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Highlights With North Korean diplomacy on track, Taiwan is the country most exposed to U.S.-China trade and strategic tensions. The Taiwanese public supports the status quo; however, a majority sees itself as exclusively Taiwanese, and the desire for independence may grow over time. Domestic political changes in mainland China and in the United States are also conducive to greater geopolitical tensions affecting Taiwan. Beijing will likely refrain from excessive pressure in the lead-up to Taiwan's November local elections ... but an independence-leaning outcome could change that. Stay overweight Taiwan within Emerging Market portfolios, but be prepared to downgrade if latent geopolitical risks begin to materialize. Feature The decision by the United States to toughen its enforcement of trade rules with China marks a shift that will have lasting ramifications.1 The U.S. is concerned not only about the trade imbalance but also the national security risk posed by China's economic might and increasing technological prowess. Hence President Donald Trump has imposed trade measures on China despite Chinese President Xi Jinping's cooperation on North Korea. Xi has enforced sanctions on the North and thus forced Kim Jong Un to the negotiating table, even getting him to consider denuclearization (Chart 1). Global financial markets may "climb the wall of worry" about the latest tariffs because the Trump administration has moderated its rhetoric in practice, notably by choosing to prosecute China in the World Trade Organization. However, the protectionist shift in U.S. policy is a lasting one. American power is declining relative to China, and the two countries no longer share the same economic interdependency that acted as a deterrent to conflict in the past (Chart 2).2 Chart 1China Gives Kim To Trump Chart 2Structural Increase In U.S.-China Tensions Taiwan is the country that is most exposed to both trade and strategic tensions between the U.S. and China (Chart 3). Indeed, BCA's Geopolitical Strategy has held since January 2016 that Taiwan is a potential geopolitical black swan.3 Does this warrant shifting to an underweight stance in EM portfolios? Not yet. But it is a left tail risk that investors should have on their radar. Taiwan Is Filled With Dry Powder There are three reasons to suspect that Taiwan geopolitical risk is understated. First, Chinese President Xi Jinping has consolidated power and made himself into Chairman Mao Zedong's peer in the Communist Party's ideological hierarchy. He is in power indefinitely. Xi has also followed his predecessor Jiang Zemin, in the 1990s, in taking a tough approach to security and defense. Implicitly he wants to make sure that unification occurs by 2049, but some argue that he wants to achieve it within his lifetime, namely by 2035. The Taiwanese public is resolutely opposed to any timetable. The fundamental risk is that economic slowdown could disappoint the aspirations of a big and ambitious middle class, which could force Xi to pursue nationalism and foreign aggression as a way to maintain domestic control (Chart 4). Beijing is still unlikely to attack Taiwan other than as a last resort, due to the American alliance system protecting it: this remains a hard constraint for now. But aggressive economic sanctions and military posturing with the intention to coerce Taiwan are much more likely than investors realize today. Chart 3Taiwan's Economy As Well As Security On The Line Chart 4China's Stability Vulnerable To Growth Slowdown Second, Taiwan's independence-leaning Democratic Progressive Party (DPP) has gained control of every level of government on the island - the presidency, the legislature, the municipalities - since the large-scale, anti-mainland "Sunflower" protests of 2014. President Tsai Ing-wen, who replaced the outspokenly pro-China President Ma Ying-jeou, is vocally uncomfortable with the status quo. She has refused to positively affirm the "1992 Consensus," which holds that there is only "One China" but two interpretations. Beijing sees this idea as the basis of smooth cross-strait relations. Tsai has not in practice tried to break the status quo, but she is clearly interested in enhancing Taiwan's autonomy. Moreover, a youthful "Third Force" has emerged in Taiwanese politics, with the backing of former presidents Lee Teng-hui and Chen Shui-bian, arguing for independence and the right to hold popular referendums on the question of sovereignty. Any success of this movement will provoke a massive response from China. Third, U.S. President Trump has suggested in several poignant ways that his tougher approach to China will entail a more robust American guarantee of Taiwan's security. While he has promised Xi to uphold the "One China policy," he is actively upgrading diplomatic and possibly naval relations with Taiwan and considering more substantial arms sales to Taiwan.4 His negotiation style suggests that he is not afraid to touch this "third rail" in Sino-American relations. Moreover, in the wake of the 1995-96 Third Taiwan Strait Crisis, and again in the wake of the Global Financial Crisis, a hugely important shift in Taiwanese national identity accelerated. Today the public mostly identifies solely as Taiwanese, as opposed to both Taiwanese and Chinese (Chart 5). This trend has abated somewhat since the DPP rose to full control in 2014-16, but a 55% majority still sees itself as exclusively Taiwanese. Among the youth, that number is 70%. This dynamic raises the possibility that a political independence movement could one day emerge. Beijing, at any rate, is watching with great concern. Of course, this shift in national identity does not imply that Taiwanese want to declare independence for the state of Taiwan anytime soon. Only about 22% want the country to move toward formal independence, and only 5% want to declare independence today. Whereas 69% are comfortable maintaining the status quo for a long time (Chart 6). The Taiwanese want to preserve their de facto independence and continue to prosper. But support for independence has grown faster than support for the status quo since the 1994 consensus. The status quo barely, if at all, holds majority support if one removes from its ranks those who eventually want to see the country declare independence. And younger cohorts have larger majorities than older cohorts in favor of independence. Chart 5Majority Of Taiwanese Are Exclusively Taiwanese ... Chart 6... Yet Majority Support Status Quo For Now The point is that there is a lot of "dry powder" in Taiwanese public opinion that could be ignited against China in the event of a change of circumstances, i.e. another military crisis or economic shock. Essentially, China is worried that someday this national identity could be weaponized. Chart 7China Gains Leverage Over Time How will China respond to the situation? So far it has not overreacted. Xi Jinping has launched more intimidating military drills and has hardened his rhetoric - including in key reports at the 2017 party congress and this year's National People's Congress. His administration has also pursued policies to emphasize its dominance, such as setting up new air traffic routes over the strait that Taiwan claims violate its rights.5 Nevertheless, the cross-strait status quo has not yet changed in any fundamental way that would suggest relations are about to explode. And this is fitting because the status quo is beneficial to the mainland, having created a vast imbalance of economic influence over Taiwan (Chart 7). This imbalance gives China the ability to use economic coercion to dissuade Taiwan's leaders from trying anything too daring. This year, in particular, there is reason to think that Xi Jinping may want to limit any provocations. Taiwan will hold local elections on November 24, an opportunity for the pro-China Kuomintang (KMT) to at least begin to claw back the political stature it has lost (Chart 8). A good showing in 2018 is essential for the KMT if it is to rebuild momentum for the 2020 general election. Tsai's and the DPP's approval ratings have fallen precipitously since her inauguration (Chart 9). Xi may deem that saber-rattling would be counterproductive by giving Tsai and the DPP a foil, when in fact the tide is already working against them. If the KMT's performance is abysmal in the November elections, then Beijing faces a problem. Its strategy of gaining influence over Taiwan through economic integration has not prevented the emergence of an exclusively Taiwanese identity. So far Beijing has not given up on this strategy but that might become a concern if the Xi administration treads softly this year and yet the DPP broadens its control of local offices. Worse still for Beijing would be sweeping gains for outspoken, pro-independence candidates, since China cannot expel them from the legislature as easily as it did their peers in Hong Kong. Chart 8Kuomintang Needs A Win In 2018 Chart 9DPP Only Leads KMT By A Little Now Bottom Line: Political changes in China, Taiwan, and the United States are conducive to souring relations across the strait. Moreover, Taiwanese national identity is dry powder that Beijing fears could be exploited by independence-leaning politicians - potentially with American backing from an aggressive President Trump. This three-way dynamic means that Taiwanese geopolitical risk is understated, despite the fact that these powers are all familiar with the dynamics and Beijing may not want to overly provoke voters ahead of local elections, knowing that heavy-handedness in 1995-96 encouraged Taiwanese uniqueness. Macro Backdrop And Trade Tensions Undermine DPP The problem for President Tsai and the ruling DPP, as local elections approach, is that the Taiwanese economy faces headwinds as Chinese and Asian trade slows down and as the Trump administration converts its protectionist rhetoric into action. Since last year, China has tightened financial conditions and regulation and has cracked down on corruption in the financial sector. The result is a slump in broad money supply that is now pointing to a drop in EM and Taiwanese exports (Chart 10). Indeed, a cyclical slowdown is emerging in Taiwan: The short-term loans impulse is weakening which suggests that Taiwanese export growth will slow further (Chart 11, top panel). The basis for this relationship is that short-term loans are used by Taiwanese businesses to fund their working capital needs as well as purchase inputs to fill their export orders. Further, broad money is also weak (Chart 11, bottom panel). Chart 10China Slowdown Spells Trouble For Taiwan Chart 11Taiwanese Money/Credit Growth Slowing The manufacturing sector is slowing, with the shipments-to-inventories ratio weak and manufacturing PMI dipping sharply (Chart 12). Worryingly, the new orders, export orders, and electronic-sector employment components of the manufacturing PMI are approaching a precarious level. Various prices of semiconductors are also starting to show signs of weakness globally which does not bode well for a market that relies heavily on this trade. The semiconductor shipment-to-inventory ratio has rolled over (Chart 13). Taiwanese exports to ASEAN are also slowing, which signifies that final demand for semiconductors is softening, as ASEAN economies lie at the final stage of the semiconductor supply chain process. Chart 12Manufacturing Indicators Rolling Over Chart 13Softness In Key Semiconductor Exports Further, global trade tensions have the potential to harm global growth and especially heavily trade-exposed economies like Taiwan. Taiwan is not guaranteed to benefit from the U.S.'s more aggressive posture toward China. Theoretically, if the U.S. imposes tariffs on goods from China that can be substituted by Taiwan, then Taiwan will benefit. But in practice, the U.S. is using tariffs as a threat to force China to open its market more to U.S. exports. One way that Beijing may respond is by purchasing American goods instead of goods that come from American allies like Taiwan. Beijing has already attempted this strategy by offering to increase imports of American semiconductors at the expense of Taiwan and South Korea. At the moment there are no details on how much of an increase China is proposing. In Table 1 we show several scenarios to assess the damage that could be inflicted on Taiwan if China substituted away from it. The impact on Taiwan's exports is not negligible. For instance, under the benign scenario, if U.S.'s share of semiconductor exports to China rise from 4%6 to 10%, then Taiwan's share of semiconductor exports to China would drop from 15% to 12%. That would amount to a $4 billion loss for Taiwan, approximately, which represents 1.4% share of its total exports and 4% of its overall semiconductor exports. This analysis assumes that the trade losses resulting from China's shift to its semiconductor import mix would harm Taiwan somewhat more than Korea. The latter holds a competitive advantage on Taiwan as Korea designs and manufactures unique semiconductors that are not as easily substitutable. At any rate, the damage to Taiwan's geopolitical and trade outlook would be more concerning than the loss of revenue. Table 1China's Trade Concessions To U.S. Could Impose Costs On U.S. Allies It is unlikely that the Trump administration is willing to accept such a deal, which is flagrantly designed to appease the U.S. at the expense of its allies. But the exercise illustrates a broader dynamic in which U.S. negotiations with China threaten to disrupt trade relationships and supply chains that have benefited Taiwan in recent decades. The result will be greater uncertainty and a higher potential for negative shocks. Chart 14China Punishes Taiwan For 2016 Election Moreover, the Trump administration has not entirely exempted allies from trade pressure. For instance, Taiwan has appreciated the dollar a bit in response to the threat of punishment for currency manipulation from the U.S. Washington has also just secured assurances from South Korea that it will not competitively depreciate the won. If agreements like these stand, and yet China makes less robust or less permanent agreements regarding its own currency, South Korea and Taiwan could suffer marginal losses of competitiveness. Taiwan is also exposed to coercive economic measures from China. Since Tsai's election, Beijing has made a notable effort to reduce tourist travel to Taiwan, which is reflected in tourism and flight data (Chart 14). Given the context of political tensions, the risk of discrete sanctions will persist and could flare up at any time if an incident occurs that aggravates the distrust between the two governments. How will investors know if Taiwanese geopolitical risk is about to spike upwards? At the moment, geopolitical risk is subdued, according to a proxy based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 15). This indicator tracks well with previous cross-strait crises. It even jumped upon the heightened tensions around the 2016 election of Tsai, and her controversial phone call with Donald Trump after his election. At the moment it suggests that cross-strait tensions have subsided significantly, despite the cutoff in formal diplomatic communication. However, the low point of the measure, and the underlying political factors outlined in the previous section, suggest that it should rise going forward. Chart 15Taiwanese Geopolitical Risk Likely To Rise From Here In the short run, it will be important to watch the Trump administration's handling of diplomatic visits and arms sales to Taiwan. Trump's signing of the Taiwan Travel Act has elevated diplomatic exchanges in a way that is mostly symbolic but could still spark an episode of heightened tension with China that would result in economic sanctions. An unprecedented naval port call could turn into an incident. At the same time, the U.S. guarantees Taiwan's security and in token of that guarantee periodically provides Taiwan with weapons packages. Beijing, for its part, always protests these sales, more or less vigorously depending on the military capabilities in question. The currently slated one is not too big but there is a rumor that it will include F-35 stealth fighter jets; other surprises could occur. Traditionally, the biggest spikes in sales have fallen under Democratic, not Republican, administrations. However, Trump may change that. There is a consensus in Washington that policy toward China should get tougher. The Taiwan Travel Act, upgrading diplomatic ties, passed with unanimous consent in both the House and Senate. Taiwanese governments have a record of increasing military spending when Republican presidents sit in Washington. And the first DPP government, under Chen Shui-bian from 2000-08, marked a clear upturn in Taiwanese military spending growth (Chart 16). If the Trump administration decides to sell Taiwan weapon systems that make a qualitative difference in the military balance, it will raise tensions with Beijing and likely prompt economic sanctions against Taiwan. Chart 16Arms Sales Could Reemerge As An Irritant In the long run, there are three key negotiations taking place in the region that could increase Taiwanese geopolitical risk: U.S.-China trade negotiations: Taiwan has benefited from China's engagement with the U.S., and with the West more broadly, and stands to suffer if they disengage. That would herald rising strategic tensions that would put Taiwan's trade and security in jeopardy. Geopolitical risk would go up. North Korean diplomacy: Kim Jong Un has met with Xi Jinping and formally agreed to hold bilateral summits with Presidents Trump and Moon Jae-in of South Korea. He has also indicated that denuclearization is on the table. If the different parties enter onto a path towards a peace treaty and denuclearization, then Taiwan might worry that the U.S. will eventually remove troops from the peninsula - far-fetched but not out of the question. Taiwan would fear abandonment and could attempt to entangle the U.S. For its part, China could believe that cooperation on North Korea requires the U.S. to give China greater sway over Taiwan. Geopolitical risk would go up. The South China Sea: These sea lanes are vital to Taiwan as well as China, South Korea, and Japan. If the U.S. washes its hands of the matter, ceding China a maritime sphere of influence, Taiwan will face both greater supply risk and greater anxiety about American commitment to its security. Beijing might be emboldened to pressure Taiwan, or Taiwan might act out to try to secure American support. Geopolitical risk would go up. Bottom Line: Taiwan's economy is entering a cyclical slowdown on the back of China's slowdown and rollover in the semiconductor industry. At the same time, trade tensions emanating from the U.S.-China negotiations and political tensions emanating from the other side of the strait suggest that Taiwan's geopolitical risk premium will rise. Over the short term, Taiwan's local elections, the referendum movement, or U.S. diplomacy or arms sales could provide a catalyst for a cross-strait crisis. Over the long term, significant changes in U.S.-China relations, North Korea, or the South China Sea could put Taiwan in a more precarious position. Investment Conclusions While the absolute outlook for Taiwanese stock prices is negative, the potential downside in share prices in U.S. dollar terms is lower than for the EM benchmark. BCA's Emerging Markets Strategy recommends that EM-dedicated investors remain overweight Taiwanese risk assets relative to the EM benchmark. First, the epicenter of China's slowdown is capital spending in general and construction in particular. Various Chinese industrial activity indicators have already begun decelerating. This is negative for industrial commodity prices and countries that produce them. Taiwan is less exposed to China's construction slump than many other EM economies. Second, China's spending on technology will not slow much. As a part of its ongoing reforms, Beijing will encourage more investment in technology as well as upgrading industries across the value-added curve. Hence, China's tech spending will outperform its expenditure on construction and infrastructure. Taiwan is poised to benefit from this relative shift in China's growth priorities. Third, there are no fresh credit excesses in Taiwan like in some other EMs. Taiwan's banking system worked out bad assets extensively following the credit excesses of the 1980s-90s. Hence it is less vulnerable than its peers in the developing world. Finally, Taiwan has an enormous current account surplus of 14% of GDP and, contrary to many other EMs, foreign investors hold few Taiwanese local bonds. When outflows from EM occur, the Taiwanese currency will fall under less pressure and its financial system under much less stress. This will allow Taiwanese stocks to act as a low-beta defensive play. Crucially, despite some appreciation to appease Trump, the Taiwanese dollar is among the cheapest currencies in EM (Chart 17). Chart 17Cheap Taiwanese Dollar Removes Risk As for heightened geopolitical risk, BCA's Geopolitical Strategy would note that while we view Taiwan as a potential "black swan," nevertheless tail risks are not the proper basis for an investment strategy. We will continue to monitor the situation so that we can alert clients when a major, market-relevant deterioration in cross-strait relations appears imminent, based largely on the factors highlighted above. If the DPP remains dominant after the local elections later this year, or if "Third Forces" make notable gains, we would suspect that the Xi administration will shift to using more sticks than carrots. This could include economic sanctions and military saber-rattling. The question then will be whether Beijing (or Washington or Taipei) attempts a material change to the status quo. Ultimately - from a bird's eye point of view - a war is more likely in the wake of Xi Jinping's elimination of term limits, consolidation of power, and the secular slowdown in China's economy and rise of Chinese nationalism. But we see no reason to fear such a catastrophic outcome in the near term. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 Trump began, as president-elect, by holding an unprecedented telephone call with the Taiwanese president. His administration has since requested a new $1.4 billion arms package, opened legal space for port calls (including potentially naval port calls) in the 2018 Defense Authorization Act, and for higher-level diplomatic meetings via the Taiwan Travel Act, which became public law on March 16, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. Military drills have involved symbolic shows, like sailing China's only operational aircraft carrier along the mid-line of the Taiwan Strait, as well as more poignant maneuvers, like drilling north and south of Taiwan simultaneously. As for rhetoric, Xi omitted from his 2017 party congress speech any reference to hopes that the Taiwanese "people" would bring about unification; in his speech after the March National People's Congress, he warned of the "punishment of history" for those who would promote secession. 6 Shown as the average of 2015 and 2017.

