Geopolitics
Highlights The financial market landscape has shifted over the past month with asset correlations changing and the so-called 'Trump trades' going into reverse. Equity valuation is stretched and plenty of risks remain. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. The economic data remain constructive for profits in the major countries. The risks posed by upcoming European elections have eased for 2017, now that the Italian election appears unlikely until 2018. The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. If a tax reform package proves too difficult to pass, then the GOP will settle for straight tax cuts and a modest amount of infrastructure spending. Market reaction to the FOMC's 'dovish hike' was overdone. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Not before September will the ECB be in a position to announce a further tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. In Japan, the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. Our views on U.S. fiscal policy and the major central banks paint a bullish picture for the dollar, and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Another key market development has been the continuing drop in risk asset correlations. This reflects falling perceptions of downside "tail risk", which is reflected in a declining equity risk premium (ERP). Absent further negative shocks, perceptions of downside risk should continue to wane, allowing risk premia and asset correlations to ease further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can focus more on long-term revenue generation rather than on guaranteeing their existence. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. The only adjustment to asset allocation we are making this month is an upgrade for U.S. high-yield based on improved valuation. Feature The financial market landscape has shifted over the past month with asset correlations changing and a number of popular trades going into reverse. First, the failure to replace Obamacare triggered a pull-back of the so-called 'Trump trades.' Stock indexes are holding up well, but the U.S. dollar has given back most of the gains made in March and the 10-year Treasury yield has dropped back to the bottom of the post-U.S. election trading range. Moreover, the negative correlation between the U.S. dollar and risk assets has flipped (Chart I-1). Even oil prices have diverged from their usual negative trading relationship with the dollar. Second, investors are questioning the FOMC's appetite for rate hikes in the coming months. They are also wondering how much longer the European Central Bank (ECB) and the Bank of Japan (BoJ) can maintain current hyper-stimulative policy settings. The whole narrative regarding equity strength, a dollar overshoot and bond price weakness may be over if there is not going to be any fiscal stimulus in the U.S., the Fed is not going to hike more aggressively than the market currently expects, and monetary policy is near a turning point in Japan and the Eurozone. Is it time for investors to become defensive, scale back on risk assets, upgrade bonds and short the dollar? We believe the answer is 'not yet', although 2017 was always destined to be a rough ride given the ups-and-downs in the U.S. legislative process and the lineup of European elections. President Trump's first 100 days are turning out to be even more tumultuous than many expected. Allegations of wiretaps and the FBI investigation into the alleged interference of Russia in the U.S. election are costing the President political capital, as well as raising question marks over the Republican Party's wish list. Simply removing the possibility of corporate tax cuts would justify a healthy haircut on the S&P 500. The political situation has admittedly become more complicated, but our geopolitical team makes the following observations: The GOP base supports Trump: Until the mid-term elections, Trump's popularity with Republican voters remains strong, which means that the President still has political capital (Chart I-2). Chart I-1Changing Correlations Chart I-2Trump Not Dead To Republicans Yet Republicans want tax reform: Even if reform gets bogged down, there is broad support for cutting taxes at a minimum. Many deficit hawks appear willing to use the magic of "dynamic scoring" to justify tax cuts as revenue-neutral. Even the chairman of the Freedom Caucus has signaled that he is open to tax reform that is not revenue neutral. Tax reform not conditional on Obamacare: The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. The Republicans will need to show success on at least one of their signature platforms before heading into the mid-term elections. The prospective savings from Obamacare's repeal are not needed to "fund" tax cuts. Infrastructure: We still expect that President Trump will get his way on additional spending on defense, veterans, infrastructure and the wall. The tax reform process will undoubtedly be full of drama and may be stretched out, adding volatility to the equity market. Our base case is that some sort of tax reform and infrastructure package will be passed by year end. However, if a reform package proves too difficult to pass, then we believe that the GOP will settle for straight-forward tax cuts and a modest amount of infrastructure spending (please see Table I-1 in the March 2017 monthly Bank Credit Analyst for the probabilities we have attached to the various GOP proposals). Tax cuts and increased spending will be positive for risk assets. The caveat is that we see little change in Trump's commitment to mercantilism. This means he will lean toward backing the border tax or tariff increases, which will offset some of the benefits for risk assets from reduced tax rates. Excess Reaction To FOMC Chart I-3FOMC & Market Disagree Beyond This Year Given the uncertainty on the fiscal side, one can't blame the FOMC for taking a "wait and see" approach. The range for the funds rate was raised to 0.75-1.00% at the March meeting, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50 bps of tightening is expected by the Committee this year, with 75 bps expected in both 2018 and 2019 (Chart I-3). The FOMC signaled in March that it was not yet prepared to adjust the 'dot plot,' sparking a rally in bond prices and a pullback in the dollar. This market reaction seemed excessive in our view. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target, as highlighted by the decision to strip the reference to the "current shortfall of inflation" from the statement. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Is The Dollar Bull Over? Still, recent market action suggests that the dollar may not get a lift from future Fed rate hikes because the outlook for global growth outside of the U.S. is brightening. Moreover, it could be that monetary policy in the Eurozone and Japan is at a turning point. There is increasing speculation that the ECB will have to taper the quantitative easing program sooner than planned. Some are even speculating the ECB will lift rates this year. The recent economic data for the euro area have indeed been stellar. The composite PMI surged to 56.7 in March, with the forward-looking new orders components hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart I-4). In addition, private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. Our real GDP model for the Eurozone, based on our consumer and business spending indicators, remains quite upbeat for the first half of the year. With unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to establish a consensus view on the ECB policy committee. The Bundesbank has been quite vocal on this issue, especially given that Eurozone headline HICP inflation reached 2% in February. The core rate of inflation remains close to 1%, but the rising diffusion index suggests that budding inflation pressure is becoming more broadly based (Chart I-5). Chart I-4Solid Eurozone Economic Data Chart I-5Eurozone Inflation Broadening Out BCA's Global Fixed Income Strategy service recently compared the current economic situation to that of the U.S. around the time of the Fed's 2013 "Taper Tantrum."1 In Chart I-6, we show "cycle-on-cycle" comparisons for the Euro Area and U.S. In the Euro Area, the number of months to the first rate hike discounted in money markets peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, this indicator has converged with the U.S. path. There is less spare capacity in European labor markets today than was the case in the U.S. when the Fed first hinted at tapering its asset purchases. Nonetheless, the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Not before September will the ECB be in a position to announce another tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. We do not believe that the ECB will raise short-term interest rates before it starts the tapering process. A rate hike would result in a stronger euro, downward pressure on inflation, and an unwanted tightening in financial conditions that would threaten the current economic impulse. This means that, between now and September, the window is still open for U.S./Eurozone interest rate spreads to move further in favor of the dollar. The European election calendar remains a risk to our view on currencies and risk assets. Widening OAT/Bund yield spreads highlight that investors remain concerned that the French election will follow last year's populist script in the U.K. and the U.S. However, our geopolitical team believes that Le Pen is unlikely to win since she trails in the polls by a 25-30% margin relative to Macron, her most likely opponent. Even if she were to pull off a win, she will not hold the balance of power in the National Assembly. Over in Germany, where the election is heating up, the fact that the Europhile SPD party is gaining in the polls means that the September vote is unlikely to be a speed bump for financial markets. The real political risk lies in Italy. While the election has been pushed off to February 2018, it appears that there will be genuine fireworks at that time because Euroskeptic parties have seized the lead in the polls (Chart I-7). In the meantime, European elections will be a source of volatility, but investors should ride it out until we get closer to the Italian election. Chart I-6Less Spare Capacity In Europe ##br##Now Vs. Pre-Taper Tantrum U.S. Chart I-7Italian Elections: The Big Risk Japanese Yield Cap To Hold Chart I-8Japanese Wages Still Disappointing Similar to our view on the ECB, we do not believe that the Bank of Japan (BoJ) will be in a position to begin removing monetary accommodation anytime soon. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. True, deflationary forces appear to have eased somewhat. Japan is also benefiting from the faster global growth on the industrial side. Nonetheless, the domestic demand story is less positive, with consumer confidence and real retail sales growth languishing. Wages continue to struggle as well (Chart I-8). This year's round of Japanese wage negotiations was particularly disappointing, with many manufacturing companies offering pay raises only half as large as those of last year. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. Our views on U.S. fiscal policy and the outlook for the major central banks paint a bullish picture for the dollar and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Admittedly, however, the next major move in global yields may not occur until the autumn when the ECB takes a less dovish tone. In the meantime, our fixed-income strategists remain underweight Treasurys within global currency-hedged portfolios. The team recently upgraded (low beta) JGBs to overweight at the expense of core European government bonds, which move to benchmark. Correlation, ERP And Hurdle Rates Chart I-9Market Correlations Are Shifting Another key market development has been the continuing drop in risk asset correlations, a trend that began before the U.S. election (Chart I-9). Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification. Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart I-10). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.2 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart I-11). But why was the ERP so elevated after 2007? Chart I-10Market Correlation And The ERP Chart I-11Modeling The Stock ##br##Correlation Within The S&P 500 The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.3 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending Chart I-12Capex Hurdle Rates Never Came Down An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.4 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart I-12). J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.5 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list, as highlighted in this month's Special Report on Brexit's implication for Scotland independence, beginning on page 19. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart I-13). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. We continue to favor higher beta developed markets where value is less stretched, such as the euro area and Japan, over the U.S. on a currency-hedged basis. Europe is about one standard deviation cheap relative to the U.S. index, although the extra value in the Japanese market has dissipated recently (Chart I-14). Moreover, both Eurozone and Japanese stocks in local currency terms will benefit from weaker currencies in the coming months, as rising inflation expectations and stable nominal interest rates result in declining in real rates, at least relative to the U.S. Chart I-13Forward Multiple Scenarios Chart I-14Eurozone Stocks Are Cheap Conclusion We have reassessed our asset allocation given that several market calls have gone against us over the past month. However, three key views argue to stay the course for now: Recent economic data support our view that a synchronized global acceleration is underway. This is highlighted by an update of the real GDP growth models we introduced last month (Chart I-15). The implication is that earnings growth will be constructive for stocks; Tax reform is still likely to be passed this year in the U.S. Moreover, were a broad tax reform package to elude the Administration, the fallback position will involve (stimulative) tax cuts, some infrastructure spending and de-regulation; and The FOMC will shift to a more hawkish tone in the coming months, while the ECB, Bank of England and Bank of Japan will maintain extremely accommodative monetary policy at least into the fall. The result is that stocks will outperform cash and bonds, while the dollar still has another 10% upside potential. The only adjustment we are making this month is in the U.S. high-yield corporate bond allocation. According to our fixed-income strategists, value has improved enough that it is worth upgrading the sector to overweight at the expense of Treasurys. Some of the indicators that comprise our default rate model have become more constructive for credit risk, including lending standards, the PMIs and profits. The combination of wider junk spreads and an improving default rate outlook have resulted in a widening in our estimate of the default-adjusted high-yield spread to 219 basis points (Chart I-16). Historically, high-yield earns a positive 12-month excess return 81% of the time when the default-adjusted spread is between 200 and 250 basis points. Chart I-15GDP Models Are Bullish Chart I-16Upgrade U.S. High Yield Turning to oil markets, we expect recent price weakness to reverse despite dollar strength. Building inventories have weighed on crude, but this is a head fake according to our commodity experts. We expect to see a sustained draw in OECD storage volumes this year, now that the year-end surge on crude product from OPEC's Gulf producers has been fully absorbed. With global supply/demand fundamentals now dominating price movements, the recent breakdown in the inverse correlation between oil prices and the dollar should persist. Oil prices will rise back toward the US$55 range that we believe will be the central tendency over 2016 and 2017. Risks are to the upside. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Shift to benchmark in Eurozone government bonds and upgrade JGBs to overweight within currency-hedged portfolios. The U.S. remains at underweight. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks over bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues in the U.S.; upgrade U.S. high-yield to overweight, but downgrade European investment-grade to underweight due to fading support from the ECB. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. Favor oil to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst March 30, 2017 Next Report: April 27, 2017 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?" dated March 7, 2017, available at gfis.bcaresearch.com. 2 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 3 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 4 Are Firms Underinvesting - and if so why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 5 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016. II. Will Scotland Scotch Brexit? This month's Special Report, on Scotland's role in Brexit negotiations, was penned by our colleagues Matt Gertken, Marko Papic, and Jesse Kurri of BCA's Geopolitical Strategy service. Scottish secessionist sentiment has increased in response to First Minister Nicola Sturgeon's decision to push for a second popular referendum on Scottish independence, tentatively set for late 2018 or early 2019, though likely to be denied for some time by Westminster. The outcome of a referendum on leaving the U.K., which eventually will occur, is too close to call at this point. The possibility will influence the U.K.'s negotiations with the EU, and vice versa. The risk of a U.K. break-up adds an important constraint to Prime Minister Theresa May's government in the Brexit talks. Since the EU also has an interest in avoiding a devastating outcome for the U.K., our geopolitical team believes that the worst version of a "hard Brexit" will be avoided. That said, independence for Scotland cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s divorce proceedings. I trust that you will find the report as insightful as I did. Mark McClellan Senior Vice President A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland's First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.'s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the "Great Repeal Bill" that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the "Phoney War" has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart II-1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart II-2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart II-3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart II-1A Second Independence Referendum... Chart II-2...Is Looking More Likely Chart II-3Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, the outcome will be "too close to call," at least judging by the data available at present. In what follows we discuss why, and how Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "the End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland resented the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. If that had happened in 2014, it was estimated that the country's fiscal deficit would have been 5.9% of GDP and that its national debt would have been 109% of GDP. (Today those numbers are 8% and 84% of GDP respectively) (Table II-1). A newborn Scotland would have to adopt austerity quickly. Table II-1Scotland Would Be A High-Debt Economy Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart II-4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Chart II-4Highly Financialized Societies Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart II-5). Brexit does indeed mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. Chart II-5Three Cheers For Brexit And The Tories It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that a new independence vote would be justified in case of "a significant and material change in the circumstances that prevailed in 2014, such as Scotland being taken out of the EU against our will." Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart II-6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart II-7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart II-6Immigration Curbs ##br##Threaten Scots Growth Chart II-7Scottish Patriots ##br##Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart II-8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart II-9). Decommissioning costs are also expected to be high as the sector is wound down. England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart II-10). Chart II-8No Golden Goose In The North Sea Chart II-9Limited Domestic Energy Supplies Chart II-10The U.K. Pays For Scotland's Allegiance Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart II-11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart II-12). Chart II-11Scotland's Deficits Getting Worse Chart II-12Scottish Financial Assets Need Currency Stability Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts II-13 and II-14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart II-15). Chart II-13Irish Independence: ##br##Poverty Not An Obstacle Chart II-14Scotland: If The Irish ##br##Can Do It So Can We Chart II-15EU Market No ##br##Substitute For British Market Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart II-16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart II-17). Youngsters are willing to take risks for the thrill of freedom, while their elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart II-16No Relationship Between IndyRef And Brexit Chart II-17Old Folks Loyal To The Union Jack The most striking indicator of Scottish secessionism is unemployment (Chart II-18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart II-19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart II-18Joblessness Boosts Independence Vote Chart II-19The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, though of course Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart II-5, page 24). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism and migration, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the common market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the common market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. Our Geopolitical Strategy service has been short EUR/GBP since mid-January and the trade is down 2%. This suggests that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer this currency trade as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken Associate Editor Geopolitical Strategy Marko Papic Senior Vice President Geopolitical Strategy Jesse Anak Kuri Research Analyst Geopolitical Strategy 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also may work against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. III. Indicators And Reference Charts The S&P 500 index has pulled back from its recent highs, but it has not corrected enough to 'move the dial' in terms of the valuation or technical indicators. Stocks remain expensive based on our valuation index made up of 11 different measures. The technical indicator is still bullish. Our equity monetary indicator has dropped back to the zero line, meaning that it is not particularly bullish or bearish at the moment. The speculation index is elevated, however, pointing to froth in the market. The high level of our composite sentiment index and the low level of the VIX speaks to the level of investor complacency. Net earnings revisions remain close to the zero mark, although it is somewhat worrying that the earnings surprises index is slowly deteriorating. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. However, the widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking ahead, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. The composite technical indicator for the 10-year Treasury shows that oversold conditions are unwinding, although the indicator is not yet back to zero. This suggests that the consolidation period for bonds is not yet complete. Oversold conditions are almost completely gone in terms of the U.S. dollar. The dollar is very expensive on a PPP basis, although it is less so by other measures. We believe the dollar has more upside. Technical conditions are also benign in the commodity complex. However, we are only bullish on oil at the moment. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market ##br##And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning Chart III-27U.S. And Global Macro Backdrop ECONOMY: Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China
Highlights Either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though our preferred long euro expression is long euro/pound near term and long euro/yuan structurally). All three of the above are just one big correlated trade. Long-term equity investors should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. But near term, remain cautious on risk-assets. Feature On the face of it, the ECB has committed to leave interest rates where they are for a very long time. "The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases"1 But take a closer look at this commitment, and an extended period of time could mean as little as a year. As things stand, "the horizon of the net asset purchases" has only nine more months to run, and "well past" could justifiably mean just six months or less beyond that. Furthermore, at the last press conference Draghi emphasized that forward guidance "is an expectation" and that the probabilities of the ECB's expectations are constantly changing. Remember also that the ECB has three policy interest rates:2 the deposit rate (-0.4%), the repo rate (0%) and the marginal lending rate (0.25%) - and the ECB doesn't have to move all three in tandem. Indeed in 2015, the ECB cut the deposit rate before the other two rates (Chart I-2). So it is quite conceivable that the ECB could hike the deposit rate before the other two rates and as soon as a year or so from now. Chart of the WeekGermany/Sweden Combination Has Run A Good Race With The U.S. Chart I-2The ECB Could Hike Its Deposit Rate Early ECB council member Ewald Nowotny hinted as much in a Handelsblatt interview last week, saying that all interest rates wouldn't have to be increased simultaneously nor to the same extent. "The ECB could raise the deposit rate earlier than the prime rate." A Major Mispricing: ECB Versus Fed This neatly brings us to one of the most extreme pricings in financial markets at the moment. The expected difference between ECB looseness and Fed tightness two years ahead stands at a 20-year extreme (Chart I-3). Chart I-3An Extreme Pricing: ECB Versus Fed Yet the percentage of the euro area population in employment is at an all-time high (Chart I-4), while on an apples for apples comparison, there is no difference between economic growth, inflation, or inflation expectations in the euro area and the U.S.3 Moreover, Draghi points out that "the risks surrounding euro area growth relate predominantly to global factors." If these global risks do materialise, it would prevent both the ECB and the Fed hiking rates through 2018. But if these global risks do not materialise, allowing the Fed to continue hiking through 2018, is it really conceivable that the ECB just sits pat? We think not. On this basis, investors should either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though we prefer long euro/pound near term and long euro/yuan structurally). We say "either or" because all three positions are just one big correlated trade (Chart I-5). Chart I-4Percentage Of Euro Area Population In##br## Employment Near An All-Time High! Chart I-5Correlated Trade: Interest Rate Futures,##br## Bond Yield Spreads, Ans EUR/USD The French Election: "System 1" And "System 2" The looming risk to this big correlated trade takes the form of the upcoming French Presidential Election. Two data points do not make a trend, but some people are worried that the same dynamic that delivered shock electoral victories for Brexit and Donald Trump in 2016 could propel Marine Le Pen to the Elysée Palace in 2017. This worry is overdone. In explaining the Brexit and Trump shock victories, an important point has been understated. These days many voters care more about politicians' personalities than policies. Emotional appeal arguably matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Both the Brexit and Trump campaigns resonated strongly with emotional System 1. A lot of voters warmed to Boris Johnson, a leader of the Brexit campaign, and to Donald Trump. By contrast, the Bremain and Hillary Clinton campaigns tried to appeal mainly to cold rational System 2. But as Kahneman explains, when cold rational System 2 competes with emotional System 1, emotional System 1 almost always wins. In this regard, the dynamic of the French Presidential election is very different to the U.K.'s EU Referendum and the U.S. Presidential Election. Charles Grant, director of the Centre for European Reform, points out that "Emmanuel Macron's personality, and notably his charm, calm authority and courage may well (emotionally) appeal to more voters than Marine Le Pen's simplistic remedies and bitterness." Therefore, a final run off between Le Pen and Macron - as now seems highly likely - does not give us sleepless nights. But we would be concerned if the final run off were between Le Pen and the much less emotionally appealing François Fillon (Chart I-6 and Chart I-7). Chart I-6A Final Run Off Between Le Pen & Macron... Chart I-7...Does Not Give Us Sleepless Nights Incidentally, both Daniel Kahneman and Charles Grant will be speaking at our forthcoming New York Conference on September 25-26, and promise to provide fascinating investment insights from their areas of expertise. So book your places now! A Better Way To Invest In Europe: Germany And Sweden All of this might suggest that the Eurostoxx50 should outperform the S&P500. Not necessarily. Extreme economic and political tail-events aside, there is almost no connection between national or regional economic relative performance and stock market relative performance. As we demonstrated in the Fallacy Of Division,4 by far the biggest driver of Eurostoxx50 versus S&P500 performance is its sector skew. The Eurostoxx50 has a major 15% weighting to banks and a minor 7% weighting to tech. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 22% weighting to tech. Furthermore, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. So relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,5 or vice-versa. Everything else is largely irrelevant. But this begs the question: can a different combination of European markets neutralise the sector skew and thereby provide a fairer head-to-head contest with the tech-heavy S&P500? At first glance, the answer seems to be no. Europe simply does not have the same type of technology companies that the U.S. has. So no combination of European markets can match the S&P500 tech exposure. On the other hand, Europe is the world-leader in a different type of technology: innovative industrial equipment and materials. It turns out that a 50:50 combination of Germany (DAX) and Sweden (OMX) matches the exposure to European industrial equipment and materials with the exposure to American tech. At the same time, the DAX/OMX combination largely removes Europe's bank overweight. The upshot is that the DAX/OMX combination has run a very good race with the S&P500 through the past 10 years, while the Eurostoxx50 has failed to keep the pace (Chart of the Week). In effect, DAX/OMX versus S&P500 reduces to Siemens, Bayer and Atlas Copco versus Apple, Microsoft and Google (Chart I-8). Compared to the euro area banks, Europe's innovative industrial equipment and materials are a much better long-term match-up against U.S. tech (Chart I-9). Indeed, my colleague, Brian Piccioni, BCA Technology strategist, points out that Bayer is a good play on the revolutionary new genetic modification technology CRISPR-Cas9.6 Chart I-8DAX/OMX Vs. S&P500 = Siemens, Bayer & Atlas Copco ##br##Vs. Apple, Microsoft & Google Chart I-9European Innovative Industrial Equipment & Materials ##br##Is A Good Match-Up Against American Tech Investors who want a long-term equity exposure to Europe should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. Nevertheless, those who can fine-tune their timing should await a better entry-point for all risk-assets. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the ECB introductory statement to the press conference, March 9 2017. 2 The deposit rate (-0.4%) is the rate at which commercial banks park their excess liquidity; the repo rate (0%) is the usually quoted policy rate for the ECB's standard money market operations; and the marginal lending rate (0.25%) is the rate at which commercial banks borrow from the central bank, usually when they cannot access interbank funding. 3 Please see the European Investment Strategy Weekly Report 'Fake News In Europe' January 26, 2017 available at eis.bcaresearch.com 4 Published on March 9, 2017 and available at eis.bcaresearch.com 5 Listed as Alphabet. 6 Please see the Technology Strategy and Global Investment Strategy Special Report 'CRISPR-Cas9: Investment Implications' March 17, 2017 available at www.bcaresearch.com Fractal Trading Model* There are no new trades this week. We are expressing a tactical short position in equities through a short exposure to the Netherlands AEX. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Trump's agenda has not derailed ... at least not yet; Europe remains a red herring ... as the Dutch showed; Turkey cannot restart Europe's immigration crisis; Supply-side reforms are still likely in France; The ECB will remain dovish for longer than expected; EUR/USD may rise in the short term, but it will relapse. Feature In this Weekly Report, we focus on the key questions regarding continental European politics. To begin, however, we will briefly address the U.S., since investors are starting to worry about whether President Donald Trump can get his legislative agenda through, given the recent testimony of FBI Director James Comey on the alleged interference of Russia in the U.S. election. There are three points to focus on in the U.S.: Chart 1Trump Not Dead To Republicans Yet The GOP base supports Trump: President Trump was always going to be a controversial president. Anyone who is surprised by it today clearly was not paying attention last year. In the long term, Trump's extraordinarily low popularity will be an albatross around his neck, draining his political capital. However, until the mid-term elections, his popularity with Republican voters is all that matters, and it remains strong (Chart 1). House Republicans have to worry that they could face pro-Trump challengers in primary elections in the summer ahead of the 2018 midterms. As such, as long as the Republican voters support Trump, he still has political capital. Republicans in Congress want tax reform: Budget-busting tax reform is not only a Trump policy, it is a Republican policy. We have already received plenty of signals from fiscal hawks in Congress that they intend to use "dynamic scoring," macroeconomic modeling that takes into account revenue-positive effects of tax cuts when assessing the impact on the budget, in order to justify cuts as revenue-neutral. Republicans are also looking at the repatriation of corporate earnings and a border adjustment tax to raise revenue. Obamacare delay may not mean much: We already pointed out before that the GOP intention to focus on Obamacare first, tax reform second, would get them in trouble.1 This is now playing out. Opposing the Obamacare replacement may make sense to small-government Tea Party members. Repeal, alone, is why they are in Congress in the first place, given the 2010 wave election. But opposing tax cuts - once justified by dynamic scoring as revenue neutral - will be much more difficult. The Tea Party is "small government" first, fiscal restraint second. In other words, if tax reform cuts taxes and reduces revenue available to Washington D.C., "temporary" budget deficits will be easy to swallow. This is not to say that the recent events have not hurt the chances of whopping tax cuts and infrastructure spending. In particular, we think that Congressional GOP members may take over the agenda if Trump loses any more political capital. And this will mean less budget-busting than Trump would have done. Also, tax reform was always going to be difficult as special interests and lobbyists were bound to get involved. Chart 2French Spreads Are Overstated In addition, the probability of an eventual Trump impeachment - were Republicans to lose the House, or grassroots Republicans to abandon him in droves - has risen. Investors can no longer ignore this issue, even though it was initially a liberal fantasy. However, all of these risks to the Trump agenda will likely spur the GOP in the House to focus on passing tax reform while they still have a majority in Congress and control of the White House. We still expect tax reform to be done this year - within the fiscal year 2018 reconciliation bill - as time now may truly be running out for Republicans. Europe, meanwhile remains a focal point in client meetings. Our view that Europe will be a geopolitical red herring in 2017 - and thus an investment opportunity - remains controversial. We will address Brexit and the new Scottish independence referendum in our report next week, to coincide with London's formal invocation of Article 50 of the Lisbon Treaty to initiate the exit proceedings. Popular support for independence in Scotland has been one of our measures of "Bregret" since last summer and it has just sprung back to life, which adds a new source of risk for investors. On the continent, investors are particularly concerned that the upcoming French election will follow the populist script from the U.K. and the U.S. last year. This worry has pushed French bond yield spreads over German bonds to the highest level since 2011, bringing French bonds into the same trend as peripheral bonds (Chart 2). Since the outbreak of the euro area's sovereign debt crisis, a tight correlation between French and Italian/Spanish bonds has signified systemic political risk. We disagree that political events represent a systemic risk to the euro area in 2017. This week, we address five critical questions inspired by challenges to our view presented by our clients in meetings and conference calls. Question 1: Is The Dutch Election Result Important? Few clients have asked for a post-mortem on the March 15 Dutch election, but many asked about the vote beforehand. It has come and gone with little fanfare. Financial media have brushed it aside as it does not fit the neat script of rising Euroskepticism on the continent. To recap, the Euroskeptic and populist Party for Freedom (PVV), led by Geert Wilders, gained five seats in the election (13% of the votes cast), bringing its total support to 20 in the 150-seat parliament. Despite the gains, however, the election was an unmitigated disaster for Wilders, as the PVV was polling strong for most of the campaign and was expected to win between 30 and 35 seats (Chart 3). In terms of its share of total votes, the PVV's performance in 2017 trails its performance in the 2010 general election and the 2009 and 2014 European Parliament elections. Not only did the PVV underperform the past year's polls, but also they only managed to eke out their fourth-best performance ever. Chart 3Dutch Euroskeptics Were Always Overrated Chart 4Austria Leans Euroskeptic... Chart 5...Yet Chose A Europhile President It is a mistake to ignore these results. They teach us three valuable lessons: Trend reversal: In April of last year we warned clients that the upcoming Brexit referendum and U.S. elections had a much higher chance of populist outcomes than the European elections in 2017.2 The basis for our controversial claim was the notion that European social-welfare states dampened the pain of globalization for the middle class. We now have two elections that confirm our view that European voters are just not as angry as their Anglo-Saxon counterparts. Aside from the Dutch, there is also the lesson from the similarly ignored Austrian presidential election last December. Despite Austria's baseline as a relatively Euroskeptic country (Chart 4), the right wing, populist candidate lost his solid lead in the last few weeks ahead of the election (Chart 5). Clients should not ignore Austria and the Netherlands, since both countries have a long tradition of Euroskepticism and their populist, anti-immigration parties are well established and highly competitive. If Euroskeptics cannot win here, where can they win? It's immigration, stupid: Investors should make a distinction between anti-immigrant and anti-euro sentiment. In both the Netherlands and Austria, it was anti-immigrant sentiment that propelled populist parties in the polls. However, as the migration crisis abated, their polling collapsed. This was clearest in the Netherlands, where asylum applications to the EU - advanced by six months - tracked closely with PVV polling (Chart 6). The distinction is highly relevant as it means that even if the populists had taken power, they would not necessarily have had enough political support to take their country out of the euro area. This is particularly the case in the Netherlands, where support for the euro remains high (Chart 7). Brexit is not helping: Much ink has been spilt in the media suggesting that Brexit would encourage voters in Europe to hold similar popular referendums. We disagreed with this assertion and now the evidence from Austria and the Netherlands supports our view.3 Chart 3 shows that the decline in the PVV's support sped up around the time of the U.K. referendum, suggesting that Brexit may even have discouraged voters from voting for the populist option. Geert Wilders was temporarily buoyed by the kangaroo court accusing him of racial insensitivity. But the sympathy vote quickly dissipated and PVV polling reverted back to the post-Brexit trend.4 Chart 6Dutch Populists Linked To Immigration Chart 7The Dutch Approve Of The Euro Bottom Line: The election in the Netherlands provides an important data point that should not be ignored. The populist PVV not only failed to meet polling expectations, it failed to repeat its result from seven years ago. Investors are ignoring how important the abating of the migration crisis truly was for European politics. Question 2: Can Turkey Restart The Immigration Crisis? The end of the migration crisis in Europe clearly played a major role in dampening support for the Dutch and Austrian populists. We expected this in September 2015, when we argued with high conviction that the migration crisis would prove ephemeral (Chart 8).5 How did we make the right call at the height of the influx of asylum seekers into Europe? Three insights guided us: Civil wars end: No civil war can last forever. Eventually, battle lines ossify into de facto borders between warring factions and hostilities draw to a close. The Syrian Civil War is still going, but its most vicious phase has ended. Civilians have either moved into safer zones or, tragically, have perished. Enforcement increases: The influx of 220,000 asylum seekers per month - the height of the crisis in October 2015 - was unsustainable. Eventually, enforcement tightens. This happened to the "Balkan route" as countries reinforced their borders and Hungary built a fence. Liberal attitudes wane: European