Sailbridge Capital 2017 - WordPress.com 21, 2016 · Sailbridge Capital 2017 . ... to a continuously changing environment where macro ... in key emerging markets in an environment

1

December 21, 2016 New York

Sailbridge Capital 2017 The defining idea of 2016 was clearly summarized in the result of the U.S. Presidential Election: immediate change. After years of little progress on economic policy, continued political wrangling, and a U.S. economy that continues to grow modestly, a deeply divided electorate in one of the most divisive presidential campaigns in U.S. history demanded immediate change. President-elect Donald Trump undoubtedly represented the option for immediate, radical change. The victory went to those that were left out of the moderate recovery, but that make half of the voters. With the Barclays Hedge Fund Index showing a 2016 YTD return of 5.5% through the end of November, and following an almost flat performance of 0.5% last year, hedge funds have achieved limited results for investors. No doubt there were some strong performers that achieved or exceeded expectations, especially those focused on distressed opportunities, but overall funds continued to struggle to post strong results in 2016. These results had been attributed to diminished competition and strangling regulations that have worked against current investment models. While these factors are no doubt important, a critical aspect of this performance has been the failure to adjust investment models to a world where economic cycles are now about half of what they used to be prior to the 2008-09 financial crisis, as well as to ongoing fundamental changes in economic structures around the world that are still part of the aftermath of the financial crisis. As the year ended, hedge funds had an unexpected, strong pick up as the surprise victory of Trump bolstered returns once the possibility of immediate and, in some instances, radical change strengthen performance possibilities that were unexpected. While much is still unknown, the key ideas of change and of producing early results suggest that growth prospects are likely to strengthen and may become sustainable should the new president-elect manages to get private investment finally going after a decade. The key driver here is the prospect of the United States going back to its traditional, growth model of banks leading the private sector to generate growth opportunities, something that the deleveraging that followed the financial crisis made impossible to achieve over the past eight years. This is a key change that may be also strengthened by a strong financial deregulation agenda that would ease strangling regulations. With his economic and foreign policies anticipated to continue rising yields and volatility wider dispersion of performance across industries will now be the new standard, thus, suggesting that a strong differentiation between investment opportunities will once again be a strong driver of performance. Investors face the unique challenge of looking for business models that respond to a continuously changing environment where macro directionality is more important than in the past, but also needs to adapt more quickly to a continuously changing opportunity landscape. This suggests that macro directionality that serves to identify key sectors and that combines simultaneously a Top-down and Bottom-up approach that relies on financial structuring of well-differentiated, equity and debt investment opportunities has a much stronger chance to succeed and deliver strong performance in a shorter horizon than the traditional investment model. By bringing together the flexibility that liquid funds have with the high yield and

2

structured cash flows that private equity opportunities provide, investment performance can be improved while reducing investment horizons to match the unique features of shorter and volatile business cycles. Sailbridge Capital Investments Fund focuses on generating sound performance by bringing together a strong macro, directional positioning and the strong value added that relies on structuring to maximize value through bridge equity and financing of mid-size companies that have a sound business model and management and a history of strong performance. In this setting, after an initial period of continued emerging markets pressures on rising yields, 2017 will likely generate strong, well differentiated investment opportunities starting in the second half of the year, in our view. Sailbridge Capital’s international investment fund is well positioned to take advantage of distressed restructuring opportunities during the first six months of 2017 as rising yields and a difficult refinancing environment will add to balance sheet pressures early in the year, especially given the prospect of further economic deceleration and currency depreciation pressures throughout most of the asset class. Restructuring opportunities allow for the refinancing of loans that would strengthen balance sheets and allow companies to regain their footing after exogenous, transitory pressures that adversely impact the performance of an otherwise well managed company. The benefits from such opportunities are usually expressed best through Mezzanine debt, warrants and, to a lesser degree, equity that allows these companies to weather transitory global pressures and thus helps them return to their growth standard. At the other extreme of the return distribution are high growth companies that are ready to consolidate their market. If they grow organically as EM companies do, it will probably take them fifteen years or so to double their size and financial results. However, if they have access to Bridge Equity they would be able to pursue a merger that would allow them to double their operations and financial results in a short span of about five years. Our focus is in developing a niche of Bridge Equity and Bridge Financing Opportunities that have a strong return potential, as they bring forward or realize future growth potential through the structuring of bridge equity that helps finance a strategic growth acquisition or, alternatively, that allow a company with depressed balance sheet valuations whether an exogenous shock to regain its footing and recapture the value that had been compromised. Sailbridge Capital business model is thus simple. We only focus on medium size companies that have strong management, a sound business model and have been operating favorably for five years or longer, but that are only distinguished by one of two type of well-differentiated opportunities. The first corresponds to companies that had been adversely impacted by a shock exogenous to the firm and that is putting strong pressures on its balance sheet and refinancing opportunities. For example, a commodity price collapse or an exchange rate devaluation that puts strong pressure on a company’s balance sheet. The emerging markets experience is that companies that are well run and have sound business models usually need only 18 to 24 months to turn their operations around, suggesting that bridge Mezzanine financing and warrants provide a unique opportunity to capture value in a relatively short investment horizon. The second focuses on companies that are ready to consolidate their industries and thus accelerate their growth through a strategic acquisition. For both opportunities, the investments horizon is no longer than five years and the fund aims at doubling its investment value over the investment period. In both instances, the management and ownership of the company are willing to repay Sailbridge Capital’s interest ahead of their own to keep the full control of a now much better run or bigger firm. The problem with traditional private equity is that it typically requires full control of the company or allows for a minority interest but over a long investment horizon that makes the investment unattractive to the management and ownership of these firms. This is

3

a strong niche as there are many companies that would benefit from the Bridge Equity or Bridge Financing if the current shareholders can regain the full control of the company over the medium term, often no more than five years. In both instances, strong value is generated by either bringing growth valuations forward or, alternatively, restoring valuations depressed by crisis-type of events in companies that are in a strong position to whether adverse, exogenous shocks. This also suggests that Sailbridge Capital investment model seeks to be robust throughout the different stages and opportunities the business cycle offers. Sailbridge Capital’s investment strategy benefits from the growing investment opportunities that will arise in emerging economies once the new U.S. credit cycle starts in 2017, particularly as private investment strengthens after a decade of weak performance, as emerging economies, notably Mexico, would benefit from being a leverage investment on U.S. growth. Sailbridge Capital thus takes advantage of shortened business cycles and global macro and political pressures to generate strong yields in relatively short investment horizons as it brings together macro-directionality with a “bottom-up” approach to generate high returns. To benefit from business cycle fluctuations, investments will thus be made in both expanding, consolidating-industry companies and in well-managed companies temporarily hit by exogenous shocks. Sailbridge Capital focuses on an underserved middle-size market with emerging markets ownership or operations content. Investment opportunities are likely to be asymmetric in 2017, as distressed opportunities in key emerging markets in an environment of rising yields during the first half of the year are followed by strong growth opportunities during the second half, particularly in Mexico. Such opportunities will likely emerge in 2017 owing to a combination of a tougher U.S. foreign policy, continued credit pressures in Europe and China during the first half of 2017 and an expansionary U.S. fiscal policy. During the second half of the year or once pending European credit issues are ordered and U.S. public policies are defined, emerging markets will start benefiting from the new credit cycle that will likely strengthen U.S. private investment following financial deregulation in the second half of 2017. By then, the uncertainty related to the North American Free Trade Agreement (NAFTA) would’ve been favorably resolved, as the changes will likely focus on some concessions and complementary agreements to extend NAFTA to areas, notably services, where the U.S. has a strong competitive advantage and Mexico’s industries are notorious for their oligopolistic structures. Unsurprisingly, we see Mexico as the global emerging market that stands to benefit most from stronger U.S. growth, once the uncertainty related to the future of the North American Free Trade Agreement is favorably resolved, probably early in the second quarter of 2017. With regards to distress opportunities, these opportunities will likely take place in industries that are capital intensive, such as Energy, Construction, Machinery and Heavy Equipment, as well as in the Financial or Banking sector. On growth opportunities and during EM pressures, firms that export or have their core sales in the United States, for example in Cost Center Services, and their costs in local EM currencies will have a solid performance that would make them strong candidates to consolidate their markets. The sectors that are key plays in U.S. markets are, of course, exports of nondurable goods, pharmaceuticals and services, particularly outsourcing companies, with dollar income based on their U.S. operations. Once trade uncertainty is resolved, we expect local telecom, media, transport and warehousing, and insurance companies to underperform, while U.S. services companies will outperform markedly. The start of a new investment cycle in the United States would allow a pent-up rise in investment in Mexico that would benefit capital intensive industries that are lagging now, especially Energy and Infrastructure,

