Elections

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

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

Highlights Stay short the rand. The South African currency has broken down, and further downside is looming. The rand is cheap for a reason. A lack of import substitution has hampered the benefits of a depreciated currency for the economy. The trade balance will deteriorate as metals prices drop due to growth deceleration in China. Lingering political uncertainty, a poor structural backdrop and reliance on foreign portfolio flows that are at risk of reversal all argue for material downside in the rand's value from current levels. Dedicated EM equity and bond portfolios should continue to underweight South Africa. Feature The South African rand posted an impressive rally in 2016 and early 2017, despite the economy's technical recession (Chart I-1). Yet recently, the rand has started breaking down, despite domestic demand data showing modest improvement. We have argued in the past that lower commodities prices and rising U.S. interest rates along with a negative political backdrop and a weak economy would put downward pressure on the rand. However, domestic demand has recently ticked up, and according to our broad money (M3) impulse, domestic demand will likely continue to improve modestly in the next several months (Chart I-2) - barring the intensifying political headwinds hurting business and consumer sentiment. The M3 impulse is the second derivative of outstanding broad money M3. Chart I-1South Africa: ##br##Economy And Currency South Africa: Economy And Currency South Africa: Economy And Currency Chart I-2South Africa: Modest ##br##Upside In Domestic Demand South Africa: Modest Upside In Domestic Demand South Africa: Modest Upside In Domestic Demand Therefore, today we are posing the following question: Can South African risk assets sell off even as domestic demand continues to recover moderately? Our answer is yes. The basis is that the balance of payments (BoP) is set to deteriorate again. What Drives The Rand? The narrative that a high carry will support high-yielding EM currencies including the rand is misplaced. Chart I-3 illustrates that there has been no positive correlation between the rand's exchange rate and its short-term interest rate differential with those in the U.S. Notably, neither the level nor direction of interest rate differential correlates positively with the value of the rand. If anything, it is the exchange rate that drives interest rates in South Africa and in many high-yielding EM markets, not the other way around. The bottom panel of Chart I-3 demonstrates that the rand's appreciation typically leads to lower interest rates, and vice versa. While in the near term the rand could be under pressure from rising U.S. interest rate expectations and a U.S. dollar rebound, the currency's medium-term outlook will continue be shaped by commodities prices. Chart I-4 demonstrates that the rand's exchange rate is strongly correlated with industrial and precious metals prices. Chart I-3Rand Drives Interest ##br##Rates Not Other Way Around Rand Drives Interest Rates Not Other Way Around Rand Drives Interest Rates Not Other Way Around Chart I-4Rand Is Correlated ##br##With Metal Prices Rand Is Correlated With Metal Prices Rand Is Correlated With Metal Prices The fundamental basis for rand depreciation going forward is a worsening BoP: Industrial metals prices will drop as China's growth slows (Chart I-5). Meanwhile, a moderate pick-up in domestic demand will lead to rising imports and a deteriorating trade balance (Chart I-2, bottom panel on page 2). Precious metals prices will also be under pressure in the near term as U.S. interest rate expectations rise, supporting the U.S. dollar. In fact, the most reliable factor driving gold prices has historically been U.S. real (TIPS) yields (Chart I-6). Chart I-5China's Money/Credit Impulses ##br##Are Bearish For Industrial Metals bca.ems_sr_2017_11_15_s1_c5 bca.ems_sr_2017_11_15_s1_c5 Chart I-6Gold Is Driven By U.S. ##br##Real Rates (TIPS Yields) Gold Is Driven By U.S. Real Rates (TIPS Yields) Gold Is Driven By U.S. Real Rates (TIPS Yields) We expect the rand to depreciate considerably and make new lows against the euro and European currencies. This will contrast with what occurred in 2014-'15, when the rand's depreciation versus the euro and European currencies was much less pronounced than versus the dollar. Chart I-7Foreigners Are Record ##br##Long South African Bonds Foreigners Are Record Long South African Bonds Foreigners Are Record Long South African Bonds As the rand falls versus the majority of DM currencies, foreign investors will be prompted to reduce their holdings of South African local currency bonds and equities. Given foreigners own 42% of the country's local government bonds (Chart I-7, top panel), the bond market will sell off further, and outflows could be meaningful. Another angle to consider is whether a revival in domestic demand would be enough to offset the above negatives and attract enough foreign capital to finance the BoP. In our opinion, not this time around. First, any domestic demand recovery in South Africa will be muted. Given lingering political uncertainty, upside in business spending and job creation will remain subdued. Notably, risks are skewed to the downside for domestic demand due to lingering political uncertainty. Second, in 2016 the rand rallied considerably, even as domestic demand was falling. During 2016 and early 2017, the rand was supported by external forces such as rising metals prices and capital flows to EM. In turn, weakening domestic demand induced an imports contraction, helping the trade balance. Presently, all of these factors are reversing. Finally, portfolio flows have been much more important than FDIs for South Africa in recent years (Chart I-8). This implies that as portfolio flows dry up, FDIs will not finance the BoP. Bottom Line: South Africa's BoP dynamics are set to deteriorate markedly, leading to a major currency downleg. Is The Rand Cheap? A Look At Import Substitution Our valuation measures show that the rand is one standard deviation cheap (Chart I-9). Chart I-8South Africa: FDI Versus Portfolio Flows South Africa: FDI Versus Portfolio Flows South Africa: FDI Versus Portfolio Flows Chart I-9The Rand's Valuation Profile The Rand's Valuation Profile The Rand's Valuation Profile However, we believe it is "cheap for a reason." Structural forces have been and remain currency bearish. Chart I-10No Import Substitution In South Africa No Import Substitution In South Africa No Import Substitution In South Africa A cheap currency leads to import substitution - i.e., domestic producers become more competitive than foreign ones, and they replace imports with locally produced goods. This in turn improves the trade balance and boosts domestic jobs and income. Stronger output growth and higher return on capital allow the economy to withstand higher interest rates. Rising return on capital and interest rates attract foreign capital (both portfolio inflows and FDI), leading to currency appreciation. In South Africa, the inherent problem is that despite substantial weakness in the currency since 2011, there has been very little import substitution. This is true across the most basic types of goods that do not require sophisticated production methods such as footwear, plastic, rubber products and textiles (Chart I-10). Astonishingly, this has continued to hold true even after the collapse of the rand in 2015 to two-standard-deviations below its fair value. Given import substitution has not materialized, economic growth has not benefited much from a depreciated currency, and all the usual drivers that typically mark a bottom in the exchange rate and jump-start sustainable currency appreciation are thus still lacking. Hence, the rand will have to stay cheap. Interestingly, in the absence of a shift from foreign to locally produced goods, a recovery in domestic demand will boost imports, benefiting foreign producers relative to local ones - i.e., "leaking" growth to the rest of the world. Bottom Line: An ongoing lack of import substitution in South Africa has been due to lingering structural malaise. Therefore, the rand will have to stay structurally cheap. Productivity Demise It is not surprising that import substitution has been non-existent, given the demise of productivity within the South African economy. When assessing competitiveness, it is essential to analyze a country's unit labor costs in U.S. dollar terms. South African unit labor costs in U.S. dollar terms have risen by 50% in the manufacturing sector, and by 160% in the overall economy since 2000 (Chart I-11). Chart I-11Comparative Unit Labor Costs In US$: ##br##South Africa & U.S. Comparative Unit Labor Costs In US$: South Africa & U.S. Comparative Unit Labor Costs In US$: South Africa & U.S. For comparison, in the U.S., overall non-farm unit labor costs in U.S. dollars have risen by 20% since 2000, and have been more or less flat in the manufacturing sector. In brief, in the past 17 years, unit labor costs in U.S. dollar in South Africa have risen substantially more than in the U.S. There are also other ramifications of lingering productivity malaise: First, in South Africa, fiscal and monetary stimuli typically widen the current account deficit more than in countries where manufacturing is able to compete with global manufacturers. Second, inflation dynamics in South Africa are even more sensitive to exchange rate movements. A large share of imports for domestic consumption ensures that South African inflation remains correlated with the exchange rate rather than with the domestic business cycle. Third, for monetary policy, the South African Reserve Bank (SARB) has been forced to pursue more pro-cyclical monetary policy - raising rates when metals prices drop and the rand depreciates. Higher interest rates amid a negative terms-of-trade shock - i.e. falling metals prices - has historically reinforced boom-bust cycles in the South African economy and created less visibility for domestic investments, further hindering long-term growth. That said, there are presently low odds that the SARB will hike rates materially, even if the rand drops substantially. The monetary authorities did not significantly cut rates amid the rand's rally in 2016-'17. Hence, odds of rate hikes are low, which heralds yield curve steepening. Bottom Line: Poor productivity has been and remains a major constraint on South African growth and a major drag on the currency. An Update On Politics The December African National Congress (ANC) presidential election is around the corner, and it is worth asking if any positive outcome for the economy and markets may emerge. We do not expect so. At this point, there are two scenarios to consider. The first is that current Deputy President Cyril Ramaphosa wins. Given his recent strong performance in key swing provinces and lack of competition from Nkosazana Dlamini-Zuma, Ramaphosa has decent chances of winning the ANC presidency. However, as our colleagues from the Geopolitical Strategy service argued, the structural reality is that the median voter in South Africa is not in a position to support a pro-market reformer willing to pursue painful structural reforms.1 In a system where policymakers are price takers in the political marketplace and not price makers, even if Ramaphosa wins, he is unlikely to address the majority of South Africa's lingering structural issues in a meaningful way. Furthermore, the rising popularity of the left-wing radical Economic Free Fighters, led by ex-Youth League Leader Julius Malema, will also be a constraint on Ramaphosa in terms of enacting supply side reforms. The second scenario is that Ramaphosa does not win, in which case he and his supporters could split from the ANC and perhaps form a new party with the Democratic Alliance (DA). It is hard to tell at the moment what this scenario would entail for the general elections in 2019. Historically, given the ANC's stronghold on the country's politics, the winner of the ANC Congress has moved on to become President of South Africa. However in the event of an ANC split, some revaluation of the political landscape would be required. Regardless of who wins the elections in 2019, a general lack of appetite for structural and painful reforms point to fiscal policy remaining lax - and being used to boost growth (Chart I-12). At 51% of GDP, the public debt burden is not yet at alarming levels. In the meantime, easy or easing fiscal stance will continue to put downward pressure on the rand. Bottom Line: Odds of structural reforms are low, regardless of who wins the December elections. Fiscal policy will remain easy, and public debt will continue to rise. This is a bad omen for the currency. Investment Recommendations We continue to recommend the following strategy: Continue shorting the ZAR versus the USD. The rand has broken down from a key resistance level, and has much more downside (Chart I-13). Chart I-12South Africa: Fiscal Deficit Is Wide South Africa: Fiscal Deficit Is Wide South Africa: Fiscal Deficit Is Wide Chart I-13The Rand: A Breakdown The Rand: A Breakdown The Rand: A Breakdown Underweight South African domestic bonds and sovereign credit relative to their EM benchmarks. Sovereign spreads have hit a strong technical resistance and are starting to bounce off (Chart I-14). Continue betting on yield-curve steepening. A lack of economic vigor will keep the SARB on hold for now, yet the country's populist fiscal stance and withdrawals by foreigners from the bond market will push up long-dated bond yields. For EM local fixed-income portfolios, we maintain the following trade: short South African and Turkish 5-year bonds / long Polish and Hungarian ones. Lastly, a few words on the stock market: Our cyclically-adjusted P/E ratio for the MSCI South Africa equity index suggests that this bourse is one standard deviation expensive (Chart I-15, top panel). Chart I-14South Africa: Sovereign Spreads ##br##To Move Above EM Benchmark South Africa: Sovereign Spreads To Move Above EM Benchmark South Africa: Sovereign Spreads To Move Above EM Benchmark Chart I-15South African Equites: ##br##Valuation & Technicals South African Equites: Valuation & Technicals South African Equites: Valuation & Technicals Interestingly, the relative performance of this bourse versus the EM benchmark might be on a precipice of a major breakdown (Chart I-15, bottom panel). Continue underweighting South African stocks. Chart I-16Banks To Outperform As Yield Curve Steepens Banks To Outperform As Yield Curve Steepens Banks To Outperform As Yield Curve Steepens As to sectors, we recommend an overweight position in banks and materials. A steepening yield curve typically benefits bank stocks (Chart I-16), while materials will in turn benefit from a depreciating currency. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to BCA Geopolitical Strategy Special Report titled, "South Africa: Crisis Of Expectations," dated June 28, 2017, link available at gps.bcaresearch.com

Highlights Catalonia is a red herring - stay focused on U.S. tax cuts; Tax cuts are on track and will swell the budget deficit; The dollar is poised for a comeback; Believe the Phillips Curve, not the "Amazon effect"; Shinzo Abe's gamble is bullish; go long USD/JPY. Feature Global investors woke up on Monday to shocking news of a mass shooting in Las Vegas and police brutality in Catalonia, where Spain's federal law enforcement attempted to break up the October 1 independence referendum. According to final figures, nearly 92% of those who voted chose to separate from Spain, setting the stage for a unilateral declaration of independence. Our views on the Catalan independence "struggle" are well known to our clients.1 We will only briefly recap them here. Instead, we focus this Weekly Report on the prospects for the U.S. dollar and on Japan's snap election. Catalan Independence: Indignation Is Not A Strategy Why are we so dismissive of the imbroglio in Catalonia? Five reasons: Police "brutality" is overstated: Catalan officials reported that 844 people had been hurt in clashes, but the BBC noted that the "majority had minor injuries or had suffered from anxiety attacks."2 Not the first referendum: The turnout was only 42.34%, as many voters refused to participate. Given that the latest polls show that only 34.7% of Catalans actually want independence, the result was unsurprising (Chart 1).3 Those who oppose independence from Spain stayed home, as they did in 2014. In fact, Table 1 shows that there were about 100,000 less "yes" voters in 2017 than three years ago. Catalonia is not Catalan: According to the latest data from the Institut d'Estadística de Catalunya, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish. This is a product of decades of migration from within Spain which has diluted Catalonia's homogeneity. For the most part, the non-Catalans belong to the working class and do not get involved in independence protests or in breathlessly tweeting about the return of dictatorship to Madrid. But if they sense that independence is being imposed on them by an elitist minority, they could let their voice be heard. A declaration of independence means nothing: A unilateral declaration without international support, or the ability to enforce it with arms, is vacuous. U.S. President Donald Trump lent his support to Spanish Prime Minister Mariano Rajoy ahead of the vote, while French President Emmanuel Macron reiterated his support for Madrid following the referendum violence. The EU has made it clear that an independent Catalonia would have to go through the accession process in order to enter the EU, which means it would not have access to the Common Market post-independence. Catalans will not resort to force en masse: Our expectation is that Catalans will not resort to force in order to breakaway from Spain. German sociologist Max Weber famously defined sovereignty as a "monopoly over the use of legitimate force" in a defined geographical territory. If a Catalan minority is unwilling to wrestle control of borders from Spain, its declarations will be irrelevant. Chart 1Catalonia: A Revolt By The Minority Catalonia: A Revolt By The Minority Catalonia: A Revolt By The Minority Table 1What Has Changed Since 2014? Is King Dollar Back? Is King Dollar Back? There is more to the referendum than the government in Catalonia is letting on. The Junts pel Sí (Together for Yes) coalition of four parties is unified only by its stance on independence. But the main two nationalist parties that make up the government are on the opposite sides of the ideological spectrum. Without the independence push, the regional government would lose its raison d'être and fall. From the market perspective, the situation in Catalonia would become relevant if the Catalan government, or militant groups in the region, decided to step up tensions by employing force. This could derail Spain's economic recovery, especially since so much of it was centered on manufacturing in the region. We do not see this as likely. First, there are no "militant groups" in Catalonia. Second, throughout the half-century long Basque conflict - which saw over thousand people killed between 1959 and 2011 - Catalonia never experienced violent unrest. Catalan extremists never got inspired by the militant Basque group ETA on any significant scale. Why? Because the independence movement in Catalonia is mainly a bourgeois, middle and upper class, "struggle" for independence that is unlikely to descend into violence. Yes, there are some farmers and blue-collar supporters of independence. But the majority of Catalonia's working class are actually not Catalan. They are either recent migrants from the rest of Europe or migrants from poorer regions of Spain. Not only are they opposed to independence, but they are openly hostile to a bourgeois minority lording their Catalan ethnic superiority over the recently arrived migrants. With Catalan tensions, the ongoing North Korean saga, and the recent tragedy in Las Vegas, there is plenty to distract investors from the most investment-relevant political issue: U.S. tax policy. Bottom Line: As we noted in February, European assets will continue to "climb the wall of worry," which includes Catalan tensions.4 Investors should fade any market reaction to the crisis in Catalonia, which is sure to dominate the news flow for at least the entirety of Q4 2017. Do Republican Voters Want Tax Cuts? The market was shocked at the end of September by President Donald Trump's tax reform plan. After months of doubting whether Republican policymakers can accomplish anything, the market reacted positively to the announcement (Chart 2). And yet a lot of skepticism remains. Primarily, the fear is that fiscally conservative Republicans in the House and Senate will stand in opposition to the plan. After all, Republicans have just failed to repeal and replace Obamacare. Why should tax policy be any different? Chart 2Sign Of Life For 'Trump Reflation' Sign Of Life For "Trump Reflation" Sign Of Life For "Trump Reflation" We have argued since November that Republicans in Congress are actually not fiscally responsible.5 Not now and not ever. As if on cue, this spring, the leader of the Tea Party-linked Freedom Caucus, Mark Meadows (R, NC) said that the upcoming tax reform effort did not have to be "revenue-neutral," a claim he repeated on NBC's Meet The Press this weekend. If the leader of the single-most fiscally conservative grouping in Congress is okay with profligacy, who is left to oppose it?!6 Republican voters might have something to say about deficit-busting tax legislation. But GOP legislators are not the only ones willing to compromise on their austerity rhetoric. Republican voters are just as comfortable with profligacy. Chart 3 speaks volumes. It shows that Americans become a lot more comfortable with a bigger government providing more services when Republican presidents are in power. Given Democrats' stable preference for more spending, the movement in the poll is mainly due to Republican and independent voters. There are two ways to interpret the data: Republican voters do not mind a profligate government, as long as the spending is aligned with their priorities. Republican voters do not actually disagree with Democrats on spending priorities, but merely doubt that Democratic policymakers can deliver on those priorities in a fiscally sustainable manner. Whatever the explanation, Chart 3 is clear evidence that the American public grows more comfortable with profligacy when Republicans are in charge. But do voters want tax cuts? The latest polls show that Americans no longer think that they pay too much in taxes (Chart 4). Republican and Republican-leaning voters do not have a problem with how much they pay in taxes, but they do have a problem with the complexity of the tax code (Chart 5). Chart 4American Voters Think Taxes Are Fair... Is King Dollar Back? Is King Dollar Back? Chart 5...But Republican Voters Think They Are Too Complex Is King Dollar Back? Is King Dollar Back? The charge that the Trump tax legislation will be a massive tax cut for the wealthy and corporations could stick with some voters, we think primarily with Democrats. Pew research polling consistently shows that Democrats, across the income brackets, agree by 70%-80% that corporations and wealthy people pay too little tax. Republican voters could be susceptible to the same argument, given that around 35%-45% of them agree with Democrats on this issue. To preempt the debate, the Trump administration is focusing heavily on tax complexity. In addition, Trump left the proposed surcharge on the wealthy - a fourth income bracket in the new plan - as yet undefined. This is on purpose. It allows the White House and Congressional GOP legislators to respond to the criticism as it develops. What could be the stumbling blocks going forward? A "Breitbart clique" revolt: A populist revolt against tax cuts for the rich could turn skittish Republicans in Congress against the legislation. The recent electoral defeat for the political establishment in the Alabama Senate primary has shown off the power of the "Breitbart clique" in itself, independent of Trump. However, a quick survey of Breitbart.com shows that the former White House Chief Strategist and Rabble-Rouser-in-Chief Steve Bannon has not unleashed his media machine against the tax plan. In fact, the only prominent Breitbart piece on the tax plan thus far has excoriated the mainstream media for misinterpreting the comments of Gary Cohn, the White House's chief economic adviser, on middle class tax cuts.7 It may be the first time that the website has ever written anything positive about Cohn. Blue State Republicans: There are 29 Republican representatives facing tough reelection campaigns next year who are based in states that voted for Secretary Hillary Clinton in 2016. These Republican representatives will staunchly oppose any proposal to end the state and local tax deduction, given that their voters will be subjected to higher rates of state and local taxes.8 These "Blue State Republicans" could scuttle the current tax blueprint in the House. Anticipating the problem, Gary Cohn has said that the removal of the deduction is not a "red line" for the administration. Senators: Republicans have only a slim margin for error in the Senate. Senators Bob Corker (R, TN) and John McCain (R, AZ) could be the two staunchest opponents to the tax reform effort. The former is a deficit hawk and critic of the president, the latter is a maverick and firmly opposed to the president. On the other hand, the usual thorn in the side of the GOP establishment, Rand Paul (R, KY), could be brought around to support the proposal. Moderates like Susan Collins (R, ME) and Lisa Murkowski (R, AK) should be watched carefully. Investors should expect more Republicans to come out in opposition to certain provisions