Elections

Highlights Trump's failures have helped fuel the bull market; Yet inflation and Trump legislative wins will embolden the Fed; The U.K. will have yet another election by 2019; Dodd-Frank repeal is a no go ... but small banks may get relief; The Tea Party just found its hard constraint ... in Kansas. Feature Investors in South Africa surprised us last week. The first question on everyone's mind was "Will Trump be impeached?" Our answer that impeachment is highly unlikely at least until the midterm elections was received with suspicion.1 The perspective of our South African clients is understandable. Their domestic assets have been underpinned since Trump's election by a phenomenon we like to call "the Trump put." The thesis posits that U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively. The result is a weak dollar, lower 10-year Treasury yields, and a rally in global risk assets (Chart 1). Of course, stubbornly weak inflation and disappointing Q1 GDP numbers bear responsibility as well as Trump (Chart 2). Chart 1The 'Trump Put' The 'Trump Put' The 'Trump Put' Chart 2Weak Inflation Fueling Bull Market Weak Inflation Fueling Bull Market Weak Inflation Fueling Bull Market For our South African clients, the fate of President Trump is irrelevant. What matters is that the American political imbroglio continues, reducing the likelihood of a hawkish mistake from the Fed, and thus keeping EM risk assets well bid. The market has generally agreed. Several assets associated with Trump's populist agenda have reversed their gains since the election. The yield curve, small caps, and high tax rate equities have all shown signs of disappointment with the Trump agenda (Chart 3). If the Trump put were to continue, we would expect U.S. bonds and stocks to rally, DXY to continue to face headwinds, and international stocks to outperform U.S. stocks. That said, the proxies for Trump's agenda in Chart 3 are starting to perk up. They may be sniffing out some positive political signs, such as the movement in the Senate on the bill repealing the Affordable Care Act (Obamacare). The budget reconciliation procedure - a process by which Republicans in Congress intend to avoid the Democrat filibuster in the Senate - requires Obamacare to be resolved before the House and the Senate can take up tax reform.2 If Obamacare clears Congress's calendar by the August recess, the odds of tax reform (or merely tax cuts) being passed by the end of 2017 will rise considerably. Second, former Director of the FBI James Comey's testimony was a non-event. We refused to cover it in these pages as we expected it to be theatre. The market had already digested everything that Comey was going to say, given that he had leaked the juiciest components of his testimony weeks ahead of the event. Chart 3Consensus On Trump Policy Failure? Consensus On Trump Policy Failure? Consensus On Trump Policy Failure? Chart 4 Third, President Trump's approval rating with Republican voters remains resilient (Chart 4). If the worst has passed with the Russian collusion investigation - which we expect to be the case now that Comey's testimony has come and gone with little relevance - we could see GOP voters rally around the president. Several clients have pointed out that our measure is less relevant given the decline in voters who identify as Republicans (Chart 5). We disagree. As long as Republican voters vote in Republican primaries, they can act as a constraint on GOP members in Congress who are thinking of abandoning the president's populist agenda. This brings us to the main event: the economy. Our colleague Ryan Swift, who writes BCA's U.S. Bond Strategy, could not care less about the ongoing political drama. As Ryan has argued in a cogent report that we highly recommend to clients, the Fed's median projection for two more 25 basis point rate hikes before the end of the year, and for PCE inflation to reach 1.9% (Chart 6), is not going to happen if inflation continues to disappoint over the summer.3 The market seems to be saying that a PCE of 1.9% is unlikely. Core PCE inflation is running at only 1.54% year-over-year through April, and will probably stay low in May given that year-over-year core CPI fell from 2% in March to 1.89% in April. Chart 5Fewer People Call Themselves Republicans Fewer People Call Themselves Republicans Fewer People Call Themselves Republicans Chart 6Inflation Relapse Would Scratch Fed Hikes Inflation Relapse Would Scratch Fed Hikes Inflation Relapse Would Scratch Fed Hikes Ryan's Philips Curve model, however, disagrees with the market. The model looks to approximate Chair Yellen's own philosophy for forecasting inflation, which she outlined in a September 2015 speech.4 Specifically, BCA's U.S. Bond Strategy models core PCE as a function of: 12-month lag of core PCE; Long-run inflation expectations from the Survey of Professional Forecasters; Resource utilization; Non-oil import prices relative to overall core PCE. BCA's core PCE model is sending a strong signal that the market's inflation expectations are overly pessimistic (Chart 7). Even after stressing the model under several adverse scenarios, Ryan concludes that it is very likely that core PCE inflation will indeed approach the Fed's 1.9% forecast by year-end. The U.S. economy is quickly running out of slack, with unemployment at a 16-year low of 4.3%. The broader U-6 rate, which includes marginally attached workers and those in part-time employment purely for economic reasons, has dropped to its pre-recession print of 8.4% (Chart 8). Chart 7Market Too Pessimistic On Inflation Market Too Pessimistic On Inflation Market Too Pessimistic On Inflation Chart 8U.S. Labor Market Running Out Of Slack U.S. Labor Market Running Out Of Slack U.S. Labor Market Running Out Of Slack Wages are also rising, with the underlying trend in wage growth having accelerated from 1.2% in 2010 to 2.4% (Chart 9). The acceleration has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 10). Chart 9Wages Heating Up Wages Heating Up Wages Heating Up Chart 10Wage Improvements Broad-Based Wage Improvements Broad-Based Wage Improvements Broad-Based BCA's Chief Global Strategist, Peter Berezin, therefore expects the Fed to raise rates in line with its own expectations. In fact, the Fed could expedite the pace of rate hikes if aggregate demand accelerates later in the year.5 It will be difficult for the Fed to ignore macroeconomic data, even if, from a political perspective, the Trump put continues. The analogy we use with clients in meetings is that of the U.S. economy as a camp fire around which the various market participants - bond and equity investors, foreign and domestic, etc. - are huddled. According to our sister publications that conduct macroeconomic research, that campfire is well lit. And according to our political research, "Uncle Donny" had a few too many drinks and is about to pour some bourbon on the fire to show the kids a good time. Chart 11Bond Bulls Feeding On Trump Failures Bond Bulls Feeding On Trump Failures Bond Bulls Feeding On Trump Failures For the Trump put to continue, we would have to see a combination of the following: GOP voters begin to abandon President Trump; Congress remains embroiled in Obamacare debates through FY2017, only seriously picking up on tax reform and other agenda items in FY2018. Greater doubts would undermine the recent uptick in assets tied to Trump's policy agenda (Chart 11). Impeachment concerns heat up again due to new revelations that implicate President Trump directly. So far impeachment talk has not correlated with the rally in Treasuries but it could do so if new evidence comes to light. Perhaps Robert Mueller, the former FBI director and special counsel investigating Russia's role in the election, will drop another bombshell later this year. In addition, for the Trump put to continue our colleagues Ryan and Peter would have to be wrong about the economy and inflation. For investors interested in playing the Trump put, and allocating funds to EM assets in particular, we would caution against it. However, given that BCA's bond and FX views have been challenged over the past several months by the Trump put, we understand why many of our clients are itching to chase the global asset rally. The summer months will be critical. Does Brexit Still Mean Brexit? We posited last week that the extraordinary election in the U.K. was about austerity and, more importantly, about repudiating the Conservative Party's fiscal policies.6 This remains our view. The most investment-relevant message to take from the election is that U.K. fiscal policy will become easier over the life of the coalition government, while monetary policy remains stuck in D - for dovish. This should weigh on the pound over the course of the year. That said, investors will begin to wonder about the longevity of the coalition between the U.K. Conservative Party and Northern Ireland's Democratic Unionist Party (DUP). In practice the coalition will have only a five-seat majority, which would be tied for the second-smallest margin since Harold Wilson in 1964 (Chart 12). Technically it is an even smaller one-seat majority. U.K. governments with a majority of fewer than ten seats are rare and usually only last one-to-two years (Harold Wilson's four-seat 1974-79 run is an exception). This bodes ill for May's government - that is, if she survives today's brewing leadership challenge from within her party. Chart 12 We have no idea if the election means a softer Brexit as we have no idea - and neither does anyone else - what that means. Generally speaking, the wafer-thin majority for the Tories means the following: "No deal is better than a bad deal" is no longer going to be acceptable to the government or the public; London will end up paying a larger "exit fee" than it probably thinks it will; There will be no favorable deal for the U.K.'s financial industry. In essence, the U.K. clearly has the weaker hand in the upcoming negotiations. Cheers went up in Brussels. Does this change anything? First, we never bought the argument that the U.K. had a strong negotiating position because continental Europeans want to export BMWs to consumers in Britain. The EU is a far bigger market for the U.K. than the U.K. is for the EU (Chart 13). On this measure alone, the U.K. was always going to be the underdog in the negotiations. Chart 13The U.K. Lacks Leverage The U.K. Lacks Leverage The U.K. Lacks Leverage Chart 14 Second, the influence of Tory Euroskeptics has been reduced. That might appear counterintuitive, given that May wanted to reduce their influence by getting a bigger majority. However, it is highly unlikely that she will get the ultimate EU deal through Westminster, with a five-seat majority, without at least some votes from the opposition. Euroskeptics will therefore either remain quiet and compliant or force May to seek a deal that Labour MPs could agree to. Which brings us to the very likely scenario that the final deal will not pass Westminster without a new election. As we argued right after the referendum, the U.K. will likely have a "Brexit election" sometime in 2019.7 There is no way around it now. At very least the ruling alliance will face a contradiction in trying to soften Brexit while maintaining a strict stance on immigration. And given the weak majority, if Labour does not play ball, the Tories will have to call a new election on the basis of the deal they conclude. Chart 15 The good news for the Conservative Party is that the polls continue to show that a majority of U.K. voters support Brexit (Chart 14). Furthermore, the two Brexit-lite campaign promises by the Labour Party and the Liberal Democrats were the least preferred policies ahead of the election (Chart 15, see next page). However, the election also saw a complete collapse in support for Euroskeptic-leaning parties, in terms of share of the overall vote (Chart 16). Could Brexit ultimately be reversed? Certainly the odds have risen. Furthermore, there does appear to be some regret amongst U.K. voters, with a recent survey showing a decline in national identification: now more Britons identify as "also European" than ever (Chart 17). Nonetheless, a full reversal of Brexit will still require an exogenous shock, such as a recession or a geopolitical calamity that convinces the U.K. that they need Europe. Investors should remain vigilant of the polls. A clear trend reversal in Chart 14 would constitute a political opportunity for the opposition parties to campaign on a new referendum. Chart 16Euroskeptics Collapsed In The U.K. Euroskeptics Collapsed In The U.K. Euroskeptics Collapsed In The U.K. Chart 17 Bottom Line: Odds of a softer Brexit have certainly risen as the Tories face considerable domestic constraints in their negotiating strategy with the EU. We continue to believe that the negotiations will not be acrimonious and therefore the pound will not fall below its lows on January 16. However, it may re-test that 1.2 level due to a coming mix of easy fiscal and monetary policy over the course of the year. U.S.: Doing A Number On Dodd-Frank Better put a strong fence 'round the top of the cliff, Than an ambulance down in the valley! - Joseph Malins, "The Fence or the Ambulance," 1895 The Republican-controlled U.S. House of Representatives passed the Financial CHOICE Act of 2017 by a vote of 233-186 on June 8. This is the GOP's second major attempt, after the Affordable Care Act, to rewrite a signature law of President Obama's administration. This time it is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, known simply as "Dodd-Frank," that is on the docket. The bill's prospects in the Senate are dim. President Trump promised to "do a number" on Dodd-Frank shortly after coming into office, by which he meant dismantling the law. The so-called "CHOICE Act" put forward by Jeb Hensarling (R-TX) now goes to the Senate, where it faces a high hurdle because Democrats can filibuster it, forcing the GOP to summon 60 votes. So the question is what kind of a "number" can the GOP actually do to Dodd-Frank, and does it matter? First a little bit of background.8 Dodd-Frank cleared Congress in the wake of the subprime financial crisis, July 2010. It had both a quixotic and a more pragmatic aim: the first to reduce the likelihood of future financial crises, and the second to improve the ability of regulators to stem risks as they emerge. The law has never been fully implemented and is best understood as a work in progress. The law grants the Federal Reserve and other agencies greater powers of oversight, prevention, and crisis management. In particular it ensures that the Fed would regulate not only banks but also non-bank investment companies and other financial firms (such as the giant insurance company AIG that had to be bailed out at the height of the crisis). It also frees the Fed of the responsibility to rescue failing institutions or dismantle them, handing those duties over to others, while still enabling the Fed to act as lender of last resort. The key provisions are as follows: Impose tougher capital standards: In keeping with the international Basel III banking reforms,9 Dodd-Frank tried to ensure that banks were better fortified against liquidity shortages in future. The new standards would apply both to domestic banks and foreign banks with American subsidiaries. Orderly Liquidation Authority: The Federal Deposit Insurance Corporation (FDIC), a major institution born amidst the Great Depression, would take over the responsibility of liquidating failing firms in the event of a crisis - assuming Treasury's go-ahead due to the systemic importance of the failing firm. Additional measures would hold the entire financial sector responsible for the bill if the FDIC made losses in the process. Each firm would have to maintain a "living will" to make the resolution process easier in the event of disaster. A new Financial Stability Oversight Council: Chaired by the Treasury Secretary and consisting of the various financial regulatory bodies, this council would identify systemically important financial companies, monitor them, and take actions to prevent crises. A new Consumer Financial Protection Bureau: The brainchild of Senator Elizabeth Warren (D-MA), the anti-Wall Street firebrand, the bureau would be funded by the Fed but otherwise entirely independent of it, and tasked with patrolling the banks on behalf of consumers. The Volcker Rule: The rule, named after former Fed Chair Paul Volcker, would force banks to curtail a number of short-term, high-risk trading activities on their own accounts, including derivatives, futures, and options, unless to hedge risks or serve bank customers. This was viewed as a partial reinstatement of the Glass-Steagall law, a Depression-era law that separated commercial and investment banking but was repealed by President Clinton in 1999. Republicans want to overturn Dodd-Frank to increase financial sector profits, credit growth, economic growth, and animal spirits. Lending has arguably suffered as a result of the new regulations (Chart 18). The share of bank loans to overall bank credit has remained subdued, reflecting bank behavior under QE and possibly also risk-aversion under tighter regulation (Chart 19). Chart 18Lending Growth Hampered By Dodd-Frank? Lending Growth Hampered By Dodd-Frank? Lending Growth Hampered By Dodd-Frank? Chart 19Banks Holding Reserves Instead Of Lending Banks Holding Reserves Instead Of Lending Banks Holding Reserves Instead Of Lending Republicans would also satisfy an ideological goal of reducing state involvement, which grew as a result of the law. In addition, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over a ten-year period.10 A very small amount, but again in line with GOP's political bent. The way the CHOICE Act would work is to create an "escape hatch" that would allow banks that maintain capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills, and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. This is supposed to boost lending, earnings, and growth. About 70% of the $18 trillion in U.S. banking assets belongs to banks defined by Dodd-Frank as "systemically important." The eight U.S. banks defined as "globally systemic important banks" account for about $9 trillion in assets and are unlikely to take advantage of the Republicans' escape hatch because they would then have to raise new capital and yet would still be subject to international Basel III regulations even if exempted from Dodd-Frank. The CBO estimates that banks holding about 2% of the bank assets held by systemically important banks (i.e. $252 billion) would opt out of Dodd-Frank (Chart 20). Chart 20 Further, the CBO estimates that, among non-systemically important banks (30% of $18 trillion total banking assets), the banks that both meet the 10% leverage ratio and would opt out of Dodd-Frank account for about 7% of U.S. banking assets ($1.26 trillion) (see Chart 20 above). Community banks (with assets under $10 billion each) and credit unions are especially likely to do so. Therefore, if the Republican bill were to become law, banks comprising something like $1.5 trillion in U.S. banking assets would become less restricted and eligible to adopt riskier trading practices free of Dodd-Frank policing. The greatest impact will be in areas with a higher concentration of small banks and credit unions than elsewhere. These U.S. banks would also, arguably, become more likely to take excessive risks and fail at some future point. Using probabilistic models for bank failures, the CBO found that the U.S.'s Deposit Insurance Fund would only suffer an additional $600 million in losses over the next ten years as a result of this increase in risk. It is a credible estimate but the reality could be far costlier if more and more banks gain the ability to bypass regulation or if banks significantly change their behavior to take advantage of the regulatory loophole. Other aspects of the bill would: Repeal the FDIC's orderly liquidation fund: The private sector would largely take over the responsibility for managing liquidations. The CBO estimates that the federal government would save an estimated $14.5 billion in liquidation costs over ten years. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: Within one year of passage, the Government Accountability Office (GAO) would audit the Fed's board of governors and the Federal Reserve regional banks, including their handling of monetary policy. The Fed's open market committee (FOMC) would also have to establish a new interest rate target, based on economic parameters, which the GAO would monitor. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. It would be re-branded as the Consumer Law Enforcement Agency and have its power to oversee institutions with more than $10 billion in assets taken away, making it, in effect, a monitor of small banks only. Cut penalties for violating regulations: However, outright criminality would be punished more severely. Various authorities and institutions would be tweaked, mostly in accordance with the general aim of reducing regulatory burdens on the financial sector. So, what options do the Republicans have going forward?11 Republicans either need 60 votes to defeat a Senate filibuster or they need procedural work-arounds like budget reconciliation. Chart 21Small Banks Benefit From Dodd-Frank Repeal Small Banks Benefit From Dodd-Frank Repeal Small Banks Benefit From Dodd-Frank Repeal Some Republicans claim that certain elements of the rewrite can be tucked into a reconciliation bill. However, reconciliation requires a single, concentrated policy focus. The GOP is currently undertaking an unprecedented two budget reconciliation bills in a single year: first, the FY2017 reconciliation procedure to repeal Obamacare, and second, the FY2018 procedure to cut taxes. Rewriting Dodd-Frank is a far cry from either health care or tax reform. Dodd-Frank measures crammed into either of these bills would likely be revoked under the so-called "Byrd Rule" which keeps the reconciliation process focused and excludes extraneous material.12 So it is unlikely that this method will work. The FY2018 budget resolution will be a critical signpost. Second, it is hard to see how a bipartisan rewrite of Dodd-Frank is possible. Dodd-Frank was the Democrats' signature response to the subprime mortgage debacle and broader financial crisis. They will not participate in dismantling it. We cannot see eight Democrats joining Republicans in the Senate for what Senator Sherrod Brown (D-OH) has called "collective amnesia." However, there is one general principle that could find its way into law: the idea of giving small, regional banks a reprieve from Dodd-Frank requirements. Even Fed Chair Janet Yellen has tentatively supported giving these banks a break.13 These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio. Politicians could at least attempt to make a popular argument for easing the burden on small community banks and credit unions, which are often vital to local communities. The same cannot be said for the Dodd-Frank rewrite as a whole, which smacks of granting impunity to Wall Street. Still, we think that even a bill focused exclusively on helping small banks would have trouble passing on its own. The legislative agenda is too busy in 2017; while 2018 will see midterm elections, when few candidates will want to appear soft on Wall Street. Instead, a provision helping small banks could pass if tacked onto the larger budget bill or bills for FY2018, if not later. It would have to be made palatable to Democrats, or else it would be perceived as a "poison pill" and risk adding to the numerous risks of government shutdown over the budget this fall. Other than these legislative options, the Trump administration can ease regulation, or relax enforcement, through executive action, as it has already promised to do. Assuming America's financial sector will get a reprieve, investors could capitalize on it by favoring small U.S. bank equities over large bank equities. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to fall back in the subsequent months, has recently perked up (Chart 21). Relative earnings have been flat over the same period. If Dodd-Frank is partially watered down, these banks should see earnings improve, which should drive up their share prices. Our colleagues at BCA's U.S. Equity Strategy are positive on global bank equities, particularly European and American ones. The latter are still relatively affordable as they undertake the long trek of recovery after a once-in-a-generation crisis (Chart 22). U.S. banks have notably better fundamentals than peers in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates (Chart 23).14 Chart 22The Long, Hard Road Of Recovery The Long, Hard Road Of Recovery The Long, Hard Road Of Recovery Chart 23U.S. Banks Well Positioned Globally U.S. Banks Well Positioned Globally U.S. Banks Well Positioned Globally In addition, the FiscalNote Financial Sector Index suggests that the flow of legislative and regulatory proposals has been steadily getting less onerous on the financial sector.15 Chart 24 is an aggregation of the favorability scores - which assess whether the bill is likely to be favorable or unfavorable to the sector - for all U.S. Congressional legislation that is determined to be relevant to the financial sector since 2006. It provides a snapshot of the regulatory environment for the financial sector at any given point in time. Chart 24Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Risks to the view? Republicans could somehow squeeze a broader Dodd-Frank rewrite through the budget reconciliation process. We think the probability of this is less than 10%. Financially, this would deliver a bigger jolt to the financial sector, and financial stocks, than currently expected. But it would still benefit small banks more than large ones. Politically, a full repeal could add to Republican woes in 2018 - particularly if it is their only legislative achievement. It may well be political suicide to contest the 2018 midterm election on two pieces of legislation: one that denies millions of Americans health insurance and another that favors Wall Street. A full rewrite would also probably increase systemic financial risks. Even deregulation just for the small banks would do so. Lawmakers, focused on restraining the "too big to fail" giants, could end up clearing the way for excesses among the pygmies. That said, excessive regulation can also fuel shadow banking, a risk in itself. And the next crisis may well emanate from somewhere other than the financial sector. Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked onto the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The Trump election rally for bank stocks has mostly fallen back. Now is an opportunity to favor small banks versus large ones on expectations of Trump getting tax cuts passed and regulatory easing of some kind. Kansas: Where Seldom Is Heard A Discouraging Word A chill went through the Tea Party's collective spine on June 6 when two-thirds of the GOP-controlled Kansas legislature overrode the veto of GOP Governor Sam Brownback to repeal a 2012 budget law that slashed taxes on income, small business, and retail sales. You heard that right: Republicans in one of America's reddest states just overrode their leader in order to increase taxes. And it was the largest tax hike in state history. We will spare our readers the nitty-gritty details of the Brownback saga. Suffice it to say that the Tea Party-friendly Kansas legislature slashed state taxes and spending under Brownback's leadership in May 2012. Brownback called it a "real live experiment" of conservative economic principles and argued that the tax cuts would pay for themselves through faster growth. Art Laffer, of "Laffer Curve" fame, allegedly consulted on these measures via the conservative American Legislative Exchange Council. The medicine proved more dangerous than the illness. Since 2012, the state has burned through a budget surplus and growth has slowed (Chart 25). Both Moody's and S&P downgraded Kansas debt. Employment gains have lagged those of neighboring states. Beginning in October 2013, Brownback began to slip in public opinion polls (Chart 26). Cuts to core government services, especially education, caused a tide of criticism. In an extraordinary development, a hundred establishment Republicans supported his Democratic opponent in the 2014 gubernatorial election. He won by a margin of 3.7% but soon afterwards fell out of favor with the public. Chart 25 Chart 26 A series of confrontations with the Kansas Supreme Court hastened his decline, mostly over education funding, which is guaranteed by the state constitution. Brownback, the legislature, and various activist groups attempted to strong-arm the courts, including by ousting four members of the Supreme Court in the 2016 elections. All four retained their posts. The new budget law raises $1.2 billion in income taxes over two years by revoking swathes of the 2012 law, particularly the income tax exemption for business owners and professionals. Brownback duly vetoed the legislation and was promptly overridden by two-thirds of a legislature that is 70% Republican. This is a remarkable event for a state as ideologically conservative as Kansas. What does it mean nationally? There are two reasons that the Kansas experiment will have a limited impact on Republican thinking nationally: Kansas has a balanced budget law (Section 75-3722), while D.C. does not ... and this helped increase the pressure on the administration; Brownback is the least popular governor of any governor in the United States (Chart 27). The blame for the whole fiasco may fall on him personally, distracting from the policy failure. Chart 27 Nevertheless, we think Kansas has set the high-water mark for an aggressive Tea Party agenda in the U.S. that focuses on fiscal conservativism to the exclusion of everything else. Republicans will take note that even as conservative of a state as Kansas has a limit when it comes to spending cuts. It was the cuts to education - which resulted in shorter schoolyears in some districts, and various other disruptions - that fatally wounded Brownback's public standing. Thus public demand for core services is a real constraint on the extent to which taxes can be slashed. Bottom Line: We expect the Trump administration to go forward with tax cuts. But we also think that Trump will get far less in spending cuts than his budget proposals pretend. As such, we expect the GOP tax reform agenda to blow out the budget deficit, a path that Kansas could not legally (or politically) take. This will be the path of least resistance for Congressional Republicans who want to slash taxes yet fear they may not survive the spending cuts necessary to pay for them.16 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, "Break Glass In Case Of Impeachment," dated May 17, 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 U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 4 Please see Janet L. Yellen, "Inflation Dynamics and Monetary Policy," Philip Gamble Memorial Lecture, University of Massachusetts-Amherst, September 24, 2015, available at www.federalreserve.gov. 5 Please see BCA Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, and Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Brexit - Next Steps," dated July 1, 2016, available at gps.bcaresearch.com. 8 We are particularly indebted to Ben S. Bernanke's account in The Courage To Act: A Memoir Of A Crisis And Its Aftermath (New York: Norton, 2015), pp. 435-66. 9 Please see BCA U.S. Investment Strategy Special Report, "Preparing For Basel III: Who Will Win, Who Will Lose?" dated September 12, 2011, available at usis.bcaresearch.com. 10 Congressional Budget Office, "H.R. 10, Financial CHOICE Act of 2017," CBO Cost Estimate, May 18, 2017, available at www.cbo.gov. 11 The Republicans managed to repeal one aspect of Dodd-Frank with a simple majority via the Congressional Review Act, an option that is now closed. U.S. oil, gas, and mineral companies can now be somewhat less transparent about payments made to foreign governments to gain access to resources. Proponents claim U.S. resource companies will gain competitiveness; opponents claim corruption will increase, particularly in foreign countries. 12 Please see Bill Heniff Jr., "The Budget Reconciliation Process: The Senate's 'Byrd Rule,'" Congressional Research Service, November 22, 2016, available at fas.org. 13 Please see Yellen's February testimony to the Senate Banking Committee, e.g. "Yellen Wants To Ease Regulations For Small Banks," Associated Press, February 14, 2017, available at www.usnews.com. 14 Please see BCA U.S. Equity Strategy Weekly Report, "Girding For A Breakout," dated May 1, 2017, available at uses.bcaresearch.com, and Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, and "Wind Of Change," dated November 11, 2016, available at gss.bcaresearch.com. 15 The FiscalNote Policy Index measures regulatory risk daily for sectors, industries, and individual companies from every legislative and regulatory proposal. Using proprietary machine-learning-enabled natural language processing algorithms, FiscalNote ingests and processes thousands of legislative and regulatory policy events, scoring each for relevance, favorability, and importance to affected sectors. 16 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com.

