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Last week marked the beginning of the 2021 Q1 earnings season, with the largest money center banks reporting. We will publish an in-depth analysis of the bank earnings on Monday, April 25, 2022, together with our colleagues from the US Investment Strategy team.  This week, 69 companies are reporting. In terms of market expectations: Quarter-on-Quarter earnings growth is expected to be -5% (Chart 1). Similar to previous quarters, we may expect a high number of earnings and sales beats.  However, it is forward guidance that will matter. Chart 1 Year-on-year earnings growth is expected to be 6.3% and 0.7% excluding the Energy sector Year-on-year revenue is expected to be 10.9%. Excluding the energy sector, the growth estimate is 8.3%. Clearly, analysts expect increasing cost pressures to take their toll on corporate profitability. There is a wide dispersion in sector-level expectations (Table 1).  Commodity sectors, such as Energy and Materials are expected to deliver the highest rates of earnings growth, driven by the shortages, exacerbated by the indirect effects of the war in Ukraine.  These are also the best-performing sectors YTD. Technology and Healthcare are expected to deliver strong earnings and sales growth, and so far appear to be immune to slowing growth and inflationary pressures. Earnings of the Consumer Discretionary sector are expected to contract as a result of soaring prices of food and energy, that sap consumer confidence and cut into discretionary spending.  In addition, demand for durable goods was pulled forward by the pandemic and is now waning.   The Financials sector is expected to experience a sharp drop in earnings.  Based on the earnings commentary of the largest banks that have reported so far (JPM, BAC, WFC, C, and MS), there are significant headwinds, which were widely  anticipated. A major drought in deal flow and slowing growth decreased demand for loans. On the bright side, banks with sizeable loan books announced that they expect net interest margins to expand. Table 1 Bottom Line: We continue monitoring 2022 Q1 earnings season for any anomalous results to gauge the health of the US corporations. 

Executive Summary Above Fair Value March’s CPI report will mark peak inflation for 2022. We recommend several ideas to profit from peak inflation. First, investors should keep portfolio duration close to benchmark. The bond market is fairly priced for the likely near-term pace of rate hikes, and long-dated forward yields are now above fair value. Second, investors should underweight TIPS versus nominal Treasuries. They should also favor inflation curve steepeners, real yield curve flatteners and outright short positions in 2-year TIPS. Third, investors should favor the 5-year nominal Treasury note relative to a duration-matched barbell consisting of the 2-year and 10-year notes. The Fed published its plan for shrinking its balance in the minutes from the last FOMC meeting. We estimate that the Fed will be able to shrink its balance sheet at its intended pace for at least the next two years before it is forced to stop. Bottom Line: Investors should position for peak inflation by keeping portfolio duration close to benchmark, by underweighting TIPS versus nominal Treasuries and by favoring the 5-year nominal Treasury note versus the 2-year and 10-year. Feature Chart 1Base Effects Kick In Next Month Last week’s March CPI report showed that 12-month core consumer price inflation came in at 6.44%, a level that will almost certainly mark the peak for the year. Several reasons justify our peak inflation call. First, base effects will send year-over-year core CPI sharply lower during the next three months (Chart 1). Monthly core CPI growth rates were 0.86%, 0.75% and 0.80% in April, May and June 2021 (Chart 1, bottom panel). These exceptionally high prints will roll out of the 12-month average during the next three months. Second, monthly core CPI grew 0.32% in March, a significant step down from the 0.5%-0.6% range that had been the norm since October. If monthly core CPI growth rates remain between 0.3% and 0.4% from now until the end of the year, then 12-month core CPI will fall to a range of 4.19% to 5.13%. We think that trends in the major components of core inflation make this outcome likely, and we could even see inflation falling to below that range. Chart 2 shows the contributions of shelter, goods and services (ex. shelter) to overall core CPI. Chart 2Monthly Core Inflation By Major Component Starting with core goods, we see that prices fell in March for the first time since February 2021. This represents an important inflection