4

Manufacturing, Machinery and Heavy Equipment, as well as the financial sector, particularly oriented towards consumer and mid-size firms credit. The pickup in investment will also improve productivity in the United States and Mexico, which in turn will keep inflationary pressures subdued. While there is, of course, a risk that the Fed could raise its funds rate more aggressively than now seen by investors, a strong pickup in investment will raise productivity markedly, thus containing inflation and allowing the Fed to move gradually, as we see five 25bps hikes, with the Fed funds rate ending 2017 at around 2%. This improvement in growth and overall activity is based on two factors that would drive private investment in the United States. The first is the final changes to NAFTA, which we see as trade expanding, not contracting as now seen. The second, of course, is a Fed that effectively raises its funds rate aggressively to 3% by the end of 2017, bringing back the memories of the 1994 financial crisis in Mexico when the Fed effectively double its short-term funding rate to 6% in a ten-month period. This time, however, the adjustment in long-term yields is already taking place and the moves in short-term rates in Mexico have aimed at anchoring the MXN Peso, which we believe will still be under some pressure in early 2017 to then rally sharply once the trade uncertainty gap is favorably closed. Thus, we still see some pressures over Mexico’s corporate sector in early 2017, followed by a strong rally later in the year. An important feature of Sailbridge Capital’s International Fund is its strong social responsibility emphasis, as it gives access to bridge equity and financing to many emerging markets companies that are well managed, have a strong business model and performance, and require bridge financing to avoid falling into bankruptcy, thus preventing unemployment; or bridge equity to accelerate growth, thus expanding job opportunities in the economy, as future growth and value is brought forward. Without bridge equity, thousands of companies will continue to grow organically and slowly, with many likely still failing during new rounds of credit and foreign exchange pressures. Without bridge financing, many other companies wouldn’t be able to weather exogenous, global shocks that could end in bankruptcy situations, as many EM companies have seen in the recent past. Without bridge equity and financing, companies also fail to develop timely business models that allow them to compete and achieve a sustainable, strong performance over time. Sailbridge Capital seeks to take advantage of the anticipated global capital rebalancing to the United States, combined with further weak global growth particularly in Europe and China, which will then be followed by strong investment opportunities in Mexico and non-levered emerging markets. Sailbridge believes that the combination of these two factors, resulting in rising medium-term yields and weaker currencies, will result first in attractive distressed investment opportunities due to global credit pressures, followed by attractive growth valuation investment opportunities in emerging markets. Sailbridge believes that over the following year: Capital will continue to rebalance from the rest of the world into the United States

o The rebalancing of capital into the U.S. will continue to gain momentum throughout 2017,

as key emerging markets slip into recession, for example Mexico or key Eastern European and Asian countries, or as recessionary pressures intensify, as it’s likely to be case in Brazil;

o This rebalancing will shift from fixed-income investments into equity investments as U.S. growth prospects strengthen in 2017;

5

o Uncertainty over trade policies and a tougher stand on U.S. foreign policy will exacerbate near-term credit pressures on leading emerging economies resulting from rising U.S. yields;

o The U.S. Dollar will appreciate markedly vis-à-vis the Euro and leading EM currencies, notably the Mexican Peso and the Brazilian Real;

o Some of the recent commodity gains will likely be offset by supply pressures, particularly in the oil industry where US shale supply and daunting fiscal pressures on key OPEC and non-OPEC countries lead to slippages during the first half of next year. We see sustained commodity price improvements starting in the second half of 2017.

Capital rebalancing and productivity gains will result in gradual Fed Action

o Capital flows into the U.S. from the rest of the world will take the U.S. equity rally into new record highs, with the appreciating US dollar also helping inflation move gradually higher than most investors now envisage;

o Whether the incoming U.S. administration succeeds or not in strengthening U.S. growth on a sustainable will hinge on the performance of private investment. After a decade of weak US private investment, mostly on weak bank lending related to the massive deleverage that began with the financial crisis of 2008, US private investment is set to strengthen as the US is finally in position to start a new credit cycle;

o Continued rising US yields, especially in the first half of 2017, would exacerbate credit pressures for European banks, EM corporates and small sovereigns, notably in Asia, Eastern Europe, the Caribbean and Central America;

o EM long-term yields and currencies will likely be under further pressure during the first half of 2017, as the US fiscal expansion gets underway.

Corporate and Sovereign Restructurings will rise in 2017

o With a ten-fold growth in bond issuance and a six-times rise in overall corporate emerging

market bank and bond debt over the past decade, a high default rate in 2017, amid rising yields and capital rebalancing during the first of the year, may result in corporate bond restructurings, particularly in Asia and Latin America, as well as in banking crises that triggers sovereign defaults in Venezuela, Ecuador, Belize, Jamaica, Greece, among others;

o EM bank debt restructurings will likely rise as well during the first half of the year.

The Great Capital Rebalancing Sailbridge Capital estimates that the U.S. financial crisis of 2008-09 and the start of the massive deleveraging process that followed the subprime mortgage debacle account for the subpar U.S. economic growth of the past six years. Despite deleveraging and its adverse impact on credit growth, every year since 2010 most economists have continued to look for, finally a sharp rebound, of over 4% in U.S. growth. Every