Highlights The current economic and profit environment supports our stance of favoring stocks over bonds. The Fed will need to see more evidence to alter its gradual path for rates. Although valuations remain elevated, they are not a great market timing tool. Margins are expanding according to the S&P 500 data, and we expect this to continue in the second half of the year. But a peak in margins next year could be the justification to scale back on overweight positions in stocks, in anticipation of slower EPS growth. Corporate balance sheets continued to deteriorate in the first quarter, but that is not enough to warrant cutting back on corporate bond positions within fixed-income portfolios. Watch real short-term rates and bank C&I lending standards, as an exit warning. Feature Environment Remains Supportive For Stocks Over Bonds Investors are wondering whether the equity and currency/bond markets are living on different planets. The dollar and Treasurys seem to be priced for sluggish economic growth, less inflation and no fiscal stimulus. Yet, the S&P 500 is stubbornly holding above the 2,400 level. Many believe that the only reason that stocks got to this level in the first place is the prospect of tax cuts, deregulation and infrastructure spending. If true, then it is only a matter of time before equity investors capitulate. We look at it another way. Yes, equities initially received a boost following the U.S. election on hopes for tax reform. But indicators such as the ratio of small-to-large-cap stocks, or high-tax companies relative to the S&P 500, suggest that the stock market has priced out all chances of any tax reform. The overall stock market has performed well despite this because of the favorable profit backdrop. The fact that Corporate America can generate such profits despite a lackluster economy is impressive. Moreover, the recent softening in inflation has led many to believe that the Fed can proceed even more slowly than the market previously believed, leading to a bond rally. This is quite a bullish backdrop for equities. One does not have to conclude that the bond and stock markets are living on different planets. The backdrop is also positive for corporate bonds versus Treasurys, despite the fact that corporate health continues to deteriorate (see below). Turning to politics, the political consequences of the extraordinary U.K. general election are still not clear. The outcome of the election does not change our core views on the U.S. dollar, equity or bond markets. The dollar has rallied, Treasury yields are higher and U.S. equity prices moved up as this report was being prepared on Friday, June 9. Looking ahead, the coalition-building process in the U.K. will take time as the horse-trading between parties proceeds. Nonetheless, our high conviction view is that the investment implications are in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. A key takeaway for investors is that, aside from Brexit, domestic fiscal policy is the driving issue in British politics. Austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Moreover, the Brexit process will continue, albeit of a potentially more "softer" variety and with a somewhat higher probability of eventual reversal.1 Will They Or Won't They? A 25-basis point rate hike is likely this week, but the FOMC will need more evidence on the direction of inflation and the economy before significantly changing the timing and pace of rate hikes or economic forecasts. The market is fully pricing in the anticipated 25-basis point rate bump, but beyond that, there is not much agreement between the Fed and the market on interest rates or economic projections. Nonetheless, as the Fed prepares its June forecast and dot plots, policymakers and the market are on the same page in terms of the labor market, inflation, and the economy in the next few years. The unemployment rate (4.3% in May 2017) is below the Fed's forecasts for 2017 (4.5%) and longer run (4.7%). The consensus outlook for the unemployment rate keeps it below the Fed's path through the end of 2018 (Chart 1, panel 3). Even assuming that the 120,000 pace of job growth in the past three months persists, the unemployment rate would remain below the Fed's view of NAIRU (Chart 2). Our unemployment rate projections are based on a stable labor force participation rate and a 1% gain in the working age population. Chart 1Fed, Market And Reality##BR##Not Too Far Apart Fed, Market And Reality Not Too Far Apart Fed, Market And Reality Not Too Far Apart Chart 2The Unemployment Rate##BR##Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios However, a closer look at what policymakers have said about prices and the trajectory of inflation in recent years suggests that the market and the Fed are not that far apart. At +1.7% in April, the PCE deflator remains near the FOMC's projection of 1.9% for this year and 2.0% in the long run. Bloomberg consensus estimates for inflation for this year and next are above the top end of the Fed's forecast range (Chart 1, panel 2). The FOMC's May minutes state that "participants generally continued to expect that inflation would stabilize around the Committee's two percent objective over the medium run as the effects of transitory factors waned." The market is still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with the economy below the Fed's estimate of full employment. We will discuss the Phillips curve in a post-GFC world in an upcoming edition of The Bank Credit Analyst. As we discussed in last week's report,2 GDP growth in 2017 is on track to exceed the Fed's 2017 target (2.1%) and is already running ahead of the Fed's GDP projection (1.8%) for the long term. The consensus forecast for GDP in 2018 and 2019 is at the upper end of the Fed's range set in March (Chart 1, panel 1). Despite the general agreement between the Fed and the market on certain aspects, they diverge on the outlook for the fed funds rate in the next 18 months (Chart 3). As of June 9, the Fed sees a total of six quarter-point rate hikes by the end of 2018. The market sees just two in the same period. The Fed and market are still far apart on rates in 2019. However, the disconnect between the Fed and the market is not as large as it was in early 2015. This disagreement was a major factor in the equity market pullback in the first few months of 2016 (Chart 3). Neither the recent weakness in the economic data nor softer-than-expected inflation readings will be enough to prompt a significant shift from the Fed in terms of the 'dot plot'. The economic surprise index has been declining for 63 days since peaking in early- to mid-March, but remains consistent with slow growth, not a recession. Economic data tends to disappoint for an average of 90 days after the economic surprise index is above 40, as it was in late 2016/early 2017 in the wake of the U.S. election (Chart 4). Chart 3Disconnect Between Fed##BR##And Market On Rates Disconnect Between Fed And Market On Rates Disconnect Between Fed And Market On Rates Chart 4Economic Surprise Index Has Rolled Over##BR##Since Early To Mid March Economic Surprise Index Has Rolled Over Since Early To Mid March Economic Surprise Index Has Rolled Over Since Early To Mid March Bottom Line: It would take a significant deterioration in the economy and labor market and in the benign inflation environment to alter the Fed's gradual rate hike plan. A backdrop of gradual hikes and eventually, a smaller balance sheet, will continue to foster the conditions under which stocks have outperformed bonds since 2009. We believe that the recent Treasury rally is overdone because the market has gone too far in revising down the path of Fed rate hikes. A re-evaluation of the outlook could see bond yields jump, sparking a small equity correction. This is not enough of a risk to scale back on equities versus bonds. Valuations, Earnings And Margins: An Update U.S. equities remain overvalued and would be even more extended if not for low rates. However, they are attractively priced relative to competing assets, such as corporate bonds and Treasurys. Valuation is not a great tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we don't foresee a sustained pullback in stocks. Looking beyond our tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Our BCA valuation indicator has deteriorated since we last published it in March 2017 and shows that U.S. equities remain expensive.3 Individually, two of the three components of the Valuation index remain in overvalued territory. The Earnings Group remains at a record high (aside from the tech bubble). The Balance Sheet group shows the same profile. Only the Yield Group, which compares stock prices with various nominal and real interest rates, suggests that equities are undervalued. Thus, U.S. stock prices are vulnerable to a sharp jump in rates, which supports our view that U.S. equity markets will perform well in an economic and inflation backdrop that allows the Fed to raise interest rates and unwind its balance sheet gradually (Chart 5). While tax cuts and infrastructure spending might provide the equity market with a "sugar high", it probably would not last long because fiscal stimulus would bring forward Fed rate hikes. Moreover, Chart 6 shows that U.S. stocks remain favorably priced relative to competing assets such as corporate bonds, Treasurys and residential housing. That said, equity valuation measures such as price-to-book or price-to-sales make the market vulnerable to shocks. Chart 5U.S. Stocks##BR##Are Overvalued... U.S. Stocks Are Overvalued... U.S. Stocks Are Overvalued... Chart 6Stocks Look Less Expensive##BR##Relative To Competing Assets Stocks Look Less Expensive Relative To Competing Assets Stocks Look Less Expensive Relative To Competing Assets Inflated valuations alone are not enough to trigger a bear market or even a significant correction in U.S. equities. Outside of aggressive Fed tightening, we will become more defensive when profits come under pressure. On this score, the decline in Q4 profits according to the NIPA data is concerning. We are in a period where margins based on the NIPA data are diverging from the S&P's measure. Like corporate earnings, there is more than one data source for profit margin data, and the data itself is a mix of art and science. In the long run, the S&P-based margin data and the data derived from the NIPA accounts tend to move together. Over shorter time horizons, however, these two metrics may diverge. The NIPA margins peaked in 2014 and have moved steadily lower since then, but the BEA-derived profit data are not closely watched by investors and are subject to significant revision. On the other hand, margins based on S&P data are followed closely by the markets, are not subject to revision and have been moving higher since end of 2015. In the past 55 years, the peak in NIPA margins has often led the S&P data at peaks; the caveat is that it is unclear whether the NIPA data led in real time because of the endless revision process for GDP and profit data.4 The margin series based on S&P data tends to lead heading into margin troughs, but it is not a reliable signal. During the long economic expansion in the 1960s, both indicators topped out around the same time (1966-67). The NIPA derived margins peaked in 1975 as the S&P margins troughed, and later in the decade, the zenith in NIPA margins peaked three years before the S&P version. Similar to the current decade the long expansion in the 1980s saw a mid-decade collapse in oil prices and margins. In the late 80s, NIPA and S&P measures peaked almost simultaneously, which was three years before the crest in equity prices. The 1990s saw unabated margin expansion through 1997 for NIPA margins; the expansion in S&P-based margins lasted until 1999 (Chart 7). Chart 7Margins, Like Profits Are Mix Of Art & Science Margins, Like Profits, Are Mix Of Art & Science Margins, Like Profits, Are Mix Of Art & Science History also shows that falling margins do not always mean declining EPS growth. In the past 40 years, when the U.S. economy was not in recession, corporate EPS growth was very high on average when margins rose. It was mostly a wash when margins dropped, with slightly negative EPS growth on average. There were two episodes (late-1990s and mid-2000s) when margins fell, but EPS growth was strongly positive (Chart 8). The stock market can also rise significantly even after margins peak for the cycle. Chart 8EPS Can Grow Even As Margins Contract EPS Can Grow Even As Margins Contract EPS Can Grow Even As Margins Contract According to S&P data we are in a phase of climbing margins and we expect EPS growth to further accelerate into year end, peaking at just under 20%, before moderating in 2018. If profit growth decelerates in 2018 and the S&P measure of margins begins to narrow again, it would send a strong signal to trim exposure, especially given lofty equity valuations (Chart 9). Chart 9Profit Growth And Margins Both Rising Profit Growth And Margins Both Rising Profit Growth And Margins Both Rising Bottom Line: Rich valuations in U.S. equities will be overlooked as most investors are focused on the S&P and not the NIPA margins. EPS growth will decelerate sharply when margins resume their mean reversion, which could be the catalyst for a major correction or bear market in stock prices. We do not expect this scenario to play out until 2018 at the earliest. Meanwhile, rising margins and profits trump expensive multiples for U.S. equities. Stay long. Corporate Bonds: Kindling And Sparks Last week's U.S. Flow of Funds release allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart 10). The level of the CHM moved slightly deeper into "deteriorating health territory." The deterioration in the Monitor over the past few years is largely reflected in the profit-related components of the CHM, including the return on capital, cash flow coverage and free cash flow-to-total debt. Chart 10Deteriorating Since 2015, But... Deteriorating Since 2015, But... Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years. Indeed, it is one of the oldest and most reliable indicators in BCA's stable of indicators. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. A blowout requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to rise, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist usually occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. Even now, inflationary pressures are so muted that the Fed can proceed quite slowly. It will be some time before real short-term interest rates are in restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. As an aside, recent weakness in the growth rate of C&I loans has contributed to concerns over the health of the U.S. recovery. However, the easing in lending standards this year points to an imminent rebound in C&I loan growth (Chart 11). Our model for C&I loans, based on non-residential fixed investment, small business optimism and the speculative-grade default rate, supports this view. Chart 11C&I Loan Growth Set To Rebound C&I Loan Growth Set To Rebound C&I Loan Growth Set To Rebound The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart 12 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, has eased on a 4-quarter moving average basis (although it ticked up in Q1 on a 2-quarter basis; Chart 13). As a result, ratings migration has improved (i.e. easing net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The moderating appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart 12Still Some Value In##BR##High-Yield Corporates Still Some Value In High-Yield Corporates Still Some Value In High-Yield Corporates Chart 13Net Transfers To Shareholders##BR##Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle, for reasons we outlined in the April 17, 2017 Weekly Report. In a nutshell, value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Bottom Line: Corporate balance sheets are still deteriorating but risk assets, including corporate bonds, should continue to outperform Treasurys and cash in the near term. We will look to downgrade risk assets when core inflation moves closer to the Fed's 2% target, which would trigger a more aggressive FOMC tightening campaign and tighter bank lending standards. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see the Geopolitical Strategy Client Note "U.K. Election: The Median Voter Has Spoken, published on June 9, 2017. Available at gps.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?" June 5, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "How Expensive Are U.S. Stocks", dated March 13, 2017 available at usis.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation and the Fed", May 8, 2017. Available at usis.bcaresearch.com.