point. Core goods, particularly autos, have been the principal driver of current extremely high inflation rates (Chart 3), and these prices will continue to fall in the coming months as supply chain issues are resolved and as goods spending reverts to its pre-pandemic trend (Chart 3, bottom panel). Few dispute that core goods inflation will be weaker going forward. However, one critical question is whether the impact from falling goods prices will simply be offset by the rising cost of services. There was indeed some evidence for this in March. Core services (ex. shelter) prices rose 0.71% in March, up from 0.55% in February. While this is a strong print, it was not sufficient to prevent a drop in overall core inflation from 0.51% to 0.32%. What’s more, March’s core services print was heavily influenced by a surge in airfares that represents a rebound from steep declines seen near the end of last year. With airfares excluded, core services inflation would have only come in at 0.50% in March (Chart 4). Chart 3Goods Inflation Chart 4Services & Shelter Inflation Finally, we turn to the outlook for shelter inflation. Monthly shelter inflation has rebounded to above its pre-COVID levels, but its acceleration has abated during the past few months (Chart 4, bottom panel). Trends in home prices and some indicators of market rents suggest that shelter inflation has some further near-term upside.1 However, shelter inflation is also very sensitive to the economic cycle and the unemployment rate. With that in mind, rapid shelter inflation during the past 12 months is mostly explained by the fact that the unemployment rate fell by almost 2.5%! With the labor market already close to full employment, this sort of cyclical economic improvement will not be repeated during the next 12 months. All in all, we think monthly shelter inflation will average close to its current level during the next nine months. Bottom Line: March’s CPI report marked an inflection point for inflation. Year-over-year inflation will fall sharply during the next few months and will settle close to 4% by the end of the year. Profiting From Peak Inflation Portfolio Duration We have been recommending an “at benchmark” portfolio duration stance in US bond portfolios since mid-February, yet Treasury yields have continued their upward march during the past two months. Our sense is that bond yields now look somewhat too high, and some pullback is likely as inflation moves lower during the next few months. First, let’s consider that the bond market is priced for 262 bps of tightening during the next 12 months (Chart 5), the equivalent of more than ten 25 basis point rate hikes at the next eight FOMC meetings. Our view is that this pricing is close to fair. Chart 5Rate Expectations A 50 basis point rate hike at the May FOMC meeting is now a near certainty. The minutes from the last meeting revealed that “many” participants would have preferred a 50 bps increase in March, but uncertainty surrounding the war in Ukraine prevented that view from becoming consensus. The Treasury curve has also re-steepened significantly during the past few weeks, a development that will ease any concerns about near-term over-tightening. It’s also worth noting that the precedent for a 50 bps hike has now been set by the Reserve Bank of New Zealand and the Bank of Canada. Both central banks lifted their policy rates by 50 bps at their most recent meetings. Chart 6Above Fair Value Beyond May, we expect to see more 25 basis point rate hikes than 50 basis point hikes. Falling inflation will ease some of the Fed’s urgency and the Fed will continue to tighten policy with the goal of getting the fed funds rate close to estimates of the long-run neutral rate by the end of the year. A 25 basis point rate increase at every meeting after May would bring the fed funds rate to a range of 2.0% - 2.25% by the end of the year, just below the Fed’s median estimate of the long-run neutral rate (2.4%). One additional 50 bps hike would bring the funds rate right up to neutral, and such a path would still be consistent with what is currently priced in the curve. Meanwhile, bond pricing at the long end of the yield curve now looks a touch cheap. The 5-year/5-year forward Treasury yield – a market proxy for the long-run neutral rate – has moved up to 2.87%, significantly above survey estimates of the long-run neutral rate (Chart 6). Some pullback closer to survey levels is likely as inflation trends lower. Bottom Line: Keep portfolio duration close to benchmark. Front-end pricing looks fair and long-dated forward yields are somewhat too high. TIPS Perhaps the most obvious way to profit from peak inflation in 