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Highlights The trade war escalation is just the catalyst and not the cause of the market correction. This year’s absolute double-digit returns have most likely already been made during the early-2019 star alignment of near-perfect conditions for investors. The remainder of the year is likely to be a much tougher going for all the major asset-classes. Short a 30:60:10 portfolio of equities, bonds, and oil, setting the profit target and stop-loss at 3 percent. In the second half of the year, the big story will be sector rotation. Healthcare is likely to flip from underperformer to outperformer versus technology. Given their sector skews, it follows that European equities are likely to outperform Chinese equities. Feature A star alignment of near-perfect conditions lifted the entire financial market complex in the early part of the year. For investors, pretty much everything that could go right did go right! (Chart of the Week). Chart of the WeekIn Near-Perfect Conditions, European Equities Performed Very Well... But Chinese Equities Performed Even Better The Federal Reserve stopped hiking interest rates; the ECB and other major central banks also pivoted to dovish; Brexit was delayed; the Italy versus Brussels spat over fiscal policy de-escalated; the drag from new emissions standards on German auto production eased; the trade war threat seemed to recede; and crucially, economic activity accelerated sharply (more about this later). A Rare Star Alignment… Which Cannot Last There was another rare star alignment: equities, bonds, and crude oil generated simultaneous strong rallies (Chart I-2). Such a star alignment is almost unheard of, because there are no set of economic circumstances that should benefit all three asset-classes at the same time. For example, if the oil price surge is inflationary – or at least less deflationary – then it should hurt bonds; if the surge is deflationary on real demand, then it should hurt equities. Equities, bonds, and oil should not surge together. Equities, bonds, and oil should not surge together, and on the extremely rare occasions they do, the simultaneous rally soon breaks down. Consider a €100 investment portfolio consisting of €30 equities, €60 long-dated bonds, and €10 crude oil. At the start of this year, the portfolio returned 10 percent in just three months. This is extremely rare, and has happened on only two other occasions in the past 25 years, in 2009 and 2016 (Chart I-3). Chart I-2A Rare Star Alignment:##br## Equities, Bonds, And Oil Surged ##br##Simultaneously Chart I-3A Rare Star Alignment: A 30:60:10 Portfolio of Equities: Bonds: Oil Gained 10 Percent In 3 Months On both previous occasions, the simultaneous rally broke down, and the portfolio went on to lose a large chunk of its 10 percent gain. Hence, at our quarterly webcast last week, we initiated a new investment recommendation: to short a 30:60:10 portfolio of equities, bonds, and oil, setting the profit target and stop-loss at 3 percent.1 When conditions are perfect, they are vulnerable to the tiniest setback. But the vulnerability emanates from the fragility of the perfect conditions, and not the precise setback. As an analogy, visualize a tree bedecked in its beautiful foliage in the autumn, and imagine you gently shake the tree. The gentlest of shakes will make the leaves collapse. At first glance, your shake caused the collapse, but in truth, your shake was just the catalyst; the underlying cause was the fragility of the autumnal foliage. Another catalyst, say a puff of wind, could have equally triggered the same collapse. When conditions are perfect, they are vulnerable to the tiniest setback. The re-escalation of the trade war has dominated the recent column inches and investment analyst missives. But just like the gentle shake of the tree, it is just a catalyst for the market correction. The underlying cause was that the simultaneous and strong rallies in all financial assets, based on a star alignment of near-perfect conditions, was vulnerable to the first blemish to the perfection. And the blemish could have been anything. Economic Activity Has Undoubtedly Accelerated… One of the things that drove up equity markets was the acceleration in economic activity. This acceleration is beyond doubt: euro area GDP prints show that growth picked up to 1.6 percent in the first quarter of 2019 from a low of 0.6 percent in the third quarter of 2018 (Chart I-4). Given the openness of the euro area economy, it is inconceivable that this growth pick-up does not reflect a more generalized acceleration in global activity.2 Chart I-4Euro Area GDP Growth Accelerated To 1.6 Percent The trouble is that we do not receive these GDP prints in real-time. From the mid-point of the quarter to which the GDP prints refer to their release date around one month after the quarter end, there is a two and a half month delay. To proxy activity in real-time, we must look at current activity indicators (CAIs) which gauge GDP growth, but are available without much of a delay. While several such indicators exist, we have found that the ZEW economic sentiment indicator (not to be confused with the current situation indicator) does the job extremely well in real-time. Current activity indicators do not help equity investors. Having said that, current activity indicators do not help equity investors. The simple reason is that the equity market is a current activity indicator itself, and it would be absurd to expect one CAI to predict another CAI! In fact, the best current activity indicator is not the equity market taken as a whole. This is because the aggregate equity market can move as a result of drivers other than current economic activity, most notably central bank policy. Therefore, it turns out that the very best current activity indicator is found within the equity market: specifically, the performance of economically sensitive equity sectors – such as industrials and financials – relative to the aggregate market (Chart I-5 and Chart I-6). Both this and the ZEW economic sentiment indicator confirm that economic activity has accelerated sharply since late last year, but has suffered a slight setback in the last month. Chart I-5The Best Current Activity Indicator Is The Relative Performance Of Economically Sensitive Equity Sectors Chart I-6The Best Current Activity Indicator Is The Relative Performance Of Economically Sensitive Equity Sectors …But Can The Acceleration In Economic Activity Continue? To be crystal clear, let’s repeat the crucial point. Economically sensitive investments do not move on the level of GDP growth; economically sensitive investments move on the real-time change in GDP growth. The simple reason is that profits growth is highly leveraged to economic growth. Hence when GDP growth picks up, the embedded ‘g’ used to calculate the present value of the investment rises very sharply, which means that today’s price also rises very sharply; and vice versa when GDP growth declines. But once GDP growth stabilizes, even at a high level, there is no further meaningful change in ‘g’, or in the price. For any remaining sceptics, Chart I-7 shows that for many years, the big moves in the Euro Stoxx 50 have resulted from the changes in euro area GDP growth.   Chart I-7The Euro Stoxx 50 Moves On Changes In GDP Growth   It follows that what investors really need is not a current activity indicator, but a future activity indicator (FAI). If investors could reliably predict the change in economic activity, then they could also reliably allocate between economically sensitive and defensive investments, as well as to the equity market as a whole.   We have found that a future activity indicator for Europe would contain three components: The domestic 6-month credit impulse. The international 6-month credit impulse, and specifically the 6-month credit impulse in China given the large volume of European exports that head to the largest emerging economy. The crude oil price 6-month impulse, where a price decline constitutes a positive impulse given Europe’s dependence on energy imports. Chart I-8The Drivers Of Europe's Future Activity Indicator Are Losing Momentum Today, we find that the 6-month credit impulse both in the euro area and in China have lost momentum; meanwhile, given the rebound in the oil price, the crude oil price 6-month impulse has clearly faded (Chart I-8). Hence, our future activity indicator suggests that in the second half of this year, euro area GDP growth is unlikely to accelerate much from the current 1.5-2 percent clip.  For investors, this means that this year’s absolute double-digit returns have most likely already been made during the early-2019 star alignment of near-perfect conditions. And the remainder of the year is likely to be much tougher going for all the major asset-classes.  Still, there are always double-digit returns to be found somewhere in the investment landscape. In the second half of the year, the big story will be sector rotation. For example, in recent reports, we highlighted that healthcare is likely to flip from underperformer to outperformer versus technology. Given their sector skews, it follows that European equities are likely to outperform Chinese equities. Fractal Trading System* This week’s recommended trade is based on an oddity. While the majority of stock markets have suffered corrections, New Zealand’s NZX 50 has escaped relatively unscathed so far, making it vulnerable to a corrective underperformance one way or another. Hence, short the NZX 50 versus the FTSE100, and set the profit target and stop-loss at 2 percent. In other trades, short China versus Japan quickly achieved its profit target. Long Nikkei 225 versus Hang Seng was also closed in profit at the end of the 65 day maximum holding period. Against these two profitable trades, long SEK/NOK was closed at its stop-loss. This leaves the Fractal Trading System with four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The precise mix of the portfolio is 29% MSCI World $, 29% German 30-year bund, 29% U.S. 30-year T-bond, 13% WTI. Please see a replay of the webcast ‘From Sweet Spot to Weak Spot’ available at eis.bcaresearch.com. 2  Quarter-on-quarter real GDP growth at annualized rates. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