Highlights The U.K. election was about austerity, not Brexit; The median voter in the U.K. and the U.S. has moved to the left; Nationalism will not satisfy the popular revolt in these countries; The pound is not likely to fall much below GBP/USD 1.2. Feature The political consequences of the extraordinary U.K. general election are still not clear. The coalition-building process will take time as the horse-trading between parties proceeds over the weekend. Our high-conviction view, however, is that the investment implications were in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. How can that be? Last year, in anticipation of unorthodox electoral results, we introduced the "Median Voter Theory."1 This theory in political science posits that policymakers are not price-makers but price takers in the political marketplace. The price maker is the median voter. Policymakers, of all stripes and colors, will attempt to approximate the policy demands of the median voter in order to win over as many voters as they can in the marketplace. Further, we argued that the median voter in the two most laissez-faire economies, the U.S. and the U.K., had moved to the left of the economic spectrum.2 The U.K. election confirms this argument. It also confirms our suspicion that the plebian revolts in these two bastions of free-market capitalism will not be extinguished merely by rallying the public around the flag and promoting nationalist themes of de-globalization.3 As such, the two trends we believe will emerge from this election, regardless of the ultimate political outcome, are: The Brexit process will continue, albeit toward a "softer" variety and with a somewhat higher probability of eventual reversal; Fiscal austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Because of this mix of policy outcomes, we expect the GBP to suffer little in the post-election environment, though heading back towards its January lows versus the USD later this year. The market will have to price in much looser fiscal policy out of the U.K. over the course of the next government, with expectations that the BoE will continue to stand pat. This Election Was About Austerity And Globalization, Not Brexit It is absolutely crucial for investors to understand that the Labour Party did not, in any way whatsoever, focus its campaign on the results of the Brexit referendum. Labour leader Jeremy Corbyn's strategy was not only to accept Brexit as a done deal, but ostensibly even to accept the "hard Brexit" of keeping the U.K. out of the Common Market, which PM Theresa May announced in a major policy speech on January 17. The three policy positions of the Labour Party on Brexit during the campaign were: Gain "tariff-free access" to the EU single market, while accepting that Common Market membership was off the table; Keep the option of negotiating a customs union - which would prohibit the U.K. from negotiating its own trade deals - on the table; Refuse the mantra that "no deal" is better than a "bad deal." Overall, these points are not too far from Tory strategy, although they are devoid of nationalist rhetoric. More importantly, the key difference between the Labour and Tory approach to Brexit was that Labour was not trying to entice blue-collar voters, battered by the winds of globalization, with promises of free-trade agreements with India and China. If last year's Brexit voters did not want a free-trade tie-up with Europe, why on earth would they support a Tory vision of free trade deals with China and India?! Jeremy Corbyn's Labour has, in other words, a much better handle on what the Brexit referendum was all about. As we concluded in our net assessment ahead of the referendum in March of last year, the vote would ultimately be about globalization and its impact on the economic wellbeing of the median voter in the U.K. (Chart 1), not the angst over the EU's technocratic elites and bureaucratic overreach.4 Yes, the latter also mattered, but not to the blue-collar voters who crossed the aisle to support the Tory/UKIP vision on Brexit. For them, Brexit was a vote against elites that have profited from globalization. Election polls gave investors a hint that blue-collar Brexit voters would shift back to Labour. Tories began to see a drop in support almost immediately after they called the election on April 18 - i.e. before May's various mistakes (Chart 2). All the subsequent gaffes by May reinforced the trend, but the trend started on the first day of campaigning. This suggested that traditional Labour voters were turning back to their bread-and-butter economic demands immediately as the campaign began. Chart 1Brits Exposed To Harsher Change Brits Exposed To Harsher Change Brits Exposed To Harsher Change Chart 2Labour Rally Began When Election Called Labour Rally Began When Election Called Labour Rally Began When Election Called Corbyn, who has been underestimated by the media for over a year, was quick to press the gas pedal on left-wing economic issues, steering clear of Brexit. In fact, if one was unfamiliar with British politics, and only focused on the Labour campaign rhetoric, one would hardly know that a referendum on EU membership had even taken place. Corbyn's campaign was straight out of the Labour playbook of the 1980s. He gambled that the median voter had swung to the left. In particular, the Labour campaign pounced on three policy issues that isolated Tory tone-deafness on the unpopularity of austerity: "Dementia tax" - May's quip that the elderly would be means-tested by including the value of their homes in assessing government support for social care ultimately proved to be profoundly self-harming. At the moment when she made the gaffe, Tories were up 11% on Labour in the polls. "Triple Lock" - May hesitated and waffled over the triple lock pension system - which was introduced by the Conservative and Liberal Democratic coalition from 2010-15. It guaranteed that government pension payouts would rise annually at the highest rate of inflation, 2.5% per year, or wage growth. She did so even as inflationary pressures built up as a result of Brexit, which similarly fell flat with voters. This is unsurprising, given that it was the Euroskeptic Tories and UKIP plan to exit the EU that caused inflationary pressures in the economy in the first place. That they then asked low-income elderly to shoulder the costs of Brexit also illustrates a profound misunderstanding of what the Brexit referendum was about. Police funding - May thought that the Manchester and London Bridge terrorist attacks would swing the vote towards the center-right, security-conscious party. She went so far as to announce that human rights concerns would not stand in the way of Britain's fight against terrorism, doubling down on nationalist rhetoric.5 Corbyn stuck to the strategy of tying everything to austerity: he condemned the attacks but criticized the Tories for significant cuts to police forces under May's watch as Home Secretary, claiming that these imperiled law enforcement's ability to keep U.K. citizens safe. Following Brexit, May did try to shift policy to the left. For example, her October 2016 speech - her first major address as the U.K. Prime Minister - blamed "globalized elites" for the pain incurred by Britain's low and medium income households. However, Tories could not help to subsequently promise corporate tax cuts and budget-saving measures. And her gaffes during the election convinced voters - many of whom may have voted for Brexit - that Tories were stereotypical Tories; i.e., not concerned for the plight of the common man. All that said, the Conservative Party will still win around 57 seats more than the Labour Party. In any previous election, that would be considered a decent, if not commanding, result. What we want to stress to clients is that the Conservative Party in fact only won 22 more seats than the combined result of the most left-wing Labour Party in half a century and an extremely left-leaning Scottish National Party. When seen from that perspective, and when we consider the Tories' 22% lead in polls at the onset of the electoral campaign, the result on June 8 is an unmitigated disaster for the party and a wake-up call: the economic preferences of the U.K.'s median voter are as left wing as they have been since the mid-1920s. Bottom Line: The U.K. election was not contested solely on Brexit. As such, investors should not overthink the implications of the election on the Brexit process and hence the implications for the pound and U.K. assets. Labour gained around 29 more seats despite firmly accepting the Brexit referendum. This is not to say that the Labour Party, were it to cobble together a governing coalition with the SNP and others, would not be quick to reverse the Brexit process and call a second referendum if the economic costs of Brexit were to rise over the course of its mandate. That is a possible scenario. But the bigger picture is that Labour's opposition to austerity politics is what made all the difference in this election. Likely Government Formation Scenarios At the time of publication of this Client Note, May's comments and the distribution of seats favor a Tory minority government (or perhaps a formal coalition) supported by the Democratic Unionist Party (DUP) of Northern Ireland. As we discussed in our just-published Weekly Report, the Northern Irish have not exercised real power in Westminster in a century, literally.6 The party won ten seats, which makes for a majority with the Tories, and thus could provide just enough support to accomplish the single goal of a Tory-led Brexit. Tories and the DUP have already been in an informal coalition due to the Tories' attempts to increase their earlier majority of only 17 seats. Nonetheless, such a coalition will be controversial and will lead to uncertainties about parliament's ability to pass a final Brexit deal in 2019. Currently, such an arrangement would see a Tory government depend on the slimmest of majorities, around two seats over the 326 needed for a nominal majority. However, because the Irish nationalist Sinn Fein MPs (who gained seven seats this time around) normally do not sit in the parliament, and because the speaker and deputy speakers do not vote, Tory's would have some buffer. (And yet the extraordinary circumstances suggest that one should not rule out Sinn Fein taking up their seats!) How much political capital would a May-led government have? Extremely little. First of all, not only did the Tories squander an extraordinary lead in the polls, but their ultimate share of the total population's vote is merely 2.4% above Labour's haul (Chart 3). In fact, the only thing that saved the Tories from opposition is the U.K.'s first-past-the-post electoral system, which allowed them to win more seats merely by being the only right-of-center option for British voters. Chart 3 In addition, it is now clear that May failed to get all of the UKIP voters to swing to the center-right, establishment party. The UKIP vote declined by over 11% in the election, but the Tory net gain in percentage terms from the last election is only half that figure. This supports our view from above that many blue-collar voters, who voted for Brexit, swung back to the Labour party the minute the election was announced, reflecting deep distrust of the Tory Party on bread-and-butter, non-Brexit issues. A slim government majority made possible by a Euroskeptic Northern Irish Party will ensure that the Brexit process continues. Would Euroskeptic Tories have a bigger say in such a government, forcing May to swing further to the nationalist right and leading to acrimony with Europe? Normally we would say "yes." However, it was May's turn to the nationalist right at the expense of nurturing left-leaning economic policies that cost her a majority. As such, we doubt that she, or her potential replacement in the wake of the disastrous result, would double-down on more Euroskepticism. That would be a profound error following a clear signal from the electorate that nationalist rhetoric and Brexit chest-beating is insufficient to bolster the Conservative Party in the post-Brexit environment. As May herself said, Brexit means Brexit. The median voter appears to agree and now wants the government to move on by turning the U.K. away from austere economic policies. We suspect the Tories understand this now. As for a potential Labour coalition with the SNP and Liberal Democratic Party, the numbers do not add up at the moment. Nonetheless, if we combine all the left-of-center parties in the U.K., their share of total vote is 52%. As such, we expect the Tories, assuming they govern, to tilt to the left on the economic front. Bottom Line: Tories are likely to produce a government in some kind of coalition with Northern Irish DUP. We highly doubt that they will double down on Euroskepticism after that strategy proved so disastrous in the election. The U.K. voters have moved on from Brexit and are not interested in re-litigating the reasons for it. They are, however, interested in seeing a definitive end to austerity. Investment Implications Another reason this election is not a game changer on anything other than domestic economic policy is that the Scottish National Party sustained serious losses of 21 seats. Former banner-bearing member Alex Salmond even lost his seat. Voters are simply not interested in the constitutional struggles within the U.K. or the EU at this point. The key takeaway for investors is that fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then. She lost sight of her own message and squandered her massive lead. The Tories had started to ease fiscal policy ahead of the election. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline beyond 2022 (Chart 4). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 5). Chart 4 Chart 5 Thus monetary and fiscal conditions are both accommodative in the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports, the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, should weigh on the pound regardless of the election outcome. We do not expect the GBP to retest its January 16, 2016 lows against the USD in the near term, but the large amount of uncertainty injected into the British political sphere will nonetheless result in a few more days of cable weakness that can be exploited by short-term traders. The competing crosswinds confusing investors in the immediacy of the election are as follow: Jeremy Corbyn's Labour is as left-wing as any major center-left party has become in the West. Yet it just won over 40% of the vote in the U.K.; Brexit remains the likely outcome of U.K.-EU negotiations, but the chances of a "super hard Brexit" or some sort of a "Brexit cliff" have been reduced as voters have repudiated May's hard right turn; The pound has already fallen on every gaffe and misstep by the Tories, suggesting that the current disappointing result, although not fully priced, was partly anticipated by the FX markets. In the long term, however, a reversal of austerity and a relatively dovish monetary policy from the BoE should be negative for the pound. While less austerity is a big plus for the economy, the inflationary momentum experienced in recent months should increase further and dampen the fiscal dividend as higher prices hurt real spending (Chart 6). This puts the BoE in a bind, in which it will be hard to move away from its super-accommodative stance even if inflation is becoming dangerous. Thanks to these dynamics, the leftward tilt for one of the previously most laissez-faire economies in the world could see the GBP ultimately retest its January 16 lows over the medium term as the recent surge in FDI could peter off, increasing the cost of financing the U.K.'s large current-account deficit. Moreover, BCA's House View calls for a higher dollar by year's end, another negative for cable. Yet a fall much below GBP/USD 1.2 is unlikely, given that uncertainty over Brexit negotiations with the EU were overstated to begin with and likely to be resolved towards a "softer Brexit" outcome over the life of the next government. Additionally, the pound is now cheap, and another pullback would result in a more than 1-sigma undervaluation relative to long-term fundamentals (Chart 7). Chart 6The BOE's Dilemma The BOE's Dilemma The BOE's Dilemma Chart 7The Pound Enjoys A Valuation Cushion The Pound Enjoys A Valuation Cushion The Pound Enjoys A Valuation Cushion Is there a message for the rest of the world from the U.K. election? Absolutely. It signals that the voters who did not benefit from globalization are singularly focused on economic issues and that distracting them with nationalism will only go so far. This is a message that the Trump administration in the U.S. will either heed over the next three years or ignore and suffer a left-wing backlash in the 2020 election that will unsettle the markets in a fundamental way.7 The bastions of laissez-faire economics - the U.K. and the U.S. - are swinging to the left. We continue to believe that investors are unprepared for the consequences of this reality. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 5 The failure of May's tough rhetoric on terrorism to help her in the polls suggests, along with other evidence, that Europeans are becoming desensitized to terror attacks. Please see BCA Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com.

Highlights The U.K. election was about austerity, not Brexit; The median voter in the U.K. and the U.S. has moved to the left; Nationalism will not satisfy the popular revolt in these countries; The pound is not likely to fall much below GBP/USD 1.2. Feature The political consequences of the extraordinary U.K. general election are still not clear. The coalition-building process will take time as the horse-trading between parties proceeds over the weekend. Our high-conviction view, however, is that the investment implications were in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. How can that be? Last year, in anticipation of unorthodox electoral results, we introduced the "Median Voter Theory."1 This theory in political science posits that policymakers are not price-makers but price takers in the political marketplace. The price maker is the median voter. Policymakers, of all stripes and colors, will attempt to approximate the policy demands of the median voter in order to win over as many voters as they can in the marketplace. Further, we argued that the median voter in the two most laissez-faire economies, the U.S. and the U.K., had moved to the left of the economic spectrum.2 The U.K. election confirms this argument. It also confirms our suspicion that the plebian revolts in these two bastions of free-market capitalism will not be extinguished merely by rallying the public around the flag and promoting nationalist themes of de-globalization.3 As such, the two trends we believe will emerge from this election, regardless of the ultimate political outcome, are: The Brexit process will continue, albeit toward a "softer" variety and with a somewhat higher probability of eventual reversal; Fiscal austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Because of this mix of policy outcomes, we expect the GBP to suffer little in the post-election environment, though heading back towards its January lows versus the USD later this year. The market will have to price in much looser fiscal policy out of the U.K. over the course of the next government, with expectations that the BoE will continue to stand pat. This Election Was About Austerity And Globalization, Not Brexit It is absolutely crucial for investors to understand that the Labour Party did not, in any way whatsoever, focus its campaign on the results of the Brexit referendum. Labour leader Jeremy Corbyn's strategy was not only to accept Brexit as a done deal, but ostensibly even to accept the "hard Brexit" of keeping the U.K. out of the Common Market, which PM Theresa May announced in a major policy speech on January 17. The three policy positions of the Labour Party on Brexit during the campaign were: Gain "tariff-free access" to the EU single market, while accepting that Common Market membership was off the table; Keep the option of negotiating a customs union - which would prohibit the U.K. from negotiating its own trade deals - on the table; Refuse the mantra that "no deal" is better than a "bad deal." Overall, these points are not too far from Tory strategy, although they are devoid of nationalist rhetoric. More importantly, the key difference between the Labour and Tory approach to Brexit was that Labour was not trying to entice blue-collar voters, battered by the winds of globalization, with promises of free-trade agreements with India and China. If last year's Brexit voters did not want a free-trade tie-up with Europe, why on earth would they support a Tory vision of free trade deals with China and India?! Jeremy Corbyn's Labour has, in other words, a much better handle on what the Brexit referendum was all about. As we concluded in our net assessment ahead of the referendum in March of last year, the vote would ultimately be about globalization and its impact on the economic wellbeing of the median voter in the U.K. (Chart 1), not the angst over the EU's technocratic elites and bureaucratic overreach.4 Yes, the latter also mattered, but not to the blue-collar voters who crossed the aisle to support the Tory/UKIP vision on Brexit. For them, Brexit was a vote against elites that have profited from globalization. Election polls gave investors a hint that blue-collar Brexit voters would shift back to Labour. Tories began to see a drop in support almost immediately after they called the election on April 18 - i.e. before May's various mistakes (Chart 2). All the subsequent gaffes by May reinforced the trend, but the trend started on the first day of campaigning. This suggested that traditional Labour voters were turning back to their bread-and-butter economic demands immediately as the campaign began. Chart 1Brits Exposed To Harsher Change Brits Exposed To Harsher Change Brits Exposed To Harsher Change Chart 2Labour Rally Began When Election Called Labour Rally Began When Election Called Labour Rally Began When Election Called Corbyn, who has been underestimated by the media for over a year, was quick to press the gas pedal on left-wing economic issues, steering clear of Brexit. In fact, if one was unfamiliar with British politics, and only focused on the Labour campaign rhetoric, one would hardly know that a referendum on EU membership had even taken place. Corbyn's campaign was straight out of the Labour playbook of the 1980s. He gambled that the median voter had swung to the left. In particular, the Labour campaign pounced on three policy issues that isolated Tory tone-deafness on the unpopularity of austerity: "Dementia tax" - May's quip that the elderly would be means-tested by including the value of their homes in assessing government support for social care ultimately proved to be profoundly self-harming. At the moment when she made the gaffe, Tories were up 11% on Labour in the polls. "Triple Lock" - May hesitated and waffled over the triple lock pension system - which was introduced by the Conservative and Liberal Democratic coalition from 2010-15. It guaranteed that government pension payouts would rise annually at the highest rate of inflation, 2.5% per year, or wage growth. She did so even as inflationary pressures built up as a result of Brexit, which similarly fell flat with voters. This is unsurprising, given that it was the Euroskeptic Tories and UKIP plan to exit the EU that caused inflationary pressures in the economy in the first place. That they then asked low-income elderly to shoulder the costs of Brexit also illustrates a profound misunderstanding of what the Brexit referendum was about. Police funding - May thought that the Manchester and London Bridge terrorist attacks would swing the vote towards the center-right, security-conscious party. She went so far as to announce that human rights concerns would not stand in the way of Britain's fight against terrorism, doubling down on nationalist rhetoric.5 Corbyn stuck to the strategy of tying everything to austerity: he condemned the attacks but criticized the Tories for significant cuts to police forces under May's watch as Home Secretary, claiming that these imperiled law enforcement's ability to keep U.K. citizens safe. Following Brexit, May did try to shift policy to the left. For example, her October 2016 speech - her first major address as the U.K. Prime Minister - blamed "globalized elites" for the pain incurred by Britain's low and medium income households. However, Tories could not help to subsequently promise corporate tax cuts and budget-saving measures. And her gaffes during the election convinced voters - many of whom may have voted for Brexit - that Tories were stereotypical Tories; i.e., not concerned for the plight of the common man. All that said, the Conservative Party will still win around 57 seats more than the Labour Party. In any previous election, that would be considered a decent, if not commanding, result. What we want to stress to clients is that the Conservative Party in fact only won 22 more seats than the combined result of the most left-wing Labour Party in half a century and an extremely left-leaning Scottish National Party. When seen from that perspective, and when we consider the Tories' 22% lead in polls at the onset of the electoral campaign, the result on June 8 is an unmitigated disaster for the party and a wake-up call: the economic preferences of the U.K.'s median voter are as left wing as they have been since the mid-1920s. Bottom Line: The U.K. election was not contested solely on Brexit. As such, investors should not overthink the implications of the election on the Brexit process and hence the implications for the pound and U.K. assets. Labour gained around 29 more seats despite firmly accepting the Brexit referendum. This is not to say that the Labour Party, were it to cobble together a governing coalition with the SNP and others, would not be quick to reverse the Brexit process and call a second referendum if the economic costs of Brexit were to rise over the course of its mandate. That is a possible scenario. But the bigger picture is that Labour's opposition to austerity politics is what made all the difference in this election. Likely Government Formation Scenarios At the time of publication of this Client Note, May's comments and the distribution of seats favor a Tory minority government (or perhaps a formal coalition) supported by the Democratic Unionist Party (DUP) of Northern Ireland. As we discussed in our just-published Weekly Report, the Northern Irish have not exercised real power in Westminster in a century, literally.6 The party won ten seats, which makes for a majority with the Tories, and thus could provide just enough support to accomplish the single goal of a Tory-led Brexit. Tories and the DUP have already been in an informal coalition due to the Tories' attempts to increase their earlier majority of only 17 seats. Nonetheless, such a coalition will be controversial and will lead to uncertainties about parliament's ability to pass a final Brexit deal in 2019. Currently, such an arrangement would see a Tory government depend on the slimmest of majorities, around two seats over the 326 needed for a nominal majority. However, because the Irish nationalist Sinn Fein MPs (who gained seven seats this time around) normally do not sit in the parliament, and because the speaker and deputy speakers do not vote, Tory's would have some buffer. (And yet the extraordinary circumstances suggest that one should not rule out Sinn Fein taking up their seats!) How much political capital would a May-led government have? Extremely little. First of all, not only did the Tories squander an extraordinary lead in the polls, but their ultimate share of the total population's vote is merely 2.4% above Labour's haul (Chart 3). In fact, the only thing that saved the Tories from opposition is the U.K.'s first-past-the-post electoral system, which allowed them to win more seats merely by being the only right-of-center option for British voters. Chart 3 In addition, it is now clear that May failed to get all of the UKIP voters to swing to the center-right, establishment party. The UKIP vote declined by over 11% in the election, but the Tory net gain in percentage terms from the last election is only half that figure. This supports our view from above that many blue-collar voters, who voted for Brexit, swung back to the Labour party the minute the election was announced, reflecting deep distrust of the Tory Party on bread-and-butter, non-Brexit issues. A slim government majority made possible by a Euroskeptic Northern Irish Party will ensure that the Brexit process continues. Would Euroskeptic Tories have a bigger say in such a government, forcing May to swing further to the nationalist right and leading to acrimony with Europe? Normally we would say "yes." However, it was May's turn to the nationalist right at the expense of nurturing left-leaning economic policies that cost her a majority. As such, we doubt that she, or her potential replacement in the wake of the disastrous result, would double-down on more Euroskepticism. That would be a profound error following a clear signal from the electorate that nationalist rhetoric and Brexit chest-beating is insufficient to bolster the Conservative Party in the post-Brexit environment. As May herself said, Brexit means Brexit. The median voter appears to agree and now wants the government to move on by turning the U.K. away from austere economic policies. We suspect the Tories understand this now. As for a potential Labour coalition with the SNP and Liberal Democratic Party, the numbers do not add up at the moment. Nonetheless, if we combine all the left-of-center parties in the U.K., their share of total vote is 52%. As such, we expect the Tories, assuming they govern, to tilt to the left on the economic front. Bottom Line: Tories are likely to produce a government in some kind of coalition with Northern Irish DUP. We highly doubt that they will double down on Euroskepticism after that strategy proved so disastrous in the election. The U.K. voters have moved on from Brexit and are not interested in re-litigating the reasons for it. They are, however, interested in seeing a definitive end to austerity. Investment Implications Another reason this election is not a game changer on anything other than domestic economic policy is that the Scottish National Party sustained serious losses of 21 seats. Former banner-bearing member Alex Salmond even lost his seat. Voters are simply not interested in the constitutional struggles within the U.K. or the EU at this point. The key takeaway for investors is that fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then. She lost sight of her own message and squandered her massive lead. The Tories had started to ease fiscal policy ahead of the election. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline beyond 2022 (Chart 4). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 5). Chart 4 Chart 5 Thus monetary and fiscal conditions are both accommodative in the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports, the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, should weigh on the pound regardless of the election outcome. We do not expect the GBP to retest its January 16, 2016 lows against the USD in the near term, but the large amount of uncertainty injected into the British political sphere will nonetheless result in a few more days of cable weakness that can be exploited by short-term traders. The competing crosswinds confusing investors in the immediacy of the election are as follow: Jeremy Corbyn's Labour is as left-wing as any major center-left party has become in the West. Yet it just won over 40% of the vote in the U.K.; Brexit remains the likely outcome of U.K.-EU negotiations, but the chances of a "super hard Brexit" or some sort of a "Brexit cliff" have been reduced as voters have repudiated May's hard right turn; The pound has already fallen on every gaffe and misstep by the Tories, suggesting that the current disappointing result, although not fully priced, was partly anticipated by the FX markets. In the long term, however, a reversal of austerity and a relatively dovish monetary policy from the BoE should be negative for the pound. While less austerity is a big plus for the economy, the inflationary momentum experienced in recent months should increase further and dampen the fiscal dividend as higher prices hurt real spending (Chart 6). This puts the BoE in a bind, in which it will be hard to move away from its super-accommodative stance even if inflation is becoming dangerous. Thanks to these dynamics, the leftward tilt for one of the previously most laissez-faire economies in the world could see the GBP ultimately retest its January 16 lows over the medium term as the recent surge in FDI could peter off, increasing the cost of financing the U.K.'s large current-account deficit. Moreover, BCA's House View calls for a higher dollar by year's end, another negative for cable. Yet a fall much below GBP/USD 1.2 is unlikely, given that uncertainty over Brexit negotiations with the EU were overstated to begin with and likely to be resolved towards a "softer Brexit" outcome over the life of the next government. Additionally, the pound is now cheap, and another pullback would result in a more than 1-sigma undervaluation relative to long-term fundamentals (Chart 7). Chart 6The BOE's Dilemma The BOE's Dilemma The BOE's Dilemma Chart 7The Pound Enjoys A Valuation Cushion The Pound Enjoys A Valuation Cushion The Pound Enjoys A Valuation Cushion Is there a message for the rest of the world from the U.K. election? Absolutely. It signals that the voters who did not benefit from globalization are singularly focused on economic issues and that distracting them with nationalism will only go so far. This is a message that the Trump administration in the U.S. will either heed over the next three years or ignore and suffer a left-wing backlash in the 2020 election that will unsettle the markets in a fundamental way.7 The bastions of laissez-faire economics - the U.K. and the U.S. - are swinging to the left. We continue to believe that investors are unprepared for the consequences of this reality. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 5 The failure of May's tough rhetoric on terrorism to help her in the polls suggests, along with other evidence, that Europeans are becoming desensitized to terror attacks. Please see BCA Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com.