Informe especial

Highlights Malaysian elections are likely in April or May and we expect will return the ruling BN coalition to power; Malaysia's banking system is vulnerable and economy is highly exposed to a relapse in Chinese growth and/or commodity prices; Thailand's military junta has delayed elections until February 2019 and may delay again, but that is not cause for a selloff; Transitions from military to civilian rule are historically positive for Thai assets relative to emerging markets; Favor Thai currency, equities, and bonds within the EM space; go long Thai local bonds versus Malaysian, currency unhedged. Feature The word is out that Malaysian Prime Minister Najib Razak will call elections ahead of Ramadan in late April or early May. The timing makes sense, as Malaysia's economy has recovered from the turmoil of 2015 and Najib has survived the political scandals that threatened to topple him (Chart 1). We expect the long-ruling Barisan Nasional coalition to emerge victorious from the vote.1 Chart 1Call Elections While Growth Is Strong Meanwhile, to the north, Thailand's military junta has delayed elections for the third time, pushing them from November 2018 to February 2019. Having revised the constitution and guided the country through the royal succession,2 the military is running out of excuses to cling to power. It is likely to hand the reins partially back to civilian politicians within the next 24 months, if not next February. The first election since the 2014 coup is likely (though not guaranteed) to favor military-backed parties. In both countries, the political status quo is familiar, and likely to persist for some time. What does this mean for investors? First, it means a degree of certainty. Second, it means mixed prospects for pro-market policies. Both BCA's Geopolitical Strategy and Emerging Markets Strategy favor Thai assets over Malaysian within the EM universe. Malaysia: Election Is Tactically Bullish At Best On the political front, there is a 45% subjective probability that the election impact will be genuinely market-positive and a 55% probability that it will be neutral or status quo. To understand this, investors need to understand how unlucky Malaysia's political opposition is. The twenty-first century was supposed to be the opposition's moment in the sun, when it would defeat the ruling Barisan Nasional (BN) coalition for the first time since the country's independence in 1957. A large and ambitious middle class was emerging on the back of export-led industrialization and a commodity bull market (Chart 2). The time seemed ripe for an unlikely coalition of middle-class progressive Malays, ethnic Chinese entrepreneurs, and rural Islamists to take power in the name of change. Unfortunately for the opposition, the 2008 election came before the global financial crisis struck and the 2013 election came before the oil price plunge of 2014 (Chart 3). The opposition made a valiant showing nonetheless. In the first case it deprived the BN of a supermajority for the first time since 1969; in the second case, it won the popular vote. But in neither case was the opposition able to win a majority of seats in parliament, as its victories were confined to a few small regions (Chart 4). Chart 2Middle Class Angst In Malaysia Chart 3Opposition Timing Unlucky... Chart 4... Can It Keep Gaining Seats? Today the opposition's bad luck continues. The Pakatan Harapan coalition, as it is now called, is headed into the yet-to-be-scheduled 2018 elections at a time when Malaysia's economy and exports have recovered along with global demand and commodity prices (Chart 5). Consumer sentiment and employment have improved, albeit from a low point. Chart 5Economy Recovers Ahead Of Vote Moreover, Prime Minister Najib, who became embroiled in scandals almost immediately after winning the 2013 election, has been cleared of wrongdoing by various authorities. What little opinion polling exists suggests that the majority of the populace still disapproves of him, but apathy is widespread.3 Needless to say it is Najib's advantage as prime minister that he gets to decide the timing of the elections. The opposition has also lost a critical partner, the Malaysian Islamic Party (PAS). Najib has lured PAS into joining BN, giving it a larger majority and putting the remaining opposition forces even farther from the 112 seats needed for a majority in the lower house (the Dewan Rakyat) (Chart 6). At the same time, Pakatan Harapan has no platform other than opposition to Najib's government. Malaysia's chief opposition leader and advocate of structural reform, Anwar Ibrahim, has entered into an unholy alliance with his former boss and arch-enemy, the long-ruling strongman Mahathir Mohamad, who will soon turn 93 years old. This alliance is manifestly self-interested and unstable. There is a scenario in which the opposition could take power - but it is the least probable. In Chart 7 we present three scenarios: the first is the best case for the opposition, the second is the best case for BN, and the third is the status quo. To these scenarios we assign subjective probabilities: Scenario 1: Opposition Takes Power (20% probability): For the opposition to win, it needs to retain all of its current 71 seats and stage a historic upset by winning all the seats in Kedah and Johor. It then needs to convince PAS to return to its fold through coalition-building. Winning every seat in Kedah and Johor is a stretch. And PAS has learned how to wield power without the opposition, so why would it rejoin? BN has granted it concessions on its Islamist agenda that the more secular opposition parties would be loath to adopt. Scenario 2: BN Wins Supermajority (25% probability): The real question is whether the BN coalition will retake the supermajority that it lost in 2008. This would require BN to win an additional 19 seats on top of retaining its current 129 seats. If BN retains its current seats and the alliance with PAS, and wins half or more of the 37 seats in Malay-dominant, or mixed-Malay, constituencies currently held by the opposition, then it will achieve this supermajority. In Chart 7 above we illustrate this scenario as an even bigger sweep in which the BN also picks up some seats that it lost in ethnic Chinese and other constituencies. Scenario 3: BN Preserves Status Quo (55% probability): In this scenario, both BN and PAS retain their seats and remain allied, but make zero gains. Najib and his government are relatively unpopular and tainted by scandal, Malaysian governance has worsened, and winning back non-Malay and mixed-Malay seats could be very difficult in practice. What would be the likely market responses to these outcomes? In Scenario 1, an opposition victory would be the most market-friendly outcome in light of Malaysia's poor governance, flagging productivity, and lackluster economy in recent years. It would demonstrate to the world that although Malaysia's demographic trajectory strongly favors the majority Malay population (Chart 8), that trajectory need not condemn the country to a future of ethnic nationalism and communal tensions. Chart 6Defection Helps Ruling Coalition Chart 7Malaysia 2018 Election Scenarios Chart 8Demographics Favor Malay Majority True, the untested Pakatan Harapan coalition would bring a great deal of uncertainty. But the authority of Mahathir, the reformist bent of Anwar, the fact that the Islamist members of the coalition are progressive, and the increased political inclusion of the ethnic Chinese, would all be seen as positives. Moreover a vote against the long-ruling BN, and the BN's expected acceptance of the vote, would show that the country is flexible enough to handle real political change, unlike many EMs. Nevertheless, this is a low probability outcome. In Scenario 2, a BN supermajority would be cheered by markets (less enthusiastically than Scenario 1) for providing a clear sense of direction. It would reaffirm the United Malay National Organization's (UMNO's) status as the institutional ruling party (the core of the BN) after a decade of apparent decay. And it would remove the uncertainty of recent government scandals and mistakes. It would also give Najib enough political capital to press forward with structural reforms (Chart 9), which he has pursued under less ideal conditions. However, the downside of Scenario 2 is that, over the long run, Malaysia's governance would likely deteriorate (Chart 10). BN would regain the ability to pass constitutional amendments on its own and would use this power to reinforce Malay nationalism and authoritarianism, which would exacerbate tensions with the pro-business Chinese community. Chart 9Najib Has Done Some Reforms Chart 10Governance Could Fall Further The third scenario - a status quo BN simple majority - is the most likely yet least market-friendly outcome. This electoral result would leave Najib only able to do piecemeal reforms and more dependent on his Islamist coalition partner, PAS. The risk is not that radical Islamism would spiral out of control - Malaysia is a moderate Muslim country - but rather that in this scenario both governance and economic orthodoxy could continue to suffer.4 Economic conditions would be better than just after the 2014 commodity bust, but would remain lackluster. The crux of the matter is whether the election enables the government to take a more proactive stance in grappling with Malaysia's latent financial risks and external vulnerabilities. The latter are significant. Indeed, BCA's Emerging Markets Strategy is underweight Malaysian assets versus their EM peers, and argues that Malaysia needs to see the following developments for investors to upgrade this bourse: Progress in recognition of non-performing loans (NPLs) and increased bank provisions. NPLs are too low given the credit boom over the past nine years, and provisions are also extremely inadequate (Chart 11, panels 1 and 2). Further, Malaysian commercial banks have artificially boosted their earnings because they have lowered their provisions for bad loans. Given that global growth and Malaysian exports are likely at or near their peak, Malaysian commercial banks will soon face rising NPLs and will be forced to increase their provisions for bad loans, putting their profit growth at risk. In a scenario where banks raise provisions by 35%, banks' operating profits would fall from 11% to zero. This presents a major risk to bank share prices (Chart 12). Chart 11Bad Loans Are Under-Recognized Chart 12If Provisions Go Up, Profits Will Fall Crucially, commercial bank share prices are extremely important for Malaysia's stock market, as they account for 35% of the country's total MSCI market cap and 38% of the index's total earnings. Commercial banks also have been largely responsible for the recent rally in Malaysian stocks. An outlook of stable demand growth in China and stable-to-higher commodities prices, so that Malaysia's economy would be able to grow without too much reliance on credit and fiscal stimulus. Currently, exports to China comprise 9% of GDP and commodities exports make up 30% of exports and 20% of GDP. An outlook for stable-to-strong currency that would lower the external debt burden and lower debt-servicing costs, which are among the highest in the EM world. In turn, the exchange rate outlook is contingent on commodities prices and the EM carry trade. Importantly, these adjustments may only take place once Chinese growth has slowed and Malaysia's external vulnerabilities have become painfully apparent to investors and discounted in financial markets. Only an opposition victory or a BN supermajority would increase the probability that Malaysia will start trying to reduce these vulnerabilities preemptively, allowing investors to look beyond the valley and price in a better structural outlook. Given that the combined subjective probability of the two scenarios is 45%, we are neutral on Malaysian politics in the near term. Our conviction level on pro-market policies is low, given that the status quo outcome offers only piecemeal reforms, while a transition to opposition rule for the first time or a return to a traditional BN supermajority would be fraught with uncertainty. Bottom Line: The current rally in Malaysian assets can continue as long as the global bull market persists and China's slowdown remains benign. However, there is no guarantee that China will remain benign, and Malaysia is poorly positioned among EMs to deal with external shocks. Thus while there is space for a tactical play on the election, the prudent long-term position is to be underweight Malaysian stocks, local bonds, and currency relative to their EM counterparts. Thailand: Stay Bullish At Least Until Elections While Malaysia prepares to hold elections, Thailand's military junta has delayed them for at least the third time. They are expected by February 2019. While we would not be surprised to see another delay, this period of military rule is getting long in the tooth, by Thai standards, and we would expect the transition to civilian rule to occur within the next year or two.5 The election delay is mildly positive for Thai risk assets, as investors have broadly approved of the junta or at least grown accustomed to it. During previous periods of military rule, such as 1991-92 and 2006-07, Thai stocks have typically underperformed the EM benchmark, both in USD and local currency terms (Chart 13). But the 2014 coup proved to be different. The government of General Prayuth Chan-Ocha has provided three fundamentally stabilizing factors: Banishing the Shinawatras: The junta forced a conclusion (for the time being at least) to the domestic political struggle that has raged in the country since 2001. It did so by ousting Prime Minister Yingluck Shinawatra and sending her to join her brother, former Prime Minister Thaksin Shinawatra, in exile, and by suppressing their rural, populist political coalition. Shepherding the royal succession: The junta's decision to throw a coup in 2014 was heavily influenced by the desire to ensure that a stable royal succession would occur upon the death of the widely revered King Bhumibol Adulyadej. Bhumibol had played a calming role in Thai politics since 1946 and was a major source of authority for the political elite. When the king's death actually occurred in October 2016, the junta was exercising strict control over the country and the succession did not occasion any significant instability. Managing the post-GFC economy: The junta brought relatively competent and stable economic management during the turbulent period in which emerging markets climbed down from the massive DM and EM stimulus policies enacted during the Great Recession. Thailand's uneventful politics differed markedly from those of Malaysia, South Korea, Turkey, Brazil and others that have seen severe considerable political upheaval since 2013. As a result, Thailand has enjoyed greater policy "certainty" over the past four years than would otherwise have been the case. Credit default swaps, for example, have collapsed from the levels witnessed during the Thai political unrest and natural disasters in 2006-13. No surprise, then, that over the past three years, financial markets have cheered any sign that the junta will stay in power for longer (Chart 14). Chart 13Thai Equities Underperform EM Peers And Long-Term Average During Military Rule Chart 14Market Content With Postponed Elections To be sure, the Thai economy faces immediate, cyclical challenges. Thailand's frequent military coups have always had a deflationary impact due to austere policies and dampened animal spirits (Chart 15). The latest coup specifically initiated a period of macroeconomic deleveraging (Chart 16), and all indications suggest that the deleveraging has farther to go. Banks are repairing their balance sheets and less ready to extend credit. Capital formation is weak and construction is subdued (Chart 17). Chart 15Thai Coups Are Deflationary Chart 16Junta Imposed Deleveraging... This is not even to mention more structural challenges: A shrinking labor force (Chart 18, top panel; High household debt levels (Chart 18, bottom panel); Chart 17...So Economy Is Subdued Chart 18Structural Headwinds A stark deterioration in governance due to frequent coups and mass protests that are violently suppressed (see Chart 10 above). Furthermore, the impending transition to civilian rule will initiate a new round of political instability. Whenever "free and fair" elections are held in Thailand (i.e. elections not stage-managed by the military), the populace almost always returns the provincial, "democratic" parties to power (the so-called "Red Shirts"), as opposed to urban, royalist parties (the "Yellow Shirts"). This was the case in 2001, 2005, 2006, 2011, and 2014. The military has adjusted the constitution and electoral system to prevent this outcome, and it may succeed in arranging the first post-coup civilian government to come to power in 2019 or 2020. But these periodic constitutional and electoral rewrites have repeatedly failed to prevent the majority of the population from winning elections and forming governments. Even if the military succeeds in rigging the first post-junta election, the return to the democratic process itself will empower the rural populists and trigger a new cycle of conflict with the royalist establishment. After all, the military junta has not resolved the fundamental grievances of the Thai population, particularly in the restive north and northeast regions, where