of the proposed tax legislation. However, the path of least resistance is not for the entire effort to fail, but rather for it to become more profligate. For example, the White House has already gestured towards a compromise with Blue State Republicans on the state and local tax deduction that would increase the deficit. Furthermore, we continue to stress that the failure of the Obamacare repeal and replace bill is not a good guide for what will happen with tax legislation. Taking away an entitlement program is politically challenging. Tax cuts, on the other hand, are generally not. Bottom Line: President Donald Trump is an economic populist. Our research into international comparisons shows that populists tend to get what they want, which is primarily higher nominal GDP growth (Chart 6). We therefore continue to expect the roughly $1.5 trillion tax cut effort - which may or may not deserve the title of tax reform - to pass. Is King Dollar Primed For A Rally? Investors should consider the proposed tax legislation a form of modest stimulus. If we assume that the $1.5 trillion in tax cuts will be offset with a combination of revenue-raising policies to the tune of 50%, it still leaves roughly $750 billion in new deficit spending (stimulus) over the next ten years. A more reasonable figure for total revenue offsets is around $400 billion, which would put the cost of stimulus at roughly $1.1 billion.9 This is not extraordinary large, but even a modest effort this far into the economic cycle could have a significant effect. BCA's Chief Global Strategist, Peter Berezin, believes that inflation is around the corner.10 So why the delay in the data? Peter points out that while the Phillips Curve has gotten a lot flatter over the past four decades (Chart 7), it remains a curve. Once the economy reaches full employment - as it has done in the U.S. (Chart 8) - the curve steepens much faster. As Peter puts it: Chart 6Populists Deliver (Nominal) GDP Growth Is King Dollar Back? Is King Dollar Back? Chart 7The Phillips Curve Has Gotten Flatter Is King Dollar Back? Is King Dollar Back? Chart 8U.S. Economy At Full Employment U.S. Economy At Full Employment U.S. Economy At Full Employment The idea that the Phillips curve steepens at low levels of unemployment is very intuitive: If excess capacity is high to begin with, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The empirical evidence supports this conclusion. Chart 9 shows that U.S. wage growth has tended to accelerate once the unemployment rate falls into the range of 4%-5%. Chart 9Watch Out For The 'Kink' In The Phillips Curve Is King Dollar Back? Is King Dollar Back? When we present Peter's argument to clients, many retort that "this time is different," namely because of phenomena like the "Amazon effect." To put that argument to rest, our colleague Mark McClellan has penned a Special Report titled, "Did Amazon Kill The Phillips Curve?"11 Mark shows that while e-commerce is undoubtedly increasing its share of retail sales (Chart 10), its contribution to annual headline CPI is modest. For example, Chart 11 shows that online prices fell relative to the overall CPI for most of the time since the early 1990s. However, e-commerce only contributed about -0.15 percentage points to annual CPI in June 2017, and has never contributed more than -0.3 percentage points. Chart 10E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share Chart 11Online Price Index Online Price Index Online Price Index To further test the impact of e-commerce on inflation, Mark focused on the parts of the CPI that are most exposed to it. If online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. He therefore combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure (Chart 12). Again, the contribution of e-commerce-heavy sectors to annual CPI is minimal. Chart 12Electronic Shopping Price Index Electronic Shopping Price Index Electronic Shopping Price Index Chart 13BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index Chart 14BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index Mark finally recalculated the e-commerce proxy using only the sectors displaying the most relative price declines - clothing, computers, electronics, furniture, sporting goods, air travel, and other goods - and assumed that all other sectors actually deflated at the average pace of the entire index. The adjusted e-commerce proxy suggests that online pricing reduced overall CPI by about 0.1-0.2 percentage points in recent years (Chart 13 & Chart 14). We find Mark's work intuitive. The "Amazon effect" is a great example of fitting a broad theory to a particular set of data, a common error in the investment community. The weak inflation print - which is a "Summer of 2017" phenomenon - is being extrapolated into a decade-long theme. But the data is clear: the deceleration of inflation since the Great Financial Crisis has been in areas unaffected by online sales, chiefly energy, food, and shelter costs. High corporate profit margins in the retail sector also argue against the idea that e-commerce represents a large positive macro supply shock. In fact, today's creative destruction in retail may be no more deflationary than the shift to "big box" stores in the 1990s. Putting it all together, the three above views provide a fairly clear signal in terms of asset implications: Geopolitical Strategy Tax Policy View: Tax legislation is a form of modest stimulus enacted by a populist White House in search of higher nominal GDP growth, and it will pass; Global Investment Strategy Phillips Curve View: The Phillips Curve is not dead, just dormant, and will steepen as the U.S. unemployment rate declines further below the equilibrium level; The Bank Credit Analyst "Amazon Effect" View: There is no "Amazon Effect." Pro-cyclical fiscal stimulus in the U.S. should be bullish for the U.S. dollar, bullish for U.S. small caps relative to large caps, and bearish for U.S. 10-year Treasuries. We are already long USD against EUR by recommending that our clients go long Euro Area equities relative to the S&P 500 with a currency hedge.12 We think there may be more upside for the USD against the yen, especially given our view of the upcoming general election in Japan below. What are the risks to a bullish USD view? Continued strong global growth is the main risk (Chart 15). Global data is improving to the point that even moribund Italy is now on fire (Chart 16). However, the positive data may be peaking. European data, in particular, looks like it is reaching its absolute highs (Chart 17). Chart 15Can Global Growth Get Any Higher? Can Global Growth Get Any Higher? Can Global Growth Get Any Higher? Chart 16Italy Is On Fire... Italy Is On Fire... Italy Is On Fire... Chart 17...As Is Europe Overall ...As Is Europe Overall ...As Is Europe Overall Particularly concerning from the global perspective is the ongoing slowdown in the pace of expansion of Chinese money and credit, which we have been arguing for almost a year is policy induced.13 Our colleague Arthur Budaghyan, Chief Strategist of BCA's Emerging Market Strategy has flagged that the official M2, as well as BCA's own custom version of broad money M3, are slowing down to new lows (Chart 18). From the broad money M3, Arthur and his team construct the M3 impulse, which leads both the Chinese leading economic indicator and the well-known "Li Keqiang index" (a growth proxy) by six months (Chart 19).14 Most importantly from the global perspective, the slowdown in Chinese money and credit growth ought to negatively impact demand for imports from China-exposed export sectors in Asia and Europe (Chart 20). Chart 18But Credit Growth In China Is Slowing bca.gps_wr_2017_10_04_c18 bca.gps_wr_2017_10_04_c18 Chart 19Chinese Credit Leads The Domestic Economy... Chinese Credit Leads The Domestic Economy... Chinese Credit Leads The Domestic Economy... Chart 20...As Well As Exports To China ...As Well As Exports To China ...As Well As Exports To China The policy-induced crackdown against money and credit growth in China should be particularly pertinent in Europe. BCA's Foreign Exchange Strategy has noted how the close trading relationship between China and Europe influences the growth delta between Europe and the U.S.15 Given the potential slowdown in China, and subsequent impact on EM economies, bullishness on Europe could be peaking. Bottom Line: Our view that a modest fiscal stimulus may be afoot is only a small part of a wider BCA bullish-USD narrative. We think it is once again time to turn bullish towards the greenback. We are opening a long USD/JPY recommendation. Our colleague Mathieu Savary, Chief Strategist of BCA's Foreign Exchange Strategy, has been long since USD/JPY hit 109 on August 11. Japan: Abenomics Will Survive Abe Japanese Prime Minister Shinzo Abe's snap election on October 22 took us by surprise. Not because of the timing, which was telegraphed by rumors in the press, but because, for Abe and the ruling Liberal Democratic Party (LDP), the upside risk is limited while the downside is unlimited. Since May 24 we have argued that Abe's political capital has peaked, based on the empirically grounded expectation that his pursuit of constitutional changes to legitimize Japan's defense forces would erode his popular support.16 This view received confirmation in early July, when Yuriko Koike, a former LDP politician, led an insurgency against the LDP in the Tokyo metropolitan elections and dealt them a historic blow in that region. At that time, we argued that Abe would not lose power anytime soon: he maintained his two-thirds supermajority in the lower house (and virtual supermajority in the upper house), did not face an election until December 2018, and could thus double down on reflationary economic policies in order to rebuild popular support.17 Chart 21An Upstart Party Challenges The LDP Is King Dollar Back? Is King Dollar Back? Now, Abe has made a risky decision to move the general election forward 14 months. He wants to capitalize on Japan's recent strong economic performance, the peaking of North Korean tensions (which are likely to decline by late next year), and an uptick in approval ratings. Last but not least, he wants to take the fight to the political opposition at a time when the rival Democratic Party is in total collapse and Governor Koike, his chief antagonist, is unready to wage a national campaign. The timing was shrewd but comes at a cost. Koike announced a new political party, the Party of Hope, just hours before Abe called the early election. In the first set of opinion polls it has sprung up to 15% approval, only nine points shy of the LDP. True, this is still 14 points short of the ruling coalition (Chart 21). But crucially, the collapse of the Democratic Party prompted its leader, Seiji Maehara, to declare that his party would not contest the new elections. This leaves its members free to join Koike's party; it also partly obviates the problem of the Democratic Party and Party of Hope stealing each other's votes.18 Throughout Abe's term we have compared his approval ratings to those of former Prime Minister Junichiro Koizumi, the LDP's last heavyweight leader, to test whether he retains political capital (Chart 22). According to this measure, he does. Yet, given Abe's long tenure and gradually declining support, this comparison only works as long as there is no viable alternative. That is because Abe's net approval rating, as well as his ability to bring star-power to the LDP, has been fading in recent years (Chart 23). Now he has called an election at the very moment that a possible alternative has emerged!19 Chart 22Abe Losing Favor Over Time Is King Dollar Back? Is King Dollar Back? Chart 23Abe Becoming A Liability Abe Becoming A Liability Abe Becoming A Liability However, we say a possible alternative for a reason: Koike herself, as yet, is refusing to run for the prime minister's slot. She is in a "dilemma of irresponsibility" in which, having just become governor of Tokyo on the pledge to put "Tokyo First," she will be criticized for flagrant ambition and flip-flopping if she abandons that post to run against Abe directly.20 As long as Koike remains on the sidelines, Abe will retain his absolute majority. It would be very difficult for a new party that is struggling to field candidates across the whole country, lacks a clear prime minister candidate, and faces competition with other opposition parties to deprive an incumbent coalition of 85 seats. (Depriving the LDP of its 50-seat party majority alone would be momentous, though conceivable.) The LDP has fallen out of power on only two previous occasions since 1955: once, briefly, in 1993, in the wake of the collapse of Japan's Heisei bubble, and once in 2009, in the wake of the global financial crisis (Chart 24). And the LDP has never lost more than 22 seats in an election year, like this year, in which economic growth is faster than the preceding year. That size of loss would leave Abe wounded but still in control.21 Chart 24The LDP Seldom Loses Elections In Japan The LDP Seldom Loses Elections In Japan The LDP Seldom Loses Elections In Japan On the other hand, if Koike changes her mind and throws herself headlong into competition with Abe, it is possible, albeit still highly unlikely, that she could pull off a historic upset.22 Currently the number of undecided voters is high at about 43%. In recent years, these voters have tended to correlate negatively with LDP support (Chart 25), meaning that LDP voters grew dissatisfied and "undecided" but then came crawling back when the party wooed them. However, Koike could change this dynamic - not only because she apparently has momentum, but also because her background and platform are substantially similar to Abe's, yet with a fresh face.23 Chart 25Undecided Voters Often Return To LDP Undecided Voters Often Return To LDP Undecided Voters Often Return To LDP Koike must make her decision by October 10. It is unlikely that she will join or that her party will field enough competitive candidates - in this respect, Abe gambled correctly in calling the election now. Barring her entrance, what is at stake is Abe's 6-seat "supermajority" in the lower house. Abe is likely to lose this advantage simply based on the Party of Hope's strength in Greater Tokyo and the Kanto Plain, augmented as it is by collaboration with the Democratic Party. A back-of-the-envelope calculation suggests that Koike could easily deprive Abe of this supermajority. Assuming that the Party of Hope performs in line with Koike's performance in the Tokyo/Kanto region in July, gaining 39% of the seats (34% of the popular vote), implies that the Party of Hope could steal as many as 47 seats from the ruling coalition on October 22 (Table 2). This is a generous estimate in giving Koike's party strong support, but a conservative estimate in assuming that it will not win a single seat outside the Tokyo/Kanto region.24 Losing this supermajority would be a big loss of momentum for Abe and the LDP that would carry over into the legislative process (where Abe would struggle to control the LDP factions and fend off corruption allegations) and future elections (where the LDP would be more vulnerable). It would sow the seeds for a leadership challenge against Abe in the LDP next September. But it keeps the LDP in power for the next four years. And its direct impact on passing bills is limited. A lower house majority would still be under the LDP leader's control, and the LDP would still have a near-supermajority in the upper house, removing any risk that it would delay bills. The only initiative likely to suffer would be Abe's treasured constitutional revisions, and yet even those would still have a fighting chance of passing the Diet. The important thing for investors to realize is that a setback or defeat for Abe will not be the death of Abenomics.25 Reflation will continue and Japanese risk assets will continue to outperform on a currency-hedged basis. Why? Table 2The Party Of Hope Threatens The LDP Supermajority From Its Base In The Tokyo/Kanto Region Is King Dollar Back? Is King Dollar Back? Abenomics is already bearing fruit: Inflation remains weak, but Japan's output gap is closing and unemployment gap is gone (Chart 26). It is only a matter of time before supply constraints put more upward pressure on prices, lowering real rates and easing financial conditions for the economy as a whole. Koike, who styles herself as a pro-business Thatcherite, will not stand in the way of growth. Monetary policy will remain dovish: The dovish shift in the Bank of Japan in 2013 was a regime change within the institution itself. Governor Haruhiko Kuroda was the leader of the change, but since then the entire policy board has been staffed with doves. In fact, in the board's recent minutes, the only dissenting voice argued for more stimulus.26 Kuroda can legally be reappointed for governor for another five years. If not, his replacement will likely perpetuate his legacy, as neither Abe nor Koike have given any hint at wanting more hawkish monetary policy. The market is right to expect barely any rate hikes over the next year and for the BoJ to continue suppressing yields even as other DM central banks become more hawkish (Chart 27). Chart 26Tight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation Chart 27Monetary Policy Will Remain Easy Monetary Policy Will Remain Easy Monetary Policy Will Remain Easy Fiscal policy will ease further: We have shown Chart 28 again and again to clients: the main failure of Abenomics so far has been Abe's own fiscal responsibility. Upon calling the election, he yet again pitched himself to voters on the basis of fiscal irresponsibility. He offered a new 2 trillion yen stimulus package and suspended his pledge to balance the budget by 2020. And while he pledged to pay for education and elderly care by raising the consumption tax from 8% to 10% as scheduled in October 2019, few doubt that he will delay a tax hike (as in 2015) if it threatens to upset his economic recovery. Meanwhile, Koike is running on a platform of easier fiscal policy: she has outright opposed the consumer tax hike, saying that to do so would be to "throw cold water on the still-intangible economic recovery." She wants more earthquake-resistant infrastructure and more social spending (e.g. childcare). She wants measures to boost the female participation rate further (Chart 29).She is hardly likely to boost consumption without continuing Abe's quest to lift wages overall (Chart 30). And in her most significant difference from Abe, she hopes to do away with nuclear power and turn Japan into a renewable energy powerhouse (inevitably requiring large-scale government subsidies and investment). Foreign policy will remain hawkish: Koike is a conservative who is in favor of constitutional revisions to normalize Japan's military. Her Party of Hope could even vote with the LDP on this issue, for a price. While it may be somewhat more China-friendly than Abe (possibly a boon for exports), it would not be willing or able to break Japan's recent trend of rising defense spending and economic diplomacy. Chart 28Fiscal Policy Will Get Easier Fiscal Policy Will Get Easier Fiscal Policy Will Get Easier Chart 29Abe And Koike Want Women Workers Abe And Koike Want Women Workers Abe And Koike Want Women Workers Chart 30Abe And Koike Want Higher Wages Abe And Koike Want Higher Wages Abe And Koike Want Higher Wages Moreover, given that Japan has a much higher ratio of public investment to private investment than other comparable countries, and that fiscal spending is limited by a massive debt load, Koike would be committed to boosting private investment just like Abe (Chart 31). Indeed, judging solely by key policy planks, the Party of Hope could almost become an LDP coalition partner. It cannot win a majority without Koike as frontrunner, and even if it did, it would lead to a fractious parliament where it would be forced to cooperate with the LDP in order to pass bills through the LDP-dominated upper house. Koike's sudden emergence does not represent a shift in national trends but rather a confirmation of the post-2011 Japanese political consensus in favor of a dovish central bank, dovish fiscal policy, and hawkish foreign policy. Chart 31Abe And Koike Want Private Investment Abe And Koike Want Private Investment Abe And Koike Want Private Investment Chart 32Not Abandoning Nuclear Power Anytime Soon Not Abandoning Nuclear Power Anytime Soon Not Abandoning Nuclear Power Anytime Soon Bottom Line: As things stand, Abe will probably lose his supermajority yet retain his majority in the lower house. This will cause some volatility and policy uncertainty in Japan. Nevertheless, the outlook is still highly reflationary. Koike reveals that the median voter favors pushing Abenomics even further. Should Koike make a dash for the prime minister's slot, she does have a small chance of coming to power. It is hard to put a probability on it until more polling data is available. The biggest policy consequence of a Party of Hope-led government would be her energy agenda of weaning Japan off of nuclear power, which would in the first instance shrink the current account surplus, as during the nuclear shutdown following the Tohoku earthquake in 2011 (Chart 32). However, a Koike majority is unlikely to materialize as things stand, and the LDP in the upper house would be a check on such policies. Go long USD/JPY in expectation of more reflation. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, and BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 2 Please see BBC, "Catalan referendum: Catalonia has 'won right to statehood,'" dated October 2, 2017, available at bbc.com. 3 We are referencing poll numbers collected by the Centre d'Estudis d'Opinió, which is run by the pro-independence government of Catalonia. In other words, if biased, the polls should be biased towards independence. 4 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 6 Apparently, the Democrats! Democratic leaders in Congress oppose tax reform policy that is not revenue-neutral. However, the GOP can ignore them as they plan to use the reconciliation procedure to pass tax policy. 7 Please see John Carney, "Mainstream Media Distort Every Single Thing Gary Cohn Says About GOP Tax Plan," dated September 30, 2017, available at breitbart.com. 8 The announced tax reform plan does not include such a proposal - nor does it provide any detail on how tax cuts would be paid for - but it has been floated as a possibility. This is because it could save the government nearly $370 billion by 2020, according to a report from the congressional Joint Committee on Taxation. 9 For revenue offsets that are likely to pass, we combine the repatriation of foreign earnings ($138 billion over the next decade), the repeal of certain corporate tax breaks ($138 billion), and the repeal of certain individual tax expenditures ($385 billion). We roughly estimate that the offset would total $400 billion, as horse-trading in Congress is likely to reduce the eventual size of overall revenue-offsets. The path of least resistance in Congress is towards more deficit spending, not less. 10 Please see BCA Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017, available at gis.bcaresearch.com. 11 Please see The Bank Credit Analyst Special Report, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017, available at bca.bcaresearch.com. 12 We recently closed our recommendation of being long Euro Area equities relative to the U.S. in an unhedged position for a 7.88% gain. 13 Please see "China: Xi Is A 'Core' Leader ... So What?" in BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016; "China: How Far Will Deleveraging Go?" in Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017; and Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 14 Please see BCA Emerging Market Strategy Weekly Report, "Copper Versus Money/Credit In China - Which One Is Right?" dated September 6, 2017, available at ems.bcaresearch.com. 15 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 18 The problem still partially exists, as the opposition remains divided by various parties, and left-wing members of the Democratic Party have formed a new Constitutional Democratic Party of Japan that will contest the election and compete with the Party of Hope as well as the ruling LDP. 19 Incidentally, she is one of Koizumi's disciples who can count on his support. 20 According to Shinjiro Koizumi, "If she runs it's irresponsible, if she doesn't run it's irresponsible ... she's in a 'dilemma of irresponsibility.'" Quoted in Robin Harding, "Yuriko Koike hits trouble in Japan election campaign," Financial Times, October 2, 2017, available at www.ft.com. 21 The 22-seat loss referred to above occurred under the leadership of Takeo Miki in 1976. 22 There have been only two occasions in which a multi-term prime minister like Abe lost power due to holding a general election - 1960 and 1972. In the latter, comparable case, Eisaku Sato, who had been in power for eight years, lost power despite the fact that economic growth had recovered from a slight slowdown in 1971. In other words, the lack of enthusiasm for Abe amid a recovering economy is an important warning sign, which we discussed in BCA Geopolitical Strategy Weekly Report, "Insights From The Road - Asia," dated August 30, 2017, available at gps.bcaresearch.com. 23 It will also be important to see if leading politicians continue to defect from other parties and flock to her ranks. Especially politicians from the LDP, and especially those who are not worried, like Mineyuki Fukuda, about losing their seats anyway. 24 It also neglects recent reforms to the electoral system that will eliminate ten seats, only one of which is likely to go to the Party of Hope. 25 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 26 Please see Bank of Japan, "Summary Of Opinions At The Monetary Policy Meeting," September 20-21, 2017, p. 5, available at www.boj.or.jp/en.