6

year, however, growth has been about half of what’s been expected, even after the massive quantitative monetary stimulus that the US Federal Reserve launched during the second half of 2010. In fact, the Fed’s quantitative stimulus ensured that growth stayed near the economy’s 2% potential, thus preventing the economy from slipping into another recession. Throughout much of the crisis, many investors failed to focus on the balance sheet impact of deleveraging, instead focusing only on the cash flow issues that provided a limited view of the forces at work in the economy. The weak recovery and the limited focus on bank balance sheet issues led many to believe that U.S. growth is bound to stay indefinitely weak, as if the economy was really in a “new normal” state of weak economic growth and subpar performance. We differ from this view and, instead, see the “abnormality” as perfectly consistent with a protracted period of deleverage and its ensuring weak private investment performance. In fact, the subpar growth is a result of the strong deleveraging efforts that began in late 2008 and early 2009, as the U.S. Federal Reserve focused on providing the liquidity and the low rate environment that facilitated each bank’s own balance sheet deleveraging efforts. This explains why credit also remained weak and U.S. growth well below the historical recovery norm. It also means that there is not much validity to the view that the United States is now condemned to a new “normal” of weak growth that needs to remain weak for the foreseeable future. In fact, the weak growth only reflects the fact that the Fed stabilized and set the conditions for each major financial institution to proceed with its own balance sheet restructuring and deleveraging that would once again restore credit and investment. Our view, based on the end of the restructuring of Legacy assets and banks’ own restructurings efforts, is that the Great U.S. Deleveraging ended during the first half of 2016, suggesting that the economy is finally able to start a new credit and strengthen growth cycle. Contrary to consensus that U.S. growth is now decelerating as the cycle is now moving to its contractionary phase, our view is that it hasn’t even started. Over the past six years, U.S. growth has been modest because the 2008-09 crisis was so severe that, far from restructuring all financial balances that were compromised during the crisis, the U.S. Federal Reserve focused on stabilizing financial markets to avoid the rupture of the credit chains, preventing the economy from falling into an economic depression. Once markets stabilized, the Fed focused on ensuring the low interest rates and the liquidity that would allow each major financial institution under pressure to begin the process of restructuring and deleveraging its financial balance. The massive deleverage that began in 2008 and early 2009 continued over the past seven years until it was essentially completed by the end of the first half of this year. Throughout this time, deleveraging resulted in a limited expansion of new private investment, as investment focused on recovering the operation of installed capacity and, hence, on equipment reposition and maintenance. The end of the massive deleveraging period in the United States and the prospect of financial deregulation in the new administration opens for the first time in almost a decade, the opportunity to start a new credit cycle. Because private investment is markedly dependent on credit, after a decade of weak, new private investment, the United States is finally able to start a new credit and private investment cycle that would strengthen economic growth and employment vigorously. Of course, being able to start a new credit cycle is a necessary, yet not sufficient condition to start it. However, given that the government relation with the banking sector is about to be normalized to its historical leadership standard, and given the strengthening bank margins, we envisage a strong chance that private investment will complement the public expansion, thus greatly increasing the likelihood of making the initial growth impulse sustainable. In fact, this process was bound to benefit the next president of the United States.

7

Sailbridge believes that U.S. monetary policy was intended to stabilize financial markets to allow major financial institutions to restructure their balance sheets and thus delever gradually over time. U.S. fiscal policy was also highly supportive of the deleveraging efforts as the U.S. government allowed the automatic stabilizers of the marked decline in revenues due to the recession and the Economic Stimulus Act of 2008 resulted in an almost 9% of GDP nominal fiscal deficit. Once the economy began to recover, the fiscal deficit declined gradually to about 2.6% of GDP this year. Both monetary and fiscal policy responded quickly and effectively to facilitate balance sheet restructurings and a return to growth. Of the 4 major economies in the world, only the United Kingdom followed the U.S. policy stance, with both the European Union and Japan pursuing for quite some time restrictive policies that restrained deleveraging efforts and a sound return to growth. While this is now changing in Japan, sharp political constraints on Germany and a flawed fiscal arrangement, has limited the ability of the European Union to address decisively impending imbalances. This is about to change as the weaker Euro will force the resolution of bank imbalances, likely through greater credit contraction and thus a sharp economic deceleration. With the deleveraging of Legacy and other compromised assets now ending in the United States, the start of the new Fed tightening cycle appears to focus on bridging the gap between what could be subpar growth and the prospect of much stronger growth beginning in late 2016 and early 2017. We believe the tightening cycle will still proceed at a relatively gradual pace in 2017, thus resulting in a cumulative 125bps Fed rate hike to 2%, or near the low end of market expectations of the Fed funds rate ending next year between 2% and 3%. This compares to the Fed’s own view of a cumulative 75bps in Fed funds rate hikes next year. After today’s Fed hike, the first hike of 2017 is likely to be during the March 14-15 meeting. The second 25bps hike may take place in June, when a regular tightening cycle will begin on June 14 and continued throughout the end of the year, suggesting 25bps hikes in each of the following meetings in July, September, October/November, and December Federal Open Markets Committee Meetings. The cumulative hike would be 125bps, following the 75bps in hikes during 2016. We see a 35% probability that the March hike be postponed to May and a 25% probability that the hikes start in March for a cumulative 150bps. This implies a spread of about 125bps to 150bps between funding rates and the 10-yr U.S. Treasury rate, which is over 100bps than the most aggressive market expectations. This also suggests that we expect the Fed’s monetary tightening cycle to continue into 2018, where another 125bps to 150 bps in hikes will likely be delivered. We expect that the start of the new U.S. administration, and thus the need for greater clarity on the scope and reach of fiscal policies to be pursued, would lead the Fed to pause, with renewed credit crisis pressures in Europe also likely to lead the Fed to pause in March or May. Once the new U.S. fiscal policy is clear and its expansionary impact is assessed, the Fed will act consistently in delivering higher Fed funds rates.

8

Source: Federal Reserve of St. Louis We believe that the U.S. monetary tightening cycle and particularly the realization of a strong deterioration in U.S. fiscal performance will continue to push long-term yields higher than they are at present, thus leading EM yields even higher as well. This will reinforce the rebalancing of capital flows into the United States and thus support the U.S. dollar and the U.S. strengthening recovery. Contrary to the consensus view that the U.S. post-Great Recession recovery is coming to an end, the sluggish U.S. recovery is fully consistent with the deleveraging period that the U.S. bank and financial institutions had to pursue for about eight years now. The best the U.S. Federal Reserve could’ve done was to keep interest rates low and provide ample liquidity (through its QE program) to keep growth performance near its 2% potential. This is exactly what the Fed did. Now, the United States is poised to begin a new credit cycle that would have a critical impact on private investment and, thus, economic growth. While being able to initiate a new cycle is a necessary yet not a sufficient condition to grow, we see the shift in the government-private sector relationship towards a mutually supportive and constructive relation as key catalyst for improved private investment. In short, the U.S. banking sector would resume its leadership, catalyst role to spark U.S. private investment and growth once again. In this regard, the outlook for the United States hinges on the strength of private investment. Strong, new private investment will likely make, in our view, the initial U.S. fiscal impulse sustainable, pushing the economy into a virtuous cycle of sound growth beyond the first year of the new government. We estimate that the large leverage positions of European governments and banks, heavy debt loads in Asian corporates and in some Sovereigns in Europe and Latin America may exacerbate credit pressures through emerging markets, particularly as yields continue to rise in 2017 and given the large emerging markets refinancing requirements of Asian and some Latin American private companies as well as of small sovereigns, risk a new round of crisis pressures that will exacerbate outflows into the first half of 2017. This suggests that commodity markets will likely be under some downward pressures early in 2017, as global growth continues to weaken, mainly in China and Europe, and key stability concerns rise again at the start of 2017. As we had envisaged, the end of China’s monetary and financial bubble is exacerbating capital

-2.4

-12

-10

-8

-6

-4

-2

02008 2009 2010 2011 2012 2013 2014 2015

U.S. Federal Nominal Fiscal Deficit (% of GDP)