about 51% of the population lives. While poverty has declined rapidly, a hallmark of economic development, this trend has supported the ambitions of the countryside. Meanwhile the share of the population making over $20 per day has only slightly risen (Chart 19). The mean-to-median household wealth ratio is rising sharply, as wealthy households are lifting the national average while the median family's wealth has been virtually flat in absolute terms (Chart 20). Chart 19Lower Middle Class Is Large... Chart 20...And Inequality Is Rising The stark disparity between Bangkok, the home of the civil bureaucracy, and the rest of the country is apparent in the fact that public sector wages are almost twice as high as private sector wages. And since the coup, the wages of bureaucrats and soldiers have risen faster than the wages of farmers (Chart 21). It is the latter who in great part fuel the rural opposition movement. All of this suggests that a new cycle of instability will begin in Thailand once civilian government resumes. The good news for investors is that this instability will creep in only gradually. The military will try to orchestrate the initial elections and civilian government (February 2019 at earliest), which means that policy will remain continuous at first. Chart 22 shows what happens to the THB/USD exchange rate, and Thai equity returns (both in absolute and relative to EM), in the months following three key phases in the Thai political cycle: (1) coups and military rule (2) military-arranged governments and initial post-coup elections (3) free and fair elections. Chart 21Stark Economic Disparities Chart 22Return To Civilian Rule Good For Stocks The first and third phases bring mixed results: coups are bad for the baht and good for equities in the short term, while free elections are good for the baht and mixed for equities. The second phase - the transition to civilian government - is the only one that produces all positive returns. Of course, the external environment will be an overwhelming factor. The THB/USD and equity performances after the 2007 post-coup election and the 2008 military-arranged government were all distorted by the global financial crisis and the V-shaped recovery in 2009. We cannot predict the external environment after Thailand's upcoming transition to civilian rule other than to say that it will likely be worse than today's (as globally synchronized growth is very strong today). What we can say is that Thai equities outperformed EM equities in all three cases of pseudo-civilian government that we observed (1992, 2007, 2008). While history may not repeat itself, the key point is that Thailand's junta has overseen relatively orthodox economic management that makes Thailand relatively well positioned to deal with external volatility and shocks - quite unlike Malaysia. The country runs a massive current account surplus of 10% of GDP. Public debt and external debt are low, as is the share of bonds owned by foreigners who could sell in a fit of volatility. The junta has also capitalized on the strong external backdrop to rebuild Thailand's foreign exchange reserves (Chart 23). And the deflationary and deleveraging tendencies of the junta period mean that Thailand does not face a significant inflation constraint, allowing the Bank of Thailand to cut interest rates if it should need to (Chart 24). Chart 23Junta Knows How To Hoard Chart 24Room To Cut Rates Thus when China's slowdown hits emerging markets, Thailand is relatively well positioned to outperform. Certainly it is better fortified against any trade or commodity shock than its neighbor to the south, Malaysia. Bottom Line: The Thai junta is getting closer to relinquishing power to a civilian government. This will initiate a new cycle of political instability in Thailand, as low- and middle-class angst and regional disparities remain. Nevertheless the junta will be in power for another 12-24 months, and the initial transition is likely to maintain policy continuity at least at the beginning. Investors can benefit from Thailand's relative stability in this regard. Investment Conclusions BCA's Geopolitical Strategy and Emerging Markets Strategy have different tactical approaches to Malaysia, with the political analysts more constructive in the short term due to the fact that the upcoming election will at least enable Najib to continue with piecemeal reforms. However, both strategy services agree that Malaysia remains highly vulnerable to the ongoing slowdown in China and any relapse in commodity prices. On Thailand, by contrast, both teams are clearly positive on this bourse, currency, and local bonds relative to their respective EM benchmarks. The macro context is stable if uninspiring. Politically, Thai politics are a liability in the long run, but not particularly so in the next 24 months. There will be a new bout of instability in two-to-five years, when the rural, populist movement elects a government that is at odds with the military and the Thai political establishment in Bangkok. Until that time, however, the junta's tight grip provides a continuation of the status quo, which has been positive for investors. Thailand stands on much more solid ground than Malaysia and many other EMs when it comes to external debt and foreign funding. It will be able to withstand considerable global/EM turmoil. Therefore Emerging Markets Strategy and Geopolitical Strategy recommend that investors go long Thai / short Malaysian local currency bonds currency unhedged: The Malaysian ringgit will depreciate versus the Thai baht in the next 12 months. The current account surplus is 10% of GDP in Thailand and 2.9% in Malaysia and will move in favor of Thailand as commodity prices slump. The outlook for foreign capital flows favors Thailand over Malaysia. Foreigners own 26% of domestic bonds in Malaysia but only 16% in Thailand. The ringgit depreciation will lead to some selling pressure in local bond markets. Thai local bonds are more immune to this risk. Thailand's public debt position is also smaller than in Malaysia especially when off-balance sheet liabilities are taken into account. That puts Malaysia's true public debt closer to 69% of GDP versus only 33% in Thailand. The Malaysian fiscal deficit is also wide (2.7% of GDP) and the government will face difficulties cutting spending and raising taxes at a time when global growth is slowing. One final word on geopolitics. In an increasingly multipolar world, certain states will be able to parlay their strategic relevance to get advantageous commercial, financial, and military deals from great powers. Both Malaysia and Thailand are well positioned to extract benefits from the U.S. and China in their great power competition. However, Thailand is unlikely to suffer from concentrated U.S. or Chinese antagonism anytime soon, whereas Malaysia faces a more complicated relationship with China due to its geographically strategic location, maritime sovereignty disputes in the South China Sea, tensions between the ethnic Malay and Chinese communities, and lack of mutual defense treaty with the United States.6 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, available at ems.bcaresearch.com. 3 Please see Hafiz Noor Shams, "Malaysia Power Shift Unlikely Despite Mahathir Factor," Financial Times, January 29, 2018, available at www.ft.com. 4 Please see footnote 1 above. 5 Thailand's current Prime Minister Prayuth Chan-Ocha has been in power since he launched the coup of May 2014. If elections are held in February 2019, this five-year period will be the third longest period of military rule since 1932. Prayuth himself is already ranked fourth out of thirteen military prime ministers in terms of his time in office. If he steps down in 2019-20 then his term would rival that of Prem Tinsulanonda in the 1980s and Plaek Phibunsongkhram in the 1950s. If he is elected and stays on as prime minister, he could rival Thanom Kittikachorn who ruled for ten years. 6 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, "The South China Sea: Smooth Sailing?" dated March 28, 2017, and Weekly Report "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com.

Highlights Risk assets find themselves in a precarious equilibrium. Record high valuations are fully justified if bond yields remain at current levels or fall, but valuations become increasingly hard to justify if bond yields march much higher. If the average of the German 10-year bund yield and U.S. 10-year T-bond yield breaks through 2%, we would downgrade equities and upgrade bonds. Stay long Italian BTPs versus French OATs. The Italian election result is not an investment game changer... ...but stay underweight the Italian equity market (MIB) on a 6-9 month horizon. Our sector stance to underweight banks necessarily implies underweighting the bank-heavy MIB. Feature "Even yet we may draw back, but once cross yon little bridge, and the whole issue is with the sword." - Julius Caesar, contemplating whether to cross the Rubicon River in 49 BC World GDP amounts to $80 trillion. But the combined value of equities and correlated risk assets such as high yield and EM debt is worth double that, around $160 trillion. Real estate is worth $220 trillion. Hence, global risk assets are worth around five times world GDP. With the value of risk assets dwarfing the world economy by a factor of five, it perplexes us that many commentators insist that causality must always run from the economy to financial markets. In fact, in major downturns, the causality usually runs the other way. Rather than economic downturns causing financial instabilities, it is more common for financial instabilities to cause economic downturns. Specifically, the last three economic downturns had their geneses in the financial markets. The bursting of the dot com bubble triggered the downturn of 2001; the large-scale mispricing of U.S. mortgages caused the Great Recession of 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession of 2011. This raises a crucial question: is there a major vulnerability in financial markets right now? Risk Assets Are As Expensive As In 2000... For at least five decades, the ratio of global equity market capitalization to world GDP (effectively, the price to sales ratio) has proved to be an excellent predictor of subsequent 10-year global equity returns (Chart I-2). Chart of the WeekWorld Equities As Highly-Valued As In 2000 On Price To Sales Chart I-2Price To Sales Has Been An Excellent Predictor Of World Equity Returns Today's extreme ratio of global equity market capitalization to world GDP has been seen only once before in modern history - at the peak of the dot com boom in 2000. In the subsequent decade global equities went on to return a paltry 2% a year. Using the particularly tight predictive relationship in recent decades, we can infer that global equities are now priced to generate 2% a year in the coming decade too (Chart of the Week). Still, equities are not as extremely valued relative to government bonds as they were in 2000. Today, the global 10-year bond yield stands near 2%, implying a broadly equal prospective 10-year return from equities and bonds. In 2000, the global 10-year bond yield stood at 5%, implying that equities would return 3% less than bonds, which they duly did (Chart I-3). Chart I-3Relative To Government Bonds, Equities Were More Expensive In 2000 On the other hand, high yield credit is more extremely valued relative to government bonds than it was in 2000. Today, the global high yield credit spread stands at a very tight 4%: in 2000, it stood at 8% (Chart I-4). So taking the combination of equities and high yield credit, we can say that risk assets are as highly valued today as they were in 2000. Chart I-4Relative To Government Bonds, High Yield Credit Was Less Expensive In 2000 ...But Risk Assets Should Be Very Expensive When Bond Yields Are Ultra-Low The record high valuation of risk assets is fully justified when government bond yields are ultra-low. This is because bond returns take on the same unattractive asymmetry - known as 'negative skew' - that equity and high yield credit returns possess. For a detailed explanation, please revisit our report Are Bonds A Greater Risk Than Equities? 1 But in a nutshell, as bond risk becomes 'equity-like' it diminishes the requirement for a superior return on equities and other risk-assets, lifting their valuations exponentially. Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative skew than 10-year bonds. So investors will demand a comparatively higher return from equities, let's say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative skew. So investors will demand the same return from equities as they can get from bonds, 2% a year (Chart I-5). Chart I-5Below A 2% Yield, 10-Year Bonds Are Riskier Than Equities At the lower bond yield, the bond must deliver 2% a year less for ten years, meaning its price must rise by 22%.2 But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%.3 All well and good, except if bond yields go back up to 4%. In which case, bond and equity prices must fall again - in proportion to their preceding rise. Hence, risk assets find themselves in a precarious equilibrium. Record high valuations are fully justified if bond yields remain at current levels or fall, but valuations become increasingly hard to justify if bond yields march much higher. However, a setback to $380 trillion of global risk assets means that yields can't march much higher without at least a temporary reversal. Unfortunately, the exact point at which the precarious equilibrium becomes threatened is hard to define. Still, we might define crossing the Rubicon as follows. If the average of the German 10-year bund yield and U.S. 10-year T-bond yield - now standing at 1.8% - breaks through 2%, we would downgrade equities and upgrade bonds. Italy: Banks More Important Than Politics On Sunday, Italy's electorate punished the establishment centre-left and centre-right parties - the Democratic Party and Forza Italia - whose combined vote share collapsed to just 33%. Italians gravitated to parties offering populist, anti-establishment and anti-migration bromides. Sound familiar? This is just a continuation of the pattern seen in recent elections in France, Germany and Austria - as well as the victories for Brexit and President Trump. Begging the question, does the Italian election result change anything for investors? Political change disrupts markets if it dislocates the long-term expectations embedded in economic agents and financial prices. The vote for Brexit changed expectations about the U.K.'s long-term trading relationships; the election of Trump changed expectations about fiscal stimulus, the tax structure, and protectionism; and the election of Macron exorcised the potential chaos of a Le Pen presidency. On this basis, the Italian election result is not an investment game changer. The one exception would be if M5S and Lega joined forces to govern, as it could throw EU integration into reverse. But the likelihood of this unholy alliance seems very low. Many people - including some of the more populist Italian politicians - claim that Italy's long-standing economic underperformance is because it is shackled to the euro. But membership of the single currency cannot be the main cause of Italy's underperformance. After all, through 1999-2007, Italian real GDP per head performed more or less in line with the U.S., Canada and France, even without a private sector credit boom. Italy's underperformance really started after the 2008 financial crisis (Chart I-6). And the most plausible explanation is that its dysfunctional banking system has been left broken for close to a decade (Chart I-7). Italy procrastinated because its government is more indebted than other sovereigns and its banking problems did not cause an outright crisis. Chart I-6Italy Has Underperformed##br## Since The Great Recession... Chart I-7...Because The Banks ##br##Were Left Unfixed But now the banking system is finally recuperating. In the past year, banks have raised almost €50 billion in much needed equity capital, the share of non-performing loans (NPLs) is down sharply having peaked at the same level as in Spain in 2013 (Chart I-8), and bank solvency is much healthier (Chart I-9). Chart I-8Italy's NPLs Are Finally Declining... Chart I-9...And Bank Solvency Is Getting Better In effect, Italy is where Spain was in 2014. So could Italy in 2018-21 repeat Spain's turnaround in 2014-17? Italy has more work to do, but on balance we remain cautiously optimistic, and express this optimism through a relative trade in bonds: long Italian BTPs versus French OATs. The connection with the Italian equity market (MIB) is more tenuous. The market's outsize exposure to banks means that sustained outperformance of the MIB requires sustained outperformance of banks. On a 6-9 month horizon, our sector stance is to underweight banks. Necessarily, this means our country stance must be to underweight Italy. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities?" published on January 25, 2018 and available at eis.bcaresearch.com 2 1.02^10 3 1.06^10 Fractal Trading Model* The rally in the Chilean peso appears technically extended. Hence, this week's trade recommendation is to short the Chilean peso versus the U.S. dollar setting a profit target of 2.7% 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 10 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Chart 6Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.