While the SPX went on an almost uninterrupted run from the Christmas Eve lows to the most recent peak, roughly a 600 point swing, a plethora of anecdotes since early-April signaled that this advance was running on fumes. First came the Barron’s cover “Is the bull unstoppable?” on April 8, then in mid-April Blackrock’s Larry Fink stock melt up headline went viral and on May 1 “Major Wall Street banks were telling clients to be ready for a sudden rip higher in the market”. More recently, UBER priced their IPO, that served as the ultimate anecdote of at least a temporary peak in stocks. Most importantly however, stocks crested the day the Fed concluded its two-day meeting on May 1, and disappointed the markets as the Fed was, at the margin, less dovish than the March meeting. Now that President Trump’s hawkish trade stance re-concentrated investors’ minds, the risk is that heightened uncertainty around a trade deal will push out the global economic growth recovery into early 2020. The implication is that the market will remain volatile and likely continue to seesaw, at least, until the late-June G20 meeting in Japan. Bottom Line: Short term equity market caution is still warranted.    

Highlights Looking past the day-to-day noise of trade-related announcements, we view the underlying odds of an actual trade agreement this year to have fallen below 50%. For the purposes of investment strategy, China-exposed investors should now simply assume that the U.S. proceeds with 25% tariffs on all imports from China. Given this, investors should stop focusing strictly on the odds of trade war, and should instead start focusing on the likely net impact of the tariff shock and China’s inevitable policy response. Simulated and empirical estimates of the impact of a 25% increase in tariffs affecting all U.S.-China trade suggest that economic conditions in China are likely to deteriorate to 2015/2016-like levels. This implies that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. The preference of policymakers is to prevent another significant episode of releveraging, but the constraints facing policymakers suggest that one is unlikely to be avoided. We see a meaningful chance that this tension will be resolved by a classic market “riot” over the coming 3 months as financial markets force reluctant policymakers to capitulate. We would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately respond as needed. We recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. Feature U.S. and Chinese negotiators failed last week to secure an agreement deferring the threatened increase in the second round tariff rate.1 The tariffs increased on Thursday at midnight for goods not already in transit to the U.S. (effectively doubling the existing tariffs), which was followed by the inevitable retaliation by China on Monday (scheduled to take effect on June 1). The retaliation, coupled with President Trump’s earlier warning that China should not do so, was taken by investors as a sign that 25% tariffs on all goods imported from China will soon be in place. As we go to press, the S&P 500, Hang Seng China Enterprises Index, and the CSI 300 are down 3.5%, 7%, and 6.9%, respectively, since President Trump’s May 5 tweet (Chart 1). Chart 1Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Stimulus Minus Shock Holding all else equal, the events of the past two weeks are strictly negative for Chinese economic growth and would thus justify a decisively bearish outlook for Chinese stock prices after the rally that has taken place over the past six months. However, all is not equal, because a substantial deterioration in the export outlook will invariably cause a response from Chinese policymakers. Over the coming few weeks, global investors are likely to remain highly focused on developments and announcements related to the trade conflict. But at this point, our geopolitical team believes that the conclusion of an actual trade agreement this year is now only a 40% probability. This underscores that China-exposed investors should, for the purposes of investment strategy, simply assume that the U.S. proceeds with 25% tariffs on all imports from China, and should broaden their focus to the outcome of a simple formula that describes the potential net outcome of this event. Two simple scenarios concerning this formula are outlined below: Scenario 1 (Bullish): Stimulus – Shock > 0 Scenario 2 (Bearish): Stimulus – Shock ≤ 0 In scenario 1, the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand from the sharp decline in exports to the U.S. In this scenario, investors should actually have a bullish cyclical outlook for China-related assets, even if the near-term outlook is deeply negative. Scenario 2 denotes a bearish outcome where China’s reflationary response is not larger than the magnitude of the shock, which includes a circumstance where the impacts are exactly offsetting (because of the higher uncertainty, and thus risk premium, that this would entail). “Solving” The Formula In order to “solve” this formula, investors need answers to the following three questions: What is the size and disposition of the likely shock to China’s economy in a full-tariff scenario? What kind of reflationary response is required in order to offset this shock? What are the odds that policymakers will deliver the required response? Simulated and empirical estimates of a 25% increase in tariffs affecting all U.S.-China trade suggest a sizeable economic impact. Charts 2 & 3 provide the IMF’s perspective on the first question. The charts show the simulated impact of a 25% increase in tariffs affecting all U.S.-China trade, and they estimate the near-term impact for China to be -1.25% for real GDP (-0.5% over the long-run) and -3.5% for real exports (-4.5% to -5.5% over the long run).   A recent IMF working paper came up with a more benign estimate of the first year impact, but a sizeable second year impact and a similar estimate of the long-term ramifications of tariff increases.2 Using a dataset with wide time and country coverage, the aggregate results of the study imply that Chinese output is only likely to fall about 0.2% in the year following the tariff increase. However, the cumulative shock to output increased sharply to roughly 1.6% in the second year of the tariff increase, with a negative yearly impact to output persisting for 5 years (with an average annual impact of -0.6% over the whole period, somewhat higher than the estimates shown in Charts 2 & 3). At the 90% confidence interval, the author’s estimates show that a tariff increase of this magnitude would imply a -1.7% average impact on output per year in the first two years following the increase. Chart 4The IMF's Shock Estimates Suggest A Serious Hit To China's Economy In order to answer the second question, investors need to have some sense of the relative magnitude of the estimates noted above. Chart 4 provides some perspective and highlights that the estimates above, were they to materialize, would do two things: Taking Chinese real GDP data at face value, it would cause the largest deceleration in China’s real GDP growth rate since 2012, when the economy slowed significantly and authorities responded forcefully. Based on the most recent data for Chinese real export growth, a 3.5% deceleration in export volume would push its growth rate to its lowest level since the global financial crisis. In practice, we doubt that China’s reported real GDP growth rate accurately reflects what occurred in 2015, and it is very possible that a similar deceleration happened in that year. However, economic similarity to the 2015/2016 episode implies that a similar policy response may also be required, a proposition that is supported by our MSCI China Index earnings recession model. Table 1 shows a set of earnings recession probabilities, based on