2022 is by shorting TIPS versus nominal Treasuries. The 10-year TIPS breakeven inflation rate has risen to 2.91%, well above the Fed’s target range of 2.3%-2.5% (Chart 7). The combination of Fed tightening and falling inflation will send this rate back toward the Fed’s target between now and the end of the year. However, the potential downside in the 10-year TIPS breakeven inflation rate is nothing compared to the 2-year rate. The 2-year TIPS breakeven inflation rate is 4.4% (Chart 7, panel 2) and this short-maturity rate is much more sensitive to the incoming inflation data. Finally, long-maturity TIPS breakeven inflation rates look elevated compared to survey estimates of long run inflation. The 5-year/5-year forward TIPS breakeven inflation rate is currently 2.46%, above the range of estimates from the New York Fed’s Survey of Primary Dealers (Chart 7, bottom panel). In addition to underweight positions in TIPS versus nominal Treasuries, we continue to see the opportunity for an outright short position in 2-year TIPS. The 2-year TIPS yield has risen significantly since the end of last year, but this has been driven by a rising 2-year nominal yield (Chart 8). Going forward, the 2-year TIPS yield still has room to rise but it’s increase will be driven less by a rising nominal yield and more by a falling 2-year TIPS breakeven inflation rate. Chart 7Inflation Expectations Chart 8Sell 2-Year TIPS Consistent with our view that the cost of short-maturity inflation compensation has more downside than the cost of long-maturity inflation compensation, we view positions in 2-year/10-year inflation curve steepeners and 2-year/10-year TIPS curve flatteners as likely to profit during the next nine months (Chart 8, bottom panel). Bottom Line: Investors should underweight TIPS versus nominal Treasuries. They should also position in inflation curve steepeners and real yield curve flatteners and hold outright short positions in 2-year TIPS. Nominal Treasury Curve Chart 9Go Long 5yr Versus 2/10 One final idea is for investors to take a long position in the 5-year Treasury note versus a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. This 5 over 2/10 trade currently offers an attractive 18 bps of yield pick-up, which is much higher than we normally see when the 2-year/10-year Treasury slope is this flat (Chart 9). In fact, a simple model of the 2/5/10 butterfly spread versus the 2-year/10-year slope shows the 5-year bullet to be very cheap relative to history (Chart 9, panel 2). This position will profit from continued 2-year/10-year curve steepening, or more likely, it will profit if the 2-year/10-year slope remains near its current level but the 2-year/5-year slope flattens as the Fed tightening cycle progresses (Chart 9, panel 3). Bottom Line: The recent steepening trend in the 2-year/10-year Treasury slope is likely exhausted, but the 5-year Treasury yield is too high relative to the current 2-year/10-year slope. Investors should go long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The Fed’s Balance Sheet Plan The minutes from the March FOMC meeting revealed the Fed’s plan for shrinking its balance sheet. This plan will likely be put into action at either the May or June FOMC meeting. Specifically, the Fed intends to allow a maximum of $60 billion of Treasuries and $35 billion of MBS to passively run off its portfolio each month. The Fed also hinted that it may decide to start with lower caps and raise them up to the $60 billion and $35 billion targets over a period of three months. However, with the market already well positioned for Quantitative Tightening (QT), this phase-in period will probably not be deemed necessary. For its Treasury securities, the Fed intends to allow a maximum of $60 billion of coupon securities to run off its portfolio each month. If fewer than $60 billion of coupon securities are maturing that month, then the Fed will redeem T-bills to reach the $60 billion target. For MBS, the Fed’s $35 billion per month cap will probably not be binding. Given the slow pace of mortgage refinancings, which will only slow further as interest rates rise, it is unlikely that there will be many months with more than $35 billion of maturing MBS. In fact, some recent Fed research estimated that average MBS runoff will be closer to $25 billion per month going forward.2 Assuming the Fed’s plan starts in June and that MBS runoff averages $25 billion per month, we calculate that the Fed’s Treasury holdings and total assets will still be above pre-COVID levels in 2026 (Chart 10). More important than the Fed’s total assets, however, are the total reserves supplied to the banking system. It is the amount of