attitudes towards migrants soured quickly as the crisis escalated. After the highly publicized welcoming message from Chancellor Angela Merkel, the tone shifted to one of quiet hostility. This significantly changed the cost-benefit calculus of the economic migrants most likely to be deported. Given that roughly half of asylum seekers in 2015 were not fleeing war, but merely looking for a better life, the change in attitude in Europe was important. Many of our clients are today worried that Turkey might deliberately restart the migration crisis as a way to punish Europe amidst ongoing Euro-Turkish disputes. The rhetoric from Ankara supports this concern: Turkish officials have threatened economic sanctions against the Netherlands, and accused Germany of supporting the July 2016 coup and the U.S. of funding the Islamic State. We call Turkey's bluff on this threat. First, the number of migrants crossing the Mediterranean collapsed well before the EU-Turkey deal was negotiated in March 2016. This puts into doubt Turkey's role in dampening the flow in the first place. Second, unlike in 2015, Turkey is now officially involved in the Syrian conflict, having invaded the country last August. By participating directly, Turkey can no longer tolerate the unfettered flow of migrants through its territory to Europe, a luxury in 2015 when it was a "passive" bystander. Today, migrants flowing through its territory are even more likely to be parties active in the Syrian war looking to strike Turkish targets for strategic reasons. Third, the Turkish economy is reliant on Europe for both FDI and export demand (Chart 9). If Turkey were to lash out by encouraging migration into Europe, the subsequent economic sanctions would devastate the Turkish economy and collapse its currency. Investment and trade with Europe make up the vast majority of its current account deficit. Chart 8Migration Crisis Well Past Its Peak Chart 9Turkey Depends On Europe Bottom Line: Turkey can make Europe's life difficult. However, the migration crisis did not end because of Turkey and therefore will not restart because of Turkey. Furthermore, Ankara has its own security to consider and will continue to keep its border with Syria closed and closely monitored. Question 3: Is A Supply-Side Revolution Still Possible In France? In February, we posited that a supply-side revolution was afoot in France.6 Since then, the Thatcherite candidate for presidency - François Fillon - has suffered an ignominious fall in the polls due to ongoing corruption scandals. This somewhat dampens our enthusiasm, given that Fillon's program was by far the most aggressive in proposing cuts to the size of the French state. Still, the new leading candidate Emmanuel Macron (Chart 10) is quite possibly the most right-wing of left-wing candidates that France has ever fielded. He quit the Socialist Party and has received endorsements across the ideological spectrum. In addition, his governing program is largely pro-market: Public expenditure will go down to 50% of GDP (from 57%) by 2022; Corporate taxes will be reduced from 33.3% to 25%; Regulation will be simplified for small and medium-sized businesses; Productive investment will be exempt from the wealth tax, which will focus solely on real estate; Exceptions to the 35-hour work week will be allowed at the company level. More important than Macron's campaign promises is the evidence that the French "median voter" is shifting. Polls suggest that a "silent majority" in France favors structural reform (Chart 11). Chart 10Macron's Huge Lead Over Le Pen Chart 11France: 'Silent Majority' Wants Reform As such, France may be ready for reforms and Emmanuel Macron could be France's Gerhard Schröder, a centrist reformer capable of pulling the left-wing towards pro-market reforms. What about the fears that Macron will not be able to command a majority in France's National Assembly? Macron's party En Marche! was founded less than a year ago and is unlikely to be competitive in the upcoming June legislative elections (a two-round election to be held on June 10 and 17). This will force Macron, should he win, to "cohabitate" with a prime minister from another party. Most likely, this will mean a prime minister from the center-right Republicans. For investors, this could be very positive. The French constitution gives the National Assembly most power over domestic affairs when the president cannot command a majority. This means that a center-right prime minister who receives his mandate from Macron will be in charge of domestic reforms. We see no reason why Macron would not be able to work with such a prime minister. In fact, the worse En Marche! does in the parliamentary election, the more likely that Macron will be perceived as non-threatening to the center-right Republicans. What if no party wins a majority in parliament? We think that Macron would excel in this situation. He would be able to get support from the right-wing of the Socialist Party and the centrist elements of the Republicans. And if the National Assembly fails to support his program, he could always call for a new parliamentary election in a year's time, given his presidential powers. In other words, investors may be unduly pessimistic about the prospect of reforms under Macron. Several prominent center-right figures - including Alain Juppé and Manuel Valls - have already distanced themselves from Fillon, perhaps opening up the possibility of a premiership under Macron. In addition, Macron himself has refused to accuse Fillon of corruption, a smart strategy given that he will need his endorsement in the second round against Le Pen and that he will likely need to cohabitate with the Republicans to govern. What of Marine Le Pen's probability of winning? At this point, polling does not look good for her. Not only is she trailing Macron by 22% in the second round, but she is even trailing Fillon by 11%. Nonetheless, we suspect that she will close the gap over the next month. Election momentum works in cycles and she should be able to bounce back, giving investors another scare ahead of the election. Bottom Line: Concerns over Emmanuel Macron's ability to pursue structural reforms are overstated. Yes, he is less ideal of a candidate than Fillon from the market's perspective, but no, we do not doubt that he would be able to cohabitate with a center-right parliament. That said, we cannot pass definitive judgment until the parliamentary election takes place in June. Question 4: Will Germans Want A Hawk In 2019? An Austrian member of the ECB Governing Council, Ewald Nowotny, spooked the markets by suggesting that Bundesbank President Jens Weidmann would be one of the two most likely candidates to replace Mario Draghi in 2019. Weidmann is a noted hawk who has opposed the ECB's easy monetary policy and even testified against Angela Merkel's government during the court case assessing the constitutionality of the ECB's Outright Monetary Transactions (OMT). The prospect of a Weidmann ECB presidency fits the narrative that Germans will want a hawk to replace Mario Draghi in 2019. The idea is that by 2019, inflation will be close to the ECB's target of 2% and Germans would be itching to beat it down. We have heard this view from colleagues and clients for some time. And we have disagreed with it for quite some time as well! As we pointed out in 2012, it was a German political decision to shift the ECB towards a dovish outlook.7 This is not to say that the ECB takes its orders from Berlin. Rather, it is that Chancellor Merkel had plenty of opportunities via personnel decisions to ensure that the ECB followed a more monetarist and hawkish line. For example, she could have signed off on former Bundesbank President Axel Weber, who was the leading candidate for the job in 2011. She refused when Weber signaled his opposition to the ECB's initial bond-buying program (the Securities Market Program). Mario Draghi was quickly tapped as the alternative candidate suitable to Berlin. Later in 2011, ECB Executive Board member Jürgen Stark resigned over opposition to the same ECB bond-buying program. Since Stark was the German member of the Executive Board, convention held that Berlin would propose his replacement. In other words, while Merkel had her pick of Germany's foremost economists, she picked her finance minister's deputy, Jörg Asmussen. Neither Draghi nor Asmussen have a strand of monetarist or inflation-hawk DNA between the two of them. ECB policy has not been dovish by accident but by design. While it is true that the ECB will inhabit a different macro environment in 2017-19 from the crisis of 2011-12, nevertheless we suspect that dovishness will continue beyond 2019 for two key reasons: German domestic politics: Germans are not becoming Euroskeptic, they are turning rabidly Europhile! If the polls are to be believed, Germans are now the most pro-euro people in Europe (Chart 12). Martin Schulz, chancellor-candidate of the center-left Social Democratic Party (SPD), is campaigning on an aggressive anti-populist, pro-EU platform. He has accused Merkel of being too reticent and of providing Europe's Euroskeptics with a tailwind due to her policies. The SPD's recent climb in the polls is stunning (Chart 13). But even if Schulz fails to win, Merkel will have to take into account his brand of politics if she intends to reconstitute the Grand Coalition with the SPD. It is highly unlikely that Schulz will sign off on a hawkish ECB president (or on the return of Finance Minister Wolfgang Schäuble for that matter). Italian risks: While we have been sanguine about this year's political risks, the Italian election slated for February 2018 is set for genuine fireworks. Euroskeptic parties have now taken a lead in the polls (Chart 14). While the election is still too close to call, and a lot of things can happen between now and then, we expect it to be a risk catalyst in Europe. The problem with Italy is that the election is unlikely to provide any clarity. A hung parliament will likely produce a weak, potentially minority government. Given Italy's potential GDP growth rate of about 0%, this means that a weak government will at some point have to deal with a recession, heightening political risks beyond 2018. Chart 12Germans Love The Euro Chart 13Pro-Europe Sentiment Drives SPD Revival Chart 14Italian Elections: The Big Risk Bottom Line: Italy will hang over Europe like a Sword of Damocles for quite some time. The ECB will therefore be forced to remain dovish a lot longer than investors think. We see no evidence that Berlin will seek to reverse this policy. In fact, given the political paradigm shift in Germany itself, we suspect that Berlin will turn more Europhile over the next several years. Question 5: What Is The Big Picture For Europe? What explains the dogged persistence of support for European integration on the continent? Even in the case of Italy - where Euroskepticism is clearly on the rise - we would bet on voters supporting euro area and EU membership in a referendum (albeit with a low conviction). Why? In 2011, at the height of the euro area sovereign debt crisis, we elucidated our view on the long-term trajectory of European integration.8 We highly recommend that our clients re-read this analysis, as it continues to inform our net assessment of Europe. Our assertion in 2011 was that Europe is integrating out of weakness, not out of misplaced hope of strength. Much of the analysis in the financial community and media does not understand this point. It therefore rejects the wisdom of integration on the basis that Europhile policymakers are blinded by ambition. In our view, they are driven by necessity. As Chart 15 suggests, the average "hard power" of the five largest economies in the euro area (the EMU-5) is much lower than the average "hard power" of the BRIC states.9 European integration is therefore an attempt to asymptotically approach the aggregate, rather than the average, "hard power" of the EMU-5. Europe will never achieve the aggregate figure, as that will require a level of integration that is impossible. But the effort lies beneath European policymakers' goal of an "ever closer union." The truth of the matter is that European nation-states - as individual sovereign states - simply do not matter anymore. Their economic weight, demographics, and military strength relative to other nations are a far cry from when Europe dominated the world (Chart 16). Chart 15European Integration Is About Geopolitics... Chart 16...And Global Relevance If European countries seek to shape their geopolitical and macroeconomic environment, they have to act in unison. This is not a normative statement, it is an empirical fact. This means that everything from Russian assertiveness and immigration crises to energy policy and trade negotiations have to be handled as a bloc. But is this not an elitist view? To what extent do European voters think in such grand geopolitical terms? According to polling, they think this way more than most analysts are willing to admit! Chart 17 shows that most Europeans - other than the British and Italians - are "in it" for geopolitical relevance and security, and only secondarily for economic growth. Even in Italy, geopolitical concerns are more important than economic performance, although levels of both suggest that Italy is again the critical risk for Europe. We suspect that it is this commitment to the non-economic goals of European integration that sustains the political commitment of both elites and the general public to the European project. As Chart 18 suggests, European voters continue to doubt that their future will be brighter outside of the bloc. Chart 17Voters Grasp The EU's Purpose ... Chart 18...And Most Want To Stay In It Bottom Line: European integration is not just an economic project. Voters understand this - not in all countries, but in enough to sustain integration beyond the immediate risks. Given this assessment, it is not clear to us that the project would collapse even if Italy left. Investment Implications Given our political assessment, we continue to support the recommendation of our colleague Peter Berezin that investors overweight euro area equities in a global portfolio.10 As Peter recently elucidated, capital goods orders continue to trend higher, which is a positive for investment spending on a cyclical horizon - helping euro area assets (Chart 19). Furthermore, private-sector credit growth remains robust, despite political risks (Chart 20). Chart 19European Economy Looking Up Chart 20Credit Growing Well Despite Election Risk Over the next 6-12 months, we see EUR/USD rising, especially as the ECB contemplates tapering its bond purchases. We recommend a tactical long EUR/USD trade as a result. The euro could rise higher if the Trump administration disappoints the market on tax reform and infrastructure spending, policies that were supposed to supercharge the U.S. economy and prompt further Fed hawkishness. Over the long term, however, we doubt that the ECB will have the luxury of hawkishness. And we highly doubt that Berlin will rebel against dovish monetary policy. In fact, investors may be using the wrong mental map if they are equating Mario Draghi's taper with that of Ben Bernanke. While Bernanke intended to signal eventual tightening, Draghi will likely do everything in his power to dissuade the market from believing that interest rate hikes are inevitably coming soon. Therefore, we suspect that EUR/USD will eventually hit parity, after a potential rally in 2017. While this long-term depreciation may make sense from a political and macroeconomic perspective for Europe, it will likely set the stage for a geopolitical confrontation between the Trump Administration and Europe sometime next year. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 4 The media has suggested that the PVV merely suffered because of the Turkey-Netherlands spat over Turkish political campaigning in the Netherlands. We see no evidence of this. First, the PVV's collapse in the polls predates the crisis by several weeks. Second, the crisis had all the hallmarks of a trap for the establishment. It is not the fault of incumbent Prime Minister Mark Rutte for adeptly capitalizing on the situation. 5 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 7 Please see "Draghi And Asmussen, Not The OMT, Are A Game Changer," in BCA Geopolitical Strategy Monthly Report "Fortuna And Policymakers," dated October 10, 2012, available at gps.bcaresearch.com. 8 Please see BCA Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 9 As measured by the BCA Geopolitical Power Index. 10 Please see BCA Global Investment Strategy Weekly Report, "Three Battles That Will Determine The Euro Area's Destiny," dated March 10, 2017, available at gis.bcaresearch.com.
Highlights Once the Brexit starting gun is fired, the EU27's high-level guidelines and red lines will create more vulnerabilities and uncertainties for the U.K. than for the euro area. The BoE will be more boxed in than the ECB. Brexit trades have more legs. We describe four structural disruptors to economies and financial markets (on page 6). Our favourite structural investment themes are Personal Product equities, euro/yuan, and real estate in Spain, Ireland and Germany. Feature "Many in Great Britain expected a major calamity... but what happened was near enough nothing ." The citation above perfectly describes the 9 months that have elapsed since the U.K.'s June 23 2016 vote to exit the EU. In fact, it refers to the 9 months that elapsed after Britain declared war on Germany on September 3 1939 - a period of calm, militarily speaking, which became known as the 'Phoney War'.1 But outside the military sphere a lot did happen in the Phoney War. Most notably, a propaganda war ensued. On the night of September 3 1939 alone, the Royal Air Force dropped 6 million leaflets over Germany titled 'Note to the German People'. Chart of the WeekOne Big Correlated Trade: Pound/Euro And Eurostoxx600 Vs. FTSE100 Brexit Phoney War And The Markets Fast forward 77 years. The 9 months since the Brexit vote has also been a period of calm, economically speaking. Indeed, the U.K. economy has sailed along remarkably smoothly. And this has fuelled a propaganda war for those who believe that Brexit's economic impact will be near enough nothing. But outside the economic sphere, a lot has happened in the Brexit Phoney War: The pound has slumped 12% versus the euro and 17% versus the dollar. The FTSE100 has surged 16%, substantially outperforming the 8% gain in the Eurostoxx600 The U.K. 10-year gilt yield is down 40 bps when the equivalent German bund yield is up 40 bps and the equivalent U.S. Treasury yield is up 90 bps. These relative moves appear to reflect different asset class stories, but it is crucial to realise that: All of these relative moves are just one big correlated trade. The relative moves in bond yields have just tracked the expected differences in central bank policy rates two years ahead (Chart I-2 and Chart I-3). This is exactly in line with the theory that a bond yield just equals the expected average interest rate over the bond's lifetime. Chart I-2Difficult Brexit = Gilt Yields Fall Vs. Bund Yields Chart I-3Difficult Brexit = Gilt Yields Fall Vs. T-Bond Yields Likewise, the moves in pound/dollar and pound/euro have also closely tracked the same expected differences in central bank policy rates (Chart I-4 and Chart I-5). Again, this is exactly in line with theory. Over short horizons, the biggest driver of exchange rates is fixed income cross-border portfolio flows - which always seek out the highest yield adjusted for hedging costs. Chart I-4Difficult Brexit = Pound/Euro Falls Chart I-5Difficult Brexit = Pound/Dollar Falls In turn, FTSE100 performance versus the Eurostoxx600 has near-perfectly tracked the inverse direction of pound/euro. Once more, this is exactly as theory would suggest. The FTSE100 and Eurostoxx600 are just a collection of multinational dollar-earning companies quoted in pounds and euros respectively. So when pound/euro weakens, the dollar earnings increase more in FTSE100 index terms than in Eurostoxx600 index terms, resulting in Eurostoxx600 underperformance (Chart of the Week). Now that the Brexit battle is about to begin in earnest, what will happen to these Brexit trades? Brexit Battle Begins It is not our intention here to forecast all the twists and turns of the Brexit battle. We will leave that to a later report. Instead, we just want to list the likely opening salvos. With Parliamentary approval now sealed, Theresa May is due to trigger Article 50 of the Lisbon Treaty in the week commencing March 27 and thereby formally begin the Brexit battle. Expect the first EU27 response within 48 hours, probably through the President of the European Council, Donald Tusk. In this response, Tusk may also give the date for the first European Council 'Brexit' summit. This EU27 Brexit summit will take place within 8 weeks of the Article 50 trigger, and likely after the two-round French Presidential Election in April/May. At the Brexit summit, the EU27 will establish its strategy, high-level guidelines and red lines for the Brexit negotiations. The European Council will present these negotiating guidelines to the European Commission. Drawing upon its own legal and policy expertise, the Commission will then draft a mandate which sets out more technical details of each area of negotiation. Next, the Council of the EU2 must approve this draft mandate by qualified majority vote (obviously excluding the U.K.) Once approved, the European Commission can begin the detailed negotiations with the U.K., keeping within the final mandate's guidelines. But what does all this mean for investors? The preceding analysis showed that the dominant driver for all Brexit trades is the expected difference in central bank policy interest rates two years ahead. Recall that not long ago the BoE was vying with the Fed to be the first to hike rates in this cycle, while the ECB was likely to ease further. But after the Brexit vote and the resulting uncertainty about the U.K.'s position in the world, the tables have turned. The EU27's high-level negotiating guidelines and red lines are likely to create more vulnerabilities and uncertainties for the U.K. than for the euro area. And now, these vulnerabilities and uncertainties are amplified by Scotland First Minister, Nicola Sturgeon, calling for a second referendum on Scottish Independence. For central bank policy, this means that the BoE will be hamstrung; whereas, absent any tail-events, the ECB can continue to back away from its extreme dovishness - a process that Draghi verbally started at the ECB Press Conference last week. Therefore, at least into the early summer, stay: Overweight U.K. gilts versus German bunds. Long euro/pound. Long FTSE100 versus Eurostoxx600 (or Eurostoxx50). Long U.K. Clothes and Apparel equities versus the market (Chart I-6). Short U.K. Real Estate equities versus the market (Chart I-7). But a word of warning for risk control. Remember that all five positions are in effect just one big correlated trade. So they will all work together, or they will all not work together! Chart I-6Difficult Brexit = U.K. Clothes And Apparel Outperforms Chart I-7Difficult Brexit = U.K. Real Estate Equities Underperform Four Disruptors The final section this week takes a wider-angle view of the world, and briefly highlights four structural disruptors to economies and financial markets in the coming years. Disruptor 1: Protectionism. Since the Great Recession, an extremely polarised distribution of economic growth has left most people's standard of living stagnant - despite seemingly decent headline economic growth and job creation (Chart I-8). Looking to find a scapegoat, economic nationalism and protectionism have resonated very strongly with voters in the U.K. and U.S. - resulting in Brexit and President Donald Trump. Other voters could follow in the same vein. But history teaches us that protectionism ends up hurting many more people than it helps. Disruptor 2: Technology. The bigger danger is that people are misdiagnosing the illness. The vast majority of middle-income job losses are not due to globalization, but due to technology. Specifically, Artificial Intelligence (AI) is replacing secure middle-income jobs and displacing workers into insecure low-income manual jobs - like bartending and waitressing - which AI cannot (yet) replace (Table I-1). And AI's impact on middle-income jobs is only in its infancy.3 The worry is that by misdiagnosing the illness as globalization and wrongly taking a protectionist medicine, the illness will intensify, rather than improve. Chart I-8Disruptor 1: Protectionism Table I-1Disruptor 2: Technology Disruptor 3: Debt super-cycles have reached exhaustion. The protectionist medicine carries a further danger. Major emerging market economies are coming to the end of structural credit booms and need to wean themselves off their credit addictions (Chart I-9). At this point of vulnerability, aggressive protectionism risks tipping these emerging economies into a sharp slowdown. Chart I-9Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 4: Equities are overvalued. Disruptors one, two and three come at a time when equities are valued to generate feeble total nominal returns over the next decade (Chart I-10). Risk premiums are extremely compressed. And if investors suddenly demand that risk premiums rise to average historical levels, it necessarily requires equity prices to adjust downwards. Chart I-10Disruptor 4: Equities Are Overvalued The long-term investment message is crystal clear. With the four disruptors in play, we strongly advise long-term investors not to follow passive (equity) index-tracking strategies. Instead, we advise long-term investors to stick to bespoke structural investment themes. Our favourite structural investment themes are Personal Product equities, euro/yuan, and real estate in Spain, Ireland and Germany. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 C N Trueman 'The Phoney War'. 2 The Council of the EU should not be confused with the European Council. 3 Please see the European Investment Strategy Special Report, "The Superstar Economy: Part 2," dated January 19, 2017, available at eis.bcaresearch.com Fractal Trading Model This week's trade is to short Netherlands equities, but wait until after the election result. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Geopolitics will not spoil the stock rally yet; European election risks remain overstated; In China, look beyond the National Party Congress; China's reforms could re-launch in 2018 ... ... But India's reforms are gaining momentum now. Feature The global economy continues to surprise to the upside, with the latest round of global purchasing managers' indices (PMIs) confirming that the business cycle continues to accelerate (Chart 1). In the context of firming global growth, the Fed's decision to hike rates may not produce as violent of a reaction from the dollar as last year, giving way to further upside in stocks. And while investors continue to fret about valuations, U.S. stocks are expensive only relative to history, not relative to competing assets, as our colleague Lenka Martinek of the U.S. Investment Strategy service points out (Chart 2).1 Chart 1Because I'm Happy Chart 2U.S. Stocks Pricey By History, Not Peers What geopolitical news could break up the party over the next six months? Europe: As we argued three weeks ago, the European electoral calendar is unusually busy (Table 1).2 However, we have also posited in our 2017 Strategic Outlook that Europe will be a red herring this year, allowing risk assets to "climb the wall of worry."3 The first test of this thesis comes today, with the Dutch general elections taking place. The polls suggest that the Dutch electorate is not following the populist trend of the Brexit referendum and U.S. election (Chart 3), but rather in the footsteps of the little noticed Austrian presidential election in December, which saw the populist presidential candidate defeated. Dutch Euroskeptics, who have led the polling throughout the last twelve months, are bleeding support as election day approaches. Meanwhile, in France, Marine Le Pen is struggling to keep momentum going with only a month and a half to the first round. Thus far, our thesis on Europe is holding. Table 1Busy Calendar For Europe This Year Chart 3Dutch Euroskeptics Are An Overstated Threat The U.S.: Investors will finally get to put numbers to President Trump's rhetoric when the White House announces its budget on March 16. As we argued last week, President Trump is who we thought he was: an economic populist looking to shake up America's status quo. That suggests he will err on the side of greater deficits and large middle-class tax cuts. We do not think Congress will bar his way, as it has rarely restrained a Republican president from profligacy (Chart 4). We could be wrong, but it is unclear if a more fiscally responsible budget would be negative for the markets. On one hand, it may disappoint optimistic growth projections, but