a model that we presented in two recent reports.3 The scenarios express the odds as a function of new credit to GDP and our calculation of China’s export weighted exchange rate, and assume a substantial decline in the new export orders component of the official manufacturing PMI, and flat momentum in forward earnings. Table 1Our Earnings Recession Model Suggests That A 2015/2016 Style Response Is Needed To Counter This Shock The table clearly highlights that a significant further acceleration in new credit to GDP, coupled with a meaningful decline in the exchange rate, is needed in order to stabilize the earnings outlook. We have previously related stability in the outlook for earnings to stability in the economy itself, given the close correlation between Chinese investment-relevant economic activity and the earnings cycle (Chart 5). Given that new credit to GDP peaked at 31.5% during the 2015/2016 episode, it seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. Policymaker Preferences Vs. Constraints This brings us to our third question: What are the odds that policymakers will deliver the stimulus required to confidently overcome the upcoming shock? It seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. If the answer was only dependent on the preferences of policymakers, the odds would be low. China has relied heavily on credit to stimulate its economy over the past decade, and Chart 6 highlights that this has come at a high cost. The BIS’ estimate of the debt service ratio of China’s private non-financial sector is already extraordinarily high relative to other countries, and another round of meaningful re-leveraging will just make this problem even worse. Chart 5Earnings Stability = Economic ##br##Stability Chart 6Further Leveraging Will Undoubtedly Make A Big Problem Even Worse   We documented in detail how this has created the risk of a debt trap for China’s state-owned enterprises in an August Special Report,4 and have presented evidence arguing that China’s policymakers appear to have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption.5 This implies that restraining credit growth to avoid further leveraging has been a reasonable policy objective during periods of relative economic stability. However, policy decisions cannot be made in a vacuum, and this is true even in the case of China. As such, instead of preferences, investors should be focused on policymaker constraints in judging likely policy actions. Given the potential for second round effects, Chinese policymakers need to calibrate their policy response to ensure a positive net impact of the stimulus minus the shock. In our view, three factors point to the conclusion that Chinese policymakers face serious economic constraints in setting their policy response: Charts 2-4 highlighted that 25% tariffs on all U.S.-China trade would constitute a meaningful shock, but it is also the case that this shock would be coming at a time when Chinese economic momentum is already relatively weak. This suggests that policymakers will have to act quickly and decisively to put a floor under economic activity. Charts 7 & 8 suggest that there are meaningful second round effects on Chinese domestic investment from external sector shocks, which raises the possibility that the impact on Chinese economic activity may be larger than Charts 2-4 suggest. Chart 7 shows that while the contribution to official real GDP growth from net exports is small, Chart 8 shows that past changes in net export contribution are reasonably correlated with subsequent changes in the contribution to growth from gross capital formation. While it is possible that this relationship is not actually causal, taking it at face value implies that the IMF’s estimate of the impact on output could be exceeded if the contribution to growth from net exports declines by 0.4% or more (holding the contribution to growth from final consumption expenditure constant). Since 2018’s change in net export contribution declined by three times this amount (1.2%), the downside risks to domestic investment from effectively quadrupling U.S. import tariffs are clear. China does not have a flexible labor market, and its political system is highly sensitive to significant job losses. Chart 9 shows that the employment situation has already seriously deteriorated in lockstep with actual economic activity, further underscoring the need for policymakers to act urgently. Chart 9The Employment Situation Is Already Deteriorating, And Will Do So Further We are open to the idea that policymakers may be able to devise a stimulative response of similar reflationary magnitude to the 2015/2016 episode without resorting to a major credit overshoot, but we are currently unable to articulate what it might be. This is an area of ongoing research for BCA’s China Investment Strategy service, but for now we assume that a credit overshoot remains the ultimate line of defense for China’s policymakers that will be deployed if the pursuit of alternative strategies fail to quickly stabilize economic activity. Investment Strategy Conclusions In our view, focusing on policymaker constraints rather than their preferences is much more likely to guide investors towards the right strategy conclusions over a 6-12 month time horizon. However, in the near-term, policy mistakes can occur, and are much more likely to occur if policymakers react to the imposition of constraints rather than anticipate their arrival. Over the coming three months, we see meaningful odds that Chinese policymakers remain reluctant to allow another episode of significant releveraging in the economy. If we are correct in our assessment of the damage that the tariff shock is likely to cause, this would set up a classic market “riot”, where policymakers are forced by financial markets to capitulate and respond forcefully to the seriousness of the economic situation. Further RMB weakness is likely. Investors should hedge their exposure and go long USD-CNH. Chart 10Investors Have A Green Light To Bet On A Lower RMB Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately deliver the stimulus required to more than offset the upcoming shock to external demand. This means that our long MSCI China Index, MSCI China A onshore index, and MSCI China Growth index trades relative to the global benchmark are explicitly cyclical in orientation, and may suffer meaningful further losses over the coming few months before ultimately recovering. As a final point, Table 1 highlighted that a meaningful decline in the exchange rate is likely required in order to stabilize the earnings outlook. Chart 10 shows that currency weakness persisted well past the trough in relative Chinese investable equity performance during the 2015/2016 episode, and we would expect a similar result in the current environment given the nature of the shock. As such, we recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade today, with high odds of a break above 7 in the coming weeks. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 The first, second, third “round” of tariffs reference the $50/$200/$300 billion tranches of imported goods subject to U.S. tariff announcements since last summer. 2 IMF Working Paper WP/19/9, “Macroeconomic Consequences of Tariffs”, by Davide Furceri, Swarnali A. Hannan, Jonathan D. Ostry, and Andrew K. Rose. 3 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks,” dated January 16, 2019, and Weekly Report “A Gap In The Bridge,” dated January 30, 2019 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” dated August 29, 2018, available at cis.bcaresearch.com. 4  Please see China Investment Strategy Weekly Report “Is China Making A Policy Mistake?,” dated October 31, 2018, available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

The recent simultaneous rise of three asset classes, that we call “the tenuous trio”, warned that something had to give: stocks, bond prices and the trade-weighted U.S. dollar cannot all go up in tandem for an extended period of time. When this happens it is typically a forewarning of an equity market snap. One simple explanation is that a rising greenback comes back and haunts equities via a negative P&L hit, albeit with a lagged effect. Irrespective of where the U.S. dollar will move in the coming months, it will continue to weigh on EPS as the surge in the greenback took root from April to November last year (bottom panel). Thus, with a six-to-nine month lag it will continue to infiltrate EPS and Q2 – which the sell-side already expects to barely breach year ago levels – will also feel the U.S. dollar’s wrath. Were the dollar to continue its ascent from current levels, it would put in jeopardy the back half of this year’s EPS growth numbers, especially Q4/2019 that sell-side analysts forecast to jump to 8%, according to I/B/E/S data. Our top down macro S&P 500 EPS model softened anew recently, warning that mid-single digit growth, at best, is more likely than low double-digit growth. Short term caution on the SPX is still warranted; please see Monday’s Weekly Report for more details.    