reserves, after all, that determine whether the Fed can maintain adequate control over interest rates. If too few reserves are supplied, then the fed funds rate will threaten to break above the upper end of the Fed’s target band and the Fed will be forced to increase reserves by either re-starting purchases or engaging in repo transactions. This is exactly what happened when the Fed was forced to abandon its last QT effort in September 2019 (Chart 11). Chart 10Fed Asset Projections Chart 11Reserve Projections Making a few additional assumptions about the growth rate of currency-in-circulation and the size of the Treasury’s General Account, we are able to forecast the path for reserves going forward (Chart 11, top panel). We estimate that reserves will fall to roughly $2 trillion by the end of 2025, still slightly above the levels that caused problems in fall 2019. Ultimately, neither us nor the Fed knows exactly what level of reserves will be adequate to maintain control of interest rates going forward. The Fed will track usage of its new Standing Repo Facility as it shrinks its balance sheet. If usage of the repo facility increases, that will be the sign that the Fed has done enough QT and it is time to start slowly increasing the balance sheet once again. Given the recently published pace of runoff, we think this won’t be story for at least another two years.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details please see US Bond Strategy Weekly Report, “A Soft Landing Is Still Possible”, dated March 15, 2022. 2 https://www.newyorkfed.org/newsevents/speeches/2022/log220302 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Dear Client, Next week, there will not be a written European Investment Strategy report; instead we will host a Webcast on April 26 with Chester Ntonifor, BCA’s Foreign Exchange Strategist. Regards, Mathieu Savary Executive Summary Cyclicals Are Not Cheap Enough Global growth remains fragile as China’s economy becomes increasingly affected by COVID containment measures. The US economy is likely to slow down significantly in the coming months, while Europe flirts with a recession. This time around, monetary policy is unlikely to provide a relief valve. While European equities may inch higher in the coming months, cyclical stocks do not offer the necessary valuation discount relative to defensive equities to compensate investors against these risks.  Heed the rotational patterns to guide near-term country and sector allocation. The French election remains an important source of risk, even though President Emmanuel Macron is still the favorite.   Bottom Line: Maintain a modest positive bias toward equities, but overweight defensive stocks at the expense of cyclicals. Focus on short-term capital protection by favoring small-cap over momentum stocks, materials over energy, and UK equities over French ones.     Chart 1So Far, Defensives Win European equities have experienced a very volatile first quarter, with a maximum drawdown of nearly 23%. Since their March 7th low, they have rebounded 18% but remain 13% below the January 5th high. Apart from the energy sector, defensives have been running the show so far this year (Chart 1). We wrote four weeks ago that the European market is likely to have made its low for the year,  but that the volatility of the first quarter of 2022 is likely to continue. We still hold this view. For now, we recommend investors stay long European equities, but defensive sector and country stances are appropriate. Cyclical stocks have corrected, but front-loaded global economic risks create additional downside. Economic Risks Abound The global economic environment remains fragile as headwinds continue to build. Cyclical equities do not seem to have fully discounted this threat. China’s economic outlook constitutes the first hindrance to global growth. COVID cases in Shanghai are surging and many Chinese cities are also witnessing an acceleration in new cases (Chart 2). The Communist Party is still adamant about its zero-tolerance policy, which suggests that these severe lockdowns will become the norm around the country. This situation creates significant downside for Chinese domestic demand, which will prompt a growth slowdown. The service sector is already feeling the pain from the lockdowns. The March import numbers also highlight an abrupt slowdown in the goods sector (Chart 3). In CNY terms, imports contracted 1.7% annually. This is a nominal number. Both global goods and commodity inflation are elevated, and thus, import volumes are weakening sharply. Furthermore, a recent Reuters article indicated that Chinese crude oil imports have already contracted 14% annually. Chart 