on the other, it would mean that the Fed would have no reason to err on the side of more rate hikes in 2017. Meanwhile, while we continue to fear protectionism's impact on the market, it is unlikely that the Trump White House will focus on trade when so many domestic priorities are looming this summer. Russia: As we argued in a Special Report with the Emerging Markets Strategy group last week, Russia may be entering a low-beta paradigm - escaping from its close embrace with oil prices - due to the combination of orthodox monetary policy, modest structural reforms, and growing confidence in its geopolitical predicament.4 This is not the time for President Putin to rattle nerves in the West. He does not want to give Europe and the U.S. a reason to cooperate. We therefore expect Russia's geopolitical risk premium to continue to decline, a boon for European risk assets (Chart 5). Chart 4Budgets: Republican Presidents##br## Get What They Want Chart 5Russia's Calm##br## Is Europe's Profit From a tactical perspective, we believe that the confluence of geopolitical forces supports our continued overweight of developed-market equities versus those of emerging markets. Within developed markets, the BCA House View is to prefer euro-area equities due to overstated geopolitical risks and favorable valuations relative to the U.S. equity market. BCA's Global Investment Strategy has pointed out that euro-area equities are one standard deviation undervalued relative to the U.S., when one applies U.S. sector weights to them (Chart 6). In addition, BCA's U.S. Bond Strategy service believes that Treasury yields have more room to rise, with growth putting upward pressure on inflation and the Fed in a rate-hike cycle. This makes sense to us given that no major geopolitical risk is materializing and considerable upside risk exists in U.S. growth due to Trump's populist policies. Chart 6European Stocks Still A Buy Relative To U.S. In what follows, we take a break from poring over geopolitical risks in Europe and the U.S. and focus on emerging markets. Since January, very few investors have asked us about EM politics, save for the occasional question about Brazil. However, the two Asian giants - China and India - are both a source of risk: the first a downside, left-tail risk and the second an upside, right-tail risk. China: What Comes After The Party Congress This Fall? Since 2013, we have been outspoken in our low expectations for China's structural reforms.5 This view was confirmed with a series of stimulus efforts that displaced reforms, including the local government debt swap program in 2014 and extensive fiscal and monetary easing in 2015 and especially 2016.6 The upside of weak reforms was better-than-expected growth in the short run, as stimulus took effect. Indeed, China has pulled off a remarkable economic turnaround since early last year: infrastructure and housing investment have increased, the weaker yuan has boosted exports, and the global recovery in commodity prices has helped producer prices to recover, easing deflationary pressures (Chart 7). Chart 7Deflationary Pressures Easing Chart 8Stimulus Dropped Off Accordingly, Chinese policymakers, who are attempting to strike a balance between stimulus and restructuring, have begun leaning against the economy's gathering momentum. Government spending has collapsed now that a 6.5% GDP growth "floor" has been established (Chart 8). A new round of property market regulatory tightening began last fall, though it has had little impact so far. Also, the People's Bank of China has begun draining some liquidity (Chart 9). Signals coming out of the "Two Sessions" over the past two weeks, namely the National People's Congress, suggest that the Chinese leadership is content with the current state of affairs. Policymakers set their growth targets for 2017 a little lower than last year's targets and a little higher than last year's actual performance (Table 2).7 It is a line so thin that it is almost imperceptible. They do not want significant change. Chart 9PBoC Draining Liquidity Table 2China's Economic Targets For 2017 This stance fits with a deeper desire to keep the economy on an even keel during a pivotal year for Chinese politics. The legislative session took place under the shadow of the Communist Party's impending 19th National Party Congress - the "midterm" meeting of the party that happens every five years and features extensive promotions, rotations, and retirements for the party leadership. This year's congress promises to be especially influential because of Xi Jinping's ascendancy and the fact that around 70% of the upper tier of leaders will be replaced. Chart 10, which we have been showing clients over the past year to dampen expectations of stimulus, reveals that the party congress is not normally an excuse to throw open the floodgates of credit and government spending. Rather, it is a reason to avoid anything that might rock the boat, whether stimulus or reform. Chart 10Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Thus while government spending has declined, it should be expected to rise again if growth slows down too much for too long. There may be a period of slowdown and market jitters before the leaders reach for the fiscal lever again, but the "Socialist Put" remains in place. Meanwhile, we are not surprised that structural reforms continue to suffer. It is not that China has eschewed all reforms but rather that its reforms have focused on centralizing power for the ruling party and alleviating some outstanding social grievances. These are positive in themselves but they do not address the key concerns of foreign investors relating to economic openness, financial stability, and the role of the state. The recent imposition of capital controls and a host of non-tariff barriers in the name of "state security" exemplify a negative trend. The delayed rollout of the property tax is also a sign of Beijing's proclivity to delay policies that may be financially risky.8 And Beijing has only tentatively attempted to cut back state-owned enterprises. Simply put, a push to overhaul any significant sector or sub-sector does not fit Beijing's priorities at the moment. However, if growth, debt, or asset prices should climb too rapidly, then we expect countermeasures to tamp them down. Even on the geopolitical front - where we have a high conviction view that tail risks to financial markets are higher than the market perceives them to be, both in China and the broader Asia Pacific - there have been some signs of the U.S. and China playing ball on a shared desire for "stability," at least for the moment.9 While we expect a negative geopolitical shock, the market will only believe it when it sees it. All of the above suggest that China will focus on "maintaining stability" this year even more than usual due to the party congress. This is clearly bullish, especially given improving U.S. and global growth. However, the mantra of "stability" and "party congress" should not prevent investors from looking beyond October or November of this year. Chart 11China Needs More##br## Credit For Same Growth Chart 12China Gets Old ##br##Before It Gets Rich Even assuming that China experiences no significant internal or external economic shocks from now until this fall, it is important to remember that China's growth potential is still slowing for structural reasons. Productivity is collapsing and credit dependency is rising (Chart 11). The slowdown stems from deep shifts such as the end of the debt supercycle in the U.S. (weak external demand), the tipping point in Chinese demographics (higher dependency ratio) (Chart 12), and the extremely rapid build-up in corporate debt (Chart 13). Chart 13Corporate Debt Skyrockets Chart 14As Good As It Gets This is what leads our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, to surmise that China is at the peak of its current economic mini-cycle. This is "as good as it gets," as he shows in Chart 14. Barring a situation in which Xi somehow fails to consolidate power at the party congress, the market impact will depend on which of two scenarios follows: First scenario: Xi achieves a dominant position in all party and state organs, yet 2018 sees a continuation of the current pattern of mini-cycles of stimulus, lackluster reform, and foreign policy aggressiveness. Xi implicitly deems the strategic cost of reform too great, as we argued he would do over the past four years, and dedicates his stint in office to the accumulation of power. Perhaps a successor will be able to use these powers to enact painful reforms in the mid-2020s; that is not Xi's immediate concern. This is short-term bullish for global and Chinese growth, long-term bearish for Chinese assets. Second scenario: Xi achieves a dominant position and uses his power to reinvigorate the country's stalled reforms. Hints of big measures emerge in the wake of the party congress in November or December, and January 2018 begins with a bang. This would necessarily mean that Xi accepts slower growth, or even that he imposes it through tighter fiscal policy, real credit control, SOE failures, and aggressive overcapacity cuts. However, Chinese productivity would begin to recover. This is short-term bearish for Chinese and global growth. However, it is the most bullish outcome for the long-term performance of Chinese assets. In China's current state - with capital controls newly reinstituted (Chart 15), Xi lauding the "central role" of SOEs in development, and Xi's administration still focused on purging the party and controlling the media - the second scenario admittedly seems far-fetched. Chart 15Are Capital Controls Working? Moreover, Xi seems averse to risky experiments at home that could weaken the country in the face of unprecedented strategic threats from the United States and Japan. Nevertheless, a 2018 reform push should not be dismissed out of hand. Why? Because an overbearing state, credit excesses, and weak productivity really do threaten the sustainability of the Chinese economy and hence the Communist Party's grip on power. Xi must keep them in check, as the current gestures toward tighter policy indicate. The government has overseen a massive monetary and credit expansion to protect the country from faltering external demand since 2008. As the current account surplus has declined, the country's massive savings have built up at home in the form of debt (Chart 16).10 Yet the investment avenues are restricted by the role of the state. As a result, the inefficient state-supported sector is getting propped up while the shadow financial sector grows wildly and creates murky systemic risks that are difficult to monitor and control. The PBoC has undertaken further extraordinary actions to keep financial conditions loose (Chart 17). Chart 16Savings Invested At Home Chart 17PBoC Lends A Helping Hand What signposts should investors watch for to see which path Xi will take after the party congress? Jockeying ahead of the party congress: The latest NPC session saw some political maneuvering. Several sixth generation leaders made appearances and spoke to media.11 Xi's supposed favorite, Chen Min'er, Party Secretary of Guizhou, distinguished himself by cutting reporters short at a press conference. Meanwhile former President Hu Jintao appeared publicly alongside his apprentice, Hu Chunhua, Party Secretary of Guangdong. Elite party gatherings in the summer, especially any retreat at Beidaihe, should be watched closely for any clues of who may be up and who down, and what general policy trajectory may be forthcoming. Xi's future: First, will Xi Jinping and Li Keqiang establish clear successors for their top two positions in 2022?12 A failure to do so will suggest that Xi intends to stay in power beyond his de facto term limit of 2022. This would mean that Xi will prioritize his own future over painful structural reforms. On the other hand, a clear commitment to a leadership transition in five years may re-focus the Xi-Li administration towards their initial commitment to economic restructuring. National Financial Work Conference: This conference is held every five years, usually connected with a major new financial reform or regulatory push, and due sometime in 2017. The government is looking into serious changes to financial regulation - including the creation of a super-ministry to house the various regulatory agencies. This, or the broader attempt to ensure adequate capitalization of banks, could be behind the delay. New central banker: Central bank governor Zhou Xiaochuan, in office since 2002, may step down this fall. He could be replaced with another technocrat to little fanfare, but his exit introduces the opportunity for shaking up the PBoC regime as a whole. Other new officials: A slew of other appointments and reshuffles will take place this year as a generation of leaders born before the Revolution retires. A new director of the state economic planner, the National Development and Reform Commission, was just named, while late last year a new finance minister took his post. These officials have yet to make their mark. Their statements should be watched closely for any shifts in economic policy emphasis. Time frames for reforms: The market is still waiting for concrete proposals and time frames for major reform initiatives, particularly opening up to foreign competition and restructuring state-owned enterprises. Overcapacity cuts have also had mixed results. We do not expect major advances on big structural reforms this year due to the party congress, but details that can be gleaned about the process and timetables could be important. Bottom Line: Watch for signs of a renewed reform drive after the nineteenth National Party Congress. Xi is not going to reverse what he has done so far. And China is not going to become a market economy on the ideal western model. But a pivot point could be in the cards next year for China to pursue some pro-efficiency reforms that it has already set out for itself in a more resolute way. Xi's decision to stay in power beyond 2022 would be bearish for reforms as it would incentivize the current "Socialist Put" model of policymaking over a genuine paradigm shift. India: What Comes After Modi's Big Win? Prime Minister Narendra Modi has won a crushing victory in India's most populous state, Uttar Pradesh, positioning himself, his Bharatiya Janata Party (BJP), and National Democratic Alliance (NDA) coalition very well for the 2019 general elections. Policymaking is going to become easier for the ruling party - though there