Highlights Portfolio Strategy Firming relative demand and input cost dynamics, the Medicare For All (MFA)-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short home improvement retail pair trade is in the early innings. Recent Changes Initiate a long S&P managed health care/short S&P semiconductors trade today, with a tight stop loss at -7%. Table 1 Feature Equities hit a speed bump last week, as President Trump’s trade related tweets instilled some fear back into the markets. Investor complacency reigned supreme and, given the liquidity crunch, risk premia exploded higher with the VIX more than doubling from the recent lows. Historically, a parabolic rise in policy uncertainty is synonymous with an equity market selloff and a widening in risk premia; last week was no different (economic policy uncertainty shown inverted, second panel, Chart 1). Adding insult to injury, given that the forward P/E multiple expansion explained all of the equity market’s advance year-to-date as we highlighted three weeks ago, the trade-related melt up in policy uncertainty caused a mini meltdown in the forward multiple as financial conditions tightened (financial conditions shown inverted, third panel, Chart 1). The implication is that short-term equity market caution is still warranted as we have been writing over the past few weeks, at least until the U.S./China trade dispute dust settles. Chart 1Caution Still Warranted Chart 2Tenuous Trio The recent simultaneous rise of three asset classes, that we call “the tenuous trio”, warned that something had to give: stocks, bond prices and the trade-weighted U.S. dollar cannot all go up in tandem for an extended period of time. When this happens it is typically a forewarning of an equity market snap (Chart 2). One simple explanation is that a rising greenback comes back and haunts equities via a negative P&L hit, albeit with a lagged effect. Irrespective of where the U.S. dollar will move in the coming months, it will continue to weigh on EPS as the surge in the greenback took root from April to November last year. Thus, with a six-to-nine month lag it will continue to infiltrate EPS and Q2 – which the sell-side already expects to barely breach year ago levels – will also feel the U.S. dollar’s wrath. Were the dollar to continue its ascent from current levels, it would put in jeopardy the back half of this year’s EPS growth numbers, especially Q4/2019 that sell-side analysts forecast to jump to 8%, according to I/B/E/S data. This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. Importantly, the 12-month forward EPS number is artificially rising. Chart 3 shows that calendar 2019 and 2020 EPS estimates continue to build a base, but the 12-month forward number has been rising since early-February. What explains the increase in the 12-month forward estimate is arithmetic. In other words, despite a multi-month downgrading of calendar 2019 and 2020 EPS, the first two quarters of next year are forecast to come in significantly higher than 2019’s first six months. As the latter roll off and the former get added to the 12-month forward EPS number, a deceiving jump occurs. For next year, we continue to expect $181 EPS, and we would lean against the double-digit EPS growth in 2020 that the sell-side currently forecasts. Our top down macro S&P 500 EPS model softened anew recently, warning that mid-single digit growth, at best, is more likely than low double-digit growth (Chart 4).   Chart 3Artificial EPS Rise Chart 4SPX Macro EPS Model Forecasts Softness Finally, one of the tech sector’s invincible subgroups is cracking with the S&P semis relative performance hitting a wall both versus the broad market ex-TMT and versus the NASDAQ 100. This is significant not only from a sentiment perspective, but also because semis have high international sales exposure in general and China in particular (Chart 5). Chart 5Vertigo Warning This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. New High-Octane Pair Trade Idea While health care and tech stocks started the year on a similar footing, a wide gulf has opened that is likely to, at least partially, reverse in the back half of the year. This dichotomy is most evident at the subsector level where managed health care stocks are still down in absolute terms for the year, whereas chip stocks are up roughly 20% year-to-date (Chart 6). This is an exploitable gap and today we suggest a new pair trade: long S&P managed health care/short S&P semiconductors. Chart 6Exploitable Reversal Looms Bernie Sanders’ revamped MFA bill sent the managed health care group to the ER. While there is heightened uncertainty surrounding MFA and we are working on a joint Special Report with our sister Geopolitical Strategy service due on June 3rd, this is likely a 2022 story. Not only will Sanders have to win the Democratic candidacy and subsequently the Presidential election, but also the GOP would have to lose the Senate. This is an extremely low probability event that has dealt a massive blow to HMO stocks. On the flip side, semis are priced for perfection. The recent catalyst for this group’s stratospheric rise was Apple’s patent settlement with Qualcomm that set in motion a 5G-related euphoria. Again 5G is a late-2021 story and a lot of good news is already priced in to semis stocks. Moreover, historically, semi cycles last four-to-five quarters and investors’ neglect of the semi downcycle is puzzling as we have recently concluded just two down quarters. Explicitly, what is truly baffling is that 12-month forward EPS are slated to contract in absolute terms and forward sales are hovering near the zero line, yet the Philly SOX index recently vaulted to all-time highs. Taken together, we would lean toward health care insurers at the expense of semiconductor stocks. Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. With regard to relative macro drivers, managed health care has the upper hand. Chart 7 shows that relative demand dynamics clearly favor HMOs and are working against chip stocks. Non-farm payroll growth is trouncing global semi billings. The message from the small business sector is similar with the labor market upbeat compared with declining global semi revenues. Finally, on the relative pricing power gauge front, overall wage inflation is outpacing DRAM prices. On all three fronts, the message is to expect a mean reversion higher in the relative share price ratio. Chart 7Buy Managed Health Care… Chart 8…At The Expense… Input cost/inventory dynamics suggest that HMOs also have the advantage. The health care insurance employment cost index is growing on a par with inflation, but semi industry employment is climbing at a rate over 5%/annum (bottom panel, Chart 8). Taking stock of medical cost inflation, costs are still melting, however global semi inventories are expanding. The upshot is that relative share prices have ample upside (middle panel, Chart 8). Finally, the previous relative valuation overshoot has returned to the neutral zone and, encouragingly, relative technicals are probing multi-year lows near one standard deviation below the historical mean. Importantly, over the past two decades every time our Technical Indicator has hit such a depressed level, a playable rebound in relative share prices has ensued (bottom panel, Chart 9). Chart 9…Of… Chart 10…Semis Nevertheless, this highly volatile market-neutral trade faces one big risk we previously alluded to: relative profit expectations are extended. In other words, the bombed out S&P semiconductor forward EPS and revenue projections are masking the relative profit and revenue backdrop (Chart 10). Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Bottom Line: Initiate a long S&P managed health care/short S&P semis pair trade today with a stop loss at the -7% mark. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively. Homebuilding/Home Improvement Retail Pair Trade Update In late-January we put on a market, sector and subindustry neutral trade preferring homebuilders to home improvement retailers (HIR) as a way to benefit from the increase in residential construction at the expense of residential investment. This trade moved in the black from the get-go and is now generating alpha to the tune of 7% since inception, but more gains are in store in the coming months. President Trump’s hawkish tariff rhetoric should keep interest rates at bay, at least for a short while, and bond market nervousness is more of a boon to homebuilders than to HIR (top panel, Chart 11). The drop in the price of mortgage credit along with minor price concessions from homebuilders are causing sales of new homes to take off versus existing home sales (middle panel, Chart 11). Granted, bankers remain willing extenders of residential loans and the latest Fed Senior Loan Officer Opinion Survey revealed that demand for residential credit is making a comeback following a near yearlong decline (not shown). As a result, relative loan growth metrics also underpin the relative share price ratio (bottom panel, Chart 11). Chart 11Still In Early Innings In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings. Importantly, the new/existing home sales–to-inventory ratio is an excellent leading indicator of relative share prices and is currently emitting an unambiguously bullish signal for homebuilders at the expense of HIR (Chart 12). Chart 12Supply/Demand Backdrop Says Stick With This Pair Trade Chart 13Relative Sales ##br##Expectations… Examining the relative demand backdrop reveals that homebuilders will continue to outshine HIR. Current readings in the NAHB home sales survey versus the remodeling survey and future expectations both point to more gains in the relative share price ratio (Chart 13). The felling in lumber prices also represents a benefit to homebuilders to the detriment of HIR. Lumber is a key building input cost in new home construction so any price liquidation is a boon for homebuilding margins. In contrast, HIR makes a set margin on lumber sales, therefore deflating lumber prices cut HIR profits (Chart 14). Chart 14…Felling Lumber Prices And … Chart 15…Bombed Out Valuations Signal More Relative Share Price Gains Finally, on the relative valuation and technical fronts, there is anything but froth. In fact, the relative price to book ratio is perched near an all-time low and relative momentum has only recently troughed and has yet to reach the neutral zone (Chart 15). In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings.       Bottom Line: Stick with a long S&P homebuilders/short S&P HIR pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P HIR indexes are: BLBG: S5HOME – PHM, DHI, LEN and BLBG: S5HOMI – HD, LOW, respectively.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

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We continue to recommend being overweight global equities and other risk assets over a horizon of 12 months. However, the apparent failure of trade talks between China and the U.S. to gain much traction poses near-term downside risks to our bullish thesis. At this point, our geopolitical team feels that the conclusion of an actual trade agreement this year is a 50/50 prospect. It is easy to envision a scenario where the Trump Administration pursues its “maximum pressure” doctrine in the hopes of wrangling out more concessions. For their part, the Chinese, rather than making sweeping reforms to their legal system as the Trump Administration is insisting, could simply choose to bide their time in the hopes that Joe Biden, an avowed free trader, becomes the next U.S. president. Ultimately, as discussed in this week’s Global Investment Strategy report, in a worst-case scenario where the trade talks break down completely, the combination of aggressive Chinese stimulus and a still-dovish Fed will likely preclude a major global economic downturn. Nevertheless, a 5% correction in global equities from current levels is entirely possible, especially in light of the strong rally since the start of the year. With this in mind, we are putting on a hedge to short the S&P 500 index. We will remove the hedge if stocks fall 5% or trade talks shift in a more positive direction. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

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We continue to recommend being overweight global equities and other risk assets over a horizon of 12 months. However, the apparent failure of trade talks between China and the U.S. to gain much traction poses near-term downside risks to our bullish thesis. At this point, our geopolitical team feels that the conclusion of an actual trade agreement this year is a 50/50 prospect. It is easy to envision a scenario where the Trump Administration pursues its “maximum pressure” doctrine in the hopes of wrangling out more concessions. For their part, the Chinese, rather than making sweeping reforms to their legal system as the Trump Administration is insisting, could simply choose to bide their time in the hopes that Joe Biden, an avowed free trader, becomes the next U.S. president. Ultimately, as discussed in this week’s Global Investment Strategy report, in a worst-case scenario where the trade talks break down completely, the combination of aggressive Chinese stimulus and a still-dovish Fed will likely preclude a major global economic downturn. Nevertheless, a 5% correction in global equities from current levels is entirely possible, especially in light of the strong rally since the start of the year. With this in mind, we are putting on a hedge to short the S&P 500 index. We will remove the hedge if stocks fall 5% or trade talks shift in a more positive direction. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

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Highlights So What? Investors should look to European assets for considerable upside. Why? In the Euro Area, investors have constantly overestimated the angst of the median voter towards the currency union. The European Parliament has few real powers, so a fractured European Parliament does not really matter. Europe’s high-beta economy should benefit from a Chinese and global rebound. Stronger European growth will translate into more credit demand and lower non-performing loans, which will boost bank earnings. Go long European banks as a tactical trade, and long European equities versus Chinese equities as a strategic play. We will also consider going long EUR/USD as a strategic play once we get clarity on potential tariffs. Feature Europe’s economy and asset markets continue to underperform in 2019 despite a global policy pivot away from tightening monetary policy and a solid quarter of Chinese credit growth. Investors are broadly unattracted to continental Europe, regularly voicing fears that it is beset by a combination of hazards: from a no-deal Brexit to the ballooning Target 2 imbalances. According to the latest Bank of America Merrill Lynch survey of fund managers, the most crowded trade remains “short European equities” (Chart 1). The doom and gloom are intriguing considering that China is stimulating its economy and will continue to do so as long as trade tensions are elevated. “Higher beta” equities, including Europe and EM, should benefit from this stimulus (Chart 2). Exports, a key growth engine for the currency union, are closely linked to Chinese credit growth (Chart 3). Chart 2Chinese Stimulus Good For "High Beta" Economies Chart 3Europe Will Benefit From Improving Chinese Growth And yet Europe remains unloved. Given that most client questions focus on the political situation – and that many ask about the upcoming May 23 European Parliament (EP) elections – we focus on both in this analysis. First, we review the latest survey data on the collective sentiment towards Europe and integration. Second, we give our insights regarding the upcoming EP elections. Our broad conclusion is simple. If our house view that global growth is about to bottom is correct, and barring a collapse in U.S.