2China's COVID Problem Chart 3Slowing Chinese Domestic Demand Chart 4Declining Shipping Costs, But For How Long? China’s COVID policy also risks adding new supply chain bottlenecks. Freight within the country is grinding to a halt and ships are queuing up outside the port of Shanghai. As lockdowns multiply around China, risks to global supply chains will increase, hence, the recent decline in shipping rates out of China may soon be undone (Chart 4). This represents a major risk for the global economy, as it would tighten constraints to global economic activity. It also threatens European profitability, as PPI inflation would outpace CPI inflation for longer than anticipated (Chart 4, bottom panel). The US also shows signs of weakness. While a US recession is unlikely, a meaningful deceleration is probable. US consumers are feeling the pinch from surging food and energy prices. Consequently, real wages are contracting 1.8% annually and consumer confidence has plunged (Chart 5). Thankfully, US households have accumulated $185 billion in excess savings since the pandemic began and their net worth has increased by $33 trillion, which should prevent a complete meltdown. Nevertheless, a further deterioration in retail sales is still very likely. Businesses are also increasingly worried. The March NFIB survey shows that Small Business Optimism is falling quickly and that few companies believe it is a good time to expand (Chart 5, bottom panel). Adding to these stresses, the most cyclical sector of the US economy is weakening rapidly. The recent rise in US mortgage rates to 5% is causing a collapse in mortgage applications for house purchases and is behind the 30% tumble suffered by homebuilder stocks (Chart 6). Chart 5US Confidence Is Falling Chart 6Tarnished US Housing Outlook Europe is in a situation worse than the US and is at risk of a recession in the first half of 2022, or, at least, a very severe growth slowdown. As we highlighted six weeks ago, the energy shock in Europe is larger than it is in the US; moreover, Europe does not enjoy the counterweight of a large commodity sector. Recent data confirm that a slowdown is imminent. The ZEW Expectations survey, the German Ifo, and the European Commission’s Consumer Confidence data are all collapsing, which is consistent with a severe shock (Chart 7). To add insult to injury, bond yields continue to rise; therefore, the only relief valve for the region is a weak currency. Global monetary policy is unlikely to come to the rescue of investors anytime soon. The Fed began lifting rates in March and, if the actions of the Bank of Canada and the Reserve Bank of New Zealand are any indication, the FOMC will increase rates by 50bps in May. The OIS curve expects a Fed Funds rate at 2.2% by year-end, which seems appropriate. With a backdrop of weakening growth, a flat yield curve and an additional increase in real rates will feed risk aversion, especially against the cyclical sectors of the market (Chart 8). Chart 7Severe Slowdown In Europe... Or Worse Chart 8Slowing Growth Meets Higher Real Rates The liquidity tightening is not a phenomenon unique to the US. 63% of global central banks have removed monetary accommodation over the past three months (Chart 9). Moreover, our BCA Monetary Index continues to deteriorate. While we cannot characterize global monetary policy as being anywhere close to tight right now, cyclical equities remain vulnerable to the liquidity slowdown. Bottom Line: The global economy is likely to deteriorate in the coming months. The impact of COVID-19 on Chinese growth will only increase, while Europe flirts with a recession in the first half of the year. Meanwhile, US growth faces swelling headwinds. Expect a meaningful deterioration in global economic surprises (Chart 10). In this context, tighter policy will feed risk aversion, which will create a particularly strong headwind for cyclical stocks. Chart 9A Global Tightening Chart 10Economic Surprises Will Fall European Cyclicals Remain Vulnerable This backdrop is not equity-friendly and points to meagre returns over the next three to six months. Nonetheless, European stocks will not generate negative returns over this time frame because European benchmarks already discount a significant portion of the negative news, as illustrated by the surge in their earnings yield (Chart 11). Importantly, inflation in Europe should peak over the summer as the commodity impulse is decelerating (Chart 11, bottom panel). Therefore, fears of stagflation will recede, which will help aggregate European shares (Chart 12). Chart 11European Stocks Already Discount A Lot Chart 12Ebbing Stagflation Fears Will Help European Equities The consequence of the additional slowdown in global growth is likely to be reflected in the relative performance of European cyclical sectors. Already, Swedish economic growth and asset prices have deteriorated (Chart 13). This poor performance does not bode well for cyclical assets, considering the heightened sensitivity of Swedish assets to the global industrial cycle. More signals point to downside for the cyclical/defensive split. While the short-term momentum of the performance of cyclicals relative to defensives is becoming oversold, its 40-week rate of change has yet to reach a paroxysm (Chart 14). Additionally, cyclicals have not experienced the kind of valuation discount associated with a full discounting of the economic and monetary headwinds described in the previous section (Chart 14, bottom panel). Chart 13Heed Sweden's Message Chart 14Cyclicals Are Not Cheap Enough The commodity sector is also at risk of a pullback. China’s economic slowdown is likely to hurt commodity demand. While this will not end the secular commodity bull market underpinned by a lack of supply capacity, it could easily cause a significant correction in commodity prices. If, as we anticipate, inflation slows this summer, the inflation-hedging demand for commodities will also pause. These dynamics would hurt mining stocks, which have avoided a serious pullback, as well as the energy sector. Thus, a correction in commodities would cause additional weaknesses for the cyclicals-to-defensives ratio (Chart 15). Yields create a supplemental risk. Historically, rising US yields and inflation expectations correlate with an outperformance of cyclical shares. However, in 2022, cyclicals have bifurcated from yields and CPI swaps (Chart 16), because higher yields currently do not signal reflation but stagflation. If yields rise further, it will hurt growth prospects and damage cyclicals. If they fall, it will likely reflect increasing growth fears, which is also negative for cyclicals. Moreover, falling yields will hurt the profit margins of financials, which are a large component of cyclicals. Therefore, cyclicals seem stuck in a lose-lose situation with respect to yields. Chart 15The Commodity Link Chart 16Yields and Cyclicals: A Lose-Lose Proposition The strength in the dollar creates the last major hurdle for cyclicals. A strong dollar both tightens global financials conditions and indicates weak growth ahead. Consequently, it often heralds a period of softness in the cyclicals-to-defensives ratio (Chart 17). How should investors position themselves? We have a long-held preference for telecommunication services stocks over consumer discretionary equities and for healthcare relative to tech shares. These trades have respectively generated hefty gains of 32% and 13% since June 2021, but they are becoming long in the tooth (Chart 18). Chart 17A Strong Dollar Hurts Cyclicals Chart 18Hedges Have Performed Strongly Related Report  European Investment StrategyThe Great Rotation As an alternative, we recommend investors stay nimble and use our Excess Returns Rotation Approach expanded in a Special Report two months ago. Below, you will find the new trades suggested by this process. Bottom Line: Cyclicals remain vulnerable. They have not reached the kind of valuation discount necessary to compensate investors for weaker growth and tighter monetary policy. To hedge against these risks, we recommended selling consumer discretionary relative to telecom stocks and tech shares relative to healthcare. However, investors should not add to those trades to mitigate against further weaknesses in cyclical stocks. Instead, investors should focus on relative rotational patterns (see next section).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Excess Returns Rotation Maps: An Update1 European Investment Styles The most noteworthy move comes from small-cap stocks, going from the “Lagging” quadrant to the “Leading” one rapidly (Chart 19). This is consistent with our view that European small-cap equities’ outperformance has further to run. The attractiveness of value stocks is thinning relative to growth stocks (Table 1). Chart 19Relative Rotation Graph: European Investment Styles Table 1European Investment Styles Positioning   Trade Recommendations (12-Month Horizon): Volatility stocks relative to momentum (unchanged) Small-cap stocks relative to momentum (new) European Sectors Chart 20 illustrates the wild ride in European equity markets in the wake of the Ukraine/Russia conflict. Most sectors experienced violent swings, moving rapidly across several quadrants. Only consumer discretionary, tech, and utilities stocks have remained in the