9

outflows and adding strong downward pressures on the Renminbi. Economic growth continues to weaken gradually as the authorities have strong control over the economy. While trend growth is likely to be now near 5%, the key risk to China would be to fall into a recession that leads to strong social pressures, notably in the south of the country. Social pressures and sizable capital outflows of about $750bn thus far in 2016 is leading the authorities to increasingly resort on capital controls, which of course only increases the resolver of market participants and companies to expedite their market exit, further exacerbating credit pressures and the Renminbi depreciation, although within a process that the government still firmly controls. The Trump Government The situation of the international economy and the continued resolution of the challenges and opportunities that the US and European financial crisis created continue to be the leading drivers of global performance. Amongst these challenges and opportunities is the recent election of Donald Trump to the presidency of the United States. Mr. Trump’s surprising victory reflects the extraordinary polarization of society, following the strong deterioration in employment, incomes and living standards on the back of the financial crisis and its ensuing Great Recession. In fact, the cost of the crisis fell disproportionately and for an extended period amongst low income groups, leading to the massive mobilization of the rural and suburban votes that resulted in Trump’s victory. The 2008 Financial Crisis was unique in that, although there is a long history of financial crises, only two others, the Crisis of 1907 and the Great Depression, are comparable to the magnitude and scope of the crisis. This time around the large cities did well, but the rest of the country, notably the rural and suburban areas, fell markedly behind, thus creating the social backlash that the Trump campaigned successfully focused on. Once he was elected, Trump changed his message focusing on speaking to the entire country to ensure governability and thus the support of the half of the people that didn’t vote for him but have the economic power. Trump the President is therefore likely to be different than Trump the candidate to ensure governability and stability, resulting in the pragmatic positions that he is now taking. In this setting, we expect that Trump will have a more constructive domestic, “inside” message, but a tougher stance to the outside world, or external message, to secure the concessions and foreign policy changes that allows the U.S. to obtain early “favorable” results, particularly on foreign policy and, in a more limited way, on trade. Inside the United States, the early results focus may emphasize strong jobs gains based on a fiscal expansion that takes advantage of the low initial level of long-term yields. To be successful, he is focusing on job creation through a public investment in infrastructure, credit improvements and thus improved private investment. This has led to the sharp back up in yields that we estimate would be reinforced by the actual fiscal expansion and actual growth gains. Because Trump will have the U.S. congress behind, especially early in his administration, and given the radical fiscal impulse he is looking for, the actual public investment expansion and tax incentives may prove strong enough to push economic growth close to 3.25%. The success and thus sustainability of his economic strategy would hinge at the end on whether private investment complements his efforts. The start of a new credit cycle that benefits from the end of the great deleveraging, strengthening bank margins, deregulation, and the return of the leading role that banks have had in every major US expansion period suggests that private investment is poised to finally strengthen, thus ensuring the sustainability of the initial fiscal impulse and further pushing growth

10

closer to the 4% Trump promised. Private investment will be the key driver of his success or failure. After a decade of little new private investment throughout the economy, private investment is poised to rise, a distinctive feature that would’ve benefited either candidate. The key implication of a more constructive “inward looking” President and a less constructive “outward looking” stance, particularly on foreign policy, is that the external uncertainty may keep international uncertainty high, which may weaken further foreign governments, and thus strengthen the negotiating stance of the United States. Because trade is an area that risks exerting sharp pressures on U.S. economic activity, the tough external position will likely center in foreign policy, where the new U.S. administration will switch to the traditional, Republican hardline stance, from the Democrat consensus building approach. This reflects more of a party-line change that would probably be exacerbated by the choices the president-elect has made in his cabinet. Europe and the Middle East are the two regions where demands will likely be the strongest amongst leading international issues, particularly centered at putting a much stronger stance against terrorism than currently in place, but drawing from resources of European and Middle Eastern countries, including troops’ participation and financing, respectively. In this context, the final trade and foreign policy agenda of the president-elect will likely have a strong emphasis on avoiding undue pressures on trade and economic activity, while pressing to advance the U.S. foreign policy agenda, particularly on security issues. From a position of strength, our view is that Trump will likely negotiate concessions and an expansion of services (where the U.S. has a strong competitive advantage), to secure complementary agreements that will end up expanding NAFTA, and with key near-term advantages to the United States. A key element that gives the Trump agenda an edge is the fact that he would count with a Republican majority in both the House and the Senate. A majority over which, especially at the start, he will likely have great influence as he gained extraordinary credibility winning an election that many in his party thought he couldn’t win, especially at the leadership level. Also, with a radical style that pushes extremes, he can negotiate significant changes, even if not achieving the extremes, a key element of his negotiating style. This suggests that he is likely to prioritize his domestic agenda, while starting to make progress on parts of the foreign agenda, particularly trade with Mexico and Middle East security issues. China and other more contentious issues will likely come later, once early successes strengthen the position of the new administration. Of all the issues that have been raised, it’s clear that the one where the public shares the strongest view is on the notion that the Trump administration will most likely bring substantive, immediate change to Washington. It’s also clear that to be successful the change needs to focus on producing early positive results. In fact, since Jimmy Carter and before that Lyndon B. Johnson and John F. Kennedy, this is the first time in almost forty years that the President-elect also has a congress majority in both the House and the Senate. Because the economy is already positioned to start a new credit cycle and deregulation will likely facilitate the process, the incoming administration has a strong opportunity to get the private sector to finally start investing after a decade. We are convinced that private investment will determine the success or failure of the new government. We see a strong chance that it will complement the early fiscal stimulus, thus making the early fiscal efforts sustainable through most of Trump’s administration. We don’t share the view of public spending crowding out private investment given their starting low levels as well as the unusually low interest rates to begin with. In fact, we see this as the end of the “New Normal” and the return to the old-fashioned “Old Normal” whereby private investment leads U.S. growth and the financial sector plays a

11

pivotal leading role in getting the private sector involved in the recovery, as it’s been the case in every major past U.S. recovery. Without private investment, of course, the initial fiscal impulse would fade, interest rates would rise much further and growth will start weakening quickly after an initial, strong bounce. Emerging Markets We believe that in 2017, emerging markets will remain under pressure early in the year as capital outflows and high leverage exacerbate credit pressures, thus continuing to weaken emerging markets growth performance during the first half of the year. Uncertainty regarding the incoming administration trade and foreign policies and concerns over a hard line will continue to weaken investment further as well as economic growth. Continued political volatility in some countries, notably Brazil, will continue to add to recessionary pressures in the near term. A key factor in this may be the drag on these economies from China, as capital outflows, high leverage and a weak Renminbi leads the Chinese authorities to look inward, rather than outward to continue to gain credibility around the emerging world, particularly with the “Revolutionary” governments that are under strong credit pressure now. The greatest pressure has been on commodity dependent countries, such as Venezuela and Ecuador, although other economies, notably El Salvador, are now underperforming as well. While some Chinese support may continue, the sharp deterioration in sovereign creditworthiness suggests that support may become sparser as the chances of a regime change continue to grow. Ecuador, for example, has been able to obtain multilateral support from the World Bank and the IMF to cope with the severe earthquake that hit the country in April 2016. It’s expected that most emerging markets will tighten monetary and fiscal conditions to stem the pressure, though exacerbating the recessionary and financial pressures throughout the emerging world. In our view, corporate borrowing, particularly in Asia and some key Latin American countries, make them especially vulnerable given already high corporate leverage ratios. In Asia, Malaysia, Singapore, and South Korea are especially vulnerable. Because U.S. interest rates are now rising and borrowing is becoming more expensive, creditors may choose to collect on the loans extended, thus exacerbating refinancing pressures, both rates and availability wise. With a ten-fold growth in bond issuance and a six-times rise in overall corporate emerging market bank and bond debt over the past decade, a high default rate during the first half of 2017 would likely trigger a wave of corporate restructurings, particularly in Asia and some Latin American countries, notably Brazil. In Latin America, for example, per the Trade Association for Emerging Markets, corporate bond debt has grown from about $45 billion during the last corporate crisis in 2001 to over $450 billion now. In 2001, Latin American corporate bankruptcies reached $16bn or 30% of the outstanding bonds issued. During the U.S. financial crisis of 2008-09, Latin American corporate bankruptcies fell to only 3.8% of the outstanding corporate bonds. However, we believe that this current rebalancing will more closely resemble 2001, not 2008, considering the much higher leverage and being now the source of the credit pressures. This means that even a 15% default rate, or half that of 2001, would results in debt restructurings of over $70 billion – or about five times the 2001 default levels. Critically, in 2008, the financial crisis originated in the United

12

States. Once the crisis stabilized, capital left the U.S. for emerging markets, thus greatly limiting any refinancing pressures at the time. During the rebalancing of capital that began in 2013, capital has been leaving emerging markets and returning to the United States, a process that is not yet fully exhausted and that has had an adverse impact on emerging credit prospects. As U.S. interest rates rise, emerging markets outflows will persist. At some point, when rates plateau and U.S. growth strengthens, capital will once again start flowing back into emerging economies, strengthening growth and overall economic performance.