Highlights 'Super Thursday' June 8 brings three potentially high-impact events for financial markets: a U.K. General Election; a ECB monetary policy meeting; and former FBI Director James Comey's testimony to the U.S. Senate intelligence committee. Each of these events has the potential to move markets - especially currencies - abruptly in either direction. Medium-term investors should use Super Thursday and its aftermath as follows: If the pound sells off, use it to buy pound/dollar. If the euro sells off, use it to buy both euro/pound and euro/dollar. Use any associated underperformance of FTSE100/Eurostoxx50 to buy this relative equity position. Feature Traders will be salivating at the prospect of three potentially high-impact events for financial markets in the space of a day: a U.K. General Election; a ECB monetary policy meeting; and former FBI Director James Comey's testimony to the U.S. Senate intelligence committee about possible collusion between the campaign of President Donald Trump and Russian officials. This report will focus on the first two of these 'Super Thursday' events. Chart of the WeekRelative Interest Expectations Must Follow Relative Economic Performance Relative Interest Expectations Must Follow Relative Economic Performance Relative Interest Expectations Must Follow Relative Economic Performance 300-340 Conservative Seats = Short-Term Pain For The Pound Chart I-2The Pound Is Where It Was When##br## The Election Was Called The Pound Is Where It Was When The Election Was Called The Pound Is Where It Was When The Election Was Called The U.K. General Election result has the potential to move the pound abruptly in either direction. Therefore, it also has the potential to drive FTSE100/Eurostoxx50 relative performance which is just an inverse currency play. But treat the U.K. election result as a trading opportunity rather than as a game changer for any investment position. Theresa May admits that she called the snap election to strengthen her narrow parliamentary majority ahead of Brexit negotiations. When she called the election, the Conservatives were riding high in the polls, and markets expected May easily to achieve her aim. Reasoning that a much strengthened majority would reduce the influence of the hard Brexiters in her party, the pound rallied (Chart I-2). But as the polls have tightened, it has given back this gain. If the number of Conservative seats does not meaningfully move up from the current 330, or worse, if the result increases uncertainty, the pound is vulnerable to a further snap sell-off. A parliamentary majority requires 326 MPs, but around 320 is enough for an effective majority because Sinn Fein MPs,1 the speaker and deputy speakers do not vote. 315 might just scrape a Conservative minority government supported by its Northern Ireland Unionist allies. Hence, if the Conservatives win 300-340 seats, a knee-jerk sell-off in the pound is likely. Chart I-3The Brexit Vote Depressed The Pound Because##br## It Depressed U.K. Interest Rate Expectations The Brexit Vote Depressed The Pound Because It Depressed U.K. Interest Rate Expectations The Brexit Vote Depressed The Pound Because It Depressed U.K. Interest Rate Expectations If the Conservatives win well above 340 seats, the pound should knee-jerk rally - as May's effective majority would strengthen enough to marginalize the hard Brexiters. If the Conservatives win well below 300 seats, the pound might also settle higher - as this is the territory of a Labour minority government supported by the Scottish National Party and Liberal Democrats, and thereby a softer Brexit. But any major moves in the pound after the election will prove to be transient, because the over-arching driver of currencies is the interplay of interest rate expectations. Chart I-3 illustrates that last year's Brexit vote depressed the pound because the shock outcome precipitated a base rate cut and depressed expectations for Bank of England interest rate policy. In contrast to the Brexit vote, the General Election result per se will not have a lasting impact on the pound because it is unlikely to change the interest rate setting calculus for the BoE relative to other central banks. The BoE has been one of the most inert central banks when it comes to changing interest rates in either direction. Last year's emergency rate cut, forced by the shock vote for Brexit, has been the BoE's only policy rate move in 8 years! We expect the BoE to continue with its policy rate inertia because U.K. real consumption is highly correlated (inversely) to inflation. When inflation is too high, real consumption is undermined, making it difficult to hike rates; when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-4). This mirror image performance of inflation and real consumption has tied the hands of the BoE for 8 years, and will continue to do so. Chart I-4Why The Bank Of England's Hands Are Tied Why The Bank Of England's Hands Are Tied Why The Bank Of England's Hands Are Tied With the BoE's hands tied, relative interest rate expectations - and therefore the medium-term direction of the pound - will depend on the other central bank in the respective cross rate. Which brings us neatly to the ECB. The ECB Must Follow The Hard Data Years of extreme and experimental central bank intervention have left markets hyper-sensitive to the slightest change of nuance in central bank communication. We have now come to a ridiculous state of affairs where reducing two instances of the sentence "the balance of risks remain tilted to the downside" in the March 9 ECB press conference introductory statement to just one instance in the April 27 statement is regarded as de facto monetary tightening! The slightest change of nuance in central bank communication can powerfully drive markets over a timeframe of a few weeks or months. As Peter Praet, the ECB Chief Economist, warns: "After a prolonged period of exceptional monetary policy accommodation, financial markets are particularly sensitive to any perceived change in the future course of monetary policy. (Therefore) any substantial change in communication needs to be motivated by some more evidence in the hard data." On this basis, we expect the ECB to acknowledge the hard data showing euro area growth is solid and broad, and downside risks are diminishing; but that the required upward adjustment in inflation remains sluggish. For euro/dollar, a mixed message such as this might create a near-term setback of around 2%, given that it has rallied strongly in the past 65 days and is now technically overbought (see page 8). We would regard a 2% setback for the euro as a medium-term buying opportunity. As Peter Praet points out, central banks' data-dependency means that policy must follow the hard data over a timeframe of six months or longer. The Chart of the Week, Chart I-5 and Chart I-6 should make this crystal clear. Relative interest rate expectations and bond yield spreads ultimately follow relative economic performance. Chart I-5Bond Yield Spreads Must Follow The Hard Data On Economic Growth Differentials... Bond Yield Spreads Must Follow The Hard Data On Economic Growth Differentials... Bond Yield Spreads Must Follow The Hard Data On Economic Growth Differentials... Chart I-6...And Inflation Differentials ...And Inflation Differentials ...And Inflation Differentials If, as we expect, euro area growth2 continues to perform in line with or better than the U.S. and U.K. - and inflation differentials continue to narrow - then relative interest rate expectations will also continue to converge. Even the ECB admits that its main growth worry comes not from the euro area economy itself but rather from "the considerable uncertainty surrounding the new U.S. Administration's policies." In this regard, observe that the post-Trump spike in U.S. interest rate expectations has barely unwound (Chart I-7). We think it should unwind more. And who knows, perhaps James Comey will be the immediate catalyst. Chart I-7The Trump Spike In U.S. Interest Rate Expectations Hasn't Unwound The Trump Spike In U.S. Interest Rate Expectations Hasn't Unwound The Trump Spike In U.S. Interest Rate Expectations Hasn't Unwound What To Do After Super Thursday Chart I-8Pound/Euro (Inversely) Drives ##br##FTSE100/Eurostoxx50 Pound/Euro (Inversely) Drives FTSE100/Eurostoxx50 Pound/Euro (Inversely) Drives FTSE100/Eurostoxx50 In summary, policy rate expectations - in relative terms - will structurally continue to: Get less dovish in the euro area. Remain broadly unchanged in the U.K. Get more dovish in the U.S. Hence, our structural preference for currencies is euro first, pound second, dollar third. Which brings us finally to what medium-term investors should do after Super Thursday. If the pound sells off, use it to buy pound/dollar. If the euro sells off, use it to buy both euro/pound and euro/dollar. And use any associated underperformance of FTSE100/Eurostoxx50 to buy this relative equity position (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Sinn Fein MPs are not eligible to vote because they refuse to pledge allegiance to the Queen. 2 Growth must be adjusted for different demographics. Our preference is to use real GDP per head based on working age (15-64) population. Fractal Trading Model* Euro/dollar is technically overbought, so traders can play a countertrend move. Target a 2% retracement. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Short Euro/Dollar Short Euro/Dollar 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 Merkel is not revolutionizing but reaffirming Germany's Europhile policy; An earlier date for the Italian election would bring market jitters forward from Q1 2018; Yet a new German-style electoral law would decrease the risks of a populist win; The Tories will retain their majority in U.K. elections. Fiscal policy will ease regardless of the outcome; Close long Chinese equities versus Hong Kong/Taiwan; remain overweight Euro Area equities. Feature Possible early elections in Italy and a narrowing lead for Theresa May in the June 8 U.K. election has unsettled investors over the past week. The former threatens to rekindle the flames of the Euro Area conflagration and has weighed on Euro Area equities (Chart 1). The latter threatens Prime Minister May's mandate and political capital, suggesting that the U.K.-EU Brexit negotiations could be acrimonious later this year. This report deals with both issues. Yes, Italy is a major risk to the Euro Area, and despite general awareness of the election, it is not clear to us that investors realize the depth of the risk. As such, Euro Area equities may outperform developed market peers right until the election. As for the U.K. election, we think its impact on global risk assets is non-existent and its impact on U.K. assets is likely to be fleeting. The bigger threat to global markets remains China. In a March report, we suggested that Chinese policymakers may be testing the waters for broad-based financial and industrial sector reform akin to their late 1990s efforts.1 These reforms could be deflationary in cyclical terms and thus a risk for global growth. We argued that the timeline for these efforts would have to wait for the conclusion of the nineteenth National Party Congress this fall and thus Beijing's policy represented a potential problem for 2018.2 Chart 1Italy Weighs On European Risk Assets Italy Weighs On European Risk Assets Italy Weighs On European Risk Assets Chart 2China: Monetary Tightening Takes A Toll China: Monetary Tightening Takes A Toll China: Monetary Tightening Takes A Toll Then again, President Xi Jinping may flout the rule of thumb in Chinese politics that aggressive policy actions should wait until after the five-year party congresses. Monetary tightening - which could be the first salvo of broader financial-sector reform - has already had negative effects on the real economy (Chart 2). The economic surprise index has corrected, as have China's PMI and LEI. Further Chinese tightening would invariably hurt Chinese demand for imports (Chart 3), which would have negative knock-on effects for EM economies, whose growth momentum appears to have already rolled over (Chart 4). Investors should carefully monitor China over the summer. Any signaling from policymakers that they are willing to move away from the "Socialist Put" and towards genuine deleveraging (not to mention their promised free-market reforms) would have negative global implications. Our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, has pointed out that Europe's economic outperformance relative to the U.S. is highly leveraged to Chinese liquidity (Chart 5).3 As such, decisions made by policymakers in Beijing will likely be more important for European asset performance than who sits in Rome's Palazzo Chigi. Chart 3Tighter Credit Impulse##br## Will Drag Down Imports Tighter Credit Impulse Will Drag Down Imports Tighter Credit Impulse Will Drag Down Imports Chart 4A Chinese Import ##br##Drag Will Hurt EM A Chinese Import Drag Will Hurt EM A Chinese Import Drag Will Hurt EM Chart 5Euro/U.S. Growth Differentials ##br##And Chinese Liquidity Euro/U.S. Growth Differentials And Chinese Liquidity Euro/U.S. Growth Differentials And Chinese Liquidity We are closing our long Chinese equities / short Taiwanese and Hong Kong equities trade for a gain of 3.45%. While policymakers are already backpedaling a bit, financial tightening inherently raises risks in an excessively leveraged economy. Europe Über Alles? Many clients are asking about German Chancellor Angela Merkel's recent comments on European unity. On the heels of the G7 summit, during which Merkel locked horns with U.S. President Donald Trump, Merkel delivered the most Europhile speech of her career: The era in which we could fully rely on others is over ... That's what I experienced over the past several days ... We Europeans truly have to take our fate into our own hands ... But we have to know that we Europeans must fight for our own future and destiny. To many in the media and financial industry the speech seemed like a massive departure from Merkel's cautious and reticent approach to European policymaking. We could not disagree more. European integration imperatives are intrinsically geopolitical, as we have argued since 2011.4 Members of the Euro Area are integrating not because of liberal idealism or misguided dogmatism on monetary union. Rather, they are engaged in a cold, calculated, and deeply realist political project to remain relevant in the twenty-first century. This net assessment has guided our analysis of various Euro Area crises. We supported our top-down theoretical view with bottom-up data showing that European voters were not revolting against integration. Integration may be elite-driven, but it has broad popular support. Support for the common currency has never dipped below 50% (Chart 6), despite a once-in-a-generation economic crisis, and most European states are pessimistic about their separate futures outside the EU (Chart 7). Chart 6Voters Approve Of The Euro Voters Approve Of The Euro Voters Approve Of The Euro Chart 7EU Exits: Not On Horizon EU Exits: Not On Horizon EU Exits: Not On Horizon German policymakers have operated within these geopolitical confines since the Euro Area sovereign debt crisis began in the waning days of 2009. At every turn of the crisis, whenever one or another German policymaker issued a "red line" regarding what "Berlin cannot accept," the correct view was to bet against that policymaker, i.e. against any Euroskeptic outcome. Since 2010, we have seen: Numerous direct bailouts of member states; A dove appointed to lead the ECB, with Berlin's blessing; Direct ECB purchases of government bonds; Deeper fiscal and banking integration of the Euro Area, albeit at a slow pace; Expansion - not contraction - of Euro Area membership; The reversal of fiscal austerity. We were able to forecast these turns because our constraint-based methodology gave us a high-conviction view that German policymakers would ultimately be forced down the integrationist, Europhile road. The German population did not revolt against these constraints. Germans are not Euroskeptic. We have no idea why many investors think they are: there is no evidence of it in data or history. German history is replete with failed efforts to unify (and lead) the European continent by hook or by crook. The country is cursed with just enough economic prowess to be threatening to its peers and yet not enough to dominate them by force. As such, it is a German national security imperative to ensure that it does not see the rest of Europe coalesce into an economic or military alliance against it. The EU and its institutions, which allow Germany to be prosperous without the threat of an enemy coalition, are therefore worth preserving, even at a steep cost. True, the costs of bailing out Greece, Ireland, Portugal, and Spain tested German enthusiasm for European integration. However, German support for the common currency never dipped below 60% amidst the sovereign debt crisis and has since rebounded to a record high of 81% (Chart 8). Only 20% of Germans are confident of a future outside the EU (Chart 9). Chart 8Rise Of The Europhile Germany Rise Of The Europhile Germany Rise Of The Europhile Germany Chart 9Germany: No Life After EU Death Germany: No Life After EU Death Germany: No Life After EU Death As such, Merkel's statement following the G7 summit is only surprising because it is explicit. Indeed, the reason Merkel made this statement now is not because she suddenly had a grand geopolitical realization, nor because Trump suddenly disabused her of a naïve belief in the benevolence of the United States. Merkel has understood Europe's imperatives for at least a decade. The real reason for her statement is domestic politics. Martin Schulz, Merkel's opponent in general elections to be held on September 24, has tapped into the rising Europhile sentiment among Germans. The Social Democratic Party (SPD) sprang back to life this year following Schulz's appointment as SPD chancellor-candidate. Despite a recent relapse for the SPD in the polls, Merkel wants to ensure that she is not vulnerable on her left flank to the more Europhile Social Democrats. In the face of this renewed threat from the SPD, the venue of Merkel's speech was highly symbolic: a summit of the Christian Social Union (CSU), the Bavarian sister party to Merkel's Christian Democratic Union (CDU), held in a beer hall no less! Bavaria is the most conservative and Euroskeptic part of Germany. Over the past two years, the CSU has flirted with abandoning its post-war electoral alliance with the CDU due to Berlin's various Europhile turns. This development threatened to undermine Merkel and her base of power from within. Merkel's speech, to the most Euroskeptic part of Germany, was designed to prepare her conservative base for a further deepening of European integration. It was not a policy shift but rather a statement that brought her rhetoric more in line with her policy actions. It was also a reminder to her core allies that they must continue on the current policy path unless they would rather have Schulz's SPD force them into even deeper European integration, and faster. What does this mean going forward? We think that the dirty word of European politics - "Eurobonds" - will come into play again. As if on cue, the European Commission has published a report that proposes bundling the debt of Euro Area sovereigns.5 The proposal is not exactly calling for Eurobonds, but rather for securitizing existing bonds into new instruments. As usual, a German finance ministry spokesperson opposed the plan. However, the path of least resistance will be towards more integration that may include such securitization. In fact, Eurobonds already exist. Europe's fiscal backstop mechanisms - formerly the European Financial Stability Facility (EFSF) and now the European Stability Mechanism (ESM) - have both issued bonds to finance sovereign bailout efforts. So has the European Investment Bank (EIB). Their bonds trade largely in line with French sovereign debt, with a 37 basis point premium over German 10-year Bunds (Chart 10). Chart 10 Most importantly, the European Commission - the executive arm of the EU - already has authority to issue bonds and even tap member states for funds in case it needs to fill a gap. As the European Commission cites in its pitch-book to bond investors (yes, you read that correctly), "should the funds available from the EU budget be insufficient, the Commission may directly draw on the Member States, without any extra decision making being required."6 Currently, EU treaties forbid bond issuance that would directly finance the budget of a member state. However, Article 143 lays down the possibility of granting mutual assistance to an EU country facing a balance-of-payments crisis, which the EU Commission handles via its €50 billion balance-of-payments assistance program. In the future, the Commission could issue bonds to finance joint, EU-wide projects for areas like defense or infrastructure. It does not appear that such a decision would require a change to EU treaties. Over the long term, the integration imperative will remain strong in Europe. Ironically, Donald Trump is probably the best thing that has happened to European unity, at least since President Vladimir Putin. However, we think media commentators may be overstating President Trump's impact. The U.S. was already growing aloof toward Europe under President Obama, who overtly tilted his foreign policy towards Asia, and President Bush, whose administration clashed with "old Europe" and merely flirted with "new Europe." With the prospect of the U.S. withdrawing its security blanket, Europeans are being forced to integrate. Otherwise they would have to deal with the full range of global crises - from debt to terrorism to migration to war - as separate, and weak, individual states. And the U.S. is unlikely to return to its post-World War II level of concern regarding European affairs anytime soon. We doubt that even a recession would greatly impede the integrationist impulse on the continent. The Great Financial Crisis was a once-in-a-generation economic crisis and yet it has deepened, not decreased, support for integration. That said, risks remain. While the median voter in Europe appears to support the elite-driven integrationist effort, the median voter in Italy is on the fence. Bottom Line: Merkel's Europhile speech in Bavaria was meant to reinforce the ongoing integrationist path to her domestic audience in an election year. We suspect that Germany under Merkel, along with France under recently elected President Emmanuel Macron, will continue down the same path. At some point in the not-so-distant future, this may include the issuance of Eurobonds for specific projects. Our long-held geopolitical view supports overweighting Euro Area risk assets, given economic momentum and valuations. However, near-term political risks in Italy are substantial and pose the main risk to our strategic view. Italy's Divine Comedy - Coming Soon To A Theater Near You? Early Italian elections - in September 2017, instead of February-May 2018 - have become a real possibility. Matteo Renzi, leader of the ruling Democratic Party (PD) and former prime minister, recently signaled that he would be willing to compromise on a new electoral law, and that it could pass as early as July, given a tentative agreement with the Forza Italia party of former prime minister Silvio Berlusconi. This would satisfy the condition of President Sergio Mattarella that a new electoral law be passed before elections can proceed. What does this development mean for markets? Italian political elites share the same integrationist goals of their European peers. There is no logic in Italian independence from the EU. Rome's ability to patrol its coastline for smugglers bringing in migrants would not improve with independence, nor would its ability to negotiate a low price for Russian natural gas. Italy is, as much as any European country, in terminal decline as a geopolitical power. Membership in the EU is therefore a natural, and realist, response to its weakness. In addition, exiting the monetary union would be fraught with risks that would overwhelm any benefits that Italian exports may gain from devaluation. It is highly unlikely that Germany, France, Spain, and the Netherlands would allow Italy - the Euro Area's third largest economy - to set a precedent of using massive currency devaluation while maintaining access to the Common Market. Rome would in fact break its Maastricht Treaty obligations. These stipulate that every member state, save for Denmark and the U.K., must become a member of the EMU. It would likely be evicted from both the EU and the Common Market. Furthermore, as we discussed in our September net assessment of Italy, the country's 19th nineteenth century unification has never made much sense.7 We would go so far as to argue that Euro Area amalgamation makes more sense than the unification of Italy. Northern Italy remains as much part of "core Europe" as London, the Rhineland, or the Netherlands, whereas the south - the Mezzogiorno - might as well be in the Balkans. We do not see how Rome would afford the Mezzogiorno on its own without access to both the EU's markets and ECB-induced low financing costs. All that said, the median Italian voter is not buying the Euro Area at the moment. 