same quadrant, the former two in “Lagging” and the latter in “Leading.” Interestingly, the European energy sector has moved into the “Weakening” quadrant (Table 2). We are taking profit on our Long Energy / Short Financials recommendation. It delivered 14% returns since mid-February and is getting long in the tooth. Chart 20Relative Rotation Graph: European Sectors Table 2European Sectors Positioning   Trade Recommendations (12-Month Horizon): Materials over energy (unchanged) Energy over financials (unchanged) Tech over communication services (unchanged) Utilities over healthcare (new) Communication services over healthcare (new) Consumer discretionary over healthcare (new) European National Markets Sectoral biases dictate the rotational patterns exhibited by European national bourses (Chart 21). The cyclicality of the German, French, and Italian markets caused them to lag behind their European counterparts. Meanwhile, the Dutch market remains solidly in the Lagging quadrant, mirroring tech equities. Only Spain and Sweden have shown signs of improvement over the past twelve weeks and should outperform the European benchmark over the short term (Table 3). Chart 21Relative Rotation Graph: European National Markets Table 3European National Markets Positioning   Trade Recommendations (12-Month Horizon): UK stocks over Dutch ones (new) UK stocks over French ones (new) Italian stocks over Swedish ones (new) UK stocks over Swedish ones (new) French Elections: Preparing For The Second Round The first round of the French presidential elections did not surprise. As in 2017, incumbent President Emmanuel Macron will face Marine Le Pen in the second round. Beyond this expected outcome, two important takeaways will be crucial in the second round: The collapse of traditional right-wing (Les Républicains) and left-wing (Parti Socialiste) parties. Far-left candidate Jean-Luc Mélenchon surprised to the upside with 22% of votes, right behind Marine Le Pen. The key implication is that the vote transfer has become more favorable to Macron (Diagram 1). In 2017, Marine Le Pen created the surprise and bested center-right candidate François Fillon by the narrowest of margins. As a result, Le Pen’s attempt to appeal to Fillon’s voters was a real threat. Today, the third largest pool of voters belongs to far-left candidate Mélenchon, who has already called upon his voters “not to give a single vote to Marine Le Pen.” Diagram 1Extrapolating France’s First-Round Election To The Second Round How does it translate into voting intentions for the second round? Assuming a full transfer of votes from the defeated candidates based on the support they made public, Macron will crush Marine Le Pen as he did in 2017. However, this is unlikely, since many voters feel stuck between a rock and a hard place, and may decide not to vote. Related Report  European Investment StrategyFrance: Macron And Macro Assuming Macron obtains only half of the voting intentions from other parties, while Marine Le Pen retains the full support from other far-right candidates’ voters, acquires half of the center-right votes, and secures a quarter of Mélenchon’s votes, the outcome will be much narrower at 53.4% vs. 46.6% in favor of Macron. This is in line with national polls. Two weeks ago, we presented the investment implications of a second Macron mandate.  Since then, we have received many questions about the market consequences should Marine Le Pen enjoy a surprise victory. While this is not our base-case, we cannot rule out the possibility of a negative shock to the markets. Chart 22A Le Pen Surprise Victory Would Hurt The Euro The only certainty within this very uncertain outcome is that Marine Le Pen would be constrained by a strong opposition in the Assemblée Nationale. Although she has changed her stance on “Frexit,” her presidency would undoubtfully carry an increased geopolitical risk within the European Union (EU) and hurt European unity and integration efforts. Thus, the resulting French isolationism would be synonymous with a weaker euro (Chart 22). French assets would be de-rated because her presidency would reverse previous reform efforts, which would hurt trend GDP growth, productivity, and the role of France within the EU. These trends are not only negative for stocks, but they would also put long-term upward pressure on OATs yields as French public finances would deteriorate meaningfully under a populist Le Pen presidency. In this context, underweighting both French equities and government bonds would be warranted.   Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Footnotes Tactical Recommendations Cyclical Recommendations Structural Recommendations