México One of the few bright stories in the world and, indeed, the only country that has been pursuing structural reforms at a time of global financial pressures is Mexico. It passed an energy and educational reform that will strengthen the country’s finances and growth prospects. Anchored in sound policies and strong industrial integration, we believe that Mexico is now firmly integrated into North America and the changes to the North American Free Trade Agreement will only make the ties between Mexico and the United States even stronger than they already are, suggesting that beginning in the second half of 2017 and early 2018, Mexico will no longer be just an emerging market but an integral part of North America. In fact, in our view, the changes to NAFTA will focus on complementary agreements and some concessions that expand trade into services, most of which were left out of the original agreement. Greater competition in services would reduce the current account surplus Mexico has with the United States and would be of great benefit to Mexico’s growth and improved income prospects over time, as the stronghold of Mexican oligopolies in services may finally be broken. It would also give the United States an area of trade where it holds a strong competitive advantage, thus improving growth and employment in the United States. Our view is that Mexico will be the first emerging economy that is fully integrated into a major developed economy and, as such, will be an integral part of North America and not just an emerging market any longer before President elect Trump leaves office, and as early as 2018. In this context, Mexico’s leading challenge has been the same for the past forty years: to grow consistently at a solid 4% to 5% pace, thus improving job creation and living standards for most of its people. Today, Mexico’s challenge is in fact the challenge of virtually every leading developed and most developing economies. The key achievements of Mexico have been a solid macro management of the economy through prudent fiscal and monetary policies. In fact, Mexico’s monetary stability reflected in its achievement of low and stable inflation for two decades and a pension reform in the late 1990s have allowed the country to build a stable a rapidly growing savings that is contributing to build a rapidly growing asset base. Still, Mexico’s challenge is to go back to the strong growth rates experienced in the 1950s and 1960s, as well as to ensure that the benefits of economic stability and growth benefit most of its people. With large income discrepancies, Mexico’s economic development hinges on the ability of the Mexican government to improve education, health, labor and energy opportunities throughout the country. Mexico’s recent growth performance has been modest and uneven to start reducing the large poverty in which most of its people still live. In fact, in the past three years, Mexico has reached a 2% average growth rate, or under half of what would be considered the growth that would allow to reduce unemployment and

13

begin improving living standards. Anchored on a young and dynamic population, Mexico’s growth potential remains strong, especially given the government’s efforts in the past twenty years to integrate the Mexican economy into the economy of the United States underpinned by sound economic policies and macro stability. Mexico’s economic growth has shown sharp variability that underscores continued vulnerability to global financial pressures. Unsurprisingly, growth has been most variable around the two-economic crisis that hit the country hard over the past two decades: during the 1994-95 financial crisis, when the economy plummeted 8%, and during the 2008-09 US financial crisis, when the economy fell again 8% (see Figure below). The similarity in the intensity of both recessions is remarkable if we consider that the 1994-95 crisis was due to Mexico’s own banking sector, while the 2008 crisis was due to the US and European crisis and mortgage problems that, of course, Mexico was not part of. Still, the severity of the 2008 crisis underscores not just the strong integration and dependence of Mexico’s performance on the U.S. performance, but the fact that both countries suffered from the same problem that the United States economy endured: a high level of leverage that cause havoc on the balance sheets of banks and financial institutions in the U.S., and on corporations in Mexico. In both instances, the Mexican peso depreciated markedly, exacerbating recessionary pressures.

Over the past year, the adjustment of the Mexican Peso has been exacerbated by its use as the preferred investor hedge for essentially any major global risk, as the peso is the only major emerging market currency that trades in size in the Chicago Future Mercantile Exchange. The participation of the Peso in the Chicago exchange dates to the 1940s when international trade payments took off. From the 1940s through the

-8%

-6%

-4%

-2%

0%

2%

4%

6%

Mexico's Economic Growth

Source: INE

14

early 1970s, currency trading centered on international trade. Starting in the early 1970s and through the mid-1990s, Mexico suffered from a series of financial and economic crises that marked a period of sharp currency and monetary instability that effectively halted the trading of the currency in the Chicago Exchange. Beginning in the late 1990s, trading resumed with a new, yet early focus on financial portfolio flows following strong global financial deregulation efforts in the late 1980s and early 1990s. It was, however, until 2006 that trading began growing markedly, as financial derivatives became fashionable hedge instruments for Mexican corporations. The strong liquidity that trading in the Peso achieved with financial portfolio flows made it attractive to global investors as a hedge for global macro risk, thus making the Peso vulnerable to international shocks, some of which of course Mexico had little to do with. This role as a hedge in a world of continued global financial risks has exacerbated the depreciation of the MXN peso and explains a large part of the over depreciation of the MXN peso in the past two years. In fact, the peso has lost over half its value (52%) vis-à-vis the U.S. dollar during the past eight years, with about 31% or almost a third of the devaluation reflecting its international hedge feature.

Source: Bloomberg

Remarkably, in a world where few countries consider pursuing the structural changes that would improve growth and productivity prospects, Mexico has approved and is now implementing a key energy reform that aims at integrating the Mexican energy market into U.S. energy markets, a modest tax reform and an education reform. This follows the success of its two most important reforms: trade reform, underpinned by the North American Free Trade Agreement, and a pension reform that established for the first time a steady savings base. The pension reform has been critical in developing a savings base that has strengthened Mexico’s financial stability since the 1994-95 crisis, particularly as its asset base is now growing rapidly and it stood at USD $140bn in September of this year. After the election of Donald Trump to the presidency of the United States, the key issue for Mexico is the future of the North American Free

17

18

19

20

21

Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16

Mexico's MXN Peso

15

Trade Agreement that Trump promised to change, or end, as he attributed subpar U.S. growth to disadvantageous trade with Mexico. Unsurprisingly, uncertainty over the future of NAFTA has halted investment and weaken overall economic activity in Mexico, adding almost another 15% to MXN Peso weakness. Our view is that until the uncertainty gap over the future of trade with the United States is closed, Mexico’s growth will continue to decelerate and the Peso will remain vulnerable to further depreciation, particularly as evidence of a sharp deceleration materialize. Mexico’s Peso may reach MXN $22 during the first quarter of 2017 to then appreciate markedly to about MXN $18, once the trade uncertainty gap is favorably resolved during March or April of next year. Accordingly, it’s in the best interest of Mexico to close the uncertainty over the future of NAFTA as soon as possible, as weaker growth and Peso pressures will undoubtedly further weaken its negotiating stance. The opportunity for North America is that the only real chance that the Trump administration would have to close an advantageous agreement would be with the Pena Nieto administration, which would need to close an agreement by the end of 2017, as 2018 will likely be a heavily contested electoral year. The window of opportunity suggests that negotiations would need to start no later than March or April of 2017 and that they would focus on new areas where the U.S. has a strong competitive advantage, notably in services, which are now the engine of U.S. growth and account for 79% of U.S. private economic activity (see Figure below).