Highlights French labor reforms stack up well against German and Spanish predecessors; We remain bullish on French industrials versus German industrials; Populism is overrated in Germany - European integration may not accelerate, but it will continue; The U.K.'s position remains weak in Brexit talks ... don't expect much from sterling. Feature On recent travels across Asia Pacific, the U.K., and the U.S., Europe has rarely featured in our conversations with clients. We proclaimed European politics a "trophy red herring" in our annual Strategic Outlook.1 Following the defeat of populists in Austria, the Netherlands, Spain, and particularly France, the market now agrees with us (Chart 1). Chart 1European Political Risk Was Overstated European Political Risk Was Overstated European Political Risk Was Overstated In this report, we ask whether there is anything left to say about Europe. First, we provide an update on French structural reforms, which we predicted with enthusiasm in February.2 Second, we give a post-mortem of the German election. Third, we dissect U.K. Prime Minister Theresa May's speech in Florence. We remain positive on near-term and mid-term prospects for European assets. We have recently closed our unhedged long Euro Area equities trade for a 7.88% gain (open from January 25 to September 6). We have reopened the position on September 6 with a currency hedge given our view that there is some downside risk for the euro in the near term. We also remain long French industrials / short German industrials, with gains of 9.30% since February 3. The French Revolution Continues President Emmanuel Macron has ignored tepid union protests and signed five decrees overhauling French labor rules on September 22. While there is more to be done, Macron's swift action just five months after assuming office justifies our optimism about France earlier this year. As we posited in February, investors are surprised every decade by a developed market that defies all stereotypes and catches the markets off guard with ambitious, pro-market and pro-business structural reforms. Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s. Sweden surprised the world in the 1990s. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own "socialist" label and moved the country to the right of the economic spectrum. Finally, the past decade's reform surprise came from Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. How do French labor reforms stack up against the German and Spanish efforts? Table 1 surveys the measures and classifies them into three categories. On unemployment benefits, Macron's effort falls short of the considerable cuts implemented as part of the Hartz reforms in Germany. However, while benefits will still be generous, France's unemployed will now be cut off if they refuse job offers that pay within 25% of the salary they previously held. On increasing labor market flexibility, we give France high marks. Reforms will simplify the termination process for economic reasons and cap damages that can be awarded to employees, in line with the Spanish experience. Macron has also managed to neuter the power of national unions by allowing firm-level collective bargaining to take precedence. France's labor bargaining reform is also a carbon copy of the Spanish effort and both are attempts to create a more German-like management-employee context. Table 1Measuring French Reforms Against German And Spanish Reforms Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? What should investors expect as a result? Spain is instructive. While its unemployment rate remains 5.8% above the Italian rate and 7.3% above the French rate, it still fell from a high of 26.3% in 2013 to 17.1% today. Meanwhile, Italian and French unemployment rates remain stubbornly high (Chart 2). In addition, Spain's export competitiveness has had one of the sharpest recoveries in Europe since 2008, whereas Italy and France continue to languish (Chart 3). Spain accomplished this feat via a considerable reduction in labor costs relative to peers (Chart 4). Chart 2Italy, France: Unemployment Still High Italy, France: Unemployment Still High Italy, France: Unemployment Still High Chart 3Spain Regained Competitiveness Spain Regained Competitiveness Spain Regained Competitiveness Chart 4Spain Cut Labor Costs Spain Cut Labor Costs Spain Cut Labor Costs The key pillar of Prime Minister Mariano Rajoy's reforms was to create a more flexible labor market so as to restore competitiveness to the economy by aligning labor costs with productivity. Reforms, passed in February 2012, removed stringent collective bargaining agreements and replaced them with firm-level agreements. This has made it easier for firms to negotiate their own labor conditions, including reducing wages as an alternative to termination of employment. France is now on the path to do the same. True, it is difficult to establish a clear causal connection between Rajoy's structural reforms and Spain's economic performance since 2008. Nevertheless, reforms also work as a signaling mechanism, encouraging investment and unleashing animal spirits by affirming the government's commitment to a pro-business agenda. Under Rajoy's leadership, Spain has moved from 62nd in the World Bank "Ease of Doing Business" survey in 2009 to 32nd in 2017, 18 spots above Italy. Given the speed and commitment of the Macron administration, we would expect an even stronger signaling effect in France. German Hartz reforms are easier to assess because more time has passed since 2005 (when the final stage, Hartz IV, was implemented). Prior to the reforms, Germany's GDP growth rate was falling and unemployment was rising (Chart 5). At least on these two broad measures, it appears that reforms were positive. Chart 5Hartz Reforms Marked Turning Point In Germany Hartz Reforms Marked Turning Point In Germany Hartz Reforms Marked Turning Point In Germany Chart 6German Long-Term Unemployment Benefits Were Cut Down To OECD Average Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Germany's problem prior to the Hartz reforms was that generous unemployment benefits discouraged unemployed workers from finding employment. Long-term benefits could be as high as 53% of the terminated salary and eligible for indefinite renewal! The Hartz IV reforms specifically targeted these benefits, with the intention of forcing the unemployed to get back to work. Germany brought these benefits into line with the OECD average (Chart 6). The long-term impact of the Hartz reforms was a dramatic decline in the unemployment rate from a bottom of 9.2% in 2001 to the still falling 3.7% of today! Reforms have also seen a steady increase in wage growth, despite the conventional view saying the opposite. Wages have been steadily rising since implementation in 2005, only slowing down during the global financial crisis and the subsequent European debt crisis (Chart 7). This does not mean that labor reforms failed. The intention of the Hartz reforms was to push people back into the labor force, not necessarily suppress their wages. Chart 8 shows the effect on the hours worked in the economy, with a clear uptrend after the reform was enacted. Chart 7German Wages Recovered... German Wages Recovered... German Wages Recovered... Chart 8...While Working Hours Increased ...While Working Hours Increased ...While Working Hours Increased In line with the previous labor reform efforts in Europe, we think that investors should expect three broad developments from French labor reforms: Competitiveness: As Chart 3 suggests, Spain and Germany have had the best export performance in Europe. By allowing companies some flexibility in setting costs, these economies were able to regain export competitiveness. As a play on this theme, we are long French industrials relative to German peers. Unemployment: Forcing the unemployed back to the labor market by ending their unemployment benefits if they refuse a job offer within 25% of the previous income level should encourage workers to get back to the labor force. Confidence: Macron's labor reforms are only the beginning of a packed agenda that also includes reducing the size of the public sector, reducing the wealth tax on productive assets, and cutting corporate taxes significantly. What of the opposition to the reform effort? What if the French leadership backs down in the face of protest? First, we must ask, what protest? The labor union response has been underwhelming. In part, this is because Macron's reforms are packed with pro-union clauses. The intention is to empower union activity at the firm level in order to neuter its activity at the national level. Second, Macron's electoral victory was overwhelming, both the presidential and legislative. Yes, turnout was low. And yes, many voted for Macron just so that Marine Le Pen would not become president. But the fact remains that 85% of the seats in the National Assembly are held by pro-reform parties, including the pro-business, right-wing Les Républicains, who want even stricter reforms. Bottom Line: Our clients, colleagues, friends, and family all tell us that France will not reform. But we have seen this film before, with Germany in the 2000s and Spain in the 2010s. One day, investors will wake up and France will be more competitive. Fin. A German Election Post-Mortem The media narrative before and after the German election tells of the rise of Alternative für Deutschland (AfD), a far-right party that campaigned on an anti-EU and anti-immigration platform. Indeed, the performance of the center-right Christian Democratic Union (CDU) and center-left Social-Democratic Party (SPD), which have dominated German politics since the Second World War, was historically poor (Chart 9). Chart 9Germany's Dominant Parties Underperformed... Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Despite the media hysterics, there were no surprises this year. The AfD performed in line with its polls, only outperforming their long-term polling average by around 2%. Meanwhile, the historic underperformance of the CDU and SPD was also due to the solid performance of the other two establishment parties, the liberal Free Democratic Party (FDP) and the center-left Greens (Chart 10). The FDP stormed back into the Bundestag by more than doubling their performance from 2013, while the Greens maintained their roughly 9% performance. Die Linke, a left-wing party whose Euroskeptic tendencies have dissipated, also gained around 9% of the vote. From a historical perspective, the combined CDU and SPD performance was bad, but roughly in line with their 2009 election result. Chart 10... While Minor Parties Outperformed Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? That said, there was no once-in-a-lifetime global recession this time around to excuse the poor performance of the two establishment parties. German GDP growth is set to be 2.1% in 2017 and the unemployment rate is at a historic 3.7%. Meanwhile, support for the euro is at 81% (Chart 11), which begs the question of why 12.6% voters decided to entrust AfD with their votes. Chart 11Germans Love The Euro Germans Love The Euro Germans Love The Euro The simple answer is immigration and the 2015 asylum crisis. The more complex answer is that AfD's performance was particularly strong in East Germany, where the party is now the second largest after the CDU. The same forces that fueled the Brexit referendum and the election of President Donald Trump are at work in Germany. Voters who feel left behind by the transition to a globalized, service-oriented economy have rebelled against a system that favors the educated and mobile voters. In Germany, the angst is particularly notable in the East, where economic progress has lagged that of the rest of the country. On the other hand, it is ludicrous to compare AfD to Brexit and Trump. After all, AfD received only 12% of the vote. This is in line with, or slightly trails, the performance of other right-wing parties in Europe (Chart 12). Yes, it is disturbing to see a far-right party back in the Bundestag, but it was also naïve to believe that Germany could remain a European outlier forever. In fact, like other right-wing parties in Europe, the party is beset with internal rivalries. Party chairwoman Frauke Petry, who represents the moderate wing of the party, decided to quit one day after the election.3 We would suspect that the party will struggle going forward, particularly now that the influx of asylum seekers has trickled down to insignificance (Chart 13). Chart 12German Far Right Performed In Line With Other European Anti-Establishment Parties Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Chart 13Refugee Crisis Is Over In Germany And Europe Refugee Crisis Is Over In Germany And Europe Refugee Crisis Is Over In Germany And Europe Going forward, Chancellor Angela Merkel will retain her hold on power. However, she will likely have to do so via a "Jamaica coalition" with the FDP and the Greens.4 Forming such a challenging coalition could take until the New Year. Particularly problematic are the positions of the FDP and the Greens on Europe. The former are mildly Euroskeptic, the latter are rabidly Europhile. Merkel's 2009-13 coalition with the FDP was similarly challenging. The FDP moved towards soft Euroskepticism after the Great Financial Crisis. It combined with CDU's Bavarian sister party - the Christian Social Union (CSU)5 - to vote against a number of European rescue efforts and institutional changes (Chart 14). Merkel had to rely on the opposition SPD, which is staunchly Europhile, to push several European reforms through the Bundestag. More broadly, both the FDP and the CSU were a brake on Merkel during this period, leading to Berlin's halting response to the Euro Area crisis. Chart 14The FDP Hampered German Rescue Efforts Amid Euro Crisis Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Going forward, a Jamaica coalition is investment-relevant for three reasons: First, it would likely pour cold water on recent enthusiasm about accelerated European integration spurred by the election of President Emmanuel Macron in France. But investors should not read too much into it. As Chart 11 clearly illustrates, Germans are not Euroskeptic. The Euro Area works for Germany. If there is a future crisis, Germany will react to it in an integrationist fashion, shoving aside any coalition agreements to the contrary. And if Merkel has to rely on opposition SPD votes to push through the evolving European agenda, she will do so, regardless of what is said between now and December. Second, Merkel will have to respond to the poor performance of her party. She has to give in to the right wing on illegal immigration. Investors should expect to see tighter border enforcement on Europe's external borders. More relevant to the markets, we expect mildly Euroskeptics critics in her own party, as well as in the FDP and CSU, to be satisfied by officially pushing for Jens Weidmann's presidency at the ECB. Weidmann has recently toned down his criticism of ECB policies - publically defending low interest rates - which is likely a strategy to make himself palatable as the next president. Third, it is widely being discussed that the FDP will demand the finance ministry from Merkel, replacing Wolfgang Schäuble. This would definitely complicate any future efforts to deal with Euro Area sovereign debt crises, were they to emerge. However, the FDP is making a mistake. If they take the finance portfolio, they will be signing off on bailouts in the future. That is a guarantee. Europe is full of moderately Euroskepic finance ministers who have done the same (see: Austria, Finland, and the Netherlands in particular). Finally, the election was a clear failure by Merkel to defend her brand. While she has not signaled a willingness to resign, it is highly likely that she will try to groom her successor over the next four years. The 63 year-old has been in power since 2005. At the moment, the list of potential names for CDU leadership is long, but devoid of star power (Box 1). The one quality of all the potential candidates, however, is that they are pro-Europe. Bottom Line: In the short term, markets have read German elections overly negatively. The euro reacted on the news as if the currency bloc breakup risk premium had risen. It hasn't. In fact, the election could prove to be a long-term bullish euro outcome, given that Merkel will likely have to acquiesce to Jens Weidmann's candidacy for the ECB presidency. The German Bundestag remains overwhelmingly pro-Europe. The now-in-opposition SPD is pro-integration, as are the likely new coalition members, the Greens. Die Linke has evolved from anti-capitalist, soft Euroskeptics to left-of-SPD Europhiles. While FDP remains committed to a mildly Euroskeptic line (pro-Europe, but opposed to further integration), its members will likely have to sacrifice this position in order to be in government in the long term. They won't say that they are doing that, but trust us, they are. The performance of Germany's populist right wing is largely in line with that of other European countries. As such, it signals that Germany is a "normal country," not that there is something particularly disturbing going on. Box 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Ursula von der Leyen (CDU): Leyen, who has served most recently as defense minister, is often cited as a likely replacement for Merkel. However, she is not seen favorably by most of the population: she has not won first place in her district in any of the past three general elections. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has argued that the European refugee crisis and debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière (CDU): Maizière, who has served as minister of interior and minister of defense, is a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could become a compromise candidate between the Europhiles and Eurohawks within CDU ranks. Though he has been implicated in scandals as defense minister, he has remained popular by drawing a relatively hard line on immigration policy and internal security. Julia Klöckner (CDU): A CDU deputy chairwoman from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel and a hence a likely candidate to replace her. While remaining loyal to Merkel, she has taken a more right-wing stance on the immigration crisis. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist," though she has insisted that AfD voters are not all "Nazis" but are mostly in the middle of the political spectrum and need to be won back by the CDU. We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe (CDU): Gröhe last served as minister of health and is a former CDU secretary general. He is very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier is in a position to capitalize on Brexit. He is a heavyweight within the CDU's leadership and a staunch Europhile. He has already declared he will run for the top state office again in 2018, though he will be 67 years old by then. The U.K.: Fall In Florence Prime Minister Theresa May tried to reset Brexit negotiations with the EU recently by giving a speech in Florence. We were told by clients and colleagues that it would be an important event, so we tuned in and listened. The speech was largely a dud. It confirmed to us the constraints on London's negotiating position as well as the challenges that Brexit poses to the British economy. May's team is struggling to navigate both. There are three things that investors should take from the speech - most which we have been emphasizing for over a year: The EU exit bill: The U.K. will pay. The one concrete point that Prime Minister May agreed with, for the first time ever, is that London will continue to pay into the current EU seven-year budget period (2014-2020). This should never have been in doubt. Britain's refusing to pay would be the equivalent of a tenant giving notice that he is ending his lease in 24 months, then refusing to pay in the interim. What May did not say is whether the U.K. would pay anything beyond its share of contribution to the EU budget. At the moment, the answer appears to be no, but we don't expect that to be the final word. Services really (really) matter: The U.K. has a competitive advantage in services. This is why May has tried to signal that she wants the broadest trade deal possible, since regular free trade agreements (FTAs) do not provide for deep integration in services. What will the U.K. give in return? May appears to want a Norway-type EU trade agreement with Canada-type liabilities. This won't fly in Brussels. The transition deal will last two years at minimum: This was never in doubt. But due to domestic political pressures, May was afraid of voicing it in public until today. Below we provide excerpts of the most relevant (or irrelevant, but comical) parts of May's speech.6 Our running commentary is in brackets. Theresa May's Florence Speech On Brexit, September 2017: A Reinterpretation By GPS It's good to be here in this great city of Florence today at a critical time in the evolution of the relationship between the United Kingdom and the European Union. It was here, more than anywhere else, that the Renaissance began - a period of history that inspired centuries of creativity and critical thought across our continent and which in many ways defined what it meant to be European. [GPS: Strong opening by May. Odd location for the speech, however. Unless she was looking to ingratiate herself with Matteo Renzi, former mayor of Florence, former prime minister of Italy, and current leader of the ruling Democratic Party]. * * * The British people have decided to leave the EU; and to be a global, free-trading nation, able to chart our own way in the world. For many, this is an exciting time, full of promise; for others it is a worrying one. I look ahead with optimism, believing that if we use this moment to change not just our relationship with Europe, but also the way we do things at home, this will be a defining moment in the history of our nation. [GPS: This is a crucial argument by proponents of Brexit, that leaving the EU is not just about leaving the bloc's oversight, but also about domestic renewal. At the heart of this view is the belief that the EU has shackled the U.K.'s potential economic output with its regulatory oversight and protectionist trade policies. For this to be true, the U.K. has to replace significance labor force growth - from the EU Labor Market - with even greater productivity growth. If the U.K. fails to do this, its potential GDP growth rate will be substantively lower in the future. We do not buy the optimism. For one, the EU has not been a drag on the U.K.'s World Bank Ease Of Doing Businness rankings, where the country ranks seventh. Second, several other EU member states are in the top 20, including Sweden, Estonia, Finland, Latvia, Germany, Ireland and Austria. Third, developed economies have been dealing with sub-standard productivity growth for over a decade, both EU members and non-members. As such, we are pretty certain that the U.K.'s potential GDP growth rate will be lower over the next decade, not higher.] And it is an exciting time for many in Europe too. The European Union is beginning a new chapter in the story of its development. Just last week, President Juncker set out his ambitions for the future of the European Union. [GPS: A nod to the reality that without the U.K. stalling its integration, Europe is now better able to build its "ever closer union." May is essentially conceding here to Charles de Gaulle's argument, articulated in the 1960s, that letting Britain into the club would ultimately be a mistake.]7 There is a vibrant debate going on about the shape of the EU's institutions and the direction of the Union in the years ahead. We don't want to stand in the way of that. [GPS: Reality check: it has literally been the foreign policy of the U.K. to "stand in the way of" of a united Europe for at least six hundred years ...] * * * Our decision to leave the European Union is in no way a repudiation of this longstanding commitment. We may be leaving the European Union, but we are not leaving Europe. Our resolve to draw on the full weight of our military, intelligence, diplomatic and development resources to lead international action, with our partners, on the issues that affect the security and prosperity of our peoples is unchanged. Our commitment to the defence - and indeed the advance - of our shared values is undimmed. Our determination to defend the stability, security and prosperity of our European neighbours and friends remains steadfast. [GPS: As we have argued repeatedly, the U.K. and EU share crucial geopolitical and economic links. As such, it is difficult to see negotiations devolving into the sort of acrimony that many have expected. May understands this and is reminding Europe of how important the U.K. role is, and will continue to be, geopolitically for Europe.] * * * The strength of feeling that the British people have about this need for control and the direct accountability of their politicians is one reason why, throughout its membership, the United Kingdom has never totally felt at home being in the European Union. [GPS: A not-so-slight dig at Europe. Basically, May is saying that U.K. voters live in a democracy. EU voters live in something else.] And perhaps because of our history and geography, the European Union never felt to us like an integral part of our national story in the way it does to so many elsewhere in Europe. [GPS: This is true and can be empirically measured (Chart 15).] Chart 15Brits Have A Strong Sense Of National Identity Brits And Only Brits Brits And Only Brits * * * For while the UK's departure from the EU is inevitably a difficult process, it is in all of our interests for our negotiations to succeed. If we were to fail, or be divided, the only beneficiaries would be those who reject our values and oppose our interests. [GPS: This is all true and very well put. But it also appears to be a line of argument designed to tug at Europe's emotional strings. Like a husband asking his wife to take it easy on him in a divorce "for the sake of the children."] So I believe we share a profound sense of responsibility to make this change work smoothly and sensibly, not just for people today but for the next generation who will inherit the world we leave them. [GPS: Literally the line about the kids followed immediately!] * * * But I know there are concerns that over time the rights of EU citizens in the UK and UK citizens overseas will diverge. I want to incorporate our agreement fully into UK law and make sure the UK courts can refer directly to it. Where there is uncertainty around underlying EU law, I want the UK courts to be able to take into account the judgments of the European Court of Justice with a view to ensuring consistent interpretation. On this basis, I hope our teams can reach firm agreement quickly. [GPS: An important concession - the first in the speech so far, and we are more than halfway through: London will apparently take into account ECJ rulings when dealing with EU citizens living in the U.K. That is a huge concession to Europe and an arrangement unlike anywhere else in the world.] * * * The United Kingdom is leaving the European Union. We will no longer be members of its single market or its customs union. For we understand that the single market's four freedoms are indivisible for our European friends. We recognise that the single market is built on a balance of rights and obligations. And we do not pretend that you can have all the benefits of membership of the single market without its obligations. [GPS: As we have said in the past, May's decision to concede this point in January was a major concession to the EU and is the reason that the negotiations are not and will not be acrimonious. If the U.K. demanded access to the Common Market without accepting the "four freedoms," it would have received an acrimonious response, given that its request would have been construed as "special treatment."] So our task is to find a new framework that allows for a close economic partnership but holds those rights and obligations in a new and different balance. But as we work out together how to do so, we do not start with a blank sheet of paper, like other external partners negotiating a free