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incorporates this view, as we are neutral on the euro, yen and pound versus the US dollar, but remain bearish on the Chinese renminbi. We discuss our view on the broader US dollar, as well as each of these currencies, next. US Dollar Following three consecutive years of dollar outperformance, it would be reasonable to assume the up-cycle is nearing an end. After all, dollar valuation is now close to its historic average level relative to the currencies of US trade partners, after adjusting for inflation. Moreover, the length of this dollar bull market is approaching that of the two prior episodes shown in Exhibit 71 and shares a similar underlying driver—tighter monetary policy in the US relative to its global peer group. But while we expect the pace of US dollar appreciation to slow, there are many reasons to believe the greenback’s outperformance can continue this year. Dollar valuation remains below the peaks reached in the 1985 and 2002 bull cycles, suggesting it is not yet prohibitively expensive. The dollar should also benefit from solid US macroeconomic fundamentals relative to other developed economies. President-elect Trump ran on a platform that includes fiscal expansion and corporate tax reform. Although his economic team’s spending plan is still forthcoming, the package could represent an economic tailwind that may justify tighter US monetary conditions at a time when foreign central banks have committed to easier policy. In turn, relatively higher US yields may entice global investors to favor US dollar assets over lower-yielding foreign-denominated alternatives. Furthermore, some elements of the new administration’s desired corporate tax reform could present material upside risk to the US dollar. For example, the destination-based tax system supported by several House Republicans disallows deductions for any imported good or service— Dollar gains are likely to be more modest and reflected in a narrower set of currencies as the dollar bull market enters its fifth year. Exhibit 71: US Dollar Real Effective Exchange Rate Dollar valuations are near their long-term average but below levels reached in past bull cycles. Z-Score 6.3 Years 6.8 Years 5.4 Years 1g 1973 1978 1983 1988 1993 1998 2003 = 2008 =—.2018 Data through November 30, 2016. Note: Z-score is calculated on data since 1973 and represents the number of standard deviations from the mean. Shaded areas highlight periods of dollar strength. Source: Investment Strategy Group, Datastream. effectively supporting US goods by making them more competitive. Economic theory suggests that free-floating currencies such as the US dollar would need to adjust higher by the amount of the tax to create equilibrium with similar goods sourced across foreign borders. Taken at face value, this implies a 20% destination tax would require a simultaneous—and potentially very disruptive—20% increase in the US dollar. A tax holiday for cash held abroad could be similarly dollar positive, in spirit if not in magnitude. While it is true that a majority of the $2.6 trillion of US corporate earnings trapped overseas are already held in US dollar assets, the greenback would still enjoy a tailwind if corporates elected to repatriate some portion of the foreign currency balance. That said, the risks to the US dollar are not exclusively to the upside, as much of the good news is embedded in current prices (see Exhibit 72). Consider that the bulk of last year’s dollar advance occurred in the two weeks following the US presidential election in November, as the market quickly discounted a portion of potential policy changes. Moreover, Federal Reserve rate hike expectations for 2017 have increased following stronger US activity data during the second half of 2016. Lastly, we expect the BOJ and ECB to maintain their highly accommodative policies again this year. With these tailwinds already Outlook | Investment Strategy Group 61 HOUSE_OVERSIGHT_014594