-China trade talks, European assets – primarily equities and the euro – should be the top performers this year.   What Does The European Median Voter Want? The Median Voter Theory is a critical concept for investors. At BCA Research Geopolitical Strategy, we believe that the median voter – not the policymaker – is the price maker in the political market place. Politicians, especially in democracies, are price takers. They are bound by constraints, of which the preferences of the median voter are the most concrete impediments to action. This concept is simple to understand, but difficult to implement. It is far easier to get lost in rumor intelligence-driven analysis of political consultants and journalists who pass on the cocktail party chatter insights gathered through speaking with policymakers. These insights focus on the preferences of the people in power. But their preferences are secondary to those of the median voter. Trust in the EU remains below 50%, but this is in line with or better than the usual trust most governments achieve. Chart 4Support For The Euro Has Been Trending Upwards In the Euro Area, investors have constantly overestimated the angst of the median voter towards the currency union. This has led many investors to keep their money off the table, or take active short positions, even when it was prudent to remain invested. The prime example is the sentiment towards the common currency itself. Support for the euro hit a low in 2013 but has shot up since then across the continent (Chart 4). Even in Italy, the support for the euro is now at an eight-year high. Many investors have remained blind to this empirical fact. Not only has the support for the currency rebounded, but it has done so by converting doubters. Chart 5 shows that the increased support for the common currency – particularly in Spain, Germany, the Netherlands, and Italy – has occurred at the same time as the opposition has fallen. In other words, it is not the “undecideds” that are switching into supporters of the euro, rather it is the opponents who are relenting. Chart 5ASupport For The Common Currency Rising... Chart 5B...As Doubters Convert Chart 6Support For The EU Also On The Rise What of the support for the EU broadly defined? Latest Pew Research polling also shows a strong rebound in support among the public in the largest member states (Chart 6). The last time we published the data – in the summer of 2016 following Brexit – the figures were much lower. Given that for many Europeans the EU is merely another layer of bureaucracy and government, the support level is impressive when put in the international context. Chart 7 shows that the trust in the EU, compared to the trust Europeans have in their own governments, falls somewhere squarely in the middle. When compared to non-European countries, Europeans have considerably more trust in the EU than Americans have in their own government and in line with the sentiment of Japanese towards their own government. In other words, the trust in the EU remains below 50%, but this is in line with or better than the usual trust most governments achieve.   Why has the median voter remained supportive of European institutions despite mixed economic performance? For one, investors – particularly outside continental Europe – continue to overstate how much emphasis Europeans put on “economic prosperity” as a key goal of the integrationist process. Sure, everyone wants a humming economy, but Chart 8 shows that for most large European economies, “peace” and a “stronger say in the world” are more cogent explanations for the EU’s raison d’être than economic performance. Now, a skeptic might argue that this is because the EU has failed to deliver on the promise of prosperity. Nonetheless, the data suggest that Europeans today no longer expect European institutions to focus primarily on economic matters. Geopolitics, particularly security and foreign policy, are not just concerns of the shadowy elites and bureaucrats in Brussels. The median voter is concerned with these matters as well. The one worrying aspect of Chart 8 is that voters in Italy and Spain don’t think the EU means much to them at all. That level of nihilism might be compatible with continued European integration today. However, it also means that both countries, particularly Italy, remain a risk whenever a recession hits. The second reason for the improvement in median voter support of European institutions is that the migration crisis of 2015 – which peaked in October 2015, merely eight months ahead of the fateful referendum in the U.K. – is done and gone (Chart 9). Illegal immigration is an issue of concern, but it has been for over half a century. In fact, every decade has seen a turn against immigration, usually following a recession. It is a recurring problem that will remain a major policy issue for the rest of the century. The path from a “policy problem” to “the end of European integration” is neither direct nor immediate. Third, terrorism has abated as an existential threat to Europe. Chart 10 shows that we have seen the end of the “bull market in terror” in Europe. Unfortunately, the data for that chart only goes to 2017, otherwise it would show an even more jarring collapse in both attacks and casualties. Chart 9The Migration Crisis Is No Longer A Crisis Chart 10The "Bull Market In Terror" Is Over   The chart is also useful in putting the latest bout of terrorism – mainly of the radical Islamic variety – in its proper historical context. Europe has been riven with far left and nationalist terror (often both) since the late 1960s. The number of casualties per year in the 1970s was nearly two times greater than the peak of the recent bout of radical Islamic terror. This is largely the case even excluding the Troubles in Ireland and Northern Ireland. There is simply no evidence that the European median voter is moving towards Euroskepticism. Although it is difficult to make the connection, we would go on to posit that the abating of the migration crisis and bull market in radical Islamic terror has allowed the median voter in Europe to assess whether breaking apart the EU would truly resolve these crises. Elements of European integration, particularly the common labor market and Schengen Agreement – which is part and parcel of the integrationist evolution – definitely make it easier for migrants and terrorists to cross borders. However, the geopolitical forces that breed both are at least partly, if not completely, non-European in origin. As such, it is not clear how individual European countries that lack any hard power would deal with these events on their own. Thus European integration is not a policy born of strength but of weakness. Chart 11 illustrates this concept empirically. It shows the percent of respondents who think their country could better face the future outside the EU. The dotted line represents the pessimistic view. An astounding 87% of Dutch responders, for example, are pessimistic about the country’s future outside the EU. We pick on the Dutch because they have tended to vote for Euroskeptic parties. Similarly, a very high number of Germans, Finns, Swedes, French, and Spaniards are lacking confidence in “national sovereignty.” Only the Italians are flirting with “going it alone,” although even in their case the momentum for sovereignty appears to have stalled, as it has in traditionally Euroskeptic Austria. Chart 11AEuropeans Lack Confidence In National Sovereignty... Chart 11B...And Believe They Are Better Off Sticking Together Many investors approach European integration with an ideological slant. But charts don’t lie. Since we founded BCA Research Geopolitical Strategy, we have used Euro Area perseverance as the premier example of how an empirically-driven approach to political analysis can generate alpha. There is simply no evidence that the European median voter