trade deal from scratch have done. In fact, we start from an unprecedented position. For we have the same rules and regulations as the EU - and our EU Withdrawal Bill will ensure they are carried over into our domestic law at the moment we leave the EU. [GPS: May is correct. The EU-U.K. trade negotiations should be relatively smooth given that the U.K. is not starting from scratch in negotiating the relationship. The Canada-EU FTA took seven years because they were starting from scratch.] So the question for us now in building a new economic partnership is not how we bring our rules and regulations closer together, but what we do when one of us wants to make changes. One way of approaching this question is to put forward a stark and unimaginative choice between two models: either something based on European Economic Area membership; or a traditional Free Trade Agreement, such as that the EU has recently negotiated with Canada. I don't believe either of these options would be best for the UK or best for the European Union. European Economic Area membership would mean the UK having to adopt at home - automatically and in their entirety - new EU rules. Rules over which, in future, we will have little influence and no vote. [GPS: We pointed out why such an arrangement would be illogical in March 2016. Essentially, the U.K. would leave the EU due to its onerous regulation and infringement on sovereignty only to accept the onerous regulation as a fait accompli with no room for British sovereignty (Diagram 1)!] Diagram 1The Central Paradox Of Brexit Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Such a loss of democratic control could not work for the British people. I fear it would inevitably lead to friction and then a damaging re-opening of the nature of our relationship in the near future: the very last thing that anyone on either side of the Channel wants. As for a Canadian style free trade agreement, we should recognise that this is the most advanced free trade agreement the EU has yet concluded and a breakthrough in trade between Canada and the EU. But compared with what exists between Britain and the EU today, it would nevertheless represent such a restriction on our mutual market access that it would benefit neither of our economies. [GPS: This is, by far, the most critical part of May's speech. She is essentially saying that a Canadian FTA deal would benefit the EU more than it benefits the U.K., a point we have made for nearly two years now. This is true. The U.K. needs access to the EU services market, where British exporters have a comparative advantage. Were they to secure an FTA deal with the EU instead, they would be giving Europe a massive advantage, given the bloc's comparative advantage in tradable goods (Chart 16). However, this takes us back to Diagram 1. What kind of a relationship does May expect to get from the EU when she is unwilling to accept any of the liabilities inherent in such a deep trade deal? That is precisely what the Common Market is for.] Chart 16Brexit Hinders U.K.'s Comparative Advantage Brexit Hinders U.K.'s Comparative Advantage Brexit Hinders U.K.'s Comparative Advantage Bottom Line: Prime Minister May's Florence speech has shown the limits of the U.K.'s negotiating position. May set a friendly tone with Europe, but she has nothing to bargain with. Much of the speech reiterated British commitment to Europe's security and its capacity to defend the continent from external threats. In exchange, May argues, the U.K. ought to receive the deepest and most expansive access to the EU Common Market without any of the liabilities that go with it. In particular, she wants access to the EU's services market, where U.K. exporters have a comparative advantage. The problem with the tradeoff between U.K. geopolitical benefits and EU economic benefits is that it suggests that London has an alternative to being a geopolitical ally to Europe! As if it could suddenly shift its geopolitical, military, and diplomatic focus elsewhere. Berlin, Brussels, and Paris will call London's bluff. The U.K. is not in North America, it is in Europe. As such, Europe's problems are the U.K.'s problems, and the U.K. must defend against them even if it receives little in return. We expect the U.K. to succumb to the reality that the EU holds most of the cards in the negotiations. The U.K. will have a lower potential GDP growth rate after Brexit. But before Brexit is solidified, we expect considerable domestic political upheaval. In the short term, there is some upside for the pound. In the long term, it is a sell. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Although she has herself played a role in kicking out the original, even more moderate, founders of the party. 4 The CDU, FDP, and Greens coalition is dubbed the "Jamaica coalition" because of their traditional colors - black, yellow, and green - which combine to make the colors of the Jamaican flag. 5 The CSU does not directly compete against the CDU on the federal level. It only fields candidates in Bavaria, where the CDU does not compete. 6 For the full transcript, please see "Theresa May's Florence speech on Brexit, full text," The Spectator, September 22, 2017, available at blogs.spectator.co.uk. 7 In turn, this will allow the EU to build up its power, develop a navy, and finally conquer the British Isles with a new armada somewhere around 2066! Geopolitical Calendar

Highlights A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. Expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. This yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD. Underweight U.K. consumer services versus the FTSE100. Overweight German consumer services versus the DAX. The September 24 German election and October 1 proposed referendum on Catalan independence are not major catalysts for the financial markets. Feature A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. As monetary policy resynchronizes, it will become clear that the extreme desynchronization of monetary policies over the past few years was the great anomaly (Chart of the Week and Chart I-2). This anomaly reached its peak in 2014 when policies at the ECB and the Federal Reserve moved in diametrically opposite directions. The ECB signalled the start of its quantitative easing just as the Fed began to end its own. Chart of the WeekThe Desynchronization Of Monetary##br## Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly Chart I-2The Desynchronization Of Monetary##br## Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly The Desynchronization Of Monetary Policy Was An Anomaly Why Did Monetary Policy Desynchronize? The extreme desynchronization of monetary policy would not have happened if it was just about economics. On the basis of the hard economic data, the ECB could have emulated the unconventional policies of the Fed, BoJ and BoE years before it eventually did in 2015. If it had, ECB policy would have been much more synchronized with the other major central banks. However, unconventional monetary policy wasn't, and isn't, just about economics. The ECB faced, and still faces, much tougher political and technical hurdles than other central banks. The euro area does not have one government, it has 19. The ECB had to convince sceptical core euro area governments that zero and negative interest rate policy and bond buying were not just a bailout for the periphery, especially with the euro debt crisis so fresh in the mind. Likewise, the euro area does not have one sovereign bond, it has 19. To design and implement an asset purchase program in the euro area is much more complicated than in the U.S., Japan or the U.K. But by mid-2014 it had become clear that each wave of unconventional monetary easing - through its impact on exchange rates - had allowed other major economies to 'steal' some inflation from the euro area (Chart I-3). With the ECB still undershooting its inflation mandate, it was becoming a dereliction of duty for the ECB not to do what the Fed, BoJ and BoE had already done several years earlier. As the saying goes, it is better for a reputation to fail conventionally, than to succeed unconventionally. Chart I-3Currency Depreciations "Steal" Inflation From Other Economies Currency Depreciations "Steal" Inflation From Other Economies Currency Depreciations "Steal" Inflation From Other Economies Why Will Monetary Policy Resynchronize? Three years and several trillion euros later, the ECB can feel it has had a fair crack at unconventional easing (Chart I-4). At the same time, the central bank must contend with fresh political and technical hurdles. How many more German bunds can it realistically buy without irking Germany's policymakers? Chart I-4The ECB Has Had A Fair Crack At QE The ECB Has Had A Fair Crack At QE The ECB Has Had A Fair Crack At QE The ECB is also aware that ultra-loose monetary policy - by compressing banks' net interest margins - endangers banks' fragile profitability. This impairs the bank credit channel which is the mainstay of private sector credit intermediation in the euro area.1 Meanwhile, the euro area's configuration of solid economic growth, solid job growth and subdued inflation is common to most large developed economies (the exception is the U.K. which we explain below). Putting all of this together, the theme for the coming years has to be monetary policy resynchronization, one way or the other. One way is that the more hawkish central banks will become less hawkish, as subdued inflation limits the scope for monetary policy tightening. The other way is that the more dovish central banks will become less dovish as the benefits of ultra-accommodation diminish and the costs rise. Or, both ways will happen together. Nowhere are negative bond yields more absurd and more inappropriate than in Sweden (Chart I-5). In just three years the economy has grown 12% and house prices have surged 50%. Furthermore, unlike in other parts of Europe, the housing market in Sweden did not suffer a meaningful setback in either 2008 or 2011. Yet Sweden's negative interest rate policy means that it stills pays people to borrow and further bid up house prices. If anywhere is at risk of a bubble from ultra-accommodative monetary policy, Sweden must be it. For bond yield spreads and currencies - which are relative trades - it doesn't really matter how the resynchronization of monetary policies occurs. We expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. And this yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD (Chart I-6). Chart 5A Negative Bond Yield ##br##In Sweden Is Absurd A Negative Bond Yield In Sweden Is Absurd A Negative Bond Yield In Sweden Is Absurd Chart I-6If The Swedish Bond Yield Shortfall ##br##Compresses, The Krona Will Rally If The Swedish Bond Yield Shortfall Compresses, The Krona Will Rally If The Swedish Bond Yield Shortfall Compresses, The Krona Will Rally The Myth Of The Beneficial Currency Devaluation Sharp depreciations in a currency result in an economy 'stealing' inflation from its major trading partners. Chart I-7 and Chart I-8 suggest that absent the post Brexit vote slump in the pound, the gap between U.K. and euro area inflation would be almost 1% less than it is. Chart I-7The Weaker Pound Lifted ##br##U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... Chart I-8...And U.K. ##br##Core Inflation ...And U.K. Core Inflation ...And U.K. Core Inflation So the Brexit vote explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. Which means that the pound's weakness has choked households' real incomes. Against this, textbook economic theory says that a currency devaluation should make a country's exports more competitive and thereby boost the net export contribution to economic growth. But in the textbook the only thing that is supposed to change is the exchange rate. The textbook assumes that the country's trading framework with its partners remains unchanged. In the case of the U.K. leaving the EU, this assumption clearly does not apply, mitigating the concept of the 'beneficial currency devaluation'. A lot of the benefits of the textbook devaluation come because firms can trade in markets that were previously unprofitable to them. This process requires investment - for example, in marketing and distribution. If Brexit means that many of those markets are no longer available, or come with tariffs, then firms will hold off making the necessary investments - unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. We also hear the myth of the beneficial currency devaluation applied to the weaker members of the euro area. As in, why don't these countries just break free from the euro, and devalue their way to prosperity? The simple answer is that if they left the euro, they would also risk losing access to the largest single market in the world - defeating the whole purpose of the beneficial currency devaluation! A Tale Of Two Consumers Chart I-9A Good Pair Trade: Long German Consumer ##br##Services, Short U.K. Consumer Services A Good Pair Trade: Long German Consumer Services, Short U.K. Consumer Services A Good Pair Trade: Long German Consumer Services, Short U.K. Consumer Services For the time being, hawkish comments from the BoE have given the pound a boost. But U.K. consumer spending now faces one of two headwinds. If the BoE follows through with a rate hike, household borrowing is likely to fade as a driver of spending. Alternatively, if the BoE backs off from its threat, the pound will once again weaken, push up inflation and weigh on real incomes. So for the time being, stay underweight U.K. consumer services versus the FTSE100. In Germany, the opposite logic applies. Stay overweight German consumer services versus the DAX. Euro strength helps German consumers in as much as it reduces the prices of imported food and energy. But for German exporters, the strong euro hurts the translation of their multi-currency international profits back into local currency terms. A good pair trade is to be long German consumer services, short U.K. consumer services (Chart I-9). Finally, regarding two upcoming political events - the September 24 German election and the October 1 proposed referendum on Catalan independence, we do not see either as a major catalyst for the financial markets. In the case of the German election, it is because no likely outcome is especially malign (or benign). In the case of the Catalan referendum, it is because it will be hard to draw any meaningful conclusion from the result, given that Madrid has ruled the referendum illegal - and many 'unionists' are unlikely to participate. Please note that there is no Weekly Report scheduled for next week as I will be at our New York Conference. I hope to see some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the euro area, small and medium sized companies tend to access credit through banks rather than through the bond market. Fractal Trading Model This week, we note an excessive underperformance of U.K. personal and household goods (dominated by BAT, Unilever, Reckitt Benckiser) versus U.K. food and beverages (dominated by Diageo and Associated British Foods). Go long U.K. personal and household goods versus U.K. food and beverages with a profit target / stop loss of 4.5%. In other trades, short nickel / long silver hit its 8% profit target, while short MSCI China / long MSCI EM hit its 2.5% stop loss. This leaves three open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long U.K. Personal and Household Goods / Short U.K. Food and Beverages Long U.K. Personal and Household Goods / Short U.K. Food and Beverages The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Even isolated North Korean attacks are unlikely to lead to a full-scale war; The USD sell-off will start to reverse once Trump makes Gary Cohn his official pick for Fed chairman; Europe is not a risk for investors ... even Italy is only a longer-term risk; France is reforming; stay long French industrials versus German. Feature Last week, in London, we were scheduled to give a talk on Sino-American tensions, East Asian geopolitical risks, and North Korea specifically. We submitted our topic of choice about a month ahead of the event, when tensions between Pyongyang and Washington were at their height. As tensions temporarily subsided following Supreme Leader Kim Jong-Un's decision to delay the planned missile launch towards Guam, several colleagues wondered if the topic was still a pertinent one. We stressed in our research that tensions would not dissipate and would continue to be market-relevant, if not critical for S&P 500.1 Unfortunately, we have been proven right. Forecasting geopolitics requires insight, multi-disciplinary methodology, and a treasure trove of empirical knowledge. But sometimes it also just comes down to using Google and looking at a calendar. For example, given the present context of heightened tensions, the annual U.S.-South Korean military exercises - Key Resolve, which occurs normally in the spring, and Ulchi-Freedom Guardian, which occurs in August - are obvious dates to monitor. They are provocations that North Korea has to respond to for both foreign and domestic audiences. Pyongyang has chosen to do so by firing an ICBM across Japan and testing a sixth nuclear device, allegedly a miniaturized hydrogen bomb. While both these actions qualitatively expand on previous acts (missile and nuclear tests), neither cross a threshold. We are still in the realm of "territorial threat display." President Trump and Supreme Leader Kim are angling their "swords," but have not dared to cross them yet. Nonetheless, our clients have pointed out that our "arch of diplomacy" approach leaves a lot to imagination. Therefore, the first insight from the road of this week is that we need to put our thinking cap on and imagine a scenario where tensions do blow over into open conflict. How do we imagine such a scenario occurring and why would it not devolve into full out war that forces the U.S. to attack the North Korean mainland? Is North Korea About To Become A Praying Mantis? We can imagine a scenario where North Korea commits an act that takes us beyond the nuanced thresholds set by recent history (Chart 1). For example, we have cited to clients that an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.2 We could see the U.S. following the script from 1988 Operation Praying Mantis in the Persian Gulf - the largest surface engagement by the U.S. Navy since the Second World War - when the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines.3 Chart 1North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long Such an increase in tensions is not our baseline case, but we assign much higher probability to it than to an all-out war on the Korean Peninsula (which we still see as highly unlikely). How would the markets react to the sinking of North Korean submarines? How would Pyongyang react? The answer to the former (market's reaction) depends on the answer to the latter (what does Pyongyang do?). Our best guess is that Pyongyang would do nothing. In fact, we may never know that North Korean submarines were sunk. We would suspect that North Korean military strategists would chalk the subs as a loss and quietly move on to more missile tests. Leadership in Pyongyang is massively constrained by its quantifiable military inferiority. This part requires a bit of "order-of-battle" analysis, so bear with us for a few paragraphs. North Korea has around 6 million military personnel, about 25% of the total North Korean population, ready to fight. Which would be great if it were preparing to charge Verdun in WWI. Unfortunately for Pyongyang, it is arrayed against one of the most sophisticated defenses ever constructed by man. To burst through the Demilitarized Zone (DMZ), its mammoth ground forces would have at their disposal about 2000 T-55s (designed in the 1950s) and an unknown number of T-72s (designed in the 1970s). The former are obsolete, but the latter are solid main battle tanks that could do damage ... that is, in a world where war was not airborne. The problem is that North Korea would lose air superiority within hours of any serious engagement leaving its tanks and ground troops vulnerable to death-from-above. Since North Korean troops would have to enter about 20 miles into South Korea to threaten Seoul with occupation, they would have to exit the range of most of their air defenses. Choosing to turn on the most powerful of their systems - such as the KN-06 with a 150km range - would leave them vulnerable to the U.S. AGM-88 HARM missiles that sniff out active radar antenna or transmitters. To protect its invading forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15 and F-16s, plus American forces that would vary in size depending how many aircraft carriers were deployed in the vicinity and whether U.S. forces in Japan were deployed to counter the attack. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would likely quickly find themselves fighting a losing battle. Once the North Korean fighter jets were destroyed, the South Korean air force would turn the invasion into a massacre. The reality is that North Korea's ground forces are just for show. Its tanks and fighter jets will never see battle. North Korea really only has two gears: P & N. The first is for "Provocation" and the second is for "Nuclear Armageddon." This is why we highly doubt that we will see our Praying Mantis scenario play out, or lead to full-scale war if it does. North Korea is constrained by its technological inferiority. It does not have the ability to conduct war across a full spectrum of engagement. Neither did Iran in 1988, which is why it never retaliated for the loss of its navy, put all its revolutionary zeal and chest-thumping aside, and sued the U.S. at the International Court of Justice instead.4 The U.S. has a range of limited military engagements, particularly at sea, that could hurt Pyongyang's ability to project what little power it has. Given our constraint-based methodology, which requires one to have some understanding of military affairs, we have a fairly high conviction view that North Korea will continue to toe-the-line of the expected and thus accepted provocations along the lines of the history surveyed in Chart 1. Going beyond that list would threaten to expose the paucity of North Korea's military capabilities. Bottom Line: We are still in for a wild ride with North Korea. As we expected, regional safe haven assets continue to perform well. We will hold on to our safe haven basket of Swiss bonds and gold, up 2.6% since August 16. Nonetheless, we expect North Korea to steer clear of provoking a war. Gary Cohn Will Collapse The USD! (But What If He Already Did?) Several fast-money clients - both in the U.S. and Asia - have a theory for why the greenback continues to suffer: Gary Cohn. The theory goes that Cohn is an ultra-dove whose job as the next Fed Chair will be to stay "behind the curve" and drive down the USD. This would accomplish President Trump's lofty nominal GDP growth goals despite legislative hurdles to his fiscal policy. It would also keep risk assets well bid and help begin rebalancing the U.S. trade deficit. What do we know of Mr. Cohn's views on monetary policy? Not much: He defended the Trump administration goal of a 3% GDP growth target, suggesting that he has a far more optimistic view of U.S. growth than the current Fed projection;5 He believes that monetary policy is "globalized," intoning at a conference in Florida quickly after the election that the Fed policy of raising rates before the rest of the world is ready to do the same would be a mistake;6 In a January 2016 Bloomberg TV interview, he said that both the U.S. and Chinese currencies were overvalued and would both have to devalue.7 People who know and have worked with Gary Cohn (including one colleague at BCA!) speak highly of his pragmatism, work ethic, and focus. Most agree that he would likely be dove-ish, but there is not a single person we have spoken to who thinks that he will be Trump's puppet. As such, his disconnected statements largely say nothing about his potential style of leadership. His most ultra-dovish, USD-slaying comment comes from January 2016, with DXY 6.9% down since then (Chart 2). Mission Accomplished Mr. Cohn? The real reason for the USD slide, aside from a persistently disappointing inflation print, has been a realization by the market that President Trump's bark has no bite. On a slew of measures, President Trump's initial bravado has dissipated into flabby rhetoric. Chart 3 shows the initial surge in optimism regarding growth, tax reform, infrastructure spending, Mexico's comeuppance, and bi-partisanship (measured as support among independents). Each data point has not only fallen back to pre-election levels, but appears to have now been desensitized to any news that would have excited it in the past. For example, NAFTA negotiations are off to a poor start, President Trump continues to bash the trade deal, and yet the peso has rallied since Trump's inauguration! Chart 2Mission Accomplished, Mr. Cohn? Mission Accomplished, Mr. Cohn? Mission Accomplished, Mr. Cohn? Chart 3Trump's Bark Has No Bite? Trump's Bark Has No Bite? Trump's Bark Has No Bite? The Fed itself has lost faith in the president. The number of FOMC members who see upside risks to inflation and GDP growth, not unrelated to fiscal policy, has fallen after a brief surge after the election (Chart 4). Chart 4The Fed Also Doubts Trump Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World What chances are there for the White House and Congress to re-write the fiscal narrative over the final quarter of 2017? As we wrote last week, Hurricane Harvey will ensure that a debt ceiling breach and government shutdown are avoided. However, Congress is likely to spend September making one last attempt at Obamacare repeal and replace, thus largely wasting the month before returning to tax reform in earnest in the new fiscal year. We expect some form of tax legislation to take shape by the end of December. Will it be comprehensive tax reform? Unlikely. It will now almost certainly be merely a tax-cutting exercise, with some revenue offsets attached to it. With the Republicans in Congress now leading the tax reform effort, it is unlikely that the budget deficit hole will be as wide as President Trump would have wanted. The problem is that both Trump's July tax reform proposal and the House GOP August plan come short of revenue-neutrality by around $3-3.5 trillion (over the decade-long period) (Table 1). Given that such a massive increase in the deficit would be unacceptable to fiscal hawks (or Democrats) in the House, we would expect tax rates to be cut by a much more modest degree. Table 1By How Much Will Republican Tax Cuts Widen The Deficit? Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World Table 1 gives a detailed survey of the preferences (Tax Cuts) and constraints (Revenue Offsets). It is difficult to see how all the constraints are overcome through the legislative process. This will force Republicans to modify their preferences on the scale of tax cuts. We would expect that a corporate tax cut from 35% to around 27-28% could be possible, along with a minimal middle-class tax cut. Anything beyond that would be overly complicated. Therein lies the paradox for Chair Cohn. The only way that he can be "behind the curve" is if the curve gets "in front of him." But why would it if any coming tax legislation has very little stimulative effect on the economy? Currently, the expected change in the Fed Funds Rate over the next two years stands at a measly 40 bps (Chart 5). That is just barely two rate hikes until September 2019. How can Mr. Cohn get the expectations any lower at this point? Bottom Line: The appointment of Gary Cohn will be a classic "sell the (USD on the) rumor, buy (the USD) on the news." We expect his appointment in late November or early December, if President Trump goes by the lead time from the past two nominations (Chart 6). That may be the time to pare back USD shorts for those investors who have been bearish on the greenback. Chart 5Hard To Drive Expectations##BR##Lower For Rate Hikes Hard To Drive Expectations Lower For Rate Hikes Hard To Drive Expectations Lower For Rate Hikes Chart 6How Long Does It Take To##BR##Confirm The Fed Chair? Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World Europe Is Not A Risk Chart 7Europe's Economy Zooming Along Europe's Economy Zooming Along Europe's Economy Zooming Along One clear insight from our five weeks on the road this summer is that Europe is no longer on anyone's radar. We had hardly any questions regarding the upcoming German or Italian elections. And while most investors were somewhat pessimistic regarding French structural reforms, none expressed any interest in betting against them either. The obvious reason is that Europe's economy has genuinely recovered (Chart 7). Consumer and business confidence are holding up while the manufacturing PMI and industrial production remain strong. That said, uniformity of view among clients across several geographies makes us nervous. On the future of the Euro Area, investors have swung wildly from morose to resigned that it is here to stay. Nonetheless, we generally agree with the consensus. Unlike at the beginning of this year, when we boldly claimed that European risks would turn out to be a "trophy red herring," we have no alpha to generate by disagreeing with the market.8 Here is why: German Election: We have a policy of not wasting our client's time by covering major geopolitical events that have no market-relevance. Germany is the world's fourth-largest economy and it will hold an election on September 24. However, we see no investment relevance in the election and therefore no reason to spend time covering it. Polls show that the center-left opposition Social Democratic Party (SPD) has arrested its decline and may force another Grand Coalition (Chart 8). The only moderately interesting question is whether Chancellor Angela Merkel's Christian Democratic Union (CDU) will be able to get its favored coalition ally, the Free Democratic Party (FDP), into government instead. The FDP has turned towards soft Euroskepticism since 2009. Its parliamentarians voted against several bills dealing with the Euro Area crisis during their 2009-2013 coalition with the CDU. That said, Chancellor Merkel has turned much more forcefully pro-Europe since the dark days of Greek bailouts and bond market rioting. The Chancellor can read the polls: Germans support the common currency at 81%, compared to 66% average between 2009-2013 (Chart 9). We expect the FDP to play along with the Europhile conversion by the CDU. Chart 8Another Grand Coalition? Another Grand Coalition? Another Grand Coalition? Chart 9Merkel Knows Germans Support The Euro Merkel Knows Germans Support The Euro Merkel Knows Germans Support The Euro If there is any significance to the calm ahead of the German election, it is that the country is at "peak normal." Its policymakers have dealt with a massive migration crisis, geopolitical crises to the East, terrorist attacks, and severe political and economic stresses in its sphere of influence, all with a near-complete absence of internal drama. This looks like either "as good as it gets," or the start of a new Golden Age in Europe, with Berlin in the lead. It is probably neither, but given European asset prices, and gearing to the growing global economy, we would remain overweight Euro Area equities going forward. Italian Election: Polls remain too-close-to-call in the upcoming Italian election, with Euroskeptic parties continuing to poll well (Chart 10). However, we are not sure one can truly call these parties Euroskeptic anymore. Despite a high level of Euroskeptic sentiment in the country (Chart 11), its Euroskeptic parties have been scared off by the failures of peers in Austria, the Netherlands, and France. Chart 10Italy: Euroskeptic Parties Poll Well... Italy: Euroskeptic Parties Poll Well... Italy: Euroskeptic Parties Poll Well... Chart 11...Reflecting Broader Euroskepticism ...Reflecting Broader Euroskepticism ...Reflecting Broader Euroskepticism Luigi Di Maio, leader of the anti-establishment Five Star Movement (M5S) in the Italian Chamber of Deputies, and Matteo Salvini, head of the right-wing, populist Lega Nord, both reversed positions on the euro this month. Di Maio will be 5SM candidate for prime minister in the upcoming elections - which must be held by May and will likely take place in February or March. He reiterated a position, which 5SM hinted at in the past, that leaving the Euro Area would only be the "last resort" if Brussels refused to relax strict budget rules. Meanwhile, the firebrand, populist, Salvini hid behind Italy's constitution, claiming that a referendum on the euro would be illegal. In the short term, this means that the election in 2018 is no longer a risk. In the long term, it does not change the fact that Italy is ripe for a bout of Euroskeptic crisis at some later stage. Migration Crisis: Bad news for right-wing populists everywhere: the migration crisis is over and in quite a dramatic fashion. This is an empirical fact (Chart 12). Europe's enforcement efforts and collaboration with Libyan authorities (such as they are) have now forced even the humanitarian agencies to abandon the Mediterranean route. One of the largest such agencies - the Migrant Offshore Aid Station (MOAS) - recently announced that it was packing its mothership, the Phoenix, for Myanmar. The group is the fourth to stop patrols for migrants. Medecins sans Frontieres, Save the Children, and Germany's Sea Eye all cited hostile actions taken by Libyan authorities towards their vessels as the main reason to stop rescuing migrants in Libyan waters. Chart 12The 'Migration Crisis' Is Definitively Over The 'Migration Crisis' Is Definitively Over The 'Migration Crisis' Is Definitively Over To be clear, what is happening in the Mediterranean is a result of European enforcement efforts, not any sudden awakening of Libyan capacity or sovereignty. The European Union and Italy are training and funding the Libyan Coast Guard, which has started to intercept humanitarian vessels, threaten them with force (often right in front of the Italian Navy!), and force them to return migrants to Libya, where they are subjected to extremely cruel internment. Prior to this development, human smugglers would launch barely seaworthy "crafts" towards humanitarian ships waiting literally yards away in Libyan waters to "rescue" the "migrants" to Europe. As such, humanitarian agencies were aiding and abetting human smuggling, by making it a lucrative enterprise with no downside risk for the smugglers. We expect the step-up in enforcement in Libyan waters to severely impair the cost-benefit calculus of attempting a Mediterranean crossing for a would-be migrant. Instead of a welcoming NGO vessel many will find themselves in Libyan Internment camps. Word will spread fast and the migration crisis will abate further. We have now come full circle on the migration crisis, which we predicted back in September 2015 would end precisely in such an illiberal fashion.9 Europe has a vicious streak ... who knew? Structural Reforms In France: In February, we penned a bullish report on France, arguing with high conviction that Marine Le Pen would lose and that structural reforms would follow.10 What is the status of the latter forecast? Despite a decline in President Emmanuel Macron's popularity (Chart 13), he is expending his political capital early in his term. He understands our "J-curve of Structural Reform" (Diagram 1). Policymakers who understand how the reform J-curve works know that they have to spend their political capital while they have it, at the beginning of their term, in order to reap the benefits, if there are any, while they are still in power. Chart 13Macron's Popularity Slips Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World Diagram 1The J-Curve Of Structural Reform Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World How do Macron's reforms compare with previous efforts? Generally speaking, Macron's reforms (Table 2) compare favorably with both the 2012 Mariano Rajoy reforms in Spain and the 2003 Hartz reforms in Germany. The Hartz reforms were instrumental in expanding temporary work contracts and restructured generous unemployment benefits. Similarly, the Rajoy reforms in Spain clarified economic grounds for dismissal and created more flexible "entrepreneur contracts." Macron's reforms fit these efforts, especially the proposals to put in place "project contracts" - an open-ended contract lasting for the duration of a project - and to establish a floor and a ceiling for allowances in cases of unfair terminations, and make termination for economic reasons easier. Table 2French Labor Reforms: The Key Bits Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World The two criticisms of the reform efforts we most often hear are that France has not had a crisis to spur reforms and that unions will launch vicious protests. The first criticism is dubious, given that France is itself emerging from the low-growth doldrums of the post-Great Financial Crisis. It is simply false to say that France has had no crisis. The French public is acutely aware that its real per-capita GDP growth has been closer to Greek levels than German ones over the last two decades (Chart 14) and that it has lost competitiveness in the global marketplace (Chart 15). One cannot have a conversation with a French friend, colleague, or client without wanting to order a strong drink!11 Chart 14France's Lost Millennium Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World Chart 15France's Lost Competitiveness France's Lost Competitiveness France's Lost Competitiveness Besides, what monumental crisis was it that propelled Germany into reforms in the early 2000s? A vicious recession? A massive bank crisis? It was neither. Germany was simply weighed down for a decade by fiscal transfers to East Germany and sensing that its export-oriented industry was facing a massive challenge from the Asian move up the value chain. It was this acute sense of competitive pressure, of falling behind, that spurred Germany to reform. With France, the acute sense of falling behind Germany (Chart 16) is at the heart of today's effort. Chart 16German Competition Puts A Fire Under France German Competition Puts A Fire Under France German Competition Puts A Fire Under France The second criticism, that the unions will hold protests, misjudges the political capital arrayed behind Macron. Despite his sagging popularity, 85.9% of the seats in the National Assembly are of pro-reform orientation (Diagram 2). The second-largest party in the parliament is Les Republicains, an even more zealously pro-reform group. This is a unique situation in French history and will allow the government to ignore protests on the street. Diagram 2The Balance Of Power In France's National Assembly Insights From The Road - The Rest Of The World Insights From The Road - The Rest Of The World In fact, two of the largest unions in France - Force Ouvrière and CFDT - have both said they would not protest the labor reforms. This leaves only the more militant CGT to protest, along with the left-wing presidential candidate Jean-Luc Mélenchon. The reason investors will still fret about protests this month is because CGT retains a strong representation in heavy industry and infrastructure sectors like energy and railways. As such, their industrial action could grind the country to a halt. We suspect that a repeat of the 1995 general strike or the 2010 French pension reform unrest - both of which CGT spearheaded - will be the final nail in the coffin of "Old France." Unlike those previous reform efforts, President Macron's effort has been clearly signaled ahead of the election and thus retains considerable democratic legitimacy. As such, any repeat of the 1995 or especially 2010 unrest would delegitimize the unions and give President Macron even more political capital. Bottom Line: We agree with the now conventional view that all is well in Europe. Stability ahead of the German election reminds investors of what a healthy country is supposed to look like. Italian election risks have dissipated. And our French structural reforms call remains on track. This gives us an opportunity to do some house-cleaning regarding our calls. First, we are closing our long French 10-year bond / short Italian 10-year bond trade for a gain of only 1 bps. Second, we are closing our overweight Euro Area equities relative to U.S. equities call for a gain of 7.88%. Given our euro-bullishness, we never recommended that this call be currency hedged. We are now reinstating it with a currency hedge. We are also closing our long German 10-Year CPI Swap for a gain of 45.5 bps. We will stick with our long French industrial equities / short German industrials, which is currently up 9.25%. This is a way we have chosen to articulate our bullish view on the reforms, although clients with greater sophistication in European sectors could come up with a more direct way to articulate the view. Separately, we are also booking profits on our long China volatility trade (CBOE China ETF Volatility Index) for a gain of 16.82%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 2 A North Korean submarine sank the South Korean corvette Cheonan in 2010, but that was still within the norm of behavior for the two countries that are still effectively at war and have contested maritime borders. 3 Romeo-class submarines are nearly 70 years old. As much as we harken back to Yugoslav engineering with pride at BCA's Geopolitical Strategy, Belgrade was never much of a naval power. Nonetheless, diesel-powered submarines are quite proficient in staying undetected and could present a problem for the U.S. Navy. At least until they had to resurface or get back to base, where nuclear-powered U.S. Virginia-class attack-subs would lie in wait for them. 4 Tehran won the court case in 2003! And the ICJ forced the U.S. to compensate Iran for its lost ships or else face invasion by the United Nations army. (We are just kidding obviously. Iran did win, but it got nothing.) Please see Pieter H.F. Bekker, "The World Court Finds that U.S. Attacks on Iranian Oil Platforms in 1987-1988 Were Not Justifiable as Self-Defense, but the United States Did Not Violate the Applicable Treaty with Iran," American Society of International Law Volume 8, Issue 25, dated November 11, 2003, available at: asil.org. 5 Please see CNBC, "Tax reform is coming in September, Trump economic advisor Gary Cohn says," dated June 29, 2017, available at cnbc.com. 6 Please see Wall Street Journal, "How Donald Trump's New Top Economic Adviser Views the World," dated December 14, 2016, available at wjs.com. 7 Please see Business Insider, "Trump and his top economic adviser have had completely different views on China," dated January 3, 2017, available at businessinsider.com. 8 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 11 Thankfully for France, the choice would still be French wine!

Highlights The Mueller investigation is part of the "Trump Put;" General White House disarray and congressional incompetence combine to produce Goldilocks conditions for U.S. equities; Mexico's frontrunner in the upcoming elections, Andres Manuel Lopez Obrador, is no Chavez; Malaysian political risks are overstated, the ruling Barisan Nasional has pushed through painful reforms; With economic growth stabilizing, cheap valuations, and overstated political risks, Malaysia could be an intriguing investment opportunity. Feature This week, we turn to two emerging markets: Mexico and Malaysia. Our approach to EMs is to look for opportunities where politics may emerge as the alpha amidst appealing valuations. We rely on our sister strategy, BCA's Emerging Market Strategy, for fundamental analysis, to which we then add our political research. We find it striking that these two EMs are the very two that stood to suffer the most should U.S. Congress have passed a border adjustment tax (Chart 1). Not only have the Republicans forsworn the border tax, but these countries will benefit from other trends, as we explain below. Before we dive into Malaysia and Mexico, however, a short note on the latest developments in the White House is in order. Clients from St. Louis, Missouri to Auckland, New Zealand are asking us the same question this summer: when does the Mueller investigation become a headwind for the SPX? Chart 1Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America The "Trump Put" Continues Our answer is that Special Counsel Robert Mueller's investigation may already be a tailwind to the U.S. equity market. The investigation, along with general White House disarray and congressional incompetence, makes up the ongoing "Trump Put."1 The American political imbroglio has combined with decent earnings and steady global growth to produce Goldilocks conditions for U.S. equities, while simultaneously weakening the USD and supporting Treasuries. The political fulcrum upon which all these assets turn is the failure of the Trump administration to deliver its promised fiscal stimulus (Chart 2). Tax reform, which was supposed to be the main vehicle of such stimulus, is increasingly looking like it will fail to live up to its hype. We still think it will pass, for three broad reasons: Chart 2Handcuffed Trump The Most Likely Scenario Handcuffed Trump The Most Likely Scenario Handcuffed Trump The Most Likely Scenario Trump's low popularity remains an albatross around the neck of GOP candidates in the November 2018 elections, with potentially ominous results. Our simple "line-of-best-fit" model between a Republican president's approval rating and the GOP's midterm performance produces a 38-seat loss in the upcoming election (Chart 3). Republicans need a legislative win and need it fast. The House has laid the groundwork for tax reform, passing the FY2018 budget resolution with reconciliation instructions focused on tax legislation. This means that the Obamacare replace and repeal effort has until October 1 to be resolved.2 Investors are conflating replacing and repealing Obamacare with tax reform. The former is an entitlement program, the latter a more popular measure that Republicans have always tried to move through Congress. It is very rare for U.S. policymakers to successfully reduce or remove an entitlement program. Cutting, even reforming, taxes is easier to justify politically. Chart 3The Clock Is Ticking For The GOP On Tax Reform Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Although we still maintain that tax reform, or mere tax cuts, will happen, they are unlikely to be as stimulative as originally advertised. Corporate and household tax rates are unlikely to be lowered by as much as originally touted. That is because Republicans in the House will demand "revenue offsets" to accomplish rate reduction, yet they have already lost key offsets like Obamacare repeal and the border adjustment tax.3#fn_3 The White House could change all that by using its considerable political capital among conservative grassroots voters and the bully pulpit to get fiscally conservative Republicans in the House to move a stimulative tax reform through Congress. But, as we noted two weeks ago, factional fighting in the White House and an ineffective chief of staff are considerable hurdles.4 A few days after we published that report, President Trump replaced Reince Priebus with retired General and Homeland Security Secretary John Kelly. While Kelly is likely to introduce some discipline into the White House, we doubt he will make the executive more effective in cajoling House Representatives to toe the administration's line on tax reform. This is because Kelly adds no legislative experience to a White House that is already quite low on it by recent historical standards (Chart 4). Chart 4Trump Administration Is On The Low End Of Congressional Experience Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Additionally, the Trump Administration continues to drag its feet on presidential appointments, hurting the effectiveness of the executive. Only 220 appointments had been sent to the Senate by July 19, compared to the average 309 during the same time period by the previous four presidents (Chart 5). The Senate is very slow in confirming the candidates, perhaps because of their unorthodox backgrounds and resumes. The average time to confirm a Trump nominee is 45 days, which is astonishing given that the Senate is controlled by Republicans. Chart 5The Trump Administration Is Dragging Its Feet On Appointments Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America In addition to the ineffectiveness of the White House, investors fret that the ongoing Mueller investigation, which has just impaneled a grand jury, could undercut the rally in risk assets. By summoning a grand jury Mueller can subpoena documents and obtain testimony of witnesses under oath. Doing so will accelerate the investigation and perhaps take it down new avenues. For example, the Kenneth Starr investigation initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky. Impeachment proceedings ensued. That said, we are sticking with our conclusion from May that investors should look through any risk of impeachment or indictment for President Trump, at least as long as Republicans hold the House of Representatives (i.e., at least until the midterms in 2018).5 In particular, there are three main reasons to fade any near-term equity market volatility: President Mike Pence - Under both impeachment rules and the 25th amendment, the U.S. president would be replaced by the vice president. Vice President Pence's approval rating largely tracks that of President Trump and is in the 40% area, but investors should note that he once stood at nearly 60% during the campaign (Chart 6). As such, the worst-case scenario for investors in the event of a post-midterm impeachment is that Trump is replaced by Pence, an orthodox Republican, and that Pence has to deal with a split Congress. And that is not bad! It would grind reforms to a halt, but at least tax reform would be out of the way by then. Midterm Election - If the Trump White House becomes engulfed in scandal, Republicans in the House will fear losing their majority. Yes, the partisan drawing of electoral districts - "gerrymandering" - has reduced the number of competitive U.S. House districts from 164 in 1998 to 72 in 2016 (Chart 7). But the Democrats managed to win the House in 2006 and the Republicans managed to take it back in 2010, so there is no reason the roles cannot be reversed yet again. However, this is not a risk, it is an opportunity. It will motivate the GOP in Congress to lock in tax and health care reform well ahead of the midterm elections. Counter-Revolution - With Trump embattled and facing impeachment, the market may let out a sigh of relief because it would mark a clear defeat of populist politics in the U.S. Much as with electoral outcomes in Europe, investors may want to cheer the defeat of an unorthodox, anti-establishment movement in the U.S. As such, we would push against any "Russia scandal"-induced volatility in the U.S. markets, at least until the midterm election. We think the market would digest the volatility and realize that Trump's impeachment, were it to occur after midterm elections, would not arrest the Republican agenda before the midterms. After all, the GOP has waited over 15 years to make Bush-era tax cuts permanent and the opportunity to do so may evaporate within the next 12 months. In addition, given the performance of high tax-rate S&P 500 equities (Chart 8), investors appear to have already discounted the failure of meaningful tax reform in the market. This means that the "Trump Put" is in full effect: investors are bidding up risk assets not because they expect something to happen (tax reform, fiscal stimulus, financial deregulation, etc.), but because they expect nothing to happen (no fiscal stimulus, no fast Fed rate hikes, no onerous regulation for businesses, etc.). Chart 6Could Be Worse ##br##Than Pence Could Be Worse Than Pence Could Be Worse Than Pence Chart 7Gerrymandering Reduces##br## Competitive House Seats Gerrymandering Reduces Competitive House Seats Gerrymandering Reduces Competitive House Seats Chart 8Investors No Longer##br## Expect Tax Reform Investors No Longer Expect Tax Reform Investors No Longer Expect Tax Reform What about the long term? A scandal-ridden White House, escalating leaks against the administration, and a mounting bureaucratic revolt against the executive cannot be good for the U.S., can they? The news flow out of Washington increasingly looks like news from Ankara, Brasilia, or Pretoria. There are two diametrically opposed directions the U.S. can take. The first is deepening polarization and policy gridlock that leads to President Trump being replaced by an even greater bout of populism in 2020 or 2024. We described this scenario recently in a pessimistic note about the coming social unrest in America.6 The alternative is that Democrats and Republicans in Congress (particularly the Senate), representing the country's elites, decide to work together on legislation. Both parties recently united to pass veto-proof sanctions on Russia with a 98-2 vote that has bound the executive to future review by Congress. And some green shoots of bipartisanship appeared over the past two weeks on tax reform and even on health care. It is too soon to say which path American policymakers will take. Investors may have to wait until after the midterm election for genuine cooperation. But it would be very positive for the U.S. economy and prospects of reform if genuine bipartisanship emerged as a reaction to the incompetence, scandal, nationalism, and populism of the White House. Bottom Line: The intensifying Mueller investigation and ongoing White House incompetence will only further fuel the "Trump Put." This is positive for U.S. equities, neutral for bonds, and bad for the dollar, ceteris paribus. A significant pickup in inflation could overwhelm the "Trump Put" and cause the dollar to rally. As such, investors should focus on inflation prospects more than politics in the White House. What If Mexico Builds A Wall First? For every action, there is an equal and opposite reaction. The election of President Donald Trump, an unabashed nationalist who campaigned on an anti-immigrant platform, is spurring the campaign of Andres Manuel Lopez Obrador, also known as AMLO, in the upcoming July 1, 2018 elections in Mexico. Obrador has been a left-wing firebrand of Mexican politics for years. He was the Head of Government of Mexico City (essentially the city's mayor) from 2000 to 2005 and contested a close election against Felipe Calderon in 2006, which he narrowly lost. He lost the 2012 election by a much wider margin, but still came second to current president Enrique Pena Nieto of the Institutional Revolutionary Party (PRI). Obrador's election campaign calls for a confrontational attitude towards President Trump, the renegotiation of NAFTA, an increase to farm subsidies, and limitations on foreign investment in Mexico. He has said that he would reverse the opening of the energy sector to foreign investment through a referendum, but that he is in favor of public-private partnerships in the sector. That said, his left-wing firebrand persona is more PR than substance. In 2012, for example, he also campaigned on cutting government expenditure and ending monopolies - not exactly Chavista credentials. Nonetheless, he quit the left-leaning Party of the Democratic Revolution (PRD) to form a more left-wing movement. Obrador's new party, the National Regeneration Movement (MORENA), did well in the 2015 midterms and is currently leading in the polls ahead of the 2018 election (Chart 9). MORENA also did well in the State of Mexico, a PRI stronghold and Nieto's home state, in the June 4 election. The ruling PRI held the state for 90 years and is accused of election-rigging in order to, only narrowly, defeat an unknown MORENA candidate this year. Chart 9MORENA Has Lead In The Polls Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Given that the election is a year away, it is too soon to make a forecast. Nonetheless, it is clear that Obrador is the frontrunner for the presidency. There are three reasons why his election may be an over-hyped risk: The Congress: For much of Mexico's twentieth century history, the president was essentially a dictator due to the one-party rule of PRI. In the twenty-first century, however, Congress has become plural, forcing the president to cooperate with the body