are still serious political and economic constraints. We have been long Indian equities relative to EM equities since the "Modi wave" began with Modi's victory in the Lok Sabha or lower house in 2014.13 The end of the commodity bull market signaled an opportunity for India, which imports about a third of its energy. The decline of global trade also heralded the outperformance of domestic demand-driven economies like India. Further, Modi's sweeping victory held out the promise for a reform agenda of tighter monetary and fiscal policy that would reduce inflation and make room for private investment to grow. This would make Indian risk assets attractive, especially relative to other EMs, which were at that time either lagging at reforms or failing to undertake them entirely. Since then we have seen Modi rack up a key legislative victory - the passage of the Goods and Services Tax, in the process of implementation - and engineer a surprise "demonetization" effort late last year to increase bank deposits, bring the country's gray markets into the open, and flush out crime and corruption.14 The ruling coalition's gains in Uttar Pradesh and a few other state elections this year are a striking vindication of popular support after this highly unconventional and controversial maneuver.15 Uttar Pradesh is the most important of these elections. It was slated to be a grand testing ground for Modi well before demonetization. It is the most populous Indian state, with about 200 million people, and the third largest state economy (producing about 10% of GDP). It is the second-poorest state, with a GDP per capita of about $730, it has the highest proportion of "scheduled castes" (untouchables), and ranks around the middle of states in terms of the Hindu share of population - all challenges for the landed, pro-business, Hindu nationalist BJP (Map 1). Politically, aside from its inherent heft in population and centrality, Uttar Pradesh sends the most representatives of any state to India's upper house (31 seats), the Rajya Sabha, where Modi lacks a majority. It is thus a key source of federal power and an important state ally. Map 1Modi's Saffron Wave Takes The Indian Core Given the above, it is hugely bullish that Modi's BJP romped to a historic victory in the state election, winning 312 out of 403 seats (about 39.7% of the vote), up from 47 seats previously. His coalition rose to 324 seats total (Chart 18). The BJP now has the largest majority of any party in the state since 1980. These results were not anticipated. A close election was predicted and opinion polls had BJP winning 157 seats, short of the 202 needed for a majority. This was only slightly ahead of its closest rival, an alliance made up of the local Samajwadi Party and its national partner, the left-leaning Indian National Congress (INC). Exit polls even suggested that the Samajwadi-INC coalition had edged ahead of the BJP. The immediate takeaway is that Modi will have better luck governing Uttar Pradesh itself now that the state government is on his side. Individual states hold the key to reform in India because of the country's size and socio-economic disparities. The state will now be expected to implement Modi's policies faithfully and push approved policies forward on its own. The second takeaway is that while Uttar Pradesh will not give Modi control of India's upper house of parliament, the Rajya Sabha, it will give him a better position there. The BJP has 56 seats in the upper house (fewer than the INC's 59), and the ruling coalition has 74, out of a total of 250. The coalition needs 52 seats for a simple majority. Uttar Pradesh will deliver 10 seats at most by the 2019 general election. Modi would have to win almost every seat of the 56 non-allied seats coming open between now and 2019 in order to win the upper house by that time (Chart 19). That is unlikely, but Modi is moving in the right direction and an upper-house majority cannot be ruled out in the long run. Chart 18Modi's Big Win In Uttar Pradesh Chart 19Modi's National Position Improves Of course, Modi has already shown with the Goods and Services Tax that he can pass very difficult legislation through the upper house without controlling a majority there. This achievement last year was perhaps an even greater surprise than the victory in Uttar Pradesh, which reinforces it. Modi also has a secret weapon: in case of a national emergency, however defined, he can call a joint session of parliament, where his coalition would carry the day. This is now more likely because it is the Indian president who is responsible for calling a joint session, and Modi is now more likely to get his candidate into that position due to the win in Uttar Pradesh. President Pranab Mukherjee, who is affiliated with the INC, will step down on July 25. Though Modi does not have all the votes in the electoral college to choose the president outright, smaller parties may fall in line now that the BJP has so much national momentum.16 Controlling the presidency will also give Modi greater influence over constitutional obstacles and gradually over the legal system. Separately, in August, Modi's alliance will be able to choose the vice president as well. More broadly, the Uttar Pradesh election marks a victory for Modi's style of appealing to voter demand for greater economic development as a general priority over longstanding religious and caste grievances that frequently determine electoral outcomes in state elections. This is a hugely significant indication for India's economic structural reform and nation building. Bottom Line: Modi's victory in Uttar Pradesh is proof that for all of India's sprawling inefficiencies, its political system is capable of responding to the large public demand for economic development. Do not underestimate reform momentum now. Modi's political capital remains high. Investment Conclusions The conventional wisdom has for decades been that China is better at reforming its economy because of its authoritarian regime, whereas India democratized too early and has thus lagged at reforms. We have never agreed with this simplistic view of economic reforms. Structural reforms are always and everywhere painful. As such, they require political capital. As our "J-Curve of Structural Reforms" posits, reforms deplete political capital as the pain spreads through the economy and opposition mounts among both the elite and the common man (Chart 20). Eventually, the government is faced with a "danger zone" in which the pain of reforms lingers, the benefits remain beyond the horizon, and all political capital is exhausted. Many leaders chose to water down the reforms, or back off from them altogether, at this point. Chart 20The J-Curve Of Structural Reform On the surface, authoritarian regimes have massive political capital with which to burst through the danger zone of reform. But this assumption is not entirely correct. In China's case, the political capital for reform came after disastrous performances by the "conservative" political forces. Reformers in China were buoyed by the failures of the "Cultural Revolution" (which ended in 1976) and the 1989 Tiananmen Square protests. Each political and social crisis gave the reformers an opening - following a consolidation period - to pursue controversial economic reforms at the expense of "conservative" forces. The fruit of these reform efforts has been the growth of China's middle class. And while this middle class expects reforms in the delivery and quality of public services, it is not interested in seeing a slowdown in economic growth, no matter how temporary or healthy it may be. As such, Chinese leaders are faced with a significant hurdle to their reform preference: how to convince the public that a slowdown is needed in order to restructure the economy. We are unsure whether the upcoming party congress will make a difference. However, we can see a scenario where President Xi decides to pursue market-friendly reforms because he sees an increase in his political capital. In particular, he may feel that he has cemented his personal dominance over his intra-party rivals and that the aggressive foreign and trade policy emanating from the Trump White House gives him a foil to blame for any downturn in growth. Reform would also be a return to Xi's original agenda, and would conform to the playbook of former president Jiang Zemin, whose precedents Xi has followed in some other areas. Given Xi's modus operandi, a post-consolidation reform drive would be executed relatively effectively and would therefore present short-term risks to Chinese and hence global growth, despite the long-term improvement. Markets are definitely not expecting such a policy pivot at the moment. China bulls are content with the current reforms, while China bears see no chance of the Xi administration changing tack. While we are just beginning to see the potential for a turn in Chinese policymaking towards reforms, India is a much clearer example of a reformist administration. Modi will feel empowered by the Uttar Pradesh election, a political recapitalization of sorts. Foreign investment will likely continue cheering Modi's ongoing revolution (Chart 21). The question now is whether Modi intends to use the infusion of political capital for genuine reforms. After all, the economy is not looking up (Chart 22). Chart 21Foreign Investors Cheer On Modi Chart 22Indian Economy Still Weak The evidence is mixed. First, Modi has not maintained strictness on fiscal spending and the budget deficit is creeping back to where it was when he took over the reins (Chart 23). Rising government spending along with higher commodity prices suggest that inflation will continue making a comeback (Chart 24). Poor food production is also driving up inflation. And higher spending and inflation pose a key threat to the sustainability of the reform agenda, since rising government bond yields will crowd out private investment. Chart 23Losing Budgetary Discipline? Chart 24Inflation Makes A Comeback Second, the RBI will be less likely to pursue a tighter monetary policy with both political influence and weak growth pressing on it. Moreover, Indian stocks are not all that cheap. In 2014, valuations were favorable and the backdrop included cheap commodities, fiscal prudence, and Modi's electoral success. Today, India is trading at its historical mean relative to EM (Chart 25), but using the equal sector weighted P/E ratio, by which India was very cheap back in 2014, India is at a 52% premium now (Chart 26). Chart 25Indian Stocks Trading##br## At Mean Against EM Chart 26Indian Stocks Pricey##br## Versus EM Sector-Weighted We are therefore taking this opportunity to close our long India / short EM trade for a 28% gain (since May 2014). We will reassess Modi's structural reform priorities in future research and gauge whether a new entry point is warranted. We remain optimistic on India in the long run as Modi certainly has the political capital for reforms. The question is whether he plans to use it. Meanwhile, we remain skeptical about China's long-term trajectory. To become fully optimistic about Chinese risk assets in absolute terms, we need to see the Xi administration chose short-term pain for long-term gain. For the time being, China continues to repress its structural problems rather than deal with them head on, relying on minimal openness, high and rising leverage, and state-owned banks and companies. India may be lagging in its reform effort, but it has at least established market reforms as a priority. And the Modi administration has built political capital through the slow and painful democratic process. Over the long term, India's approach is more sustainable. If President Xi wastes the opportunity afforded to him by the upcoming party congress, we suspect that China will face a much higher probability of left-tail economic risks than India over the long term. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "How Expensive Are U.S. Stocks?," dated March 13, 2017, available at usis.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and "China: The Socialist Put And Rising Government Leverage" in Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA China Investment Strategy, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 8 Please see Chong Koh Ping, "No plans for NPC to discuss property tax," Straits Times, March 5, 2017, available at www.straitstimes.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. 11 China's leadership is typically referred to in terms of "generations," with Mao Zedong and his peers the first generation, Deng Xiaoping and his cohort the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth. The fifth generation was born in the early 1950s, the sixth generation was born in the early 1960s. 12 Xi may tweak retirement norms to let close allies, like Wang Qishan, the anti-graft attack dog, stay on the Politburo Standing Committee. This might also suggest that Xi himself intends to overstay his age limit in 2022. 13 Please see Geopolitical Strategy Special Report, "Long Modi, Short Jokowi," dated August 28, 2014, available at gps.bcaresearch.com, and Emerging Markets Strategy Special Report, "Long Indian / Short Indonesian Stocks," dated July 30, 2014, available at ems.bcaresearch.com. 14 Please see "India: Demonetization And Opportunities In Equities," in Emerging Markets Strategy Weekly Report, "EM: Untenable Divergences," dated December 21, 2016, available at ems.bcaresearch.com. 15 Though the mixed results also indicate persistent regional differences. Modi's coalition won seats in Uttarakhand and Manipur but lost them in Goa and Punjab. Gujarat, Modi's home state, will hold elections later this year. Himachal Pradesh will also vote this year and will be a subsequent testing ground. 16 Please see Gaurav Vivek Bhatnagar, "BJP Sweep in UP Will Impact Decision on President, Rajya Sabha Numbers," The Wire, March 12, 2017, available at https://thewire.in/116044/bjp-sweep-will-impact-decision-president/
Highlights We discuss three "battles" that will shape the investment landscape in the euro area over the remainder of the decade. Battle #1: Reflation Versus Deleveraging - Reflation will triumph over the next 12 months. For the time being, this justifies an overweight position in euro area equities. Beyond then, the outlook is likely to darken. Battle #2: Hawks Versus Doves - The doves will win. Germany will reluctantly accept an overheated economy and higher inflation. Stay short the euro. Battle #3: Globalists Versus Populists - Marine Le Pen will lose this year's election, but Europe's populist parties will finally gain the upper hand by the end of the decade. Buy gold as a long-term hedge. Feature Market Update Global equities are technically overbought in the short term, but the longer-term cyclical (12-month) trend remains to the upside. Chart 1 illustrates the "reflation trade" in a nutshell. The Citigroup global economic and inflation surprise indices have surged and now stand at their highest combined level in the 14-year history of the series. While tracking estimates for Q1 U.S. GDP growth have fallen, this is mainly because of negative contributions from government spending, net exports, and inventories. Taken together, these three factors have shaved about 1.4 percentage points off of Q1 growth according to the Atlanta Fed's GDPNow model (Chart 2). Private final domestic demand is still growing at a reasonably robust 2.6% pace, and forward-looking indicators such as the ISM indices suggest that this number could rise over the next few quarters. Chart 1The Reflation Trade In One Chart Chart 2Underlying U.S. Growth Is Still Healthy As such, it is not too surprising that U.S. equities have had little trouble digesting the prospect of a March Fed rate hike. The market is still pricing in less than three rate increases this calendar year. Four hikes would not be out of the question. Investors should remain positioned for a stronger dollar and higher Treasury yields. We continue to favor higher beta developed markets such as the euro area and Japan over the U.S. on a currency-hedged basis. The Battle For Europe History is often shaped by great battles. Sometimes these are of the military variety. But often they transcend physical conflict, pitting competing ideas, interests, and trends against one another. In the remainder of this week's report, we discuss three economic and political battles that will determine Europe's fortunes over the next 12 months and beyond. Battle #1: Reflation Versus Deleveraging The euro area grew faster than the U.S. in 2016, the first time this has happened since 2008. While the U.S. is likely to resume pole position in 2017, we still expect the euro area economy to expand at an above-trend pace. That should be enough to keep unemployment on a downward trajectory. The euro area economic surprise index remains in positive territory. The composite PMI rose to 56 in February - the highest level since April 2011 - with the forward-looking "new orders" component hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart 3). In addition, private-sector credit growth has sped up to the fastest pace since the 2008-09 financial crisis (Chart 4). All this is good news for the region. Investors should overweight euro area equities on a currency-hedged basis over the next 12 months. Chart 3Euro Area Growth Holding Up Well Chart 4Euro Area: Accelerating Private-Sector ##br##Credit Growth Beyond then, things look murkier. The ECB's Bank Lending Standards survey showed a modest tightening in lending standards for business loans in Q4 of 2016 (Chart 5). Private-sector debt levels also remain elevated across the region, which is likely to dampen credit demand (Chart 6). Both of these factors suggest that loan growth could begin to moderate later this year. Chart 5Slight Tightening In Lending Standards ##br##For Business Loans And Mortgages In Q4 Of 2016 Chart 6Still A Lot Of Debt If the positive impulse from rising credit growth does begin to fade, GDP growth will fall off. Whether that proves to be just another run-of-the-mill "mid-cycle slowdown" or something more nefarious will depend on the policy response. On the fiscal side, the period of extended austerity has ended. The fiscal thrust in the euro area turned positive last year, the first time this has happened since 2010. The European Commission is advising member states to loosen fiscal policy further this year, but the governments themselves are targeting a modest tightening (Chart 7). With a slew of elections slated for this year, budget overruns will be hard to avoid. Nevertheless, barring a significant economic slowdown, no major European economy is likely to launch a large fiscal stimulus program anytime soon. Thus, while fiscal policy will not be a drag on growth, it will not provide much of a tailwind either. Chart 7European Commission Recommending Greater Fiscal Expansion This puts the ball back in the ECB's court. As we discuss next, monetary policy is likely to stay highly accommodative. That should help extend the cyclical recovery into 2018. Battle #2: Hawks Versus Doves Jean Claude Trichet's decision to raise rates in 2011 would have gone down as the most disastrous blunder the ECB ever made, were it not for his even more disastrous decision to raise rates in 2008. Mario Draghi has gone out of his way to avoid repeating the mistakes of his predecessor. Nevertheless, the risk is that the improving growth backdrop instills a false sense of complacency. There is no doubt that Draghi has become more confident about the economic outlook. The ECB revised up its growth and inflation projections for 2017-18 at this week's meeting and signaled that it was unlikely to extend its targeted longer-term refinancing operations, or TLTROs. The ECB is also likely to further reduce the value of its monthly asset purchases in 2018 with a view towards phasing them out completely by the end of that year. It is possible that these steps could trigger a "taper tantrum" in European government debt markets of the sort the U.S. experienced in 2013. If that were to happen, we would see it as a buying opportunity. As Draghi stressed during his press conference, wage growth is anemic. Without faster wage growth, inflationary pressures will remain muted. Granted, euro area headline inflation reached 2.0% in February. However, this was mainly the result of base effects stemming from higher food and energy prices. Our expectation is that headline inflation will fall back close to 1% by the end of the year. This is where core inflation currently stands. One should also keep in mind that the trade-weighted euro has depreciated by 8% since mid-2014 (Chart 8). To the extent that a weaker euro has put upward pressure on import prices, this has caused core inflation to be higher than it would otherwise have been. In contrast, the trade-weighted U.S. dollar has appreciated by 24% over this period. Yet, despite the diverging path between the two currencies, core inflation in the euro area remains noticeably lower than in the U.S. This is true even if one excludes housing costs from the U.S. CPI in order to make it more comparable to the European estimate of inflation. Excluding shelter, U.S. core inflation is currently 43 basis points higher than in the euro area (Chart 9). The point is that the Fed is much further along the path to monetary policy normalization than the ECB. Chart 8A Stronger Dollar Has Restrained U.S. Inflation... Chart 9...Yet Core Inflation In The U.S. ##br##Is Still Higher, Even Excluding Housing If that were all to the story, it would be enough to justify the ECB's wait-and-see approach. But there is so much more. Start with the fact that the euro area's poor demographics, high debt levels, and dysfunctional institutions all imply that the neutral rate - the interest rate consistent with full employment - is lower there than in the U.S. How does one ensure that real rates can fall to a low enough level in the event of an economic slowdown? One solution is to target a higher inflation rate. If inflation is running at 1% going into a recession, it might be impossible to bring real rates down much below -1%. But if inflation is running at 3%, real rates can fall to as low as -3%. This implies that the ECB should actually target a higher inflation rate than the Fed. Then there are the internal constraints imposed by the common currency. Countries with flexible exchange rates can adjust to adverse economic shocks by letting their currencies depreciate. That is not possible within the euro area. If one or a few countries in the region are suffering while others are not, the unlucky ones have to engineer an "internal devaluation." This requires that wages and prices in the ill-fated countries decline in relation to those in the better-performing ones. However, if inflation is already low in the latter, outright deflation may be necessary in the former, something that only a deep recession can achieve. The travails experienced by the peripheral countries over the past eight years brought home this lesson in stark and painful terms. Will Germany accept higher inflation? There is little in its recent history to suggest that it won't. Mario Draghi was not the odds-on favorite to become ECB president. That job was supposed to go to Axel Weber, the former president of the Bundesbank. Weber met with Angela Merkel on February 10, 2011. During this meeting with the chancellor, he made it clear that he did not support the ECB's emergency bond buying. Merkel balked and so the next day Weber tendered his resignation. Six months after that, ECB board member and uber-hawk Jürgen Stark quit, leaving the ECB more firmly in the control of the doves.1 Chart 10Germans Turning Radically Europhile Merkel's preference for a less hawkish ECB leadership wasn't solely based on altruistic feelings towards her European compatriots. Politically, Merkel knew full well that Germany would be blamed for the breakup of the euro area. Economically, German taxpayers also stood to lose a lot from a breakup. It is easy to forget now, but Germany spent 8% of GDP during the global financial crisis on bailing out its own banks. All that effort would have been for naught if German banks had been forced to write off billions of euros in loans that they had extended to peripheral Europe. Critically, the demise of the euro would have also saddled German exporters with a much more expensive Deutsche Mark, thus blowing a hole through the country's gargantuan current account surplus. The calculus has not changed much over the last six years. Germany may not welcome higher inflation, but the alternative is much worse. If anything, the polls suggest that German voters have become even more Europhile since the euro crisis ended (Chart 10). This gives Draghi even more free rein. For investors, this implies that the ECB is unlikely to raise rates for the next two years, and perhaps not until the end of the decade. As inflation expectations across the euro area drift higher, real rates will fall. This will push down the value of the euro. We expect EUR/USD to approach parity over the course of this year. Battle #3: Globalists Versus Populists First Brexit, then Trump, and now Le Pen? The spread between French and German 10-year government bond yields briefly touched 68 basis points in February, the highest level since the euro crisis (Chart 11). While the spread has edged down since then, investors remain on edge. Betting markets are currently assigning a one-in-three chance that Le Pen will become president, close to the odds that they were giving Donald Trump before his surprise victory (Chart 12). Chart 11Investors Worried About The Coming ##br##French Election Chart 12Will Le Pen Rule? Wanna Bet? There is little doubt that populism is in a secular "bull market." However, that doesn't mean that every populist politician is going to win every single election. For all their faults, U.S. nationwide presidential election polls were not that far off the mark. The RealClearPolitics average had Clinton up by 3.2% going into the election. She won by 2.1 points. Where the polls fell flat was at the state level. They completely underestimated Trump support in the Rust Belt states of Pennsylvania, Ohio, Michigan, and Wisconsin. That's not an issue in France, where the presidential vote is tallied at the national level. Le Pen currently trails Macron by 26 percentage points in a head-to-head contest (Chart 13). It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. The only way that Le Pen could win is if one of the two leftist candidates drops out.2 However, given the animosity between Benoit Hamon and Jean-Luc Mélenchon, that is almost inconceivable. And even if that did occur, the odds would still favor Macron slipping into the final round. As such, investors should downplay risks of a populist uprising this year. Beyond then, things are likely to get messier. At some point, Europe will face another downturn, either of its own doing or the result of an external shock. Many voters have been reluctant to vote for populist leaders out of fear that the ensuing economic turmoil could leave them out of a job. But if they have already lost their jobs, that reason goes away. Chart 14 shows the strong correlation between unemployment in various French départements, and support for Marine Le Pen's National Front. If French unemployment rises, her support is likely to increase as well. The same goes for other European countries. Chart 13Macron Leads Le Pen By A Mile Chart 14Higher Unemployment Would Benefit Le Pen In addition, worries about large-scale immigration from outside Europe will continue to work to the advantage of populist leaders. Recent immigrants and their children have sometimes struggled to integrate into European society. This has manifested itself in the form of low labor participation rates, poor educational achievement, elevated involvement in criminal activity, and high welfare usage. The problem has been especially acute in European countries with very generous welfare states (Chart 15). Chart 15Many Immigrants To Europe Are Lagging Behind The reaction of establishment parties to mounting concerns about immigration has been completely counterproductive. Rather than acknowledging the problems, they have sought to censor uncomfortable "hatefacts" and stage show trials of populist leaders - such as the one Marine Le Pen will likely be subjected to for her alleged crime of tweeting graphic photos of terrorist atrocities. This strategy will backfire and the result will be a wave of populist victories towards the end of the decade. With that in mind, investors should consider buying some gold as a long-term hedge. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see BCA Geopolitical Strategy, “Europe: Game Was Changed A Long Time Ago,” in a Monthly Report, “Fortuna And Policymakers,” dated October 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, “Europe – Election Update, France,” in a Weekly Report, “Donald Trump Is Who We Thought He Was,” dated March 8, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades