HOUSE_OVERSIGHT_014726.jpg

4 BAT scenarios To us, the key question is not when tax reform will pass (likely sooner than what is priced in). Far more important for financial markets in our view, especially for the rates and FX markets, is what tax reform means for inflation. The recent divergence between inflation breakevens and real yields reflects to a large part to the increasing consensus that tax reform will be stagflationary. We are less sure this will be the case and this is why. In our view, there are four possible paths in terms of how the border adjustment tax proposal could play out: e Scenario 1: This is the baseline of the Republican architects of the proposal who see a 25% appreciation of the USD to offset the 20% new tax on imports. In this scenario, because of the USD appreciation the inflationary impact of the border adjustment tax will be limited. In fact, it is very likely in this scenario that the second round effects of the USD appreciation (for example on commodity prices and emerging markets) will stoke deflationary fears. e Scenario 2: In this scenario, we would get the BAT as proposed but the USD does not go up because the new administration sees a strong USD as incompatible with its trade policy. We suspect this scenario has become the baseline for the market. We disagree this is the most probable outcome. In our view, it would be difficult if not impossible for Republican leadership to push through tax changes that would lead to potentially very unpopular price hikes ahead of the mid-term elections next year. e Scenario 3: In this scenario the BAT would not make it into the tax reform and the proposed corporate tax cut is financed by running up the fiscal deficit. This could be easier to sell politically than Scenario 2, especially given that the Republicans plan to deliver personal income tax cuts at the same time. In this scenario, the USD will rally as the Fed continues to hike and rate differential drives the USD higher. Chart 6: The four different fates of the border adjustment tax proposal Scenario 1: Ryan-Brady proposal Medium probability: +25% USD increase = Little increase USD{ 17, BE|| in inflatian Scenario 2: Ryan-Brady proposal + Low probability: little USD increase = Big increase in —— > USD |, BET Inflatinn BAT Scenario 3: No BAT + bigger fiscal Medium probability: deficit = Little increase in inflation -— > USDt, BE| Scenario 4: VAT instead of BAT = Medium probability: 41\\ Smaller increase in inflation > USD* 1, BET | Source: BofA Merrill Lynch Global Research BankofAmerica <2” 6 Cause and Effect | 13 February 2017 Merrill Lynch HOUSE_OVERSIGHT_014726