or see his reforms stalled. Given recent elections (Chart 10), it is highly unlikely that Obrador would have a congressional majority behind him, thus forcing him to temper his policies. Chart 10Mexico's Rising Political Plurality Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America The PAN-PRD Alliance: An unlikely alliance of the conservative National Action Party (PAN) and the center-left PRD has emerged as a reaction to the rise of MORENA in the polls. (These two parties have a history of cooperating against PRI presidents.) The two parties come from completely opposite ideological spectrums, but successfully joined forces in several state elections in 2016. It is unlikely that the two parties will unify sufficiently to field a single candidate - they failed to do so in the June 4 State of Mexico elections - but they may get enough votes to form a plurality in Congress. Mexicans do not lean left: Unlike most of Latin America, Mexico is a conservative country. Most Mexicans either think of themselves as centrist or lean right (Chart 11). While our data stops in 2015, the historical trend is clear: Mexico is a right-leaning country. As such, it is highly unlikely that AMLO will be able to manipulate the country's democratic institutions - which have been strengthened over the past twenty years - to turn Mexico into Venezuela. Chart 11Mexicans Lean Right Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America We would therefore fade any politically induced volatility in Mexican assets. Next year, investors should prepare to "sell the rumor and buy the news" (you read that right), as Mexican election fever grips the markets. Given current macroeconomic fundamentals, an entry point in Mexican assets may develop if they sell off ahead of the election - but they are not a buy at the moment. BCA's Emerging Market Strategy has pointed out in a recent report that:7 Inflation is well above the central bank's target and is broad based (Chart 12). Notably, wage growth is elevated (Chart 13). Given meager productivity growth, unit labor costs - calculated as wage-per-hour divided by productivity (output-per-hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will, in turn, prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Chart 12Inflation is Above Target Inflation is Above Target Inflation is Above Target Chart 13Wage Inflation Is High Wage Inflation Is High Wage Inflation Is High Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail a further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart 14). This will weigh on corporate profits and share prices. Even though non-oil exports and manufacturing output are accelerating (Chart 15), non-oil exports - which make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. That said, the positive for Mexico is that the Mexican peso remains cheap (Chart 16) and may rally against other EM currencies. Our EM strategists suggest that investors should overweight MXN versus ZAR and BRL. Chart 14Domestic Demand to Buckle Domestic Demand to Buckle Domestic Demand to Buckle Chart 15Exports are Robust Exports are Robust Exports are Robust Chart 16Peso is Cheap Peso is Cheap Peso is Cheap If EM currencies depreciate or oil prices drop, it would be difficult to see MXN rally against the USD. However, MXN should outperform other currencies, especially given that political risks in Mexico are far lower than they are in Brazil and South Africa. Bottom Line: The Mexican markets may get AMLO-fever in 2018. Obrador is a clear frontrunner in the election to be held a year from now. However, AMLO will face off against constitutional, political, and societal constraints. As such, we would fade any politically induced risks in Mexican markets. Go strategically long MXN versus BRL and ZAR and look for an entry point into Mexican risk assets over the next 12 months. Malaysia: Hold Your Nose And Buy We have been broadly bearish on Malaysia since August 2015, but the upcoming elections - due by August 2018, but we expect to occur sooner rather than later - are likely to cause the markets to re-price Malaysian assets (Chart 17). The country's fundamentals are not rosy, and it remains vulnerable to a slowdown in China, a drop in commodities prices, and bad loans. Nevertheless, its underperformance is late, and this fact, combined with the political outlook, suggests that it will outperform for a while. Malaysia is in the midst of a long saga of party polarization that began amid the Asian Financial Crisis, when Prime Minister Mahathir Mohamad ousted his ambitious deputy, Anwar Ibrahim. Both men hailed from the dominant party of the country's ethnic Malay majority: the United Malay National Organization (UMNO), which is the center of Barisan Nasional (BN). The BN is a multi-ethnic coalition that has held power in one form or another since independence in 1957. Anwar went on to lead the reformasi (reform) movement, creating an opposition coalition of strange bedfellows: his own urban Malay People's Justice Party (PKR), the ethnic Chinese DAP, and the Islamist PAS. In the 2008 general elections, the opposition shocked the BN, depriving it of a two-thirds super-majority for the first time since 1969. In the 2013 general elections, the opposition won the popular vote, though BN retained control of parliament due to inherent advantages in the electoral system (Chart 18). Hence the past two elections, particularly the last one in 2013, have shaken the political system to the core. Since the 2013 shock, the opposition has had its sights set on the 2018 election, and a series of blows to the Najib government have given cause for hope. First, exports and commodity prices plunged from 2014 to 2016, damaging the economy and giving the opposition a grand opportunity to attack the administration (Chart 19). Second, Najib was personally implicated in a massive scandal involving 1MDB, a sovereign wealth fund that Najib helped create and from which he allegedly embezzled $700 million (!). Street protests emerged in 2015 and suddenly Najib faced a revolt from the old guard within his own party (including Mahathir himself). Chart 17Malaysian Underperformance Is Late Malaysian Underperformance Is Late Malaysian Underperformance Is Late Chart 18Opposition Threatens UMNO's Dominance Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Chart 19Commodities Should Help Malaysian Exports Commodities Should Help Malaysian Exports Commodities Should Help Malaysian Exports The problem for the opposition, however, is timing. The 2008 election occurred before the worst of the global financial crisis had been felt; the 2013 election occurred before the full impact of the commodity bust; and now the ruling coalition's fortunes are recovering in time for the upcoming election - which, of course, the prime minister schedules to his advantage. Thus, the opposition once again faces an uphill battle in this election cycle: The Malaysian economy has beaten expectations, growing by 5.6% in the first quarter of 2017, the fastest rate in two years. This was driven mainly by exports and the manufacturing sector (Chart 20). Money supply growth is strong while the credit impulse has bottomed and is approaching positive territory (Chart 21). The 1MDB scandal has mostly dissipated. Najib publicly confessed that the $700 million found in his personal account was a donation from a foreign government, and Saudi Arabian authorities confirmed this, prompting Najib to return the money. Malaysia's attorney general, anti-corruption commission, and central bank have all cleared Najib of wrongdoing, and his popular support has recovered from the fever pitch of the scandal in 2015-16, as demonstrated by the net-gain for BN in by-elections since 2013, and the fact that the BN saw its share of seats rise from 27% to 37% in the 2016 Sarawak State Assembly elections. This state's local elections have tended to foreshadow national elections, and it has the largest representation of any state in the national parliament (31/222). The opposition is split. Najib has courted the Islamist opposition party, PAS, peeling it away from the opposition coalition. Without PAS, the opposition falls from 89 seats in parliament to 71 seats, which is 41 shy of a majority. Even in the best case scenario for the opposition in the upcoming election, in which the opposition holds all seats from 2013 and Bersatu gains all of UMNO's seats in Kedah and Johor, the opposition would still fall 16 seats shy of a majority. Chart 20Growth Is Strong Growth Is Strong Growth Is Strong Chart 21Credit Cycle Is Picking Up Credit Cycle Is Picking Up Credit Cycle Is Picking Up Bottom Line: Our baseline case holds that Najib and BN will retain control of the government in the upcoming election on the back of the fading scandal, economic recovery, and a shrewd practice of dividing political enemies. What Does A Najib Win Mean? Is a Najib/BN victory positive for Malaysian risk assets? We think so, at least relative to other EMs. While Malaysia would benefit in the long run from breaking the BN's monopoly over parliament, the immediate consequence of an opposition victory would be confusion as the various opposition parties have widely divergent interests ... and zero governing experience. On the other hand, Najib's government has undertaken some significant reforms, expanded infrastructure, and improved government finances, making his corrupt and pseudo-authoritarian government not as market unfriendly as one might expect: As a result of weak commodities, cuts in subsidies, and the introduction of a goods and services tax (GST) and a tourism tax, Malaysia's fiscal deficit has improved from 5.5% in 2013, when Najib took office, to 3.1% today (Chart 22). The government is on a path to close the deficit by the end of the decade. The GST has allowed the government to reduce its dependency on oil revenues. Non-tax revenues, which include oil royalties, have decreased from 35% in 2010 to only 20% of total revenue, while indirect taxes (which include GST) have increased from 17% to 28% of revenue (Chart 23, top three panels). There are plans to increase the goods covered by the GST in the near future. The government has cut subsidies in fuel and cooking gas, taking advantage of low oil prices. The government had also eliminated subsidies in cooking oil and sugar. Subsidies as a percent of total expenditures have declined from almost 20% in 2014 to only 9% today (Chart 23, bottom panel). The government has expanded infrastructure, completing a mass rail transit extension in Kuala Lumpur, connecting the two East Malaysian states of Sabah and Sarawak via a 2,000 km highway, and attracting Chinese investment from the One Belt One Road program. The latter entails China building an East Coast Rail Link to connect the west and east coasts. Upon completion, this link will enable shippers to circumvent the port of Singapore and reach the South China Sea in a shorter time period. Chart 22Austerity Works Austerity Works Austerity Works Chart 23Tax Reforms Paid Off Tax Reforms Paid Off Tax Reforms Paid Off One perceived drawback of Najib's government is that in order to stay in power, he has had to court the Islamist PAS party, as mentioned above, specifically by allowing it to promote aspects of shariah law in the country's parliament. However, Malaysia is not at risk of being swept away by an imaginary rising tide of Islamic extremism. The country is very diverse, and Malay Muslims make up only a little more than half of the population. Malaysians are highly religious, but they are also highly tolerant, as they have lived among other races and religions since independence (Chart 24). Moreover, Islam is regulated and bureaucratized in Malaysia, which discourages the emergence of charismatic, anti-establishment religious leaders and the development of extremist movements. Finally, the government has an absolute need to win votes both in the Borneo states of Sabah and Sarawak, which have sizable Christian and non-Malay populations (adding up to more than half), and in the population centers of Kuala Lumpur and Penang. This means that it is not likely to allow PAS (or other Islamist movements) to go too far. Chart 24Malaysians Are Tolerant Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Bottom Line: Najib's government is corrupt and has authoritarian leanings, but has improved its management of the economy and public finances, and is not getting out of control with Islamism or populism. We would not expect a sustained market sell off in the face of a BN victory in upcoming polls. By contrast, if the opposition coalition wins a majority, it offers the long-term promise of a more inclusive and competitive political system that would be good for Malaysia, but would bring greater policy uncertainty in the short term. The opposition would likely have a low probability of achieving major reforms, as the BN party-state conglomerate would fight tooth and nail against it. A positive knee-jerk market response to an opposition win - on the expectation that "regime change" raises the probability of pro-market reforms - would likely be ephemeral. Investment Conclusion A key internal risk to the Malaysian economy stems from the country's fairly sizable debt, which may eventually become unsustainable. Yet at the moment, household and government debt are both rolling over even as growth is improving (Chart 25). A key external risk stems from China. Chinese politics are likely to shift from a tailwind for Chinese growth - fiscal stimulus and the need for stability ahead of the National Party Congress - to a headwind, as stimulus subsides and reforms are rebooted in 2018.8 We do not expect China's investment in Malaysia to fall sharply, since it is tied to a broad, long-term, strategic plan; nor do we see Malaysia as overexposed to Chinese imports or tourism. Nevertheless, Malaysia would suffer to some extent, and it is indirectly vulnerable as Malaysian exports to ASEAN and tourists from ASEAN are significant, and ASEAN would suffer from a Chinese slowdown. In short, China is a risk, albeit not as direct or major as one might think. The Malaysian ringgit has already become the best-performing currency this year. Yet this recent appreciation has not come near to reversing the currency's roughly 20% depreciation since 2014. A cheap currency, combined with robust external demand, should be a tailwind for Malaysian exports and the broader economy (Chart 26). Moreover, the rising price of key Malaysian exports like energy and palm oil should be positive for Malaysian equities (Chart 27). Chart 25Debt Is High, But Is Rolling Over Debt Is High, But Is Rolling Over Debt Is High, But Is Rolling Over Chart 26Cheap Currency Is A Tailwind For Exports Cheap Currency Is A Tailwind For Exports Cheap Currency Is A Tailwind For Exports Chart 27Commodities Support Equity Prices Commodities Support Equity Prices Commodities Support Equity Prices At the same time, valuations are attractive. Malaysian equities have underperformed the EM universe and its ASEAN peers since 2013 (see Chart 17 above). Malaysian equities have lost considerable value relative to their EM peers, and are trading at a discount relative to ASEAN peers. Compared to historical valuations, Malaysian equities are also trading at a discount (Chart 28 A and B). Chart 28aMalaysia Is Cheap Compared To Peers... Malaysia Is Cheap Compared To Peers... Malaysia Is Cheap Compared To Peers... Chart 28b...And Its Historical Valuation ...And Its Historical Valuation ...And Its Historical Valuation Bottom Line: The likely start of a new credit cycle, improving government finances, a persistently cheap currency, and the likelihood of an acceptable policy status quo should put a tailwind behind Malaysian risk assets. We recommend going long Malaysian equities relative to their EM peers. Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst Emerging Markets Strategy stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?," dated February 8, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 7 Please see BCA Emerging Market Strategy Weekly Report, "The Case For A Major Top In EM," dated July 12, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com.

Dear Client, We hope that you will find value in this report, a product of collaboration between BCA’s Geopolitical Strategy and EM Equity Sector Strategy. My colleagues Oleg Babanov and Matt Gertken look for investment opportunities in the recent geopolitical changes on the Korean Peninsula. The election of President Moon Jae-in will be a boon for domestic consumer sentiment and relations with China. This will produce a tailwind for the consumer-oriented South Korean stocks, which have high exposure to the country’s trade with China. We deliver this report to you both for its investment value and as an example of BCA Research commitment to seek alpha in the intersection of economics, markets, and geopolitics. Kindest Regards, Marko Papic Senior Vice President Chief Geopolitical Strategist Overweight South Korea Consumer Staples We are recommending an overweight position in select South Korean consumer staples on a long-term (one year-plus) time horizon. A decline in geopolitical tensions between South Korea and China, and a potential improvement on the Korean peninsula, will provide tailwinds to the performance of Korean consumer staples, which have high exposure to China. We expect Chinese tourist numbers to Korea to recover gradually, and sales of South Korean products in mainland China to pick up over the rest of the year. Presidential elections in South Korea and a slowly improving economy are bolstering consumer sentiment and aiding a turnaround in retail sales in the country, with companies in the consumer space displaying better earnings momentum and trading at more attractive valuations than their EM peers (Table 1). Image Sector Backdrop We are turning cautiously positive on consumer staples in South Korea. We believe the following factors will trigger a turnaround in consumer sentiment and support share price performance of consumer-oriented South Korean stocks. Geopolitics Image The election of President Moon Jae-in by a wide margin, as well as a geopolitical shift toward more accommodative policy on China, will alleviate geopolitical risks and help consumer sentiment. Moon has already kicked off his administration's tenure with considerable political capital. For one, his administration represents a return to stable and legitimate government after over a year of turmoil surrounding the scandal, impeachment and removal of former President Park Geun-hye - a relief for South Korean voters. What's more, voter turnout was higher than usual, at 77%, and Moon's margin of victory over his closest contender was over 15%, the second-highest since South Korea became a full-fledged democracy in 1987 (Chart 1). There are also institutional factors playing to Moon's advantage. He was the leading contender for the presidency even without Park being removed from office - but if she had not been removed, he would have taken office in January 2018. Now, Moon has half a year longer in office than he otherwise would have had before he faces his first serious political hurdle in the April 2020 legislative elections. This half year could make a difference. Since Korean presidents serve a single, five-year term, they often become lame ducks in the second half of their term, and therefore move rapidly on policy in the first half while their political capital is high. The only significant domestic political constraint on Moon is the rival left-of-center party, the People's Party. It holds the kingmaker position in the legislature, with the ability to give a majority to either Moon's ruling Democratic Party or to the conservative opposition (Chart 2). However, the People's Party has serious weaknesses and has been compelled by its voting base to cooperate on much of Moon's platform of expanding social spending and thawing relations with North Korea and China. Moreover, the conservative opposition is discredited and fractured. Thus, Moon has limited political constraints. Given that his administration is competent - i.e. the clear populist elements are not joined with a lack of experience or pragmatism - the key question is what policies he will prioritize while his political capital is high. Image Chart 3THAAD Deployment Hurt ##br##Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade It is our view that China-exposed companies stand to benefit in the short term as China eases sanctions over the recently deployed U.S. THAAD missile defense system (Chart 3), and as better relations with China benefit the economy more broadly (Chart 4). However, if Moon prioritizes China and North Korea excessively, he risks squandering his political capital. Korea remains stuck in the middle of U.S.-China tensions that are growing on a secular basis. Tensions with the U.S. will rise as a result of Moon's orientation, and North Korean political risks will remain elevated over the medium and long term. Moon's attempts to engage with North Korea will collide with Trump's efforts to ratchet up pressure against it. Image Therefore, Moon is likely to find the most success in his domestic agenda of increasing government spending, hiring more public workers, raising wages and instilling worker protections, expanding the social safety net and subsidizing small- and medium-sized enterprises. These measures will boost both public and private consumption. We do not have particularly high hopes for Moon's ability to reform the so-called 'chaebol', a South Korean term denoting large, typically family-owned corporate conglomerates, but his attempt to do so will add a modicum of corporate governance and competitiveness improvements that markets will likely cheer. Macroeconomics With improvement in the geopolitical situation, stabilization in the local political system following the Park Geun-hye scandal and new elections has aided in a recovery in consumer sentiment (Chart 5). Meanwhile, a rebound in total employment numbers together with a decline in household debt is providing support to consumer spending (Charts 6A, 6B, 6C). Chart 5Consumer Confidence Is ##br##Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Chart 6ANumber Of Employed ##br##Higher Than In 2015... Number Of Employed Higher Than In 2015... Number Of Employed Higher Than In 2015... Chart 6B...While The Household Debt ##br##Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... Chart 6C...Aiding A Recovery##br## In Retail Sales ...Aiding A Recovery In Retail Sales ...Aiding A Recovery In Retail Sales Sector Specifics From a sector perspective, South Korean consumer staples remain highly competitive, outperforming their EM peers (Chart 7). At the same time, valuations are attractive for South Korean companies (Charts 8A & 8B). Chart 7South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... Chart 8ASouth Korean Companies Trading At Cheaper ##br##Valuations Since Mid-2016... South Korean Companies Trading At Cheaper Valuations Since Mid-2016 South Korean Companies Trading At Cheaper Valuations Since Mid-2016 Chart 8B...And At One Standard Deviation Below ##br##Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average Furthermore, bottom-line expansion of South Korean companies remains strong, supported by solid margin trends (Charts 9A, 9B, 9C). Chart 9A...Earnings Growth In South Korea##br## Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers Chart 9B...With Gross Margin Nearly Twice ##br## The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... Chart 9C...And EBTIDA Margin Is Steadily ##br## Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers We also like the fact that the net debt level for South Korean consumer staples companies is low to negative, while companies have managed to generate excess free cash flow. One undesirable implication, however, is notoriously low dividend yields, which are discouraging investors and raising corporate governance issues (Charts 10A, 10B, 10C). Taking into account the factors listed above, we have created a portfolio of six South Korean consumer staples stocks (Table 2). Chart 10ADebt Levels Have Fallen Significantly ##br## Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Chart 10B...While Cash Generation ##br## Has Recovered... ...While Cash Generation Has Recovered... ...While Cash Generation Has Recovered... Chart 10C...But Dividend Yields ##br## Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low Image The Overweight Basket Chart 11Performance Since June 2016: ##br## Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Amorepacific Corp (090430 KS): A leading beauty and cosmetics producer in South Korea (Chart 11). Founded in the 1940s by Yun Dok-jeong as a company distributing camellia oil for hair treatment, the company was inherited by Yun's son and later grandson, who became the second-richest man in South Korea, controlling directly 10% of the company's free float. Today, Amorepacific is the world's 14th largest cosmetics company, with oversight of some 33 brands around the world such as Etude House, Sulwhasoo and others. In terms of revenue, the bulk is generated by beauty and cosmetic products (91%), where luxury cosmetics constitute 43%, followed by premium brands with 18%. Personal care products contribute 9% to total revenue. Geographically, 70% of revenues are generated in South Korea, and another 19% in China. Amorepacific reported weaker-than-expected first-quarter 2017 financial results on April 24. Revenue increased by 5.7% year over year, with falling Chinese tourist numbers weighing on local sales, and weaker sales in mainland China. At the same time, cost of sales went up by 10.6% year over year, which resulted in gross margin compression by 100 basis points. As a result of an operating cost increase of 8.4% year over year, mainly driven by SG&A expansion (increased labor costs and one-off bonus payments), operating profit fell 6.2% year over year. Operating margin finished at 20.2% compared to 22.8% same period last year, while EBTDA margin contracted to 17.8% from 19.5% last year. Weak operating performance and disproportionate expense growth led to the bottom line falling 15% year over year. Amorepacific is currently trading at a forward P/E of 30.0x, while the market is forecasting an EPS CAGR of 13% over the next three years. We believe the share price will continue to recover strongly, taking into account that easing tensions with China will restore demand and organic volume growth as well as strong momentum in overseas sales, supporting an earnings recovery. Chart 12Performance Since June 2016: ##br## E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM E-Mart (139480 KS): Number one hypermarket brand in South Korea (Chart 12). E-Mart was established in 1993 and has grown into the largest hypermarket and discount store chain in South Korea, operating over 148 branch locations locally and another 16 in China. In 2006 the company also acquired its largest competitor in the country - Wal-Mart Korea - strengthening its market share. Additionally, E-Mart runs speciality shops such as "Emart" discount stores, the "Emart Mall" online store, "Emart Traders," an everyday low-price store, as well as pet and sports/outdoor stores. In terms of revenue breakdown, the flagship E-Mart brand is responsible for 78% of total revenue, followed by the food distribution and supermarket segment with 7% each respectively. From a geographic perspective, 98% of revenue originates in South Korea and only 2% in China. E-Mart reported first-quarter 2017 financial results on May 11, missing estimates. Revenue growth was solid, up 7.4% year over year, helped by 1% same-store sales growth in the main hypermarket segment, while cost of sales increased by 6.5% year over year, which resulted in gross margin falling slightly by 20 basis points to 28.2%. Operating profit increased by 2.8% year over year, weighed on by a year-on-year jump in operating expenses of 11.1%. Operating margin stood at 4.1%, down from 4.3% in 2016, while EBITDA margin finished virtually flat at 6.7%. Thanks to better operating performance, the bottom line improved by 5% year over year. The main detraction to performance came from one-off store opening expenses and a negative calendar effect. E-Mart is currently trading at a forward P/E of 14.0x, while the market is forecasting an EPS CAGR of 9% over the next three years. A store restructuring program is currently underway, and management has done well in accelerating closures of non-performing stores, which has already led to cost savings and margin turnaround. We expect this process to continue. Together with strong performance of the discount and online segments, this should warrant a further re-rating of the share price. Chart 13Performance Since June 2016: ##br## GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM GS Retail (007070 KS): Number one convenience store chain in South Korea (Chart 13). GS Retail is part of the GS Group, a former part of LG Group and the sixth-largest conglomerate in South Korea, which controls just under 66% of the company. GS Retail was incorporated back in 1971 and today operates GS25 - the largest convenience store brand in South Korea - as well as other brands such as GS Supermarkets, Watsons - a health and beauty chain, and Parnas Hotel. The largest contributor to total revenue is the convenience store segment, with 77%, followed by the supermarket business with 20% and the hotel operation with 3%. Geographically, all the revenue originates in South Korea. GS Retail reported first-quarter 2017 financial results on May 11. Revenue displayed strong growth, up 12.5% year over year, driven by solid performance in the convenience store segment (+21% year over year), while cost of sales increased by 12.3% year over year, which brought gross margin up by 20 basis points to 18.4%. A 15% year-over-year increase in operating costs due to the ongoing consolidation of the Watsons business brought operating income down slightly by 1.5% year over year, suppressing operating margin by 20 basis points to 1.4%. EBITDA margin stood at 5.9% compared to 6.2% a year ago. Despite weak operating performance, the bottom line grew by 18.8%, helped by a non-operating gain and lower interest expenses. GS Retail is currently trading at a forward P/E of 19.6x, while the market is forecasting an EPS CAGR of 14% over the next three years. We expect the non-convenience store segments to contribute more to performance in the second part of the year. Furthermore, non-performing supermarket store closedowns together with seasonally strong second and third quarters, where the summer weather typically helps sales, should support stock performance. Chart 14Performance Since June 2016: ##br## H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM LG Household & Healthcare (051900 KS): Producer of the very first cosmetic products in Korea (Chart 14). LG H&H was incorporated in 1947 by Koo In-Hwoi, the founder of LG Corp., and had the initial name Lucky Chemical Industrial Corp. The company produced the first-ever Korean cosmetic product, "Lucky Cream," followed by "Lucky Toothpaste." From 1995 to 2001, LG H&H was part of LG Chem before being spun off. In addition to the cosmetics and household goods businesses, the company also acquired Coca Cola Beverage in 2007, turning itself into an exclusive bottler and distributor of Coca Cola products in South Korea. In terms of revenue breakdown, the cosmetics business contributes 53% to overall revenue, followed by personal products with 27% and the soft drink division with 20%. Geographically, 84% of revenue originates in South Korea, followed by China with 8% and Japan with 4%. LG H&H reported better-than-expected first-quarter 2017 financial results on April 28. Revenue expanded by 5.3% year over year, driven by strong sales in the luxury cosmetics and beverage segments, while cost of sales grew by 4% year over year, bringing gross margin 50 basis points higher to 60.9%. Furthermore, operating income displayed strong growth, up 11.3%, helped by good management of operating expenses (+4.5% year over year). As a result, operating margin improved by 90 basis points to 16.2% and EBITDA margin finished at 16.9%, up from 15.7% last year. The bottom line increased by 11.9% year over year, helped by strong operating performance. LG H&H is currently trading at a forward P/E of 24.1x, while the market is forecasting an EPS CAGR of 8% over the next three years. As with Amorepacific, the trigger to a re-rating in the share price of LG H&H is the improving geopolitical situation. We expect tourist numbers to South Korea to gradually increase, which will aid in both sales recovery and earnings revisions, while strong momentum in the luxury cosmetics segment will contribute to further margin expansion. Chart 15Performance Since June 2016: ##br## KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM KT&G Corp (033780 KS): Korea Tobacco & Ginseng (Chart 15). Initially founded as a government monopoly with the name "Korea Tobacco & Ginseng," the company was later privatized and rebranded as the "Korea Tomorrow & Global Corporation." Today, the company is the largest tobacco company in South Korea, controlling the majority of the local market. The company also has extensive exposure to Eastern European countries. In addition to the tobacco business, KT&G also has a pharma arm, the Korea Ginseng Corp. The revenue stream is broken down into the cigarette business, which contributes 60% to overall revenue, followed by the ginseng-pharma segment, adding another 30%. KT&G reported in-line first-quarter 2017 financial results on April 27. Revenue increased by a solid 8% year over year, helped by strong ginseng sales, which expanded despite a market contraction and were also alleviated by market share gain and higher prices. Cost of sales, meantime, were up 12.7%, bringing gross margin down to 59.4% from 61.1% previously. Due to a strong increase in operating costs (+11.3% year over year), driven by higher SG&A expenses, operating income edged up only 0.6% year over year. Operating margin fell 45 basis points from last year, while EBITDA margin stood at 35.5%, or 80 basis points lower compared to the same period last year. The bottom line fell by 17.5% year over year, weighted on by higher foreign exchange losses. KT&G is currently trading at a forward P/E of 12.8x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. Several factors have been weighing on the company's share price recently, including the introduction of warning messages on cigarette packages and the introduction of e-cigarettes in the domestic market - making the stock one of the cheapest among its global peers (~20% discount). We believe that worries regarding e-cigarette introduction and projections of the Japanese experience are overstated due to differences in law (e.g. prohibition of smoking indoors), as well as the age composition of the market. Furthermore, we expect a strong revival in overseas sales in the second part of the year, with less headwinds from foreign exchange swings and double-digit growth due to low base effects - as well as an offset to flat local market expansion via higher selling prices. Chart 16Performance Since June 2016: ##br## Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Nongshim (004370 KS): Farmer's Heart (Chart 16). Nongshim, or Farmer's Heart, was founded in 1965 under the name Lotte Food Industrial Company, and later changed its name. The company first focused on ramyun (instant noodle) production, later expanding into snacks - it was the first to introduce the "Shrimp Cracker" as well as beverages. Today, Nongshim is the largest ramyun and snack company in South Korea, selling to over 100 countries, with production facilities in Korea, China and the U.S. From a revenue perspective, ramyun products contribute 67% to total revenue, followed by other food products with 17.5% and snacks with 15.6%. Geographically, most sales occur in South Korea, with 80%, followed by the U.S. with 10% and China with 8%. Nongshim reported slightly better-than-expected first-quarter 2017 financial results on May 15. Revenue declined slightly by 2.2% year over year due to a fall in domestic ramyun sales by 9%, while cost of sales actually declined by 5% year over year, which led to a gross margin improvement by 190 basis points to 33.7% (helped by price increases.) Operating income was virtually flat year over year, as operating costs increased by 4%. Operating margin stood at 5.85% compared to 5.70% in 2016, while EBITDA margin declined to 7.9% from 9.4% last year. Nongshim is currently trading at a forward P/E of 18.5x, while the market is forecasting an EPS CAGR of 5.6% over the next three years. We expect a reversal of weak sales in China (-5% year over year) due to an easing of the geopolitical situation. Furthermore, Nongshim has already begun to claw back market share, helped by new starts and forced price hikes among its competition, which will continue to help turn around margins and improve profitability. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Amorepacific Corp (090430 KS); E-Mart (139480 KS); GS Retail (007070 KS); LG Household & Healthcare (051900 KS); KT&G Corp (033780 KS); Nongshim (004370 KS). ETFs: At the moment, there are no ETFs with significant consumer staples sector exposure for South Korea. Funds: At the moment, there are no funds with significant consumer staples sector exposure for South Korea. Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case We believe that one of the main risks is the geopolitical situation and further developments surrounding North Korea. Although the usual springtime tensions have passed, the underlying dynamic remains highly precarious. North Korea has not moderated its behavior despite President Moon's olive branch and U.S. President Trump continues to prioritize the issue and threaten bolder action. Any kind of escalation in tensions, whether they be driven by North Korea or the U.S., would negatively affect both Chinese interests and the new South Korean administration's attempts at engagement. Given that South Korea has not yet fully reversed the THAAD missile deployment, for instance, it is possible that China could maintain or intensify its informal sanctions on South Korea, such as travel and product bans, and that renewed tensions could depress overall consumer sentiment in South Korea. We are also cognizant that debt levels in the South Korean manufacturing sector as well mass layoffs in shipyards and a slowdown in exports could continue to create pressure on household disposable income levels and, in turn, spending. However, President Moon's efforts for a supplementary budget to support employment in the public sector, if approved, should alleviate some pain from layoffs. On a company level, we see increased price competition as one of the main risks to our investment case. Since many of the companies in the basket are market leaders, they will need to defend their market share aggressively in case of increased competition. Furthermore, for companies operating abroad, we see increased expansion costs as one of the risk factors for future performance. Finally, Chinese economic policy pose a risk to our view. The fiscal spending and credit impulse in China have rolled over, suggesting that demand will slow in the coming months. Moreover, the Communist Party’s ongoing “deleveraging campaign” – a crackdown on various risky financial practices and the shadow banking sector – raises the risks of a policy mistake. A slowdown in China would have negative repercussions for the South Korean companies most exposed to China and the broader Korean economy. Nevertheless, we think Chinese authorities are willing and able to meet their growth target this year. Oleg Babanov, Senior Editor obabanov@bcaresearch.co.uk Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.co.uk

Highlights Italy cannot rely on currency devaluation to make up for poor competitiveness, as it did before the euro; Italian voters are becoming more Euroskeptic - the elections due by May 2018 pose a serious risk, as do elections thereafter; Necessary structural reforms, not in the cards at present, would be painful and could exacerbate the Euroskeptic trend in Italy; The mere suggestion of a referendum on the euro would cause a banking crisis ... though voters would likely decide to stay in the Euro Area; The ECB will surprise on the dovish side; EUR/USD will weaken slightly below parity by mid-2018; European equities will continue to outperform U.S. equities. Feature European politics have been a boon to investors in 2017 (Chart 1). Instead of destabilizing populism, investors have gotten promises of pro-market reforms. This positive development is as we expected: we dubbed European politics "a trophy red herring" in our 2017 Strategic Outlook1 and predicted the pro-market turn in France.2 Alas, Italy remains a Sword of Damocles hanging over Europe's head. Whereas public sentiment in Europe has turned decisively in favor of integration since 2013, it remains indecisive in Italy (Chart 2). The Italian "median voter" continues to flirt with Euroskepticism, which explains why the country's anti-establishment parties have not softened their Euroskepticism to the same degree as their peers elsewhere in Europe. Chart 1European Stocks Outperform American European Stocks Outperform American European Stocks Outperform American Chart 2Italians Doubting The Euro Monetary Union Italians Doubting The Euro Monetary Union Italians Doubting The Euro Monetary Union In this report, we attempt to answer several questions concerning Italy: What is structurally wrong with Italy? Why is Euroskepticism appealing to Italian voters? What would happen if Euroskeptics won the upcoming election and called a referendum on Euro Area membership? What would happen if Italy left the Euro Area? Italy's Purgatory: Aversion To Creative Destruction Italy has a structural productivity problem (Chart 3). Given weak labor force and productivity growth, Italy will be in and out of recessions for much of the next decade as its growth rate oscillates around zero. Particularly concerning is the steep decline in the country's total factor productivity, which suggests that Italians struggle to make use of technological innovation and that the economy is extremely inefficient. Chart 3 There is a vast literature detailing the structural problems of the Italian economy.3 We focus on the three most important impediments: The unproductive South, the Mezzogiorno, remains Europe's backwater; The public sector is riven with inefficiencies; Education and innovation remain sub-par. The first problem with Italy is that it remains an extremely bifurcated economy. Its northern regions, particularly Lombardy, are as wealthy as any in Europe (Map 1). Productivity rates and education standards are on par with core Europe (Chart 4). However, the Mezzogiorno has consistently pulled the aggregate Italian averages down (Chart 5). Chart Chart 4 Chart 5 As the industrialized North was rebuilt after the Second World War, and as productivity and labor force growth rates surged, the backwardness of the Mezzogiorno was conveniently ignored. Since the late 1990s, however, productivity rates have declined in all of the developed world. For Italy, this means that the one-third of the population that lives in the unproductive South is no longer a rounding error. At its root, Italy's problem is that its unification in 1861, the Risorgimento, never went far enough to integrate the south and thus left a bifurcated economy that exemplifies the north-south divide in Europe as a whole.4 Several of the reform efforts undertaken by the Matteo Renzi-led Democratic Party (PD) government have sought to address the disparity between the North and the Mezzogiorno. However, these reforms will take time to bear fruit. Previous efforts have fallen short due to half-hearted implementation. The second structural problem is that Italy's public sector is large, riven with inefficiencies, and largely funded via corporate taxes due to poor overall tax collection. Italy's social security contributions are high, accounting for about 13% of GDP. Of this burden, the employer contribution rate is one of the highest in the world, only surpassed by France and Germany (Chart 6). Chart 6 Chart 7 Despite a developed-world tax burden, Italy has a developing-world system of tax collection. For example, its VAT revenue ratio is well below the OECD average, at the level of an emerging market (Chart 7).5 If the VAT revenue ratio was improved to the OECD average, Italy would see its VAT receipts rise by about €45 billion per year (enough to recapitalize all of its banks, for example, or reduce employers' social security contributions by a third). Not only is tax collection of poor quality, but paying taxes is exorbitantly difficult. The World Bank's "Paying Tax" indicator - which measures the cost and time of paying taxes - nestles Italy between Kenya and São Tomé at 126th out of 190 spots! For comparison sake, its Mediterranean peers Spain and Portugal are 37th and 38th respectively on the same index while even Greece is significantly better at 64th.6 Italy again ranks with EM countries on the World Bank's overall "Doing Business" report (Chart 8). It scores extremely low in the category of "enforcing contracts," where it finds itself sandwiched between the Gambia and Somalia, at the 108th rank! It takes more time - three years - to enforce a contract in Italy than in Pakistan, Egypt, and Mozambique. Chart 8 Public sector inefficiencies are not a result of nostalgia for Roman-era bureaucracy. Instead, Italy's administrative hurdles are a means to stifle domestic creative destruction and protect its numerous small and medium-sized businesses - many family-owned - from competition. Instead of fostering competition through innovation and investment, Italian industrial policy since the Second World War has largely relied on currency depreciation to boost competitiveness. This strategy ceased to be effective with the adoption of the euro, but the country never pushed through painful reforms to adjust to the new reality. While it is difficult to prove a counterfactual, we are not sure that even currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 9 illustrates. Finally, Italy's educational system is in need of a massive overhaul. Some improvement in educational attainment was apparent by 2015 (Chart 10). However, the quality of Italian education is still woefully inadequate if measured by the results of post-secondary and tertiary education on literacy proficiency (Chart 11). Chart 9Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Chart 10 Chart 11 Italian firms are not making up for the poor educational attainments of the labor force with higher investment in knowledge-based capital - software, research, training, or management (Chart 12). There are likely three reasons for this outcome. First, low productivity begets low potential GDP growth, which hurts firms' top line prospects and incentives to invest. Second, decades of reliance on currency devaluation for competitiveness has discouraged Italian corporates from investing in R&D. Third, a plethora of small Italian family-owned businesses lack the resources to leverage their intellectual property with management and technology to become globally competitive. Chart 12 Last time Italy faced a painful recession - 1992-1995 - it did what had worked best since the Second World War: it devalued its way out of trouble (Chart 13A). Yet a comparable devaluation did not work for Italy in recent years, with exports failing to lead the way to recovery despite a 20% drop in EUR/USD since mid-2014 (Chart 13B). Why? Chart 13ACurrency Devaluation Has Not ##br##Worked This Time Around (I) Currency Devaluation Has Not Worked This Time Around (I) Currency Devaluation Has Not Worked This Time Around (I) Chart 13BCurrency Devaluation Has Not ##br##Worked This Time Around (II) Currency Devaluation Has Not Worked This Time Around (II) Currency Devaluation Has Not Worked This Time Around (II) Many of Italy's exports go to Euro Area peers. In 1995, the percentage was 48%, today it is 41%. As such, the devaluation in the 1990s was against those peers, allowing Italian exports to the EU Common Market to surge. Nonetheless, the lack of any growth in exports still does not make sense, given the large depreciation in the euro and the fact that 60% of Italy's exports are still destined for non-Euro Area markets. Bottom Line: Italy has failed to keep up in competitiveness over the past twenty years precisely because its reliance on devaluation worked wonders for the economy in the pre-euro era. Instead of committing itself to structural reforms, Italy has preserved its post-Second World War institutions that were expressly designed to limit creative destruction and domestic competition. Unlike France, which has largely an arithmetic problem, Italy has a genuine productivity problem. For Italy to boost economic growth, it will have to do a lot more than adjust a few labor laws or raise the retirement age (both of which it has already done!). It needs deep structural reforms that are impossible without a strong electoral mandate that gives the next government sufficient political capital for reforms. Such a mandate is unlikely to come in the next election, leaving Italy in a purgatory of its own making. Political Risks: An Assessment Current polls show that the ruling, center-left PD is running neck-and-neck with the anti-establishment and Euroskeptic Five Star Movement (M5S) (Chart 14). Also in the mix are the center-right Forza Italia (FI), of former Prime Minister Silvio Berlusconi, which has itself flirted with mild Euroskepticism, and the staunchly anti-EU Lega Nord (LN). The power of Italy's establishment and Euroskeptic parties is perfectly balanced (Chart 15) ahead of the general election, which has to take place before May 20, 2018. The exact date is as yet unclear, with President Sergio Mattarella insisting that it take place after parliament passes a new electoral law that will make the electoral system uniform for both houses of parliament. A recent agreement between the main four parties on an electoral bill broke down, again pushing the date to the second quarter of next year. With the election now likely a year away - and with European populists in retreat across the continent - should investors breathe a sigh of relief? Chart 14Euroskeptic Five Star Movement Challenges Ruling Democrats Euroskeptic Five Star Movement Challenges Ruling Democrats Euroskeptic Five Star Movement Challenges Ruling Democrats Chart 15Euroskeptics Roughly Equal To Establishment Parties In Polls Euroskeptics Roughly Equal To Establishment Parties In Polls Euroskeptics Roughly Equal To Establishment Parties In Polls No. Italy remains the political risk in Europe. There are three broad reasons we remain concerned about Italian politics: The Median Italian Voter Is Flirting With Euroskepticism Policymakers are not price makers in the political marketplace, but price takers. The price maker is the median voter.7 In Europe, the Euroskepticism of the median voter has been massively overstated by the media and markets. Across the Euro Area, support for the common currency has surged since 2013 (Chart 16), likely reflecting an improving economy and the deeply held belief among European voters that continental integration is an intrinsic good. It took some time for anti-establishment politicians to sound off the median voter, but when they did, they adjusted their stances. As such, initially Euroskeptic anti-establishment parties across the continent - from Greece's SYRIZA and Spain's Podemos to Finland's "Finns Party" - have abandoned overt Euroskepticism and moved towards the middle ground on European integration. Politicians who have refused to be price takers - and insisted on campaigning from an inflexible, Euroskeptic position - were punished by the political marketplace (case in point: Marine Le Pen). Italy, however, has not seen a recovery in support for European integration. This is in large part due to the fact that the Italian economy has remained a laggard since 2012 (Chart 17). But it may also reflect the fact that the siren song of currency depreciation remains appealing to a large segment of the Italian electorate. Both M5S and Lega Nord have been vociferously arguing that Italy was far more competitive before joining the Euro Area and that simple currency devaluation would turn Italy from a land of locusts into a land of milk and honey. Chart 16Support For The Euro Has Risen Everywhere Else Support For The Euro Has Risen Everywhere Else Support For The Euro Has Risen Everywhere Else Chart 17Lagging Economy Has Hurt Support For The Euro Lagging Economy Has Hurt Support For The Euro Lagging Economy Has Hurt Support For The Euro Italy's Relationship With The EU Is Transactional We have long contended that both European patricians and plebeians support further integration.8 Chart 18 shows that a strong majority of Europeans is outright pessimistic about the future of their country outside of the EU. Why? Because, as Chart 19 suggests, the EU stands for geopolitical stability and a stronger say in the world. Chart 18Most Europeans Fear Life Outside The EU Most Europeans Fear Life Outside The EU Most Europeans Fear Life Outside The EU Chart 19 For a majority of Europeans, the European project is essential for peace and stability in Europe. We would argue that this is not just a product of two world wars in the twentieth century. It is also a product of newfound Russian assertiveness, migration crisis, and a growing ideological distance between Europe and its former security guarantor, the U.S. Italians, on the other hand, appear to be significantly more "transactional" than their European peers. For example, Chart 19 shows that Italians stand apart in being significantly less concerned about "peace" and having a "stronger say in the world." A plurality of Italians has also become confident in the country's future outside of the EU (Chart 20). Italians also appear to have the most negative perception of immigrants, perhaps due to the fact that they are at the frontline of Europe's migration crisis (Chart 21). Chart 20Italians Not So Afraid Of Life Outside The EU Italians Not So Afraid Of Life Outside The EU Italians Not So Afraid Of Life Outside The EU Chart 21 Why such a discrepancy in views between Italy and the rest of the continent? First, Italians have traditionally had a much more parochial view of the world. Regional differences matter a lot more to Italians than continental ones. Italians are already being asked to subsume one identity (regional) for another (national), so going a step further (supranational) may be too much. Data suggests that about half of all Italians are unwilling to go further (Chart 22). Second, Italy joined the EU as a considerably less developed economy than its core European peers. As such, membership was always sold to Italians from a transactional perspective and thus they do not give supremacy to geopolitical over economic forces. Chart 22Italians Less Likely To See Themselves As Europeans Italians Less Likely To See Themselves As Europeans Italians Less Likely To See Themselves As Europeans Elections Are Unlikely To Be Cathartic Italian Euroskeptics have consistently performed well in the polls for well over a year. Short of a significant surge in support for Matteo Renzi's PD, which we doubt will happen, polls are likely to continue to be tight until the election. The anti-establishment M5S performed extremely poorly in the June 11 municipal elections, failing to make the second-round run-off of the mayoral election in any of the major cities. However, we would fade the significance of this result given the national polls. As such, the best hope for investors is that anti-establishment forces suffer a modest defeat in next year's election. Short of a strong economic recovery that significantly reduces unemployment, an election win for the Italian establishment will not be as cathartic as the just-concluded election in France. And what are the odds of an outright Euroskeptic win? They are low, below 20%. M5S has no incentive to form a weak minority government, support an establishment-led government, or enter a risky coalition with Euroskeptic Lega Nord. It understands that remaining in the opposition would allow it to reap the benefits when the eventual coalition between establishment parties loses steam. The most likely scenario in next year's election is either an establishment Grand Coalition (40%), or a minority center-left government led by the ruling PD and supported on a case-by-case basis by the other parties (40%).9 Neither outcome is likely to survive the entire length of the mandate. Bottom Line: The long-term problem for investors is that the Euroskeptic narrative appears to be quite appealing to a large proportion of the Italian public. As such, even if the market avoids a crisis in 2018, one will likely emerge by 2020. The only way to avoid it would be a strong electoral mandate for deep structural reforms that boost productivity, which is not a likely outcome of the next election. But even if such reforms were initiated, we assume that their short-term consequences would be economic and political pain, which would sour support for establishment parties further and potentially deepen Euroskeptic sentiment in the country. As such, in the rest of the report, we examine what investors should expect in case the anti-establishment parties eventually take power in Italy. While such an outcome is unlikely in 2018, it may happen eventually. Leaving The Euro Is A Panacea... The political analysis above begs a simple question: Why are Italians more likely to be lured by the sirens of leaving the Euro Area than the French or Spanish have been? Fundamentally, the Italian experience is one of relatively successful devaluations. In the early 1990s, Italy was also suffering from a period of un-competitiveness, which prompted the current account to move from a 0.6% of GDP surplus in 1987 to a 2.5% of GDP deficit in 1992 (Chart 23). This deterioration reflected two factors. One was the notorious European Exchange Rate Mechanism (ERM), which forced European currencies to move in lockstep with each other. The second was the fact that Italian unit labor costs had been in a bull market relative to the rest of the European community countries, rising by 380%, 140%, and 370% against German, France, and the Netherlands, respectively, between 1970 and 1991. Thanks to this confluence of events, Italy was in a bind. By early 1992, Italian real wages were contracting. More than a surge in inflation, this contraction reflected intensifying competitive pressures and the implementation of fiscal austerity (Chart 24). Investors ended up punishing Italian assets; Italian yields moved up, with spreads relative to Germany widening from 350 basis points to 750 basis points by September 1992. Chart 23Lack Of Competitiveness Caused Current Account Deficits... Lack Of Competitiveness Caused Current Account Deficits... Lack Of Competitiveness Caused Current Account Deficits... Chart 24...And Contributed To Falling Real Wages ...And Contributed To Falling Real Wages ...And Contributed To Falling Real Wages By that point, Italian authorities chose to let the previously stable lira fall, resulting in a 30% devaluation versus the deutschemark by the end of Q1 1993. Thanks to this easing, by the beginning of 1994 Italian spreads had fallen back below 300 basis points. However, the Italian economy was still under duress, real wages were still contracting, and financial markets revolted again. By February 1995, Italian spreads had gone back up to 480 basis points. In the spring of 1995, the pressures came to a boiling point and the lira was once again devalued versus the deutschemark, suddenly plunging by an additional 20% or so. After this painful adjustment, real wage growth moved back into positive territory, the current account deficit morphed into a surplus, and the economy recovered. Moreover, thanks to the previous wave of fiscal austerity and the rebound of the economy, the government's primary balance, which stood at a deficit of nearly 4% of GDP in 1987, hit a 5% surplus by 1998. Chart 25Domestic Demand Never Recovered From Financial Crisis Domestic Demand Never Recovered From Financial Crisis Domestic Demand Never Recovered From Financial Crisis So why is this experience so important? Today, Italy already runs a large current account surplus of 2.5% of GDP. But unlike in the 1990s, this improvement reflects first and foremost a contraction in imports, itself the symptom of an ill domestic economy. However, like in the early 1990s, the Italian economy remains tired. Real GDP is still 7% below its 2008 peak, while domestic demand continues to linger at a stunning 8.5% below its pre-GFC levels (Chart 25). Real wages are contracting at a 1.4% pace as the unemployment rate remains more than 2.5% above the OECD's estimate of NAIRU. Real estate prices, after having contracted from 2012 to 2016, are only growing in the low single digits. Capex generally is also tepid. This situation suggests that Italy needs even easier monetary policy than what it is getting from the ECB. As the argument goes, if Italy were to devalue its currency today, it would be able to boost its exports, ease domestic monetary conditions, and create the ideal circumstances for generating growth. Moreover, to push the argument to its extreme - something populist politicians are prone to do - Italy should ditch the euro and re-dominate its debt in lira. The Bank of Italy could then monetize this debt to keep interest rates low. Since Italy runs a primary fiscal surplus of 1.4% of GDP, Italy does not need to access the debt market for a few years, and thus it would be irrelevant if it loses access to the market. In other words, outside of the euro, a world of Chianti and creamy cannolis awaits the Italians. ... Well, Maybe Not If this seems too nice to be true, that is because it is. The exit-and-devalue narrative misses the point that financial markets and conditions matter a great deal. The problem with this story is the banking sector. The Italian banking sector is presently saddled with NPLs of €330bn, representing 74% of the banking system's capital and reserves (Chart 26). In and of itself, this is a big problem. However, it is a manageable one, especially with the backstops created by European institutions, notably the support of the ECB. However, without Europe's backstop, this debt load becomes a lot harder to manage. And that's only part of the problem. A deeper issue is the large holdings of treasury bonds (BTPs) of Italian banks. Currently, Italian banks hold 10% of their assets in BTPs, an amount equivalent to 90% of their capital and reserves (Chart 27). In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of breakup - as estimated by Dhaval Joshi who writes our European Investment Strategy sister service - of 20% over the subsequent five years (Chart 28).10 Chart 26Italian Banks Carry Loads Of Bad Loans Italian Banks Carry Loads Of Bad Loans Italian Banks Carry Loads Of Bad Loans Chart 27Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Chart 28Italian Spreads Signal Euro Break-Up Threat Italian Spreads Signal Euro Break-Up Threat Italian Spreads Signal Euro Break-Up Threat Now, if Italy comes to be governed by Beppe Grillo's M5S, markets will move fast to discount an eventual referendum on Italy's euro membership - even if only a non-binding and consultative referendum, which would still have a powerful political effect.11 In this environment, it is unlikely that the ECB would support Italian assets. The ECB has already played an active role in Italian politics. It was a September 2011 letter by Mario Draghi and Jean-Claude Trichet that prompted the resignation of Berlusconi in November 2011. It was only after Italian policymakers committed to structural reforms that Draghi was willing to utter his famous "whatever it takes" pledge of ECB support. There is practically no chance that the ECB would extend such a guarantee to an M5S-led government looking to play chicken with the Euro Area and default on Italian debt. Chart 29A Drop In Credit Impulse Would Herald Recession A Drop In Credit Impulse Would Herald Recession A Drop In Credit Impulse Would Herald Recession This is why the situation could become nasty, and fast. With only 53% of Italians in favor of the euro, pricing in a 50% probability of Italy leaving the Euro Area would result in BTP-bund spreads of around 900 basis points! In the process, Italian bonds could lose 40% to 50% of their value - assuming that German bunds rally on risk aversion flows - which would result in a potential 35% to 45% hit to Italian banks' capital and reserves. Even if markets remained relatively calm, and BTP prices only fell by 25% to 30%, investors would discount bank capital by around 25%. With the large overhang of NPLs, Italian banks would be for all intent and purposes insolvent. We already expect the Italian credit impulse to become a drag on Italian growth in 2018, but if banks are threatened with insolvency as a result of political dynamics, this same credit impulse is likely to fall at rates not experienced since the GFC. This would result in yet another recession in Italy (Chart 29). Like in Greece in 2015, we would expect that this economic pain would prompt Italian voters to rethink their inclination to leave the Euro Area. In other words, the mere thought of exiting the Euro Area would bring forward the cost of such a strategy, giving voters essentially a preview of their future pain. Moreover, with 45% of BTPs held in private hands outside of Italy, and Italy's foreign debt hanging at 126% of GDP, Europeans outside of Italy have a lot of Italian exposure. This suggests that the financial channel of transmission would cause stress in the European banking sector outside of Italy as well. As a result, in all likelihood, this threat would prompt the return of dovish language by the ECB that could weigh on the euro. The fall in the euro would also nullify Italians' need to exit the Eurozone. Even if the scenario above looks remote, the euro could fall as soon as markets begin discounting an M5S victory. For example, in Canada, the Parti Quebecois won the 1994 election promising a referendum on the question of Quebec independence. As a result of that electoral victory, the loonie quickly dipped by 6%. A move back to EUR/USD 1.05 in case of a Beppe Grillo victory thus sounds reasonable as the market would quickly move to discount some probability of an eventual euro referendum in Italy. Bottom Line: The mere suggestion of a referendum on the euro in Italy would have immediate market consequences. The result would be the almost instantaneous insolvency of large portions of the country's banking system, the loss of ECB support, deposit flight, and an almost certain recession. The relationship between politics, markets, and the economy is therefore dynamic, with non-linear outcomes. As markets discount a higher probability of Italian Euro Area exit, voters will discount a higher probability of non-optimal economic outcomes. As such, we highly doubt that Italian voters - who remember, are only flirting with Euroskepticism - would commit to a future outside of the Euro Area. What If Italy Says Arrivederci? What if we have misjudged Italian voters and they vote to exit the Euro Area regardless of the costs? Based on the IMF's External Sector Report's Individual Economy Assessments, the Italian real effective exchange rate is overvalued by around 25% against Germany alone and around 15% against a GDP-weighted average of Germany, France, Spain, Netherlands, and Belgium. However, these amounts grossly underestimate the potential fall in the lira. These estimates are based on competitiveness measures alone, and they do not take into account the negative domestic economic developments associated with falling BTP prices and impairments to banks' balance sheets. Such economic malaise would prompt a massive easing of policy by the newly empowered Bank of Italy, which would also weigh on the lira. Additionally, the Bank of Italy would have little credibility. This would be doubly so in a M5S-led government intent on pursuing unorthodox policy choices. Historically, Italy has been tolerant of elevated inflation, which means that investors would likely bid up inflation protection on Italian assets, a process that would weigh on Italian real interest rates. Additionally, Italian households and businesses would likely ratchet up their own inflation expectations. As a result, this would drive Italian inflation higher and prompt even more downward pressure on real rates. This is the perfect recipe for a downward spiral in the lira against the euro. In this kind of environment, the lira could fall 75% against the euro. Would Italy become a trade champion with this magnitude of currency devaluation? Doubtful. As we have mentioned, Italy's competitiveness problems are not just a function of domestic labor costs relative to those of the rest of the Euro Area. They also reflect the fact that Italy has not moved up the value chain and is competing head-to-head with EM nations that have a much lower cost base. Additionally, the purpose of the euro was to prevent precisely the kind of competitive currency devaluation that plagued Europe in the post-war period. If Italy ditches the euro and devalues its currency by 50% or more, then the other European nations are likely to punish Italy with tariffs, defeating one of the key reasons to re-introduce the lira in the first place. The last thing Europeans would want to establish is a precedent of a major European economy massively devaluing against its Common Market peers for economic gain. This would be the undoing of not just the Euro Area, but European integration itself. In fact, Italy is contractually obligated - as is every EU member state other than Denmark and the U.K. - to obtain EMU membership under the Maastricht Treaty that establishes the European Union. While such a contractual obligation is irrelevant in the face of a sovereign nation's decision to abrogate an international treaty, it does give Italy's EU peers the legal cover to evict Italy from the Common Market should it break its Maastricht pledges. What about the dynamics of the euro itself? After all, without its weakest major member, the Euro Area will be stronger and the euro will become more competitive. However, the early 1990s experience is once again instructive. During the first phase of devaluation of the lira from 1992 to 1994, the deutschemark too came under pressure. This pressure also reflected the fact that the USD was rising between Q3 1992 and the beginning of 1994. However, by early 1995 the deutschmark had recouped all its loss versus the USD (Chart 30). We would expect similar dynamics to be at play, and again, a lot will depend on the dollar's trend. We expect the dollar index (DXY) to peak in 2018 around 108-110, or a bit more than 10% above current levels. This would hurt the euro. Moreover, the likely need for a dovish ECB to ease the blow to the European banking system (from potentially large losses on any Italian assets) would add to the downward pressure on the euro. As a result, an Italian exit should result in a fall to EUR/USD 0.9. However, this would represent a massive buying opportunity. The euro would be extremely cheap, and the economy would ultimately handle the Italian shock (Chart 31). Chart 30Lira Devaluation Temporarily Dragged Down The Deutschemark Lira Devaluation Temporarily Dragged Down The Deutschemark Lira Devaluation Temporarily Dragged Down The Deutschemark Chart 31An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity Additionally, the pain that Italy would incur as it faced currency collapse, runaway inflation, and loss of market access to the EU Common Market should act as a strong deterrent for future Euro Area exit attempts. As such, while the probability of Italy's Euro Area exit may be higher than zero, the probability of any subsequent exits is essentially zero. We would therefore expect any euro selloff to be violent but brief. Chart 32Italian Public Debt: Stuck In Muck Italian Public Debt: Stuck In Muck Italian Public Debt: Stuck In Muck Bottom Line: We doubt Italy will ever leave the euro. In all likelihood, the economic pain caused by the mere thought of a referendum would be enough to deter Italians from voting for what would amount to economic suicide. Instead, we would expect Italy to muddle through: its public debt dynamics will worsen, but it will not implode. The IMF expects the government debt-to-GDP ratio to fall toward 125% of GDP by 2022 (Chart 32). We think this is too optimistic. It relies on a big drop in the private sector's investment-saving gap. We think that Italy's entrenched productivity deficit and lack of investment opportunities south of the Alps will ensure that savings remain in excess of investment by a similar degree as today. This would cause the public debt-to-GDP ratio to move toward 140% of GDP by the middle of next decade. This is not a great scenario, but it is not a catastrophe either. In exchange for modest reforms, the ECB would continue to support Italy with dovish monetary policy and unfettered access to emergency liquidity. As a result, we expect European interest rates to remain slightly below what average Eurozone numbers would justify. As such, we continue to anticipate no hike in the ECB's repo rate for the foreseeable future. This, along with greater labor market slack in Europe than the U.S., underpins our view that EUR/USD will ultimately weaken slightly below parity. Investment Conclusions All other things being equal, currency devaluation is a valuable reflationary tool. In Italy's case, however, there are two impediments to using it. First, Italy has lost competitiveness precisely because it relied on the FX lever in the past. Its governance, education, and economic institutions have atrophied as domestic interest groups favored protecting themselves against creative destruction. Second, when it comes to politics, "all other things are rarely equal." It is highly unlikely that the rest of Europe would idly stand back while Italy switched to the lira and devalued it against the euro. This is for three reasons: First, it would set a dangerous precedent for other EU member states if Italy, the Euro Area's third-largest economy and the world's eighth largest, was allowed to reflate via competitive devaluation. Second, it is unlikely that Euro Area peers would accept Italy's devaluation amidst a globally low growth context where export market share is already tough to come by. Third, Italy's government would likely be led by populist, anti-establishment policymakers who would represent a domestic political threat to Italy's European neighbors. As such, it would be in the interest of the rest of Europe to ensure that a M5S-led Italy collapsed after leaving the Euro Area, and then begged to re-enter the core European club. The investment conclusions from the analysis above are very state dependent and represent a playbook for investors going forward. Right now, with the probability of an outright M5S victory low, our base case scenario remains unchanged. The euro will weaken by mid-2018 to slightly below parity as the ECB will maintain a more dovish policy stance than the Fed. European equities are likely to continue to outperform U.S. equities. However, if Beppe Grillo manages to eke out a majority in 2018 or later, investors might be in for a bumpy ride. The euro's fall from grace is likely to be much swifter and European assets could suffer a period of volatility and underperformance relative to the U.S. Ultimately, European stocks will resume their upward relative trajectory as any Italian referendum is likely to result in Italy staying in the euro. Finally, in the highly unlikely case that Italy votes to leave the Euro Area, the euro could plunge to EUR/USD 0.9; European assets, banks especially, could suffer greatly against their U.S. counterparts; and bund yields would likely fall below 0%. The lira would fall by 75% against the euro and Italian bonds would suffer losses north of 50%, in local currency terms. As Italy plunged to its post-Euro Area Inferno, however, we would expect European assets to represent the buying opportunity of a lifetime. Italy's fall from grace would only tighten European integration going forward. 1 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Please see OECD, "Economic Surveys: Italy 2017," available at oecd.org; and Sara Calligaris, et al.,"Italy's Productivity Conundrum," European Commission, dated May 2016, available at ec.europa.eu. 4 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 5 The VAT revenue ratio (VRR) is defined as the ratio between the actual value-added tax (VAT) revenue collected and the revenue that would theoretically be raised if VAT was applied at the standard rate to all final consumption. This ratio gives an indication of the efficiency and the broadness of the tax base of the VAT regime in a country compared to a standard norm. 6 Please see World Bank Group and PwC, "Paying Taxes 2017," available at www.pwc.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 3, 2011, and Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 9 A minority government would, however, have to obtain a confidence vote in both chambers of the Italian Parliament in order to govern, as per Article 94 of the Italian Constitution. 10 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com. 11 According to Article 75 of the Italian Constitution, referendums are not permitted in the "case of tax, budget, amnesty and pardon laws, in authorization or ratification of international treaties." Nonetheless, a Euroskeptic government could still call for a non-binding referendum on the euro. While its result would not create a legal reality for Italian exit from the Euro Area, it would create a political one. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com We Read (And Liked) ... Why Nations Fail - The Origins Of Power, Prosperity, And Poverty Why Nations Fail is as much about why nations succeed as why they fail.1 World history is replete with examples of the latter, whereas the former is a rarity even today. Economist Daren Acemoglu and political scientist James A. Robinson seek to answer why that is so. Distilling the book to its bottom line is challenging. There is no neat theory of how the world works. Instead, the authors tell their story through case studies replete with "critical junctures," "path dependency," and "small differences." Acemoglu and Robinson do not peddle in false parsimony, but rather try to develop a narrative that explains a complex process. While they never make the point explicitly, the authors define success as a combination of geopolitical relevance (power), escaping the "middle income trap" (prosperity), and some level of equality (escaping poverty). A country that achieves some semblance of all three, and maintains it for a long time, is "successful." At the heart of successful economies is the process of creative destruction. And at the heart of each example of failed states - from the Roman Empire to the Soviet Union - are impediments to such destruction. The recipe to success therefore boils down to "having an idea, starting a firm, and getting a loan." The discipline of economics - and its disciples at the IMF and the World Bank - would appear to be more than capable of taking it from there. But they are not. Why? For Acemoglu and Robinson, the empirical evidence is overwhelmingly stacked against economics and its practitioners. Armies of developmental economists have failed to bring billions of people out of poverty and many of their suggestions have in fact been detrimental. Economics is incapable of resolving the problem of development because it "has gained the title Queen of the Social Sciences by choosing solved political problems as its domain."2 And societal development is a political problem. The first such political problem that Acemoglu and Robinson attempt to explain is the paradox of development. Why don't leaders always choose prosperity? History is replete with examples of how elites actively subvert creative destruction, which is paradoxical given that it would make their societies wealthier and more powerful in the collective sense. From the patricians of Rome, elites of Venice, the szlachta of Poland, the samurai of Japan, to the landed aristocracy of England prior to the Glorious Revolution, those in positions of power consciously limit economic progress. The answer lies in political institutions. When political power is exclusive, unchecked, and limited to a select-group, its value increases. The more power one gains, the greater the political, economic, and societal rewards one can extract from it. The reverse is true when political institutions are inclusive, checked, and open to upwardly mobile entrepreneurs. In that case, the value of political power declines and thus elites are less likely to expend resources to protect their access to it. As such, the key conditions for economic development are inclusive political institutions that allow non-elites to petition the government, keep it in check through an independent judiciary, call it to account with free media, and eventually participate in governing directly. These inclusive political institutions are, in turn, more likely to give rise to inclusive economic institutions, which enshrine the process of creative destruction at the heart of the country's political and economic system. Why is it so difficult to engineer development? Because most trained economists working for international developmental agencies are focused on changing economic institutions. They take the politics of a country as an a priori. However, it is politics that determines economics, not the other way around. A powerful example in the book is the process of de-colonization in Africa. Despite a dramatic change of political leadership, post-colonial governments preserved the extractive economic institutions set up by their former colonial masters. Why? Because they never bothered to truly enfranchise their citizens. In other words, they kept the exclusive political institutions of colonialism largely in place. Once that decision was made, it was inevitable that extractive economic institutions would remain in place as well. In fact, in most examples, economic institutions became more extractive and political institutions more exclusive. Acemoglu and Robinson published their book in 2012, at the height of the "Beijing Consensus" narrative. It is easy to see how most of their examples are applicable to China today, particularly the chapter dealing with the decline of the Soviet Union. The message is that rapid economic growth under exclusive political institutions is possible, but unsustainable. China will therefore either evolve its political institutions or face the fate of the Soviet Union. We generally tend to agree with this analysis, but time horizons are difficult to gauge. For example, Acemoglu and Robinson themselves admit that the Soviet Union grew rapidly for 40 years before it faced limits and 60 years before it collapsed. By those measures, Chinese policymakers may still have decades before crisis forces their hand. A much more interesting question, one that Acemoglu and Robinson spend very little time discussing, is what happens to societies where elites capture political institutions and alter them from inclusive to exclusive? Two examples they detail briefly are the Roman and Venetian republics. In both, relatively inclusive political systems with inclusive economic institutions were captured by rapacious elites who then proceeded to limit access to both with the particular intention of limiting creative destruction. For global investors, this is the process that will have greater implications than the run-of-the-mill collapse of authoritarian and semi-authoritarian regimes. The entire global financial system today depends on the domestic stability of countries like the U.S. and the U.K., perhaps the most successful political systems in the world. And yet, voters in both are itching for radical change as a reaction to elite overproduction and growing income inequality. On one hand, voter discontent could lead to a messy political process, if not an outright revolution, that reestablishes the inclusive institutions that have underpinned their prosperity and power for centuries. On the other, it could lead to the collapse of the inclusive republic and the rise of an exclusive empire. 1 Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 2 Economist Abba Lerner, quoted at the end of Chapter 2 by the authors. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com