Developed Countries

Highlights Every diversified currency portfolio should hold the yen as insurance against rising market volatility. However, for tactical investors, the latest dovish shift by global central banks almost guarantees the Bank of Japan will err on the side of stronger stimulus (explicitly or indirectly). Our bias is that USD/JPY could trade sideways in the next three to six months, but EUR/JPY could test 132 by year-end. Carefully monitor any shift in yen behavior in the coming months, in particular its role as a counter-cyclical currency. Investors who need to hedge out sterling volatility should favor GBP calls. Hold onto the USD/SEK shorts established last week, currently 1.6% in the money. USD/NOK shorts are looking increasingly attractive, as will be discussed in next week’s report. Feature The yen has proven an extremely tough currency to forecast in the last few years. Carry-trade investors who used widening interest rate differentials between the U.S. and Japan in 2018 to forecast yen weakness got decimated in the February and March 2018 equity drawdowns. More agile investors who timed the global equity market bottom in early 2016 have been shifted to the wayside on yen shorts, as the currency has strengthened since then. For value-based investors, the yen that was 14% cheap on a fundamental basis in 2015 is 19% cheaper vis-à-vis fair value today. Seasoned investors recognize the need to pay heed to correlation shifts, as they can make or break forecasts. In the currency world, the most recent have been dollar weakness after the Federal Reserve first tightened policy in December 2016, dollar weakness in 2017 despite four Fed rate hikes and more recently, yen resilience despite the equity market rally since 2016. In this report, we revisit traditional yen relationships to identify which have been broken down, and which still stand the test of time. Trading Rules A rule of thumb still holds true for yen investors: buy the currency on any equity market turbulence (Chart I-1). In of itself, this advice is not sufficient. If one could perfectly time equity market corrections, being long the yen will be low on a long list of alpha-generating ideas. Chart I-1The Yen Is A Risk-Off Currency The power of the signal comes when macroeconomic conditions, valuations and investor sentiment all align in a unifying message. Back in late 2016, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the Bank of Japan (BoJ). Having recently introduced yield curve control (YCC), the market was grappling with the dovish implications for the currency, arguably the most significant change in monetary policy by any central bank over the last several years. In retrospect, this was the holy grail for any contrarian investor. Given that backdrop, the yen strengthened by circa 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs for the yen rally. This backdrop underlines the golden rule for trading the yen, primarily as a safe-haven currency. Economically, the net international investment position of Japan is almost 60% of GDP, one of the largest in the world. On a yearly basis, Japan receives almost 4% of GDP as income receipts, which more than offsets the trade deficit it has been running since the middle of last year (Chart I-2). It is therefore easy to see why any volatility in markets could lead to powerful repatriation flows back to Japan. Chart I-2Japan's Income Receipts Are Quite Large One other factor to consider is that during bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows (Chart I-3). Chart I-3Hedging Costs Have Risen The global picture today has some echoes from 2016. Growth is slowing everywhere and markets have staged a powerful bounce from the December lows. This has been in anticipation of a better second half of this year. In the occasion that data disappointments persist beyond the first half, especially out of China, stocks will remain in a “dead zone,” which will be potent fuel for the yen. This is not our baseline scenario, as we expect growth to bottom in the second half of this year, but it remains an important alternative to consider at a time when Japanese growth is surprising to the downside. If the BoJ is preemptive and eases monetary policy, the yen will weaken. But the odds are highly in favor of the yen strengthening before. Bottom Line: Every diversified currency portfolio should hold the yen as insurance against rising market volatility. The BoJ’s Next Move By definition, any data dependent central bank will be behind the curve, but the incentive for the BoJ to act preemptively this time around is getting stronger. The starting point is that history suggests the consumption tax hike, scheduled for October this year, will be disastrous for the economy. Since the late 1990s, every time the consumption taxed has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5%-1%, this is a highly unpalatable outcome (Chart I-4). More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is slowing, with growth in the third quarter of last year clocking in at -2.4%. Chart I-4The Consumption Tax Hike Will Be Negative However, things are not that simple for the Japanese Prime Minister Shinzo Abe’s administration. Despite relatively robust economic conditions since the Fukushima disaster, consumption has remained tepid, even though there has been tremendous improvement in labor market conditions. By the same token, the savings ratio for workers has surged (Chart I-5). If consumers are caught in a Ricardian equivalence negative feedback loop,1 exiting deflation becomes a pipe dream for the central bank. Chart I-5Strong Labor Market, Weak Consumption The good news is that the government realizes this and has been taking steps to remedy the situation. At the margin, this is positive: The Japanese government recently passed a law that will allow the largest inflow of foreign workers into the country. There are about 1.5 million foreign workers in Japan today, who collectively constitute circa 2% of the labor force. The importance of foreign labor cannot be understated. Due to Japan’s demographic cliff, foreign workers were responsible for 30% of all new jobs filled in 2017. Assuming public aversion towards immigration remains benign, as is the case now (these are mostly lower-paying jobs in sectors with severe labor shortages), the government’s target to attract 350,000+ new workers by 2025 will go a long way in alleviating the country’s chronic labor shortage. This will also be marginally beneficial for consumption. Abe’s government hopes to offset the consumption tax hike with increased social security spending, especially on child education. For example, preschool and tertiary education will be made free of charge, financed by the tax hike. Labor reform has gone a long way to increase the participation ratio of women in the labor force (Chart I-6), but the reality is that almost 50% of single mothers in Japan still live below the poverty line, according to the BoJ. This is because many of them remain temporary workers. Temporary workers receive about half the pay of full-time workers’ and are not privy to most social security benefits. This has contributed to the surge in the worker’s savings ratio. Alleviating this source of uncertainty could help solve the consumption problem. Chart I-6Rising Female Participation In The Labor Force Transactions made via cashless payments (for example, via mobile pay) will not be subject to the 2% tax increase for nine months. Cashless payments in Japan account for less than 25% of overall transactions – among the lowest of developed economies. Increasing the share of cashless payments will help lift the velocity of money, which will be a positive development for the BoJ (Chart I-7). Chart I-7Money Velocity Is Still Falling Finally, the Phillip’s curve appears to be finally working in Japan, with wages accelerating at a 1.4% pace. Provided the government continues to indirectly put pressure on big firms to raise wages by at least 2-3% in upcoming Shunto wage negotiations, this trend should continue. An extended period of rising wages will help shift the adaptive mindset of Japanese households away from deflation (Chart I-8). Chart I-8Rising Wages Will Help At The Margin The BoJ pays attention to three main variables when looking at inflation: Core CPI prices, the GDP deflator and the output gap, in addition to other measures. The recent slowdown in the economy has tipped two of those indicators in the wrong direction (Chart I-9). This makes it difficult for the Abe administration to declare victory over deflation – something he plans to do before his term expires by September 2021. Chart I-9Inflation Variables Are Softening The perfect cocktail for the Japanese economy will be expansionary monetary and fiscal policy. But despite government efforts to offset the consumption tax hike with higher spending, the IMF still projects the fiscal drag in Japan to be 0.7% of GDP in 2019. This puts the onus on the BoJ to ease financial conditions. At minimum, this suggests that either the stealth tapering of asset purchases by the BoJ could reverse and/or new stimulus could be announced. Bottom Line: The swap markets are currently pricing some form of policy easing in Japan over the next 12 months. Ditto for Japanese banks (Chart I-10A and Chart 10B). Given the recent dovish shift by global central banks, the probability of a move by the BoJ has risen. Any surprise move will initially strengthen USD/JPY. However, given the probability that the dollar weakens in the second half of this year, our bias will be to fade this move. Portfolio investors can use this as an opportunity to buy insurance, should markets become turbulent in the next few months. Chart I-10AThe Market Is Pricing In A Dovish BoJ (1) Chart I-10BThe Market Is Pricing In A Dovish BoJ (2) Corporate Governance, Profits And The Equity/Yen Correlation Once global growth eventually bottoms, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital (Chart I-11). Depending on whether investors choose to hedge these inflows or not, this will dictate the yen’s path. At present, the cost of hedging does not justify sterilizing portfolio flows (see Chart I-3). Chart I-11Corporate Governance Could Lift Return On Capital The traditional negative relationship between the yen and the Nikkei still holds (Chart I-12). Weakening global growth is negative for the export-dependent Nikkei, and positive for the yen. This is because weakening global growth dips Japanese inflation expectations, and leads to higher real rates. This tends to lift the cost of capital for Japanese firms. Chart I-12The Yen/Equity Correlation Could Shift That said, another factor has been at play. Over the past few years, an offshoring of industrial production has been eroding the benefit of a weak yen/strong Nikkei. In a nutshell, if company labor costs are no longer incurred in yen, then the translation effect for profits is minimized on currency weakness. Investors will need to monitor the equity market/yen correlation over the next few years. It remains deeply negative, but could easily shift, dampening the yen’s counter-cyclical nature. Back in the 80s and 90s, the yen did shift into a pro-cyclical currency. Bottom Line: A dovish shift is increasingly likely by the BoJ. Meanwhile, our bias remains that if markets rebound in the second half of this year, this will be marginally negative for JPY. This could also put EUR/JPY near 132 by year end. A Few Notes On The Pound Recent market developments have become incrementally bullish for sterling. After Tuesday’s second defeat for Prime Minister Theresa May's Brexit deal, and again Wednesday’s rejection of a no-deal Brexit by 312 votes to 308, the probability is rising that the U.K. will either forge a deal for a more orderly separation with the EU or hold a new referendum altogether. Tuesday’s loss was expected because the EU had not offered a viable compromise to the Irish backstop - a deal that will keep Northern Ireland in the EU customs union beyond the transition date of December 2020. Meanwhile, Wednesday’s vote to leave the union sans arrangement was simply unpalatable for Parliament, given economics 101. Almost 50% of U.K. exports go to the E.U. A no-deal Brexit at a time when global exports are in a soft patch, and with much higher tariffs, was a no go for the majority.2 Complete sovereignty of a nation is and has always been a desirable fundamental right. For the average U.K. voter that has not benefited much from globalization, the risk was that Parliament repeatedly failed to pass a motion asking for an extension to the March 29 deadline. As we go to press, this risk has faded as MPs have voted 412 to 202 for a delay. An extension will likely be granted till the May 23-26 EU elections. The preference for an extension has been echoed by EU Commissioner President Jean-Claude Junker, Chief Negotiator Michel Barnier and Dutch Prime Minister Mark Rutte, all heavyweights in this imbroglio. For sterling investors, what is clear is that developments over the next few weeks will be volatile, but increasingly bullish. Admittedly, GBP has already rallied from its December lows. But long-term GBP calls still remain cheap, despite rising volatility (Chart I-13). Our fundamental models also suggest cable is cheap relative to its long-term fair value and it will be tough to the pound to depreciate if the dollar weakens in the second half of this year (Chart I-14). Chart I-13GBP Calls Are Cheap Chart I-14The Pound Is Cheap Bottom Line: The probability of a no-deal Brexit has fallen. Going forward, risk reversals suggest sterling calls remain relatively cheap to puts. Investors who need to hedge out any sterling volatility should therefore favor GBP calls. Housekeeping Our short AUD/NZD position hit its target of 1.036 this week. We are closing this trade for a 7% profit. As highlighted in last week’s report,3 a lot of bad news is already priced into the Australian dollar, which is down 37% from its 2011 peak. Outright short AUD bets are therefore at risk from either upside surprises in global growth, or simply the forces of mean reversion.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. 2 Please see Geopolitical Strategy Weekly Report, titled “The Witches’ Brew Keeps Bubbling…,” dated March 13, 2019, available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled “Into A Transition Phase,” dated March 8, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data in the U.S. continue to soften: The nonfarm payrolls came in at 20k in February, missing the forecast by 160k. Core consumer prices in February decelerated to a 2.1% year-on-year growth. Nonetheless, February average hourly earnings increased 3.4% year-on-year. Moreover, the unemployment rate in February fell to 3.8%. Lastly, retail sales in January grew at 0.2% month-on-month, outperforming expectations. The DXY index depreciated by 0.7% this week. The U.S. economy keeps growing above trend, but at a slower pace than last year. During the 60 minutes interview with CBS last weekend, Federal Reserve Chair Jerome Powell emphasized that while it is difficult for the economy to keep growing near 4% every year, it remains very healthy and any near-term recession is unlikely. We favor underweighting the dollar as we enter into a transition phase, where non-U.S. growth outperforms. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been promising: German factory orders in January came in at -3.9% year-on-year, improving from the last reading of -4.5%. The euro area industrial production month-on-month growth came in at 1.4% in January, outperforming expectations. In France, the Q4 nonfarm payrolls increased to 0.2% quarter-on-quarter, double the forecast. German consumer prices stayed at 1.7% year-on-year in February. EUR/USD appreciated by 1.2% this week. We favor overweighting the euro as easing financial conditions put a floor under growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: M2 money supply missed expectations in February, coming in at 2.4%. Besides, machine tool orders fell by -29.3% year-on-year in February. Total machinery orders were also weak in January, coming in at -2.9% on a year-on-year basis. Lastly, foreign investment in Japanese stocks was -1.2 trillion yen, while investment in Japanese bonds fell to 245.7 billion yen. USD/JPY has been flat this week. A dovish move by the BoJ is likely and it could further cheapen the yen. If global growth bottoms in the later half of this year, this will be bad news for the yen, given its counter-cyclical nature. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mostly positive: In January, industrial production and manufacturing production both outperformed expectations, with industrial production coming in at -0.9% year-on-year and manufacturing production coming in at -1.1% year-on-year. GDP growth in January came in at 0.5% month-on-month, higher than expectations. GBP/USD appreciated by 1.1% this week. Cable rallied after the parliament vote on Wednesday. The sentiment remains positive since chances of a no-deal Brexit have diminished. We recommend long-term call options on cable to capture any upside potential. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia continue to deteriorate: Home loan growth in January contracted to -2.6%. The National Australian Bank business confidence index fell to 2 in February, while the business conditions index fell to 4. Consumer confidence in March decreased to -4.8%. AUD/USD moved up by 0.4% this week. The housing market and overall economy continue to weaken in Australia. However, the Australian dollar is at a 10-year low suggesting much of the bad news is priced in. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Electronic card retail sales came in at 3.4% yoy, slightly lower than the previous reading of 3.5%. Food price index in February fell to 0.4% month-on-month. NZD/USD increased by 0.9% this week. We remain underweight NZD/USD, on overvaluation grounds. We are also closing our short AUD/NZD position for a 7% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have confirmed robust labor market conditions: The unemployment rate in February came in line at 5.8% while the participation rate increased to 65.8%. New jobs created in February were 55.9k, the strongest since 1981, beating analysts’ forecasts of zero job creation. February average hourly wage growth also increased to 2.25% year-on-year. However, housing starts in February fell to 173.1k, underperforming expectations. USD/CAD fell by 0.6% this week. The Canadian economy, especially the housing sector continues to show signs of weakness, despite a strong labor market. The risk is that overvaluation in the housing market and elevated debt levels impair consumer spending power. While the rising oil price helps, we think the benefits are more marginal than in the past. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Producer and import price growth in February fell to -0.7% year-on-year. EUR/CHF appreciated by 0.3% this week. Our long EUR/CHF trade is now 0.5% in the money since initiated on December 7, 2018. We continue to favor the euro versus the swiss franc as the later benefits less from a bottoming in global growth. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mostly positive: Overall consumer price inflation in February fell to 3% year-on-year; however, core inflation increased to 2.6% yoy. Producer prices also increased by 8% year-on-year in February. USD/NOK depreciated by 1.8% this week. Our long NOK/SEK trade is 2.8% in the money over two months. We continue to overweight NOK due to the cheap valuations and rising oil prices. The pickup in inflation also allows the Norges bank to become incrementally hawkish. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been disappointing: In February, consumer price inflation fell to 1.9% yoy. The unemployment rate climbed to 6.6% in February. USD/SEK depreciated by 1.5% this week, mainly due to the recent weakness in the dollar. We remain positive on the SEK versus USD based on an expected pickup in the Swedish economy and cheap valuations. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

We continue to expect copper prices to increase in the near term, as China’s credit cycle bottoms and DM central banks soften their monetary-policy stance. Fiscal and monetary stimulus in China also will be supportive of base metals prices going forward. The evolution of the Sino - U.S. trade negotiations remains a risk to our view, given how important the outcome of these talks will be for investors’ expectations and sentiment. Markets appear to be discounting a positive outcome. Anything that scuppers these talks – or results in a no-deal outcome – will be a negative for base metals, copper in particular. Our tactical long copper position is up by 1.2% since we initiated it last week. Highlights Energy: Overweight. Russian oil companies are expected to keep production lower until July, when the current OPEC 2.0 production-cutting agreement now in place expires. We expect the deal will be extended to year-end.1 Separately, the risk of a complete shutdown in Venezuela’s oil industry rose significantly, as a power failure in most of the country all but eliminated potable water supplies and significantly reduced oil exports. Base Metals/Bulks: Neutral. High-grade iron-ore prices got a boost this week as Vale was ordered to temporarily suspend exports from its primary port at Guaiba Island terminal in Rio de Janeiro state, according to Metal Bulletin’s Fastmarkets.2 The price-reporting agency’s 62% Fe Iron Ore Index rose $1.46/MT at $85.25/MT Tuesday. Precious Metals: Neutral. Spot gold is back above $1,300/oz, on the back of monetary policy easing among important central banks. This also is supporting base metals globally (see below). Ags/Softs: Underweight. Grain markets continue to drift sideways, awaiting definitive news re Sino - U.S. trade talks, specifically when presidents Xi and Trump will meet to finalize a deal (see below). Separately, wheat and corn inventories are expected to rise on the back of higher supplies and lower exports, the USDA forecast in its latest world supply-demand estimates. Feature Recent data releases confirm our view that global growth will remain weak in 1Q19 and early 2Q19. This will continue to put downward pressure on cyclical commodities – chiefly base metals and oil (Chart of the Week). Chart of the WeekGlobal Growth Slows In 1Q19 The persistence of the slowdown provoked major central banks to adopt a dovish stance in the short-term. This is easily seen in the recent actions by the U.S. Fed, the European Central Bank (ECB), the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA), all of which have communicated a pause in their rate normalization policies.3 At the moment, the frail global growth is partly balanced by expectations of a positive outcome re the ongoing Sino - U.S. trade negotiations (Chart 2). In the coming months, we expect the effect of accommodative DM monetary policy combined with an expansion in China’s credit (more on this below) and fiscal stimulus – i.e., tax cuts announced earlier this month amounting to almost $300 billion (~ 2 trillion RMB) meant to support policymakers’ GDP growth targets – will go a long way toward reversing the earlier contraction. The effect of these policy decisions will be apparent in 2H19. Chart 2China Growth To Hook Higher China’s Credit Cycle Bottomed In December 2018 The evolution of China’s credit cycle remains a central pillar to our view commodity demand growth in 2H19 will surpass consensus expectations. The massive growth reported in China’s January credit statistics revived investors’ expectations that China’s banks will re-open the credit valves as they did in 2016.4 In our view, this number does signal a bottom in China’s credit cycle, and implies Chinese – and indirectly EM – growth will bottom sometime this year. However, we still are not expecting a complete blowout credit expansion this year. We continue to believe Chinese policymakers will focus on stabilizing credit in 1H19 with moderate increases in supply, and start increasing stimulus in 2H19 or 2020 in order to maximize its effect later in 2020 ahead of the 100th anniversary of the founding of the Chinese Communist Party (CCP) in 2021. The soft February credit number released this week supports this argument.5 China’s Credit Cycle Matters For Base Metals Demand The relationship between China’s credit cycles and base metal prices endures and remains robust. We measure China’s aggregate credit using bank and non-bank claims on non-financial enterprises, households, local and central governments, and non-bank financial institutions. This corresponds to adding outstanding central and local government bonds to China’s Total Social Financing (TSF).6 The annual change in aggregate credit – or its impulses – do not perfectly capture the cycles in global base metal demand. These variables provide interesting signals about the direction and magnitude of movements in credit, however, they do not track base metals’ price cycles accurately and consistently (Chart 3). Chart 3Metals Price Cycles Don't Track Changed In China's Credit To decompose this variable into its trend and cycle, we use a proxy of the credit cycle constructed using the Hodrick-Prescott and Hamilton filters, and the standardized 12-month credit impulse (Chart 4).7 Chart 4China's Credit Cycle Proxy We find that our credit cycle proxy Granger causes base metal prices, import volume and industrial activity (Table 1).8 On average, it leads these variables by 4-6 months (Chart 5). Hence, we believe our credit cycle proxy provides valuable information about future commodity demand in China. Table 1China Credit Cycle Correlations In fact, when regressing copper prices and the LMEX against it, we found that 60% and 58% of the variation in copper prices and the LMEX, can be explained by the linear relationship with our China credit cycle proxy, respectively (Chart 6). Chart 6China's Credit Cycle and Metals Prices Given the leading property of China’s credit cycles with respect to industrial activity and metal prices, we included this new proxy in our Global Industrial Activity (GIA) index.9 This improves the correlation of our index with copper prices (Chart 7). Chart 7Credit Cycle Improves BCA's GIA Currently, our models suggest copper prices should increase in the coming months as China’s credit cycle bottoms and DM central banks soften their monetary policy stance. The evolution of the China-U.S. trade negotiations remains a risk to our view as the outcome will weigh on investors’ expectations and sentiment. China’s Vs. DMs’ Credit Cycles Between 2009 and 2014, China’s credit cycle lagged the U.S. and EU’s broad money cycles (Chart 8). This counter-cyclicality is partly explained by its elevated level of exports to the U.S. and of hard goods to Europe. When the global economic cycle works in China’s favor – i.e., when the Fed and ECB are accommodative or fiscal stimulus is deployed in either or both regions – China’s exports rise as U.S. and EU aggregate demand increases. This typically reduces the need for endogenous fiscal or monetary stimulus within China. Chart 8China's Credit Cycle Lags U.S., EU Money Cycles On the other hand, when the global economic cycle contracts and fiscal and monetary policy ex China becomes a headwind, Chinese policymakers typically need to deploy fiscal and monetary policy to keep growth going, or at least avoid a contraction in their economy. Between 2016 and 2017, DM and China credit cycles aligned and increased simultaneously. Taking into account the 4-to-6-month lag between the time credit supply is increased and commodity demand rises, this created bullish conditions for metals and oil from 2H16 to 1H18, pushing copper prices up by 60%. In 2018, both regions’ cycles rolled over. Base metals markets currently are experiencing the consequences of this contraction in credit availability and tightening of financial conditions generally. Going forward, we expect China will step in to raise domestic demand and offset the impact of the decline in credit availability elsewhere, which is affecting demand for its exports in the short-term. In the medium-term, the U.S. and EU, along with India, do not appear to be inclined to absorb Chinese exports to the extent they did in the past, which means the pivot to domestically generated growth through consumer- and services-led demand is the most viable alternative Chinese policymakers have to keep growth on target. Bottom Line: The dovish turn of major DM central banks combined with a bottoming of China’s credit cycle will support cyclical commodities at the margin in the coming months. During the second half of this year, we expect a more significant pick up in China’s credit, setting the stage for a year-end rally in base metal prices. As a consequence, the impact of China’s credit growth on base metals demand could diminish compared to previous stimulus targeting industrial demand.   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      Please see “Russia’s oil companies ready to cut output until July: TASS,” published by reuters.com March 12, 2019. 2      Please see Fastmarkets MB’s Daily Steel, March 12, 2019. 3      Please see “Pervasive Uncertainty, Persuasive Central Banks,” published by BCA Research’s Global Fixed Income Strategy March 12, 2019. It is available at gfis.bcaresearch.com. 4      Please see “China Macro And Market Review,” published by BCA Research’s China Investment Strategy March 13, 2019. It is available at cis.bcaresearch.com. 5      See footnote 4 above. 6      For more details please see “EM: A Sustainable Rally Or A False Start?” published by BCA Research’s Emerging Market Strategy March 7, 2019. It is available at ems.bcaresearch.com. 7      Hamilton notes the HP filter can be problematic. In general, we agree with critics of the filter (i.e. it results in spurious dynamics that are unrelated with the true data-generating process, it has an end-point bias which affects its real-time properties, and it is highly dependent on the parameter selection). However, there are some arguments in support of using the HP filter to proxy the credit cycle. First, as long as there are no clear theoretical foundation for an accurate measurement of the credit cycle, empirical validation should remain the number one criteria by which one selects its proxy. Second, credit cycles vary in duration and this weakens the ability to construct a reliable proxy. The usual parameter used with the HP filter favors short-term cycles (i.e. ~ 2 years) while the Hamilton filter focuses on medium-term cycles (i.e. ~ 5 years). Therefore, both can convey useful information. Third, China’s aggregate credit variable in level has a quasi-linear trend and is roughly approximated by a trend-stationary process with breaks in the trend and constant. Such a process should converge in limit when decomposed using the HP filter. Please see James D. Hamilton (2018), “Why You Should Never Use the Hodrick-Prescott Filter,” The Review of Economics and Statistics, vol 100(5), pages 831-843. and Phillips, Peter C. B. and Jin, Sainan (2015), “Business Cycles, Trend Elimination, and the HP filter,” Cowles Foundation Discussion Paper No. 2005. 8      Granger causality refers to a statistical technique developed by Clive Granger, the 2003 Nobel Laureate in Economics, which is used to determine whether one variable can be said to have caused (or predicted) another variable, given the past performance of each. Using standard econometric techniques, Granger showed one variable can be shown to have “caused” another, and that two-way causality also can be demonstrated (i.e., a feedback loop between the variables can exist based on the historical performance of each). 9      Please see “Oil, Copper Demand Worries Are Overdone,” published by BCA Research’s Commodity & Energy Strategy February 14, 2019. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades ​​​​​​​

Underweight In last month’s downgrade of the S&P pharma index to underweight, we highlighted that headwinds to drug prices would weigh on the sector’s earnings profile.1 This week’s CPI report confirmed this negative pricing view with prescription drugs falling into outright deflation; in fact industry pricing power is falling at its fastest rate in more than 15 years (second panel). Despite collapsing prices, pharma inventories have continued to climb which indicates that prices may have to fall further to clear out excess supply (third panel). The upshot is that, though they still trail the broad market by a wide margin, the recent uptick in both short- and long-term relative earnings estimates may be premature (bottom panel). Bottom Line: An increasingly difficult pricing environment means more downside lies in store for S&P pharma earnings estimates and, consequently, share prices; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, AGN, MYL, NKTR, PRGO. Deflating Drug Prices Bode Ill For Pharma Profits   1      Please see BCA U.S. Equity Strategy Weekly Report, “ Reflating Away” dated February 19, 2019, available at uses.bcaresearch.com.

Highlights Analysis on South Africa is published below. The “EM” label does not guarantee a secular bull market. None of the individual EM bourses has outperformed DM on a consistent basis over the past 40 years. EM share performance in both absolute terms and relative to DM has exhibited long-term cycles of around seven to 10 years. Getting these cycles right is instrumental to successful investing in EM. EM investing is predominantly about exchange rates. From a long-term (structural) perspective, EM equities are only modestly cheap in absolute terms but are very cheap versus the U.S. Feature We often receive questions from asset allocators about the long-term outlook for EM equities and currencies. The general perception among longer-term allocators is that while EMs may underperform over the short term, they always outperform developed markets (DM) in the long run. Consistently, the overwhelming majority of investors’ long-term return forecasts ascribe the highest potential return to EM equities and bonds among various regions and asset classes. This week we focus on the historical long-term performance of EMs. Contrary to popular sentiment, our findings show that EM stocks and currencies have not outperformed their U.S./DM peers in the past 40 years – as long as EMs have existed as an asset class. Hence, there is no guarantee that EM share prices and currencies will always outperform their DM counterparts on a secular basis going forward. Notably, EM share performance in both absolute terms and relative to DM has exhibited long-term cycles of around seven to 10 years. Getting these cycles right is instrumental to successful investing in EM. At the moment, the odds are that the current bout of EM equity and currency underperformance is not yet over, and more downside is likely before a major upturn emerges. The “EM” Label Does Not Guarantee A Secular Bull Market EM share prices have been in a wide trading range since 2010 (Chart I-1), despite the 10-year bull market in the S&P 500. Chart I-1Lost Decade For EM Stocks Remarkably, there is no single EM bourse that has been in a bull market during this decade (Chart I-2 and Chart I-3). This proves that this has indeed been a “lost” decade for EM. Chart I-2Individual EM Bourses: A Very Long-Term Perspective Chart I-3Individual EM Bourses: A Very Long-Term Perspective Historically, secular bull markets have been followed by bear markets not only in the boom-bust economies of Latin America, EMEA and Southeast Asia but also in former Asian tiger economies including Korea, Taiwan and Singapore (Chart I-4). This is despite the fact that per-capita real income has been growing rather rapidly in these Asian economies. Chart I-4Former Asian Tigers: Long-Term Equity Performance Remarkably, China and Vietnam have been exhibiting similar dynamics over the past 20 years – rapid per-capita real income growth and poor equity market returns (Chart I-5). Chart I-5China And Vietnam: Stock Prices And GDP Per Capita The message from all of these charts is as follows: Periods of industrialization and urbanization – even if successful – do not always entail structural bull markets. The U.S. fits this pattern as well. During the period between 1870 and 1900, the U.S. was experiencing industrialization and urbanization along with many productivity enhancements such as the steam engine, electricity and infrastructure construction. Even though America’s prosperity and real income per-capita levels surged during this period, corporate earnings per share and stock prices were rather flat (Chart I-6). Chart I-6The U.S. In The Late 1800s: Stocks, Profits And GDP Hence, rising per-capita real income and prosperity do not translate into higher share prices on a consistent basis. This is not to say that no country can ever deliver healthy stock market gains in the long run. Some certainly will, and it is our job to identify and expose these to clients. The point is that the “emerging market” status does not guarantee a structural bull market. Asset Allocation: Play Cycles Chart 7 illustrates that EM relative equity performance versus DM in general and the U.S. in particular has gone through several major swings over the past 40 years. Remarkably, none of the individual EM bourses has outperformed DM on a consistent basis over this time frame (Chart I-8A and I-8B). Chart I-7EM Versus DM: Relative Total Equity Returns Chart I-8ANo Single EM Bourse Has Outperformed DM In Past 40 Years Chart I-8BNo Single EM Bourse Has Outperformed DM In Past 40 Years Failure to outperform DM stocks is not only inherent for bourses in twin-deficit and inflation-prone regions/countries such as Latin America, Russia, Turkey, South Africa and South East Asia (including India), but it has also been true for share prices in rapidly growing countries such as China and Vietnam (Chart I-9). Chart I-9Chinese And Vietnamese Stocks Have Not Outperformed DM Remarkably, equity markets in the former Asian tigers – Korea, Taiwan and Singapore – have also failed to outperform their DM peers in the past 40 years (Chart I-10). This is in spite of the fact that real income per-capita growth in these Asian nations has by far outpaced that in both the U.S. and DM (Chart I-11). Chart I-10Former Asian Tigers Have Not Outperformed DM Equities... Chart I-11…Despite Economic Outperformance Evidently, the assumption that EM stocks will outperform DM equities on the back of higher potential growth rates is not validated by historical data. First, higher potential growth does not always ensure robust realized GDP growth. Second, even if real GDP-per-capita growth rises considerably, this does not always guarantee superior equity market returns. Some of the reasons for this include productivity benefits being transferred to employees rather than to shareholders, chronic equity dilution, and a misallocation of capital that boosts economic growth at the expense of shareholders. Bottom Line: EM relative stock performance versus DM has been fluctuating in well-defined long-term cycles. In our view, EM relative equity performance has not yet reached the bottom in this downtrend. We downgraded EM stocks in April 2010 and have been recommending a short EM equities / long S&P 500 strategy since December 2010 (please refer to Chart I-7 on page 5). EM Investing Is Primarily About Exchange Rates Exchange rates hold the key to getting EM equity cycles right for international investors. As demonstrated in Chart I-12, historically the bulk of EM equity return erosion has been due to currency depreciation. Chart I-12EM Investing Is All About Exchange Rates Exchange rates of structurally weak EM economies depreciate chronically. Common reasons include lack of productivity growth, high inflation, current account deficits, uncontrolled fiscal expansion, and reliance on volatile foreign portfolio flows. Periods of currency depreciation also occur in emerging Asian economies that have low inflation and typically run current account surpluses. Chart I-13 shows spot rates for Korea, Taiwan and Singapore versus the SDR which is a weighted average of USD, the euro, JPY, GBP, and CNY.1 Chart I-13Former Asian Tiger Currencies: Wide Fluctuations None of these Asian-tiger currencies has consistently appreciated versus the SDR. As in the case of share prices, there have been multi-year exchange rate swings. Further, U.S. dollar total returns on EM local bonds are also primarily driven by their currencies (Chart I-14). Consequently, the cycles in EM local currency bonds match EM exchange rate cycles. Chart I-14Total Return On Local Currency Bonds EM credit spread fluctuations are also by and large contingent on their exchange rates. Credit spreads on EM sovereign and corporate U.S. dollar bonds gauge debt servicing risk. The latter is highly influenced by exchange rates. Currency depreciation (appreciation) increases (decreases) debt servicing costs thereby affecting credit spreads. Bottom Line: Exchange rate fluctuations are driven by macro crosscurrents, making macro an indispensable know-how for EM investing. We maintain that EM currencies are susceptible to renewed weakness against the U.S. dollar as China’s growth continues to weaken, weighing on EM growth and thereby their respective exchange rates (Chart I-15). In turn, the U.S. dollar is a countercyclical currency and does well when global growth decelerates. Chart I-15EM Currencies Are Pro-Cyclical Valuations: The Starting Point Matters… In recent years, a long-term bullish case for EM equities and currencies has often been made on the grounds of cheap valuations. Chart I-16 illustrates the equity market-cap weighted real effective exchange rate for EM ex-China, Korea and Taiwan – a measure that is pertinent for both EM equity and fixed-income investors.2 It reveals that EM currency valuations are only slightly below their historical mean. Chart I-16EM Ex-China, Korea, Taiwan Currencies Are Modestly Cheap As to the CNY, KRW and TWD, their valuations are not at an extreme, and the CNY holds the key. The main long-term risk to the RMB is capital outflows from Chinese households and companies as discussed in February 14 report. For long-term investors, the pertinent equity valuation yardstick is the cyclically adjusted P/E (CAPE) ratio. The idea behind the CAPE model is to remove cyclicality of corporate profits when computing the P/E ratio – i.e., to look beyond a business cycle. Hence, the CAPE ratio is a structural valuation model – i.e., it works in the long term. Only investors with a time horizon greater than three years should use this valuation measure in their investment decisions. Our CAPE model gauges equity valuations under the assumption of per-share earnings converging to their trend line. The latter is derived by a regression of the cyclically adjusted EPS in real U.S. dollar terms on time. The EM CAPE ratio presently stands at 0.5 standard deviations below its historical mean (Chart I-17). This means EM stocks are modestly cheap from a long-term perspective. Meanwhile, the U.S.’s CAPE ratio is very elevated (Chart I-18). Chart I-17EM Equities Are Modestly Cheap From AA1 Structural Perspective Chart I-18U.S. Stocks Are Expensive From AA1 Structural Perspective On a relative basis, EMs are very attractive relative to U.S. stocks (Chart I-19). This entails that the probability of EM stocks outperforming U.S. equities is very high from a secular perspective – longer than three years. Chart I-19EM Equities Are Cheap Versus U.S. From AA1 Structural Perspective Nevertheless, a caveat is in order. Our CAPE model assumes that EPS in real U.S. dollar terms will rise at the same pace as it has historically. The slope of the time trend – the historical compound annual growth rate (CARG) of EPS in inflation-adjusted U.S. dollar terms – is 2.8% for EM and 2% for the U.S. Please note that we determined the earnings time trend (trend line) using historical ranges – 1983 to present for EM, and 1935 to present for the U.S. Hence, these CAPE models assume that EM EPS will grow 0.8 percentage points (2.8% minus 2%) faster than U.S. corporate EPS in inflation-adjusted U.S. dollar terms, as they have done historically. Under this assumption, EM stocks are considerably cheaper than the U.S. market. That said, in the medium term, corporate earnings are the key driver of EM share prices, and contracting profits pose a risk to EM performance, as discussed in our February 21 report. Bottom Line: From a long-term perspective, EM equities and currencies are only modestly cheap in absolute terms. Based on our CAPE ratio model, EM stocks are very cheap versus the U.S. However, the CAPE ratio is a structural valuation measure, and only investors with a time horizon of longer than three years should put considerable emphasis on it. …But Beware Of A Potential Value Trap If for whatever reason there is a change in the slope of the EM EPS long-term trend – i.e., per-share earnings fail to expand in the coming years at their historical rate, as discussed above, our CAPE model would be invalidated. In such a case, EM share prices are unlikely to enter a secular bull market in absolute terms and outperform their U.S. counterparts structurally. The key to sustaining the current upward slope in the long-term trajectory of EPS in real U.S. dollar terms is for EM/Chinese companies to undertake corporate restructuring and increase efficiency. Critically, recurring Chinese credit and fiscal stimulus as well as cheap and abundant money from international investors have not fostered corporate restructuring in China, nor in other EM countries. The basis is that easy and cheap financing and economic growth propped-up by periodic Chinese stimulus has made companies complacent, undermining their productivity and efficiency. The ultimate outcome will be weak corporate profitability over the long run. Another long-term risk to corporate earnings in China and some other EMs is the expanding role of the state in the economy. In these circumstances, China/EM corporate profitability will also suffer over the long run. The basis is that in any country the private sector is better than the government in generating strong corporate earnings. Bottom Line: Without structural reforms and corporate restructuring in EM/China, EM stocks are unlikely to outperform their DM peers on a secular basis. Investment Conclusions The medium-term EM outlook remains poor for the reasons we elaborated on in last week’s report titled, EM: A Sustainable Rally or A False Start? Further, investor sentiment on EM is very bullish, and positioning in EM equities and currencies is elevated (Chart I-20). We continue to recommend underweighting EM stocks, credit markets and currencies versus their DM counterparts and the U.S. in particular. Chart I-20Investors Are Very Bullish On EM From a long-term perspective, EM equity and currency valuations are modestly cheap. However, a durable long-term expansion in EM economies is contingent on a sustainable bottom in Chinese growth. The latter hinges on deleveraging and corporate restructuring in China, neither of which have occurred to a meaningful extent. For EM equity portfolios, we presently recommend overweighting Mexico, Brazil, Chile, central Europe, Russia, Thailand and Korean non-tech stocks. Our current (not structural) underweights are South Africa, Indonesia, India, the Philippines, Hong Kong and Peru. Within the EM equity space, two weeks ago we booked triple-digit profits on our strategic long positions in EM tech versus both the overall EM index and EM materials stocks, respectively. These positions were initiated in 2010. The basis for these strategic recommendations was our broader theme for the decade of being long what Chinese consumers buy, and short plays on Chinese construction, which we initiated on June 8, 2010. This week we are closing our long central European banks / short euro area banks equity position. We recommended it on April 6, 2016, and it has produced a 14% gain since then. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com South Africa: Debt Deflation Or Currency Depreciation? South Africa’s public debt dynamics are on an unsustainable track. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in South Africa. The gap between government local currency bond yields and nominal GDP growth is at its widest in over the past 10 years (Chart II-1). Meanwhile, the primary fiscal deficit is 0.75% of GDP (Chart II-2). Chart II-1South Africa: An Unsustainable Gap Chart II-2South Africa Has Not Had A Primary Fiscal Surplus In A Decade Faced with very low real potential GDP growth stemming from the economy’s poor structural backdrop, the authorities in South Africa ultimately have two choices to stabilize the public debt-to-GDP ratio: Tighten fiscal policy substantially, trying to achieve persistent large primary budget surpluses; or Inflate their way out of debt, which would require a large currency depreciation to boost nominal GDP growth above borrowing costs. With this in mind, we performed a simulation on public debt, assuming fiscal tightening but no substantial currency depreciation (Table II-1). The first scenario uses the 2019 consolidated budget government assumptions and projections for nominal GDP, government revenues and expenditures, i.e., it is the government's scenario. In this scenario, the public debt-to-GDP ratio rises only to 58% by the end of the 2021-‘22 fiscal year. However, government forecasts always end up being optimistic. We believe this scenario is implausible due to its overestimation of nominal GDP, and hence government revenue growth. As the government tightens fiscal policy, nominal GDP growth and ultimately government revenue will disappoint substantially. For the second scenario, we used government projections for fiscal spending in the coming years, but our own estimates for nominal GDP and government revenue growth. Notably, excluding interest payments and fiscal support for ailing state-owned enterprises like Eskom, nominal growth of government expenditures in the current year is at 7.5%, and estimated to be 6.8% the next two fiscal years. That is why we project nominal GDP and government revenue growth to be very weak. The basis of our assumption is as follows: Barring considerable currency depreciation, as the authorities undertake substantial fiscal tightening in the next three years, nominal GDP and consequently government revenue growth will plunge. Importantly, government revenues exhibit a non-linear relationship with nominal GDP – government revenues fluctuate much more than nominal GDP (Chart II-3). Chart II-3Government Revenues Are 'High-Beta' On Nominal GDP Growth As government revenue growth underwhelms, the primary deficit will widen and the public debt-to-GDP ratio will escalate, reaching 70% of GDP by the end of the 2021-‘22 fiscal year, according to our projections (Table II-1). Overall, without considerably lower interest rates and material currency depreciation, the government’s financial position will enter a debt deflation spiral. Fiscal tightening will hurt nominal growth damaging fiscal revenues. As a result, the fiscal deficit will widen – not narrow – and the debt-to-GDP ratio will rise. Therefore, the only feasible option for South Africa to stabilize public debt is to reduce interest rates dramatically and depreciate the currency. This will engender higher inflation and nominal growth, thereby boosting government revenues and capping the public debt burden. At 10%, the share of foreign currency debt as part of South Africa’s public debt is low. Hence, currency depreciation will do less damage to public debt dynamics than keeping interest rates at high levels. On the whole, the rand is a very structurally weak currency, and is bound to depreciate due to deteriorating public debt dynamics. Chart II-4 plots the real effective exchange rate of the rand based on CPI and PPI. It is evident that its valuation is not yet depressed. Chart II-4The Rand Is Modestly Cheap Meanwhile, cyclical headwinds also warrant currency depreciation (Chart II-5). Chart II-5Widening Trade Deficit Warrants Currency Depreciation Market Recommendations Continue shorting the ZAR versus the U.S. dollar and the MXN. Consistent with the negative outlook for the exchange rate, investors should underweight South African local currency government bonds and sovereign credit within respective EM portfolios. Finally, we recommend EM equity portfolios remain underweight South African equities. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1       Special Drawing Rights. The value of the SDR is based on a basket of five currencies: the U.S. dollar, the euro, the Chinese renminbi, the Japanese yen, and the British pound sterling. 2      We exclude these three currencies since their bourses have very large equity market cap in the EM stock index and, hence, would make any aggregate currency measure unrepresentative for the rest of EM.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Await the U.K. parliament to coalesce a majority on a on a credible strategy for Brexit that is also acceptable to the EU27. At that point, buy the pound, the FTSE250, and U.K. homebuilder shares. An eerie calm has descended over developed economy currencies. But the Chinese yuan has rebounded sharply. Stay tactically overweight emerging market currencies, cyclical equity sectors, and equities versus bonds. But don’t expect these rallies to last beyond the summer. Feature Chart of the WeekAn Eerie Calm Has Descended Over The Currency Markets. Why? End Of The Road For May From the moment almost three years ago that the U.K. voted to leave the EU, it was clear that a rational and measured Brexit would require the U.K. to remain in a customs union with the EU. Rational and measured because a customs union would protect the cross-border supply chains which are vital to so many U.K. businesses. Rational and measured because a customs union would avoid a hard customs border on the island of Ireland, and thereby prevent a break-up of the U.K. Rational and measured because a customs union would best deliver on the narrow 52:48 vote to leave the EU, which was driven by a desire to control migration and the supremacy of the European Court of Justice – both of which are compatible with remaining in a customs union – rather than a desire to strike independent trade deals – which is not. Yet Theresa May did not steer to this rational and measured Brexit, because she knew it would rip apart the Conservative party, a hard minority of which sees the sovereignty of trade policy as its Holy Grail. Beholden to this minority, May put her party interest above the national interest. But now, May has run out of road. Her Brexit deal has been rejected twice by huge parliamentary majorities. In the coming days, parliament, through a series of indicative votes, is likely to wrest control of the Brexit process from the government. So far, parliament has expressed what it is against (a no-deal Brexit), but it has yet to express what course of action it is for. We await the U.K. parliament to coalesce a majority on a credible strategy for Brexit that is also acceptable to the EU27. At that point, irrespective of the exact strategy, we will buy the pound, the FTSE250, and U.K. homebuilder shares. Important Message From The Currency Markets An unusually eerie calm has descended over the currency markets (Chart of the Week). For the past six months, GBP/USD has drifted within a tight 5 percent range, USD/JPY has also moved within a similarly narrow range, and EUR/USD has been trapped within an even tighter 3 percent range (Chart I-2 and Chart I-3). Chart I-2GBP/USD And EUR/USD Have Been Very Calm Recently Chart I-3USD/JPY Has Also Been Very Calm Recently The calm is eerie because Brexit tensions have actually intensified as the Article 50 clock has run down without a breakthrough; the Federal Reserve has made a dramatic volte-face from its sequential rate hikes; the ECB has pivoted back to dovish after the German economy narrowly avoided a technical recession; and the Japanese economy contracted sharply in the third quarter of 2018. Adding to the eeriness of the calm in currency markets, the equity and bond markets have experienced wild gyrations. Global equities plunged 20 percent before quickly recovering most of the losses, while long bond prices moved by close to 15 percent1 (Chart I-4 and Chart I-5).1 Chart I-4While Equities Have Been Turbulent, Currencies Have Been Calm Chart I-5While Bonds Have Been Turbulent, Currencies Have Been Calm Given all of this turbulence, why have currency markets remained a relative oasis of calm? The simple answer is that exchange rates are, by definition, relative prices. And in the major economies, growth and inflation rates have moved in the same direction by the same amount at roughly the same time. In fact, looking at quarter-on-quarter growth rates, the major economies have all recently experienced identical 1.5 percent slowdowns: from 4 to 2.5 percent in the U.S.; and from 2.5 percent to around 1 percent in both the euro area and the U.K.2  (Chart I-6 - Chart I-8). Chart I-6U.S. GDP Growth Slowed By 1.5 Percent Chart I-7Euro Area GDP Growth Slowed By 1.5 Percent Chart I-8U.K. GDP Growth Slowed By 1.5 Percent Markets do not care about the level of growth. They care much more about the change in growth. Financial markets are a discounting mechanism, and what matters most to the price is the change in the assumptions that are embedded within it. For example, if the price were discounting a major economy to grow at 4 percent and that rate of growth subsequently fell to 2.5 percent, then the seemingly benign outcome of respectable growth would cause interest rate expectations to decline. In another major economy, if growth slowed from 2.5 percent to 1 percent, it would precipitate a broadly similar decline in interest rate expectations.  In this situation of synchronised and meaningful slowdowns across major economies, and the consequent policy responses, equity and bond absolute prices would experience wild gyrations. By contrast, currencies are relative prices. So if the decline in major economy growth rates and interest rate expectations were broadly similar, currency markets would remain a relative oasis of calm. Which perfectly describes the observation of the last six months. This observation of near-identical slowdowns in the major economies supports our thesis that their genesis came from outside the developed economies, which we expounded in A European Cycle ‘Made In China’. And now we present the smoking gun. While an eerie calm has descended over developed economy currencies, all the action has been in emerging economy currencies, especially the Chinese yuan which has rebounded sharply. The message from the currency markets reinforces our thesis: last year’s growth downswing and the current upswing were made in China (see final chart). Never Focus On Levels Of Economic Growth It is worth repeating that a head-to-head comparison of growth rates across different economies is a meaningless exercise. Here’s a simple way to grasp this crucial point: a 1.5 percent growth rate would be a very pleasing outcome for Europe, it would be a very unpleasing outcome for the U.S., and it would be a catastrophic outcome for China. The reason is that if a population is growing, the economy needs to generate real growth well in excess of the rate of population growth to improve (per person) living standards. That excess comes from productivity growth which lifts standards of living and wellbeing. In the case of Germany or Japan where the population is not growing, or is indeed shrinking, the GDP growth rate that is consistent with these rising standards of living is much lower than in those economies where the population is growing (Chart I-9 and Chart I-10). Chart I-9The Same Productivity Growth In The Euro Area And The U.S. ... Chart I-10... Generates Different GDP Growth Necessarily, an economy with weaker demographics – like Germany or Japan – will flirt with technical recessions much more often than one with population growth – like the U.S. or China. But this is just Arithmetic 101. It doesn’t mean that Germany or Japan are in a fundamentally worse shape when it comes to all-important productivity growth and improving wellbeing. Just as important for investors, earnings per share (eps) growth depends on productivity growth and not on GDP growth. Granted, higher GDP from an increasing population will boost a firm’s sales, but without increasing productivity, the firm will have to hire more staff to produce those sales. In essence, the firm will have to employ more capital – issue more shares – which means than earnings per share will not grow. To reemphasise, levels of GDP growth, in themselves, do not drive financial markets. The Perils Of Data-Dependency Recently, the world’s major central banks have become even more wedded to ‘data-dependency’, for two reasons: first, under ever increasing external scrutiny, objectivity to the economic data boosts the transparency and rationale of central bank policy; second, data-dependency acts as a foil to politicians who might want to influence or interfere with the independence of monetary policy. No names mentioned! We applaud the central banks for their good intentions. Yet enhanced data-dependency also carries perils, as it increases the amplitude of the ever-present and natural oscillations in economic growth. The reason is that the high-profile hard data on which monetary policy ‘depends’ such as CPI inflation and GDP growth record what happened in the past, and sometimes in the distant past. Meanwhile, a monetary policy shift today will act on the economy in the future due to the unavoidable lags in transmission. It follows that enhanced data-dependency is akin to a crop farmer who uses last season’s depressed price, from oversupply, to justify planting much less seed for next season. The inevitable undersupply at next season’s harvest will then cause the crop price to surge. Making the farmer plant much more for the following season, at which point the price will collapse again. And the oscillations will continue ad infinitum. Unfortunately, the more backward the data on which policy actions depend, the higher the amplitude of the price and output oscillations.   Right now, growth sensitive investment positions are midway through exactly such an up-oscillation, justifying a near-term overweight in emerging market currencies, cyclical equity sectors, and equities versus bonds. But these rallies are highly unlikely to last beyond the summer (Chart I-11). Chart I-11The Recent Mini-Cycle Is ‘Made In China’ Stay tuned for the next turn. Fractal Trading System* We are pleased to report that long DAX versus the 30-year bund achieved its 2.5 percent profit target which is now crystallised and closed. This week we note that the sharp sell-off in AUD/CNY is close to the limit of tight liquidity that has signaled recent reversals in this cyclical currency cross. Accordingly, this week’s recommended trade is to go long AUD/CNY. Set a profit target of 1.5 percent with a symmetrical stop-loss. 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-12 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. * 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   Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 The German 30-year bund. 2 Based on annualised quarter-on-quarter real GDP growth rates. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation 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 So What? The late-cycle rally still faces non-trivial political hurdles. Why? U.S.-China trade talks, the U.S. threat of tariffs on auto imports, and Brexit continue to pose risks. A shocking revelation from the Mueller report could have a temporary negative impact on equity markets. A bombshell would increase Trump’s chances of removal from office. We give 35% odds to tarrifs on autos and auto parts, and 10% odds to a hard Brexit. Feature In our February 6 report we outlined how a “Witches’ Brew” of geopolitical risks had the potential to short-circuit the late-cycle equity rally. A month later, that brew is still bubbling. President Donald Trump’s approval rating has rebounded but going forward it faces challenges from negative headlines (Chart 1). These include a soaring trade deficit, a large influx of illegal immigrants on the southern border, a weak jobs report for February, a setback in North Korean diplomacy, and an intensification of the scandals plaguing Trump’s inner circle. Chart 1Don't Get Comfortable Just Yet, Mr. President Each of these issues calls into question the effectiveness of Trump’s core policies and the stability of his administration, though in reality they are only potentially problematic. While Special Counsel Robert Mueller’s forthcoming report poses a tail risk, the substantial threat remains Trump’s trade policy.  Indeed, investors face “the persistence of uncertainties related to geopolitical factors” and the “threat of protectionism,” according to European Central Bank President Mario Draghi, who spoke as he rolled out a new round of monetary stimulus for Europe and its ailing banks. What did Draghi have in mind? The obvious culprits are the U.S.-China trade talks, the U.S. threat of tariffs on auto imports, and Brexit. There were other issues – such as “vulnerabilities in emerging markets” – but the first three are the most likely to have turned Draghi’s head. The global economic outlook is likely to improve on the back of Chinese stimulus and policy adjustments by the ECB and Federal Reserve. But growth has not yet stabilized and financial markets face additional volatility due to the fact that none of these “geopolitical factors” is going to be resolved easily. The good news is that Trump, overseeing a precarious economy ahead of an election, has an incentive to play softball rather than hardball.  Mueller’s Smoking Gun? News reports suggest that Mueller will soon issue the final report of his investigation into President Trump’s election campaign links with Russia. There is really only one way in which the Mueller report could be market relevant: it could produce smoking-gun evidence that results in non-trivial impeachment proceedings. Any scandal big enough to remove Trump from office or clearly damage his reelection chances is significant because financial markets would dislike the extreme policy discontinuity (Chart 2). Anything short of this will be a red herring for markets, though admittedly many of our clients disagree. Very little is known about what Mueller will report and how he will interpret his mandate. Mueller’s investigation may or may not make it to the public in full form, at least initially, and he may or may not make any major additional indictments. Congress will strive to get access to the report, which is internal to the Justice Department, while spin-off investigations will proliferate among lower-level federal district attorneys and congressional committees. The legal battle, writ large, will run into the 2020 election and beyond. House Democrats alone can decide whether to bring articles of impeachment against Trump, but the case would be struck down in the Senate if it did not rest on ironclad evidence of wrongdoing that implicated Trump personally. Republican Senators will not jump ship easily – especially not 18 of them. That would require a sea change in grassroots support for Trump. Trump’s approval among Republicans remains the indicator to watch, and it is still strong (Chart 3). If this number crashes in the aftermath of the Mueller report, then Trump could find himself on a Nixonian trajectory, implying higher odds of a Senate conviction (Chart 4). At that point, markets would begin discounting a Democratic sweep in 2020, with business sentiment and risk assets likely to drop at the prospect of higher taxes and increased regulation (Chart 5). Chart 5A 2020 Democratic Sweep Would Dent Business Sentiment After all, if scandals remove Trump from office, then not only is a Democrat likely to win the White House, but any Democrat is likely to win – even a non-centrist like Bernie Sanders or other Democratic candidates like Kamala Harris who have swung hard to the left. Meanwhile, the odds of Democrats taking control of the Senate (while keeping the House) will rise. With Democratic candidates flirting with democratic socialism and proposing a range of left-wing policies, the prospect of full Democratic control of the legislative and executive branches would weigh on financial markets. We doubt that the Mueller report can fall short of a smoking gun while still dealing a fatal blow to Trump. The Democrats control the House, so if the scandal grows to gigantic proportions, they will impeach. Yet if they impeach without an ironclad case, Trump will be acquitted. And if Trump is acquitted, it is hard to see how his chances of reelection would fall. The impeachment of former President Bill Clinton looms large over Democrats, since it ended up boosting his popularity. If Democrats are overzealous to no end, it will help Trump’s campaign. If Trump should then win re-election, he will have veto power and likely a GOP Senate, so his policies will remain in place. The outcome for markets would be policy continuity, though the market-positive aspects of Trump’s first term may not be improved while the market-negative aspects, such as his trade policy and foreign policy, may reboot. Mueller is an all-or-nothing prospect: he either leads us to the equivalent of the Watergate Tapes or not. Lesser crimes are unlikely to have a decisive impact on the election. But volatility is likely to go up as the report comes due, just as it did during the Lewinsky scandal (Chart 6), at least until the dust settles and there is clarity on impeachment. And an equity sell-off at dramatic points in the saga cannot be ruled out, especially if global factors combine with actual impeachment (Chart 7). Chart 6Impeachment Proceedings Likely To Raise Vol... Chart 7… And Potentially Dampen Returns Bottom Line: A specific, shocking revelation from the Mueller report could have a negative impact on equity markets and risk assets, but any such moves would be temporary as long as the growth and earnings backdrop remain positive and Mueller does not drop a bombshell that increases Trump’s chances of removal from office. Separating The Budget From The Border The president faces adverse developments on the southern border after having initiated a controversial national emergency in order to transfer military funds to construct new barriers. The U.S. has seen an abnormally large increase in apprehensions and attempted entries this year (Charts 8A & 8B). Ultimately the influx calls attention to the porous southern border and as such may help to justify Trump’s policy focus. For now it raises the question of why the administration’s tough tactics are failing to deter immigrants. Meanwhile his emergency declaration has divided the Republican Party, with several members likely to join with Democrats in a resolution of disapproval that Trump will veto. Congress will not be able to override the veto, but Trump’s decree also faces challenges in the judicial system. We doubt that the Supreme Court will rule against him but it certainly is possible. The ruling is highly likely to come before the election. Meanwhile Trump is kicking off the FY2020 budget battle with his newest request of $8.6 billion for the border wall and cuts to a range of discretionary non-defense spending. The presidential budget is a fiction – it is based on unrealistic cuts to a range of government programs. Any budget that is passed will bear no relation to the administration’s proposals. Opinion polls referenced above clearly demonstrate that Trump’s approval rating suffered from the recent government shutdown. This does not mean that he will conclude the next budget battle by the initial deadline of October 1 or that a late-2019 shutdown is impossible. He might accept a short shutdown to try to secure defense spending that would arguably legitimize his repurposing of military funds for border construction. But his experience early this year means that the odds of another long-running, bruising shutdown are low. Might Trump refuse to raise the debt ceiling later this year to get his way on the wall? This is even less likely than a shutdown due to the negative impact that a debt ceiling constraint would have on social security recipients and bond markets. Trump also has the most to lose if the 2011 budget caps snap back into place in 2020 due to any failure of the FY2020 negotiations (Chart 9). As such, the debt ceiling – which the Treasury Department can keep at bay until the end of the fiscal year in October – and the 2020 budget may be resolved together this time around. In short, Trump will be forced to punt on congressional funding for the wall later this year and will have to campaign on it again in November 2020, with the slogan “Finish the Wall.” This is a market-positive outcome, as the hurdles to fiscal spending in 2020 are likely to be reduced: Trump will have to concede to some Democratic priorities and abandon his proposed cuts. The Democrats, for their part, are likely to have enough moderates to get the next budget over the line with Republican support. To illustrate, Republicans only need 21 votes for a majority, while no fewer than 26 Democrats were recently chastised by House Speaker Nancy Pelosi for cooperating with Republicans. The implication is that a bipartisan majority can be found. Since Trump cannot get his budget cuts, and does not really even want them, the projected contraction of the budget deficit in 2020 will be reduced or erased (Chart 10). On the margin, this would support higher inflation and bond yields.  The biggest threat to Trump’s reelection is still the risk that the long business cycle will expire by November next year. However, the exceedingly low February payrolls print was misleading – the unemployment rate fell and wage growth was firm (Chart 11). American households are in relatively good shape and that bodes well for Trump, for the time being. Chart 11American Households Are In Good Shape Bottom Line: The economy is relatively well supported and Trump and the Democrats are ultimately likely to cooperate on the budget under the table, reducing the risks of a debt ceiling breach, or an extended government shutdown later this year, or a fall off the 2020 stimulus cliff. The Trade Deficit: Trump’s Pivot To Europe Trade policy is where Trump’s challenges merge with Draghi’s woes. The U.S. trade deficit lurched upwards to a ten-year high of $621 billion in 2018 (Chart 12). The trade deficit is uniquely important to Trump because he campaigned on an unorthodox protectionist agenda in order to reduce it. It will be very difficult for him to evade the consequences if the deficit is higher, as a share of GDP, in November 2020 than it was in January 2017. Chart 12Trade Deficit Jump Is A Blow To Trump The underlying cause of the rising deficit is that a growing American economy at full employment with a relatively strong dollar will suck in larger quantities of imports. This effect is overriding any that Trump’s tariffs have had in discouraging imports. Meanwhile the global slowdown, reinforced by trade retaliation and negative sentiment, are harming U.S. exports (Chart 13). The administration’s policies of fiscal stimulus combined with encouraging private investment are guaranteed to lead to a higher current account deficit, barring an offsetting (and highly unlikely) rise in private saving. The current account deficit must equal the gap between domestic saving and investment and a rising fiscal deficit represents a drop in saving. Chart 13Trade War Hurting U.S. Exports What does the trade deficit imply for the U.S.-China talks? On one hand, the U.S. could put more pressure on China after feeling political heat from the large deficit. On the other hand, China has always offered to reduce the bilateral trade deficit directly through bulk purchases of goods, particularly commodities. It is Trump’s top negotiator, Robert Lighthizer, who has insisted that China make structural changes to reduce trade imbalances on a long-term and sustainable basis.1  In a sign of progress, the U.S. and China have reportedly arrived at a currency agreement. No details are known and therefore it is impossible to say if it would mean a more “market-oriented” renminbi, which could fluctuate and have a variable impact on the trade deficit, or a renminbi that is managed to be stronger against the dollar, which would tend to weigh on the deficit, as Trump might wish. The two negotiating teams are working on the text of five other structural issues that should also mitigate the deficit. Moreover, China’s new foreign investment law, if enforced, could increase American market access by leveling the playing field for foreign firms. However, there is still no monitoring mechanism, the two presidents have not scheduled a final signing summit, and the deterioration in North Korean peace talks also works against any quick conclusion. If Trump concludes a deal, the next question for investors is whether he will impose Section 232 tariffs on auto and auto imports on the EU and other partners (Chart 14). The European Commission’s top trade negotiator, Cecilia Malmstrom, recently met with Lighthizer in Washington to discourage tariffs. She refused to admit agriculture into the negotiations, as per a U.S.-EU joint statement in July 2018, but proposed equalizing tariffs on industrial goods as a way for both sides to make a positive start (Chart 15). She said that the U.S. repealing the Section 232 steel and aluminum tariffs are necessary for any final deal. And she reiterated that any new tariffs (e.g., the proposed Section 232 tariffs on autos and auto parts) would prevent a deal and provoke immediate retaliation on $23 billion worth of American exports. Malmstrom also said that the EU would prefer to work with the U.S. on reforming the World Trade Organization and addressing China’s trade violations. This approach fits with that of Japan, which has joined the U.S. and EU in trilateral discussions toward reforming the global trade architecture in a bid to mitigate U.S. protectionism and constrain China. The problem with the EU’s position is that once the U.S. and China make a trade deal, the U.S. will not have as immediate of a need to form a trade coalition against China (other than in dealing with WTO issues). Moreover, Japan will be forced to accept a deal with the U.S. in short order. A rotation of Trump trade policy to focus on Europe is likely. We give 35% odds to tariffs on autos and auto parts. The USMCA will increase the cost of production in North America while Europe is so far excluding cars from negotiations with the U.S., so there is room for a clash. But any tariffs on autos will be less sweeping than those against China. Trump will play softball rather than hardball for the following reasons: The public is less skeptical of trade with Europe and Japan than with China. The auto sector is heavily concentrated in the Red States and many states that are heavily exposed to trade with the EU are also critical to Trump’s reelection (Map 1). Section 232 tariffs that are required to be enacted by May 18 would have plenty of time to impact the U.S. economy negatively by November 2020. Congress and the defense establishment are against a trade war with U.S. allies, while bipartisanship reigns when it comes to tougher actions toward China. The bilateral trade deficit is less excessive with Europe than with China (see Chart 12 above). The U.S. carmaker and auto parts lobby are unanimously against the tariffs – and in fact has called for the removal of the steel and aluminum tariffs in a stance that echoes that of the EU. The existing steel and aluminum tariffs provide Trump with leverage in the negotiations with the EU and Japan, whereas the U.S. has agreed not to impose new tariffs on these partners while trade negotiations are underway. New tariffs would nix negotiations and ensure that the ensuing quarrels are long and drawn out, with a necessarily worse economic impact. To initiate a new trade war in the wake of the U.S.-China war would be to undercut the positive impact on trade, financial conditions, and sentiment that is supposedly driving Trump’s desire for a China deal in the first place. The U.S. eventually will need to build a trilateral coalition to hold China to account and ensure that it does not slide back into its past mercantilist practices. Even limited or pinprick tariffs will have an adverse impact on equity markets, given that they will hit Europe at a time when its economy is decelerating dangerously and when Brexit uncertainty is already weighing on European assets and sentiment (see next section).  This may be why both the U.K. and Germany have recently softened their positions on Chinese telecom company Huawei, which they have been investigating for national security concerns related to the rollout of 5G networks. They are signaling that they are not going to sacrifice their relationship with China if the U.S. is dealing with China bilaterally while threatening to turn around and slap tariffs on their auto exports. If the U.S. goes ahead with tariffs – on the basis that its China agreement allows it to isolate Europe – the EU will not be a pushover, as exports to the U.S. only amount to 2.6% of GDP (Chart 16). The result of the U.S.-China quarrel has been a deepening EU-China trade relationship and that trend is set to continue (Chart 17), especially if the U.S. continues to use punitive measures that increase the substitution effect and the strategic value of the Chinese and European markets to each other. Chart 16The EU Will Not Be A Pushover In Face Of U.S. Tariffs Chart 17EU-China Trade Relationship Deepening Bottom Line: In the wake of any U.S.-China agreement, we give a 35% chance that Trump will impose tariffs on European cars and car parts. Such tariffs are not our base case because they are unlikely to shrink the U.S. trade deficit and would have a negative impact on the Red State economy. But lower magnitude tariffs cannot be ruled out – and the impact on the euro and European industrial sector would clearly be detrimental in the short run. Assuming that global and European growth is recovering, a tariff shock to Europe’s carmakers could present a good opportunity to buy on the dip. Any U.S.-EU trade war will ultimately be shorter-lived and less disruptive than the U.S.-China trade war, which is likely to resume at some point even if Presidents Trump and Xi get a deal this year. The United Kingdom: Snap Election More Likely A series of important votes is taking place in Westminster this week, with the end result likely to be an extension to negotiations over a withdrawal deal at the EU Council summit on March 21. Conditional on that extension, the odds of a new election are sharply rising. The first vote, as we go to press on Tuesday, has resulted in a rejection of Prime Minister Theresa May’s exit plan by 149 votes – the second rejection after her colossal defeat in January by 230 votes. The loss was expected because the EU has not offered a substantial compromise on the contentious Irish “backstop” arrangement, which would keep Northern Ireland and/or the U.K. in the European Customs Union beyond the transition date of December 31, 2020. All that was offered was an exit clause for the U.K. sans Northern Ireland. But Northern Ireland is part of the U.K. and the introduction of additional border checks on the Irish Sea would mark a new division within the constitutional fabric. This is unacceptable to the Conservative Party and especially to the Democratic Union Party of Northern Ireland, which gives May her majority in parliament. On Wednesday, we expect the vote for a “no deal” exit, in which the U.K. simply leaves the EU without any arrangements as to the withdrawal (or future relationship), to fail by an even larger margin than May’s plan. Leaving without a deal would cause a negative economic shock due to the automatic reversion to relatively high WTO tariff levels with the EU, which receives 46% of the U.K.’s exports and is thus vital in the maintenance of its trade balance and terms of trade (Chart 18). It is impossible to see parliament voting in favor of such an outcome – parliament was never the driving force behind Brexit, with most MPs preferring to remain in the EU.     Chart 18No Deal Brexit A Huge Blow To U.K. The risk is that parliament should fail repeatedly to pass the third vote this week, a motion asking the EU for an extension period to the March 29 “exit day.” This is unlikely but possible. In this case, the supreme decision-making body of the U.K. will be paralyzed. A bloodbath will ensue in which the country will either see Prime Minister May ousted, a snap election called, or both. If the extension passes, the EU Council is likely to go along with the decision. It is in the EU’s near-term economic interest not to trigger a crash Brexit and in its long-term interest to delay Brexit until the U.K. public decides they would rather stay after all. The problem is that it will not want to grant an extension for longer than July, when new Members of the European Parliament take their seats after the May 23-26 EU elections. The U.K. may be forced to put up candidates for the election. What good would an extension do anyway? The likeliest possibility is, yet again, a new election. The conditions are not yet ripe for a second referendum, though the odds are rising that one will eventually occur. The Labour Party has fallen in the opinion polls amidst Jeremy Corbyn’s indecisive leadership and a divisive platform change within the party to push for a second Brexit referendum (Chart 19). An election now gives May’s Conservatives an opportunity to build a larger and stronger majority – after all, in the U.K. electoral system, the winner takes all in each constituency, so the Tories would pick up most of the seats that Labour loses. May’s faction might be able to strengthen its hand vis-à-vis hard Brexiters who have less popular support yet currently have the numbers to block May’s withdrawal plan. Chart 19A New Election Would Be Opportunistic Theresa May might be unwilling to call an election given her fateful mistake of calling the snap election of 2017. If she demurs, she could face an internal party coup. There is a slim chance that a hard Brexiter could take the helm, bent on steering the U.K. out of the EU without a deal. Parliament, however, would rebel against such a leader. Ultimately, the economic and financial constraints of a crash Brexit are too hard and we expect that the votes will reflect this fact, whether in an adjusted exit deal or a new election. But both outcomes require an extension.  However, we must point out that the constitutional and geopolitical constraints alone are not sufficient to prevent a crash out: parliament is the supreme lawmaking authority and there is no other basis for the U.K. to leave in an orderly fashion. The United Kingdom has survived worse, as many hard Brexiters will emphasize. A crash is a mistake that can happen. But the odds are not higher than 10%-20% given the stakes (Diagram 1). Diagram 1The Path To Salvation Remains Fraught With Dangers With the EU economy not having stabilized and the U.S. contemplating Section 232 trade tariffs, Brexit is all the more reason to be wary of sterling, the euro, and European equities in the near term, especially relative to the U.S. dollar and U.S. equities. Gilts can rally even in the event of an extension given the uncertainty that this would entail, though the BCA House View is neutral. Bottom Line: Expect parliament to ask for an extension. At the same time, the odds of a new election have risen sharply. The absence of a new election could lead to a power struggle within the Tory party that could escalate the risk of a hard Brexit, though we still place the odds at 10%. A second referendum is rising in probability but will only become possible after the dust settles from the current crisis. Investment Conclusions The ECB’s stimulus measures are positive for European and global growth over a 6-to-12-month time frame. They suggest that financial assets could be supported later in the year, depending in great part on what happens in China. China’s combined January and February total social financing growth reinforces our Feb 20 report arguing that the risk of stimulus is now to the upside. As People’s Bank Governor Yi Gang put it, the slowdown in total social financing last year has stopped. The annual meeting of the National People’s Congress also resulted in largely accommodative measures on top of this credit increase. Nevertheless, stimulus operates with a lag, and for the reasons outlined above we are not yet willing to favor EUR/USD or European equities within developed markets. A 35% chance of tariffs is non-negligible. We expect U.S. equities to outperform within the developed world and Chinese equities to outperform within the emerging world on a 6-to-12 month basis.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1      Lighthizer now has bipartisan support in Congress, whose members will lambast Trump if he squanders the historic leverage he has built up in exchange for a shallow deal that only temporarily weighs on the trade deficit.