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 50% (Chart 11). Similarly, a plurality of Italians appears to be confident in the country's future outside the EU (Chart 12). Chart 11Italy A Clear Outlier On The Euro Italy A Clear Outlier On The Euro Italy A Clear Outlier On The Euro Chart 12Italians Willing To Go Solo? Italians Willing To Go Solo? Italians Willing To Go Solo? Of course, only about a third of Italians identify themselves as only "Italians," largely in line with the Euro Area average and nowhere near the trend in Britain, where the share of the public that feels exclusively British has generally ranged from half to two-thirds (Chart 13). Nevertheless, the Euroskeptic trend in Italy is real and jeopardizes European integration. Our high-conviction view that European politics would be a "red herring" in 2017 was originally based on data that showed that voters in the Netherlands, France, and Germany increasingly supported European integration. This allowed us to dismiss polls that suggested that Euroskeptic politicians - such as Geert Wilders or Marine Le Pen - would do well in this year's elections. Even if they did perform well, the median voter's stance on European integration would force such policymakers to modify their Euroskepticism. This process has already happened in Spain (Podemos), Finland (The Finns, formerly known as the True Finns), and Greece (SYRIZA). In Italy, however, the median voter's Euroskepticism has not abated. As such, parties such as the Five Star Movement (M5S) and Lega Norde (LN) have no political incentive to modify their Euroskepticism. In fact, LN has done the opposite, evolving from a liberal and pro-EU regional sovereignty movement into a far-right, anti-immigrant, Euroskeptic, and nationalist Italian party -- a full brand overhaul. The timing of the upcoming election is difficult to forecast. Nonetheless, Renzi's compromise on changing electoral rules has now increased the probability that the election be held in Q4 2017, instead of Q1 2018. Renzi reportedly favors the same date as the German election, September 24. To accomplish this timetable, the new electoral law would have to be rushed through Italy's bicameral Parliament. The Chamber of Deputies - the lower house - is expected to vote on the compromise law in the first week of June, with the Senate passing the law by July 7. Given that the top four parties all seem to agree with adopting a German-style electoral system - proportional representation, with parties required to gain at least 5% of the vote to gain any seats - this ambitious timeline is possible. However, there are still some minor outstanding issues, which could drag out the process until the fall. In addition, local elections scheduled for June 11 (with a second-round run-off on June 25) could change the calculus of the ruling PD. If Renzi's party underperforms, he may back away from early elections, although the message would be that a strong populist performance in early 2018 is more likely. Polls have not budged much for the past 18 months, although Renzi's PD lost support around the time of its failed December 2016 constitutional referendum (Chart 14). The market may find solace in the fact that the revised electoral law would grant no "majority-bonus" to the winner, virtually ensuring that the Euroskeptic M5S cannot govern on its own. Chart 13Majority Of Italians Are Also Europeans Majority Of Italians Are Also Europeans Majority Of Italians Are Also Europeans Chart 14Ruling Party And Populist M5S Neck-In-Neck Ruling Party And Populist M5S Neck-In-Neck Ruling Party And Populist M5S Neck-In-Neck The risk to the market, however, is that M5S outperforms and then creates a limited coalition with right-wing Euroskeptics. Such a coalition could have the singular goal of calling a "non-binding, consultative" referendum on Italy's Euro Area membership. The official M5S line is that it would call such a referendum "if fiscal policies of the Euro Area did not change." Either way, the Italian constitution forbids referendums on international treaties, but a consultative referendum would give impetus to Euroskeptic parties to start negotiating a Euro Area exit for the country. There are two reasons why such an outcome is possible, if not our base scenario. First, a German-style 5% threshold will eliminate the votes cast for a number of minor parties from the overall calculation. These currently combine to make up about 18% of the total vote. This means that the parties that meet the 5% minimum will gain a larger share of seats in the parliament than they gained of the overall popular vote (82% of the vote will hold 100% of the seats), as is the case in Germany. There is a chance that both the PD and M5S get a considerable seat boost in the final tally that puts them close an overall majority. Second, much will hinge on whether the right wing - and Euroskeptic - Fratelli d'Italia (FdI) enter parliament. They are currently polling at about 5% of the vote. If they gain seats, it would significantly increase the percentage of total seats held by Euroskeptic parties. There is no evidence at the moment that M5S, which is on the left of the policy spectrum, would contemplate such an electoral alliance with LN and FdI. The party remains opposed to any coalitions and we suspect that it would not break its pledge to pursue the highly risky strategy of calling a referendum on the Euro Area. The M5S stands for a lot of different things: anti-corruption, anti-establishment, youth empowerment, etc. Euroskepticism is one of its pillars, not a singular objective. In fact, party leader Beppe Grillo recently attempted to abandon the Euroskeptic alliance with UKIP at the European Parliament to join the ultra-liberal, and Europhile, Alliance of Liberals and Democrats for Europe. Various factions vying for control of the movement oscillate between overt Euroskepticism, aloofness toward Europe, and open support for European integration. In addition, Italian voters may adjust ahead of the election by switching their support away from the various minor parties currently polling below 5% and toward the four major parties. This will likely benefit the ruling PD more than any other party. Out of the four parties highly unlikely to cross the 5% threshold - Campo Progressista (CP), Movimento Democratica e Progressista (MDP), Alternativa Popolare (MP), and Sinistra Italiana (SI) - three are centrist or aligned with the PD. One (Sinistra Italiana) would likely see its voters split between the PD and M5S (Chart 15). Such vote migration would clearly benefit the center-left PD, which Renzi is likely counting on in accepting the German-style proportional electoral system.8 Chart 15Most Minor Party Votes ##br##Would Help Ruling Democrats Most Minor Party Votes Would Help Ruling Democrats Most Minor Party Votes Would Help Ruling Democrats Bottom Line: Investors trying to make sense of the Italian election will find relief in the new electoral law. A purely German-style system - given the current level of factionalism in Italian politics - is unlikely to produce a populist government in Italy. In fact, the center-left PD could see a boost in support as voters switch away from minor parties. The tentative compromise on the electoral law has both increased risks by making an earlier election more likely and decreased risks by reducing the probability of an anti-market result. That said, there is still a possibility that M5S crosses the ideological aisle to form an alliance with right-wing Euroskeptics to try to take Italy out of the Euro Area. We doubt that they will do so. Nonetheless, it will be appropriate to hedge such a risk in currency markets closer to the date of the election, once the date is known. We therefore closed our long EUR/USD recommendation last week for a gain of 3.48%. Whatever the outcome of the election, Italian political risks will remain the main threat to European integration (and assets) going forward. We therefore expect the ECB to keep one eye on Italy, forcing it to be less hawkish than it otherwise would be. We will explore Italian politics and economy further in an upcoming report with our colleagues at BCA's Foreign Exchange Strategy. U.K.: The Election Is About G The latest polling averages show that Prime Minister Theresa May's Conservative Party maintains a 5% lead over Jeremy Corbyn's Labour Party, despite Labour's remarkable rally since early elections were called on April 18 (Chart 16). One projection of actual parliamentary seats that takes into account the crucial factor of voter turnout suggest that the Tories could add from 15 to 34 seats to their 2015 take of 330 seats - and this roughly matches our back-of-the-envelope calculation that the Tories could pick up 11 seats on account of the Brexit referendum (Table 1).9 Chart 16Labour Revives On Snap Election Labour Revives On Snap Election Labour Revives On Snap Election Table 1Referendum Results Offer Some Simple Gains For Tories Has Europe Switched From Reward To Risk? Has Europe Switched From Reward To Risk? There have been only two other cases in recent memory in which Britain's incumbent party led by double digits two months ahead of an election: 1983 and 2001. In the first case, Margaret Thatcher followed up the hugely successful Falklands campaign by expanding her popular support in the final two weeks to win a huge 144-seat majority. In the second case, Tony Blair lost some of his lead but still won the election handily.10 There has not been a case in recent memory where a double-digit lead dropped into single digits as quickly as it did this past month. Moreover, looking at the latest individual polls, it is too soon to say that Labour's rally has ended. Indeed, YouGov's model even shows the Conservatives losing their majority.11 Snap elections are always a gamble, as we have stressed throughout this campaign.12 There is no question that Labour has the momentum and May is feeling the heat. Yet the Tories have a fairly solid foundation of support at the moment. First, they are still polling above 40% support, almost 10% higher than before the referendum, reflecting the rally-around-the-flag effect after voters' surprising decision to leave the EU. They even poll above 40% among working-class voters, the original base of Labour, and the country's aging demographic profile also heavily favors them. (Youth turnout would have to surprise upward to upset the Tories.) Second, the Tory strategy of gobbling up supporters of the U.K. Independence Party (UKIP) has succeeded (Chart 17). UKIP has no raison d'être after achieving its foundational goal of Brexit. The Conservative Party's decision to hold a referendum on the EU was, in fact, driven by this rivalry from the right flank. UKIP posed the chief threat to the Tories through its ability to dilute their vote share in Britain's first-past-the-post electoral system. Now, almost all conservative voters will vote for the Conservative Party, while Labour must still compete with the Liberal Democrats, Greens, Scottish National Party, and Welsh Plaid Cymru in various constituencies (Chart 18). Chart 17Tories Keep Devouring UKIP Tories Keep Devouring UKIP Tories Keep Devouring UKIP Chart 18Labour Has Rivals, Tories Do Not Labour Has Rivals, Tories Do Not Labour Has Rivals, Tories Do Not Third, while May's popularity is merely converging with her party's still-buoyant level, Corbyn is less popular than both May and his own party (Chart 19). Corbyn still has a net negative favorability and is seen as less "decisive" and less "in touch" with voters than May. Fourth, voters still see Brexit as the most important issue of the election (Chart 20) and May as the best candidate to manage the tricky exit negotiations ahead. Because Brexit is the driver, the benefit of the doubt goes to the Tories. The 2015 elections, the EU referendum, the polls since the referendum, and the parliamentary votes (driven by popular pressure) enshrining the referendum result all suggest a great deal of public momentum on this key issue. The only truly historic development that could have broken this momentum, given that the economy is holding up, is the Tory decision to seek a "hard Brexit," i.e. exit from the EU's Common Market. Yet opinion polls show that Brexit still has the support of a majority of likely voters; moreover, 55% of voters would rather have "no exit deal" than "a bad exit deal."13 If voters still see this as the defining issue, then the Tories still have a key advantage. On the other hand, perceptions of Jeremy Corbyn and Labour have improved rapidly and May's simultaneous popularity slump is especially important in this election. She is a "takeover prime minister" (having initially gained the office when Cameron resigned rather than leading her party into an election as the presumed prime minister) and thus highly vulnerable. This election is largely about her need for a "personal mandate."14 Her political missteps (both real and perceived) are very much at issue in this particular election. Chart 19May Lifts Tories, Corbyn Drags Labour May Lifts Tories, Corbyn Drags Labour May Lifts Tories, Corbyn Drags Labour Chart 20 If polls continue to narrow, the election could produce a "hung parliament," in which no single party holds the 326 seats necessary for a majority in the House of Commons. What should investors expect in that scenario? First, May would have the chance to rule a minority government or form a coalition. A minority government would be weak, vulnerable to collapse under pressure, and would have a harder time controlling the Brexit negotiations. As for a coalition, there is very little chance that the other major parties would cooperate with her - the Liberal Democrats would not reprise their role as coalition partner from 2010-15. But there is a slim chance that the Democratic Unionist Party (DUP) of Northern Ireland could unite with the Tories to obtain a majority. The DUP has not exercised real power in a century, literally, and several of its members do not normally even take their seats in Westminster. However, the party is Euroskeptic and could provide just enough support to accomplish the single goal of a Tory-led Brexit. Suffice it to say that this outcome is not impossible - the Tories have been courting the DUP for months and the existence of a historic "common cause" changes the usual parliamentary dynamic. Still, this arrangement would be highly unusual, causing a massive uproar, and would lead to all kinds of uncertainties about parliament's ability to pass a final Brexit deal in 2019. Second, assuming May fails, the Labour Party would have to rule in the minority or form a coalition (if informal) with the Scottish National Party, LibDems, Plaid Cymru, Greens, and others. Here are the most likely outcomes of such an arrangement, in broad brush strokes: Brexit will in all likelihood proceed, given that all parties have professed respect for the referendum outcome. Since the new government would likely not seek to curtail immigration as strictly, it could seek to retain membership in the Common Market. However, a la carte membership in the Common Market remains the greatest difficulty with the EU member states, and therefore it is possible that even Labour would have to accept the logic of exiting the Common Market. In fact, we could see Labour's insistence on access to the Common Market producing more acrimony with the EU than the Tory clean-break strategy. Nevertheless, the odds of a "Brexit cliff" in which the U.K. exits without a trade deal would fall from their already low level, given Labour's unwillingness to let that happen. Despite moving ahead with Brexit, a Labour-led government would increase the relatively low probability of an eventual reversal of the decision, given that it would be more inclined to accept or encourage such an outcome in the face of a bad exit deal, a recession, or other challenges that cause public opinion to shift. The Scottish National Party would probably sideline its demands for a second Scottish independence referendum - especially given that polls supporting a second referendum have floundered for the time being - though not permanently.15 Fiscal spending would increase as a result of Labour's and the SNP's campaign promises and greater focus on domestic social issues. Even if May avoids squandering her party's majority (our baseline case), there are several important takeaways from her drop in the polls: Chart 21Dementia Tax' Gaffe Added To Tory Woes Dementia Tax' Gaffe Added To Tory Woes Dementia Tax' Gaffe Added To Tory Woes The median voter wants government support: The Labour Party's rally began as soon as elections were called, with left-leaning voters switching away from the LibDems once they saw a chance to challenge the ruling party. But the Tories took a hit from May's unprecedented (and publicly awkward) reversal on a party manifesto pledge only days after publishing it (Chart 21). The pledge, now infamous as the "dementia tax," was an attempt at fiscal tightening by which the government would include the value of an elderly person's home in the assessment of their financial means when it came to government support for social care. By contrast, Labour has rallied on the back of a party manifesto that promises fiscal expansion in various categories, including £7.7 billion additional funds for health care, social care, and nursing. More broadly, National Health Service funding, rent caps, and a higher "living wage" are the top four campaign pledges that gain above 60% popular support. As we elucidated last year, the two economies that most enthusiastically embraced a laissez-faire model - the U.S. and the U.K. - are now experiencing the most effective swing to the left.16 The U.K. campaign confirms that, with the Tories minimizing cuts and Labour offering greater spending. Brexit means Brexit: 69% of the public claims that government should follow the referendum outcome, and 52% favor Theresa May's proposed Brexit strategy. The opposition parties are not openly opposing the referendum outcome, as mentioned. Moreover, Labour's pledge to prevent the U.K. leaving the bloc without a trade deal is one of the least popular campaign pledges (only 31% approve), while the Liberal Democrats' pledge to hold a second nationwide referendum on the outcome of the exit talks is also unpopular (34% approve) (Chart 22). Labour is recovering support by focusing on its bread-and-butter, left-wing, social platform. Terrorism is not driving voters: The tragic terrorist attacks at parliament, Manchester, and London Bridge have hardly given May and the Tories any additional support despite being the party viewed as stronger on security. Amid a bull market in terrorism, British voters, like European peers, are becoming somewhat inured to periodic attacks against "soft" targets.17 Health is a bigger concern than immigration: A large majority of Britons think immigration has been too high in recent years, but only about 25% think it is a major issue facing the country, compared with 43% who cite health care as a major issue (see Chart 20 above). These are not completely independent issues because many people believe that immigrants are putting pressure on scarce health care resources. Immigration is closely tied to Brexit and will remain a burning issue if the government does not convince voters that it is more vigilant. But the Labour Party's greater support on health care (as well as education and other social issues) is a growing liability to the Tories as Brexit becomes more settled. If Brexit was a revolt against the elites, it is not necessarily the only manifestation of that revolt. The elitist Tories should be careful that they do not rest on their laurels having been on the right side of that particular issue. The key takeaway is that, aside from Brexit, fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then.18 Chart 22 That is also why the ruling party has already eased fiscal policy. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline to beyond 2022 (Chart 23). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 24). Chart 23 Chart 24 The Tories are also claiming that they will reboot the country's industrial strategy to improve productivity, which will become all the more imperative if they even partially follow through on their pledge to cut immigration numbers from the current annual ~250,000 to under 100,000, which will necessarily reduce labor force growth and thus also potential GDP growth.19 The National Productivity Investment Fund will need a projected £23 billion just to get on its feet. Given that Labour is proposing even more ambitious spending increases (£49 billion additional spending through 2022), the direction of U.K. politics - away from austerity - is clear regardless of the election outcome. Finally, our colleagues at BCA's Global Fixed Income Strategy expect the Bank of England to maintain loose monetary policy for the foreseeable future, being unable to turn more hawkish against inflation in the context of continued risks and uncertainties related to Brexit.20 Thus monetary and fiscal conditions are both accommodative for the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports,21 the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, could weigh on the pound regardless of the election outcome. As such, we closed our short USD/GBP last week for a gain of 3.34%. Bottom Line: We do not expect a hung parliament; most signs suggest that the Tories will retain at least a weak majority. However, a hung parliament that produces a Labour-SNP alliance would not likely reverse Brexit (though it would make a reversal more conceivable). Such an alliance could eventually result in an exit deal that is both less politically logical than the Tory deal (because London would pay to stay in the Common Market yet have less say in how it is managed) and more favorable to the British economy in the long run (because retaining the benefits of Common Market access). But this is not a foregone conclusion. We maintain our view that Brexit itself has largely ceased to have concrete market-relevant impacts other than a decline in Britain's long-term potential GDP growth. There are two reasons for this. First, May has ruled out membership in the Common Market and thus has removed a potential source of acrimony with Brussels over any "special treatment." Second, the EU does not want to precipitate a crisis in the U.K. that could reverberate back onto the continental economy. Investment Implications We remain strategically overweight European equities relative to their U.S. peers, a trade that has returned 7.39% thus far. We would remind clients that we closed our long GBP/USD and long EUR/USD tactical trades last week for 3.34% and 3.48% gains, respectively. We are also booking a 3.45% profit on our "One China Policy" strategic trade (long Chinese equities as against their Taiwanese and Hong Kong peers). We still think policymakers will do everything they can to keep China's economic growth stable ahead of the party congress this fall, but, as we discussed in our May 24 missive,22 the decision to tighten financial regulation is risky and threatens to cause unintended consequences. 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, “China Down, India Up?” dated March 15, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, “Political Risks Are Understated In 2018,” dated April 12, 2017, available at gps.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, “ECB: All About China?” dated April 7, 2017, available at fes.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, “Europe’s Geopolitical Gambit: Relevance Through Integration,” dated November 3, 2011; and “Europe: The Euro And (Geo)politics,” dated February 11, 2015, available at gps.bcaresearch.com. 5 Please see European Commission, “Reflection paper on the deepening of the economic and monetary union,” May 31, 2017, available at ec.europa.eu. 6 Please see European Commission, “EU Investor Presentation,” April 7, 2017, available at ec.europa.eu. 7 Please see BCA Geopolitical Strategy Special Report, “Europe’s Divine Comedy: Italian Inferno,” dated September 14, 2016, available at gps.bcaresearch.com. 8 The only minor party that is Euroskeptic, FdI, is just close enough to the 5% threshold that its voters are unlikely to abandon it. They will not likely give the Euroskeptic Lega Norde and M5S much of a boost. 9 Please see Lord Ashcroft Polls, “2017 Seat Estimates: Overall,” May 2017, available at lordashcroftpolls.com. 10 In the 1997 election, Tony Blair and Labour led by double digits, but they were in the opposition. Their lead in the polls shrank slightly before Blair won a 178-seat majority, even larger than Thatcher’s 144 seats in 1983 and Clement Attlee’s 147 seats in 1945. 11 Please see YouGov, “2017 UK General Election Model,” accessed June 6, 2017, available at yougov.co.uk. 12 Please see BCA Geopolitical Strategy Weekly Report, “Buy In May And Enjoy Your Day!” dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see Anthony Wells, “Attitudes to Brexit: Everything We Know So Far,” March 29, 2017, available at yougov.co.uk. 14 Please see footnote 12 above. 15 Please see The Bank Credit Analyst and Geopolitical Strategy Special Report, “Will Scotland Scotch Brexit?” dated March 30, 2017, available at bca.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, “The End Of The Anglo-Saxon Economy?” dated April 13, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, “Brexit Update: Does Brexit Really Mean Brexit?” dated July 15, 2016, and “Brexit Update: Red Dawn Over Britain” in Geopolitical Strategy Monthly Report, “King Dollar: The Agent Of Righteous Redistribution,” dated October 12, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, “With Or Without You: The U.K. And The EU,” dated March 17, 2016, available at gps.bcaresearch.com. 20 Please see BCA Global Fixed Income Strategy Weekly Report, “Adventures In Fence-Sitting,” dated May 16, 2017, available at gfis.bcaresearch.com. 21 Please see “Brexit: A Brave New World” in BCA Geopolitical Strategy Weekly Report, “The ‘What Can You Do For Me’ World?” dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, “Northeast Asia: Moonshine, Militarism, And Markets,” dated May 24, 2017, available at gps.bcaresearch.com.

Highlights Markets have gone too far in pricing out the Republican's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections. A bill that at least cuts taxes should be forming by year end. The risk is that continued political turbulence, now including the possibility of impeachment, distracts Congress and delays or completely derails tax reform plans. Fortunately for the major global equity markets, corporate profits are providing solid support. We expect U.S. EPS growth to accelerate further into year end, peaking at just under 20%. The projected profit acceleration is even more impressive in the Eurozone and Japan. Corporations are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end that will favor the latter two bourses in local currency terms. EPS growth will fall short of bottom-up estimates for 2017, but what is more important for equity indexes is the direction of 12-month forward EPS expectations, which remain in an uptrend. The positive earnings backdrop means that stocks will outperform bonds for the remainder of the year even if Congress fails to pass any market-friendly legislation. The FOMC is "looking through" the recent soft economic data and slower inflation, and remains on track to deliver two more rate hikes this year. The impact of the Fed's balance sheet runoff on the Treasury market will be limited by several factors, but a shrinking balance sheet and Fed rate hikes will force bond yields to rise faster than is currently discounted. Policy divergence will push the dollar higher. The traditional relationship between the euro/USD and short-term yield differentials should re-establish following the French election. The euro could reach parity before the next move is done. "Dr. Copper" is not signaling that global growth will soften significantly this year. Chinese growth has slowed but the authorities are easing policy, which will stabilize growth and support base metals. That said, we remain more upbeat on oil prices than base metals. Feature Investors have soured on the prospects for U.S. tax reform in recent weeks, but the latest travails in Washington inflicted only fleeting damage on U.S. and global bourses. The S&P 500 appears to have broken above the 2400 technical barrier as we go to press. Market expectations for a more tepid Fed rate hike cycle, lower Treasury yields and related dollar softness undoubtedly provided some support. But, more importantly, corporate profits are positively surprising in the major economies and this is not just an energy story. The good news on company earnings should continue to drive stock prices higher this year in absolute terms and relative to bond prices. It is a tougher call on the dollar and the direction of bond yields. We remain short duration and long the dollar, but much depends on the evolution of U.S. core inflation and fiscal policy. A Death Knell For U.S. Tax Reform? Chart I-1 highlights that the market now sees almost a zero chance that the Republicans will ever be able to deliver any meaningful tax cuts or infrastructure spending. Many believe that mushrooming political scandals encumbering President Trump will distract the GOP and delay or derail tax reform. Indeed, impeachment proceedings would be a major distraction, although this outcome would not necessarily lead to an equity bear market. The historical record shows that the economy is much more important than politics for financial markets. BCA's geopolitical strategists looked at three presidential impeachments, covering the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974) and the President Clinton's Lewinsky Affair (January 1998 to February 1999).1 Watergate was the only episode that coincided with a bear market, but it is difficult to pin the market downturn on Nixon's impeachment since the U.S. economy entered one of the worst post-war recessions in 1973 that was driven by tight Fed policy and an oil shock. Impeachment would require that Trump loses support among the Republican base, which so far has not happened. The President still commands the support of 84% of Republican voters (Chart I-2). Investors should monitor this support level as an indicator of the President's political capital and the risk of impeachment. Chart I-1Fading Hopes For Tax Reform Fading Hopes For Tax Reform Fading Hopes For Tax Reform Chart I-2 We believe that markets have gone too far in pricing out Trump's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans see eye to eye. The odds are good that an agreement to cut taxes will be formed by year end. Congressional leaders want tax reform to be revenue neutral, but finding sufficient areas to cut spending will be extremely difficult. They may simply require that tax cuts are paid for in a 10-year window. This makes it possible to lower taxes upfront and promise non-specific spending cuts and revenue raising measures down the road. Or, Congress may pass tax reform that is not revenue neutral through the reconciliation process, which would require that tax cuts sunset at some point in the future. Tax cuts would give stocks a temporary boost either way but, as we discuss below, it may be better for corporate profits in the medium term if Congress fails to deliver any fiscal stimulus. Profits, Beats And Misses While economists fret over the soft U.S. economic data so far this year, profit growth is quietly accelerating in the background (Chart I-3). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at about 18%, before moderating in 2018. Profit growth is accelerating outside of the energy sector. The projected acceleration in EPS growth is equally impressive in the Eurozone and Japan. The favorable profit picture in the major economies reflects two key factors. First, profits are rebounding from a poor showing in 2015/16, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart I-4). Our short-term forecasting models for real GDP, based on a mixture of hard data and surveys, continue to flag a pickup in economic growth in the major economies (Chart I-5). Chart I-3Top-Down Profit Projection Top-Down Profit Projection Top-Down Profit Projection Chart I-4EPS Highly Correlated With Industrial Production EPS Highly Correlated With Industrial Production EPS Highly Correlated With Industrial Production Chart I-5GDP Growth Poised To Accelerate GDP Growth Poised To Accelerate GDP Growth Poised To Accelerate The U.S. model's forecast paints an overly rosy picture, but it does support our view that Q1 softness in the hard data reflected temporary factors that will give way to a robust rebound in the second and third quarters. The Eurozone economy is really humming at the moment, as highlighted by our model and recent readings from the IFO and purchasing managers' surveys. Indeed, these indicators are consistent with real GDP growth of nearly 3%! Our GDP models are also constructive for Japan and the U.K., although not nearly as robust as in the U.S. and Eurozone. Chart I-6Profit Margins On The Rise Profit Margins On The Rise Profit Margins On The Rise Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row (Chart I-6). Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.2 The hiatus of wage pressure may not last long, and we expect the "mean reversion" in profit margins to resume next year. But for now, our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). Profit margins are also on the rise in Japan and the Eurozone. Margins in the latter appear to have the most upside potential of the three major markets, given the fact that current levels are still depressed by historical standards, and that there remains plenty of slack in the European labor market. We are not incorporating any margin expansion in Japan because they are already very high. Nonetheless, we do not expect any "mean reversion" in margins over the next year either, because the business sector is going to great lengths to avoid any increase in the wage bill despite an extremely tight labor market. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end: The U.S. is further ahead in the global profit mini recovery and year-ago EPS comparisons will become more difficult by the end of the year. The drag on corporate profits in 2017 from previous dollar strength will be larger than the currency drag in the Eurozone according to our models, assuming no change in trade-weighted exchange rates in the forecast period (Chart I-7). The pass-through of past yen movements will be a net boost to EPS growth for Japanese companies this year.3 Currency shifts would favor the Japanese and the Eurozone markets versus the U.S. even more if the dollar experiences another upleg. We expect the dollar to appreciate by 10% in trade-weighted terms. A 10% broad-based dollar appreciation would trim EPS growth by 2½ percentage points, although most of this would occur in 2018 due to lags (Chart I-8). Eurozone and Japanese EPS growth would receive a lift of 2 and ½ percentage points, respectively, as their currencies depreciate versus the dollar. Chart I-7Currency Impact On EPS Growth Currency Impact On EPS Growth Currency Impact On EPS Growth Chart I-8A 10% Dollar Rise Would Trim Profits A 10% Dollar Rise Would Trim Profits A 10% Dollar Rise Would Trim Profits Finally, the fact that profits in Japan and the Eurozone are more leveraged to overall economic growth than in the U.S. gives the former two markets the edge as global industrial production continues to recover this year and into 2018. Japanese and Eurozone equity market indexes also have a higher beta with respect to the global equity index. The implication is that we remain overweight these two markets relative to the U.S. on a currency hedged basis. Lofty Expectations Even though the message from our EPS models is upbeat, our forecasts still fall short of bottom-up estimates for 2017. Is this a risk for the equity market, especially in the U.S. where valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table I-1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in the recession. But even outside of 2008, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart I-9 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years since the Great Recession. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the trend in 12-month forward estimates (which remains up at the moment). Chart I- Chart I-9S&P 500 Follows ##br##12-month Forward EPS S&P 500 Follows 12-month Forward EPS S&P 500 Follows 12-month Forward EPS The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth U.S. expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. The Fed's Balance Sheet: It's Diet Time The minutes from the May FOMC meeting reiterated that policymakers plan to begin scaling back on reinvesting the proceeds of its maturing securities of Treasurys and MBS by the end of the year. The Fed is leaning toward a gradual tapering of reinvestment in order to avoid shocking the bond market. Still, investors are rightly concerned about the potential impact of the balance sheet runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. Chart I-10 Chart I-10 presents a forecast for the flow of Treasurys available to the private sector, taking into consideration the supply that is absorbed by foreign official institutions and by the Fed. The bottom panel shows a similar calculation for the aggregate supply of government bonds from the U.S., Japan, the Eurozone and the U.K. While the supply of Treasurys has been positive since 2012, the net flow has been negative for these four economies as a whole because of aggressive quantitative easing programs. This year will see the largest contraction in the supply of government bonds available to the private sector, at US$800 billion. The flow will become less negative in 2018 even if the Fed were to keep its balance sheet unchanged (mostly due to assumed ECB tapering). If the Fed goes ahead with its balance sheet reduction plan, the net supply of government bonds from the major economies will move slightly into positive territory for the first time since 2014. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" for the path of future short rates. Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables and the stock of assets held by the Fed as a share of GDP. Just for exposition purposes, let us take an extreme example and assume that the Fed simply terminates all re-investment as of January 2018 (i.e. the runoff is not tapered). In this case, the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a contraction of roughly 10 percentage points of GDP (Chart I-11). Applying the IMF interest rate model's coefficient of -0.09, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. Chart I-11Fed Balance Sheet Runoff Scenario Fed Balance Sheet Runoff Scenario Fed Balance Sheet Runoff Scenario However, it is more complicated than that. The impact on yields is likely to be tempered by two factors: The balance sheet may never fully revert to historic norms relative to GDP. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).4 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. Fed Outlook: Mostly About Inflation The May FOMC minutes confirmed that the FOMC is "looking through" the soft economic data in the first quarter, chalking it up to temporary factors such as shifts in inventories. They are also inclined to believe that the moderation in core CPI inflation in recent months is temporary. The message is that policymakers remain on track to deliver two more rate hikes this year, in line with the 'dot plot' forecast. The market is pricing almost a 100% chance of a June rate hike. However, less than two full rate hikes are expected over the next year, which is far too benign in our view. Investors have been quick to conclude that recent economic data have convinced Fed officials to shift from a "gradual" pace of rate hikes to a "glacial" pace. Treasurys rallied on this shift in Fed expectations and a decline in long-term inflation expectations. The 10-year TIPS breakeven inflation rate has dropped to about 1.8%, the lowest level since before the U.S. election. This appears to us that the bond market over-reacted to the drop in core CPI inflation from 2.2% in February to 1.9% in April. The evolution of actual inflation will be critical to the outlook for the Fed and Treasury yields in the coming months. Our U.S. fixed-income strategists have simulated a traditional Phillips Curve model of inflation (Chart I-12).5 The model projects that core PCE inflation will reach 2.1% by December, even assuming no change in the unemployment rate or the trade-weighted dollar. Inflation ends the year not far below the 2% target even in an alternative scenario in which we assume that the dollar appreciates and that the full-employment level of unemployment is lower than the Fed currently assumes. Chart I-12U.S. Inflation Should End Year At 2% U.S. Inflation Should End Year At 2% U.S. Inflation Should End Year At 2% Thus, the trend in inflation should reinforce the FOMC's bias to keep tightening policy, forcing the bond market to reassess the pace of rate hikes discounted in the curve. That said, if we are wrong and inflation does not trend higher in the next 3-4 months, then it is the FOMC that will be forced to reassess and our short duration recommendation will probably not pan out on a six month horizon. Longer-term, last month's Special Report highlighted that we have reached an inflection point in some of the structural forces that have depressed bond yields. This month's Special Report, beginning on page 20, builds on that theme with a look at the impact of technological progress on equilibrium bond yields. With respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. Stay overweight corporate bonds within fixed income portfolios for now. While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten policy for an extended period, outside of removing negative short rates and tapering QE purchases a bit further in 2018. The euro has appreciated versus the dollar even as two-year real interest rate differentials have moved in favor of the dollar since the end of March. This divergence probably reflects euro short-covering following the market-friendly French election outcome. Next up are the two rounds of French legislative elections in June. Polls support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus. In the meantime, we do not see any risk factors emanating from the Eurozone that could upset the global equity applecart in the near term. Moreover, the traditional relationship between the euro/USD exchange rate and 2-year real yield differentials should now re-establish. The implication is that the euro could reach parity before the next move is done. Dr. Copper? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 25% on a year-ago basis, but has fallen by 5% since February (Chart I-13). From their respective peaks earlier this year, zinc and copper are down about 7-10%, nickel has dropped by 18% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Chart I-13What Are Commodities Telling Us? What Are Commodities Telling Us? What Are Commodities Telling Us? Some of our global leading economic indicators have edged lower this year, as we have discussed in previous reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart I-14). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over. Both the PMI and housing starts are correlated with commodity prices. The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: The authorities wish to slow credit growth, but there is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Both direct fiscal spending and infrastructure investment have picked up noticeably this year (Chart I-15). Finally, the PBoC re-started its Medium-Term Lending Facility and recently made the largest one-day cash injection into the financial system in nearly four months. Chart I-14China Is The Main Story ##br##For Base Metals Demand China Is The Main Story For Base Metals Demand China Is The Main Story For Base Metals Demand Chart I-15Direct Fiscal Spending And ##br##Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. Fading fears about a China meltdown may give commodities a lift later this year. Our commodity strategists are particularly positive on crude oil, as extended production cuts from OPEC and Russia outweigh the impact of surging shale production, allowing bloated inventories to moderate. In contrast, the backdrop is fairly benign for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Investment Conclusions: Accelerating corporate profit growth in the major advanced economies provides a healthy tailwind and suggests that stocks could perform well under a couple of different scenarios in the second half of 2017. If the rebound in U.S. economic growth from the poor first quarter is unimpressive and it appears that Congress will be sidetracked by political turmoil in the White House, then the S&P 500 should benefit from the 'goldilocks' combination of healthy profit growth, low bond yields, an accommodative Fed and a soft dollar. If, instead, U.S. growth rebounds strongly and Congress makes progress on the broad outline of a tax reform bill over the summer months, then stocks should benefit from the prospect of stronger growth in 2018. Rising bond yields and a firmer dollar would provide some offset for stocks, but would not derail the equity bull market as long as inflation remains below the Fed's target. Our model suggests that U.S. inflation will remain below-target for the next several months, but could be near 2% by year end. This scenario would set the stage for a more aggressive Fed in 2018, a surge in the dollar and possibly a bear market in risk assets next year. We are therefore comfortable in predicting that the stock-to-bond total return ratio will continue to rise for at least the remainder of this year. The tough part relates to bond yields and the dollar, since the above two scenarios have very different implications for these two asset classes. Our base case is closer to the second scenario, such that we remain below benchmark in duration and long the dollar. That said, much depends on the evolution of U.S. core inflation and U.S. politics. Both are particularly difficult to forecast. A failure for core PCE inflation to pick up in the next 3-4 months and/or continuing political scandals in Washington would force us to reconsider our asset allocation. Of course, there are other risks to consider, including growing mercantilism in the U.S., Sino-American tensions and North Korea. At the top of the list are China and Italy. (1) China China remains our geopolitical strategists' top pick as the catalyst most likely to scuttle our upbeat view on global risk assets in 2017.6 Our base case assumption is that policymakers will not enact wide-scale financial sector reform, which would entail a surge in realized non-performing loans and bankruptcies and defaults, ahead of the Fall Party Congress. The regulatory crackdown so far seems merely to keep the financial sector in check for a while. The government has already stepped back somewhat in the face of the liquidity squeeze, and fiscal policy has been loosened (as mentioned above). All of the key Communist Party statements have emphasized that stability remains a priority. Nonetheless, it may be difficult for the authorities to manage the deleveraging process given nose-bleed levels of private-sector leverage. Politicians could misjudge the fragility of the financial system and investors might front-run the reform process, sending asset prices down well in advance of policy implementation. (2) Italy We have flagged the next Italian election as a key risk for markets because of polls showing that voters have become disillusioned with the euro. It appeared that an election would not take place until 2018, and we have downplayed European elections as a risk factor for 2017. However, the 5-Star Movement has now backed a proportional electoral system, which raises the chances of an autumn election in Italy. This would obviously spark turbulence in financial markets in the months leading up to the event. Turning to emerging markets, the pickup in global growth and a modest bounce in commodity prices would support this asset class. However, our view that the dollar is headed higher on the back of Fed rate hikes keeps us from getting too excited about EM stocks, bonds or currencies. Our other recommendations include the following: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. on a currency-hedged basis. Overweight the dollar versus the other major currencies. Overweight small caps stocks versus large in the U.S. market. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2017 Next Report: June 29, 2017 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 7, 2017, available at gps.bcaresearch.com 2 Please see The Bank Credit Analyst, "Overview," April 017, available at bca.bcaresearch.com 3 Currency shifts affect earnings with a lag, which in captured by our models. 4 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets ," dated May 24, 2017, available at gps.bcaresearch.com II. Is Slow Productivity Growth Good Or Bad For Bonds? This month's Special Report was written by Peter Berezin, Chief Global Strategist for BCA's Global Investment Strategy Service. The report is a companion piece to last month's Special Report, which argued that some of the structural factors that have depressed global interest rates are at an inflection point. These factors include demographic trends and the integration of China's massive labor supply into the global economy. Peter's report focuses on technology's impact on bond yields. He presents the non-consensus view that slow productivity growth likely depresses interest rates at the outset, but will lead to higher rates later on. Not only could sluggish productivity growth lead to higher inflation, it could also deplete national savings. Both factors would be bond bearish, reinforcing the other factors discussed in last month's Special Report. I trust that you will find the report as insightful and educational as I did. Mark McClellan Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart II-1 If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-3The Shift Towards Software ##br##Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Chart II-4 Chart II-5 Chart II-6 Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-8 Chart II-9U.S. Interest Rates Soared In The ##br##1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Chart II-10The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart II-14 Chart II-15Aging Will Reduce ##br##Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart II-17 Chart II-18Savings Heavily Skewed ##br##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Chart II-19Falling Capital Goods Prices Have Allowed ##br##Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-20 Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed ##br##Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The breakout in the S&P 500 above 2400 in May has further stretched valuation metrics. Measures such as the Shiller P/E and price/book are elevated relative to past equity cycles. The price/sales ratio is in a steep rise too. However, our U.S. Composite valuation metric, which takes into consideration 11 different measures of value, is still a little below the one sigma level that marks significant overvaluation. This is because our composite indicator includes valuation measures that take into account the low level of interest rates. Of course, these measures will not look as favorable when rates finally rise. Technically, the U.S. equity market has upward momentum. Our Equity Monetary Indicator has remained around the zero line, meaning that it is not particularly bullish or bearish at the moment. Our Speculation Index is high, pointing to froth in the market. The high level of our Composite Sentiment Index and low level of the VIX speaks to the level of investor complacency. The U.S. net revisions ratio jumped higher this month, and it is bullish that the earnings surprise index advanced again. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little "dry powder" left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking forward, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. It is disconcerting that our Europe WTP suffered a pull-back over the past month. Nonetheless, we believe that accelerating corporate profit growth in the major advanced economies provides a strong tailwind and suggests that stocks remain in a window in which they will outperform bonds. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as we have reached an inflection point in some of the structural forces that have depressed bond yields. We also believe that the combination of Fed balance sheet shrinkage and rate hikes will lead to higher bond yields than are currently discounted in the market. Technically, our composite indicator has touched the zero line, clearing the way for the next leg of the bond bear market. The dollar is very expensive on a PPP basis, although it is less so by other measures. Technically, the dollar has shifted down this year, crossing the 200-day moving average. That said, according to our dollar technical indicator, overbought conditions have been totally worked off, suggesting that the currency is clear to move higher if Fed rate expectations shift up as we expect. Moreover, we believe that policy divergence in the overall monetary policy stance between the U.S. on one side and the ECB and BoJ on the other will push the dollar higher. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights Geopolitical risks remain overstated in 2017, but China and Italy could scuttle the party; June elections in France and the U.K. are not market-movers; But early Italian election is a risk that could prompt the ECB to stay easy, close long EUR/USD for a gain; U.S. budget reconciliation process may be arcane, but is vital to understand upcoming tax reform process; Investors should expect details of tax reform by Q4 2017, but legislation may only pass in Q1 2018. Feature We turned the traditional adage of "sell in May and go away" on its head last month in a report titled "Buy In May And Enjoy Your Day!"1 So far so good (Chart 1). The fundamental reasons behind the breakout is the narrowing of the global equity risk premium on the back of easy monetary policy and a recovering global economy (Chart 2) two trends that our colleagues at the Global Alpha Sector Strategy highlighted last September.2 Since then, geopolitical risks cited as likely to end the party have been largely overstated.3 We continue to worry about Chinese financial sector reforms, U.S. politics, Sino-American tensions, signs of growing U.S. mercantilism, prospects of early Italian elections, and especially the developments in North Korea. But these remain risks for 2018, rather than 2017.4 Chart 1Blow-Off Phase Has Resumed Blow-Off Phase Has Resumed Blow-Off Phase Has Resumed Chart 2Global ERP Has Room To Fall Global ERP Has Room To Fall Global ERP Has Room To Fall There are still some "loose ends" to tie up from the first quarter, including the upcoming French legislative and U.K. general elections. On the former, there is nothing to say other than that investors should indeed prepare for a "French Revolution," by which we mean a supply-side revolution.5 Current seat projections based on the latest polling have pro-market, centrist, Europhile parties controlling between 85-92% of the National Assembly following the two-round elections in mid-June (Diagram 1).6 Diagram 1French National Assembly Seat Projection Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep Yes. In France. Skeptical commentary will surely rain on the centrist parade by pointing out that anti-establishment presidential candidates won nearly 50% of the vote in the first round of the presidential election (true), that Marine Le Pen will be back even stronger in 2020 (false), or that the electoral system is designed to suppress the populist vote (yes, so what?). We are not as perceptive nor profound as the witty op-ed writers. Our far simpler conclusion is that the French National Assembly will elucidate the revealed preference of the French electorate, given the electoral rules that are quite familiar to all French voters. And that preference appears to be for pro-market, and quite possibly painful, structural reforms. We remain long French industrials relative to German ones, but our clients may find alternative ways to play the upcoming free-market revolution in France. On the British front, Tory PM Theresa May is facing her first genuine crisis. The impact of the Manchester terrorist attack on the election is difficult to forecast. However, May's "dementia tax" gaffe has clearly given Labour new life in the polls (Chart 3). What most commentators saw as a clear shoo-in for the Conservative Party has now become a competitive, if not exactly tight, race. Chart 3Labour Gains... Labour Gains... Labour Gains... Chart 4...But Tories Keep Devouring UKIP ...But Tories Keep Devouring UKIP ...But Tories Keep Devouring UKIP We would note that despite Labour's rise in the polls, May's strategy of suppressing the UKIP vote by campaigning from the nationalist right is paying off. As Chart 4 illustrates, UKIP voters appear to be switching to the Tories en masse: UKIP has gone from support of 20% in April 2016 to under 5% today. Given Britain's first-past-the-post electoral system, May's strategy of swallowing the UKIP whole is a savvy move. It will eliminate the probability that UKIP siphons votes away from the Tories in competitive constituencies. Our own, highly conservative, estimate gives the Tories a minimum of 11 gained seats (Table 1). This is based on constituencies that voted for Brexit but where Labour and the Liberal Democrats won by less than 5% in the last election. Table 1Minimal Scenario Gives Tories 11 New Seats For Their Majority Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep We do not think that the election will have much impact on the Brexit process. Political risks peaked in January when May announced that she planned to take the U.K. out of the EU Common Market. We pointed out at the time that this decision made it highly unlikely that the U.K. and EU negotiations would take an acrimonious turn.7 The market agreed with us, with the pound bottoming in mid-January. We continue to believe that the Brexit process will have no investment relevance for global assets. As for U.K. equities and the pound, a larger-than-expected seat grab by the Tories (375+) at the upcoming election would likely strengthen the pound further, which in turn could weigh on the FTSE 100 (with the FTSE 250 being less affected). A disappointing result, one where the Conservative Party fails to reach 350 seats, could create temporary headwinds for the pound. The one risk that remains on our horizon is faster-than-expected deleveraging in China. As we mentioned in our report last week, China's financial crackdown raises near-term risks (Chart 5).8 We do not think that policymakers are looking to enact wide scale financial sector reform, which would entail a surge in realized non-performing loans, bankruptcies, and defaults ahead of the Fall Party Congress. However, Chinese investors and businesses may already be looking ahead to 2018. Chart 5Policymakers Are Inducing Financial Risk... Policymakers Are Inducing Financial Risk... Policymakers Are Inducing Financial Risk... Chart 6...At A Time When Vulnerability Is Growing ...At A Time When Vulnerability Is Growing ...At A Time When Vulnerability Is Growing China's reserves-to-M2 ratio - an IMF-proposed measure that captures Chinese reserves of liquid assets against those that its residents could potentially liquefy as part of wide scale capital flight - has continued to decline (Chart 6). Measures of quarterly net portfolio flows and capital flight show that the Q4 2016 outflows accelerated sharply after a slowdown in outflows in the previous two quarters (Chart 7), although we have no information for Q1 2017. More recently, there has been a stunning surge in Bitcoin prices. The crypto-currency is up 65% since the start of May, which cannot be attributed to Euro Area fears given the victory of Europhile Emmanuel Macron in the French election. Could it be related to policy uncertainty in China? We think yes (Chart 8). China remains our pick for the risk that is most likely to scuttle our sanguine view on global risk assets in 2017. Chart 7Chinese Outflows Restarted In Q4 2016 Chinese Outflows Restarted In Q4 2016 Chinese Outflows Restarted In Q4 2016 Chart 8Chinese Uncertainty Is Bitcoin's Gain Chinese Uncertainty Is Bitcoin's Gain Chinese Uncertainty Is Bitcoin's Gain The final risk to investors that we have been tracking this year is inaction by U.S. Congress on the tax reform front. We have received many client questions regarding when investors should expect to see tax reform legislation and when (and how) it is expected to pass. We turn to this question in the rest of this report. Market Relevance Of The Budget Reconciliation Process The U.S. legislative process is complicated, arcane, and highly mutable. We have tried to spare our clients as much of the headache of U.S. congressional procedure as possible.9 However, the budget reconciliation process underpins current efforts to reform both the 2010 Affordable Care Act (Obamacare) and enact tax reform. To understand how, when, and whether the GOP-controlled Congress will pass these pieces of legislation, it is necessary for investors to learn the basics of the reconciliation process in particular, and the budget process more broadly. Budget reconciliation - or simply, reconciliation - simplifies the process of passing a budget and was introduced by the Congressional Budget Act of 1974.10 To understand why reconciliation matters, we first have to explain how the U.S. Congress sets the budget. The U.S. Budget Process The U.S. budget process (Diagram 2) begins with the U.S. president submitting the White House budget request to Congress. This is a largely ceremonial act as Congress has the power over the appropriations process. Diagram 2U.S. Budget Process: A Tentative Timeline Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep Congress takes into account the president's request as it formulates a budget resolution, which both houses of Congress pass but which is not presented to the president and does not actually constitute law. The resolution sets out the guidelines for the budget process, which is supposed to ultimately produce an appropriations bill. It is this bill, also referred to as a budget bill, which appropriates funding for the various federal government departments, agencies, and programs. Under a revised timetable in effect since 1987, the annual budget resolution is supposed to be adopted by both chambers of Congress by April 15, giving legislators sufficient time to then pass a budget bill by the start of the fiscal year on October 1. However, there is no obligation to do so. In fact, Congress failed to pass a budget resolution for most of President Obama's two terms in office due to a high degree of polarization between the Democrats and Republicans. As such, the government was funded via "continuing resolutions," which merely extended pre-existing appropriations at the same levels as the previous fiscal year. Reconciliation Process Where does the reconciliation process fit? It was originally introduced to simplify the process of changing the law on the books in order to bring revenue and spending levels into line with the budget resolution. The crucial feature of the process, and the reason we are focusing so much on it, is that it limits the debate in the Senate to 20 hours, thus automatically preventing any Senator from filibustering the ultimate legislation that emerges from the reconciliation process. No filibuster, no need to reach 60 Senate votes to invoke cloture, an act that ends the debate in the chamber. In the current context, where the Republican Party controls 52 seats, this means that the Republicans can use the reconciliation process to pass legislation that would otherwise be "filibustered" in the Senate. The reconciliation procedure is a very powerful legislative tool by which Congress can pass controversial legislation, as long as such legislation has an impact on government revenues or spending levels. Tax legislation, obviously, would impact government revenues. George W. Bush used the reconciliation procedure to lower taxes in 2001 and 2003. His father, George H. W. Bush used reconciliation to raise taxes in 1990 (and thus roll back some of the Ronald Reagan 1986 tax reform). The 1996 welfare reform - the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 - was also passed via the reconciliation process. Obamacare was not passed via the reconciliation procedure. The main portion of the bill - including almost all of its key provisions - was passed at the beginning of the 111th Congress in 2009 when the Democrats held 58 seats in the Senate following the momentous 2008 election.11 It was the subsequent amendments to the original bill that required the reconciliation process due to the death of Massachusetts Senator Ted Kennedy, particularly several crucial funding provisions. The one unifying feature of all reconciliation bills is that they must have an impact on the budget, essentially by changing the revenue or spending levels of the federal government. If the bill introduces extraneous provisions that deviate from the budgetary requirement, then these can be struck out by invoking the so-called "Byrd rule." Waiving the Byrd rule requires an affirmative vote of three-fifths of the Senate, which is 60 votes. As such, it essentially requires the 60-seat majority needed to also invoke cloture, making the entire reconciliation process redundant. Bottom Line: The budget reconciliation process allows U.S. Congress to pass legislation without the a 60-seat Senate majority. However, procedural rules require the provisions of a reconciliation bill to deal exclusively with legislation that impact government revenue or spending levels. Timing Since the introduction of the procedure in 1974, there have been 24 reconciliation bills, three of which were vetoed by the president. The reconciliation process begins with the passing of the budget resolution, which sets out the "reconciliation instructions." However, since the procedure was introduced, it has rarely progressed along the intended timeline. The very first reconciliation act in 1980 was introduced in a budget resolution that passed well after the April 15 deadline, in mid-June. And the ultimate appropriations bill, the Omnibus Reconciliation Act of 1980, was only signed into law in early December 1980, so essentially two months after the start of FY1981 on October 1. Investors should therefore understand that the U.S. budget process has no real firm deadlines. The schedule is highly malleable. A reconciliation bill also does not have to be passed with the actual budget. Despite being initiated by the budget resolution, reconciliation runs parallel to the budget process. For example, Congress has already set appropriations for FY2017, but the reconciliation bill on Obamacare - set by the FY2017 budget resolution - is still in negotiations. Diagram 3 illustrates that half of all reconciliation bills were passed after the start of the fiscal year for which they were introduced in a budget resolution. And five reconciliation bills were passed in the calendar year of the fiscal year for which they were supposed to reconcile the budget, basically mid way through the fiscal year. Diagram 3Timing Of Reconciliation Procedures Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep This is important in the current context because investors are waiting for tax reform legislation which is supposed to be passed via the budget reconciliation process for FY2018. However, the GOP-controlled Congress has not even finished the budget process for FY2017. In fact, the budget resolution for FY2017 only passed the House on January 13, 2017. As we learned above, U.S. budget process guidelines call for the budget resolution to have been passed by April 15, 2016. As such, the Obamacare repeal and replace bill, if it were to ultimately pass the Senate, would certainly be the most delayed reconciliation bill ever. In fact, we could see the current Congress passing the FY2017 reconciliation bill in the waning days of FY2017! Congressional rules only allow one budget resolution to be active at any one time. In fact, as soon as a new budget resolution is passed, the old reconciliation instructions are made void. As such, investors have to wait for the Republicans to decide what they plan to do with the Obamacare reconciliation bill before they begin contemplating tax reform. Bottom Line: Republicans in Congress decided to issue reconciliation instructions as part of the FY2017 budget resolution, which passed in January. As such, investors have to wait until that process ends - with either Obamacare repeal or failure of the bill - before Congress can produce a FY2018 budget resolution with reconciliation instructions for tax reform. We suspect that the FY2018 budget resolution will be passed sometime between the end of the August Congressional recess, on September 5, and December. But that is just a guess (Diagram 4). It could happen earlier, in July, if Obamacare is dealt with over the next month. Diagram 4Tentative U.S. Political Timeline Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation Rules And Tax Reform Changing America's complex tax laws is precisely the sort of legislative action that reconciliation was designed to facilitate. That said, investors are still not sure whether the Trump administration and Congress will be able to agree on comprehensive tax reform that includes lowering top rates for corporations, or whether they will merely agree to cut household taxes on households. Some clarity will emerge once the Republican-controlled Congress passes the FY2018 budget resolution, which will contain reconciliation instructions for either comprehensive tax reform (most likely) or merely household tax reform (unlikely). At that point, the length of the reconciliation process will depend on how much agreement there is surrounding tax reform. Diagram 3 shows that tax cuts - such as those in 2001 and 2003 - take relatively little time to pass. Tax reform, on the other hand, could take a while longer given multiple competing interests. If comprehensive, we would expect tax reform to be passed by the end of Q1 2018. Would that mean that tax cuts would only be effective from January 1, 2018? Or, even less bullish, from the start of FY2019? No. The GOP would have the option of making tax cuts retroactive and thus can avoid a huge market disappointment if tax cuts come later in the next year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.12 Can reconciliation be used to pass budget-busting tax reform, as we have argued investors should expect? You bet! From 1980 to the 1990s the reconciliation procedure was primarily used - and in fact designed - to reduce the deficit through reductions in mandatory spending, revenue increases, or both. It has since become a tool to expand deficits. This was most famously done by the Bush era reconciliation bills in 2001 and 2003, which introduced large tax cuts. The aforementioned Byrd rule forces any provision of a bill that increases the deficit beyond the years covered by the reconciliation bill to "sunset." In the case of the 2001 and 2003 bills, this meant that Bush-era tax cuts expired in 2011 (estate tax) and 2013 (which investors will remember as the "fiscal cliff"). The sunset period does not have to be ten years, it could conceivably be a lot longer, in effect making tax reform permanent, as far as most investors' time horizons are concerned. Following the Democratic Party sweep in the 2006 midterm elections, the Democrat-controlled Senate changed reconciliation rules to prohibit any deficit-increasing measures, regardless of the sunset clause loophole. However, the Republicans changed the rules back in 2015, after they re-took the Senate in the 2014 midterm election. This is crucial for two reasons: first, it means that the current procedural rules on the books allow deficits to be blown out via the reconciliation procedure and second, it establishes that the current cohort of Republicans in Congress is fiscally profligate, despite media punditry to the contrary. Bottom Line: The reconciliation process was designed to facilitate precisely the type of legislation that Republicans will try to pass via tax reform. According to the current procedural rules, such legislation can increase the budget deficit, as long as it sunsets at the conclusion of the budgetary period set out by the legislation (normally 10-years, but it could be longer). We suspect that tax reform will take until Q1 2018 to pass, but Republicans will be able to make its effects retroactive to January 1, 2017. The Big Picture - What Does It All Mean For Fiscal Policy? We expect the Republican-held Congress to attempt to pass comprehensive tax reform over the next four quarters. If the GOP fail to agree on "revenue offsets" for corporate tax cuts, we could see the Republican Congress electing to pass simple tax cuts for households, as the Bush-era tax cuts of 2001 and 2003 did. To facilitate such legislation politically, the Republicans will rely on "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue lost through tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, factors that actually add to revenues. In other words, "tax cuts pay for themselves." It is true that the Congressional Budget Office (CBO) will balk at dynamic scoring. But we doubt that "egghead, socialist economists" will stand in the way of tax reforms. As we discussed above, the CBO's score will ultimately only force the Republicans to "sunset" tax reform legislation, not scuttle it. The market disagrees with us. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 9). Chart 9Market Has Voted: No Fiscal Stimulus Market Has Voted: No Fiscal Stimulus Market Has Voted: No Fiscal Stimulus We think the market is making a serious mistake by taking the Republican mantra of "revenue neutral" - meaning that any tax cuts would need to be offset by other revenue-raising measures - tax reform seriously. This is easier said than done. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - will all face resistance from vested interests. We suspect that the GOP will produce some revenue offsets, but not enough to have a revenue-neutral tax reform. The path of least resistance, therefore, will be to bust the budget and then force the measures to expire over the life of the budget-setting window. White House budget director Mick Mulvaney has already floated the idea of extending the 10-year budget scoring window to 20 years. This would allow tax reform measures, even if they are characterized by the CBO as profligate, to expire in two decades. That's practically a lifetime away, as far as any investor is concerned. What is the investment significance of a stimulative tax reform package? Our colleague Peter Berezin has recently pointed out that it is ironic that fiscal stimulus is coming to America only when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year, as the Fed responds to greater fiscal thrust with tighter monetary policy.13 We encourage our clients to read BCA Special Report "Beware The 2019 Trump Recession," penned by Martin Barnes in March, which details the likely path that assets and the economy will take over the next two years.14 In the short term, the market will continue to fret that tax reform is doomed and that Republicans are committed to austerity. However, budget-busting tax reform could begin to be priced in by the market well before the reconciliation bill is ultimately passed. We suspect that the outlines of tax reform will emerge this summer. The market may realize that stimulus is coming as soon as the FY2018 budget resolution, containing tax reform instructions, is passed in Q3 or Q4 2017. Such a realization later this year could augur a violent snap-back in the USD. Currently, the two-year real interest rate differentials between the euro area and the U.S. have widened by 58 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 10). We have been long EUR/USD since March 22,15 in expectations that investors would be busy covering their euro hedges that they put on in the lead up to the French elections, the outcome of which we have had a high conviction on since November.16 However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will ultimately subside (Chart 11). Chart 10Widening Real Rate ##br##Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Chart 11Speculators Are Long The Euro##br## For The First Time In Three Years Speculators Are Long The Euro For The First Time In Three Years Speculators Are Long The Euro For The First Time In Three Years We are therefore closing our USD short versus both the euro and the pound, for gains of 3.48% and 3.34% respectively. As we expected, the ECB is going to look to guide investors towards a "dovish" tapering of its QE program. Speaking before the European Parliament's committee on economic affairs, ECB President Mario Draghi confirmed that "very accommodative financing conditions" reliant on "a fairly substantial amount of monetary accommodation" would continue. The ECB will have to make a decision whether to extend its sovereign bond purchase program into the next year or start winding it down as planned. Given news flow out of Italy that an election may be planned as early as September, the ECB may be forced to stand pat until after the end of the year. Given our view that tax reform in the U.S. would ultimately happen, and that it would eventually be marginally stimulative, any resurfacing of political risks in Europe - which we are expecting - should be negative for the EUR/USD. What should investors do about European equities? We are cautious. As we have been pointing out to our clients since September of last year, Italy is the political risk in Europe.17 However, we think that most investors are willing to bet that European equities can survive Italian political turbulence. This could be a mistake in the short term, as we think that Euroskeptic (albeit evolving) Five Star Movement could win a plurality in the next election. In the long term, Italy will become ECB's proverbial boulder, that Draghi must push up a hill like Sisyphus, only to see it roll down to the bottom with each bout of Italian political instability. As such, Italy's instability will force ECB to set its monetary policy for the weakest link in the Euro Area (Italy), rather than the aggregate. This should be positive for Euro Area risk assets, but negative for the euro, all other things being equal. 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, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Strike While The Iron Is Hot," dated September 2, 2016, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com. 6 The dates for the two rounds of the legislative elections are June 11 and 18. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 We draw on several overviews of the budget reconciliation process in this report. Please see David Reich and Richard Kogan, Center on Budget and Policy Priorities, "Introduction To Budget 'Reconciliation'," dated November 9, 2016, available at cbpp.org; Megan S. Lynch, Congressional Research Service, "The Budget Reconciliation Process: Timing Of Legislative Action," dated February 23, 2016, available at fas.org; and Megan S. Lynch, Congressional Research Service, "Budget Reconciliation Measures Enacted Into Law: 1980-2010," dated January 4, 2017, available at fas.org. 11 To reach the required 60 seat filibuster-proof majority the Democrats relied on some luck and cunning. Democrat Al Franken unseated Republican Incumbent Norm Coleman in a recount in Minnesota and Arlen Specter, a Republican from Pennsylvania, switched his party affiliation to Democrat. 12 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and the courts upheld the legislation. Hence, there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar tax years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 13 Please see BCA Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight," dated May 26, 2017, available at gis.bcaresearch.com. 14 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Macron has won in France; Economic reforms are forthcoming; Euroskeptic parties are moving to the center; Yet Italy remains a real risk; Stick to long French industrials versus German; stay long EUR/USD for now. Feature "A chair, a table, or a bench would be elected rather than her [Le Pen] in this country." - Jean-Luc Mélenchon Third-party candidate Emmanuel Macron is the new president of France following his win over populist and nationalist Marine Le Pen (Table 1). The victory was resounding, with polls underestimating support for the centrist, and vociferously Europhile, Macron (Chart 1). Macron's victory was all the more impressive given the low turnout, which should have favored Le Pen. Table 1Results Of French Presidential Election Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 1Underestimating Emmanuel Underestimating Emmanuel Underestimating Emmanuel There are numerous narratives competing to make sense of the election in France. Our conclusion is simple: Marine Le Pen got trounced by a 39-year old political neophyte with no party organization and an investment-banking background. Le Pen wasn't so much defeated as she was routed, in a veritable Battle of Sedan for the European populists. What does this mean for investors? First, European assets are about to "rip." Second, the EUR/USD may have some more upside in the short term. Third, investors remain overly complacent about Italy, which we think has a good chance of breaking the trend of victories for the centrist forces in Europe. However, this is a story for 2018 and thus off the radar screen for investors at the moment. Le Pen Loses More Than Macron Wins Left-wing firebrand, and surprise first-round performer, Jean-Luc Mélenchon forecast in April that "a chair, a table, or a bench" would defeat Le Pen head-to-head. Naturally, the comment was self-serving for Mélenchon as he was trying to convince swing voters to support his campaign. Nonetheless, we fully agree with his assessment! Not only did Le Pen lose, but she lost to a political neophyte with investment banking on his resume. In France... In 2017... Chart 2Le Pen's Flaw Is The Euro Le Pen's Ceiling Is Support For The Euro Le Pen's Ceiling Is Support For The Euro So what happened? It is not a coincidence that Le Pen got precisely the same proportion of voters as the percent of the French public that does not support the euro, around 30-35%. Le Pen's popularity has in fact closely mirrored French Euroskepticism for years, peaking in 2013. Chart 2 essentially illustrates that Le Pen's ceiling is determined by the Euroskeptic mood of the country. We have stressed to clients since the December 2015 regional elections that Le Pen's Euroskpeticism is a major handicap to her political fortunes. In that election, her Front National (FN) was massacred in the second round despite a highly favorable context for an anti-establishment, nationalist party. The election took place on the heels of an epic migration crisis and a massive terrorist attack (which occurred just 23 days before the election).1 The Front National was defeated in all 13 mainland French regions, despite leading in six following the first round. As such, investors should ignore both the positive and negative hype surrounding the media coverage of Macron. The main lesson of the French election is that Euroskepticism does not pay political dividends, not that Le Pen still has a chance in the next election or that Macron has pulled off an extraordinary victory. The upcoming legislative elections - set for two rounds on June 11 and 18 - will cement our call on Le Pen and FN. Polls are sparse, but what we have thus far suggests that Macron's En Marche and the center-right Les Républicains will capture the vast majority of seats in the legislature (Table 2). We do not have enough polling data to gauge the reliability of this forecast, but it does make sense given FN's previously weak electoral performances in legislative and regional elections. In fact, following Macron's strong performance on May 7, we would be surprised if FN gets more than 15-20 seats in the National Assembly. Table 2Macron May Have To Work With The Republicans Stick To The Macro(n) Picture Stick To The Macro(n) Picture What matters for investors is the likely strong performance in the legislative elections for the center-right Les Républicains. Its presidential candidate François Fillon was the leading centrist candidate to get into the second round for most of early 2017 and only faded due to his corruption scandal (Chart 3). His primary challenger - Bordeaux mayor and former conservative Prime Minister Alain Juppé - in fact was comfortably leading all candidates before he was bested by Fillon in late November in party primaries (Chart 4). Chart 3Scandal, Not Policies, Killed Fillon Scandal, Not Policies, Killed Fillon Scandal, Not Policies, Killed Fillon Chart 4Juppe Led The Race Before Fillon Took Over Juppé Led The Race (Prior To Fillon) Juppé Led The Race (Prior To Fillon) A Macron presidency supported by Les Républicains in the National Assembly could be the best outcome for investors. On the international stage - where the president has no constraints - France will be led by a committed Europhile willing to push Germany towards a more proactive - rather than merely reactive - policy. On the domestic stage - where the National Assembly dominates - Macron's cautiously pro-growth agenda will be pushed further to the right by Les Républicains. In our view, the best outcome would be either genuine "cohabitation," where Macron's En Marche does not get a majority and he is forced to cohabitate with a center-right prime minister, or an En Marche sweep. The worst outcome would be a hung parliament, where Les Républicains refuse to cooperate with En Marche so as not to give Macron any further political wins. We continue to believe that the context is ripe for genuine structural reforms. We expanded on this topic in a February report titled "The French Revolution" and will not repeat the arguments here.2 Suffice it to say that a "silent majority" in France appears ready to incur the pain of reforms (Chart 5). As a play on the reform theme, we have been long French industrial equities / short German industrial equities on a long-term horizon (Chart 6). The idea is that French reforms should suppress wage growth and make French exports more competitive vis-à-vis their main competitor, Germany (Chart 7). Chart 5"Silent Majority" Wants Reform Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 6France Will Revive, Germany Is Peaking France Will Revive, Germany Is Peaking France Will Revive, Germany Is Peaking Chart 7Reforms Could Close This Gap Reforms Could Close This Gap Reforms Could Close This Gap Bottom Line: As we have expected for years, Marine Le Pen is unelectable due to her opposition to European integration. At the minimum, this should allay the fears of many investors that Frexit is a possibility. It has never even been close.3 At its most optimistic, Macron's victory will usher in a period of economic reforms in France. The Big Picture: Europe's Populists Defeated In April 2016 - ahead of the U.K. EU referendum and the U.S. general election - we made a controversial call: Anglo-Saxon populists would surprise to the upside in the upcoming plebiscites, whereas continental European would underperform.4 The U.K. has subsequently chosen Brexit and the U.S. electorate has chosen Donald Trump, both outcomes that we noted were more likely than the consensus expected. On the other side of the ledger, populists were defeated in two Spanish elections (December 2015 and June 2016), the Austrian presidential election in December 2016, and the Dutch general election in April 2017. The latest defeat for the anti-globalization populists is surprising because it happened in France, a country with a long tradition of both. One cannot blame relative economic performance for the outcome, as France has clearly underperformed the U.S. on both the growth and employment fronts (Chart 8). Nor can it be blamed on a more sanguine security situation: since 2015, France has experienced far more tragedy due to terrorist attacks than the U.S. and has been in a state of emergency since the November 2015 terror attack (Chart 9). And while France has largely avoided the 2015 European migration crisis, it was at least far more threatened by it than the U.S. due to mere geography. Chart 8Economic Woes Not Lacking In France... Economic Woes Not Lacking In France... Economic Woes Not Lacking In France... Chart 9... Nor Is Threat Of Terrorism Stick To The Macro(n) Picture Stick To The Macro(n) Picture In our view, the long-term socio-economic context is more important than the day-to-day economic and security situation in explaining the success of populists. The French social welfare state - which is onerous, inefficient, and clearly in need of reform (Chart 10) - has nonetheless played a crucial role in tempering the appeal of anti-establishment politics. Chart 10France: Welfare State Needs Reform Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 11Anti-Establishment Candidates Win... The Median Voter Has Lost In America... The Median Voter Has Lost In America... Unlike the U.S. - which has seen the real median household income decline over the past two decades and grow much slower than the economy (Chart 11) - European countries have redistributed the gains of globalization in such a way as to ensure that more people benefit from it (Chart 12). Income inequality has grown in Europe regardless, but to a much lower level - and by a lower magnitude - than in the U.S. (Chart 13). This is perhaps most pronounced in France, where the top 10% of households by income retain much the same share of the economy as they did in 1950 (Chart 14). Chart 12Redistributing Globalization's Gains ...And Won In Europe ...And Won In Europe Chart 13U.S. & U.K.: Outliers On Inequality Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 14France: Inequality Flat For 70 Years France: Inequality Flat For 70 Years France: Inequality Flat For 70 Years Many of our clients in the U.S. and the U.K. have reacted negatively to our view above. Our analysis is not meant to endorse French levels of social welfare spending. In fact, we are bullish on France precisely because we expect Emmanuel Macron to reduce French state largesse over time. We merely point out that the political effect of a redistributive socio-economic system is greater stability and centrism of the voting public in the midst of a painful socio-economic context. The median voter in Europe is simply not as angry as the median voter in the U.S. This is not by chance, but rather by design. Europe's "socialism" is a relatively modern development and a product of Europe's disastrous inter-war period, which instilled a fear of a populist backlash against failed economic policies of the time. The inter-war period saw the rise of both left- and right-wing extremism, which fed on each other with increasing intensity. These included a failed communist revolution in Germany (1918-1919), a failed Nazi coup in Germany (1923), a fascist takeover of Italy (1925), a Nazi takeover in Germany (1933), far-right unrest in France (1934), and the Spanish Civil War (1936-1939). These political upheavals were a product of both the Great Depression and the First World War. But they were also colored by Europe's socio-economic context at the time: very high wealth inequality at the beginning of the twentieth century. In fact, Europe had a much higher starting level of wealth concentration than the U.S., resulting in a much sharper correction during the inter-war period (Chart 15). What most commentators who forecast Europe's doom after the Great Recession missed is that the socio-economic context matters. It is the reality through which voters filter contemporary events. In Europe's case, the median voter was in a much better place to deal with the post-2008 economic and financial crises because Europe's "socialism" had dampened the negative consequences of globalization. In the U.S., and we would argue in the U.K. to a much lesser extent, the median voter was far more exposed to the vagaries of globalization and thus was (and remains) more open to anti-establishment political outcomes. This is the great paradox of the past 18 months: that the two best performing economies in the developed world - the U.S. and the U.K. - experienced the greatest level of populism. To us, it is not much of a paradox. Economic performance is by nature a study of the mean performance, whereas political forecasting deals with the median outcomes. This is not to say that the French are not angry with elites. After all, nearly 50% of the votes cast in the first round of the election went to anti-establishment candidates (Chart 16). However, French voters are not angry enough to want a dramatic reordering of their society, particularly in terms of their support for European institutions. What about other countries in Europe? A trend is emerging across the continent where anti-establishment parties are retaining their commitment to economic redistribution, anti-immigrant sentiment, or unorthodox foreign policy, but abandoning their Euroskepticism for the sake of competitiveness. The best examples of this trend are Spain's Podemos and Greece's SYRIZA, which have evolved in a short period of time into mainstream left-wing parties. Meanwhile, parties that retain an official strategy of Euroskepticism are increasingly finding out that the "Euroskeptic ceiling" is real. As such, these parties are struggling between remaining politically competitive and staying true to their Euroskeptic ideals: Germany: The German Euroskeptic Alternative Für Deutschland (AfD) party has been beset by massive internal conflict and identity crisis. Ousted leader Frauke Petry tried to move the party towards the center, but was rebuked at an April party congress. The AfD is still polling just under 10% (Chart 17), and will therefore enter the Bundestag in the September 24 election, but its leadership is torn between openly embracing the German alt-right and setting a course as a conservative alternative to Angela Merkel's Christian Democratic Union. We would expect the party to enter the Bundestag, but only just, in the upcoming election. Chart 15U.S. And France: Different ##br##Starting Points Of Inequality... Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 16French Voters##br## Are Angry French Voters Are Angry And Anti-Establishment Feeling High French Voters Are Angry And Anti-Establishment Feeling High Chart 17German Euroskeptics To ##br##Squeak Into Bundestag, At Best German Euroskeptics To Squeak Into Bundestag, At Best German Euroskeptics To Squeak Into Bundestag, At Best Austria: The presidential candidate of the anti-establishment Freedom Party of Austria (FPO), Norbert Hofer, tried mightily to soften his Euroskepticism ahead of the December 2016 elections. He failed and lost the election despite a solid lead in the polls for much of the year. Austria is set to hold general elections by October 2018 and support for the FPO has clearly peaked (Chart 18). Given that all other parties in Austria are pro-EU, the FPO is likely to remain isolated. Finland: The "True Finns," since rebranded as just "The Finns," were once the only competitive Euroskeptic party in northern Europe. They did very well in the 2015 general election and entered the governing coalition. To do so, they compromised on their Euroskeptic positions and became largely irrelevant, with a big dip in support (Chart 19). April municipal elections went terribly for The Finns, with the Europhile Green League emerging as the big winner. An upcoming party congress in June will determine the future of the party and whether it swings towards populism or centrism. Chart 18Austrian Anti-Establishment Has Peaked Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 19Finnish Anti-Establishment Has Peaked Stick To The Macro(n) Picture Stick To The Macro(n) Picture Italy: The one party to watch over the next several months is Italy's Five Star Movement (5SM). There is evidence that 5SM is itself riven by internal conflict over how far to take its Euroskepticism. And several moves by party leadership - including attempting to leave the legislative alliance with UKIP at the European Parliament level - appear designed to pursue the political center. The problem, however, is that there is little evidence that the Italian median voter is as committed to European integration. This remains the key risk for Europe going forward. Bottom Line: Populism has underperformed in continental Europe, much to the surprise of most commentators. Europe's economic redistribution has dampened demands for anti-establishment outcomes. Evidence suggests that Euroskeptic parties will continue to migrate to the center, at least as far as European integration is concerned, in the near future. One outlier to this view is Italy, which we elaborate on below. Investment Implications European risk assets should continue to outperform the U.S. in the coming months. The European economy continues to fire on all cylinders, whereas the U.S. appears to have hit a soft patch, according to the sharply divergent Economic Surprise Indexes (Chart 20).5 The euro may benefit from the reduction in risk premia for the time being. We will retain our long EUR/USD for now, but look to close it over the summer as we doubt the ECB's commitment to a hawkish turn in monetary policy ahead of critical risks in 2018. At the forefront of those risks is the upcoming Italian election. As we have argued repeatedly for two years, the Italy's Euroskeptic turn is real and underpinned by data. Whereas the median European has been far less Euroskeptic than the conventional wisdom has held, the median Italian is becoming more Euroskeptic. We spent a week in Europe warning clients in London, Paris, and Zurich of the upcoming Italian risks. There was little appetite for our bearish view. Even clients in the U.K. who previously held deeply skeptical views of the Euro Area's ability to survive have changed their view on Italy. Why such complacency? The oft-repeated refrain was that Italian politics have always been a mess. The election, which is highly likely to produce either a weak coalition or a hung parliament, will therefore not produce a definitive outcome worthy of risk premia. We highly disagree with this view. Our concern with Italy is not the current polling of Euroskeptic parties, but rather the underlying turn in the Italian electorate towards greater acceptance of a future outside of Europe (Chart 21). If the median voter is more willing to entertain Euroskeptic outcomes, than the Euroskeptic parties will not be forced to adopt a centrist position, as they have done in the rest of Europe. Chart 20U.S. Economy Hits A Soft Patch U.S. Economy Hits A Soft Patch U.S. Economy Hits A Soft Patch Chart 21Italy: The Real Risk To Euro Area Italy: The Real Risk To Euro Area Italy: The Real Risk To Euro Area Nonetheless, investor complacency tells us that European asset outperformance could last well into late 2017. There will be no immediate risk rotation from the French election to the Italian one. The market will have to be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus, likely in Q1 2018. Until then, the party will continue. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, 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 BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 5 Please see BCA Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, available at gss.bcaresearch.com.

Highlights The headwinds against commodity currencies are still brewing, the selloff is not over. Global liquidity conditions are deteriorating and EM growth will disappoint. The valuation cushion in commodity currencies and EM plays is not large enough to compensate for the red flags emanating from financial markets. The euro is peaking. A capitulation by shorts is likely early next week. A move to 1.12 should be used to sell EUR/USD. Feature Commodity currencies have had a tough nine weeks, weakening by 5% in aggregate, helping boost our short commodity currency trade returns to 3.8%. At this juncture, the key questions on investors' minds is whether or not this trend will deepen and if this selloff will remain playable. We believe the answer to both questions is yes. A Less Friendly Global Backdrop When observed in aggregate, the past 12 months represented a fertile ground for commodity currencies to perform well as both global liquidity and growth conditions were on one of the most powerful upswings in the past two decades, lifting risk assets in the process (Chart I-1). Chart I-1The Zenith Is Passing The Zenith Is Passing The Zenith Is Passing Global Liquidity Is Drying When we look at the global liquidity picture, the improvement seems to be over, especially as the Fed, the key anchor to the global cost of money, is more confidently embracing its switch toward a tighter monetary policy. It is true that U.S. Q1 data has been punky at best; however, like the Fed, we think this phenomenon will prove to be temporary. Recently, much ink has been spilled over the weakness in the auto sector. However, when cyclical spending is looked at in aggregate, the picture is not as dire and even encourages moderate optimism. Driven by both corporate and housing investment, cyclical sectors have been growing as a share of GDP (Chart I-2). This highlights that poor auto sales may have been a sector specific development and do not necessarily provide an accurate read on the state of household finances. Chart I-2Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Moreover, the outlook for household income is still positive. Our indicator for aggregate household disposable income continues to point north (Chart I-3). As we have highlighted in recent publications, various employment surveys are suggesting that job growth should improve in the coming months.1 Also, this week's productivity and labor cost report showed that compensation is increasing at a nearly 4% annual pace. This healthy outlook for household income, combined with the consumer's healthy balance sheets - debt to disposable income stands near 14 year lows while debt-servicing ratios are still near 40 year lows - and elevated confidence suggests that house purchases can expand. With the inventory of vacant homes standing at 11 year lows, this positive backdrop, along with the improving household-formation rate, is likely to prompt additional housing starts, lifting residential investment (Chart I-4). Chart I-3Bright U.S. Household ##br##Income Prospects Bright U.S. Household Income Prospects Bright U.S. Household Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up For the corporate sector, the strength in survey data is also likely to result in growing capex (Chart I-5). Not only have "soft" data historically been a good leading indicator of "hard" data, but the outlook for profit growth has also improved substantially. Profit growth is the needed ingredient to realize the positive expectation of business leaders embedded in "soft" data. Profit itself is very often dictated by the trend in nominal revenue growth. The fall in profits in 2016 mostly reflected the fall in nominal GDP growth to 2.5%, which produced a level of revenue growth historically associated with recessions (Chart I-6). As such, the recent rebound in nominal GDP growth, suggests that through the power of operating leverage, profit should also continue to grow, supporting capex in the process. Chart I-5Business Confidence Points ##br##To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving ...Especially As A Key Profit Driver Is Improving ...Especially As A Key Profit Driver Is Improving With the most cyclical sector of the U.S. economy still on an upswing, the Fed will continue to increase rates, at least more aggressively than the 45 basis points of tightening priced into the OIS curve over the next 12 months. With liquidity being sucked into the U.S. economic machine, international dollar-based liquidity, which is already in a downtrend, is likely to deteriorate further (Chart I-7). Moreover, global yield curves, which were steepening until earlier this year, have begun flattening again, highlighting that the tightening in global liquidity conditions is biting (Chart I-8). This will represent a continuation of the expanding handicap against global growth, and EM growth in particular. Chart I-7Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity Global Growth Conditions Are Also Past Their Best, Especially In EM Global growth conditions are already showing a few troubling signs, potentially exerted by the tightening in global liquidity. To begin with, while our global leading economic indicator is still pointing north, its own diffusion index - the number of nations with improving LEIs versus those with deteriorating ones - has already rolled over. Normally, this represents a reliable signal that growth will soon peak (Chart I-9). For commodity currencies, the key growth consideration is EM growth. Here too, the outlook looks precarious. The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing. Chinese monetary conditions have been tightening abruptly (Chart I-10, top panel). Moreover, this tightening seems to be already yielding some results. The issuance of bonds by smaller financial firms has been plunging, which tends to lead the growth in aggregate total social financing (Chart I-10, bottom panel). This is because the grease in the shadow banking system becomes scarcer as the cost of financing rises. Chart I-9Deteriorating Growth##br## Outlook Deteriorating Growth Outlook Deteriorating Growth Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening Chinese Monetary Conditions Are Tightening Chinese Monetary Conditions Are Tightening This situation could continue. Some of the rise in Chinese interbank rates to two-year highs reflects the fact that easing capital outflows have meant that the PBoC can tighten monetary policy through other means. However, the recent focus by the Beijing and president Xi Jinping on financial stability and bubble prevention, suggests that there is a real will to see tighter policy implemented. This means that the decline in total credit growth in China should become more pronounced. As a result, this will weigh on the country's industrial activity, a risk already highlighted by the decline in Manufacturing PMIs (Chart I-11). Additionally, this decline in credit growth tends to be a harbinger of lower nominal GDP growth, and most importantly for EM and commodity producers, a foreboding warning for Chinese imports (Chart I-12). Chart I-11China Industrial ##br##Growth Worry China Industrial Growth Worry China Industrial Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Financial markets are already flashing red signals. The Canadian Venture exchange and various coal plays have historically displayed a tight correlation with Chinese GDP growth.2 Today, they are breaking below key trend lines that have defined their bull markets since the February 2016 troughs (Chart I-13). This message is corroborated by the recent weakness in copper, iron ore, and oil prices. Additionally, the price of platinum relative to that of gold is also breaking down. While the VW scandal has a role to play, this breakdown is also a symptom of the pain on growth created by the tightening in global liquidity conditions. In the past, the message from this ratio have ultimately been heeded by EM stock prices, suggesting that the recent divergence is likely to be resolved with weaker EM asset prices (Chart I-14). Confirming this risk, the sectoral breadth of EM equities has also deteriorated, and is already at levels that in the past have marked the end of stock advances (Chart I-15). At the very least, the narrowing of the EM bull market should prompt investors in EM-related plays to pause and reflect. Chart I-13Two Worrisome Breakdowns##br## On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Platinum's Dark Omen For EM Platinum's Dark Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally The Falling Participation In The EM Rally The Falling Participation In The EM Rally This moment of reflection seems especially warranted as EM assets do not have much cushion for unanticipated growth disappointment. The implied volatility on EM stocks is near cycle lows, so are EM sovereign CDS and corporate spreads (Chart I-16). This picture is mimicked by commodity currencies. Even after the recent bout of weakness, the aggregate risk-reversal in options points to a limited amount of concern, and therefore, a growing risk of negative surprises (Chart I-17). Chart I-16Little Cushion##br## In EM Assets Little Cushion In EM Assets Little Cushion In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well If commodity currencies have already depreciated in the face of a slightly soft dollar and perky EM asset prices, we worry that further weaknesses will emerge if the dollar strengthens again and EM assets self-off on the back of less liquidity and more EM growth disappointment. If the price of platinum relative to that of gold was a signal for EM assets, it is also a good indicator of additional stress in the commodity-currency space (Chart I-18). Chart I-18Platinum Raises Concerns ##br##For Commodity Currencies As Well Platinum Raises Concerns For Commodity Currencies As Well Platinum Raises Concerns For Commodity Currencies As Well We remain committed to our trade of shorting a basket of commodity currencies. AUD is the most expensive and most exposed to the Chinese tightening of the group, but that doesn't mean much. The Canadian housing market seems to be under increased scrutiny thanks to the combined assault of rising taxes on non-residents and growing worries about mortgage fraud, which is deepening the underperformance of Canadian banks relative to their U.S. counterparts. If this two-front attack continues, the housing market, the engine of the domestic economy, may also prove to weaken faster than we anticipated. Finally, the New Zealand dollar too is expensive even if domestic economic developments suggest that its fair value may be understated by most PPP metrics. Bottom Line: The outlook for the U.S. economy remains good, but this will deepen the tightening in global liquidity. When combined with the tightening of monetary conditions in China, this suggests that global industrial activity and EM growth in particular could disappoint, especially as cracks in the financial system are beginning to appear. Moreover, EM assets and commodity currencies do not yet offer enough of a valuation cushion to fade this risk. Stay short commodity currencies. Macron In = Buy The Euro? The euro has rallied a 3.6% since early April, mostly on the back of Emmanuel Macron's electoral victories. Obviously, the last big hurdle is arriving this weekend with the second round. The En Marche! candidate still leads Marine Le Pen by a 20% margin. Wednesday's bellicose debate is unlikely to overturn this significant lead. The Front National candidate's lack of substance seems to have weighed against her in flash polls. If anything, her performance might have prompted some undecided Mélanchon voters to abstain or cast a "vote blanc" this weekend instead of picking her. This was her loss, not Macron's win. Does this mean that the euro has much upside? A quick rally toward 1.12 early next week still seems reasonable. New polls are beginning to show that En March! might perform much better than anticipated in the legislative election. Also, the center-right Les Républicains should also perform very well, resulting in the most right wing, pro-market Assemblée Nationale in nearly 50 years. While these polls are much too early to have any reliability, they may influence the interpretation by traders of Sunday's presidential election. However, we would remain inclined to fade any such rally. As we highlighted last week in a Special Report, our EUR/USD intermediate-term timing model shows that the euro is becoming expensive tactically, and that much good news is now in the euro's prices (Chart I-19).3 Additionally, investors have been excited by the rebound in core CPI in the euro area, a development interpreted as giving a carte-blanche to the ECB to hike rates sooner than was anticipated a few months ago. Indeed, currently, the first hike by the ECB is estimated to materialize in 27 months, versus the more than 60 months anticipated in July 2016. We doubt that market participants will bring the first rate hike closer to the present, a necessary development to prompt the euro to rally given our view on the Fed's tightening stance. We expect the rebound in the European core CPI to prove transient. Not only does European wage dynamics remain very poor outside of Germany, our country-based core CPI diffusion index has rolled over and points to a decelerating euro area core CPI (Chart I-20). Chart I-19EUR/USD: ##br##Good News In The Price EUR/USD: Good News In The Price EUR/USD: Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient European Core CPI Rebound Should Prove Transient European Core CPI Rebound Should Prove Transient Additionally, as we argued four weeks ago, tightening Chinese monetary conditions and EM growth shocks weigh more heavily on European growth than they do on the U.S.4 As such, our EM view implies that the euro area's positive economic surprises might soon deteriorate. Therefore, the favorable growth differential between Europe and the U.S. could be at its zenith. Shorting the euro today may prove dangerous, as a violent pop next week is very possible if the last euro shorts capitulate on a positive electoral outcome. Instead, we recommend investors sell EUR/USD if this pair hits 1.12 next week. Moreover, for risk management reasons, despite our view on the AUD, we are closing our long EUR/AUD position at a 6.9% gain this week. Bottom Line: Emmanuel Macron's likely victory this weekend could prompt a last wave of euro purchases. However, we are inclined to sell the euro as economic differentials between the common currency area and the U.S. are at their apex. Moreover, European core CPI is likely to weaken in the coming quarters, removing another excuse for investors to bid up the euro. Close long EUR/AUD. A Few Words On The Yen The yen has sold-off furiously in recent weeks. The tension with North Korea and the rise in the probability of a Fed hike in June to more than 90% have been poisons for the JPY. We are reluctant to close our yen longs just yet. Our anticipation that EM stresses will become particularly acute in the coming months should help the yen across the board. That being said, going forward, we recommend investors be more aggressive on shorting NZD/JPY than USD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "Healthcare Or Not, Risks Remain", dated March 24, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report titled "Updating Our Intermediate Timing Models", dated April 28, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The Fed decided to keep the federal funds rate unchanged at the 0.75% - 1% range. The Committee highlighted the Q1 GDP weakness as transitory, as the labor market has tightened more since their last meeting, inflation is reaching its 2% target, and business investment is firming. Continuing and initial jobless claims both beat expectations; However, ISM Manufacturing PMI came in less than expected at 54.8; PCE continues to fluctuate around the 2% target, coming in at 1.8% from 2.1%; ISM Prices Paid came in at 68.5, beating expectations. Furthermore, the Committee expects that "near-term risks to the economic outlook appear roughly balanced", and that "economic activity will expand at a moderate pace". The market is now pricing in a 93.8% probability of a hike. We therefore expect the dollar to continue its appreciation after the French elections. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Macron's lead over Le Pen has risen after the heated debate between the two rival candidates. We believe these dynamics were a key bullish support for the euro in the run up to elections as the possibility of a Le Pen victory is being completely priced out. Adding to this optimism is a plethora of positive data from Europe. Business and consumer confidences have both pick up. German HICP came in at 2% yoy; Overall euro area headline CPI came in at 1.9%, and core at 1.2%. Nevertheless, labor market data in the peripheries, as well as the overall euro area, was disappointing. We believe this highlights substantial slack in the economy, and will keep the ECB from increasing rates any time soon. We expect the euro to climb in the short run, but the longer-run outlook remains bleak. Look to short EUR/USD at 1.12. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Economic data in Japan has been positive this past week: The unemployment rate went down to 2.8%, outperforming expectations. Retail trade annual growth came in 2.1%, also outperforming expectations. The jobs offer-to-applicants ratio came in at 1.45. This last number is significant, as this ratio has reached it 1990 peak, and it provides strong evidence that the Japanese labor market is very tight. Eventually, this tight labor market will exert pressures on wage inflation. In an environment like Japan, where nominal rates are capped, rising inflation would mean a collapse in real rates and consequently a collapse on the yen. Thus, we are maintaining our bearish view on the yen on a cyclical basis. On a tactical basis, we continue to be positive on the yen, given that a risk-off period in EM seems imminent. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In spite of the tougher rhetoric coming from Brussels recently, the pound has maintained resilient and has even gain against the U.S. dollar. Indeed, recent data from the U.K. has been positive: Markit Services PMI came in at 55.8, outperforming expectations. Meanwhile, Markit Manufacturing PMI came in at 57.3, crushing expectations. Additionally, both consumer credit and M4 money supply growth also outperformed. Overall we continue to be positive on the pound, particularly against the euro, as we believe that expectations on Britain are too pessimistic, while the ability for the ECB to turn hawkish limited given that peripheral economies are still too weak to sustain tighter monetary conditions. Against the U.S. dollar the pound will have limited upside from now, given that it has already appreciated substantially. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA left its cash rate unchanged at 1.5%. The Bank also stated that its "forecasts for the Australian economy are little changed." It remains of the opinion that the low interest rate environment continues to support the outlook. This will also be a crucial ingredient to generate a positive outcome in the labor market in the foreseeable future. This past month has been very negative for the antipodean currency, with copper and iron ore prices displaying a similar behavior, losing almost 10% and 25% of their values since February, respectively. With China tightening monetary policy, and dissipating government spending soon to impact the Chinese economy, we remain bearish on AUD. In brighter news, the Bank's trimmed mean CPI measure increased by 1.9% on an annual basis, beating expectations of 1.8%. This is definitely a positive, but economic slack elsewhere could limit this development. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Data for New Zealand was very positive this week: The participation rate came in at 70.6%, outperforming expectations. Employment growth outperformed expectations substantially in the first quarter of 2017, coming in at 1.2%. The unemployment rate also outperformed coming in at 4.9% This recent data confirms our belief that inflationary pressures in New Zealand are stronger than what the RBNZ would lead you to believe. Indeed, non-tradable inflation, which measures domestically produced inflation is at its highest since 2014. Eventually, this will lead the RBNZ to abandon its neutral bias and embrace a more hawkish one, lifting the NZD in the process, particularly against the AUD. Against the U.S. dollar the kiwi dollar will likely have further downside, as the tightening in monetary conditions in China should weigh on commodity prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The oil-based currency has once again succumbed to fleeting oil prices, depreciating to a 1-year low. U.S. crude inventories have recently been declining by less than expected and production in Libya has been increasing. Moreover, headline inflation dropped 0.5% from its January high of 2.1%. The Bank of Canada acknowledged the weak core CPI data in its last monetary policy meeting, but instead chose to focus on stronger economic data to change their stance to neutral. As the weakness in oil prices proves temporary due to another likely OPEC cut, headline inflation should pick up again. However, labor market conditions and economic activity remain questionable based on the weakness of recent data: retail sales are contracting 0.6% on a monthly basis, and the raw materials price index dropped 1.6%. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales growth came in at 2.1%, crushing expectations. However, Aprils PMI underperformed coming in at 57.4 against expectations of 58.3. Additionally, the KOF leading indicator came in at 106, al coming below expectations. EUR/CHF now stands at its highest level since late 2017 and while data has not been beating expectations it still very upbeat. We believe that conditions are slowly being put into place for the SNB to abandon its implied floor, given that core inflation is approaching its long term average. Therefore, once the French elections are over, EUR/CHF will become an attractive short, given that the euro will once again trade on economic fundamentals rather than political risks. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The krone continues to depreciate sharply. This comes as no surprise given that oil is now down 13% in 2017. Overall we expect that oil currencies will outperform metal currencies given that oil prices will have less sensitivity to EM liquidity and economic conditions. That being said, it is hard to be too bullish on oil if China slows anew, even if one believe that the OPEC deal will stay in place . This means that USD/NOK could have additional upside. On a longer term basis, there has been a slight improvement in Norwegian data, as nominal retail sales are growing at a staggering 10% pace, while real retail sales are growing at more than 2%, which are a 5-year and a 2-year high respectively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The April Monetary Policy meeting delivered an unexpected decision, with members deciding to extend asset purchases till the end of the year, while delaying the forecast for a rate hike to mid-2018. Recent inflationary fluctuations and weak commodity prices support the Riksbank's actions. Forecasts for both inflation and the repo rate were lowered for 2018 and 2019. The Riksbank highlighted that "to support the upturn in inflation, monetary policy needs to be somewhat more expansionary", and is prepared to be more aggressive if need be. This increasingly dovish rhetoric by the Riksbank contrasts markedly with the FOMC's hawkish tilt, a dichotomy that will prove bearish for the krona relative to the greenback. Implications for EUR/SEK are a little more blurred, as the ECB will also remain dovish for the foreseeable future. However, Sweden's attentive and cautious stance on its currency's strength will cap any downside in EUR/SEK. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades