweight local currency government bonds as well. A new trade: go long 7-year Argentine local currency government bonds, currency unhedged, yielding 15%. Dedicated EM and FM investors should remain overweight Argentine equities via the local market or the more liquid ADR market versus their respective benchmarks, and stay with the long Argentina/short Brazil equity trade. The Argentine FM benchmark and local Merval index are energy heavy, with 20% and 33% of their total market cap, respectively, comprising of energy companies. As we believe energy plays will outperform other commodities plays, particularly industrial metals, Argentine equities will benefit.6 Meanwhile, bank stocks, which account for 38% and 15% of the FM and Merval markets, respectively, are poised to perform well. As there was no credit buildup, unlike in many EMs, the looming rise in non-performing loans (NPL) will not hit earnings much. Moreover, private commercial banks have shifted massively into government bonds since 2014. Public debt holdings have risen 4-fold since 2014, and banks will reap capital gains on these investments as local rates drop. As government bond holdings now stand at nearly 20% of commercial banks total assets, these earnings streams will compensate from a compression in net interest margins (NIM) as interest rates continue falling. As to valuations, although price-to-book values seem elevated, we believe that these valuations have been distorted by hyperinflation. The value of shareholder equity did not rise as much as stock prices and earnings rose with hyperinflation. Thus, we believe Argentine equities will continue to benefit from a genuine re-rating story, and valuations are much cheaper than may appear using conventional metrics. Santiago E. Gómez, Associate Vice President Santiagog@bcaresearch.com 1 Please refer to the Emerging Markets Strategy and Frontier Markets Strategy Special Report titled, "Argentina: Short-Term Pain, Long-Term Gain," dated September 7, 2016, available at fms.bcaresearch.com 2 Please see Judsun, Ruth (2012), "Crisis and Calm: Demand for U.S. Currency at Home and Abroad From the Fall of the Berlin Wall to 2011," International Finance Discussion Papers, no. 1058. Board of Governors of the Federal Reserve System November 2012. 3 Please refer to the Emerging Markets Strategy Weekly Report, titled "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available on at ems.bcaresarch.com 4 Please refer to the Emerging Markets Strategy Weekly Report, titled "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available on at ems.bcaresarch.com 5 Please refer to the Emerging Markets Strategy Special Report, titled "Brazil: The Honeymoon Is Over," dated August 3, 2016, available at ems.bcaresarch.com 6 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Got "Trumped," dated November 16, 2016, available at ems.bcaresarch.com

Special Report

"That as the only possible policy in our day for a conqueror to pursue is to leave the wealth of a territory in the complete possession of the individuals inhabiting that territory, it is a logical fallacy and an optical illusion in Europe to regard a nation as increasing its wealth when it increases its territory, because when a province or state is annexed, the population, who are the real and only owners of the wealth therein, are also annexed, and the conqueror gets nothing." 1 Norman Angell's "The Great Illusion" posited in the early 1910s that war would be futile for developed nations, especially given the rising importance of economic and financial ties. Nevertheless, the arms race from the late-1800s gained momentum and eventually led to the Great War, dealing a devastating blow to his arguments. The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. Not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc (Chart 1).2 The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service has shown to be a key investment theme.3 Chart 1U.S. Defense Spending Is More Than The Rest Of The World Combined While we are not arguing that WWIII will erupt in the coming years, the purpose of this Special Report is to identify the winning global equity sectors from the intensifying global arms race (Chart 2): global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the U.S. defense stocks are the only game in town, but undiscovered Chinese, and to a lesser extent Russian, defense stocks are intriguing as are Israeli defense and tech stocks (please refer to the Appendix below for ticker symbols). Chart 2Intensifying Global Arms Race Late 19th/Early 20th Century: Militarism, Globalization & Finance Back in the late-1800s, the ascendancy of Germany was challenging the hegemony of Britain, fueling a European-wide arms race. Smaller newly formed states were also on the hunt for the latest and greatest weaponry. During the Balkan Wars of 1912-13 airplanes were deployed in combat for the very first time, highlighting the importance of new technology. Behind this explosive European rearmament were a few large British companies (Vickers Sons & Maxim Ltd, Armstrong and Whitworth, and Coventry Ordnance Works). "By 1905, its capital of £7.4 million ranked Vickers sixth amongst British companies; Armstrong Whitworth, with 5.3 million pounds capital was eleventh".4 Basil Zaharoff, who acted as general representative for business abroad for Vickers,5 was reputedly one of the richest men in the world.6 Moreover, globalization was on the rise in the late 19th century, as evidenced by global imports as a percentage of GDP (Chart 3). Industrialization coupled with imperialism and the colonization of Asia and sub-Saharan Africa along with population growth and rising demand for commodities were key drivers behind the jump in 19th century globalization. Finally, all of this was made possible by cross-boarder finance. Trade finance and credit growth skyrocketed in the late-1800s and the rising interconnectedness of global financial centers was most evident in the 1907 stock market panic that originated in the U.S., but spread like wildfire to the rest of the world. Chart 3Twin Peaks Of Globalization? Chart 4Heeding The Early 1960s Parallel What About The 1960s? The idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis (Chart 4), bolstering demand once again for military contractors. The mutually assured destruction (MAD) doctrine of military strategy and national security policy declared overtly in the early-1960s by U.S. defense secretary Robert McNamara and the Space Race competition between the Cold War rivals also have striking similarities with today, as far as investment implications are concerned. Parallels With Today China's ascendency to a world power large enough to challenge the hegemony of the U.S. is a sea change.7 The rearmament of East Asia is reminiscent of late 19th and early 20th century Europe and involves Japan, Australia, South Korea, Vietnam and India. All of the Middle East, along with Turkey and Russia, are on a structural military spending spree. European NATO fringe states are also arming furiously (Chart 5), trying to thwart Russia's regional ambitions. In the U.S., despite the Budget Control Act of 2011 (sequestration), the CBO projects that defense spending will rise gradually from $586 billion in 2015 to $739 billion by 2026 (Chart 6). This is before any push for a fiscal spending thrust that both presidential candidates have proposed, which would include increased defense outlays. While as a percentage of GDP defense spending may drift sideways, in absolute terms it will likely rise, and thus boost demand for defense contractors. Chart 5Stealthy Rise In Defense Outlays Chart 6CBO Estimates New Defense Spending Highs Globalization has hit an apex recently (Chart 3).8 The world is still licking its wounds from the recent GFC, where U.S. financials stocks were so intertwined with their global peers that the crisis effectively brought down to its knees the global financial system and gave birth to unorthodox monetary policy that Central Banks are still currently deploying. Global Rearmament Beneficiaries If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global defense stocks as a structural bet will pay handsome dividends. The global push away from austerity and toward more fiscal spending should also support aggregate defense demand. Thus, there are high odds that global defense stocks are primed to deliver absolute positive returns, irrespective of where the broad global equity market drifts in the next five years. Similar to Vickers and Armstrong and Whitworth making impressive stock market strides early last century, global defense stocks should continue to be high flyers. The early-1960s U.S. aerospace & defense (A&D) stocks are the only close stock market parallel we have come across in our analysis (given data constraints) and comparing this index's available metrics of that era with today is in order. A big pushback to the U.S. Equity Strategy service's constructive view on the U.S. defense index (since the late-2015 inception) has been that the valuations of these stocks are already full, leaving no valuation cushion for any mishaps (Chart 7). True, defense stocks are on the expensive side, but not if they manage to grow into their valuations, as we expect. Relative performance was up over 100% in a span of four years in the 1960s (Chart 8), as U.S. aerospace & defense industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95% (Chart 8). A&D factories were humming, racing to fulfill orders as U.S. military expenditures were thriving (Chart 4). Chart 7Buy Global Defense Stocks Chart 8In The 1960s A&D Factories Were Humming... This demand surge translated into a jump in sector sales momentum (Chart 4), and given the industry's high operating leverage, earnings and book values soared. From trough to peak, sector EPS rose more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled (Chart 9). That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the global defense index (that is a pure play on global defense spending). For comparison consistency, we use U.S. A&D figures. Currently, U.S. A&D IP is contracting, with resource utilization running at 80%. U.S. A&D relative performance has risen a mere 30% since the Great Recession (Chart 10). Chart 9...Boosting The Allure Of ##br## A&D Stocks Chart 10If History At Least Rhymes, ##br## There Is Still Ample Upside... Likely, the advance is still in the early innings, and analysts have been very slow to upgrade their EPS estimates accentuating the apparent overvaluation. Importantly, 5-year forward relative EPS growth estimates are deep in negative territory which is very perplexing given the upward trajectory of industry demand (Chart 11). Given that we only have access to data for MSCI All-Country World aerospace & defense long-term EPS expectations the caveat is that some of the poor expectations and performance could be because of the waning aerospace delivery cycle. Unlike the deteriorating health of the broad corporate sector, profit margins are expanding and net debt-to-EBITDA is a comfortable 1.2x. Similarly, interest coverage ratio is near an all-time high of 8x (Chart 12), while the overall markets EBIT/interest expense ratio is half that. Chart 11...Especially ##br## Given Depressed Analysts' Expectations Chart 12Defense ##br## Wins Championships Global defense sector return on equity (ROE) is almost 30% and rising (Chart 13), whereas global non-financial corporate (NFC) ROE is hitting multi-year lows, with the U.S. NFC ROE plumbing all-time lows (Chart 14). Free cash flow is also growing briskly and the industry is making greenfield investments, with capex growing 9.5% year-over-year, the mirror image of the global NFC sector that is pruning capital outlays (middle and bottom panels, Chart 13). Chart 13Defense Flexing ##br## Its Muscles... Chart 14...Vs. The Atrophy In The U.S. ##br## Non-Financial Corporate Sector On the valuation front, modest overvaluation exists, as portrayed by the high relative price-to-cash flow and price-to-book multiples. However, the global defense stocks forward P/E ratio and EV/EBITDA multiple are on an even keel with the broad market (Chart 15), and if our thesis that a secular uptrend in defense-related demand looms proves accurate, then these stocks are not expensive, but on the contrary still represent a buying opportunity. Chart 15Mixed Signals On The Relative Valuation Front Chart 16Defense Is The Best Offense The Rise In Terrorism, Global Space Race And Cyber Security Threat The unfortunate structural increase in terrorist activity will also embolden governments around the world to step up defense spending (top panel, Chart 16).9 The latter tends to move in long cycles. U.S. defense industry revenues have already begun to outpace those of the overall S&P 500, and a prolonged upturn lies ahead, based on the message from the previous upcycle. From a cyclical perspective, the defense capital goods shipments-to-inventories ratio is outpacing the overall manufacturing sector (second panel. Chart 16), reinforcing the case for ongoing earnings outperformance. The same also holds true in Europe. Western European terrorist attacks have increased, heralding further relative gains for the euro area aerospace & defense index (bottom panel, Chart 16). Beyond the disastrous spike in terrorism, the global space race is also gaining traction, with China spearheading the charge. There is a good chance that China will attain geosynchronous orbit satellites (residing more than 20,000 miles above the earth), challenging U.S. space dominance. India's space aspirations are grand and it is slowly and stealthily rising up the ranks on the space race. Moreover, as more countries aim to have manned space missions, that translates into higher space budgets and thus firming demand for space-related expenditures (Chart 17). Chart 17Space, The Final Frontier Finally, the number of cyber-attacks is also on the rise globally. Defending against attacks is a challenge. Not only does the cyber space domain definition remain elusive, but tracking hackers down is also increasingly difficult given the vastest of the internet, lack of global uniform policing methods and physical country borders. Crudely put, it is a lot easier for a Chinese or Russian hacker to deal a blow, for example, to U.S. nuclear infrastructure rather than physically deliver an attack. All of this suggests that investment in anti-hacking and counter cyber-attack capabilities is necessary around the globe in order to thwart cyber-terrorism. Risks To Our View While there is conceivably a risk that China will abruptly halt its intense militarization and make a U turn in its long-term strategy of becoming a military superpower, we assign a very low probability to such a turn of events. The global push for more fiscal spending may not materialize, which would be a risk to our sanguine global defense spending view. As Paul Volcker and Peter Peterson recently opined in a NY Times article10 - offering a different view from the always-articulate Larry Summers - prudent and fiscally responsible spending is in order given the excessive debt-to-GDP ratio that is probing war-like levels (Chart 18). This excessive debt overhang is not only a U.S. phenomenon, but also a global one spanning both advanced and emerging economies. Chart 18Excessive Debt Is A Risk To Bullish View On Global Defense Stocks One final risk is that the world will enter a prolonged peace phase and global terrorism will get quashed, with conflicts dying down in the Middle East, Russia reining in its imperialistic ambitions and China ceasing to stir the waters in the South and East China Seas. We would also assign low odds to this optimistic "no conflict phase" scenario, but it would indeed be welcome. Investment Conclusion Factors are falling into place for a structural outperformance period in the global defense index. The early-1900s and early-1960s parallels, coupled with the trifecta of terrorism, space race and cyber security all point to upbeat demand for defense-related goods and services. Expressing this buoyant view can be done from a bottom up perspective. The Appendix below highlights all the companies in the global defense index we track from Datastream and the alternative one from Bloomberg. An investable proxy is the U.S. aerospace & defense index as the U.S. dominates global A&D indexes and aerospace outfits also sport significant defense corporate segments (please see the Appendix below for relevant tickers). There are also three fairly liquid ETFs mimicking the U.S. A&D index: ITA:US, PPA:US & XAR:US. Moreover, below are a few more speculative investment ideas. Given China's dominance of global defense spending (ex-U.S.) we are confident that Chinese A&D stocks will also be eagerly sought after and deliver alpha in the coming years (please refer to the Appendix below for a list of China plays). If one has the resilience and the stomach to invest in Russian equities given high political and currency risk, then Russian A&D stocks may be a desirable vehicle. Russia remains a massive weapons exporter with a large sphere of influence. We would not underestimate the returns in local currency of some Russian A&D stocks (the Appendix below lists some Russian A&D listed firms). Finally, Israel A&D and IT companies either listed on NASDAQ or domestically in Tel Aviv offer some great opportunities for investors that can handle riskier investments. Not only Israel's geography, but also its intense IT/military focus and entrepreneurial culture imply that a number of these companies will be long-term winners (please see the Appendix below for relevant tickers). While most of the drones, space-related, and highly specialized IT companies are private, there is a drone and an anti-hacking ETF (IFLY:US & HACK:US). On the space front, we are tracking an index that comprises a number of space-related constituents that we show in the Appendix below. Nevertheless, most of these companies are categorized under A&D. Bottom Line: We are initiating a structural overweight in the global defense index with a longer-than-usual five year secular investment horizon. The re-rating phase in this index is still in the early innings. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com Appendix Table A1BI Global Defense Primes Competitive Peers Table A2World Defense Index (DS: DEFENWD) Table A3S&P 500 Aerospace & Defense Index ##br## (S5AERO Index) Table A4China ##br## Aerospace & Defense Table A5Russia & Israel Aerospace & Defense Table A6Kensho Space Index 1 Angell, Norman (1911), The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, (3 ed.), New York and London: G.P. Putnam's & Sons. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com 3 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com 4 Angell, Warren, Kenneth (1989), Armstrongs of Elswick: Growth In Engineering And Armaments To The Merger with Vickers, London, The Macmillan Press Ltd. 5 http://www.oxforddnb.com/index/38/101038270/ 6 https://www.britannica.com/biography/Basil-Zaharoff 7 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com 8 Please see BCA Geopolitical Strategy, "The Apex Of Globalization - All Downhill From Here," in Monthly Report, "Winter Is Coming," dated November 12, 2014, available at gps.bcaresearch.com 9 Please see BCA Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gps.bcaresearch.com 10 http://www.nytimes.com/2016/10/22/opinion/ignoring-the-debt-problem.html?_r=0

Highlights Chart 1Upside Risks & Uncertainty The evidence of economic acceleration continues to pile up and we maintain our view that bond yields will be higher than current forwards by the end of 2017. In the near-term, however, the bond market has been too quick to discount a more positive growth outlook, especially considering still-elevated levels of economic policy uncertainty. Our cautious optimism is echoed by the readings from our global PMI models and also by the Fed. The minutes from December's FOMC meeting revealed that more participants saw upside risks to growth and inflation than saw downside risks, but also that this improved economic forecast was judged to be more uncertain than any Fed forecast since 2013 (Chart 1). We remain bond bears on a 12-month horizon, but advocate a benchmark duration stance in the near term. A period of flat bond yields is the most likely outcome until elevated uncertainty levels revert to a more normal range (see the global economic policy uncertainty index). Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 82 basis points in December and by 478 basis points in 2016. The index option-adjusted spread tightened 6 bps on the month and 42 bps on the year. At 122 bps, the spread is currently well below its historical average (134 bps). Corporate spreads have tightened substantially since last February despite elevated gross leverage (Chart 2).1 As we pointed out in our end-of-year Special Report titled "Seven Fixed Income Themes For 2017",2 it is very rare for spreads to tighten when leverage is in an uptrend. While a rebound in profit growth will likely cause the uptrend in leverage to abate this year, spreads have already moved to discount a significant reversal. Although valuations are by no means attractive, accelerating economic growth and still-accommodative Fed policy will keep spreads at tight levels during the first half of this year. This sweet spot will persist at least until TIPS breakeven inflation rates return to pre-crisis levels, which would likely presage a hawkish shift in Fed policy. Energy sector debt returned 12.5% in excess of duration-equivalent Treasuries in 2016, compared to excess returns of under 5% for the overall corporate index. Despite this large outperformance, energy credits still appear attractive according to our model (Table 3), and should continue to outperform into the New Year. Table 3ACorporate Sector Relative Valuation##br## And Recommended Allocation* Table 3BCorporate Sector##br## Risk Vs. Reward* High-Yield: Underweight Chart 3High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 188 basis points in December and by 1539 basis points in 2016. The index option-adjusted spread narrowed 46 bps on the month and 251 bps on the year. At 383 bps, it is currently 137 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default backdrop, we are actively looking to upgrade our allocation to high-yield debt. However, valuations do not present a sufficiently compelling opportunity at the moment. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is below 150 bps (Chart 3). This is close to one standard deviation below the long-run average. Historically, we have found that a default-adjusted spread between 100 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of close to zero. With the spread in this range, a 90% confidence interval would place 12-month excess returns between -3% and +4%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in December, but underperformed by 11 bps in 2016. The conventional 30-year MBS yield rose 5 bps in December, completely driven by a 5 bps increase in the rate component. The compensation for prepayment risk (option cost) and option-adjusted spread were both flat on the month. In 2016, the conventional 30-year MBS yield rose 6 bps. This was driven by a 12 bps increase in the rate component that was partially offset by a 9 bps decline in the option-adjusted spread. The option cost increased 3 bps on the year. Our underweight in MBS is predicated upon very low option-adjusted spreads, relative both to history and other comparable spread product (Chart 4). Historically, the option-adjusted spread is correlated with net MBS issuance and eventually we expect rising net issuance to lead the option-adjusted spread wider. Importantly, purchase applications have remained firm in the face of higher mortgage rates even though refinancings have collapsed (bottom panel). Another tail risk for the MBS market is the possibility that the Fed ceases the reinvestment of its mortgage portfolio. While we do not expect this to occur in 2017, with two rate hikes now in the bank the fed funds rate is approaching levels where the Fed might begin to consider it. A new Fed Chair in early 2018 might also be more inclined to wind down the balance sheet. Government Related: Overweight Chart 5Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 27 basis points in December. Foreign Agency and Sovereign bonds outperformed by 84 bps and 83 bps respectively, while Local Authorities outperformed by 22 bps. Domestic Agency bonds and Supranationals were a drag on performance during the month, underperforming the Treasury benchmark by 10 bps and 7 bps respectively. The government-related index outperformed the duration-equivalent Treasury benchmark by 150 bps in 2016. The best performing sub-sectors for the year were Sovereigns (outperformed by 322 bps), Local Authorities (outperformed by 286 bps) and Foreign Agencies (outperformed by 258 bps). Domestic Agency bonds outperformed Treasuries by 38 bps, while Supranationals underperformed by 11 bps. Foreign Agency bonds and Local Authority bonds continue to appear attractive relative to U.S. corporate credit, after adjusting for credit rating and duration. We recommend focusing our government related allocation in these two sectors. In contrast, Sovereigns and Supranationals both appear expensive relative to U.S. corporate credit, and we recommend avoiding these sectors. Spreads on Domestic Agency debt have room to tighten in the near-term (Chart 5). Spreads widened to the top of their recent range last month on rumors that the new government could seek to speed up the process of GSE reform. We view these concerns as premature. This week we also remove our recommendation to favor callable agencies over bullets. Bullets have tended to outperform when the 2/5 Treasury slope steepens (bottom panel). We expect the 2/5 curve to be biased steeper in the first half of this year. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 134 basis points in December, but underperformed the index by 103 basis points in 2016 (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 8% in December, but increased 13% during 2016. At present the average M/T ratio is 98%, only slightly below its post-crisis average (Chart 6). Although M/T ratios moved higher last year, trends in issuance and fund flows suggest they are still too low. As we noted in our year-end Special Report,4 our tactical model of the M/T yield ratio - based on issuance, fund flows, ratings changes and economic policy uncertainty - pegs current fair value for the average M/T yield ratio at 112%. Further, as was also highlighted in our year-end report, the municipal credit cycle is likely to take a turn for the worse in late 2017, with muni downgrades starting to outpace upgrades. This analysis is based on indicators of state & local government budget health that tend to follow our indicators of corporate sector health with a two year lag. Just last month Moody's downgraded $1.6 billion worth of the City of Dallas' general obligation debt from Aa3 to A1. The downgrade was justified based on the city's poorly funded public safety pension plan. Attention will increasingly turn to underfunded public pensions when state & local government budget health starts to deteriorate later this year. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher and flattened in December. The 2/10 slope flattened by 1 basis point on the month and the 5/30 slope flattened 6 bps. For 2016 as a whole, the Treasury curve bear-steepened out to the 10-year maturity. The 2/10 slope steepened 4 bps and the 5/30 slope flattened 12 bps. In our year-end Special Report,5 we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen in the first half of 2017. This steepening will be driven by continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. A steepening curve environment will cause bullet trades to outperform barbells. On top of that, the 5-year bullet is currently extremely cheap on the curve (Chart 7). For these reasons we recommended entering a long 5-year bullet, short 2/10 barbell trade on December 20. This trade has already returned 8 bps since initiation, even though the 2/10 slope has flattened 10 bps during this period. A resumption of curve steepening will cause our long 5-year bullet, short 2/10 barbell trade to perform even better in the months ahead. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in December, and by 331 bps in 2016. The 10-year TIPS breakeven rate increased by 1 bp in December and by 41 bps in 2016. At present it sits at 1.96%, still well below the 2.4% to 2.5% range that is consistent with the Fed's 2% inflation target. As we explained in our year-end Special Report,6 the Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly back away from a hawkish policy stance should breakevens fall. But while breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. It is difficult for the Fed to drive long-dated inflation expectations higher while it is in the midst of a tightening cycle. For this reason, trends in actual inflation will be a more important determinant of TIPS breakevens than in the past. And while there are indications that the uptrend in realized inflation will persist, notably recent accelerations in wage growth and survey measures of prices paid (Chart 8). There is currently no indication that core and trimmed mean inflation are breaking out to the upside (bottom panel). We remain overweight TIPS relative to nominal Treasuries on the expectation that long-dated breakevens reach the 2.4% to 2.5% range in the second half of 2017, and that core PCE inflation reaches the Fed's 2% target by the end of the year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 17 basis points in December but outperformed the Treasury benchmark by 94 bps in 2016. Aaa-rated ABS underperformed Treasuries by 21 bps in December but outperformed by 75 bps in 2016, while non-Aaa ABS outperformed the benchmark by 13 bps in December and by 257 bps in 2016. The index option-adjusted spread for Aaa-rated ABS widened by 11 bps in December, but tightened by 10 bps in 2016. Further, the spread differential between Aaa-rated auto ABS and Aaa-rated credit card ABS narrowed substantially in 2016. The option-adjusted spread for Aaa-rated auto loan ABS has tightened by 20 bps since the end of 2015, while the option-adjusted spread for Aaa-rated credit card ABS has tightened by 10 bps. We have previously noted that, after adjusting for spread volatility, Aaa-rated auto loan ABS no longer offer an attractive opportunity relative to Aaa-rated credit cards (Chart 9). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, given the low spread differential and divergences in collateral credit quality (bottom panel). As was noted in the Appendix to our year-end Special Report,7 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except for Baa-rated corporates and Caa-rated high-yield in 2016. With spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. Non-Agency CMBS: Underweight Agency CMBS: Overweight Chart 10CMBS Market Overview Agency CMBS underperformed the duration-equivalent Treasury index by 40 basis points in December, but outperformed by 117 bps in 2016. The index option-adjusted spread for Agency CMBS widened 10 bps in December but tightened 6 bps in 2016. Agency CMBS still offer 50 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (51 bps) and greater than what is offered by conventional 30-year MBS (26 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in December, but outperformed by 313 bps in 2016. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps in December but tightened 48 bps in 2016. It has recently moved well below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Treasury Valuation Chart 11Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.31% (Chart 11). Our 3-factor version of the model, which also incorporates the global economic policy uncertainty index, places fair value at 2.02%. The lower fair value is the result of a large spike in the global economic policy uncertainty index in November that barely reversed in December (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. However, unusually high uncertainty is one reason we are reluctant to adopt a below benchmark duration stance for the time being even though we expect yields to be higher in 12 months. At the time of publication the 10-year Treasury yield was 2.37% For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). With the MCI having just reached this estimate of equilibrium, the shaded region in Chart 13 shows the expected path of the federal funds rate assuming that the MCI remains at its equilibrium level. The upper-end of the shaded region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the shaded region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios As can be seen in Chart 13, both the market and Fed are discounting a move in the MCI above its equilibrium level. This would be consistent with behavior witnessed in past cycles when the MCI broke above its equilibrium level several years before the next recession. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights The economy is near full employment, but betting on significant inflation is premature. Market-based inflation expectations have risen substantially in recent weeks but these moves are not corroborated by survey measures of inflation expectations. Consumer inflation expectations are very well anchored due to ongoing deflation in many frequently purchased goods and services. We are on high alert for a near-term equity pullback, with Chinese liquidity tightening as a potential catalyst. Feature Chart 1Market-Based Inflation ##br##Expectations Breaking Out After years of focusing on deflation, the possibility of inflation has made a comeback on investors' radars. The shift makes sense, given that the labor market is now operating near full employment. The December payroll report showed that payrolls increased by 156,000, slightly lower than the 3-month average of 165,000. But, average hourly earnings increased by 0.4%, suggesting that slightly weaker employment growth is not due to sluggish demand, and reflects a smaller available pool of workers. However, as we explain below, the potential for a major inflation surge is low in 2017 and is premature as an investment theme. We are on high alert for a near-term pullback to the equity bull market, given that valuation and sentiment are stretched. But as we outline, the threat to the equity market is less likely to be domestic inflation than an external event, such as the fallout from tightening liquidity in China (similar to what occurred in mid-2015 and early 2016). In the past few weeks, one-year inflation expectations have moved to their highest level since mid-2014, when oil prices were above $110/bbl. Long-run inflation expectations have also spiked since the U.S. election (Chart 1). The extent to which this trend is judged sustainable, and provides an accurate forecast for general inflation, has important investment implications. Our view is that, although TIPS could move a bit higher, the market move should not be interpreted as a harbinger for a broad-based inflation acceleration. Policymakers consider a range of inflation expectations measures, but in recent years, market-based measures have garnered a lot of attention. The 5-year/5-year forward TIPS breakeven rate in particular is often viewed as the market's assessment of whether the Fed can successfully achieve its inflation target. According to the Minutes of the December FOMC meeting, the recent rise in market-based inflation expectations was discussed at length. On this basis, the rise in TIPS is important as it could have a significant role in setting monetary policy. Beyond that, we have argued for some time that a major challenge for firms this cycle will be to raise selling prices, i.e. a lack of pricing power will restrain profit margins and, ultimately, earnings growth. If the recent pick-up in market-based inflation expectations heralds a more robust rise in actual inflation, then profits could positively surprise this year. The Rise In TIPS Is Partially Energy-Driven... Since 2010, there has been a strong correlation between oil prices and TIPS (Chart 2). The correlation has somewhat confounded policymakers.1 In theory, any oil price shock, even if it is considered to be permanent, should not exert any lasting impact on long-dated forward measures of inflation expectations. The reason is that as long as the Fed is committed to its 2% inflation target, then the market should expect that monetary policy will prevent a one-time shock to oil prices from having any permanent effect on the overall inflation rate. This is why, in theory, the 5-year/5-year forward TIPS breakeven rate is a good indicator for policymakers. Chart 2Oil Prices And Breakevens As our fixed income team explained in a report last year,2 the main reason for the tight correlation between TIPS and oil prices stems from the market perception that monetary policy has been constrained. Prior to the financial crisis, oil prices rose from below $40 in 2003 to $140 in 2008. During that time, long-dated breakevens remained stable. One possible explanation for this lack of correlation is that the Fed tightened policy during this period, offsetting the inflationary impact from higher oil prices. But in 2015-2016, when oil prices fell from above $100 to below $40, breakevens plunged alongside. If the market perceives monetary policy to be constrained by the zero lower bound, then it could be the case that the cost of inflation compensation is highly sensitive to falling oil prices because the market perceives that the Fed has no ability to offset the deflationary shock. In other words, the 5-year/5-year TIPS breakeven rate has fallen because the zero lower bound is challenging the credibility of the Fed's inflation target. Our U.S. fixed income team forecasted that breakevens will head higher once oil prices move up and that the correlation between oil prices and breakevens will eventually weaken as the fed funds rate moves further away from the zero lower bound. The bottom line is that TIPS are most likely being unduly affected by energy price movements. ..And Only Thinly Corroborated By Alternative Inflation Indicators Despite our bias that the recent moves in market-based inflation expectations are exaggerated, TIPS are not the only gauge sending a more inflationary signal. This week's ISM manufacturing and non-manufacturing surveys both reported an uptick in prices paid (Chart 3). According to the manufacturing survey, 18 out of 21 recorded inputs were up in price over the past month. However, the bulk of these are commodities that have gone up in price alongside other financial market prices, and it is not clear the extent that the price rise is physical demand-driven, or financial demand-driven. In the non-manufacturing survey, the price rise was not quite as broad-based, but is nonetheless suggestive of upward price pressure. The NFIB small business survey also hinted at higher prices, although much more modestly than the ISM surveys (Chart 3). The Atlanta Fed's Business Inflation Expectations Survey has not broken out of the range that has held since 2011. There was no change in inflation expectations from the most recent survey of professional forecasters. Meanwhile, as we noted last week, consumers are not at all worried about inflation. In fact, according to the Conference Board survey, consumer inflation expectations are at a new cyclical low! At least part of the reason that consumers do not expect more inflation is likely due to their experience with frequently-purchased items. Table 1 shows inflation rates for selected high-frequency spending items, which account for about 30% of the total CPI basket. The table makes it easy to understand why perceptions about inflation are low: almost half of the items in the table are in deflation and only two are above the Fed's target of 2%. It may not matter that a good or service accounts for a small share of spending: if its price is going up/down at a steady pace, then there will be an impact on perceptions about inflation. Currently, very low or negative rates of inflation among frequently purchased items are likely pulling down consumers' perceptions of broad-based inflation. In this sense, one could argue that inflation expectations are very well-anchored. Chart 3Survey-Based Inflation ##br##Expectations More Mixed Table 1Inflation Rates For Selected ##br## High-Frequency Spending Items Actual Inflation Will Stay Subdued In 2017... Chart 4Only Mild Uptrend Likely In 2017 For many years, we have deconstructed core CPI and core PCE into their three major components to better understand and forecast the trend in consumer price inflation (Chart 4). Performing this exercise today continues to give a fairly benign forecast for inflation. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017. Core goods inflation (25% of core CPI) will also remain very low and possibly stay in deflationary territory. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 4, panel 3), and so will stay depressed as long as the bull market in the dollar remains intact. Wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 4, bottom panel). This component, which accounts for 25% of core CPI, is the most likely source of inflation pressure now that wages are beginning to rise. But as we wrote in a Special Report on November 28, 2016, any wage inflation and pass-through is likely to be very gradual based on several structural headwinds at play this cycle. All in all, core PCE may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next six - twelve months. ...And Don't Blame Government Spending For Higher Inflation When It Does Come One missing ingredient from the above analysis is the likelihood that the political environment will become inflationary. This subject has been thoroughly covered by the financial press. Our own view has been that upcoming policies may not turn out to be particularly inflationary, at least not this year. For example, Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions in 2017. As for proposed personal tax cuts, the impact is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that many companies are already flush with cash and effective tax rates are well below statutory levels. Our benign view about the impact of government spending on inflation is shared by researchers at the St Louis Federal Reserve. In a recent paper,3 researchers looked at periods when the central bank was not working to offset the potentially inflationary effects of fiscal policy, e.g. between 1959 and 1979, when the Fed followed a policy in which it accommodated increases in inflation. They found almost no effect of government spending on inflation. For example, a 10 percent increase in government spending during that period led to an 8 basis point decline in inflation. Note that this period covers years of when the economy was operating at full employment and below. As the researchers point out, this does not imply that countercyclical government spending is ineffective at boosting output, but it simply demonstrates that empirical evidence of inflation related to government spending is thin. The bottom line is that we view the likelihood of significant inflation pressure as low in 2017. The implication is that under this scenario, the Fed can afford to adjust their "dots" gradually, diminishing the risk for stocks and bonds of an aggressive adjustment to the policy backdrop. Equity Correction: Will China Be A Contributing Factor? Chart 5Is China Liquidity Tightening##br## A Repeat Threat To U.S. Equities? Over the past few weeks, we have argued that the odds of a meaningful equity correction are running high, given the aggressive rise in bond yields and exaggerated move in sentiment relative to only minor upside surprises in economic and earnings growth. We are still on high alert for this outcome and believe that one possible trigger is tighter liquidity conditions in China, which are aimed at supporting the renminbi. Indeed, just like the start of 2016, the Chinese renminbi is kicking off 2017 on a weak note. Chinese policymakers are again tightening rules to limit capital outflows: earlier this week, they adjusted the FX basket used to set the CNY's official daily fix. The new FX basket will include 24 currencies (up from 13). Consequently, the weight of the U.S. dollar drops from 26.4% to 22.4%. This will make it easier for the authorities to target a relatively stable renminbi versus the basket even as USD/CNY pushes higher. These attempts to support the renminbi is leading to tighter liquidity conditions and higher interbank interest rates. In Hong Kong, 3-month CNH Hibor has spiked to 10%. In the past, a combination of a weaker renminbi and rising interbank rates has spelled trouble for U.S. and global equities (Chart 5). There is no guarantee that history will repeat itself and one big difference with the sharp market sell-offs in mid-2015 and early 2016 is that the Chinese economy is not as weak as it was then. The PMIs released this week were generally firm. Overall, we are positive on equities and negative on bonds on a 12-month horizon but still see the risk of a correction to the Trump trade as elevated. Thus, investors should continue to stick close to benchmark tactically, looking to implement positions after a pullback in stock prices. Like in 2015 and early 2016, China could provide the trigger to that pullback if the authorities give up on capital controls and allow a sharp depreciation of the RMB. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard-N… 2 Please see U.S. Bond Strategy Weekly Report "A Tale Of Two Rallies", dated March 29, 2016, available at usbs.bcaresearch.com 3 https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-…