is moving towards Euroskepticism. A broad trend has existed since 2013 of rising support for the common currency, the euro. And a mini up-cycle in support for broader European institutions appears to be present since 2016, probably due to the combination of Brexit, an abating migration crisis, and the end of the bull market in terror. Bottom Line: The median voter supports both the euro and broad European integration. This is an empirical fact. But … Euroskeptics Are Winning Seats! Chart 12Anti-Establishment Parties Are Gaining Seats Despite the comfort of our empirical data, the reality is that anti-establishment parties continue to increase their share of parliamentary seats across the continent (Chart 12). In the recent Spanish election, for example, the populist Vox managed to win 10.3% of the vote. Headlines immediately picked up on the extraordinary performance, noting that Euroskeptics have finally established a foothold in Spain. Spanish Prime Minister Pedro Sánchez, the leader of the victorious Socialist Party, has welcomed the characterization as a foil to his program, promising to build a pro-European bloc with other left-leaning parties. Sánchez is playing politics. He understands how broadly European integration is supported in Spain and is trying to paint his opponents – who disagree with him on many issues, but not on Spain’s membership in the EU and EMU – as being on the other side of the median voter’s preferences. In reality, Vox is not a hard Euroskeptic party. It is right wing on immigration, multiculturalism, and the centralization of the Spanish state, but on Europe Vox merely wants less integration from the current, already highly integrated level. Anti-establishment parties are realizing that the median voter does not want to abandon European integration. As such, the right-leaning anti-establishment parties are focusing on anti-immigrant and anti-multicultural policies, while the left-leaning are focusing on anti-austerity politics. But there appears to be an emerging truce on integration. We forecast this transition in our 2016 report titled “After Brexit, N-Exit?” We posited that anti-establishment parties would increasingly focus on anti-immigration policies, while reducing the emphasis on Euroskepticism, in order to remain competitive. We now have a number of examples of this process, from Italy’s Lega to Finland’s the Finns Party. Which brings us to the election at hand: the EP election on May 23. Ironically, the EP election gives Euroskeptics the best chance at winning seats. First, the turnout has been falling for decades (Chart 13) given the dubious relevance of the legislative body (more on that below). Second, Euroskeptic voters tend to be highly motivated during EP elections as they get to vote “against Europe.” Third, ironically, EP elections allow Euroskeptics to build pan-European coalitions with their fellow skeptics. Despite the hype, the latest seat projections give Euroskeptics merely 26% of the seat total in the body, or just under 200 seats in the 750-seat body (Diagram 1). Chart 14 shows that the support for Euroskeptics has actually taken a serious dip following the Brexit referendum, with the overall continent-wide support remaining around 20%. This is broadly the same level at which the support was five years ago, giving Euroskeptic parties no gain in half a decade. Diagram 1Euroskeptics Expected To Hold Only A Quarter Of The Seats All that said, if a fifth of Europe’s electorate is voting for anti-integrationist parties in the midst of the most important European-wide election, that must be a bad sign for Europe. Right? Wrong. The media rarely unpacks the Euroskeptics beyond citing their overall support figures. However, we have gone beyond merely citing the three leading Euroskeptic blocs. Instead, we have separated the individual Members of European Parliament (MEPs) from across the three Euroskeptic blocs into four camps: Eastern European Camp – These are MEPs from EU member states that are former members of the Warsaw Pact or former Republics of the Soviet Union. Hardcore Camp – These are committed Euroskeptics who genuinely want their countries to leave European institutions. The Dutch Party for Freedom wants to see the Netherlands leave both the EU and the EMU. However, parties such as the Swedish Democrats and the Finns Party are more nuanced. Nonetheless, we erred on the side of apocalypse and added them all to the hardcore camp. Classical Camp – These are MEPs who would have fit the Euroskeptic definition back in the 1990s. They generally do not have a problem with the EU, but tend to be skeptical of the EMU and definitely do not want to see any further integration (although some would welcome integration on the military front). Italy’s Lega belongs to this camp, at least since the 2017 election, given the reorientation of the party’s policy away from criticizing the EMU and toward anti-immigrant policies.  On The Way Out Camp – The U.K. MEPs will eventually be forced to exit the EP given the eventual departure of the U.K. from the EU. In this camp, we have thrown all the U.K. MEPs who sit in Euroskeptic groupings, which includes both UKIP MEPs and Conservative Party members – even those who are not actually anti-EU. Diagram 2Almost Three Quarters Of Euroskeptic MEPs Are Bluffing Diagram 2 shows the distribution of the currently 311 Euroskeptic MEPs. The largest portion, by far, are Eastern European MEPs. The second-largest portion are MEPs from the U.K., who are either on their way out or about to become the “lamest ducks” in the history of any legislature. What does this mean? First, that almost three quarters of the Euroskeptic MEPs are essentially bluffing. Eastern European Euroskepticism is a geopolitical oxymoron. Investors should ignore any Euroskeptic rhetoric from Eastern Europe for two reasons. First, many Eastern European economies remain highly dependent on the EU for structural funding (Chart 15). But even that crude measure does not illustrate the benefit of EU membership. If Eastern and Central European countries were to leave the EU, they would lose access to the common market, a huge economic cost given their close integration with the German manufacturing supply chain. Second, and perhaps more importantly, the EU is a critical geopolitical anchor for the former Warsaw Pact member states. As much as the Polish and Hungarian Euroskeptic MEPs like to speak of the “tyranny of Brussels,” they all remember all too clearly the actual tyranny of Moscow. As such, Eastern Europe’s Euroskepticism is a bluff, a rhetorical political tool to blame the ills of poor governance on Brussels for the sake of domestic political gains. It holds no actual threat to European integration or its institutions given that the alternative to Brussels is… Moscow. This is why the three Euroskeptic blocs will find it difficult to cooperate in the future. The Eastern European-heavy European Conservatives and Reformists (ECR) are highly skeptical of Russia, as the largest party in the bloc is the Polish Law and Justice (PiS) Party. The PiS is highly critical of Moscow’s foreign policy and is the ruling party of Poland. Its rhetoric is on occasion illiberal and anti-EU, but it has also changed domestic policy when pressured by Brussels. The ECR is expected to be the smallest Euroskeptic party, with 55 MEPs. The genuinely hard-core Euroskeptic bloc is the Europe of Nations and Freedom (ENF). It is expected to win 58 MEPs and is dominated by genuine, long-time, anti-EU parties such as Marine Le Pen’s National Rally of France (formerly the National Front) and the Dutch Party for Freedom. However, its latest iteration is likely to be dominated by Matteo Salvini’s Lega, which is Italy’s ruling party and has taken a decided turn towards soft Euroskepticism. Finally, the moderately Euroskeptic Europe of Freedom and Direct Democracy (EFDD) is expected to win 57 seats. However, its largest bloc are the ruling Italian Five Star Movement (M5S) and an assortment of Euroskeptic British MEPs, including Niger Farage. Italy’s M5S has already toned down its Euroskeptic rhetoric given that it now sits in Rome and runs the EMU’s third-largest economy. Meanwhile, U.K. MEPs will be largely irrelevant, raising the question of whether EFDD should even be classified as Euroskeptic in the next EP. Bottom Line: When all is said and done, the European Parliament election is a much-hyped non-event. By our count, only about 60 out of approximately 190 Euroskeptic MEPs will be actual hard-core Euroskeptics (or, just 8% of the entire EP). The rest are either reformed centrists – the two major Italian parties, Lega and M5S – on their way out – U.K. Euroskeptics – or are just bluffing – all Eastern European MEPs. That said, the EP seat distribution will reflect the polarization and fracturing observed in most national parliaments across of Europe. It is likely that neither the center-left nor the center-right will have enough seats to select the European Commission President. Does Any Of This Even Matter? Does the EP election even matter? To answer this question, we first have to assess whether the European Parliament itself matters. Both the proponents and opponents of the EU overstate the bloc’s supranational institutions: the EP and the Commission. A fractured European Parliament does not really matter ... In fact, the European Parliament has few real powers. The true power in the EU is vested in the European Council. The European Council could be conceived of as an upper chamber of a combined EU legislature, the Senate to the European Parliament’s House of Representatives (to put into U.S. context). It is comprised of the heads of government of EU member states and is therefore elected on the national, not supranational, level. It is, by far, where most power resides in the EU. The Commission, on the other hand, is the EU’s technocratic executive. Its members are not democratically elected, but are chosen by the European Council and approved by both the Council and the EP.1  The EU Commission President is elected according to the Spitzenkandidat system. The party grouping that secures a majority governing coalition in the EP gets to name their leader as the candidate for the European Commission President. This system is not enshrined in EU law, it is merely a convention. In fact, it was designed to try to boost the voting turnout for the EP elections. The idea being that Europe’s voters would turn out to vote if it meant that their votes would ultimately determine who gets to head the European Commission. At the end of the day, the European Council has to approve the Spitzenkandidat. And, according to the letter of the law, the European Council can ultimately even ignore the Spitzenkandidat suggestions of the European Parliament and propose their own head of the European Commission. As such, the fact that Diagram 1 suggests a fractured European Parliament does not really matter. The European Council could, in the end, simply find a consensus candidate and have national governments instruct their MEPs to vote for that candidate in the EP. In fact, the European Parliament has few real powers. It is one of the only legislatures in the world with no actual legislative initiative (i.e., it cannot produce laws!). It gets to hold a ceremonial vote on new EU treaties – the treaties that act as a constitution of the bloc – but cannot veto them. On most important matters – including the EU budget – the Parliament cannot overrule the European Council (the heads of national governments), which means that it cannot subvert the sovereignty of the EU member states. In the political construct that is the EU, it is the upper-chamber that holds all the power (if we are to extend the analogy of the European Council as the “Senate”). Another important thing to remember is that MEPs are rarely unaffiliated. The vast majority are members of national parties on the national level. Few, if any, are actual supranational agents. In fact, most MEPs fall into two categories. They are either young up-and-comers being groomed for a successful career on the national level – the level that actually matters – or they are past-their-expiration-date elders looking for a cushy retirement posting that includes frequent, taxpayer-funded, trips between Brussels and Strasbourg.  Bottom Line: The importance of the EP is vastly overstated by both Europhiles and Euroskeptics. Its role within the EU legislative process has been increasing through treaty evolution and convention. However, the true power in the EU still rests with the national governments and the EP can be sidelined if the European capitals so desire. Furthermore, while the EP is a supranational body with supranational powers, its soul is very much national. This is because most of its MEPs either have an eye on returning to domestic politics or are emeriti of domestic politics looking for one last bout of relevance. Investment Implications Given our sanguine view of European politics, and the BCA House View that global growth should bottom (Chart 16), investors should look to European assets for considerable upside. This is particularly the case if the U.S. and China overcome their cold feet and conclude a trade deal. Our colleague Peter Berezin, BCA’s Chief Investment Strategist, has proposed that investors go long European banks as a tactical trade. Peter has pointed out that banks are now trading at distressed valuations (Chart 17).2  Given a Chinese and global rebound, and barring a total relapse into trade war, Europe’s high-beta economy should benefit, leading to higher bond yields in core European markets.This has tended to help European bank stocks in the past (Chart 18). Stronger economic growth will also translate into more credit demand and lower non-performing loans. This will boost bank earnings (Chart 19). Chart 16Growth Is Recovering In The U.S. And China Chart 17European Banks: A Good Value Play Chart 18Euro Area: Higher Bond Yields Bode Well For Bank Stocks Chart 19More Credit, Fatter Bank Earnings In addition, U.S. dollar outperformance is long-in-the-tooth. If global growth is truly bottoming, and assuming a trade deal is done,  then the policy divergence that has favored the greenback should be over (Chart 20). As such, we will consider going long EUR/USD as a strategic play once we get clarity on China tariffs and potential tariffs on U.S. auto imports (the latter risk is rising from 35% to 50% given Trump’s willingness to take risks this year). Chart 20If Trade War Subsides, Dollar May Fall Chart 21A Reversal In Tech Outperformance Supports Long Europe/China Finally, Dhaval Joshi, BCA’s Chief European Strategist, believes that Europe is a clear tactical overweight to China.3 Part of the reason is that the two markets are mirror opposites of each other in terms of sector skews. China is overweight technology and underweight healthcare, while Europe is overweight healthcare and underweight technology. The year-to-date outperformance by global technology stocks relative to healthcare is long in the tooth and ripe for a correction (Chart 21). Given our positive structural assessment of European political risk, we recommend going long European equities and short China as a strategic play.   Marko Papic Consulting Editor marko@bcaresearch.com Footnotes 1      For the American context, the Commission would be what the various U.S. Departments would look like if they were serving at the pleasure of the U.S. Senate. While the analogy is not perfect, it does capture the fact that the EU’s executive is controlled by the European Council. 2      Please see BCA Global Investment Strategy Weekly Report, “King Dollar Is Due For A Breather,” dated April 26, 2019, available at gis.bcaresearch.com. 3      Please see BCA Research European Investment Strategy Weekly Report, “Suffering Market Vertigo,” dated May 2, 2019, available at eis.bcaresearch.com.