Informe especial

Highlights Economy: The Italian economy is enjoying a solid, if unspectacular, cyclical upturn led by exports, but inflation pressures remain subdued. Banks: The health of Italian banks has improved drastically over the last year, with liquidity, solvency, and systemic risks fading for the time being. Politics: Euroskepticism will not be the major issue in the election given an expanding economy, but none of the likely outcomes will lead to a prudent fiscal policy. ECB: The inevitable tapering of ECB asset purchases later in 2018 will not have a meaningful impact on Italian government bond valuations - as long as the ECB does not begin to raise rates soon after. Upgrade Italian government bonds to neutral until signs of an economic slowdown in Italy emerge. Feature Italy's financial markets have been on quite a roll over the past year. Italian equities are up 13% since the beginning of 2017 in local currency terms, well above the 8% increase in overall Euro Area stocks (Chart 1). Italian government bonds returned 1.8% over that same period (also in local currency terms), massively outperforming core European equivalents that have suffered significant losses as global bond yields have risen substantially. Investors have been focusing on the upbeat news of a cyclical economic expansion and the improving health of Italian banks, which has helped reduce the risk premia on Italian financial assets (Chart 2). At the same time, markets are not pricing in any political risk in the run-up to next month's Italian parliamentary elections that could end up with, at best, yet another unstable coalition government. Chart 1Italy Has Been##BR##A Star Performer Chart 2Investors Are Focusing On Italian Growth,##BR##Not Politics Most importantly, the growing pressure on the European Central Bank (ECB) to begin shifting away from the era of extreme monetary policy accommodation threatens to remove a major buyer of Italian debt. This is a large problem down the road, as the easy money policies of the ECB have helped paper over a lot of structural cracks that still exist in Italy. In this Special Report, jointly prepared by BCA's Global Fixed Income Strategy and Geopolitical Strategy teams, we examine the outlook for Italian financial assets, both in the short run heading into the March 4th election and also over a medium-term perspective. Specifically, we look at the ultimate measure of Italian risk - the Italy-Germany government bond yield spread. Our conclusion is that Italy's economy and financial markets may be better placed to survive the more volatile global investment backdrop in 2018 than is commonly believed. Beyond this time horizon, however, Italian politics remains a risk. The Economy: Looking Better, But Highly Levered To Global Growth Italy's economy is enjoying a relatively strong economic expansion, judged by its own modest standards. Real GDP grew 1.5% last year, delivering the fourth consecutive year of growth following the recession in 2012-13. That was slower than the 2.5% pace witnessed across the entire Euro Area. The cyclical trend in Italy, however, remains highly correlated to that of its common currency neighbors, as all have benefitted from the easy financial conditions created by ECB policy (Chart 3). Consumer spending has been a modest contributor to the current economic upturn. Consumer confidence is steadily climbing and approaching its 2015 highs, yet retail sales volumes are only growing at a 1% pace. Sluggish incomes are the reason. Real wage growth has struggled to stay positive in the years since the last recession and now sits at a mere 0.25% (Chart 4). Against this backdrop, Italian consumers have been reluctant to significantly run down savings or ramp up debt to support a faster pace of consumption. The household debt/GDP ratio is only 42%, well below the Euro Area median. The decline in Italian interest rates, however, has helped free up income available for spending; the household debt service ratio is now sitting at 4.5%, one full percentage point below the 2012 peak (bottom panel). Chart 3Italian Growth Is Out Of The Doldrums Chart 4A Modest Pick-Up In Consumer Spending A bigger boost to Italian growth has come from the corporate sector. Business confidence has been steadily improving in response to the cyclical upturn in global economic growth. Exports, which now represent about one-third of Italian GDP, are growing just over 5% in real terms. This has helped boost industrial production and capacity utilization, with the latter reaching the highest level since 2007 (Chart 5). Companies have responded by ramping up capital spending, which grew 4.6% (year-over-year) in Q3 2017. Structurally, problems of poor labor productivity continues to plague Italian companies, however, and it remains to be seen if the rise in the euro over the past year will begin to have an impact on sales and profits. For now, the cyclical industrial upturn will likely continue as long as global growth, and specifically export demand, remain buoyant. Another underappreciated driver of the current Italian expansion has been mildly stimulative fiscal policy. Italy benefited from four consecutive years of positive "fiscal thrust", i.e., the change in the cyclically-adjusted primary budget balance (Chart 6). This was a welcome relief given the austerity that was imposed on Italy after the European Debt Crisis, which drained 3% from the Italian economy from 2011 to 2013. The IMF is projecting that Italian fiscal policy will turn restrictive this year and in 2019 but, as we discuss later in this report, the upcoming Italian election is likely to deliver a government that will go for more fiscal stimulus, not less. Chart 5An Expansion##BR##Fueled By Exports Chart 6Fiscal Tightening Will Not Happen,##BR##Post-Election The labor market recovery from the 2012 recession has been slow. Italy's unemployment rate is 10.8%, down from a peak level of 13% in 2014 but still well above the OECD's estimate of full employment (NAIRU). For Italy, the youth unemployment rate remains a major problem - at 33%, it is easily the highest among European countries and continues to fuel support for the anti-establishment Five Star Movement. More generally, Italy's relatively high unemployment rate is not necessarily a sign of underlying economic malaise. Italy's labor force participation rate has risen from a low of 60.4% in August 2010 to 64.5% at the end of 2017 (Chart 7). The steadily improving economy is drawing discouraged workers back into the labor force, as we predicted it would in 2012,1 with the extra labor supply ensuring that Italian wage growth will stay sluggish for some time. On a related note, Italy's inflation remains well below the ECB's 2% target rate. Headline HICP and core HICP inflation are 1% and 0.6%, respectively. These levels are also well below the Euro Area aggregate levels, which are 1.35% and 1.2% for headline and core HICP, respectively. Although consumer spending has improved in Italy, it has not been strong enough to put upward pressure on consumer prices, and weaker wage growth will not force businesses to raise prices to protect profitability. In addition, the IMF projects that Italy's output gap will not close until 2022, or three years after the overall Euro Area gap will be eliminated (Chart 8). Chart 7Plenty Of Labor Market Slack In Italy Chart 8No Sign Of Inflation Pressures Bottom Line: The Italian economy is enjoying a solid, if unspectacular, cyclical upturn. This is being led by exports and flowing through into domestic production and investment. Inflation pressures remain subdued, however, given ample slack in labor markets. The Banks: Drastic Improvement, But Risks Remain The Italian banking system has a well-earned reputation of being dysfunctional, undercapitalized and plagued by non-performing loans (NPLs). However, last summer, the ECB declared that two Italian banks were "failing or likely to fail," prompting state intervention. The Italian government followed that with a E5.4 billion bailout for Monte dei Paschi di Siena, Italy's fourth largest bank. Given the tight correlation between Italy's relative financial asset performance and its banking sector, these actions were met with loud cheers from investors as both Italian equities and bonds rallied. Standard & Poor's credit rating agency then raised Italy's sovereign debt rating to BBB, citing "subsiding risks" in the banking sector. As a result, investors' fears have eased, as evidenced by recent successful capital raisings and the collapse in bank credit default spreads (CDS) for the major banks, which have now fallen to nearly the same levels as their European counterparts (Chart 9). The health of the Italian banking system has improved drastically over the past year given the improving economy. Italy still sits on a large absolute amount of non-performing loans at E274 billion, but this is a risk has receded quickly from its peak of E328 billion in Q1 2017. The continued economic recovery and sales of bad loans have pushed the NPL ratio down to approximately 15%, well below its peak of over 19% (Chart 10). The Bank of Italy's recent Financial Stability Review projects that the one-year forward default probability from a sample of nearly 300,000 indebted companies has fallen to 1% in mid-2017 from 2.5% in 2013. Fewer new loans are becoming impaired, which is encouraging given the ongoing pressures on the banks from the ECB and the Italian government to improve asset quality. Chart 9Italian Bank Risk##BR##Has Declined Chart 10Banks Better Capitalized,##BR##But NPLs Remain A Problem The rise in capital ratios over the last year is also a very positive development. For the major banks, liquidity coverage ratios are nearly 200%, the ratio of tangible equity to tangible assets has skyrocketed to nearly 7%, and the Tier 1 capital ratio has increased to 14.8%. Even with the introduction of the IFRS 9 accounting rules in January, which is estimated to reduce the Tier 1 ratio by 38bps, capital levels are high and will allow for banks to operate more normally. Bank earnings rebounded in Q4 2017 on the back of aggressive cost cutting, falling loan impairments and solid net interest income. Margins remain stubbornly weak, even though the yield curve has been steepening since early 2015. Going forward, earnings expectations do not seem overly optimistic, particularly in relation to long-term averages. The continued acceleration in economic growth will provide a considerable tailwind. Lending volumes should rise, albeit at a relatively slow pace, due to improving business confidence. Asset quality is set to strengthen as NPLs decline further, reducing the cost of capital and loss provisions. Bank expenses will also decline due to additional layoffs and a reduction in branch locations. However, despite the substantial improvement in their balance sheets, the Italian banking system is far from invulnerable. Apart from the obvious downturn in economic growth, banks are heavily exposed to Italian government bonds. Holdings of government debt securities as a percentage of total assets have declined considerably to 9% from nearly 11% a year ago, but still remain much higher than levels seen during the euro debt crisis (Chart 11). This suggests that fears of the so-called "doom loop" - where the credit quality of the government and the banks are intertwined through bond holdings – may arise once again in the future if Italy suffers another sovereign debt crisis. Another potential source of risk to the banking sector is the housing market. Unlike its EU counterparts, where house prices have been in an uptrend since 2013, house prices in Italy have been collapsing in both nominal and real terms since 2008, falling -20% and -28% respectively (Chart 12). The Italian real estate market is facing multiple headwinds: poor demographics, a lack of property investors dampening transaction volumes, banks aggressively selling repossessed homes at large discounts, and a large stock of unsold properties. Further declines could damage asset quality and impair bank balance sheets. Nevertheless, prices in nominal terms appear to be stabilizing. As real GDP growth continues to recover, the real estate market should eventually start to catch up. Chart 11Can The 'Doom Loop' Be Broken? Chart 12No Recovery In Italian House Prices Bottom Line: The health of Italian banks has improved drastically over the last year. Cost cutting has been aggressive, capital levels have risen, and non-performing loans are slowly declining in a growing economy. Recently added macro-prudential measures will provide additional buffers. As such, liquidity, solvency and systemic risks have faded for the time being. The Political Outlook: Acute Pain Is Gone, But Chronic Risks Linger Italian equity and bond markets have priced out political risk in the country's asset markets over the past 12 months, and for good reasons: New election rules: The October 2017 electoral rule changes have made it highly likely that the next government in Italy will be a coalition government, reducing the probability of a runaway electoral performance by an anti-establishment party.2 Anti-establishment becomes the establishment: Italy's populists have dulled their edge by moving to the middle on the key question of Euro Area membership. The anti-establishment Five Star Movement (M5S) announced in early January that "it is no longer the right moment for Italy to leave the euro." The party's leader, Luigi Di Maio, pledged to remain "comfortably below the antiquated and stupid three percent level" EU deficit limit. The party followed this announcement by slaughtering its final sacred cow and renouncing its promise never to form a coalition with traditional, centrist parties. Migration crisis has ended: While continental Europe has gotten relief from the migration wave since early 2016, Italy continued to be impacted throughout 2017. Nonetheless, the EU's intervention in Libyan security and politics has successfully, and dramatically, altered the trajectory of migrants arriving in Italy and Europe as a whole (Chart 13). Current polls show that no single party is close to the 40% threshold needed to win the election outright, although the ostensibly center-right coalition of Forza Italia, Lega Nord, and Fratelli d'Italia is the closest (Chart 14). Predicting the outcome of the election is therefore impossible, other than to guarantee that the next Italian government will be a coalition. Chart 13Italians (And Europeans) Reject Immigration Chart 14Italy: No Party Will Rule Alone New electoral rules - which favor coalition building - and poor turnout in a recent regional election will encourage parties to make extravagant promises, particularly on the spending side of the ledger. Italian politicians understand that, in a coalition government, the partner can always be blamed for why election promises fell by the wayside. This has produced a deluge of unrealistic promises.3 What should investors know about the upcoming election? First, the center-right is not the center-right. When investors hear that the "center right is likely to win," they are likely to bid up assets in expectation of structural reforms and prudent fiscal policy. If the recent polling performance of Forza Italia and Lega Nord has in any way contributed to the appreciation of Italian assets, we would caution investors to fade the rally. Former PM Silvio Berlusconi, leader of Forza Italia, has promised to reverse crucial (and bitterly fought) employment law reforms. Meanwhile, his coalition partner Matteo Salvini, leader of Lega Nord, has promised to scrap pension cuts altogether. The proper characterization for the Forza-Lega alliance is therefore "conservative populism," not pro-market center-right. In fact, the two parties are the most vociferously anti-EU and anti-euro of the four major parties, with Lega still pushing for the abolishment of the euro and even for an EU exit. For a summary of the most market-relevant electoral promises, please refer to Box 1. Box 1: Italian Electoral Promises Of Major Parties Presented in the order of current polling Five Star Movement (M5S) Italy's anti-establishment party wants to abolish 400 laws, including a web of regulation that makes it difficult for businesses to invest. The promise is unusually "supply-side" oriented for an anti-establishment party, but Italy's establishment has made the business environment difficult. In addition, the party wants to invest in technology and clean energy. What is truly anti-establishment is that M5S has promised to provide a monthly universal income of E780, but also to introduce means-testing for public services so that the well-off pensioners do not receive them. It also seeks broad justice system reforms, including a crackdown on corruption and the mafia, building new prisons, and hiring more police. Its immigration plans are centrist, if not right-leaning, with plans to repatriate migrants back to their original countries. Democratic Party (PD) Led by former PM Matteo Renzi, the Democratic Party (PD) is contesting elections on the basis of its past achievements, which includes passing the 2015 "Jobs Act," mitigating the country's banking crisis, and keeping up the pulse of the otherwise sclerotic economy. Current caretaker PM Paolo Gentiloni remains popular, in part because of his no-nonsense, humble approach to governance. Other than minor proposals - scrapping the TV license fee that finances the national Rai network and raising the minimum wage - the party is largely standing pat in terms of promises. The PD-led government has clashed with the EU, including over its 2018 budget proposal, which the Commission criticized as a "significant deviation" from the bloc's fiscal target. However, aside from its disagreements with the Commission over fiscal policy, PD is broadly pro-Europe and pro-euro. Forza Italia Populist Forza is proposing a flat tax of 23%, which would abolish the current staggered income tax rate. It would also abolish taxes on real estate, inheritance, and transportation, and expand reprieves to tax payers with financial problems. The party would double minimum pension payments and scrap the 2015 "Jobs Act." That said, leader Silvio Berlusconi has said that his proposals would respect the EU's 3% of GDP budget deficit target - in fact that his government would eliminate the deficit completely by 2023 - and that it would rein in the debt-to-GDP ratio to 100%. However, it is unclear how the math would actually work. At the same time, a collision course with the EU is likely as the party wants not only to end budget austerity but also to revise EU treaties, including the fiscal compact, and to pay less into the EU's annual budget. Lega Nord The other populist party looks to out-do the more establishment Forza by proposing an even lower flat tax rate of 15%. The revenue shortfall would be made up by aggressive enforcement against tax cheats. The party is the most Euroskeptic of the major Italian parties, arguing that a Euro-exit is in the country's national interest and should be contemplated unless fiscal rules set out by the Maastricht Treaty are scrapped. Leader Matteo Salvini recently suggested that he had changed his position on the euro, but the chief economist of the party - Claudio Borghi - has since reversed that position, stating that "one second after the League is in government it will begin all possible preparations to arrive at our monetary sovereignty." This last statement is more in keeping with the Lega's recent history of euroskepticism. Second, the electoral platforms of all four major parties are profligate. The flat tax proposal by Forza and Lega is likely the most egregious. Generally speaking, Berlusconi's previous governments can be associated with a rise in expenditure, deficits, and debt levels, with no real track record of fiscal prudence. Even during the boom years (2001-2006), Berlusconi failed to reduce the budget deficit. By contrast, the center-left has been marginally more fiscally prudent (Chart 15), with a considerable improvement in the country's budget balance under each Democratic Party-led government (Chart 16). Chart 15Italy's Debt Dynamics Are Contained Chart 16Democratic Party Is Relatively Prudent Given the mildly Euroskeptic positioning of the conservative populist coalition and their likely bias toward profligacy, we would rank the currently most likely electoral coalition as the least pro-market. Below are the three potential outcomes and their likely impact on the markets: Scenario 1 - Populist Coalition Probability of winning: 35% - Polls currently put the Forza-Lega coalition in a clear lead and only several percentage points away from the likely 40% threshold needed to secure a majority. Fiscal impact: We would assign a 100% probability that the Forza-Lega coalition would negatively impact the country's budget balance, with debt levels most likely rising. Reform impact: There is a 0% probability of pro-growth, structural reforms being passed by the conservative populist coalition. As such, investors should stop referring to the Forza-Lega alliance as a center-right alliance. European integration: We would assign a high probability, around 50%, that a Forza-Lega government would threaten to exit the Euro Area at some point during its mandate. This is based on a two-fold assumption that there will be a recession at some point during its reign and that its electoral platform reveals the potential for a serious Euroskeptic turn not only by Lega Nord but also by the formerly staunchly pro-EU Forza Italia. Scenario 2 - Grand Coalition Probability of winning: 35% - If the Forza-Lega coalition fails to win enough votes, the second-most likely outcome would be a grand coalition between Forza Italia and the center-right Democratic Party (PD), perhaps with both M5S and Lega joining in. Fiscal impact: Given that all four major parties are essentially looking to spend more money and collect less revenue, we would expect that the country's budget balance would be negatively impacted in this scenario. However, both PD and M5S have less profligate electoral platforms. As such, the impact would likely be a lot less dramatic than if Forza-Lega coalition won. Reform impact: With Forza-Lega potentially in a grand coalition, we would expect the probability of pro-growth reforms to be just 25%. European integration: We would assign a very low probability, essentially 0%, that a grand coalition