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currencies. The fact that the Central Bank of Brazil will be looking to cut rates in the face of a Fed tightening cycle makes the BRL especially vulnerable in 2017. We would recommend buying MXN against BRL as a relative value trade. 5. The best hedge against escalation of trade friction The rise of populism means that policies will become less predictable and less market friendly. This should be especially true in the area of international trade. Even though a trade war is not our central scenario, the risk of trade friction will likely be much greater than anything we have seen in recent years. For Donald Trump’s trade policy to work he needs a weak USD. Meanwhile, with increased concerns about the long-term ill effect of debt-fuelled expansion, Beijing seems to have become resigned that China needs a weaker RMB (Chart 11}. This could set the US and China on a collision course in 2017. To hedge against the possibility of an escalation of trade tension between China and the US, we would recommend buying a 10 delta USD call/CNH put that would benefit from either an increase in risk premium or an acceleration of renminbi depreciation between now and the inauguration of the new US president on January 20 (Chart 12). 6. Contagious populism will benefit the GBP Brexit and the election of Donald Trump could help bolster nationalistic and anti- globalization parties elsewhere by lending legitimacy to their causes. With major elections coming up in France, Holland and Germany next year and the possibility of early elections in Italy, investors will be on tenterhooks, as anti-globalization movements could further undermine public support for the European project at a time that the Eurozone is still recovering from the peripheral crisis. It is not our central scenario that right wing parties will take power in any of these countries next year. However, after the surprise victories of the Brexit camp and Trump, investors are likely to demand greater risk premium ahead of these votes. We think this could lead to further reversal of the rally in EUR/GBP this year and would recommend selling the cross at the current level. 7. Not all reflation trades are born equal Reflation trades have skyrocketed since the US election. Commodities, mining stocks, commodity currencies, and inflation indexed bonds generally have outperformed. However, we would caution against the indiscriminate buying of inflation-linked assets, as the general theme is not supported by fundamentals in all inflation-linked markets. Eurozone 10y20y inflation breakeven has jumped over the past week to 1.96%, near the year’s high, but more importantly, approaching the ECB’s “below but close to 2%” Chart 11: RMB trade weighted basket Chart 12: EUR/GBP spot 106 0.95 104 0.9 102 0.85 100 0.8 98 0.75 96 0.7 94 0.65 10/1/2015 1/1/2016 4/1/2016 7/1/2016 10/1/2016 1/1/2010 Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Bankof America 2 Merrill Lynch Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 HOUSE_OVERSIGHT_014735