Source: U.S. Bureau of Economic Analysis

Manufacturing14%

Other goods7%

Retail trade and Wholesale trade

13%

Finance, insurance, real estate, rental, and

leasing24%

Professional and business services

14%

Educational services, health care, and social

assistance10%

Other services18%

U.S. Private Economy: Share of Goods & Services (Q3 2016)

16

In our view, once the three teams get together to begin negotiations, the uncertainty gap would close quickly, leading Mexico’s peso to rally and pent-up demand to strengthen growth rapidly as well, as the negotiations would focus on some concessions, particularly related to the auto industry, and, most importantly, on extending trade to services, where the U.S. has a strong competitive advantage and Mexico has been trying unsuccessfully to open these sectors to competition. Extending NAFTA to services would help the United States reduce rapidly its current account deficit, as its about $10bn services surplus with Mexico would rise quickly. It would prove a watershed for job creation in the United States, also benefiting Mexico, where the quality of jobs and incomes would be greatly benefited. More importantly, the complementary agreements that extend NAFTA to services would allow North America to be finally fully economically integrated. Because reducing goods trade with Mexico would lead to a sharp contraction of U.S. manufacturing activity and, therefore, a strong rise in unemployment, disproportionately affecting adversely employment amongst those that took Trump to the presidency. Further, we see the U.S. negotiating team quickly focusing on the key areas of opportunity for the United States, instead of tariffs or minimum U.S. content that would prove devastating to U.S. economic activity, not just Mexico. Thus, and given the tremendous work laid out by NAFTA itself, we see a strong chance of wrapping up the changes to the agreement and receiving congressional approval by the end of 2017. While negotiating substantive changes to NAFTA that benefit the United States won’t be the priority of the Trump administration, negotiating and closing an agreement before the end of Trump’s term is. Because Pena Nieto is the only reasonable prospect for a strong, favorable agreement, and his ability to close any agreement ends by the end of next year, NAFTA will likely be one of the parallel key areas of work, particularly given the focus of Trump on “early results and gains,” and the strong chance of closing a very favorable agreement for North America. In this sense, we see the negotiations expanding NAFTA, not curtailing it and Mexico becoming more, no less integrated into the United States economy. We thus see Mexico finally becoming a full, integral part of North America’s economy starting in 2018 or 2019, rather than just an emerging market. Over the past twenty-two years, the North America Free Trade Agreement raised Mexican exports eightfold to USD $400bn from just $50bn in 1993. Of this, 81% are exports to the United States, underscoring the both the dominance of U.S. markets and the geographic location. With exports accounting for about a third of Mexico’s annual income, exports to the United States make for one-fourth of Mexican income. A significant decline in exports to the United States would, of course, have a huge impact on Mexico’s economic activity. For example, double-digit tariffs, which we see as highly unlikely, would reduce Mexican exports by about 25%, thus resulting in an over 6% contraction in Mexico’s GDP based on its direct effect alone. With strong impact over investment and consumer spending, as we are now seeing, the recession would be well over 10%, which would of course be a more severe recession than those endured in either 1995 or 2008. Mexico’s growth potential would, of course, also declined markedly, suggesting even lower equilibrium growth rates than now seen. This, of course, explains the immediate, post-U.S. election Peso depreciation in an already volatile international context. The reason why this scenario is highly unlikely is because 40% of Mexican exports come from U.S. companies operating in Mexico and Mexico is also the second most important market for U.S. exports today. A retaliatory increase in tariffs or other restrictions to trade that reduce U.S. exports to Mexico by 40% would result in a direct, 1.2% contraction of the U.S.

17

economy, which together with the decline in U.S. investment and consumer spending, would result in a 2.5% recession, or about half the 2008 Great recession. This would lead to a loss of about 5 million jobs, with a disproportionate number in manufacturing. In practice, the impact would be much greater because tariffs are almost at the limit allowed by the World Trade Organization, which suggests that the U.S. would leave the WTO, and thus be subjected to a wave of tariffs by many countries, implying that the combined trade impact and recession on job destruction would be greater than that of the 2008 financial crisis. Both the economic and political impact of such scenario would derail any chances of success for the Trump administration. He would disproportionately affect adversely the very people that took him to the presidency. Of course, the U.S. congress would never approve trade policy changes that would lead by construction to a major recession and widespread unemployment. Because the challenge is to generate strong employment gains relatively early on, our view is that the focus would be in negotiating some concessions and an expansion of the agreement into services and others new areas of opportunity and business. Should Trump achieve early employment gains (through fiscal expansion), it’d be irrelevant how he changes the agreement if it strengthens U.S. business opportunities, a highly likely scenario.

China In 2017, the end of China’s monetary and financial bubble will exacerbate capital outflows and, thus, continue to add strong downward pressures to both the Renminbi and economic growth. As trend growth declines to about 4%, the risk for China is that deceleration pressures exacerbate social pressures. In fact, China needs growth well above 7% to avoid the kind of social pressures seen by the close of 2015, as this is the least growth that allows that more people rise above the poverty line than those falling below it, as

0.00

50,000.00

100,000.00

150,000.00

200,000.00

250,000.00

300,000.00

350,000.00

400,000.00

450,000.00

Mexican Exports (in USD billion)

TOTAL USA

18

seen over the past decade. Critically, this would be the first time that China would fail to improve overall living standards since its move to start forming a market economy. The social pressures that this would bring would not only increase China’s resolve to increase its global sphere of influence but would also risk significant economic and social setbacks as the authorities’ resort to more control measures to keep Chinese society under control. Indeed, after relying on more monetary and liquidity expansion in the past two years to postpone the inevitable adjustment, the authorities have resorted recently to greater control measures that have only increased the resolve of market participants to expedite their market exit. This has led to a situation in which the additional liquidity is sterilized through both capital outflows and a weaker currency, suggesting that the pressures on the Renminbi are now self-financed. This suggests that the ability of the Chinese government to alleviate economic pressures through further liquidity may come to an end in 2017, as further liquidity injections not only lead to capital outflows and a sharp deceleration, but also to high inflation, which would immediately raise poverty levels in a discreet fashion. Still, with ample international reserves, the Chinese authorities can manage the adjustment. Our view is that China has ample reserves (of about $3.05trn) and enough control of the financial system to be able to manage and thus smooth the adjustment. Chinese holdings of U.S. Treasuries declined to about $1.12trn, its lowest level since 2012 and below Japan’s $1.13trn, as interventions to ease the pressure on the Renminbi have accelerated given the authorities’ efforts to prevent liquidity and credit from contracting too rapidly, reinforcing the self-financing pressures on foreign reserves and the Renminbi that we see as a key concern in accelerating pressures and further reliance in controls and other distortions that lead to a more rapid deterioration in economic growth and inflation prospects. While the authorities will likely sell Treasuries in large amounts to smooth the currency adjustment, they may look for a much more meaningful correction of the currency next year to strengthen Chinese competitiveness in export markets, particularly during the first half of the year. Besides the economy and social pressures amid an unfavorable monetary dynamic, the biggest challenge for China next year will likely be its relationship with the Trump administration. Our view is that the President-elect will likely focus on the multiple critical Chinese issues (such as foreign policy, trade, and security) only after it has made significant progress in his domestic agenda and the parts of the foreign agenda that can lead to relatively quick, favorable results (such as NAFTA). This suggests that considering the complexity of the relationship, the Trump administration is unlikely to tackle key Chinese issues, such as trade and security, until about half way in his presidency. Europe Sailbridge Capital believes that the Trump presidency would accelerate the depreciation of the Euro, which may be exacerbated by the failure to pursue a comprehensive restructuring for some of the leading financial institutions in the region, including Deutsche Bank, Credit Suisse, among others, in the past few years; instead favoring limited monetization efforts on the part of the European Central Bank that will also

19

likely deepen deceleration pressures throughout the region at a time that the United States is likely to see its economy grow at a faster pace, particularly in 2017. Unsurprisingly, the Euro depreciation will add to restructuring pressures of bank balances throughout Europe and, particularly, in Italy, Germany and France. With the Euro weakening below 1 next year, the European Central bank won’t be able to rely on short-term liquidity solutions to ease growing bank balance sheet pressures, suggesting that the Euro depreciation would add to restructuring pressures. The compromised bank balances and the new need to restructure them suggest that credit will be contracting markedly throughout Europe, further adding to deceleration pressures and to Euro weakness. We expect that the Euro will fall below parity, thus raising concerns over the future of the monetary union. Our previous expected level of EUR $1.05 has been attained and we are now looking for the Euro to test the EUR $1 mark in early 2017, which we see as a strong resistance level for the European Central Bank, as concerns mount over the end of the monetary union as European growth weakens markedly at the start of 2017. With many countries facing already strong fiscal pressures, weaker growth and a determined new President-elect in the United States would add to the pressures over the future of the monetary union as financial markets continue to test the political determination to keep Europe together through further German support, particularly in an electoral year that would likely imply that limited German support would be forthcoming to ease the marked slowdown that may take place in key European countries, notably Italy and France. Even in Germany, Deutsche Bank’s restructuring efforts will likely continue into 2017, particularly as the U.S. Department of Justice will likely still assess penalties of about $7bn (compared to the original expectation of $14bn in penalties), rekindling concerns over Deutsche Bank’s capital needs. Thus, we see the stock again under pressure as the year ends and in early 2017, particularly as the Euro depreciates, restructuring efforts will probably become much more difficult to complete. As of December 17, 2016, the consensus forecast amongst 34 polled investment analysts covering Deutsche Bank AG advises investors to hold their position in the company. This has been the consensus forecast since sentiment deteriorated starting in February 2015. Despite the hold recommendation, the 12-month price target for Deutsche Bank AG share has a median target of $13.75. On December 19, the stock fell 3.7% to $18.31, and a good 33% above the target price, suggesting that the shares may remain under pressure. In fact, considering its limited restructuring progress and unlikely support from the German government, the share price is like to fall the bank’s share price low of $11.48 on September 29. Our view is that Euro weakness and US penalties will likely exacerbate the bank’s capital needs, further adding to pressures on its stock price as well as on restructuring efforts that must be much stronger than now seen. On October 6 of this year, Deutsche Bank announced an additional 1,000 jobs reduction after the reduction of 3,000 jobs in June. These are all part of the 9,000 jobs being reduced worldwide to make the Group more competitive as part of its Strategy 2020, which will likely require many more front-loaded job cuts, in our view. Without government assistance, at least through most of 2017, Deutsche Bank will likely have to intensify its restructuring efforts eventually unwinding most of the operations of the bank and, thus, keeping its commercial bank structure as its core new bank. Deutsche Bank’s derivatives exposure may result in a large bail-in of creditors that will exacerbate the ensuing credit contraction. This would still require support from the German government and any support ahead of the election may derail the reelection aspirations of Angela Merkel. Since the current Bundestag first sat on October 22, 2013, the latest date for the next election is October 22 of 2017. The earliest date is August 27, 2017, or the first Sunday after August 22nd. Recent elections have been held in late September to avoid the school holidays. 300 out of 598 seats are needed for a Bundestag

20

majority. Angela Merkel announced on November 20th that she will stand for reelection as German Chancellor as she runs for a fourth term next year and she takes on populists, which as in the rest of the world, are growing in popularity, especially as her refugee policies continue to impact adversely her popularity. Still, she represents stability in uncertain times. The Anti-immigrant party Alternative for Germany entered Berlin’s state parliament for the first time after winning 14.2% of the vote, while Merkel’s Christian Democratic Union (CDU) was pushed out the ruling coalition after winning just 17.6% of the vote, suggesting that the possibility of populist, nationalistic change remains high and dependent on the economic and financial performance of the European Union and Germany. Our view is that with Trump placing more demands on a weakening Europe and a Euro that continues to depreciate, her chances of winning the election may be more limited than now seen by most investors. Because the pressures on the Euro and European growth are taking place at a time where international investors rely on the U.S. dollar and Treasuries as a safe heaven, political pressures and opposition to standing policies will likely continue, in our estimation. Once parity is broken and restructuring and deceleration pressures intensify while government can do even less than when they had the opportunity to lead restructurings, political pressures to unite or divide Europe will also grow. Of course, given the likely economic pressures on the Euro, growth and jobs, the pressures to split may likely be the greatest the European Union has since implementing its monetary union in January 1999. This would prove, by our estimate, the greatest challenge to the future of the European Union. The key issue for Europe, of course, is that the existing monetary union requires a fiscal union to be successful. A fiscal European union, in turn, requires the kind of political and cultural union that still escapes Europe. In fact, limited country specific fiscal room to maneuver, especially now that yields are rising, is leading European debt to remain flat at the upper level of its range, near 90% of GDP, a time when bank restructurings would require more government support (Figure below). Unsurprisingly, the key test for the future of the European Union will likely be a renewed focus to forge a deeper union. This will entirely depend on the will of the European people at a time where economic and monetary pressures will probably test their resolve. Global trends, of course, don’t suggest a favorable outcome. However, for Europe, its future may hinge on the German election and the electorate’s will to keep the union together, a scenario that may have a better chance.

Source: OECD

60

70

80

90

100

Sep-06 Feb-08 Jun-09 Nov-10 Mar-12 Aug-13 Dec-14 Apr-16

European Governments Debt Consolidated (as % of GDP)

Source:

21

In our view, the sharp credit contraction that may follow banks’ balance sheets restructurings, including the reduction of outstanding derivatives positions and their move to the clearance market early next year, as well as Trump’s foreign policy pressures on Europe and the continued slide of the Euro will decelerate European growth markedly in early 2017, thus leading to a new round of capital outflows. This would weaken non-US international growth as it leads to further pressures on commodity prices and therefore on emerging markets, especially early in the year. In this setting, the United States is not only likely to lead the world’s recovery, but Europe will lag markedly, thereby exacerbating the pressures on the Euro and thus finally forcing Europe to face the restructuring challenges it has long avoided in the hopes of stronger growth that limits restructuring challenges. Growth and investment, of course, follow restructurings, that is a period where the losses are finally assigned, thus finally opening up new investment opportunities. We are clearly not there yet when it comes to Europe. The Euro will likely suffer accelerated depreciation pressures once it breaks below parity, forcing the European authorities to demand strong bail-ins from creditors to finally pursue the kind of restructurings that had been avoided for the past seven years. The German government will eventually have to help with the restructuring of Deutsche Bank after a sharp bail-in takes place and the authorities are finally able to separate its commercial bank, which will become the new Deutsche Bank and thus focus on the German depositor and German corporations and commercial companies, from its investment bank where derivatives and other credit problems remain. The commercial bank will be the new Deutsche Bank, while the investment bank will largely be part of new “bad bank” that would lead the final restructuring of compromised balances. Losses will be inflicted on creditors, exacerbating credit pressures, and on shareholders. The bail-in will exert strong, adverse pressures on other European financial institutions, notably banks and pension funds, not just in Germany but also in France and Italy, amongst other European countries. The process will be self-reinforcing through European countries and will require the leadership of the Central Bank and European governments to order the process, a key aspect that may only follow much greater bank and financial pressures, thus exacerbating the corrections. This round may prove to be the final round of systemic pressures that will eventually be followed by a new period of expansion on the back of U.S. growth and renewed investments in Europe during the second half or last quarter of 2017. In the meantime, Europe will lag the United States, in our perspective. Key Global Monetary Trends Monetary trends have been critical in identifying global investment opportunities in the past eight years. After leading central banks brought interest rates to historically low levels, they turned to strong quantitative monetary expansions to support the deleveraging efforts that banks began after the 2008 financial crisis. Low interest rates and expanded liquidity were instrumental in creating the conditions for the start of the massive deleverage process that began in 2008, notably in the United States and the United Kingdom. Because growth remained low and deleveraging threatened a new round of recessionary pressures, central banks began relying on quantitative monetary stimulus to keep leading economies from entering a new recession. The effort helped keep growth modest and, of course, to avoid a new recession, except in Europe as the Euro area fell into a recession in the second quarter of 2012. In fact, the United Kingdom led the global recovery, followed by the United States, as their central banks were the most aggressive in expanding liquidity early on, putting the economy back on track to grow. The Bank of England,

22

for example, had a 200% balance sheet expansion starting in the second half of 2008 and early 2009, providing by far the most monetary stimulus amongst the four most important central banks in the world (Figure below). The Fed followed, with most of its liquidity efforts starting in very late 2008 and mainly in 2009, as it expanded its balance sheet markedly, by about 150%. The European Central Bank lagged, with a relatively modest expansion of about 35% at the time. The Bank of Japan didn’t even bother until the second half of 2013, when its monetary expansion really took off to reach 316.7% last month. Unsurprisingly, the Yen appreciated throughout most of this period, until recently when money creation has finally catched up to lead the Yen to finally depreciate.

Source: Bloomberg The Bank of England ended its monetary expansion during the second half of 2012 and leveled its monetary expansion at a sizable 330.5%. The U.S. Fed lagged the Bank of England until 2013 when a new monetary expansion began and effectively almost doubled the quantitative expansion to 382.4% in 2014, from about 200%. This helped the U.S. recovery gained some momentum, particularly into 2015. After 2014, quantitative support ended but has remained near the upper level of the range. The U.S. Quantitative Expansion (QE) consisted of three easing programs that began in December 2008 and ended in October 2014 (see Table below). The first expansion focused in the purchase of $1.350 trillion in Agency Mortgage Back Securities and Agency debt from December 2008 thru March 2009 during the worst part of the crisis. This effort was followed with purchases of $300bn of Treasury Securities in March 2009. The second expansion was announced in August 2010 and began in November 2010 thru June 2011 focusing on purchases of $75bn per month in long-dated U.S. Treasuries up to a total of $600bn. The goal of this phase was to lower long-term yields to facilitate bank deleveraging through long-term refinancing of balance sheet positions. Finally, the third expansion focused once again in the purchase of Agency Mortgage Back Securities and longer-dated Treasuries to facilitate the financial system deleveraging process that finally ended this year.

ECB, 168.21%

FED, 382.40%

BOE, 330.54% BOJ, 316.71%

-50%

0%

50%

100%

150%

200%

250%

300%

350%

400%

2008 2009 2010 2011 2012 2013 2014 2015 2016

23

QE1, December 2008 to March 2010

Period Amount Instrument

Quantitative Easing 1 Dec-08 600 bn Agency (MBS) and Agency debt

Quantitative Easing 1 Mar-09 750 bn Agency (MBS) and Agency debt

Quantitative Easing 1 Mar-09 300 bn Treasury Securities

QE2, November 2010 to June 2011

Period Amount Instrument

Quantitative Easing 2 Nov-2010 - Jun-2011 600 bn Longer dated Treasuries/75 bn monthly

QE3, September 2012 to December 2013

Period Amount Instrument

Quantitative Easing 3 Sep-2012 Agency (MBS) / up to 40 bn monthly

Quantitative Easing 3 Dec-2012 Agency (MBS) / up to 40 bn monthly

Quantitative Easing 3 Dec-2012 Longer dated treasuries/45 bn monthly

Quantitative Easing 3 Dec-2013 - Oct-2014 Tapering back/Rate of 10 bn at each meeting

Source: US Federal Reserve The European Central Bank, unlike the U.S. Federal Reserve, pursued a modest quantitative expansion until 2012 when the program grew almost three-fold following renewed credit pressures. However, in 2013, the European Central Bank took away almost the entire monetary support to bring it back to its pre-2012 level of just under 50%. Starting in 2015, the European Central Bank, which by then was even lagging the Bank of Japan, began expanding its monetary stimulus until reached 168.2% of its 2008 level, or less than half that of the United States. The markedly lagging monetary stimulus in Europe, of course, didn’t help restructuring efforts, but it clearly underscores the Bundesbank hawkish position that reflects concerns that Germany may end up disproportionately paying for any monetization of bank problems (rather than the countries involved). This also explains why European restructuring efforts have been so limited until now and why renewed, strong downward pressure on the Euro will likely lead the Bundesbank to bail-in creditors and force restructurings to contain the costs to the German tax payer. It also underscores the European Union fundamental fiscal flaw, as it doesn’t allow for the fiscal flexibility that the United States and the United Kingdom has in directing fiscal (and thus monetary) support.

24

Against these monetary trends, the British pound has depreciated 57.3%, while the Euro has dropped 47.8% since July 2008. Without Brexit, the pound would’ve outperformed the Euro, as bank deleveraging and growth policies have been far stronger than in Europe. The Euro, of course, remains overvalued as the most critical bank restructuring efforts remain ahead, not behind us, suggesting that the currency will continue to fall. In a key German election year, this would probably lead the Bundesbank to be ever more vigilant on monetizing bank troubles, which will only make the restructuring more severe and thus the ensuing credit contraction and deceleration, recession pressures much greater. The Yen is finally now depreciating as its quantitative monetary creation is finally catching up to the kind of stimulus pursued by the Bank of England. Above all, the currency that has underperformed the most is the Mexican Peso, which has depreciated by 100% in the past eight years, as it acts as a hedge on virtually every global risk through its trading in the Chicago Futures Exchange.

Source: Bloomberg The depreciation of the Mexican peso gathered momentum after the first half of 2013, when emerging markets started to underperform markedly. Since July of 2015, when the local market was looking for a MXN Peso appreciating to MXN $13, the peso lost another 28.3%, even surpassing the British Pound 23% depreciation (see Figure below). The Euro has depreciated only 3%, but it remains the most overvalued global leading currency, suggesting that it will likely continue to fall as bank restructurings finally become unavoidable and, in fact, the German government forces a much deeper bail-in to limit monetary support as the election draws near.

USD-GBP, 57.37%

USD-MXN, 100.57%

USD-EUR, 47.75%

USD-JPY, 6.82%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

2008 2009 2010 2011 2012 2013 2014 2015 2016

Key Currency Changes (%)

25

Source: Bloomberg Jose M. Barrionuevo

USD-GBP, 23.12%

USD-MXN, 28.37%

USD-EUR, 3.10%

USD-JPY, -7.43%

-30%

-20%

-10%

0%

10%

20%

30%

40%

2015-07-01 2015-10-01 2016-01-01 2016-04-01 2016-07-01 2016-10-01