contemplates Euro-exit during its mandate. However, a global recession that impacts Italy would almost certainly force such a government to fall as Euroskeptic parties withdrew their support, thus shortening the electoral mandate. This means that a grand coalition is the least viable and least stable outcome. It would allow the Euroskeptic Forza-Lega to campaign from a populist, Euroskeptic, position. Scenario 3 - Center-Left Coalition Probability of winning: 30% - A PD-M5S coalition is less likely despite being mathematically the most likely. This is because M5S has not said that it would ever join a coalition with the PD; only that it would join a grand coalition with all parties. Nonetheless, such a coalition makes the most sense ideologically now that M5S has abandoned its Euroskepticism. Fiscal impact: Both parties are looking to expand the minimum wage, with M5S arguing for a universal basic income. It is very likely that the impact on the budget balance would be negative, although we would not expect extreme profligacy. Reform impact: Given the electoral platform of M5S and the reform record of PD, we assign a healthy 75% probability for pro-growth structural reforms. Despite the view that M5S is an anti-establishment party, it is actually quite pro-reform, with several of its proposals in the past being characterized as impacting the supply-side. Investors should remember that being anti-establishment does not mean being anti-reform, especially in Italy where the establishment has an atrocious record of being pro-reform! European integration: We do not think that the M5S move to the middle on European integration is false. Forcing it to be in government, particularly once a recession hits over the course of its mandate, will only lock in its establishment position on European integration. As we have expected for some time, the M5S has followed the path of other Mediterranean, left-leaning, anti-establishment parties on the euro, with both Podemos (Spain) and SYRIZA (Greece) now being fully pro-Europe. As such, the probability that a PD-M5S government considers Euro-exit during its mandate is 0%. Counterintuitively, a PD-M5S coalition is therefore the most pro-market option for Italy. It would be relatively fiscally prudent and would surprise to the upside on structural reforms. In addition, it would give Italy a five-year window during which no challenge to its membership in European institutions is possible (provided that the coalition does not rely on small parties whose exit threatens the stability of government). This outcome could extend the current rally in Italian assets, although that rally is already long-in-the-tooth. On the other hand, a Forza-Lega coalition is the least stable. First, we believe that such a coalition has a 50% probability of challenging Italy's membership in European institutions at the first sign of a domestic recession. Lega is outwardly Euroskeptic, even at the top of the global economic cycle and with a healthy Italian recovery underway. Meanwhile, Silvio Berlusconi has consciously evolved his Forza Italia towards a more Euroskeptic position. In addition, we believe that this populist alliance would be fiscally profligate and would not attempt any structural reforms. This political outcome is therefore an occasion to underweight Italian sovereign bonds. Finally, a grand coalition would have a neutral market impact. However, due to structural political risks, we would expect such a government to collapse at the first sign of economic hardship.4 This would open up the risk of a Euroskeptic electoral challenge and a potential market riot as the likelihood of brinkmanship with Brussels and Berlin rises.5 We encourage our clients to revisit our "Divine Comedy" series on Italy, where we have set out the argument for why Euroskepticism continues to have appeal in Italy. We would briefly remind our readers that: Italians remain Euroskeptic despite a European-wide recovery in support for the common currency (Chart 17); Italians are increasingly confident in a future outside of Europe (Chart 18), whereas such a trend is not identifiable in wider Europe (Chart 19); Chart 17Italy Lags In Support For Euro Chart 18Italians Optimists About Future Outside EU While Europeans are increasingly comfortable with dual-identities (national and continental), Italians are increasingly identifying as strictly Italian (Chart 20); Chart 19Europeans Pessimists About Future Outside EU Chart 20We Are Italian (Not European)! Italians do not see the EU as a geopolitical project, leaving them more likely to focus on the transactional and economic nature of their relationship with Europe (Chart 21); Chart 21Italians View The EU In Transactional Terms On net, Italians are the most anti-immigrant people in core Europe (Chart 22), which suggests that the migration crisis hit them quite hard. Any restart of that crisis could push the country towards anti-EU politicians; Chart 22Italians Are Staunchly Anti-Immigration Finally, we would remind investors that many Italians continue to see FX devaluation as a panacea that can save the economy. Our view is that Italy has, by far, the highest baseline level of Euroskepticism among Euro Area members. The March 4 election is important because the next government will likely have to face a recession and a global downturn during its mandate. A grand coalition or a populist coalition would both leave Italy more vulnerable to Euroskeptic alternatives. This is because a grand coalition would most likely collapse at the first sign of a recession whereas a populist government would itself turn to Euroskepticism. If the election produces either of these outcomes, we would assign a very high probability - near 50% - that Italy produces a global risk off event sometime within the next five years. Bottom Line: The upcoming Italian parliamentary election is difficult to call, but one thing seems certain - the winning coalition will seek to ease fiscal policy. Euroskepticism will not be the major issue in the election given the expanding economy; yet, in two of the scenarios discussed above, it will come back with a vengeance after the next Italian recession. The ECB: Don't Fear The QE Unwind If there is one consensus view on Italy among investors (at least among the BCA clients that ask questions on Italy!), it is that Italian government bonds will suffer significant losses when the ECB begins to unwind its easy money policies. For many people, 10-year bonds trading with less than a 2% yield, with a government debt/GDP ratio near 130%, in a country with a structural low growth problem and perpetually unstable politics, just screams "bubble" - one that will end badly when the ECB is eventually forced to stop buying government bonds. With the broader Euro Area economy now operating at full employment, an announcement of a tapering of asset purchases by the ECB is inevitable. Our base case remains that the ECB will announce during the summer that the bond buying program will be wound down by year-end. After that, maturing bonds will be reinvested, with the first interest rate hike not taking place until the latter half of 2019. How the ECB communicates that message to the markets will be critical in avoiding a "Taper Tantrum 2.0." Already, the ECB is sending a bit of a mixed message with its current asset purchases. Officially, the central bank has been aiming to distribute its monthly pace of asset purchases along the lines of the ECB's Capital Key, which is roughly correlated to the size of each Euro Area country. This rule was put in place by the ECB to avoid any accusations that the central bank would politically favor the more indebted countries when executing its bond buying. Yet a look at the ECB's actual data on its monthly purchases shows that the Capital Key limits have often been breached, and for what appears to be reasons rooted in politics (Chart 23). The ECB exceeded the Capital Key limit on French bonds in the run-up to last year's French presidential election. The limit on Italian bonds was also consistently breached for much of last year, as investors were beginning to grow more concerned about potential ECB tapering and anti-euro factions winning the next election in Italy. We shared those concerns, which led us to downgrade Italian government bonds to underweight in Global Fixed Income Strategy in late 2016, both in absolute terms and versus Spanish debt. That call has obviously not worked out as we hoped. In fact, a counterintuitive result occurred where Italian bonds outperformed German debt in 2017, even as the ECB was already beginning to slow the pace of its bond buying. That can be seen in Chart 24, which shows the annual growth rate of the ECB's monetary base (which proxies the flow of bonds purchased by the ECB) versus both the Italy-Germany 10-year government bond spread (top panel) and the annual excess return of Italian government bonds relative to German debt (bottom panel).6 There has been no reliable correlation between the pace of ECB buying and the Italy-Germany spread, but there has been a very strong correlation with relative returns. When the ECB was buying more bonds in 2015 and 2016, Germany was outperforming Italy. The opposite occurred last year when the ECB started to dial back the pace of its purchases. Why? Most likely, it was because the Italian economy was starting to gain momentum, which helps alleviate (but not eliminate) the debt sustainability fears about Italy's massive debt stock. The ECB's other extraordinary policy tool, low interest rates, has been an even bigger support for Italian debt sustainability. The government of Italy has been able to consistently issue bonds with coupons below 1% in the years after the ECB went to its zero interest rate policy (ZIRP) in 2014, according to the Bank of Italy (Chart 25). This has lowered the average interest rate on all outstanding Italian government bonds from 4% to 3% over that same period. This also reduced the ratio of Italian government interest payments to GDP by nearly one full percentage point over the past three years (bottom panel). Chart 23The Capital Key Is Only##BR##A 'Guideline' For ECB QE Chart 24Less ECB Bond Buying =##BR##Italian Bond Outperformance! Chart 25ZIRP/NIRP More Helpful##BR##For Italy Than QE Italy still has a significant long-run fiscal problem, however. The gross government debt/GDP ratio of 126% is only dwarfed by Japan and Greece within the developed markets (Chart 26). Even when looked at on a net basis (i.e. excluding the debt owned by Italian government entities like state pension funds) and, more importantly, after removing the bonds owned by the ECB, Italy still has a stock of debt equal to 100% of GDP (Chart 27). This is the highest in the Euro Area for countries eligible for the ECB's asset purchase program. Chart 26Italy's Debt Problems Have Not Gone Away Chart 27Still A Big Stock Of Italian Debt, Net Of ECB Purchases Importantly for market perceptions of Italy's debt sustainability, the ECB absorbing 15% of the stock of Italian government bonds has provided some wiggle room for an expansion of fiscal deficits without materially affecting long-term interest rates. That is no small matter, given how it is highly likely that the winner of the March 4th Italian election will step on the fiscal accelerator. Bottom Line: The inevitable tapering of ECB asset purchases later in 2018 will not have a meaningful impact on Italian government bond valuations - as long as the ECB is not planning on quickly raising interest rates soon after tapering. Upgrade Italian government bonds to neutral until signs of an economic slowdown in Italy emerge. Investment Conclusions After assessing the four main drivers of Italian bond risk premia - economic growth, the health of the banks, domestic politics and ECB monetary policy - it is clear that the state of the economy is the most important factor. If Italian growth is strong enough, investors will feel more comfortable about chasing the higher yields on Italy's government bonds and be a lot more relaxed about its Euroskeptic leanings. Given Italy's heavy reliance on exports as the driver of the current cyclical upturn, this means Italian financial assets are a levered play on global growth. The next most important factor is the ECB's monetary policy, but specifically, its interest rate policy and not its asset purchase program. Chart 28Upgrade Italian Debt To##BR##Neutral Until Growth Rolls Over This week, we are upgrading our recommended allocation to Italian government bonds to neutral from underweight in Global Fixed Income Strategy. At current yield levels and spreads to core European debt, a move all the way to an overweight recommendation is not ideal. Yet the case for Italian bond underperformance on the back of political uncertainty and eventual ECB tapering is even less ideal. Moving to neutral is a sensible compromise between a positive cyclical backdrop with poor valuation. Going forward through 2018, we will monitor the Italy Leading Economic Indicator (LEI) as a signal for when to consider downgrading Italian debt. If the LEI begins to hook down, that would be a bearish sign for the relative performance of both Italian government bonds and Italian equities (Chart 28). In addition, any indication that the ECB is considering not only tapering its bond buying, but also raising interest rates, could pose a problem for Italian assets. Although given the low starting point for any shift higher in policy rates, it would likely take several interest rate increases before Italian economic growth would start to be negatively impacted. Over a longer-term time horizon, investment implications are difficult to gauge. Structurally, both from an economic and political perspective, Italy is the least stable pillar of European economy. As such, it still has a potential to be a source of global risk-off if an economic downturn negatively impacts the current political stability. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Demographics And Geopolitics, Part I: A Silver Lining?", dated October 10, 2012, available at gps.bcaresearch.com. 2 The new Italian Electoral law - also known as Rosatellum - is particularly negative for Five Start Movement (M5S). First, it assigns over a third (37%) of the seats using a first-past-the-post system. This will hurt M5S, which lacks a geographical base where it can guarantee easy electoral district wins. Second, the vote eliminates a seat bonus for the party that wins a plurality of votes, forcing the winning coalition to gain at least around 40% of the vote to govern. Eliminating the bonus hurts M5S as it has led other parties in the polls. That said, a coalition government almost guarantees that fiscal spending will increase over the course of the next administration, given that budget outlays will be used to grease-the-wheels of any coalition deal. 3 The Italian public, known for its knack for satire, has parodied the electoral platforms with a Twitter hashtag #AboliamoQualcosa ("let's abolish something"). Twitter and Facebook have suggested that everything from French carbonara to vegan Bolognese should be abolished (BCA's Geopolitical Strategy heartily agrees with both suggestions!). 4 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 6 It is important to note that the relative returns shown in the bottom panel Chart 24 are calculated using the Bloomberg Barclays benchmark Treasury indices for Italy and Germany. These indices include debt across all maturities for both countries, not just the benchmark 10-year Italy-Germany spread shown in the top panel.

Highlights The "Pocketbook Voter Theory" says that voters will reward politicians who deliver economic success; Nevertheless, congressional Republicans face significant headwinds in the mid-term elections in November; The popularity of the GOP tax cuts, especially among independent voters, bears constant monitoring this year; Beyond 2018, voters will face persistent inequality and demand policies that provide sustainable income gains; Trade protectionism and redistribution will be on the bill in the 2020 elections. Feature There is little debate in the investment community that politics matters more today than it did in the past. But most investors are still unsure about how to assess political risk - both to the upside and downside. The Geopolitical Strategy team has been providing a framework for analysis and applying political science concepts since its inception in May 2012. This report introduces an important idea that has been guiding our analysis over the years: the Pocketbook Voter (PBV) theory. The PBV theory rests on the important observation that in politics, voters are price makers and policymakers are price takers. This makes understanding voter preferences fundamental for forecasting policy outcomes. This is particularly important today because the combination of declining potential growth rates and elevated debt levels is a recipe for continued heightened policy uncertainty (Chart 1). Over the coming years, voters will continue to demand legislation that attempts to overcome the absence of sustainable and satisfactory gains in household income. More consequentially, the slow growth of the income pie may push voters toward redistributionist policies. Chart 1Income Down + Debt Up = Higher Policy Uncertainty Investors should prepare for considerable change to both domestic and international economic arrangements. As this publication has been arguing for the past several years, many of the investor-friendly policies that underpinned the glorious bull market in risk assets since the early 1980s will be reversed.1 Voters will ultimately determine how far the pendulum will swing. Pocketbook Voter Theory The PBV theory states that voters reward political leaders who deliver positive economic outcomes.2 A strong economy increases the likelihood of re-election, whereas a weak economy decreases it. The link between economic conditions and voting patterns tends to be strongest in the United States.3 Most of the academic literature on the PBV theory has emphasized retrospective assessments of the economy. The pre-election performance of important economic variables, such as the unemployment rate, GDP growth, and consumer confidence, is shown to predict electoral outcomes. According to these metrics, Republicans (GOP) in Congress should be confident heading into this November's mid-term elections. The unemployment rate is near 50-year lows, consumer confidence is at a 20-year high, and GDP growth has gained some momentum in recent quarters - with BCA's economists expecting further strength in 2018 (Chart 2). The recently passed Tax Cuts and Jobs Act (TCJA) will also put more money in voters' pocketbooks courtesy of Republican policymakers. However, both history and polling data are weighing on the GOP's chances in November. Currently, the U.S. government is unified, with Republicans controlling both the executive and legislative branches. Voters have rejected the incumbent party the last three times a mid-term election was held under unified government. Democrats were badly beaten in 1994, when Republicans won a stunning 54 seats in the House of Representatives; in 2006, voters rewarded Democrats with control of the House and de facto control of the Senate; and in 2010, Republicans thumped the Democrats in the House by the largest margin of victory in a mid-term election since 1938. The approval rating of Congressional Republicans and the president also present a problem for the GOP in November. As of December 11, 78% of voters disapproved of the way Congress was handling its job. That is slightly higher than the 77% congressional disapproval rating before the 2010 election loss for Democrats, and visibly higher than the 67% and 70% disapproval ratings before the 2006 and 1994 mid-term elections, respectively. Democrats also continue to hold on to a growing lead in the "generic ballot," which has some predictive power (Chart 3). Chart 2Cyclical Conditions Are Solid Chart 3Democrats Ahead In The Polls As we have highlighted in previous reports, President Trump's low approval rating of 39% also reduces the likelihood that Republicans will keep the 22 seats needed to remain the majority party in Congress (Chart 4). Chart 4Trump's Low Approval Ratings Is Bad For GOP In 2018 On balance then, the deck is stacked against the Republicans in the coming election. The economy is firing on all cylinders, but that was also the case in November 2016 when Americans voted for dramatic political change. In fact, the unemployment rate had fallen from 6.6% in 2014 to 4.6% in November 2016, whereas it has only marginally improved more recently. Meanwhile, only 25% of independent voters approve of the GOP's tax legislation.4 Heightened partisanship will make voter perceptions among independents a particularly important factor in determining the outcome of the 2018 election. Investors should monitor Trump's approval rating among these voters and their evolving view of the Republican tax legislation, which will certainly underpin the GOP's campaign message on why they should be re-elected (Chart 5). But it remains to be seen how the equity bull market will translate into Republican political fortunes, given that the median American voter is not heavily invested in stocks (Chart 6). Chart 5Only Republicans Like Trump Chart 6Most Voters Don't Directly Own Stocks Partisanship And The PBV Theory Voter perceptions of the economy have always been influenced by party identification. The role of partisanship in politics has become especially important in the U.S. as political polarization has reached its highest recorded level in 150 years (Chart 7). Reflecting the growing divide between the policy preferences of each party, the core political values held by American voters are not best described by demographic factors such as race, income, or religion, but by party identification - and by a wide margin (Chart 8). A recent Pew Research Center survey found that 86% of Americans believe that conflict between Democrats and Republicans is either strong or very strong.5 The same survey found that the likelihood of conflict based on race or income was only 65% and 60%, respectively. And since 2012, the percentage of Americans who see very strong conflict between the Democrats and Republicans has risen substantially from 47% to 64%. Chart 7Highest Level Of Polarization In 150 Years Chart 8Party Affiliation Means A Lot Today The link between partisanship and voter perceptions of the economy can be strong, and became very clear after the recent election. Before President Trump was elected, only 14% of Republicans felt that national economic conditions were excellent or good. After his victory, that same number skyrocketed to 57%.6 This implies that retrospective assessments of economic conditions will continue to be susceptible to partisan interpretations. However, the gap between some Republicans and Democrats on views regarding the role of government in the economy, the U.S.'s participation in the global economy, and the fairness of the current economic system has been narrowing. Specifically, the Pew Research Center recently divided Republicans into four distinct typologies: Core Conservatives, New Era Enterprisers, Country First Conservatives, and Market Skeptic Republicans. The latter two groups represented 43% of the Republicans surveyed - let's call them "Change Republicans," as they are most supportive of changes to the current economic system.7 Among Change Republicans, only 15% felt that the "U.S. economic system is generally fair to most Americans." Comparatively, 75% of the remaining two groups of GOP voters believe the current system is fair. This wide gap in current perceptions on the effectiveness of today's economic model makes Change Republicans more receptive to policies aimed at redefining the role of government and redistributing income. This conclusion has important consequences for policy beyond 2018. Prospective PBV Theory And The 2020 Election Although most analyses of the PBV theory have focused on retrospective assessments of economic well-being, scholar Michael Lewis-Beck and others have found that future expectations of income growth are statistically more important in determining voting patterns.8 As a result, prospective PBV theory suggests that voters will often look beyond current economic conditions and assess policy proposals that will influence future economic potential. In recent decades, income growth has slowed while debt levels have increased. In addition, inequality has increased on three important levels. Separating income inequality into three groups is useful because it helps forecast where voters will demand changes in policy. Chart 9Globalization: No Friend To DM Middle Class The first level of unequal growth has unfolded on the global stage, as middle-class voters in developed economies experienced the slowest level of income gains among the world's population - and by a large margin (Chart 9). The second level of inequality has occurred within the U.S. economy, between capital (owners) and labor (workers) (Chart 10). And the third level of inequality has materialized most starkly within labor, as the highest income earners have reaped big rewards while the rest of Americans have experienced basically zero gains in real income since the early 1980s (Chart 11). Chart 10Politically Unsustainable Chart 11Will The GOP Tax Bill Make America More Unequal? These observations are likely going to play a central role in the policy prescriptions offered by both candidates in the 2020 presidential election. In terms of U.S. trade policy, Republicans under Trump have become much less inclined to support free trade. Before the global financial crisis, 57% of GOP voters felt that trade agreements were a good thing for the United States. Fast-forward to April 2017, and only 36% of Republicans felt the same way.9 The near-term risk of protectionism centers on the renegotiation of NAFTA. The U.S. is much less economically dependent on NAFTA compared to Canada and Mexico and, more importantly, the political benefits associated with abrogating the deal could push President Trump and his mercantilist cabinet toward doing so.10 Investors should remain short the Mexican peso. The greater risk associated with voter demands for trade protectionism centers on China. The Trump administration began with a mere "shot across the bow" and has not initiated a trade war with the Chinese so far. However, a diplomatic resolution of U.S. tensions with North Korea, or a failure to renegotiate NAFTA, would put more pressure on President Trump to turn his attention to the large American trade deficit with China - as he often did during the 2016 presidential election. (As long as North Korea remains the top foreign policy priority, Trump will need Chinese cooperation that will in turn, at least partially, reduce his appetite for trade conflict.) Ironically, the growing share of income that has accumulated to capital owners relative to labor over the past 20 years did not dissuade Republicans from cutting corporate taxes. This strategy could prove to be very risky. In fact, just a few months before the passage of the GOP tax plan, a majority of Americans surveyed by Pew believed that tax rates on corporations and large businesses should be increased.11 Perhaps a more important reason for the widening gap between capital and labor has been technology. But a recent survey showed that only 7% of Americans feel that their own job or profession will be very vulnerable to robots or computers during their lifetime (Chart 12). This implies that voter demand for policies that reduce the impact of technology on inequality remain less likely than tax policies that put gradual downward pressure on corporate profits. Investors should expect Democrats to focus squarely on the rise in corporate profits and the absence of meaningful wage growth in the 2020 election. Chart 12Most People Don't Think They##br## Are Vulnerable To Technology The final piece of the puzzle for Democrats in the 2020 election will be redistributionist policies that shift income from the top earners to the rest of the population. This political strategy is supported by the effects of previous tax reform on income inequality - highlighted in Chart 11. Specifically, while previous rounds of tax reform have obviously benefited the U.S.'s highest income earners, the vast majority of Americans, as mentioned, experienced zero gains in real income after the Reagan and Bush tax plans were implemented. Compared to protectionism or redistribution from the corporate sector, movement on legislation to tax high-income earners could be relatively slow moving. First, only 43% of Americans think that taxes should be raised on people earning more than $250,000; and only a quarter of Republican voters support that proposition.12 And second, despite stark inequality and a low level of upward mobility in the United States, six-in-ten Americans still believe that people who work hard tend to get ahead.13 These two observations of voter preferences could weigh on the appeal of policy proposals that aim to redistribute income from the top 1% to the rest of the income pool. Trade protectionism, and a reversal of some of the corporate tax cuts, are more politically feasible. Concluding Thoughts Retrospective assessments of economic well-being can be helpful in forecasting electoral outcomes. The U.S. economy has found its footing, the labor market is strong, and confidence is up. However, these factors will likely prove insufficient to protect Republicans from the difficult task of retaining a majority government in the face of declining popular support. Divided government is not necessarily a bad outcome for investors. Recall that during the most recent period of divided government from November 2010 to November 2016, the S&P 500 rose by 80%! Even impeachment proceedings against the president could fail to derail the rising stock market, as occurred in the late 1990s.14 But as the 2020 election approaches, presidential candidates will be increasingly responding to voter demands for more protectionism, policies that shift income from companies to workers, and proposals that raise taxes on the wealthiest Americans. The former two will have some chance of passage. Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, and BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 2 For the seminal treatise on the PBV theory, please see Michael Lewis-Beck, Economics And Elections: The Major Western Democracies, (Ann Arbor: U of Michigan P, 2000). 3 Please see Alberto Alesina and Howard Rosenthal, Partisan Politics, Divided Government, And The Economy, (Cambridge: Cambridge UP, 1995). 4 Please see Frank Newport, "Public Opinion And The Tax Reform Law," Gallup, dated December 21, 2017, available at news.gallup.com. 5 Please see John Gramlich, "Far More Americans Say There Are Strong Conflicts Between Partisans Than Between Other Groups In Society," Pew Research Center, dated December 19, 2017. 6 Please see Pew Research Center, "Views Of Job Situation Improve Sharply, But Many Still Say They're Falling Behind Financially," dated November 7, 2017, available at www.people-press.org. 7 Please see Pew Research Center, "Political Typology Reveals Deep Fissures On The Right And Left," dated October 24, 2017, available at www.people-press.org. 8 See footnote 2, pp. 120. 9 Please see Bradley Jones, "Support For Free Trade Agreements Rebounds Modestly, But Wide Partisan Differences Remain," Pew Research Center, dated April 25, 2017, available at www.pewresearch.org. 10 Please see Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 11 Please see Hannah Fingerhut, "More Americans Favor Raising Than Lowering Tax Rates On Corporations, High Household Incomes," Pew Research Center, dated September 27, 2017, available at www.pewresearch.org. 12 Please see footnote 11. 13 Please see footnote 7. 14 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. Geopolitical Calendar

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Informe especial

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Highlights The centrist consensus is breaking down across the developed world; In its place is rising political plurality, with non-centrist and anti-establishment parties gathering support; This trend is not to be feared by the markets; Political systems that encourage political plurality - such as those of continental Europe - are more stable in the long run than those promoting political duopoly; Establishment parties in Europe can neuter single-issue parties by selectively adopting their agenda; Emergence of a third party in the U.S. would be positive for both the markets and the economy in the long run. Feature Chart 1European Border Enforcement Is Effective Germany's Social Democratic Party (SPD) signaled on November 23 a willingness to entertain another Grand Coalition with its rival the Christian Democratic Union (CDU). If coalition talks reproduce the centrist coalition that has ruled Germany since 2013, the risk of a new election will be averted. While European markets breathe a sigh of relief, there is much to be concerned about. First, the left-leaning, liberal Socialists will likely force Chancellor Angela Merkel to accept that family reunification for asylum claimants will remain an eligible migration route into the country. This means that the 1.3 million asylum seekers that have entered Germany since 2015 will be able to apply for family members to join them, swelling the numbers of migrants from Africa and the Middle East. This could raise tensions inside Germany and increase support for anti-establishment parties. This risk is overstated, as asylum seekers to Germany have collapsed since the EU stepped up enforcement of its borders after the 2015 crisis (Chart 1). Nonetheless, the perception that Merkel is soft on migrants will hound her for the remainder of what we believe will be her last term in power. Second, the SPD performed terribly in the September election, garnering only 20.5% of the popular vote, its worst performance since March 1933 (Chart 2).1 If the German Socialists enter another Grand Coalition, it will leave the anti-establishment, anti-immigrant, and anti-EU Alternative für Deutschland (AfD) in the ceremonial role of the leader of the opposition.2 Chart 2The Center-Left Has Collapsed In Germany This brings up the larger concern for investors: collapse of the centrist monopoly on political power in the West writ large. Germany is hardly the only country that is facing centrifugal forces that are eroding the hold on power by the center-left and center-right establishment parties. Across a number of critical economies, the center-left and center-right political behemoths are giving way to new entrants into the political system. This political plurality means that post-World War Two era centrist duopolies are breaking down as new parties, many of them anti-establishment and populist, enter the scene. Should investors fear this development? The consensus says yes. We disagree. Even in the United States, we doubt that a "third party" would be a negative development. Introducing The Political Concentration Index Chart 3 shows the developed economy measure of our BCA Political Concentration Index (PCI), which we constructed using the Herfindahl-Hirschman index normally used to measure the level of monopoly in a particular industry.3 Our modified index measures political - rather than economic - monopoly. We replace "firms" with "parties" and "industry" with "political system" (i.e., country). A country with a single ruling party would register a 1 on the index, while a country with 10, equal-sized parties in its parliament would register a 0.1. Chart 3Political Plurality Is On The Rise In The Developed World As Chart 3 illustrates, the developed economy concentration of political power has declined considerably. Power is concentrated in the hands of more and more political parties. Chart 4 shows the PCI of ten major western economies, illustrating that the culprits for the overall collapse of political monopoly are Australia, Canada, Germany, Spain, Sweden, and the Netherlands. Our indicator would illustrate an even greater decline of political concentration if we excluded the U.S. and the U.K. Somewhat surprisingly, Italy is actually holding up well, with current levels of political concentration in line with the post-World War Two era and higher than the free-wheeling 1990s. Chart 4Political Concentration Is On The Decline Across The Developed World France also surprisingly illustrates rising political concentration, at least relative to the 1980-1990s. However, this result also reveals the weakness of our index. Our measure is ignorant of the rise and fall of major parties. As such, it has failed to take into account the massive political earthquake that has occurred in France, where President Emmanuel Macron's La République En Marche! (REM) has completely replaced the Socialist Party as the main center-left French party. This shift is not picked up by the index as the degree of concentration of political power in the French National Assembly remains unaltered. Overall, the data confirm the suspicions of many of our clients that the political consensus is breaking down across the western world. There are likely three culprits: The economic dimension is eroding in relevance: The post-World War Two organization of western political parties across the left-right economic spectrum echoed the late-nineteenth and early-twentieth century cleavages between the conservative bourgeoisie and revolutionary proletariat. The Industrial Revolution created immense wealth across Europe and North America, but also immense inequalities. As the urban proletariat grew in size, it demanded political and economic rights. For example, the German SPD remained committed to a radical proletariat revolution almost right up until the First World War. While the question of economic redistribution remains relevant today, the left-right economic axis is not as cogent in a world where living standards have risen massively since the turn of the last century. Culture wars: With the vast majority of western voters no longer responding to basic, Malthusian needs, identity issues are rising in prominence and drawing votes away from the centrist parties arrayed along the left-right economic spectrum. Several single-issue parties have found a permanent foothold in the political system, from the German Greens (since 1980) to the U.K. Independence Party (since 1993). A number of young and old parties have found particular success focusing on immigration, most prominently the Dutch Party for Freedom (founded in 2006), the Swedish Democrats (founded in 1988), the AfD (founded in 2013), and the New Zealand First party (founded in 1993). Generational cleavages: Voters born after the Cold War are particularly drawn to new and anti-establishment parties. Spain's Podemos and Italy's Five Star Movement (M5S) have had particular success appealing to young voters. Similarly, parties with a strong anti-immigration and anti-globalization focus have found success recruiting older voters. There is no single unifying theory that explains the erosion of the left-right economic spectrum as the defining political cleavage in the West. For example, France's Front National - anti-establishment, Euroskeptic, and anti-immigration - is particularly successful in recruiting young French voters, whereas its populist peers generally have not. Each country has its own set of idiosyncratic variables that explain how the political system is evolving. These range from endogenous factors (political system, demographics, ethnic makeup) to exogenous factors (economic crisis, membership in the EU, geopolitical risk, etc.). Even in the case of the U.S. - which shows no decline in political concentration (Chart 4), as Republicans and Democrats so far maintain a grip on their duopoly - numerous cleavages are evolving. Primary elections, particularly in the Republican Party, are pitting anti-establishment candidates - often ideologically aligned with the small government "Tea Party" - against establishment centrists. While these anti-establishment policymakers are officially aligned with the GOP, they often operate as an independent bloc in the House of Representatives. Bottom Line: For a number of reasons, different in each political system, the left-right economic spectrum is no longer driving voter preferences. Hence it should no longer serve as a starting point of analysis. Politicians who realize this - such as President Donald Trump or President Emmanuel Macron, both of whom challenged left-right orthodoxies on economic policy - are rewarded with surprising upsets. Our Political Concentration Index suggests that a trend is underway. Should investors fear the trend? The short answer is no. Political Plurality Is Stabilizing Political plurality should not be feared. True, in the short term, political plurality will produce political volatility. Aside from the ongoing German coalition talks, investors may remember the recent Spanish and Greek elections. Both countries had to hold two elections before producing a relatively stable political equilibrium due to the breakdown in what were traditionally two-party systems.4 Our PCI obviously suggests that similar outcomes are likely and to be expected. Germany could still become a case in point and Italy looms ominously in Q1 2018. However, there are three reasons why risks of more political plurality are overstated. The first is obvious. Chart 5 is the same as our Chart 3, but we have grafted onto it average GDP growth and unemployment rates. There is no clear difference in economic performance between periods of rising and falling political concentration. Chart 5The Economy Does Not Drive Political Concentration The second is also obvious from Chart 5. There appears to be a pattern in the rise and fall of political concentration. In other words, investors should not necessarily extrapolate today's low concentration into the future. We suspect that the reason for the natural oscillation in our index is also the third reason that more political plurality is not a risk to the markets and the economy. A field of multiple parties allows establishment, centrist politicians to steal certain popular aspects of the electoral platform of the anti-establishment parties. Over time - what appears to be a roughly 7-year interval, or two electoral cycles on our chart - the establishment simply swallows the most competitive portions of the anti-establishment platform, repackages it in a way that is palatable for the median voter, and rebrands it as an establishment policy. The recent Austrian election is a perfect case study. Austria held a general election this year in October and the anti-establishment Freedom Party (FPÖ) came in third with 26% of the vote, a 5.5% increase from its 2013 outcome. It was not, however, the best performance for the FPÖ, as it had several strong performances in the late 1990s (Chart 6). Furthermore, investors often make the mistake of only comparing the performance of a party to the last election. In case of Austria, that means that analysts are ignoring four years' worth of polling data. In the particular case of the FPÖ, that means ignoring that the party's 26% performance was an absolute crushing collapse. As Chart 7 shows, the FPÖ went from leading in the polls for much of 2016, at one point reaching 35% support, to coming in third. Why? Chart 6Austrian Populists Have Been Here Before Chart 7The Establishment Stole FPO's Thunder As we illustrate in Chart 7, the Austrian establishment was not stupid. The center-right People’s Party (ÖVP) appointed 31-year-old Sebastian Kurz as its leader in May 2017. Kurz promptly shifted the ÖVP towards the FPÖ’s policy on immigration while retaining centrist views on literally everything else. From that point until the election, the centrist ÖVP crushed the FPÖ in the polls (the ultimate vote swing was nearly 15%). What the Austrian example shows is that a plural political system allows establishment, centrist parties to co-opt portions of the anti-establishment agenda without bringing them on board. In the long term, single-issue parties that focus on anti-globalization, immigration, the environment, or low-income families could see their support erode as the establishment parties adopt portions of their electoral manifesto, without setting-off major political earthquakes. Our forecast is that anti-immigration, populist parties in Europe have likely seen their peak in 2017. Other center-right parties will observe Kurz's success.5 There is simply no reason for them to stand in favor of open borders for asylum seekers in Europe going forward, particularly since newly arrived immigrants cannot vote. As such, it is far more likely that Kurz becomes a model for conservatives rather than, say, Angela Merkel. We concede that Merkel may be the last conservative holdover on immigration. She appears to be stuck defending her decision made in 2015 and is unable to pivot away from that episode. Our strong conviction view is that her successor as head of the CDU will have no such qualms and that the next conservative Chancellor of Germany will close all non-European immigration avenues to the country. Bottom Line: BCA's Political Concentration Index illustrates that political pluralism abates every seven years, or two electoral cycles. This is because single-issue and anti-establishment parties introduce new ideas and policies into the political marketplace, allowing the establishment players to co-opt some of those ideas and win elections without causing a dramatic - and market shattering - break with the past. Beware Of Political Duopolies Is there nothing that investors should fear in our data? No, they should fear persistent political monopolies and duopolies. Take the U.S. and the U.K. It is interesting that the two countries that have experienced the most populist political outcomes in the past two years - Brexit, Trump - are also consistently rated as having the highest political concentration (see Chart 4 on page 4). Why? We suspect that it is because the establishment parties in both political systems try to be catch-all, "big tent" conglomerates that capture a wide array of ideological views on several issues.6 By trying to capture diverse positions, including some fringe ones, they are in danger of becoming entrapped by them. One of the reasons for the "big tent" nature of Anglo-Saxon parties is the "first-past-the-post" electoral system of individual electoral districts. Unlike proportional representation systems favored on the European continent, first-past-the-post electoral systems radically reduce the incentives for small parties to launch independent campaigns.7 For example, UKIP captured 12.7% of the vote in the 2015 election, but it was awarded only one seat in the House of Commons. Such a record of failure is difficult to maintain for any political entity over a long period of time. Eventually, small parties are swallowed whole by their big tent counterparts. The problem with swallowing the whole party, instead of merely biting off an anti-establishment issue here and there, is that the big tent parties often swallow more than they can chew. In the case of the U.K.'s Conservative Party (which has almost wholly swallowed the anti-establishment UKIP), it has been forced to push forward with Brexit, which is dragging on the economy and making it difficult to govern. In the case of the Republican Party in the U.S., the Republicans absorbed the anti-establishment Tea Party, but the two wings of the party are at risk of descending into open warfare. The particular danger for U.S. parties is that their primary elections are normally poorly attended, particularly in midterm election years that lack the star-power of presidential candidates. This means that a candidate representing the far-left or far-right fringe can often win a candidacy with merely 4%-7% of the electorate in each district (the average turnout for primary elections in a midterm year).8 They then can easily proceed to be elected to the House of Representatives due to the fact that so few American electoral districts are truly competitive (Chart 8). As these anti-establishment voices gather force in Congress - 41 members of the GOP belong to the Tea Party-aligned Freedom Caucus for example - they can heighten already considerable polarization by preventing compromise (Chart 9). Chart 8No Competitive Districts Left In The U.S. Chart 9Polarization In The U.S. Is Historically High A heightened state of political polarization, which persists throughout the term in office, is far more market-relevant than heightened volatility around an election produced by more political plurality. For the most part, Europe's political systems have weathered a severe double-dip recession (triple-dip in Italy's case!), a massive loss of political confidence in European institutions, and a Biblical migration crisis with relatively few early elections (Table 1). In this turbulent period, many European governments have pushed through draconian austerity measures, far-reaching economic structural reforms, and agreed to fund or receive costly bailout programs. When anti-establishment parties came to power - as they legitimately did in Greece - they quickly migrated to the middle in order to govern, needing the votes of other parties. Table 1Europe: Less Volatile Relative To Context Empirically speaking, there is no evidence that low political concentration is therefore inferior to the perceived stability of high political concentration exhibited in the U.S. and the U.K. The American and British economies both have seen generally better economic performances since 2008, yet they are struggling with dramatic bouts of populism in 2016.9 In the U.K.'s case, Brexit will reduce potential GDP. In the U.S.'s case, Trump's tax cuts will be inflationary, could hasten the next recession, and will likely exacerbate income inequality. We do not have a view on whether a third party will emerge in the U.S. Political polarization is a powerful trend at present, and since by definition it promotes the existence of two opposing ideological camps, it reinforces the two-party system. Republicans want to maintain control of the conservative base and hence cannot afford to let the Tea Party split off, while Democrats want to control the liberal base and cannot afford to let the progressive wing split off. If either party fractures, the other benefits. Nevertheless, there is nothing unique about the U.S. electoral system that would prevent a breakdown of the American political duopoly: other first-past-the-post systems exhibit political plurality, most notably in Canada. If a third party does emerge, we would wager that it would increase, not decrease, political stability; and reduce, not increase, political polarization. For example, if Tea Party policymakers were to run as independent candidates, it would free up both Tea Partiers and centrist Republicans to pursue their preferred policies in Congress. Centrist Republicans could vote with the Tea Party on matters of common concern and vote with the Democrats on issues where the Tea Party is deemed to be on the fringe. The basic ability to pass a budget would not be hindered by the Tea Party's single-mindedness on government spending, yet voters demanding tighter budgets would not be denied representation. Alternatively, if a new single-issue party emerged, say one favoring tighter immigration policy, Republicans would be free to co-opt aspects of its view on immigration and neutralize the threat of losing votes. They would not be forced to absorb the entire party and pursue hardline policies that would cause gridlock with Democrats. Bottom Line: Empirical evidence since the 2008 Great Financial Crisis does not support the conventional wisdom that low political concentration (i.e., political plurality) is less favorable for investors than high political concentration. Both the U.S. and the U.K., which score the highest on our PCI, have produced highly volatile political outcomes. Investment Implications Investors should not worry about the emergence of new parties in Europe. Particularly harmless are single-issue parties, specifically those focusing on tighter immigration controls. Conservative parties across Europe have already adopted more stringent immigration policies while still sounding sane, a potent electoral mix relative to some of the populist anti-immigrant parties currently vying for the votes of concerned citizens on the continent. Meanwhile, we do not fear the emergence of a third, or fourth, party in the U.S. In fact, such a development could play a role in reducing historically high political polarization in the country. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Yes. That 1933 election. 2 There is no official "leader of the opposition" in Germany and as such the AfD leadership is merely ceremonial. The left-wing Die Linke was in the same position from 2013-2017 with little effect. In fact, Die Linke saw only an incremental increase in its support (0.6%) between the two elections. 3 Regular readers of Geopolitical Strategy will know that we are big fans of the Herfindahl-Hirschman index. We have applied it before to measure geopolitical hegemony. Originally, the index was designed to assist in competition law and antitrust cases as it is an indicator of the amount of competition between firms in a particular sector. The formula for the index is shown below, where si is the market share of firm i in the market, and the N is the number of firms; 4 Spain held an election in December 2015 and another in June 2016. The latter produced a minority government led by the center-right People's Party that is essentially supported by the Spanish Socialists Workers' Party (PSOE). Greece similarly held two elections, one in January 2015 and another in September of that year. 5 The German, establishment, Free Democratic Party (FDP) did so in the most recent election, copying ÖVP's focus on tight immigration policy. It has seen its support rise to 10.7%, a substantive increase from 2013. 6 We admit that the case for the U.K. as a political duopoly is harder to make given that there are third (and fourth) parties; although both the Labour Party and the Conservative Party have cleavages on the economy, globalization, and European integration that few European peers have. This is largely due to both parties' attempt to capture a diverse coalition of views. 7 First-past-the-post refers to an electoral system where the country is divided into electoral districts. In each electoral district, the party that wins the most votes generally sends its candidate to the legislature. While there are some variations on this model, and some mixed systems, this electoral system tends to favor political duopolies. In political science, this tendency has often been referred to as Duverger's law (named after the French sociologist Maurice Duverger who first observed this phenomenon). 8 Please see Elaine C. Kamarck, "Increasing Turnout In Congressional Primaries," Center for Effective Public Management at Brookings, dated July 2014, available at brookings.edu. 9 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com.

Highlights Overstated geopolitical risks in 2017 are giving way to understated risks in 2018; The reshuffle of China's government raises policy headwinds for global growth and EM assets; U.S. politics will be roiled by a leftward turn and Trump's protectionism and foreign policy; Italian politics, more than German, is the chief threat to European risk assets; Volatility and the USD will rise; shift to neutral on European risk assets; close tactical long on Chinese Big Banks. Feature BCA's Geopolitical Strategy has operated this year on a high conviction view that geopolitical risks would be overstated, thus generating considerable upside for risk assets. Our analysis focused on three particular "red herrings": European populism, U.S. politics, and Brexit.1 Meanwhile we identified North Korea as a genuine geopolitical risk, though not one that would cause us to change our "risk on" outlook. We therefore take issue - and perhaps offense - with the contemporary narrative that "geopolitics did not matter" in a year when the S&P 500 rose by 15% and VIX plumbed historic lows (Chart 1). Stocks rose and the VIX stayed muted precisely because geopolitical risks were overstated earlier in the year. Investors who correctly assessed the balance of geopolitical risks and opportunities would have known to "buy in May and enjoy your day."2 At the same time that we encouraged investors to load up on risk this year, we cautioned that 2018 would be a challenging year.3 Three themes are now coming into focus as 2017 draws to a close: Politics has become a headwind to growth in China as Beijing intensifies deleveraging and structural reforms; U.S. fiscal and monetary policy favor the USD, which will reignite trade protectionism from Washington D.C.; Italian elections may reignite Euro Area breakup risk. In this report, we update our view on these three risks. Data out of China are particularly concerning: broad money (M3) growth has decelerated sharply with negative implications for the economy (Chart 2).4 M3 is at last ticking up but the consequences of its steep drop have not yet translated to the economy. Our message to clients since 2016 has been that the nineteenth Party Congress would mark a turning point in President Xi Jinping's tenure, that he would see his political capital replenished, and that Beijing's pain threshold would therefore rise appreciably in 2018. Hence we do not expect any new stimulus to be quick in coming or very large. Chart 1Buy In May And Enjoy Your Day Chart 2China's Money Impulse Spells Slowdown What happens in China will not stay in China. Signs of cracks are emerging in the buoyant global growth narrative (Chart 3), with potentially serious consequences for emerging markets (EM) (Chart 4).5 Chart 3Signs Of Cracks Forming Chart 4EM Manufacturing: Rolling Over China: Ramping Up For The New Year Crackdown The aftermath of the Communist Party's nineteenth National Party Congress is unfolding largely as we expected: with a reboot of President Xi Jinping's reform agenda. Chinese economic data are starting to reflect the consequences of tighter policy since late last year (Chart 5), and BCA's China Investment Strategy has shown consumer-oriented sectors outperforming industrials and materials since the party congress, as the reform drive would have one expect.6 China's policymakers have already allowed the monetary impulse - the rate of growth in the supply of money - to slow to the lowest levels in recent memory. This bodes ill for Chinese imports and base metal prices (Chart 6), as BCA's Emerging Market Strategy has emphasized.7 Chart 5Expect More Disappointments From China Chart 6Chinese Imports And Base Metals At Risk It is true that policymakers will re-stimulate the economy when they reach their pain threshold, but with Xi Jinping's political capital replenished and the party and state unified under him, we expect that threshold to have moved higher than financial markets expect. Yes, the government will try to prevent its policies from being highly disruptive and destabilizing - as with the People's Bank of China injecting liquidity to ease rapidly rising bond yields (Chart 7) - but the bottom line is that it is pressing forward with tightening. How can we be so sure that this policy trajectory is set? The initiatives in the early stages of implementation after the congress confirm our view that the central government is hardening the line on several key economic-political fronts: Financial regulatory overhaul: People's Bank Governor Zhou Xiaochuan has made a series of dire comments about China's financial risks and the danger that it is reaching a "Minsky Moment," or accumulation of risks that will end in a catastrophe.8 Zhou's likeliest replacements are both financial reformers, and one of them, Guo Shuqing, is the hawkish regulator who has led the crackdown on shadow lending this year (Chart 8). Moreover, whoever heads the central bank will have the benefit of new financial oversight capabilities. The Financial Stability and Development Commission (FSDC), a new entity charged with coordinating the country's various financial regulatory agencies, has just held its first meeting. Its inaugural chairman, Vice-Premier Ma Kai, is likely to retire soon, but rumors are swirling that his replacement will be Liu He, President Xi's top economic thinker and a reformist, who wrote an ominous article about excessive leverage in the People's Daily in May 2016 and has now made it onto the Politburo. If Liu He takes charge, given his very close relationship with Xi, the FSDC will be irresistible. If not, the FSDC will still be effective, judging by the fact that Ma Kai's replacement will likely be someone, like Ma, who sits on both the Politburo and State Council. Chart 7China's Bond Yields Rising Sharply Chart 8Shadow Banking Has Peaked Local government crackdown: Local government officials in two cities in Inner Mongolia have canceled urban metro projects due to excessive debt, reportedly under orders from the central government. Other cities in other provinces have suggested that approvals for such projects are being delayed.9 In other words, the central government is no longer endlessly accommodating debt-financed local government projects, even projects that support priority goals like urbanization and interior development. This news, so soon after the party congress, is likely to be the tip of the iceberg, which suggests that local government spending cannot be assumed to shake off its weakening trend anytime soon (Chart 9). Top officials pointed out local government leverage as a systemic risk, along with shadow banking, at the National Financial Work Conference in July, and both the outgoing finance minister and the outgoing central bank chief have called for reining in local governments. The latter's comments were formally endorsed by being included in the Communist Party's official "party congress study guide," suggesting that they are more than just the parting advice of a soon-to-be retiree. Property tightening: China's real estate sector, which provides 22% of investment in the country, is feeling the squeeze from financial tightening and targeted measures to drive out speculation since October 2016 (Chart 10). More, not less, of a squeeze is expected in both the short and long term. In the short term, inspections of commercial housing for corruption and speculative excesses could exert an additional dampening effect. In the medium and long term, the Xi administration plans to roll out a nationwide property tax, according to Huang Qifan, an economic policymaker tied to the legislature, "in the near future, not ... 10-20 years. It could happen in the next several years."10 The tax was delayed in 2016 amid economic turmoil. A national property tax would be an important fiscal reform that would tamp down on the asset bubble, rebalance the growth model, and enable the government to redistribute wealth from multiple homeowners to lower income groups. Chart 9Local Government Spending Is Weak Chart 10Property Tightening Continues Industrial restructuring: Environmental curbs on outdated and excess industrial capacity are continuing. Although China aggressively cut overcapacity in coal, steel and other sub-sectors over the past twelve months, it continues to face larger overcapacity than other economies (Chart 11), particularly in glass, cement, chemical fertilizers, electricity generation and home construction. It is also possible that SOE restructuring will become more aggressive. Currently, SOEs listed on the Shanghai exchange are rallying relative to the A-share market, as they have tended to do when the Communist Party reaffirms its backing of the state sector (Chart 12). However, announcements of SOE reforms in this administration have also triggered phases of under-performance. SOEs targeted for reforms face greater scrutiny of their finances and operations.11 Moreover, any SOE is vulnerable to the new wave of the anti-corruption campaign.12 National Supervision Commission: The new anti-corruption czar, Zhao Leji, will be a very influential figure if he is even to hold a candle to his predecessor, Wang Qishan. Zhao is to oversee the creation of a nationwide anti-corruption system that targets not only the Communist Party, as before, but every public official. The new commission will have branches at each level of administration (city, province, central government) and will combine the various existing anti-corruption agencies under one head. The purpose is not merely to root out political enemies (as administration critics, with some justice, would argue) but also to improve the effectiveness of policy implementation and address public grievances that threaten to undermine the regime. The latest environmental curbs have shown that employing anti-corruption teams to help enforce broader economic policy can be highly effective. Xi and Zhao Leji look set to extend this practice to state ministries, including financial regulators.13 It is not clear whether they will succeed in rebuilding the regime's legitimacy in public eyes, but in the short term an initiative like this should send a chilling effect throughout the state bureaucracy, similar to that which occurred among local government party chiefs in 2014 after the initial anti-corruption campaign was launched.14 Chart 11Overcapacity Still A Problem For China Chart 12SOEs Preserved, But Face Reforms In short, preparations are under way for Xi's second five-year term in office. (Perhaps not his last term, as the party congress also made clear.)15 New agencies and personnel suggest that the administration is embarking on an intensification of policy tightening. Tougher policy is viewed as necessary, not optional: top leadership has repeatedly stated that a lack of action on systemic threats will lead to regime-threatening crises down the road.16 Chart 13China's Impact On Global Growth How will this agenda impact the rest of the world? Our colleagues at China Investment Strategy hold that China may step up reforms but will not do so in a way that will negatively impact China's imports or key assets like base metal prices.17 However, from a political perspective, we view the combination of Xi's political capital with the new financial and anti-corruption commissions as likely to increase policy effectiveness to an extent that causes banks to lend less eagerly and local governments and SOEs to err on the side of less borrowing and spending. This will reduce demand for imports and commodities and will also raise the tail-risk of excessive tightening. China's contribution to global growth had fallen over the years, but has recently rebounded on the back of stimulus in 2015-16 (Chart 13). As such, it will not take much of a drag on import growth in 2018 to have a global impact. The most exposed commodity exporters to China (outside of oil) are Brazil, Chile and Peru (with Indonesia and South Africa also at risk), while the most exposed exporters of capital goods are Taiwan and South Korea, followed by Southeast Asia (the Philippines, Malaysia, Vietnam and Thailand). Looking at the China-exposed countries whose stocks rallied the most while China stimulated in 2016, the prime candidates for a negative impact in 2018 will be Brazil and Peru, and less so Hungary and Thailand. Bottom Line: The Xi administration is rebooting its reform agenda and has a higher tolerance for pain than the market yet realizes. Centralization, deleveraging and industrial restructuring have been deemed necessary to secure the long-term stability of the regime. China's policy risks are understated and the next wave of stimulus will not be as rapidly forthcoming as financial markets expect. U.S.: Trouble In (GOP) Paradise Markets have rallied throughout the year despite a lack of policy initiatives from the U.S. Congress. Judging by the performance of highly taxed S&P 500 equities, the rally this year has not been about the prospects of tax reform (Chart 14).18 Rather, markets have responded to strong earnings data and a lack of policy initiatives. Wait, what? Yes, markets have rallied because nothing has been accomplished. Investors just want President Trump and the Republican-held Congress to maintain a pro-business regulatory stance (Chart 15) and not do anything anti-corporate. Doing nothing is just fine. Chart 14Market Has Doubted Tax Reform Chart 15Market Has Cheered De-Regulation Here Come The Socialists Dems The Democratic Party leads the 2018 generic Congressional vote polling by 10.8%, up from 5.9% in May (Chart 16). The generic ballot polling is notoriously unreliable as most U.S. electoral districts are politically designed to be safe seats - "gerrymandered" - and as such are unlikely to respond to nation-wide polling (Chart 17). However, Republican support has fallen and Democratic candidates have performed extremely well this year. Chart 16U.S. Public Leans Democratic Chart 17Electoral System Reduces Competition First, candidates for governor in Virginia and New Jersey have outperformed their polling in November elections. Second, in the four special elections this summer, Democrats narrowed Republican leads by 18%. If the electoral results from Table 1 are replicated in 2018, Republicans could face a massacre in the House of Representatives. In addition, Republicans are suddenly vulnerable in Alabama, where the anti-establishment Senate candidate, and Breitbart-endorsee, Roy Moore is struggling with accusations of pedophilia (Chart 18). Table 12017 Special Elections Are Ominous For The GOP Chart 18Republican Senate Majority May Lose A Seat Why should investors fear a Democratic takeover of the House of Representatives? Yes, the odds of impeachment proceedings against President Trump would rise, but we are on record saying that investors should fade any impeachment risk to assets.19 The greater risk is that the Democratic Party has turned firmly to the left with its new manifesto, "A Better Deal." A strong performance by unusually left-of-center Democratic candidates could spook financial markets that have been lulled into complacency by the lack of genuine populism from the (thus far) pluto-populist president. Protectionism While most investors are focused on the ongoing NAFTA negotiations - which we addressed in last week's Special Report20 - we would draw attention again to the shift towards protectionism by the Republicans in the Senate. Normally a bastion of pro-business free-traders, the Senate has turned to the left on free trade. Senator John Cornyn (R, Texas) has introduced a bill to make significant reforms to the process by which the United States reviews foreign investments for national security, led by the Committee on Foreign Investment in the United States (CFIUS). Two further bills, one in the House and another in the Senate, would also significantly tighten access to the U.S. by foreign investors. China is foremost in their sights. In early 2018, investors will also be greeted by two significant decisions. First, on tariffs: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. The International Trade Commission has already determined that imports of these goods can cause material injury to U.S. industries, so Trump merely has to decide whether to impose tariffs (likely from 35% to 50%), import quotas (which have never received limits from courts), or bilaterally negotiated export limitations from trade partners.21 The consequences would go beyond the current, country-specific tariffs on these items, setting a precedent that would expose a wide range of similar imports to punitive action, and more broadly would signal to the world that the U.S.'s protectionist turn under Trump is real.22 Second, the White House has allegedly completed a comprehensive review of China policy under way since June.23 The review is said to focus on economic rather than strategic matters and to call for the use of punitive measures to insist that China alter tactics long complained about by the United States, including intellectual property theft, export subsidies, and forced tech transfer from joint ventures in China. Already the U.S. is investigating China for intellectual property theft under Section 301 of the 1974 Trade Act, with results that could prompt tariffs no later than August 2018.24 As if on cue, Wang Yang, a new inductee on China's Politburo Standing Committee and a prominent reformer, wrote an editorial in the People's Daily declaring that China should protect intellectual property, not require tech transfers, and give foreign firms equal treatment under the "Made in China 2025" plan.25 China has made similar promises and the U.S. has made similar threats many times before, so decisions in the coming months will be telling. Ultimately we fear that President Trump may feel compelled to ratchet up protectionism in 2018 for two reasons. First, Americans within his populist base will grow restless as they do the math on the tax legislation and realize that their champion is not quite the populist they voted for. Trump will need to re-convince them of his protectionist credentials and independence from Washington elites and the policy status quo. Second, if our view on Chinese slowdown and American fiscal thrust is correct, the USD bull market should restart in 2018. This would hurt U.S. export competitiveness, expand the trade deficit, and motivate U.S. companies to invest abroad, a paradox of President Trump's tax and fiscal policy. The White House may, therefore, be compelled to reach for mercantilist solutions to an FX problem. Foreign Policy The final reason to worry is a "Lame Duck" presidency. Far more predictable presidents sought relevancy abroad late in their mandate. For example, President George H. W. Bush committed troops to Somalia on his way out of the White House. President Bill Clinton bombed Yugoslavia. Given Trump's dismal approval polling and a potentially historic "wave" election for the Democrats in November, President Trump could similarly shift focus to geopolitics. If that shift includes confronting regional powers like China (and/or North Korea), or Iran, risk premiums may rise. In the meantime, we expect tax cuts to pass. The going is getting tougher in the Senate. The decision to include the repeal of the Obamacare individual mandate - designed to cut another $300 billion in government spending over the next ten years - will make it more difficult to secure 51 Senate votes. We maintain our view that the final legislation may need until Q1 to pass. Between now and then, legislators may need a failure or two in order to realize that the clock is ticking toward the midterms. Bottom Line: Markets have cheered lack of action from the Congress. However, the going will get tougher in 2018 as investors fret about protectionism, President Trump's itch to remain relevant, and a potential takeover of the House by the most left-of-center Democratic Party in a generation. Europe: Germany Is A Passing Risk, Focus On Italy The collapse of coalition talks in Germany is not a structural concern for Europe. The breakdown in the negotiations occurred because of the immigration debate, in which the right-of-center Christian Social Union (CSU) and the Free Democratic Party (FDP) struck out a different position from the ruling Christian Democratic Union (CDU) and the liberal Green Party. Of course, the disagreement is not about immigration today, given that inflows of asylum seekers this year has been well below past flows (Chart 19A). Rather, the fundamental disagreement is over how the CDU and its leader Angela Merkel handled the 2015 migration crisis and how it will be handled in the future. Chart 19ANo Immigration Crisis Today Chart 19BGermans Love Europe For investors, what matters is that there is no substantive disagreement over the EU, European integration, or Germany's role in it. The mildly euroskeptic FDP did not draw any red lines. The reason is obvious: the German euroskeptic constituency is small, shrinking, and largely already captured by the Alternative for Germany (AfD) anti-establishment party (Chart 19B). Germans are objectively the most europhile people in Europe. Going forward, a new election would cause further political uncertainty. On the margin, it could cause business confidence to stall. However, Germany runs a 14 billion euro budget surplus and is not expected to launch any structural reforms or fundamental economic changes. As such, if the formation of a government is delayed by three-to-six months, the economic implications will be fleeting. In fact, the result of a new election could be a Grand Coalition between the CDU and Socialists, which would be positive for European integration. However, as we have argued before, hopes for a significant restart of integration have probably run ahead of reality.26 For us, Italy is the immediate concern. Italy passed a new electoral law in late October, setting the stage for the election due by May 2018. The consensus in the news media is that the president will call elections in January, with the vote taking place sometime in March.27 The consensus is that the new law will make it more difficult for the populist Five Star Movement (M5S) to win a majority of seats in the Italian Parliament. In addition, it will give a lift to the parties with strong regional ties - such as the governing Democratic Party (PD) and Lega Nord. Chart 20Italy Set For A Hung Parliament The nuances of the new law are largely irrelevant, however, given the close polling of the three electoral blocs. The most likely outcome will be a hung parliament (Chart 20). Nonetheless, we can still learn something from the law: the Italian establishment parties are cooperating to subvert the electoral chances of M5S. The ruling PD and the center-right Forza Italia of former Prime Minister Silvio Berlusconi are working together to design an electoral system that favors the pre-election norm of coalition-building and parties with strong regional representation. Neither of these factors fits M5S's profile. This suggests that the two centrist blocs will be able to put together an establishment coalition following the election. On one hand, this will give stability to the Euro Area for at least the duration of that government. On the other hand, the underlying data continues to point to structural euroskepticism in Italy. Unlike their European peers, Italians seem to be flirting with overt euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 55% (Chart 21). Similarly, over 40% of Italians appears to be confident in the country's future outside the EU (Chart 22). These are ominous signs for the future. Still, both M5S and the mildly euroskeptic Lega Nord have tempered their demands for an exit from the common currency union. The official stance of the M5S is that the exit from the Euro Area is only "option B," that is, an option if the bloc is not reformed. Meanwhile, Lega Nord is on record opposing a referendum on membership in the currency union because it is illegal.28 Chart 21Italians Stand Out For Distrust Of Euro Chart 22Italians Not Enthusiastic About EU The stance of Italy's euroskeptics will change as soon as it is convenient. The country's establishment is likely making a mistake by contemplating a grand coalition alliance. Unless such a government develops a serious plan for painful structural reforms - it will not - it will likely waste its mandate and fall at the first sign of recession or crisis. At that point, the only alternative will be the M5S, which will stand alone in opposition to such an ineffective government. Investors can therefore breathe a sigh of relief in the medium term. Italy will likely not be a source of risk-off in 2018 or even 2019, although it is still the main risk in Europe for next year and bears monitoring. However, in the long term, we maintain that Italy will be a catalyst for a serious global risk-off episode within the next five years. We remain optimistic that such a crisis will ultimately strengthen Italy's commitment to the Euro Area, as we outlined in a recent Special Report.29 But that is a low conviction view that will require constant monitoring. Could there be another scenario? Several clients have asked us if an Emmanuel Macron could emerge in Italy? Our answer is that there already was an Emmanuel Macron: Matteo Renzi, the former prime minister and current PD leader, was Macron before Macron. And yet he failed to enact significant structural and constitutional reforms. Yet two potential candidates may be ready to swoop in from the "radical center" position that Renzi and Macron characterize. The first is ECB President Mario Draghi. He is widely respected in Italy and is seen as someone who not only allayed the Euro Area sovereign debt crisis, but also stood up to German monetarist demands in doing so. The second is Fiat-Chrysler CEO Sergio Marchionne, one of the world's most recognizable business leaders and a media star inside and outside Italy. If the centrist coalition begins to fray by the end of 2019, both of these individuals may be available to launch a star-studded campaign to "save Italy." Bottom Line: We remain cautiously optimistic about the upcoming Italian elections. While our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a euroskeptic one, nevertheless risks abound and require monitoring. Investment Implications There are a lot of unknowns heading into 2018. What will become of U.S. tax cuts? How deep will the policy-induced slowdown become in China? What will President Trump do if he becomes the earliest "Lame Duck" president in recent U.S. history? Will he embark on military or protectionist adventures abroad? Asset implications are unclear, but we offer several broad takeaways. First, the VIX will not stay low in 2018. Second, the USD should rally. Both should happen because investors are far too complacent about the Fed's pace of hikes and because of potential global growth disappointments as Beijing tinkers with the financial and industrial sectors. Chart 23AEuro Area Versus U.S. Growth: Don't Ignore China (I) Chart 23BEuro Area Versus U.S. Growth: Don't Ignore China (II) Third, it is time to close our recommendation to be overweight European risk assets. European equities have a higher beta to global growth due to the continent's link to Chinese demand. As our colleague Mathieu Savary has pointed out, when Chinese investment slows, Europe feels it more acutely than the U.S. (Chart 23). Chart 24U.S. Dollar Rebound = EM Pullback We are also closing our tactical long position on China's big banks versus its small-to-medium-sized banks. This position has been stopped out at a loss of 5%, despite the riskier profile of the latter banks and the fact that their non-performing loans are rising. Faced with these challenges, Beijing decided to open the door to foreign investment and too ease regulations on these banks so that they can lend to small cap companies as part of the reform drive. These actions inspired a rally relative to the Big Banks that worked against our trade. As financial tightening will continue, however, we expect this rally to be short-lived, and for big banks to benefit from state backing. Our highest conviction view is that it is time to short emerging markets. Our two core views - that politics will become a tailwind to growth in the U.S. and a headwind to growth in China - should create a policy mix that will act as a headwind to EM (Chart 24). The year 2017 may therefore turn out to have been an anomaly. Emerging markets outperformed as China aggressively stimulated in 2016 and as both the U.S. dollar and bond yields declined. This mix of global fiscal and liquidity conditions proved to be a boon for EM, giving it a liquidity-driven year to remember. That year is now coming to an end. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 China's official broad money (M2) measure has also sharply decelerated, as have all measures of China's money. We prefer BCA's Emerging Market Strategy's broader M3 measure. The official M2 has underestimated the amount of new money in China because banks and shadow banks have done extensive off balance sheet lending. The M3 measure includes bank liabilities excluded from M2, it is calculated by taking the total of non-financial institution and household deposits, plus other financial corporation deposits, and other liabilities. Please see BCA Emerging Market Strategy, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Temporary Short-Term Risks," dated November 10, 2017, available at fes.bcaresearch.com and BCA Emerging Markets Strategy Weekly Report, "EM: Cracks Are Appearing," dated November 15, 2017, available at ems.bcaresearch.com. 6 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 8 Zhou's comments should not be interpreted merely as a farewell speech of a retiring central bank governor, since they echo the general policy shift in the administration since December 2016's Central Economic Work Conference, and April 2016's Politburo meeting, toward tackling financial risk. For Zhou's comments, please see "China's central bank chief lays out plans to avert future financial crisis," South China Morning Post, November 4, 2017, available at www.scmp.com. 9 Xianyang in Shaanxi, and Wuhan in Hubei. Please see Wu Hongyuran and Han Wei, "Another City Halts Subway Projects Amid Financing Concerns," Caixin, November 13, 2017, available at www.caixinglobal.com. 10 Please see Kevin Yao, "China central bank adviser expects less forceful deleveraging in 2018," Reuters, November 15, 2017, available at www.reuters.com. 11 The latest official announcement claims that an additional 31 SOEs will be listed for restructuring. Please see "More SOEs to be included in reform plan," People's Daily, November 16, 2017, available at en.people.cn. 12 We fully expect SOEs to be subjected to rigorous treatment from the National Supervision Commission. Note that the crackdown on overseas investment earlier this year merely touches the tip of the iceberg in terms of the SOE corruption that could be revealed by probes. See, for example, the following report on the National Audit Office's public notice on SOE fraud and irregularities, "20 Central Enterprises Overseas Investment Audit Revealed A Lot Of Problems," Pengpai News (Shanghai), June 26, 2017, available at news.163.com. 13 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "Policy Mistakes And Silver Linings," dated October 7, 2015, and "Legacies Of 2014," dated December 17, 2014, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 16 Xi Jinping has called financial security an important part of national security and declared that "safeguarding financial security is a strategic and fundamental task in the economic and social development of our country." Please see Wang Yanfei, "Leaders aim to fend off financial risks," China Daily, April 26, 2017, available at www.chinadailyasia.com. For Zhao Leji's post-congress comments on this topic in the People's Daily, please see "China faces historic corruption battle, new graft buster says," The Guardian, November 11, 2017, available at www.theguardian.com. 17 See footnote 6. 18 More anecdotally, a clear majority of our clients disagrees with our bullish prospects of tax cuts. 19 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 21 Please see Chad P. Bown, "Donald Trump Now Has The Excuse He Needs To Open The Floodgates Of Protectionism," Peterson Institute of International Economics, October 9, 2017, available at piie.com. 22 Other measures could follow thereafter. For instance, the Commerce Department will issue its final report on steel and aluminum in January and Trump could decide to take punitive actions on these goods under Section 232 of the 1962 Trade Expansion Act. Please see Ana Swanson, "Democrats Pressure Trump to Fulfill Promise to Impose Steel Tariffs," New York Times, October 26, 2017, available at www.nytimes.com. 23 The review itself began in June, around the time when Trump's and Xi's initial "100-day plan" to improve trade relations expired. The report that the review is completed is from Lingling Wei et al, "Beyond Trump-Xi Bond, White House Looks to Toughen China Policy," Fox Business News, November 19, 2017, available at www.foxbusiness.com. See also Adam Behsudi et al, "White House conducting wide-ranging review of China policy," Politico, September 28, 2017, available at www.politico.com. 24 The U.S. Trade Representative Robert Lighthizer is supposed to finish his investigation into intellectual property under Section 301 of the 1974 Trade Act within a year of August 18, 2017. Please see Gary M. Hnath and Jing Zhang, "Trump Administration Initiates Section 301 Investigation of China's Acts, Policies and Practices Related to Technology Transfer, Intellectual Property and Innovation," dated August 25, 2017, available at www.lexology.com. 25 Please see "Chinese vice premier pledges fair treatment of foreign firms as China opens up," Reuters, November 10, 2017, available at www.reuters.com. 26 Please see BCA Geopolitical Strategy Weekly Report, "Stick To The Macro(n) Picture," dated May 10, 2017, available at gps.bcaresearch.com. 27 Just in time to get a new government in place ahead of the World Cup! Oh wait... Too soon? 28 Which is an odd position to take given their supposed anti-establishment orientation. For example, the U.K. referendum on EU membership was non-binding, and yet it took place and had relatively binding political consequences. 29 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com.