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The role of fundamentals From a purely mechanical perspective, we could stop the analysis here and choose those currencies with better risk-reward prospects according to the metrics so far described. However, in order to analyze carry trades with relatively short investment horizon, we need to complement our analysis with our views on future exchange rates dynamics. We expect US rates to continue moving higher and the USD to strengthen across the board due to easier US fiscal policy and significant uncertainty regarding foreign policy. In EM, we think LatAm is the region that will suffer the most in the new global scenario, followed by Asia. We find EEMEA relatively more resilient to US driven shocks. We want to avoid countries with high financing needs (i.e., high fiscal and current account deficits). We also prefer trades with neutral commodity exposure. Since carry trades tend to underperform when US rates are moving higher and the USD strengthens, we want at least to avoid USD funded carry trades, crowded carry trades and currency crosses highly exposed to the USD factor. Hedging the USD factor leaves us with the pure carry exposure, which by being a price factor, is also related to standard measures of risk, as well as idiosyncratic factors. Best carry trade: Cherry picking among rotten cherries Given our views, and focusing on those trades where ex-ante high carry is consistent with ex-ante expected returns, we choose our best carry trades across EM and DM. Since DM currencies offer very low carry vs the USD, there are not many attractive carry opportunities in DM in a strong USD environment, so much so that the most attractive carry proposition is simply to go long USD/JPY. Since this trade is mostly predicated on a strong USD view and is being developed in other sections of this report we refer the reader to those sections (please see: USD/JPY will the main beneficiary of Trump win, FX: GOP sweep emboldens core USD/JPY view, Long EUR/JPYAsia: short JPY/KRW). Therefore, we focus mostly on EM or EM/DM carry trades. EEMEA: short EUR/RUB We like selling EUR/RUB (spot 69.28, target 66.15, stop 71.02). We see EEMEA as relatively more resilient to higher US rates, though with some heterogeneity within the region. On the one hand, high current account deficit countries like Turkey or South Africa should continue suffering from a re-pricing of risk. On the other hand, CEE countries are expected to some more resilience. One currency we find particularly attractive is the Russian ruble, which still offers an attractive risk-adjusted carry, controlling for standard measures of risk such as implied volatility and maximum drawdown. The outcome of the US election should remove some risk premium from Russian assets as the geopolitical backdrop improves. Economic activity is expected to pick up in 2017. A hawkish central bank, coupled with a favorable external position and an energy-driven current account surplus will likely limit its exposure to a reversal in capital flows. On the geopolitical side, we expect Russian foreign policy to become more conciliatory Chart 66: Oil prices are a major risk factor Chart 67: Russia tends to be more market-friendly with lower oil 15 Si agi i ——0)il price, $/bb] ——10y MA Ukraine Georgia nigis 100 Privatization, 1.0 4 Gaidar,reforms War Start of Yukos 50 Perestroika ae Y Afganistan 0.5 seat! === RUB/(EUR,CAD,COP) Jan 4 13 =10 “Russia == RUB/EUR Jan 4'13 =100 On st st © mOmWwmoen oye DN Tt SES RSS Sape orga sseooocars === Brent oil (RHS ¢madama dc BA tC BRA ERA ERA EL BH a SESSESSSSSESSESSSISE Jan-13 Jul-13 Jan-14 Jul-14. Jan-15 Jul-15 Jan-16 Jul-16 Source: BofA Merrill Lynch Global Research, Bloomberg Source: BofA Merrill Lynch Global Research, Bloomberg 38 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Bankof America Merrill Lynch HOUSE_OVERSIGHT_014768