Elections

Highlights Chart 1European Policy Uncertainty Down European Policy Uncertainty Down European Policy Uncertainty Down Macron remains on target to win the French election, but Italy looms as a risk ahead; Fade any relief rally after South Korean elections; Russia is not a major source of geopolitical risk at present; Stay underweight Turkey and Indonesia within the EM universe. Feature The supposed pushback against populism is emerging as a theme in the financial industry. The expected defeat of nationalist-populist Marine Le Pen in the second round of the French election on May 7 has reduced Europe's economic policy uncertainty, despite continued elevated levels globally (Chart 1). We are not surprised by this outcome. A year ago, ahead of both the Brexit referendum and the U.S. election, we cautioned investors that it was the Anglo-Saxon world, not continental Europe, which would experience the greatest populist earthquake.1 The middle class in the U.S. and the U.K. lacks the socialist protections of large welfare states (Chart 2), leading to frustrating outcomes in terms of equality and social mobility (Chart 3). In other words, the gains of globalization have not been redistributed in the two laissez-faire economies. Hence the Anglo-Saxon world got Trump and Brexit while the continent got market-positive outcomes like Rajoy, Van der Bellen, Rutte, and (probably) Macron. Chart 2Given The Qualities Of The##br## Anglo-Saxon Economy ... What About Emerging Markets? What About Emerging Markets? Chart 3...Brexit And Trump ##br##Should Not Be A Surprise What About Emerging Markets? What About Emerging Markets? Looking forward, we agree with the consensus that Marine Le Pen will lose, as we have been stressing with high conviction since November.2 Despite a poor start to the campaign, Macron remains 20% ahead of Marine Le Pen with only four days left to the election (Chart 4). Could the polls be wrong? No. And not just because they were right in the first round. Polls are likely to be right because French polls have an exemplary track record (Chart 5) and there is no Electoral College to throw off the math. Chart 4Le Pen Unlikely To Bridge This Gap Le Pen Unlikely To Bridge This Gap Le Pen Unlikely To Bridge This Gap Chart 5French Polls Have Strong Track Record What About Emerging Markets? What About Emerging Markets? As we go to press, the two candidates are set to face off in an important televised debate. Given Le Pen's post-debate polling performance in the first round (Chart 6), we doubt she will perform well enough to make a change. Next week, we will review the second round and its implications for the legislative elections in June and French politics beyond. Overall, we think Europe's policy uncertainty dip is temporary, as the all-important Italian election risk looms just ahead in 2018.3 For now, we are sticking with our bullish European risk asset view, but will look to pare it back later in the year. Chart 6Debates Have Not Helped Le Pen Debates Have Not Helped Le Pen Debates Have Not Helped Le Pen Chart 7Commodity Currencies Suggest Global Trade Is At Risk... Commodity Currencies Suggest Global Trade Is At Risk... Commodity Currencies Suggest Global Trade Is At Risk... What about emerging markets? With investors laser-focused on developed market political risks - Trump's policies and protectionism, European elections, Brexit, etc - have EM political risks fallen by the wayside? Chart 8...And Commodities Are At Risk Too ...And Commodities Are At Risk Too ...And Commodities Are At Risk Too Chart 9China's Growth To Decelerate Again China's Growth To Decelerate Again China's Growth To Decelerate Again We don't think so. According to BCA's Emerging Market Strategy, the recent performance of the commodity currency index (an equally weighted average of AUD, NZD, and CAD) augurs a deceleration of global growth in the second half of this year (Chart 7) and a top in the commodity complex (Chart 8).4 At the heart of the reversal is the slowdown in China's credit and fiscal spending impulse (Chart 9).5 Given China's critical importance as the main source of EM final demand (Chart 10), the slowdown in money and credit growth is a significant risk to EM growth in the latter part of the year (Chart 11).6 Chart 10EM Is Leveraged To China Much More Than DM EM Is Leveraged To China Much More Than DM EM Is Leveraged To China Much More Than DM Chart 11China: Money/Credit Growth Is Slowing China: Money/Credit Growth Is Slowing China: Money/Credit Growth Is Slowing At the heart of China's credit slowdown are efforts by policymakers to cautiously introduce some discipline in the financial sector. Chinese interbank rates have risen noticeably, which should have a material impact on credit growth (Chart 12). Given that the all-important nineteenth National Party Congress is six-to-seven months away, we doubt that the tightening efforts will be severe. But they may foreshadow a much tighter policy in 2018, following the conclusion of the Congress, when President Xi has full reign and the ability to redouble his initial efforts at reform, namely to control the risks of excessive leverage to the state's stability. With both the Fed and PBoC looking to tighten over the next 12-18 months, in part to respond to improvements in global inflation expectations (Chart 13), highly leveraged EM economies may face a triple-whammy of USD appreciation, Chinese growth plateauing, and easing commodity demand. In isolation, none is critical, but as a combination, they could be challenging. Chart 12Chinese Policymakers End The Credit Party? Chinese Policymakers End The Credit Party? Chinese Policymakers End The Credit Party? Chart 13Global Tightening Upon Us? Global Tightening Upon Us? Global Tightening Upon Us? In this weekly report, we take an around-the-world look at several emerging economies that we believe are either defying the odds of political crisis or particularly vulnerable to growth slowdown. South Korea: Here Comes The Sunshine Policy, Part II South Korea's early election will be held on May 9. The victory of a left-wing candidate has been likely since April 2016, when the two main left-wing parties, the Democratic Party and the People's Party, won a majority of the 300-seat National Assembly. It has been inevitable since the impeachment of outgoing President Park Geun-hye in December - whose removal was deemed legal by the Constitutional Court in March - for a corruption scandal that split the main center-right party and decimated its popular support after ten years of ruling the country.7 The only question was whether Moon Jae-in, leader of the Democratic Party and erstwhile chief of staff of former President Roh Moo-hyun, would finally get his turn as president, or whether Ahn Cheol-soo, an entrepreneurial politician who broke from the Democratic Party to form the People's Party, would defeat him. At the moment, Moon has a significant lead in the polls, while Ahn has lost the bump in support he received after other candidates were eliminated through the primary process (Chart 14). Moon's lead has grown throughout the recent spike in saber-rattling between the United States and North Korea, which suggests that Moon is most likely to win the race. The debates have also hurt Ahn. Moon leads in every region, among blue collar and white collar voters, and among centrists as well as progressives. Also, the pollster Gallup Korea has a solid track record for presidential elections going back to 1987, with a margin of error of about 3%, so Moon is highly likely to win if polls do not change in Ahn's or Hong's favor. The key difference between Moon and Ahn boils down to this: Moon is the established left-wing candidate and has mainstream Democratic Party machinery backing him, a clear platform, and experience running the country from 2003-8. Ahn does not have experience in the executive branch (Blue House) and his policy platform is less clear. His party is a progressive offshoot of the Democratic Party, yet he is bidding for disenchanted center-right voters, a contradiction that has at times given him the appearance of flip-flopping on important issues. Thus Ahn's election would bring greater economic policy uncertainty than Moon's, though Ahn is more business-friendly by preference. Regardless, the new president will have to work with the opposing left-wing party in the National Assembly if he intends to get anything accomplished. The combined left-wing vote is 164, yielding only a 13-seat majority if the two parties work together. Differences between them will cause problems in passing legislation. It would be easier for Moon to legislate with his party's 119-seat base than for Ahn with his party's 40-seat base, unless Ahn can steer his party to cooperate with the center right like he is trying to do in the presidential campaign. Markets may celebrate the election regardless of the victor because it sets the country back on the path of stable government. The Kospi bottomed in November when the political crisis reached a fever pitch and has rallied since December 5, when it became clear that the conservatives in the assembly would vote for Park's impeachment. This suggested an early government change to restore political and economic leadership. The market rallied again when the Constitutional Court removed Park, which pulled the presidential elections forward to May and cut short what would otherwise have been another year of uncertainty until the original election date in December 2017 (Chart 15). Chart 14South Korea: Moon In The Lead What About Emerging Markets? What About Emerging Markets? Chart 15Korean Stocks Cheered Impeachment Korean Stocks Cheered Impeachment Korean Stocks Cheered Impeachment Investors can reasonably look forward to an increase in fiscal thrust after the election, particularly if Moon is elected. Table 1 compares the key policy initiatives of the top three candidates - both Moon and Ahn are pledging increases in government spending. Note that South Korean fiscal thrust expanded in the first two years of the last left-leaning government, i.e. the Roh Moo-hyun administration (Chart 16). Table 1South Korean Presidential Candidates And Their Policy Proposals What About Emerging Markets? What About Emerging Markets? Chart 16Left-Wing Leaders Drive Up Fiscal Spending Left-Wing Leaders Drive Up Fiscal Spending Left-Wing Leaders Drive Up Fiscal Spending Beyond any initial relief rally, however, investors may experience some buyer's remorse. South Korea is experiencing a leftward swing of the political pendulum that is not conducive to higher growth in corporate earnings. This is the implication of the April legislative elections and the collapse of President Park's support prior to the corruption scandal; it will also be the takeaway of either Moon's or Ahn's election win over a discredited conservative status quo (both fiscal and corporate). The leftward shift is motivated by structural factors, not mere political optics. Average growth rates have fallen since the Great Recession, yet South Korea lacks the social amenities of a slower-growing developed economy. The social safety net is comparable to Turkey's or Mexico's and wages have been suppressed to maintain competitiveness (Chart 17). Inequality has grown dramatically (Chart 18). Chart 17Keeping Labor Cheap Keeping Labor Cheap Keeping Labor Cheap Chart 18Fueling The Populist Fire What About Emerging Markets? What About Emerging Markets? Therefore the policies to come will emphasize redistribution, job security, and social benefits. Moon's policies, in particular, are aggressive. He has pledged to require the public sector to increase employment by 5% per year and add 810,000 jobs by 2022, and to expand welfare for the elderly regardless of their income level. This will swell the budget deficit and public debt, especially over time, given South Korea's demographic profile, which is rapidly graying (Chart 19). Moon also intends nearly to double the minimum wage, require private companies to hire 3-5% more workers each year, depending on company size, and give substantial subsidies to SMEs that hire more workers. He supports a hike in corporate taxes, though the details of any tax changes have yet to be disclosed. Chart 19Society Turning Gray Society Turning Gray Society Turning Gray Ahn's policy preferences are more focused on productivity improvements than social welfare. While Moon panders to middle-aged workers concerned about job security - among whom he leads Ahn by 30 percentage points - Ahn panders to the youth, who are currently battling an unemployment rate of 11%. He would pay subsidies to young workers while they look for jobs immediately after graduation ($266 per month) and for the first two years of their employment at an SME ($532 per month). He would direct budgetary funds to research and development, high-tech industries, and job training. The SME policies speak to the general dissatisfaction with the cozy relationship between large, export-oriented industrial giants - the chaebol - and the political elite. Both Moon and Ahn will attempt to remove subsidies and privileges from the chaebol, potentially forcing them to sell or spin-off branches that are unrelated to their core business, and will seek to incentivize SMEs. Chaebol reform is a long-running theme in South Korean politics with very little record of success, but the one thing investors can be sure of on this front is greater uncertainty regarding policies toward the country's multinationals. Bottom Line: South Korea is experiencing a swing of the political pendulum to the left regardless of who wins the presidential race on May 9. What About Geopolitics? Internationally, Moon, if he wins, will attempt to improve relations with China and North Korea at the expense of the U.S. and Japan. His voter base came of age during the democracy movement of the 1980s and is friendlier toward China and less hostile toward North Korea than other age groups (Chart 20 A&B). Ahn may attempt a similar foreign policy adjustment, but he is less willing to confront the United States. His attempt to woo the youth will constrain any engagement with Pyongyang, since young South Koreans feel the least connection with their ethnic brethren to the north. Given that a Moon presidency would be paired with that of Trump, it would likely precipitate tensions in the U.S.-Korean relationship. News headlines will announce that South Korea is "pivoting" toward China, much in the way that U.S. ally the Philippines was perceived as shifting toward China after President Rodrigo Duterte's election in 2016. This will be an exaggeration, since Koreans still generally prefer the U.S. to China and view North Korea as an enemy (Chart 21). Nevertheless, there is potential for real, market-relevant disagreements. Chart 20Moon's Middle-Aged Constituency What About Emerging Markets? What About Emerging Markets? Chart 21Constraints On The Sunshine Policy What About Emerging Markets? What About Emerging Markets? In the short term, the risk is to trade, given the South Korean Left's strain of opposition to the U.S.-Korea free trade agreement (KORUS) and Trump's intention to renegotiate it, or even impose tariffs. Trump is bringing a protectionist tilt to U.S. trade policy - at very least - and he is relatively unconstrained on trade so we consider this a high-level risk over his four-year term in office. Trade tensions could become consequential if South Korea breaks with the U.S. over North Korea, angering the Trump administration. At the same time, South Korea's trade with China (Chart 22) is a risk due to China's secular slowdown, protectionism, and intention to move up the value chain and compete with South Korea in global markets. Chart 22South Korea's Twin Trade Risks South Korea's Twin Trade Risks South Korea's Twin Trade Risks In the short and long term, Moon's attempt to revamp Kim Dae-jung's "Sunshine Policy" of economic engagement and denuclearization talks with North Korea could create serious frictions with the U.S. What Moon is proposing is to promote economic integration so that South Korea has more leverage over the North, which is increasingly reliant on China, and also to reduce military tensions via negotiations toward a peace treaty (the 1950-3 war ended with an armistice only). The idea is to launch a five-year plan toward an inter-Korean "economic union." This would begin by re-opening shuttered cooperative projects like the Kaesong Industrial Complex and Mount Kumgang tours and later establish duty-free agreements, free trade zones, and multilateral infrastructure projects that include Russia and China.8 The problem is that any new Sunshine Policy - which is ostensibly a boon for the region's security - will clash with the Trump administration's attempt to rally a new international coalition to tighten sanctions on North Korea to force it to freeze its nuclear and ballistic missile programs. North Korea will want to divide the allies and thus will be receptive to China's and South Korea's offers of negotiations; the U.S. and Japan will not want to allow any additional economic aid to the North without a halt to tests and tokens of eventual denuclearization. How will this tension be resolved? Trump is preparing for negotiations and over the next couple of years the U.S. and Japan are highly likely to give diplomacy at least one last chance, as we have argued in recent reports.9 Eventually, if the U.S. becomes convinced of total collaboration between China and South Korea with the North (i.e. skirting sanctions and granting economic benefits), while the North continues testing capabilities that would enable it to strike the U.S. homeland with a nuclear weapon, some kind of confrontation is inevitable. But first the U.S. will try another round of talks. The "arc of diplomacy" could extend for several years, as it did with Iran (Chart 23), if the North delays its missile progress or appears to do so. Chart 23The 'Arc Of Diplomacy' Can Last For Several Years What About Emerging Markets? What About Emerging Markets? Despite our belief that the North Korean situation will calm down as diplomacy gets under way, South Korea is seeing rising geopolitical headwinds for the following reasons: Sino-American tensions: U.S.-China competition is growing over time, notwithstanding the apparently friendly start between the Trump and Xi administrations.10 Trump's North Korea policy: The Trump administration has signaled that the U.S. does not accept a nuclear-armed North Korea and the need to maintain the credibility of the military option will keep tensions at a higher level than in recent memory.11 Japanese re-armament: Japanese tensions with China and both Koreas are rising as Japan increases military expenditures and maritime defenses and moves to revise its constitution to legitimize military action.12 The costs of peace: If diplomacy prevails, South Korean engagement with the North still poses massive uncertainties about the future of the relationship, the North's internal stability amid liberalization, whether the transition to greater economic integration will be smooth, and whether the South Korean economy (and public finances) can absorb the associated costs. This is not even to mention eventual unification. Bottom Line: The current saber-rattling around the Korean peninsula is not over yet, but tensions are soon to fall as international negotiations get under way. Still, geopolitical risks for South Korea are rising over the long run. Investment Conclusions The currency will be the first to react to the election results and will send a signal about whether the fall in policy uncertainty is deemed more beneficial than the impending rise in pro-labor policies. Beyond that, the won has been strong relative to South Korea's neighbors and competitors (Chart 24). The Korean central bank is considering cutting rates at a time when fiscal policy is set to expand substantially, a negative for the currency. Chart 24Won Strength, Yen Weakness Won Strength, Yen Weakness Won Strength, Yen Weakness Therefore we remain short KRW / long THB. Thailand, another U.S. ally, is running huge current account surpluses, is more insulated from U.S.-China geopolitical conflicts, and has navigated tensions between the two relatively well. We expect a relief rally in stocks due to resolution of the campaign and the likelihood of an easing in trade tensions with China. However, this is the only reason we are not yet ready to join our colleagues in the Emerging Markets Strategy in shorting Korean stocks versus Japanese. We will look to put on this trade in future. We do not have high hopes for Korean stocks over the long run due to the headwinds listed above. As for bonds, both Moon's and Ahn's agendas, particularly Moon's, will be bond bearish because they will increase deficits and debt. At the short end of the curve, yields may have reason to fall; but the long end should reflect looser fiscal policy, the worsening debt and demographic profile, and increasing geopolitical risk, whether from conflicts with the U.S. and North Korea, or from the rising odds of a greater future burden from subsidizing (or even merging with) North Korea. Therefore we recommend going long 2-year government bonds / short 10-year government bonds. Russia: Defying Odds Of A Political Crisis Russia has emerged from the oil-price shocks scathed, but unbowed.13 Its textbook macro policy amid a severe recession over the past two years has been exemplary: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart 25). The fiscal deficit is still large at 3.7%, but it typically lags oil prices (Chart 26). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $40/bbl Urals crude. Chart 25Russia Has Undergone##br## Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Chart 26...Which Is##br## Now Over ...Which Is Now Over ...Which Is Now Over Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel (the price of oil in rubles at the $40 bbl Urals) and sell foreign exchange when the oil price is below that level (Chart 27). The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Chart 27Oil Price Threshold For New Fiscal Rule Oil Price Threshold For New Fiscal Rule Oil Price Threshold For New Fiscal Rule Chart 28Forex Reserves Have Stabilized Forex Reserves Have Stabilized Forex Reserves Have Stabilized The recovery of oil prices and strict macroeconomic policy has allowed Russia to stabilize its foreign exchange reserves (Chart 28), although they remain at a critical level as a percent of broad money supply. However, the GDP growth recovery will be tepid and fall far short of the high growth rates of the early part of the decade (Chart 29). Chart 29Russia: ##br##Recovery Is At Hand Russia: Recovery Is At Hand Russia: Recovery Is At Hand Chart 30Inventories Remain Far ##br##Above Average Levels Inventories Remain Far Above Average Levels Inventories Remain Far Above Average Levels Russian policymakers should be cautiously optimistic. On one hand, they have been able to withstand a massive decline in oil prices. On the other, the situation is still precarious and warrants caution given the delicate situation in oil markets. OECD oil inventories remain elevated and could precipitate an oil-price collapse without OPEC's active oil-production management (Chart 30). From this macroeconomic context, we would conclude that: Russia will abide by the OPEC 2.0 production-cut agreement: While the new budget rule will go a long way in insulating the ruble from swings in oil prices, Russia is still an energy exporter. As such, we expect Russia to play ball with Saudi Arabia and continue to abide by the conditions of the OPEC deal. Thus far, Russia has been less enthusiastic in cutting production than the Saudis, but still going along (Chart 31). Russia will not destabilize the Middle East: While Russia will continue to support President Bashar al-Assad of Syria, its involvement in the civil war will abate. Moscow already began to officially withdraw from the conflict in January. While part of its forces will remain in order to secure Assad's government, Russia has no intention of provoking its newfound OPEC allies with geopolitical tensions. Russia will talk tough, but carry a small stick: Shows of force will continue in the Baltics and the Arctic, but investors should fade any rise in the geopolitical risk premium (Chart 32). It is one thing to fly strategic bombers close to Alaska or conduct military exercises near the Baltic States; it is quite another to act on these threats. In fact, Russia has been doing both since about 2004 and its bluster has amounted to very little with respect to NATO proper. This is because Russia depends on Europe for almost all of its FDI and export demand and it is only in the very early innings of replacing European demand with Chinese (Chart 33). As long as Russia lacks the pipeline infrastructure to export the majority of its energy production to China, it will be reluctant to confront Europe. Chart 31Moscow Will Play ##br##Ball With OPEC Moscow Will Play Ball With OPEC Moscow Will Play Ball With OPEC Chart 32Fade Any Spike ##br##In Geopolitical Risk Fade Any Spike In Geopolitical Risk Fade Any Spike In Geopolitical Risk Chart 33Russia Relies On Europe;##br## China Not A Replacement What About Emerging Markets? What About Emerging Markets? As we have posited in the past, energy exporters are emboldened to be aggressive when oil prices are high.14 When oil prices collapse, energy exporters become far more compliant. Nowhere is this dynamic more true than with Russia, whose military interventions in foreign countries have served as a sure sign that the top of the oil bull market is at hand! Bottom Line: We do not expect any serious geopolitical risk to emanate from Russia, despite the supposed souring of relations between the Trump and Putin administrations due to the U.S. cruise-missile strike against Syria.15 And we also do not expect President Putin to manufacture a geopolitical crisis ahead of Russia's March 2018 presidential elections, given that his popularity remains high and that the opposition is in complete disarray. While Russia may continue to talk tough on a number of fronts, investors should fade the rhetoric as it is purely for domestic consumption. Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16.16 The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press allege. Yes, presidential powers have expanded. In particular, we note that: The president is now both head of state and government and has the power to appoint government ministers; The president can issue decrees; however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections; however, he needs three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, overriding a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, he would lose much of his ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum that gives him more power. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart 34). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart 34Turkey's Ruling Party Struggles To Get Over 50% Of The Vote What About Emerging Markets? What About Emerging Markets? Second, Erdogan is making a strategic mistake by giving himself more power. It will focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it means that all the blame will go to him in hard times. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. Events in Turkey since the referendum have already confirmed our view. Despite rumors that the state of emergency would be lifted following the referendum, the parliament in fact moved to expand it by another three months. Furthermore, just a week following the plebiscite, the government suspended over 9,000 police officials and arrested 1,120 suspects of the attempted coup last summer, with another 3,224 at large. This now puts the total number of people arrested at around 47,000. Investors are confusing lack of opposition to stability. Yes, the opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy stumbles. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Any Gezi Park-style unrest would hurt Erdogan's credibility. May Day protests saw police scuffle with protesters in Istanbul, for example. Given his penchant for equating any dissent with terrorism, President Erdogan is very likely to overreact to any sign that a social movement is rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan's or the AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart 35Turkey Constrained By European Ties Turkey Constrained By European Ties Turkey Constrained By European Ties Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on the EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart 35). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions, which we are certain the EU would impose, would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Conclusions BCA's Emerging Market Strategy recommends that clients re-instate short positions on Turkish assets, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart 36). This is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart 37). Such extremely strong loan growth means that credit excesses continue to be built. Chart 36Liquidity Injections Reaccelerating Liquidity Injections Reaccelerating Liquidity Injections Reaccelerating Chart 37Money And Credit Growth Strong Money And Credit Growth Strong Money And Credit Growth Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart 38, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart 38, bottom panel). The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart 39). Without this support from the CBT, the lira would be much weaker than it currently is. That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart 38Turkish Stagflation Turkish Stagflation Turkish Stagflation Chart 39Turkey Props Up The Lira Turkey Props Up The Lira Turkey Props Up The Lira We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart 40, top panel). Chart 40Weak Lira Will Push Interbank Rates Higher Weak Lira Will Push Interbank Rates Higher Weak Lira Will Push Interbank Rates Higher Historically, currency depreciation has always been negative for banks' stock prices as net interest margins will shrink (Chart 40, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: We are already short the lira relative to the Mexican peso. In addition, we are recommending two new trades based on the recommendations of BCA's Emerging Market Strategy: long USD/TRY and short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Indonesia: A Brief Word On Jakarta Elections President Joko "Jokowi" Widodo saw his ally, Basuki Tjahaja Purnama (nicknamed "Ahok"), badly defeated in the second round of a contentious gubernatorial election on April 19. Preliminary results suggest that Ahok received 42% against 58% for his contender, Anies Baswedan, a technocrat and defector from Jokowi's camp whose own party only expected him to receive 52% of the vote. This was a significant setback. Jokowi's loss of the Jakarta government is a rebuke from his own political base, a loss of prestige (since he campaigned to help Ahok), and a boost to the nationalist opposition party Gerindra and other opponents of Jokowi's reform agenda. Ahok is a Christian and ethnic Chinese, which makes him a double-minority in Muslim-majority Indonesia, which has seen anti-Chinese communal violence periodically and has also witnessed a swelling of Islamist politics since the decline of the oppressive secular Suharto regime in 1998. Ahok fell under popular scrutiny and later criminal charges for allegedly insulting the Koran in September 2016 by casting doubt on verses suggesting that Muslims should not be governed by infidels. Mass Islamist protests ensued in November. Gerindra exploited them, as did political forces behind the previous government of Susilo Bambang Yudhoyono and trade unions opposed to the Jokowi administration's attempt to regularize minimum wage increases.17 Ahok's sound defeat shows that the opposition succeeded in making the race a referendum on him versus Islam. Despite the blow, Jokowi's popularity remains intact (Chart 41). The latest reliable polling is months out of date but puts Jokowi 24% above Prabowo Subianto, leader of Gerindra, whom he has consistently led since defeating him in the 2014 election. Jokowi remains personally popular, maintains a large coalition in the assembly, and is still the likeliest candidate to win the 2019 election. Jokowi's approval ratings in the mid-60 percentile are comparable to those of former President Yudhoyono at this time in 2007, and the latter was re-elected for a second term. Moreover Yudhoyono slumped at this point in his first term down to the mid-40 percentile in 2008 before recovering dramatically in 2009, despite the global recession, to win re-election. In other words, according to recent precedent, Jokowi could fall much farther in the public eye and still recover in time for the election. However, Jokowi will now have to shore up his support among voters with a strong Muslim identity, which is a serious weak spot of his, as indicated in the regional electoral data in Table 2. Jokowi relies on two key Islamist parties in the National Assembly. He cannot afford to let opposition grow among Muslim voters at large (notwithstanding Gerindra's own problems working with Islamist parties). Chart 41Jokowi Still Likely To Be Re-Elected In 2019 What About Emerging Markets? What About Emerging Markets? Table 2Islamist Politics A Real Risk For Jokowi What About Emerging Markets? What About Emerging Markets? He clearly faces a tougher re-election bid now than he did before. Risks to China and EM growth on the two-year horizon are therefore even more threatening than they were. And since a Prabowo victory would mark the rise of a revanchist and nationalist government in Indonesia that would upset markets for fear of unorthodox economic policies, the political dynamic will be all the more important to monitor. These election risks also suggest that traditional interest-group patronage is likely to rise at the expense of structural economic reform over the next two years. Bottom Line: We remain bearish on Indonesian assets. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com. 5 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Toward A Desynchronized World?" dated April 26, 2017, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017; and Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, all available at gps.bcaresearch.com. 8 Please see "Moon Jae-in's initiative for 'Inter-Korean Economic Union," National Committee on North Korea, dated August 17, 2012, available at www.ncnk.org. 9 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 10 For our latest feature update on what is one of our major themes, please see BCA Geopolitical Strategy and EM Equity Sector Strategy, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 11 Please see footnote 7 above. 12 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 13 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 16 An original version of this analysis of Turkey appeared in BCA Emerging Market Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 17 Please see "Indonesia: Beware Of Excessive Wage Inflation" in BCA Emerging Markets Strategy Special Report, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at ems.bcaresearch.com.

Highlights Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. There are also some worrying signs in our global forward-looking growth indicators for 2018, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. first-quarter economic data. They also went too far in pricing out U.S. fiscal action. It is positive for risk assets that centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. Italian elections could be troublesome, but that is a story for next year. The fact that China finally appears willing to apply pressure to Pyongyang is good news. North Korea might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. Disappointing U.S. Q1 real GDP growth largely reflects weather and seasonal adjustment factors. The deceleration in bank credit growth is also temporary. The window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals remain constructive. Importantly, signs of improving pricing power in the U.S. corporate sector are finally emerging, which should allow margins to expand somewhat in the coming quarters. The bond rally has depressed yields to a level that makes fixed-income instruments highly vulnerable to a reversal of the factors that sparked the rally. Market expectations for the fed funds rate are far too benign. The ECB will announce the next tapering step later this year, and may remove the negative deposit rate. But the central bank will not be in a position to lift the refi rate for some time. Yield spreads will shift in a way that allows one last upleg in the U.S. dollar. The recent pullback in oil prices will not last, as OPEC and Russia manage global stockpiles lower this year. Feature Chart I-1Reflation Trades Returning? Reflation Trades Returning? Reflation Trades Returning? Traders and investors gave up on the global reflation story in early April, sending the 10-year U.S. Treasury yield below the year's trading range. Missile strikes, European elections and U.S. saber rattling regarding North Korea lifted the allure of safe havens such as government bonds (Chart I-1). At the same time, the Fed was unwilling to revise up the 'dot plot', doubts grew over the ability of the Trump Administration to deliver any stimulus and U.S. data releases disappointed. The major equity indexes held up well against the onslaught of bad news, but looked increasingly vulnerable as April wore on. The market gloom was overdone in our view, and it appears that financial markets have now returned to a 'risk on' phase. It is difficult to forecast the ebb and flow of geopolitical news so we cannot rule out another bout of risk aversion. Nonetheless, the global economic backdrop remains upbeat and tensions regarding North Korea have eased. President Trump also unveiled his Administration's tax reform plan, raising hopes of a fiscal boost to the economy. Moreover, investors have read too much into the distorted U.S. first quarter data, and our corporate pricing power indicators support our constructive earnings view in 2017. There are clouds hanging over the outlook for 2018, but the backdrop will favor risk assets for most of this year. Investors should remain overweight equities versus bonds and cash, and bullish the dollar. Geopolitics Weigh On Risk Tolerance President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. The fact that China finally appears willing to apply pressure to Pyongyang is good news. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. The safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances. Chart I-2Macron Appears Set For Victory Macron Appears Set For Victory Macron Appears Set For Victory Turning to Europe, investors breathed a sigh of relief following the first round of the French Presidential election. The pre-election polls turned out to be correct, and our Geopolitical Team has no reason to doubt the polls regarding the second round (Chart I-2). We expect Macron to sweep to victory on May 7 because Le Pen will struggle to get any voters from the candidates exiting the race. What should investors expect of a Macron presidency? A combination of President Macron and a right-leaning National Assembly should be able to accomplish some reforms. Several prominent center-right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister. This is positive for the markets as it means that French economic policy will be run by the center-right, with an ultra-Europhile as president. Over in the U.K., the big news in April was Prime Minister Theresa May's decision to hold a snap election, which reduces the risk of a "hard Brexit". The current slim 12-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories who would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservatives are able to increase their seats in Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. U.S. Fiscal Policy: Positive For 2017, But Long-Term Negative Chart I-3Long-Term U.S. Budget Pressures Long-Term U.S. Budget Pressures Long-Term U.S. Budget Pressures The drama will be no less interesting in Washington in the coming weeks. As we go to press, Congress is struggling to pass a bill to keep the U.S. government running through the end of fiscal year 2017 (the deadline is the end of April). We expect a deal will get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. Both events could see temporary safe-haven flows into Treasurys. However, markets may have gone too far in pricing-out tax cuts or fiscal stimulus. For example, high tax-rate companies have given back all of their post-election equity gains. Even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. "Dynamic scoring" will be used to support the argument that the tax cuts will self-funding through faster growth. We also expect that Trump will get his way on at least a modest amount of infrastructure spending. The so-called Trump trades may wither again in 2018, but we see a window this year in which the stock-to-bond total return ratio lifts as growth expectations rebound. Looking further ahead, it seems likely that the U.S. budget deficit is headed significantly higher. Health care and pension cost pressures related to population aging are well known (Chart I-3). A recent Special Report by BCA's Martin Barnes highlighted that "it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlement programs and preventing a massive rise in the budget deficit."1 There is simply not enough non-defense discretionary spending to cut. Larger U.S. Federal budget deficits could lead to a widening fiscal risk premium in Treasury yields, although that may take years to show up. Perhaps more importantly, the U.S. government sector will be a larger drain on the global pool of available savings in the coming years. We highlight in this month's Special Report, beginning on page 20, that there are several key macro inflection points under way that will temper the "global savings glut" and begin to place upward pressure on global bond yields. A Temporary Soft Patch Or Something Worse? The first quarter GDP report for the U.S. is due out as we go to press, and growth is widely expected to be quite weak. The retail sales and PCE consumer spending data have fed concerns that the U.S. economy is running out of gas, despite the surge in the survey data such as the ISM. We believe that growth fears are overdone. Financial markets should be accustomed to weak readings on first quarter GDP. Over the past 22 years, the first quarter has been the weakest of the four on 12 occasions, or 55% of the time. Second quarter GDP growth has been faster than Q1 growth 70% of the time. A large part of the depressed Q1 GDP growth rate and lackluster "hard data" readings likely reflect poor seasonal adjustment and weather distortions. The "soft" survey data are more consistent with the labor market. Aggregate hours worked managed to increase by 1.5% at an annualized rate in Q1. If GDP growth really was barely above zero, this would imply an outright decline in the level of labor productivity. Even in a world where structural productivity growth is lower than it was in the past, this strikes us as rather implausible. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have pulled back from their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in the weather-impacted "hard" data in May and June. What about the slowdown in commercial and industrial loan growth and corporate bond issuance late in 2016 and into early 2017? This is a worry, but it partly reflects the lagged effects of the contraction in capital spending in the energy patch. C&I loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that the defaults have waned, this process will soon go into reverse. Higher profits more recently have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 bn in issuance in Q1, the highest level on record (Chart I-4). The rest we chalk up to uncertainty surrounding the U.S. election. The recent spikes in the political uncertainty index correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November. There has been a close correlation between these spikes and the deceleration in C&I loan growth. CEOs are also holding back on capex in anticipation of new tax breaks from Congress. The good news is that bond issuance has rebounded strongly in January and February of this year (Chart I-5). The soft March U.S. CPI release also appeared to be quirky, showing a rare decline in the core price level in March (Chart I-6). However, the March reading followed two months of extremely strong gains and it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart I-4U.S. Bank Credit Slowdown Is Temporary U.S. Bank Credit Slowdown Is Temporary U.S. Bank Credit Slowdown Is Temporary Chart I-5U.S. Corporate Bond Issuance Is Rebounding U.S. Corporate Bond Issuance Is Rebounding U.S. Corporate Bond Issuance Is Rebounding Chart I-6U.S. Inflation: Sogginess Won't Last U.S. Inflation: Sogginess Won't Last U.S. Inflation: Sogginess Won't Last Global Economic Data Still Upbeat For the major industrialized economies as a group, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4½% in February on a year-over-year basis (Chart I-7). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession that was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart I-8). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the six months to March (Chart I-9). Chart I-7Global Pick-Up On Track Global Pick-Up On Track Global Pick-Up On Track Chart I-8Manufacturing Rebound Is Not About Energy Manufacturing Rebound Is Not About Energy Manufacturing Rebound Is Not About Energy Chart I-9U.S.: Non-Energy Production Surging U.S.: Non-Energy Production Surging U.S.: Non-Energy Production Surging The weak spot on the global data front has been capital goods orders (Chart I-7). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart I-7, third panel). Improving CEO sentiment, accelerating profit growth and activity surveys all suggest that capital goods orders will catch up in the coming months. That said, one risk to our positive capex outlook in the U.S. is that the Republicans fail to deliver on their promises. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital spending. As for China, the economic data are holding up well and deflationary pressures have eased. Fears of a debt crisis have also ebbed somewhat. That said, fiscal and monetary stimulus is fading and it is a worrying sign that money and credit growth have decelerated because they tend to lead production. Our China experts believe that growth will be solid in the first half of the year, but they would not be surprised to see a deceleration in real GDP growth in the second half that would weigh on commodity prices. Bond Market Vulnerable To Fed Re-Rating A rebound in the U.S. activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A May rate hike is unlikely, but we would not rule out June. The bond market is vulnerable to a re-rating of the path for the fed funds rate because only 45 basis points of tightening is priced for the next 12 months. This is far too low if growth rebounds as we expect. The FOMC also announced that it intends to start shrinking its balance sheet later this year by ceasing to reinvest both its MBS and Treasury holdings. Our bond strategists do not think this by itself will have much of an impact on Treasurys because yields will continue to be closely tied to realized inflation and the expected number of rate hikes during the next 12 months (Chart I-10). Fed policymakers are trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. It is a different story for mortgage-backed securities, however, where spreads will be pressured wider by the lack of Fed purchases. All four of our main forward-looking global economic indicators appear to have topped out, except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past (Chart I-11). Nonetheless, all four are still consistent with robust growth. They would have to weaken significantly before they warned of a sustained bond bull market. Chart I-10Shrinking Fed Balance Sheet: ##br##Bearish For Bonds? Shrinking Fed Balance Sheet: Bearish For Bonds? Shrinking Fed Balance Sheet: Bearish For Bonds? Chart I-11Leading Indicators: ##br##Some Worrying Signs Leading Indicators: Some Worrying Signs Leading Indicators: Some Worrying Signs The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is the most concerning at the moment. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The bottom line is that global bond yields have overshot on the downside: underlying U.S. growth is not as weak as the Q1 figures suggest; market expectations for the fed funds rate are too benign; the Republicans will push ahead with tax cuts and infrastructure spending; the global economy has healthy momentum, and the majority of the items on our Duration Checklist suggest that the bond bear market will resume; the ECB will announce another tapering of its asset purchase program this autumn, placing upward pressure on the term premium in bond yields across the major markets; and the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. We recommend keeping duration short of benchmarks within fixed-income portfolios. One Last Leg In The Dollar Bull Market Chart I-12ECB In No Hurry To Lift Rates ECB In No Hurry To Lift Rates ECB In No Hurry To Lift Rates While we see upside for the money market curve in the U.S., the same cannot be said in the Eurozone. The economic data have undoubtedly been robust. The composite PMI is booming and capital goods orders are in a clear uptrend. Led by gains in both manufacturing and services, the composite PMI rose from 56.4 in March to 56.7 in April, a six-year high. The current PMI reading is easily consistent with over 2.0% real GDP growth (Chart I-12). This compares favorably to the sub-1% estimates of trend growth in the euro area. Private sector credit growth reached 2½% earlier this year, the fastest pace since July 2009. Despite this good news, the ECB is in no rush to lift interest rates. The central bank will taper its asset purchase program further in 2018, but ECB President Draghi has made it clear that he will not raise the refi rate until well after all asset purchases have been completed, which probably will not be until late 2019 at the earliest (although the ECB could eliminate the negative deposit rate to ease the pressure on banks). Unemployment is still a problem in Spain and Italy, while core CPI inflation fell back to just 0.7% in March. The euro could strengthen further in the near term if Macron wins the second round of the French elections, easing euro break-up fears. Nonetheless, we expect the euro to trend lower on a medium-term horizon versus the dollar as rate expectations move further in favor of the greenback. Some real rate divergence is already priced into money and currency markets, but there is room for forward real spreads to widen further, possibly pushing the euro to parity versus the dollar before this cycle is over. We are also bullish the dollar versus the yen for similar reasons. On a broad trade-weighted basis, we still expect the dollar to rally by another 10%. Positive Signs For U.S. Corporate Pricing Power Chart I-13U.S. Corporations Gaining Pricing Power U.S. Corporations Gaining Pricing Power U.S. Corporations Gaining Pricing Power Turning to the equity market, it is still early days for Q1 U.S. earnings, but the results so far are positive for a pro-risk asset allocation. After a disappointing Q4, positive Q1 earnings surprises for the S&P 500 are on track to match their highest level in two years, with revenue surprises also materially higher than previous quarters. At the industry level, banks and capital goods companies stand out: the former registered an earnings beat of nearly 8%, and it was nearly 12% for the latter. We highlighted the positive 2017 outlook for U.S. corporate profits in our March 2017 Monthly Report. Earnings growth is in a catch-up phase following last year's profit recession, which was related to energy prices and a temporary slowdown in nominal GDP growth relative to aggregate labor costs. Proprietary indicators from our sister publication, the U.S. Equity Sectors Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart I-13). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly-based across industries (as shown by the diffusion index in the chart). As a side note, the Profit Proxy provides some evidence that recent softness in core CPI inflation will not last. Second, the upward march of wage growth appears to be taking a breather (Chart I-13). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching perpetually-optimistic bottom-up estimates for 2017 (Chart I-14). Many companies have supported per share profits in this expansion via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart I-15 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same is true for GDP. Chart I-14U.S. Profit Model Is Very Upbeat U.S. Profit Model Is Very Upbeat U.S. Profit Model Is Very Upbeat Chart I-15U.S. Corporate Finance Cycle Comparison May 2017 May 2017 Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity issuance since 2009, which includes the impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions (positive values shown in Chart I-15 represent net equity withdrawals). CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Nonetheless, buybacks have boosted EPS growth by almost 2% over the past year according to our proxy (Chart I-16). We expect this tailwind to continue given the positive reading from our Capital Structure Preference Indicator (third panel). Firms have a financial incentive to issue debt and buy back shares when the indicator is above zero. Stronger global growth should continue to power an acceleration in corporate earnings outside the U.S. over the remainder of the year. Chart I-17 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Our profit indicators remain constructive for the U.S., Eurozone and Japan. Chart I-16Incentive To Buy Back ##br##Stock Remains Strong Incentive To Buy Back Stock Remains Strong Incentive To Buy Back Stock Remains Strong Chart I-17Global Profit ##br##Growth On The Upswing Global Profit Growth On The Upswing Global Profit Growth On The Upswing It is disconcerting that the rally in oil prices has faltered in recent days as investors worry that increased U.S. shale production will thwart OPEC's plans to trim bloated inventories. A breakdown in oil prices could spark a major correction in the broader equity market. Indeed, commercial oil inventories finished the first quarter with a minimal draw. The aim of last year's agreement between OPEC and Russia to remove some 1.8mn b/d of oil production from the market in 2017 H1 was to get visible inventories down to five-year average levels. They are well short of that goal. Without trimming stockpiles to more normal levels, storage capacity remains too close to topping out, which raises the risk of another price collapse. This is an extremely high-risk scenario for states like Saudi Arabia, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. This is the reason why our commodity strategists expect the OPEC/Russia production cuts to be extended when OPEC meets on May 25. This will significantly raise the odds that OECD commercial oil stocks will be drawn down to more normal levels. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. Investment Conclusions Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. Admittedly, some of the U.S. data have been disappointing given the extremely upbeat survey numbers. There are also some worrying signs in our global forward-looking growth indicators, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. economic data in the first quarter. They also went too far in pricing out U.S. fiscal action. As for European political risk, centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. There are legitimate reasons to be concerned about the economic and profit outlook in 2018. Nonetheless, we believe that the window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals are constructive. The passage of market-friendly fiscal policies in the U.S. later in 2017 will be icing on the cake. Perhaps more importantly, we are finally seeing signs that pricing power in the U.S. corporate sector is improving, allowing margins to expand somewhat in the coming quarters. Our profit models remain upbeat for the major advanced economies and for China. It has been frustrating for those investors looking for an equity buying opportunity. Despite the surge in defensive assets such as gold and Treasurys, the major equity bourses did not correct by much. Value remains stretched in all of the risk asset classes. Nonetheless, investors should stay positioned for another upleg in the stock-to-bond total return ratio in the coming months. Perhaps the largest risk lies in the bond market. The rally has depressed yields to a level that makes bonds highly vulnerable to a reversal of the factors that sparked the rally. Within an underweight allocation to fixed-income in balanced portfolios, investors should overweight investment- and speculative-grade corporate bonds in the U.S. and U.K. We are more cautious on Eurozone corporates as the ECB's support for that sector will moderate. Looking ahead to next year, our bond strategists foresee a shift to underweight credit given the advanced nature of the releveraging cycle in the U.S. corporate sector. Our other recommendations include: 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. in currency-hedged terms. Continue to favor defensive over cyclical equity sectors in the U.S. for now, but a shift may be required later this year. Overweight the dollar versus the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market. Recent underperformance is a buying opportunity. Value has improved and cyclical conditions favor small caps. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst April 27, 2017 Next Report: May 25, 2017 1 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies and Fantasies," dated April 5, 207, available at bca.bcaresearch.com II. Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria May 2017 May 2017 The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The Saving ##br##And Investment Curves May 2017 May 2017 The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex May 2017 May 2017 (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped Chart II-6Hollowing Out Hollowing Out Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock Macro Impact Of Labor Supply Shock Macro Impact Of Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China Working-Age Population To Shrink in G7 and China Working-Age Population To Shrink in G7 and China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Globalization Peaking? Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort Income And Consumption By Age Cohort Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements May 2017 May 2017 Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers May 2017 May 2017 No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 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 modest correction in April did not improve equity valuation by much in any of the major markets. Our U.S. valuation metric is still hovering just below the +1 sigma mark, above which would signal extreme overvaluation. Measures such as the Shiller P/E ratio are flashing red on valuation, but our indicator takes into consideration 11 different valuation measures. Technically, the U.S. equity market still has upward momentum, while our Monetary indicator is neutral for stocks. The Speculation index indicates some froth, although our Composite Sentiment indicator has cooled off, suggesting that fewer investors are bullish. The U.S. net revisions ratio is hovering near zero, but it is bullish that the earnings surprise index jumped over the past month. First-quarter earnings season in the U.S. has got off to a good start, while the global earnings revisions ratio has moved into positive territory for the first time in six years (see the Overview section). 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 power' 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. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. April's rally in the U.S. bond market dragged valuation close to neutral. However, we believe that the market is underestimating the amount of Fed rate hikes that are likely over the next year. Now that oversold technical conditions have been absorbed, this opens the door the next upleg in yields. Bonds typically move into 'inexpensive' territory before the monetary cycle is over. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, the dollar has shifted down this year to meet support at the 200-day moving average and overbought conditions have largely, but not totally, been worked off. We still believe there is more upside for the dollar, despite lofty valuation readings, due to macro divergences. 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-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro 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

Highlights Markets will survive late spring and summer unscathed; Macron will win the French election; Trump's agenda is not going down in flames; U.K. snap polls support our sanguine view on Brexit; Fade the rally in Treasuries and bet against unwinding of Trump reflation; Stay tactically long EUR/USD, long the pound, and long French industrials vs. German. Feature One of the oldest adages of Wall Street is to "sell in May and go away." Data reinforce the conventional wisdom, with a strategy of staying on the sidelines during the summer months clearly outperforming the alternative of staying long every month (Chart 1). Chart 1Sell In May And Go Away Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Should investors adopt the same approach in 2017? Certainly the risks are skewed to the downside due to investor complacency and a busy political schedule: Complacency: Investor complacency has been spectacularly elevated ahead of Q2 this year. Our colleague Anastasios Avgeriou of BCA's Global Alpha Sector Strategy, who has been flagging warning signs since early February, lists four measures of complacency that peaked in April (Chart 2).1 The SKEW index, controlled for by the VIX, rose above 12 early in April, warning that at least a tactical pullback is at hand. The Yale U.S. one year institutional confidence index hit an all-time high of 98.68% in February. Similarly, the Minneapolis Fed's market-based probability of a 20%+ correction in the S&P 500 dropped to below 10%, a level last seen during the peak of the previous bull market in 2007 (bottom panel).2 Political Schedule: April and May have an unusually high number of high-profile deadlines, meetings, and elections packed into a tight space: April 26: U.S. President Donald Trump is expected to announce key details of his long-awaited tax reform plan; April 28: The U.S. government's stopgap funding measure, the continuing resolution, will expire - leading to a government shutdown if no replacement is passed; April 29: The EU Council will hold its "Brexit Summit" to either approve, amend, or reject Council President Donald Tusk's proposed negotiation guidelines;3 May 7: The second round of the French presidential election will be held; May 9: An extraordinary presidential election will take place in South Korea; Mid-May: U.S. President Donald Trump will present his full budget proposal, including tax plans, spending cuts, and growth projections; May 19: Iran holds its presidential election; May 25: The OPEC meeting in Vienna will determine whether to extend the current production-cut agreement. In this Weekly Report, we focus on the three most immediate risks to the markets: the second-round of French presidential election, U.S. domestic politics, and the upcoming election in the U.K. We will also address downside risk to oil prices in an upcoming joint report, to publish tomorrow, with BCA's Commodity & Energy Strategy. Our conclusion is that while risks are indeed skewed to the downside by the mere combination of investor complacency and volume of potential tail-risks, the market will likely emerge from the summer doldrums unscathed. As such, any market downturns are an opportunity to buy on dips. As we recently warned, however, the real risks will emerge in 2018.4 France: Fin? Centrist Emmanuel Macron has won the first round of the French presidential election with a narrow victory over nationalist Marine Le Pen (Table 1). As expected, the two will now contest the second round on May 7. France will subsequently hold a two-round legislative election on June 11 and 18. Chart 2Complacency At A Peak Complacency At A Peak Complacency At A Peak Table 1France: First-Round Election Results Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Investors learned three things from the first round of the French presidential election: Polls are right: Repeat after us: polls are not wrong, pundits are.5 Neither the Brexit referendum nor the U.S. presidential election came as a huge surprise to those who read polls objectively. In both cases, the outcome was inside the margin of error. Hopefully, the first round of the French presidential election will set aside the notion that all polls are useless and therefore investors are better off interpreting chicken entrails for election forecasting. In fact, polls in France have not significantly underestimated Marine Le Pen's nationalist party - Front National - since the 2002 election (Chart 3). Le Pen has no momentum: Le Pen consistently polled in the high 20s throughout late 2016 and 2017, but ended with only 21.43% of the vote on April 23 (Chart 4). In fact, she only narrowly improved on her 2012 performance of 17.9%, which is astounding considering everything that has happened in France since then (terrorist attacks in particular). Macron has meanwhile nearly doubled his polling from late 2016. French voters are angry: Protest and anti-establishment candidates came away with 49.62% of the vote (Chart 5). Chart 3FN Rarely Outperforms Its Polling Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Chart 4Le Pen's Momentum Is Gone Le Pen's Momentum Is Gone Le Pen's Momentum Is Gone Chart 5French Voters Are Angry... French Voters Are Angry... French Voters Are Angry... What to make of these three lessons? First, if lessons A and B are correct, then Le Pen is toast on May 7 (Chart 6).6 According to a poll conducted from April 17 to 21, Le Pen will struggle to get any voters from Mélenchon and Socialist candidate Benoît Hamon (Chart 7). This should not be surprising to anyone who knows France and its history: the left and the right just do not get along. We construct a "Le Pen best case scenario" out of the data by giving her all the voters who said they would abstain in the second round. Let's say that they were lying and are secret Le Pen supporters. She still loses (Chart 8)! Chart 6...But Not That Angry ...But Not That Angry ...But Not That Angry Chart 7Most Voters Will Swing To Macron Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Chart 8The No-Shows Can't Win It For Le Pen Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! But surely a major terrorist attack could turn it around for Le Pen, right? Wrong. Macron is not pro-terrorist. Why would the French turn to a Russian-financed nationalist with no clear plan on how to prevent terrorism or stop refugee flows into Europe other than to close French borders?7 (And that description is not fake news!)8 They wouldn't. And there is empirical evidence to prove that French voters see through Le Pen's empty rhetoric. We highly recommend our clients read our February report titled "The French Revolution" where we conducted a careful study of the 2015 December regional elections.9 These elections occurred only 23 days following the November 2015 terrorist attacks in Paris and at the height of that year's migration crisis. It was as if the fates conspired with Le Pen's Front National (FN) to create a perfect storm. And yet the election was a crushing loss for the nationalists who came away with nothing in the second round. Chart 9French Public Supports The EU And Euro French Public Supports The EU And Euro French Public Supports The EU And Euro But hold on a minute. Are the French really about to elect a former investment banker for president even though 50% of them are "angry," as suggested by our lesson C? Well, yes. The "anger" is complicated. Mélenchon received a lot of the disgruntled Socialist Party voters who jumped the Hamon ship after it sunk during the latter's woefully uninspiring debate performances. These are not hard-core Euroskeptic voters. In fact, both Mélenchon and Le Pen moderated their Euroskepticism in the run up to this election to broaden their base of support. Le Pen promised that she would abide by the results of a referendum on the EU even if it went against her will, as polls currently suggest it would (Chart 9). And Mélenchon suggested that exiting the EU would only be his "Plan B," in case his plan to renegotiate the Treaty of the EU failed. What should investors expect of a Macron presidency? While the "French Thatcherite" François Fillon may have been more welcome to the markets than Macron, we think that a combination of President Macron and right-leaning National Assembly could accomplish some reforms. Polling for the legislative elections in June is scarce, but Le Pen's party is highly unlikely to outperform Le Pen herself. Judging by the December 2015 regional elections and Fillon's pre-scandal polling, the center-right Les Républicains are likely to win at least a plurality of seats in the legislative elections. Several prominent center right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister.10 This is highly positive for the markets as it means that French economic policy will be run by the center right, with an ultra-Europhile as president. Bottom Line: Nothing is over until it is over. Le Pen obviously still has a chance to win given that she is one of the two people running in the French election. However, given current polling, Macron is highly likely to become the next president of France. Hold tactical long EUR/USD and strategic long French industrial equities / short German industrial equities. But start thinking about closing long euro positions. The U.S.: From Math To Magic There are three reasons for global investors to worry about U.S. politics at the moment: Government shutdown: The U.S. government will face a shutdown on April 28 if the continuing resolution (CR) is not extended (via another CR) or if an omnibus funding bill is not passed. The risk for investors is that Senate Democrats could filibuster an omnibus bill that contains a conservative "poison pill" such as funding the wall on the border with Mexico or defunding Planned Parenthood. This would result in a partial government shutdown. Our view is that there is no time to find a long-term solution and the Republicans will have to extend current spending levels via short-term CRs, possibly until the end of the fiscal year on October 1. Given that the government has already been funded for half of the current fiscal year via short-term CRs, it may be the only way that Republicans can avoid a showdown with Democrats in the Senate. Obamacare repeal and replacement: The Senate and the House passed a budget resolution on January 13 that included "reconciliation instructions" allowing for the repeal of Obamacare in an eventual reconciliation bill.11 The reconciliation procedure allows measures that impact government spending and revenue - budgetary matters - to pass through Congress with a simple majority, i.e. without the need for 60 votes to defeat a filibuster in the Senate.12 These instructions are believed to "expire" at the end of May or thereabouts, giving Republicans one more month to replace Obamacare without causing greater traffic jams down the road.13 There are two hurdles to this process. First, the Tea Party-linked "Freedom Caucus" opposed the original Obamacare proposal and needs to be placated with provisions that may put off centrist Republicans in the Senate. Second, both the original Paul Ryan plan and the soon-to-be-revealed alternative are likely to be challenged by the Democrats under the reconciliation rules.14 Trump at first appeared willing to walk away from repealing Obamacare - which seemed to make sense given that the bill he endorsed imposes a roughly $700 billion burden on U.S. households (Chart 10). However, he has since decided that he needs the bill's roughly $320 billion in savings over ten years in order to pay for the "hyuge" tax cuts he has promised.15 Tax reform: Also coming into focus in April and May is tax reform. The White House is set to release key tax-reform details as we go to publication. Further, Trump has to deliver his full FY2018 budget in mid-May. Unlike the budget Trump released in mid-March, the May edition will include the tax proposals, measures on "mandatory" or entitlement spending, and growth projections. Concurrently, Congress has to start working on its budget resolution for FY2018, which, as mentioned, will enable using reconciliation to pass the tax bill with a mere 51 votes in the Senate. Again, the Freedom Caucus is a potential hurdle. Investors fear they will demand that any tax bill be strictly revenue neutral and thus foul up the legislative process. Chart 10Obamacare Repeal Hits Households Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Confused yet? You are not alone! We have noticed from client meetings and the financial media a growing obsession with details of upcoming reforms and the arcane congressional rules that will govern the legislative process. This is a mistake. Investors should step back and focus on the big picture: Trump is an economic populist who wants to see a higher rate of nominal GDP growth; Republicans are a party that favors tax cuts; Legislative rules are meant to be broken. As such, the key question is whether President Trump can bend the will of the Freedom Caucus, which plays the role of the antagonist in his efforts to clear all three hurdles listed above. We have no reason to believe that he cannot. In fact, all signs are pointing to the Freedom Caucus playing ball with the White House: Rhetoric has changed: Mark Meadows (R- North Carolina), Chairman of the Freedom Caucus, has confirmed that he is not demanding revenue-neutral tax reform plan and that he is open to a compromise on Obamacare. The Freedom Caucus is reportedly getting closer to accepting a health-care bill that passes the deadly issues to the states, allowing state legislatures to make their own decision on whether to remove the most popular regulatory requirements of Obamacare. Politically, this is a brilliant move. It allows both the Tea Party and moderate Republicans to declare victory by claiming that they upheld "state rights" - a core conservative principle - while giving conservative governors and state legislatures the option of eroding Obamacare at a state level. Moderates in the Senate, the theory goes, will not have to shoot down the new health bill for fear of a popular backlash since they presumably reside in states that will opt to keep the Obamacare measures in question (essential health benefits, community ratings, etc). The bill is by no means guaranteed to pass, but the point is that the Freedom Caucus has changed its tune after having been blamed for failing to repeal Obamacare, when repeal was one of the main reasons they were elected in the first place. Trump retains political capital: President Trump's polling with Republican voters has improved since the strike against Syria (Chart 11). He retains political capital with GOP voters and is therefore still a threat to the Freedom Caucus if he should campaign against them in the 2018 midterm primaries. The electoral threat is real: The Tea Party-favored candidate in Georgia's special election on June 20, Bob Gray, came in third place with just over 10% of the vote.16 Notably, a Trump-linked super PAC fielded campaign ads against Gray, helping propel the moderate candidate - Karen Handel - to the run-off against the Democratic challenger. While the media has obsessed about the surprise performance by Jon Ossoff, the first Democrat to make the district competitive since 1978, we are certain that House Freedom Caucus members have taken notice of Gray's fate. The message from the White House is clear: don't mess with Donald Trump. Trump will use carrots as well as sticks with the Freedom Caucus. To that end, we wish to remind our clients of "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 loss of tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, consequences that actually add to revenues. In other words, "tax cuts pay for themselves." Republican legislators have been using dynamic scoring to justify deficit-busting tax cuts for decades. And there is some truth to their claim that tax cuts generate revenue. For instance, while it is true that President Bush's White house vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 12). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 13). And we are being conservative in those numbers. Chart 11Trump In Line With##br## GOP Predecessors Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Chart 12Bush Was Right,##br## CBO Was Wrong! Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Chart 13Dynamic Scoring Will Offset About 10% ##br##Of Revenues Lost To Tax Cuts Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Treasury Secretary Steven Mnuchin was anything but conservative when he explicitly told investors to expect a tax reform plan paid for largely by dynamic scoring. Speaking on the sidelines of the IMF and World Bank spring meetings in Washington, Mnuchin said, Some of the lowering in (tax) rates is going to be offset by less deductions and simpler taxes, but the majority of it will be made up by what we believe is fundamentally growth and dynamic scoring. We have been arguing since November that investors should expect tax cuts that rely on dynamic scoring to justify their deficit-busting effects.17 Mnuchin's comments, after several hints from other legislators, confirm that this is indeed the plan. For the Freedom Caucus, dynamic scoring provides a defense against the accusation that their tax cuts increase the budget deficit. That said, data clearly shows that voters care less about deficits - their concerns have subsided with the deficits themselves (Chart 14).18 It remains to be seen whether Trump's team expects for dynamic scoring to do all the heavy lifting in justifying tax cuts or whether real tax reforms are still on the agenda. Even assuming Trump rejects the House GOP's border adjustment tax (which is apparently hanging onto life by a thread), he can offset revenue losses by repatriating companies' foreign earnings, moderating tax cuts for high-income earners, and closing loopholes. These offsets would add to whatever he saves from repealing Obamacare and cutting regulations.19 Chart 14Americans Not So Worried About Deficits Now Americans Not So Worried About Deficits Now Americans Not So Worried About Deficits Now Chart 15Trump Lags Average Predecessor Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Ultimately, Republicans of all stripes know that if they fail to produce some legislative "wins" then they will be left with nothing to campaign on in the midterm elections except for their affiliation with President Trump's very poor nationwide approval rating (Chart 15). The current polling foreshadows a 36-seat slaughter in the upcoming midterm elections for the Republicans in the House (Chart 16). This would give Democrats a majority. Several clients have asked us if this makes tax reform less likely. We do not think so. It simply means that Republicans have 18 months to pass their most treasured policies - and much less time if they want the economic growth spurt to help them get reelected. They may not have an opportunity like this for decades. Bottom Line: Investors should step back and focus on the big picture: Trump remains popular with GOP voters, the Freedom Caucus understands this threat, and - to quote Pink Floyd - magic makes the world go round. Investors should fade the rally in Treasurys, as our colleague Peter Berezin of BCA's Global Investment Strategy recently recommended. We are sticking with our "Trump reflation" 2-year/30-year Treasury curve steepener and initiating a recommendation that clients go short the January 2018 fed funds futures contract (Chart 17).20 Chart 16Republicans Heading For Huge Defeat In 2018 Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Chart 17Short Jan '18 Fed Funds Futures Short Jan '18 Fed Funds Futures Short Jan '18 Fed Funds Futures Brexit: Early Elections Reinforce Our GBP Call British Prime Minister Theresa May's decision to hold early elections vindicates our view that the political risks of Brexit peaked - and GBP bottomed - in mid-January when May declared that her country would leave the EU's common market (Chart 18).21 At that time, May frontloaded the worst expectations of negotiations while simultaneously removing the most contentious issue: common market access. With the U.K. decisively "out," i.e. not trying to take the EU's market while rejecting its people, the EU had less of a reason to make an example of the U.K. to other countries whose Euroskeptics might think they could pick and choose what they want from the bloc. Now May and the Tories are on track for a big electoral win that will not only confirm her government's strategy but also give her more maneuverability to handle the negotiations: May's Personal Mandate: May is a "takeover" prime minister - she emerged as leader in the party reshuffle after her predecessor David Cameron's resignation following the "Leave" outcome of the referendum. Takeover prime ministers are historically weaker than "elected" prime ministers and do not last as long in office - on average they rule for 3.3 years, as opposed to six for their elected peers (Chart 19). In other words, May's position was tenuous. This was especially likely to be the case as the country entered the rocky period of formal exit in 2019 and general elections in 2020. Her struggles in turn could have threatened the Brexit deal or her party's control. At the same time, May has received a bigger "bounce" in popular opinion after assuming office than other takeover prime ministers have done (Chart 20), partly as a result of the rally-around-the-flag effect after the referendum shock. Thus, it was eminently sensible to seek public approval of her leadership at this time. Chart 18GBP Bottomed When U.K. ##br##Forswore Common Market GBP Bottomed When U.K. Forswore Common Market GBP Bottomed When U.K. Forswore Common Market Chart 19Theresa May Faced##br## A Short Tenure Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Chart 20May Received ##br##A Brexit Boost Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! A Thin Majority: The Conservative Party has also rallied post-referendum, especially in contrast with the divided Labour Party, under Jeremy Corbyn, that will hit its lowest point since 1918 if it performs according to current polling (Chart 21). Yet the government has a thin majority in parliament of only 17 seats, among the thinnest majorities in recent decades (Chart 22). This is a liability heading into the parliamentary vote on the final exit deal with the EU in 2019, raising the menace of a "Brexit cliff" in which the U.K.'s two-year negotiating period could expire without any EU deal at all. That would be an unmitigated disaster. With a greater majority, May will be able to cow the other parties further and whip her own party's backbenchers into shape. There was also a festering scandal about the Conservative Party's 2015 fundraising that could trigger a number of by-elections jeopardizing the thin majority.22 2022 is better than 2020: The Tories also faced the prospect of running for re-election in 2020, one year after Brexit actually occurs. By that time negative economic effects (not to mention any cyclical downturn) are more likely to be felt by the public than today. The Tories would also have to face the public immediately after any embarrassing compromises in the EU negotiations. Although Labour is currently in free fall - as illustrated by the astounding loss to the Tories in the by-election in Copeland in February23 - the next two years provide opportunities for revival. The negotiations may be messy, the economy will suffer as reality sets in,24 and the union itself may come under threat from a second Scottish referendum.25 Hence the new election timeline will suit the Tories better than the old, giving them till 2022 to cement Brexit itself and address some of the effects of the aftermath before facing voters. Chart 21Labour In The Doldrums Labour In The Doldrums Labour In The Doldrums Chart 22Tories Want A Bigger Majority To Manage Brexit Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! Few doubt that May's timing is impeccable. There can be backlash from election opportunism and voter fatigue, but May's popular approval and the national atmosphere do not suggest it will be significant. Pollsters project from current opinion polls that she will secure a 100-seat majority or greater, and since 1997 party-preference polling has become more, not less, predictive of parliamentary seats after elections. Moreover our extremely conservative estimate based exclusively on opportunities that the Tories have to snatch seats from rivals at odds with the Brexit referendum suggests that they cannot do worse than to add 11 seats to their majority (Table 2). Table 2Minimal Scenario Gives Tories 11 New Seats For Their Majority Buy In May And Enjoy Your Day! Buy In May And Enjoy Your Day! In turn, a bigger majority more securely linked to Theresa May's leadership will bring greater maneuverability in the EU talks and assurance that she can get her final deal through parliament - even if it is an ugly one. How do the elections affect the EU? Contrary to the posturing on both sides, the early election will send a further electoral confirmation to the EU that the U.K. is dead-set on leaving and that the EU cannot deliberately negotiate a bad deal in hopes that the U.K. will change its mind. It could hardly hope to overturn domestic politics and elicit a reversal on Brexit after a third national electoral outcome in favor of leaving the union. Yet the EU saw the writing on the wall already. EU Council President Tusk's negotiating guidelines are not vindictive.26 The EU is opening the possibility of a multi-year transition period after the formal 2019 exit date and acknowledging the need under Article 50 of the Lisbon Treaty to take account of the future relationship, i.e. to provide a framework for a trade deal. The City of London stands to lose the most, but the guidelines are so far fairly tame outside of the financial sector. Moreover, we do not expect a harder line to emerge from the EU Council meeting on April 29. Already the Dutch, Irish, and Danish have called for negotiations on a trade agreement to begin promptly, essentially agreeing with Britain's urgent timeline.27 True, the probability that Macron will be the next French president - along with a likely shift toward a more outspoken Europhile stance in Germany after elections in September - presents the prospect of a "clash" with May's triumphant Tories. Macron has called for a "strict approach" to negotiations, has threatened to model his pro-market reforms in France in such a way as to steal "banks, talents, researchers, academics" from the U.K., and has suggested that the U.K. can at best hope for a deal comparable to Canada's Free Trade Agreement with the EU. That would set a low bar for the U.K.'s all-important services exports (Chart 23). However, Macron is an establishment player who will not significantly change France's position in the negotiations from what it would have been otherwise. (A Le Pen presidency obviously would mark a change by throwing the EU into chaos, but it is highly unlikely.) France is going to demand with the rest of the EU that the U.K. pay its dues (namely a 60 billion-euro budget contribution), but it is not in the interest of France or the EU to impose, effectively, a British recession - not while they seek to cultivate their own economic recoveries. Moreover, wreaking vengeance would not necessarily discourage Euroskeptics on the continent. With Le Pen mortally wounded, the significant Euroskeptic threat lies in Italy, where an imperious approach to Brexit from Germany and France may not be well received (Chart 24). Chart 23Services Are Key For The U.K. Services Are Key For The U.K. Services Are Key For The U.K. Chart 24Punishing The U.K. May Not Dissuade Italy Punishing The U.K. May Not Dissuade Italy Punishing The U.K. May Not Dissuade Italy Bottom Line: May's early election helps remove additional political risk by giving her party more maneuverability in negotiations and a greater ability to "make do" with what the Europeans give. Though this is highly unlikely to lead to a "soft Brexit" (common market access, customs union membership, subordination to the European Court of Justice), it is much more likely to prevent Britain from sailing off into a "no deal" abyss. To be clear, we can still see scenarios in which a reversal of Brexit is possible, as discussed previously,28 but they are very low probability. The snap election enables May's government to be flexible in the negotiations and accept some difficult truths in the final deal, which will reinforce the existing tendency of the EU to avoid causing a destabilizing "punitive" break. Both sides of the Channel are positioning for a relatively market-friendly outcome. We maintain our view that the pound has bottomed. Our short USD/GBP recommendation is up 2.85% since March 29 and short EUR/GBP is up 0.14% since January 25. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Alpha Sector Strategy Weekly Report, "Eerie Calm," dated February 10, 2017, available at gss.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Caveat Emptor," dated March 24, 2017, 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 Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 6 French toast in fact... we'll be here all night folks! 7 The reason this plan does not make sense is because most perpetrators of terrorist attacks in France have been French or European citizens. Le Pen's plan amounts to closing the barn door after the horse has bolted. 8 Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at bloomberg.com. 9 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 10 Former conservative prime ministers Jean-Pierre Raffarin and Alain Juppé, as well as other prominent members of Les Républicains have already announced that they would support Macron in the second round. 11 Please see "S. Con. Res. 3 - A concurrent resolution setting forth the congressional budget for the United States Government for fiscal year 2017," United States Congress, available at www.congress.gov. 12 For a great summary of the arcane procedure, please see "Introduction to Budget 'Reconciliation,'" dated November 9, 2016, available at cbpp.org. 13 If Republicans choose to delay beyond May, they will have to delay producing the fiscal year 2018 budget resolution. This is possible but introduces problems for next year's budget appropriations and the tax reform measures which will depend on the yet-to-be-written FY2018 budget resolution's reconciliation instructions. "The reconciliation legislation that the GOP is using to partially repeal and replace the ACA has a half-life. It will expire when Congress begins drafting the fiscal 2018 budget blueprint, which will likely be sometime in May. So if Republicans want to resurrect the AHCA and avoid the need for bipartisan votes in the Senate, they will have to vote on the bill within the next several weeks." Please see Baker and Hostetler LLP, "GOP Struggles To Revive Health Bill," Lexology, April 7, 2017, available at www.lexology.com. 14 In short, reconciliation can only be used to pass bills that impact spending and revenue. As such, any changes to Obamacare that do not impact fiscal matters could be found inadmissible by the Senate parliamentarian and thus could defeat the entire bill. There is of course always the "nuclear option" of simply ignoring the ruling of the Senate parliamentarian, but it is not clear whether the Senate GOP would want to go "Kim Jong-Un" twice in the same year! 15 Please see Congressional Budget Office, "American Health Care Act," March 13, 2017, available at www.cbo.gov. 16 Georgia's sixth congressional district is holding this special election to fill the seat left vacant by Tom Price, the new Secretary of Health and Human Services, as appointed by Trump. 17 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 18 Wouldn't dynamic scoring fail to pass the "smell test" with the CBO? Yes, it would. The CBO will likely ignore Republican "magic" and apply actual "math" to the tax proposal. However, this is not an impediment to passing tax reform as the reconciliation rules can still be used as long as the legislation expires after ten years. This is how President George W. Bush passed tax cuts in 2001. 19 A study by the conservative American Action Forum suggests that Trump's regulatory cuts may save $260 billion over ten years. This is a likely source of savings to justify tax cuts, and Trump is only getting warmed up when it comes to deregulation! For the study, please see Sam Batkins, "Fiscal Benefits Of The CRA, Regulatory Reform," April 20, 2017, available at www.americanactionforum.org. 20 Please see BCA Global Investment Strategy Weekly Report, "Fade The Rally In Treasurys," dated April 21, 2017, available at gis.bcaresearch.com. 21 Please see 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 "Conservatives fined £70,000 over expenses by election watchdog," Channel 4 News, March 16, 2017, available at www.channel4.com. 23 The Conservatives won the Copeland seat for the first time since 1982 after the Labour MP Jamie Reed's resignation there. 24 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. 25 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 27 Please see "Brexit Shouldn't Delay Trade Talks Too Long, Say Leaders," Bloomberg, April 21, 2017, available at www.bloomberg.com. 28 See note 26 above. Geopolitical Calendar

Highlights The U.S. dollar correction is entering its last innings as investors now only discount marginally more than one rate hike by the Fed over the next 12 months. The last leg of the USD's weakness is likely to be prompted by technical and political factors. Beyond this, the outlook for the U.S. economy remains healthy, yet investors have pared down their expectations, suggesting that positive surprises should emerge. The conciliatory tone of the so-called currency manipulator report suggests that the hopes of a Plaza 2.0 accord should get dashed. EUR/GBP has downside. Feature The dollar continues to decline. Doubts about President Trump's pro-growth agenda and higher borrowing costs are creating worries about future economic growth. Treasury Secretary Mnuchin's admonition that fiscal reform may be delayed only added fuel to the fire. The reality is a bit more nuanced than this. The global economy just experienced one of its most broad-based periods of improvement in decades. Earlier this year, our global economic and financial diffusion index, based on 106 indicators, hit its highest level since 1999 (Chart I-1). This upswing caused global growth expectations to surge, as highlighted by large moves in the global and U.S. stock-to-bond ratios. Chart I-1Broad-Based Economic Upswing Has Lifted Growth Expectations Broad-Based Economic Upswing Has Lifted Growth Expectations Broad-Based Economic Upswing Has Lifted Growth Expectations Still, such a pace of improvement is hard to maintain. The handicap is even greater given one of the sharpest increases in global borrowing costs of the past thirty years. Thus, an almost unavoidable growth disappointment is currently underway, as illustrated by the sudden swoon in global economic surprises. As negative surprises accumulate, it is natural for investors to tame their growth expectations, and in the process, to have pulled down their expectations for the level of the Fed funds rate 12 months out (Chart I-2). Unsurprisingly, the dollar has corrected in the process. Going forward, the flattening yield curve and weak inflation expectations could cause market expectations for the Fed Funds rate to fall further (Chart I-3). A downgrade in Fed expectations could push the DXY toward 97 - particularly given that the greenback currently stands at a crucial support (Chart I-4). Chart I-2A Full Rate Hike Has Been ##br##Purged From Expectations A Full Rate Hike Has Been Purged From Expectations A Full Rate Hike Has Been Purged From Expectations Chart I-3The Source Of ##br##The Worry The Source Of The Worry The Source Of The Worry Chart I-4Dollar At ##br##Crucial Spot Dollar At Crucial Spot Dollar At Crucial Spot Moreover, while our dollar capitulation index is already flirting with oversold readings, it can remain in that territory for extended periods of time. In fact, as long as this indicator stays below its 13-week moving average, the dollar tends to remain under downward pressure (Chart I-5). This would suggest that the window of weakness in the dollar has yet to be closed and that a break toward 98-97 in DXY is still very likely. Chart I-5Momentum Still A Headwind For The Dollar Momentum Still A Headwind For The Dollar Momentum Still A Headwind For The Dollar Outside of growth considerations, politics could also contribute to a last wave of selling in the dollar against the euro. Macron, the centrist candidate for the French presidency, is currently polling 25% of voting intentions for the first electoral round this weekend, ahead of Marine Le Pen. Yet the press continues to focus on Jean-Luc Mélanchon's surge in the polls, despite the fact that his popularity gains have stalled at 19%. This means that markets may get positively surprised Sunday night when French electoral results come in as the implied probability of a Le Pen / Mélanchon second round has risen. If as is more likely, Macron, not Mélanchon, makes it to the second round, it is important to remember that in head-to-head polls, he currently scores 64% vs 36% for Marine Le Pen (Chart I-6). Beyond these short-term dynamics, the outlook for the dollar continues to look brighter. To begin with, major leading indicators of the U.S. economy still point to a rebound later this year: The ISM manufacturing highlights that the decline in credit growth may be a temporary episode (Chart I-7). Chart I-6Positive Euro Stock This Weekend? Positive Euro Stock This Weekend? Positive Euro Stock This Weekend? Chart I-7U.S. Credit Growth Will Pick Up U.S. Credit Growth Will Pick Up U.S. Credit Growth Will Pick Up The U.S. CEO Confidence survey is at a 12 year high, and points toward both stronger capex and GDP growth (Chart I-8). The soft job number in March is likely to have been an aberration, as various indicators suggest that job growth will remain perky (Chart I-9). Moreover, this is happening in an environment where labor market slack is likely to prove limited. Not only is the headline U-3 unemployment rate now in line with NAIRU, but also hidden labor market slack - as approximated by discouraged workers and part-time workers for economic reasons - has greatly normalized (Chart I-10), suggesting that healthy job creation should result in accelerating wage growth this year. The elevated level of consumer confidence along with the healthy state of household finances - debt to disposable income still stands near 15-year lows and debt-service payments are at multi-generational lows - are together pointing toward stronger consumer spending. Chart I-8When CEOs Are Happy, ##br##So Is The Economy When CEOs Are Happy, So Is The Economy When CEOs Are Happy, So Is The Economy Chart I-9Soft March Payrolls: ##br##An Aberration Soft March Payrolls: An Aberration Soft March Payrolls: An Aberration Chart I-10U.S. Labor Market ##br##Slack Is Limited U.S. Labor Market Slack Is Limited U.S. Labor Market Slack Is Limited U.S. Labor Market Slack Is Limited U.S. Labor Market Slack Is Limited These developments are important as our Composite Capacity Utilization Gauge for the United States has now firmly moved into no-slack territory (Chart I-11). As such, improvements in the U.S. economy later this year will give the Fed plenty of ammunition to increase rates. Thus, we think that markets are ultimately underestimating the FOMC's capacity to lift rates by only anticipating marginally more than one rate hike over the next 12 months. Chart I-11U.S. Capacity Constraints Are Getting Hit U.S. Capacity Constraints Are Getting Hit U.S. Capacity Constraints Are Getting Hit As a result, buy any further dips in the dollar. We are already long the USD against commodity currencies, but will use any weakness to close our short USD/JPY trade and begin accumulating the dollar against the euro. In terms of level, we will close our short USD/JPY position at 107 and look to open a short EUR/USD bet at 1.10. Bottom Line: Markets are revising down their expected path for U.S. interest rates, causing a correction in the dollar in the process. After a period of robust and widespread growth improvement, expectations had become lofty and a period of indigestion was all but inevitable. However, forward looking indicators for U.S. growth are still healthy. With U.S. spare capacity becoming increasingly limited, investors are in the process of overdoing their downward adjustment in future U.S. rates. Use any further pull back in the U.S. dollar to buy the greenback. Currency Manipulators On Notice? Not Really This week, the U.S. Treasury published its annual report on Forex policies for the U.S.'s major trading partners, the so-called currency manipulator report. This time around, the report was especially interesting in light of the aggressive campaign rhetoric from President Trump. Chart I-12Conditions For Inflation Are ##br##Emerging In Japan Conditions For Inflation Are Emerging In Japan Conditions For Inflation Are Emerging In Japan Six countries were highlighted as hitting two of the three criteria necessary to be labeled currency manipulators. These were China, Germany, Japan, South Korea, Switzerland, and Taiwan. Most interesting was the tone of the discussion around China and Japan. Regarding China, the Treasury acknowledged that the PBoC is intervening in the currency market, however not to depress the value of the yuan, but to support it. The discussion was centered on the need for China to ease import restrictions and promote household consumption in order to narrow both the overall current account surplus and the bilateral trade surplus with the United States. These would be steps in the right direction to normalize the Sino-U.S. trade disequilibrium without entering in an all-out trade war. The discussion vis-à-vis Japan was also nuanced. Obviously, Japan's US$69 billion trade surplus with the U.S. was flagged, but the Treasury also acknowledged that the country's 3.7% current account surplus mostly reflected a very large positive income balance. Additionally, the Treasury also recognized that the large surplus was a reflection of Japan's poor domestic demand and that Japan needed to complement its very accommodative monetary policy with further fiscal boost and reforms. We interpreted this comment as a tacit acceptance that Abenomics and the BoJ's policy were squarely domestically focused and that the weak yen was a casualty, not the ultimate end-goal of these policies. With this recognition, it seems unlikely that the calls for a Plaza 2.0 accord would go anywhere. Instead, we expect similar demands to the one exerted on China to take precedence: more opening of the domestic market to imports and more Japanese FDI in the U.S. With this, the U.S. will live with a very dovish BoJ. In this optic, a key development emerged this week in Japan. Two BoJ governors have been replaced by two Abe philosophical allies, Mr. Hitoshi Suzuki and Mr. Goshi Kataoka. Therefore, Japan's monetary policy will remain very accommodative going forward as the near total control of the board by ultra-doves reinforces the institution's commitment to "irresponsible" monetary policy. Most importantly, our Composite Capacity Utilization Gauge for Japan is now in the zone where core inflation should accelerate (Chart I-12). This suggests that inflationary dynamics are likely to emerge after the current wave of global negative economic surprises abates. This should result in exactly what the BoJ wants: lower real rates and higher inflation expectations. This would be poisonous for the yen. Any further yen rally should be used to once again short the JPY. With regards to Germany, the Treasury acknowledged that ECB monetary policy is out of Berlin's control, but it would like to see more efforts to boost domestic demand, and a higher real exchange rate. In other words, at this point the Treasury seems to be hoping for higher German inflation more than for a higher euro. This too is re-assuring considering the initial aggressive stance of the Trump administration toward Germany. Switzerland, Korea, and Taiwan are in slightly more precarious conditions as all have been engaging in open market operations to depress the value of their currencies in recent years. However, with the softened tone exhibited toward China, Japan, and Germany, there is a high chance that the Treasury will find ways to turn a blind eye on these countries going forward. Bottom Line: The current U.S. administration is softening its tough rhetoric on trade and it is coming to grips with the reality that it may not be able to bully its trading partners into appreciating their currencies. Instead, Trump is likely to have to be content with fewer trade barriers to access these nations, and further efforts to stimulate domestic demand, which indirectly may help U.S. exports to these countries. We see these developments as steps in the right direction that should decrease the risks currently hanging over global trade. Politics Abound: What To Do With The Euro And The Pound? This week, Theresa May called for a snap election on June 8. The market perceived this announcement as very positive for the U.K.: it will decrease the risk of a very harsh form of Brexit. A larger Conservative victory, which seems highly likely based on current polls, implies that May will be less reliant on the most extremist Brexiters to govern. As such, the U.K. is perceived to be more likely to concede on some key EU demands such as Brussels's request that London pays the GBP 60 billion it owes to the EU's 2014-2020 budget. If these demands are met by the U.K., it is expected that the EU will be less intransigent when it comes to negotiating transitional agreements. On these dynamics, GBP/USD rallied 2.2% on Tuesday and now stands above its 200-day moving average for the first time since that fateful June 2016 night. EUR/GBP too was hurt by the pound rally, retesting its post referendum lows. What is the outlook for GBP/USD and EUR/GBP? The picture for EUR/GBP is the cleanest. A quick rally next week if Macron clenches a spot in the second round of the French election is very likely, especially as investors might have discounted the positive implications of the election on the pound too quickly. Any such rally should be used to begin building short EUR/GBP positions. EUR/GBP is currently trading 12% above its PPP fair value, but it is also trading at a large premium to real interest rate differentials (Chart I-13, top panel). Moreover, investors are starting to adjust upward the expected path of short rates in the U.K. relative to the euro area. This historically has been associated with a stronger pound (Chart I-13, bottom panel). Additionally, as we have argued, the negative factors affecting the U.K. economy are well known. Yet, the stability of long-term U.K. household inflation expectations suggests that the adjustment in consumption in response to high inflation caused by the lower pound could be limited as households may look through any temporary bump in inflation.1 Finally, positioning and sentiment on EUR/GBP are extremely stretched. Historically, such extended levels of bullishness toward the euro relative to the pound have been followed by sharp sell-offs in EUR/GBP (Chart I-14). Chart I-13Real Rates Points To ##br##EUR/GBP Downside Real Rates Points To EUR/GBP Downside Real Rates Points To EUR/GBP Downside Chart I-14Investors Are Positioned For##br## Further Euro Strength Investors Are Positioned For Further Euro Strength Investors Are Positioned For Further Euro Strength When it comes to the GBP/USD, the pound may continue to rebound in the short term toward 1.35. However, the upside in GBP/USD is likely to be capped if our bullish view on the dollar does pan out. This is why we prefer to express positive views on the pound via a short position in EUR/GBP. Bottom Line: The June 8 U.K. general election is important as it does increase the probability that Theresa May will be able to soften the U.K.'s negotiating stance on key budgetary points regarding Brexit. This means that longer and smoother transitional agreements between the U.K. and the EU are likely to emerge at the end of the Article 50 negotiations. Meanwhile, EUR/GBP is expensive relative to PPP metrics and rate differentials. The risk of a breakdown below 0.83 is growing, especially as investors are not positioned for a rally in the pound against the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the U.K. economy, please refer to the Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 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 greenback's weakness has been a result of declining price and wage pressures this month. A weaker than expected jobless claims and Philadelphia Fed Manufacturing Survey are both indications of the current economic soft patch. However, this is a temporary setback that will do little to alter the Fed's intended hiking cycle. The DXY is currently at a crucial technical level and could face significant pressure from an appreciating euro in the run-up to the French elections. After the outcome of these elections is digested, a return to robust U.S. data will likely propel the greenback upwards as the Fed will keeping lifting rates relative to the rest of the G10. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 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 The euro strengthens on the back of an optimistic interpretation of Praet's speech in New York. The central banker alluded to diminishing growth risks, but pointed out that short-term risks still remain. It seems that markets have priced in the end of the ECB's easing cycle. Further lifting the euro is expectations that Emmanuel Macron is on his way to the second round of the French election. However, it remains true that peripheral economies are stumbling along with high unemployment and little-to-no wage growth, which points toward widening U.S./European real rate differentials in the longer term. Inflation figures remained unchanged in March both in monthly and annual terms. An annual core inflation figure of 0.7% implies that inflationary pressures remain muted. A bearish outlook on the euro after the French elections is warranted. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 ECB: All About China? - April 7, 2017 Healthcare Or Not, Risks Remain - March 24, 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 On Tuesday the Japanese parliament nominated Hitoshi Suzuki and Goshi Kataoka to replace two members of the BoJ who had been serial dissenters of Governor Kuroda. This development is important as both of the nominees are known reflationists, which confirms our thesis that the Abe government is committed to support Kuroda's agenda. As the BoJ becomes increasingly dominated by doves, Kuroda will have more leeway in implementing radical reflationary measures, which is bearish for the yen on a cyclical basis. On a tactical basis, we believe the downtrend in USD/JPY might be approaching its last legs, given that we expect the dollar correction to end soon. On the other hand, a risk-off period in the markets seems probable, thus we will stay short NZD/JPY to capture investor's risk aversion. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 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 Cable surged following Theresa May's call of a snap election as the market became less bearish on the U.K. economy given that the election provides an opportunity for the Prime Minister to assert her power over the more radical MPs, and thus set the stage for a softer Brexit. We continue to be relatively optimistic on the pound, particularly against the euro, as we believe that the market is too pessimistic on the U.K. economy. Furthermore, the BoE has shown much less dovish than the ECB as Governor Carney has stated that they will undergo "some modest withdrawal of stimulus" in the next few years, while many members seem to be leaning towards a rate hike. Taking these factors into account, as well as the overly bullish positioning on the euro relative to the pound, we are now confident in shorting EUR/GBP. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 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 antipodean currency experienced significant downside amidst dovish remarks by the RBA. Highlighted in the minutes were worries associated with the labor market, with members citing higher unemployment and underemployment as contributors to faltering wage growth. As a corollary, the rise in underlying inflation is expected to be "more gradual", with headline inflation expected to reach its 2% target sometime this year. However, members also stressed the role of energy prices, which could complicate the process. An important observation is the adverse impact of Hurricane Debbie on coal production, a major export for Australia. In merrier news, China's economy outperformed expectations, achieving a growth rate of 6.9% in Q1. However, this is a backward looking indicator and likely corroborates the AUD's strength in Q1, while the recent weakness in Chinese capital spending plans and residential property prices are more accurate indicators of future AUD development. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 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 This week, kiwi headline inflation came at 2.2%, not only surpassing expectations but also reaching the upper half of the 1%-3% target inflation range for the RBNZ. This confirms our suspicion that inflationary pressures in New Zealand are much stronger than what the RBNZ would lead you to believe, and opens the possibility that the RBNZ could abandon its neutral bias for a more hawkish one. This should help the NZD outperform the AUD on a cyclical basis, given that the Australia's domestic inflationary pressures are much weaker. On a tactical basis, we continue to be short the NZD relative to the JPY, given that a China induced risk-off episode will boost safe heavens and hurt carry currencies. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 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 Within the commodity space, CAD should benefit against other commodity currencies. Oil is likely to face relatively consistent global demand vis-a-vis other commodities, such as industrial metals, as it is more insusceptible to the "unwinding of the Trump trade". Moreover, BCA foresees an extension of the OPEC production cuts for the remainder of the year, which will support oil-based currencies. Faltering capital expenditure in China will work against industrial metal demand, further accentuating this development. Limiting the CAD's upside, however, is a stronger USD this year, most probably after April is over. Real rate differentials will evolve in favor of the USD, limiting the upside to commodity prices in general. The result will be an outperformance of CAD relative to AUD and NZD. Finally, the recent non-resident tax implemented by Ontario my cause hick-ups in Canada's largest housing market. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 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 Economic data in Switzerland continues to improve as various measures such as manufacturing PMI, employment PMI and purchase prices have reached 2011 highs. These developments along with rising inflation, will reassure the SNB that the unofficial floor under EUR/CHF has been effective. Nevertheless, we expect the SNB to keep this floor in place until the end of the year, as not only do French elections pose a short term risk, but core inflation and wage growth would have to stay high for a sustainable period of time for the SNB to consider removing accomodation. Moreover, the removal of the floor would likely be gradual, as the SNB has learned from 2015 that a sharp appreciation in the franc could quickly undo any economic progress. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Although USD/NOK has been quite uncorrelated with oil in recent months, EUR/NOK continues to be highly correlated with oil prices. Overall, we expect the NOK to exhibit weakness against the dollar on a cyclical basis given that dollar bull markets tend to weigh on this cross. Moreover, the Norges Bank will continue to have a dovish bias, given that inflation is falling sharply and economic conditions remain weak. However, on a tactical basis, it is possible that the NOK outperforms the AUD, given that base metals are more sensitive to weaknesses in the Chinese economy. Oil, on the other hand, should stay relatively resilient, given that an extension of the OPEC deal until the end of the year seems very likely. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 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 SEK has largely been trading on the news flow from the U.S. and the euro area following a quiet week in Sweden. Similar to the DXY, USD/SEK is at a crucial technical spot, and EUR/SEK is likely to continue its uptrend in the run-up to the French election. Next week's Riksbank meeting is the last meeting before asset purchases end in June. As inflationary pressures are unlikely to subside substantially, we firmly believe that asset purchases will not be extended further. Nevertheless, while not shifting the policy rate, the Riksbank is likely to reiterate that a future cut is more likely than a future hike, especially as recent inflation figures have disappointed. This is likely to help USD/SEK in the longer run. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Treasury yields have slumped since early March, helping to push down the dollar. Slower U.S. growth in the first quarter of the year, weak inflation readings, uncertainty on tax reform, the prospect of a government shutdown, and rising political risks in Europe have all contributed to the Treasury rally. Looking out, U.S. growth should accelerate while growth abroad will stay reasonably firm. The market is pricing in only 34 basis points in rate hikes over the next 12 months. This seems too low to us. Go short the January 2018 fed funds futures contract. Feature What Explains The Treasury Rally? Global bond yields have swooned since early March. The 10-year Treasury yield fell to as low as 2.18% this week, down from a closing high of 2.62% on March 13th. A number of fundamental factors have contributed to the Treasury rally: Recent "hard data" on the U.S. growth picture has been somewhat disappointing. The Atlanta Fed's model suggests that real GDP expanded by only 0.5% in Q1 (Chart 1). So far this month, hard data on payrolls, housing starts, and auto sales have fallen short of consensus expectations. Credit growth has also decelerated sharply (Chart 2). The prospect of tax cuts this year have faded. Treasury Secretary Steven Mnuchin told the Financial Times on Monday that getting a tax bill through Congress by August was "highly aggressive to not realistic at this point."1 Meanwhile, worries about a government shutdown - possibly coming as early as next week - have escalated. Recent inflation readings have been on the soft side. Core CPI dropped by 0.12% month-over-month in March, the first outright decline since 2010. China's growth outlook remains cloudy. Government officials warned this week that recent measures undertaken to cool the housing sector will begin to bite later this month.2 Concerns that the French election will feature a runoff between the "Alt-Right" candidate, Marine Le Pen, and the "Ctrl-Left" candidate, Jean-Luc Mélenchon, have intensified (Chart 3). Euroskeptic parties also continue to make gains in Italy (Chart 4). Chart 1A Disappointing First Quarter A Disappointing First Quarter A Disappointing First Quarter Chart 2Credit Growth Slowdown Credit Growth Slowdown Credit Growth Slowdown While none of the things listed above can be easily dismissed, the key question for fixed-income investors is whether bond yields are already adequately discounting these risks. Keep in mind that markets are pricing in only 34 basis points in Fed rate hikes over the next 12 months (Chart 5). This is substantially less than the median "dot" in the Summary of Economic Projections, which implies three more hikes between now and next April. Chart 3French Elections: A Many-Way Race? French Elections: A Many-Way Race? French Elections: A Many-Way Race? Chart 4Euroskepticism Is On The Rise In Italy Euroskepticism Is On The Rise In Italy Euroskepticism Is On The Rise In Italy Chart 5Markets Are Too Sanguine About The Fed's Rate Hike Intentions Markets Are Too Sanguine About The Fed's Rate Hike Intentions Markets Are Too Sanguine About The Fed's Rate Hike Intentions U.S. Economy Still In Reasonably Good Shape Our view on rates for the next year is closer to the Fed's than the market's. Yes, the "hard data" on U.S. growth has been lackluster. However, as we discussed last week, the hard data may be biased down by seasonal adjustment problems.3 Moreover, the hard data tend to lag the soft data, and the latter remain reasonably perky. Reflecting the strength of the soft data, our newly-released Beige Book Monitor points to an improving growth picture across the Fed's 12 districts (Chart 6). Worries about plunging credit growth are also overstated. While the increase in interest rates since last year has likely curbed credit demand, some of the recent deceleration in business lending appears to be due to the improving financial health of energy companies. Higher profits have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has also allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 billion in issuance in Q1, the highest level on record (Chart 7). Chart 6Fed Districts See Things Improving Fed Districts See Things Improving Fed Districts See Things Improving Chart 7More And More Leveraged Loans Fade The Rally In Treasurys Fade The Rally In Treasurys Looking out, business lending should pick up. The Fed's Senior Loan Officer Survey indicates that banks stopped tightening lending standards to businesses in Q1. This should help boost the supply of credit over the coming months (Chart 8). Meanwhile, the recovery in the manufacturing sector will bolster credit demand. Chart 9 shows that an increase in the ISM manufacturing index leads business lending by 6-to-12 months. Chart 8Bank Lending Standards: Stable For Businesses, Tighter For Consumers Bank Lending Standards: Stable For Businesses, Tighter For Consumers Bank Lending Standards: Stable For Businesses, Tighter For Consumers Chart 9Manufacturing ISM Points To A Pick Up In Business Lending Manufacturing ISM Points To A Pick Up In Business Lending Manufacturing ISM Points To A Pick Up In Business Lending As far as household credit is concerned, higher interest rates and tighter lending standards for consumer loans (especially auto loans) are both headwinds. Nevertheless, overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows (Chart 10). And while delinquencies have edged higher, they are still well below their historic average (Chart 11). Chart 10Lower Household Leverage Lower Household Leverage Lower Household Leverage Chart 11Despite Slight Uptick, Delinquency Rates Remain Well Contained Despite Slight Uptick, Delinquency Rates Remain Well Contained Despite Slight Uptick, Delinquency Rates Remain Well Contained A reasonably solid growth picture should help lift inflation over the coming months. Chart 12 shows that inflation tends to accelerate once unemployment falls below its full employment level. The U.S. headline unemployment rate currently stands at 4.5%, below the Fed's estimate of NAIRU. Other measures of labor market slack also point to an economy that is quickly running out of surplus labor (Chart 13). As such, it is not surprising that the Atlanta Fed's wage tracker continues to trend higher, as has the NFIB's labor compensation gauge and most other measures of labor compensation (Chart 14). Chart 12The Phillips Curve Appears To Be Non-Linear Fade The Rally In Treasurys Fade The Rally In Treasurys Chart 13Disappearing Labor Market Slack Disappearing Labor Market Slack Disappearing Labor Market Slack Chart 14U.S.: Broad Measures Pointing To Rising Wage Pressures Wage Growth Trending Higher U.S.: Broad Measures Pointing To Rising Wage Pressures Wage Growth Trending Higher U.S.: Broad Measures Pointing To Rising Wage Pressures Wage Growth Trending Higher U.S. Political Risks Will Diminish... The political risks which have pushed down Treasury yields since early March should also subside over the coming weeks. Concerns that the Trump administration will be unable to pass tax cuts are overblown. Unlike in the case of health care, there is virtual unanimity among Republicans in favor of cutting taxes.4 Congressional hearings on tax reform are scheduled to begin next week. We expect Trump to move quickly to get a deal done. He needs a political victory and this is his best shot. We are also not especially worried about the prospect of a government shutdown. Congress needs to agree on a bill to extend government funding beyond April 28 when congressional appropriations are set to expire. So far, Republican leaders are pursuing a sensible strategy of keeping controversial items - including funding for a border wall and cuts to Obamacare subsidies - out of the bill in the hopes of attracting enough Democrat support to avoid a filibuster in the Senate. Without the inclusion of these contentious measures, it would be politically difficult for the Democrats to take any action that triggers a government shutdown, as they would be blamed for the outcome. ...As Will Risks In Europe... Chart 15The French Are Not Euroskeptic The French Are Not Euroskeptic The French Are Not Euroskeptic In the U.K., Prime Minister Theresa May's decision to hold a snap election reduces the risk of a "hard Brexit." The current slim 17-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories. These uncompromising MPs would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservative Party is able to increase its control over Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. Worries about the outcome of French elections should also diminish. Opinion polls continue to signal that Emmanuel Macron will make it to the second round of the presidential contest. If that happens, he would be a shoo-in to win against either Marine Le Pen or the far-left challenger Jean-Luc Mélenchon. Even in the unlikely event that Le Pen or Mélenchon ends up prevailing, their ability to push through their agendas would be severely constrained. Neither candidate is likely to secure a majority in the National Assembly when legislative elections are held in June. French presidents have a lot of leeway over foreign affairs, but need the support of parliament to change taxes, government spending, regulations, or most other aspects of domestic policy.5 Also, keep in mind that France's place in the EU is enshrined in the French constitution. Any modifications to the constitution would require that a referendum be called. Considering that French voters are highly pessimistic of their future outside of the EU, it would require a seismic shift in voter preferences for France to end up following the U.K.'s example (Chart 15). ...And In China Lastly, the risks of a trade war between the U.S. and China have eased following President Trump's summit with President Xi. This should help stem Chinese capital outflows. On the domestic front, the government's efforts to clamp down on property speculation will cool the economy. However, as our China team has pointed out, this may not be such a bad thing, given that recent activity has been strong and parts of the economy are showing signs of overheating. Investment Conclusions Chart 16Bet On The Fed Bet On The Fed Bet On The Fed The reflation trade will eventually fizzle out, but our sense is that this will be more of a story for late next year than for 2017. For now, underlying global growth is still strong and the sort of imbalances that usually precipitate recessions are not severe enough. If there is going to be one big surprise in the U.S. fixed-income market this year, it is that the Fed sticks to its guns and keeps raising rates at a pace of roughly once per quarter. With that in mind, we recommend that clients go short the January 2018 fed funds futures contract as a tactical trade (Chart 16). A rebound in U.S. rate expectations will lead to a widening in interest rate differentials between the U.S. and its trading partners. This will produce a stronger dollar. The yen is likely to suffer the most in a rising rate environment, given the Bank of Japan's policy of keeping the 10-year JGB yield pinned close to zero. On the equity side, we continue to recommend a modestly overweight position in global stocks. Investors should favor Japan and the euro area over the U.S. in local-currency terms. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Sam Fleming, Demetri Savastopulo, and Shawn Donnan, "Interview With Steven Mnuchin: Transcript," Financial Times, Monday April 17, 2017. 2 Li Xiang, "Real Estate Investment Likely To Slow Down," Chinadaily.com.cn, April 18, 2017. 3 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Towards Parity," dated April 14, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Global political risks are understated in 2018; U.S. policy will favor the USD, as will global macro trends; Trump's trade protectionism will re-emerge; China will slow, and may intensify structural reforms; Italian elections will reignite Euro Area breakup risk. Feature In our last report, we detailed why political risks are overstated in 2017.1 First, markets are underestimating President Trump's political capital when it comes to passing his growth agenda. Second, risks of populist revolt remain overstated in Europe. Third, political risks associated with Brexit probably peaked earlier this year. Next year, however, the geopolitical calendar is beset with potential systemic risks. First, we fear that President Trump will elevate trade to the top of his list of priorities, putting fears of protectionism and trade wars back onto the front burner. In turn, this could precipitate a serious crisis in the U.S.-China relationship and potentially inspire Chinese policymakers to redouble their economic reforms - so as not to "let a good crisis go to waste." That, in turn, would create short-term deflationary effects. Meanwhile, we fear that investors will have been lulled to sleep by the pro-market outcomes in Europe this year. The series of elections that go against populists may number seven by January 2018 (two Spanish elections, the Austrian presidential election, the Dutch general election, the French presidential and legislative elections, and the German general election in September). However, the Italian election looms as a risk in early 2018 and investors should not ignore it. Investors should remain overweight risk assets for the next 12 months. Our conviction level, however, declines in 2018 due to mounting geopolitical risks. Mercantilism Makes A Comeback Fears of a trade war appear distant and alarmist following the conclusion of the Mar-a-Lago summit between U.S. President Donald Trump and his Chinese counterpart Xi Jinping. We do not expect the reset in relations to last beyond this year. Trump has issued a "shot across the bow" and now the two sides are settling down to business - but investors should avoid a false sense of complacency.2 Investors should remember that candidate Trump's rhetoric on China and globalization was why he stood out from the crowd of bland, establishment Republican candidates. Despite the establishment's tenacious support for globalization, Americans no longer believe in the benefits of free trade, at least not as defined by the neoliberal "Washington Consensus" of the past two decades (Chart 1). We take Trump's views on trade seriously. They certainly helped him outperform expectations in the manufacturing-heavy Midwest states of Michigan, Pennsylvania, and Wisconsin (Chart 2). And yet, Trump's combined margin of victory in the three states was just 77,744 votes -- less than 0.5% of the electorate of the three states! That should be enough to keep him focused on fulfilling his campaign promises to Midwest voters, at least if he wants to win in 2020.3 Chart 1America Belongs To The Anti-Globalization Bloc Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chart 2Protectionism Boosted Trump In The Rust Belt Protectionism Boosted Trump In The Rust Belt Protectionism Boosted Trump In The Rust Belt In 2017, Trump's domestic agenda has taken precedent over international trade. The president is dealing with several key pieces of legislation, including the repeal and replacement of the Affordable Care Act, comprehensive tax reform, the repeal of Obama-era regulations, and infrastructure spending. However, there is considerable evidence that trade will eventually come back up: President Trump's appointments have favored proponents of protectionism (Table 1) whose statements have included some true mercantilist gems (Table 2). Table 1Government Appointments Certifying That Trump Is A Protectionist Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Table 2Protectionist Statements From The Trump Administration Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Secretary of Treasury Steven Mnuchin, who is not known as a vociferous proponent of protectionism, prevented the G20 communique from reaffirming a commitment to free trade at the March meeting of finance officials in Baden-Baden, Germany.4 Such statements were staples of the summits over the past decade. The Commerce Department - under notable trade hawk Wilbur Ross - looks to be playing a much more active role in setting the trade agenda under President Trump. Ross has already imposed a penalty on Chinese chemical companies in a toughly worded ruling that declares, "this is not the last that bad actors in global trade will hear from us - the games are over." He is overseeing a three-month review of the causes of U.S. deficits, planning to add "national security" considerations to trade and investment assessments, proposing a new means of collecting duties in disputes, and encouraging U.S. firms to bring cases against unfair competition. Ross is likely to be joined by a tougher U.S. Trade Representative (who has historically been the most important driver of trade policy in the executive branch). In addition, we believe that Trump's success on the domestic policy front, in combination with the global macro environment, will lead to higher risk of protectionism in 2018. There are three overarching reasons: Domestic Policy Is Bullish USD: We do not know what path the White House and Congress will take on tax reform. We think tax reform is on the way, but the path of least resistance may be to leave reform for later and focus entirely on tax cuts in 2017. Whatever the outcome, we are almost certain that it will involve greater budget deficits than the current budget law augurs (Chart 3). Even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows (Chart 4). This will perpetuate the dollar bull market. Chart 3Come What May, Trump Will Increase The Budget Deficit Come What May, Trump Will Increase The Budget Deficit Come What May, Trump Will Increase The Budget Deficit Chart 4A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation Chinese Growth Scare Is Bullish USD: At some point later this year, Chinese data is likely to decelerate and induce a growth scare. Our colleague Yan Wang of BCA's China Investment Strategy believes that the Chinese economy is on much better footing than in early 2016, but that the year-on-year macro indicators will begin to moderate.5 This could rekindle investors' fears of another China-led global slowdown. Meanwhile, Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally on the interbank system. The seven-day repo rate, a key benchmark for Chinese lending terms, has surged to its highest level in two years, according to BCA's Foreign Exchange Strategy. It could surge again, dissuading small and medium-sized banks from bond issuance (Chart 5). Falling commodity demand and fear of another slowdown in China will weigh on EM assets and boost the USD. European Political Risks Are Bullish USD: Finally, any rerun of political risks in Europe in 2018 will force the ECB to be a lot more dovish than the market expects. With Italian elections to be held some time in Q1 or Q2 2018 - more on that risk below - we think the market is getting way ahead of itself with expectations of tighter monetary policy in Europe. The expected number of months till an ECB rate hike has collapsed from nearly 60 months in July 2016 to just 20 months in March, before recovering to 28 months as various ECB policymakers sought to dampen expectations of rate hikes (Chart 6).6 In addition, our colleague Mathieu Savary of BCA's Foreign Exchange Strategy has noted that a relationship exists between EM growth and European monetary policy (Chart 7), which suggests that any Chinese growth scares would similarly be euro-bearish and USD-bullish.7 Chart 5Interbank Volatility Will ##br##Dampen Chinese Credit Growth Interbank Volatility Will Dampen Chinese Credit Growth Interbank Volatility Will Dampen Chinese Credit Growth Chart 6Market Is Way Ahead Of ##br## Itself On ECB Hawkishness Market Is Way Ahead Of Itself On ECB Hawkishness Market Is Way Ahead Of Itself On ECB Hawkishness Chart 7EM Spreads, ECB Months-To-Hike: ##br##Same Battle EM Spreads, ECB Months-To-Hike: Same Battle EM Spreads, ECB Months-To-Hike: Same Battle The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. There are two parallels that investors should be aware of: 1971 Smithsonian Agreement - President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."8 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening a reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table.9 Economists in the cabinet opposed the surcharge, fearing retaliation from trade partners, but policymakers favored brinkmanship.10 The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. 1985 Plaza Accord - The U.S. reached for the mercantilist playbook again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 8). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that Americans were serious about tariffs. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 9). Chart 8Dollar Bull Market And ##br## Current Account Balance Dollar Bull Market And Current Account Balance Dollar Bull Market And Current Account Balance Chart 9The U.S. Got What It ##br##Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism as a negotiating tool in recent history. In fact, Trump's Trade Representative, the yet-to-be-confirmed Robert Lighthizer, is a veteran of the latter agreement, having negotiated it for President Ronald Reagan.11 Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. The problem is that 2018 is neither 1971 nor 1985. The Trump administration will face three constraints to using currency devaluation to reduce the U.S. trade imbalance: Chart 10Globalization Has Reached Its Apex Globalization Has Reached Its Apex Globalization Has Reached Its Apex Chart 11Global Protectionism Has Bottomed Global Protectionism Has Bottomed Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that engineers structural bull markets in the euro and RMB respectively. For Europe, the risk is that peripheral economies may not survive a back-up in yields. For China, monetary policy tightness would imperil the debt-servicing of its enormous corporate debt horde. Apex of Globalization: U.S. policymakers could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 10), average tariffs appear to have bottomed (Chart 11), and the number of preferential trade agreements signed each year has collapsed (Chart 12). Temporary trade barriers have ticked up since 2008 (Chart 13). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Geopolitics: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. is still involved in European defense, its geopolitical relationship with China is hostile. What happens when the Smithsonian/Plaza playbook fails? We would expect the Trump administration to switch tactics. Two alternatives come to mind: Protectionism: As the Nixon surcharge demonstrates, the U.S. president has few legal, constitutional constraints to using tariffs against trade partners.12 As the Trump White House grows frustrated in 2018 with the widening trade imbalance, it may reach for the tariff playbook. The risk here is that retaliation from Europe and China would be swift, hurting U.S. exporters in the process. Dovishness: There is a much simpler alternative to a global trade war: inflation. Our theory that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation and growth pick up. But what if the Fed decides to respond to higher nominal GDP growth by hiking rates more slowly? This could be the strategy pursued by the next Fed chair, to be in place by February 3, 2018. We do not buy the conventional wisdom that "President Trump will pick hawks because his economic advisors are hawks" for two reasons. First, we do not know that Trump's economic advisors will carry the day. Second, we suspect that President Trump will be far more focused on winning the 2020 election than putting a hawk in charge of the Fed. Chart 12Low-Hanging Fruit Of Globalization Already Picked Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chart 13Temporary Trade Barriers Ticking Up Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Bottom Line: Putting it all together, we expect that U.S. trade imbalances will come to the forefront of the political agenda in 2018. This will especially be the case if the USD continues to rally into next year, contributing to the widening of the trade deficit. We expect any attempt to reenact the Smithsonian/Plaza agreements to flame out quickly. America's trade partners are constrained and unable to appreciate their currencies against the USD. This could rattle the markets in 2018 as investors become aware that Trump's mercantilism is real and that chances of a trade war are high. On the other hand, Trump may take a different tack altogether and instead focus on talking down the USD. This will necessitate a compliant Fed, which will mean higher inflation and a weaker USD. Such a strategy could prolong the reflation trade through 2018 and into 2019, but only if the subsequent bloodbath in the bond market is contained. China Decides To Reform Presidents Trump and Xi launched a new negotiation framework on April 6 that they will personally oversee, as well as a "100 Day Plan" on trade that we expect will result in a flurry of activity over the next three months. One potential outcome of the meeting is a rumored plan for massive Chinese investment into the U.S. that could add a headline 700,000 jobs, complemented with further opening of China's agricultural, automotive, and financial sectors to U.S. investment and exports. Investors may be fêted with more good news, especially with President Trump slated to visit China before long. President Trump, a prominent China-basher, may decide that the deals he brings home from China will be enough to convince the Midwest electorate that he has gotten the U.S. a "better deal" as promised. This would enable him to stabilize China relations in order to focus on other issues, as all presidents since Reagan have done. However, we doubt that the Sino-American relationship can be resolved through short-term trade initiatives alone. There is too much distrust, as we have elucidated before.13 The 100-day plan is a good start but it carries an implicit threat of tariffs from the Trump administration if China fails to follow through; and China is not likely to give Trump everything he wants. Moreover, strategic and security issues are far from settled, despite some positive gestures. As such, we expect both economic and geopolitical tensions to resurface in 2018. Meanwhile Chinese policymakers may decide to use tensions with the U.S. as an opportunity to redouble efforts towards structural reforms at home. Since the Xi Jinping administration pledged sweeping pro-market reforms in 2013, the country has shied away from dealing with its massive corporate debt hoard (Chart 14) and has only trimmed the overcapacity in sectors like steel and coal (Chart 15). It fears incurring short-term pain, albeit for long-term gain. However, if Beijing can blame any reform-induced slowdown on the U.S. and its nationalist administration, it will make it easier to manage the political blowback at home, providing a means of rallying the public around the flag. Chart 14China's Corporate Debt Pile Still A Problem... China's Corporate Debt Pile Still A Problem... China's Corporate Debt Pile Still A Problem... Chart 15...And So Is Industrial Overcapacity ...And So Is Industrial Overcapacity ...And So Is Industrial Overcapacity China has, of course, undertaken significant domestic reforms under the current administration. It has re-centralized power in the hands of the Communist Party and made steps to improve quality of life by fighting pollution, expanding health-care access, and loosening the One Child policy. These measures have long-term significance for investors because they imply that the Chinese state is responsive to the secular rise in social unrest over the past decade. The political system is still vulnerable in the event of a major economic crisis, but the party's legitimacy has been reinforced. Nevertheless, what long-term investors fear is China’s simultaneous backsliding on key components of economic liberalization. Since the global financial crisis, the government has adopted a series of laws that impose burdens on firms, especially foreign and private firms, relating to security, intellectual property, technology, legal (and political) compliance, and market access. Moreover, since the market turmoil in 2015-16, the government has moved to micromanage the country’s stock market, capital account, banking and corporate sectors, and Internet and media. The general darkening of the business environment is a major reason why investors have not celebrated notable reform moves like liberalizing deposit interest rates or standardizing the business-service tax. These steps require further reforms to build on them (i.e. to remove lending preferences for SOEs, or to provide local governments with revenues to replace the business tax). But all reforms are now in limbo as the Communist Party approaches its “midterm” party congress this fall. Most importantly for investors, the government has still not shown it can "get off the train" of rapid credit growth that has underpinned China's transition away from foreign demand (Chart 16). The country's relatively robust consumer-oriented and service-sector growth remains to be tested by tighter financial conditions. And the property sector poses an additional, perpetual financial risk, which policymakers have avoided tackling with reforms like the proposed property tax (a key reform item to watch for next year).14 The PBoC's recent tightening efforts come after a period of dramatic liquidity assistance to the banks (Chart 17), and even though interbank rates remain well below their brief double-digit levels during the "Shibor Crisis" in 2013 (see Chart 5 above, page 6), any tightening serves to revive fears that financial instability could re-emerge and translate to the broader economy. Chart 16China's Savings Fueling Debt Buildup China's Savings Fueling Debt Buildup China's Savings Fueling Debt Buildup Chart 17PBoC Lends A Helping Hand PBoC Lends A Helping Hand PBoC Lends A Helping Hand What signposts should investors watch to see whether China re-initiates structural reforms? Already, personnel changes at the finance and commerce ministries, as well as the National Development and Reform Commission and China Banking Regulatory Commission, suggest that the Xi administration may be headed in this direction. Table 3 focuses on the steps that we think would be most important, beginning with the party congress this fall. Given current levels of overcapacity and corporate leverage, we suspect that genuine structural reform will begin with a move toward deleveraging, and involve a mix of bank recapitalization and capacity destruction, as it did in the 1990s and early 2000s. These reforms included the formation of new central financial authorities, like policy banks, regulatory bodies, and asset management companies, to oversee the cleaning up of bank balance sheets and the removal of numerous inefficient players from the financial sector.15 They eventually entailed transfers of funds from the PBoC, from foreign exchange reserves, and from public offerings as major banks were partially privatized. On the corporate side, the reforms witnessed the elimination of a range of SOEs and layoffs numbering around 40% of SOE employees, or 4% of the economically active workforce at the time. Table 3Will China Launch Painful Economic Restructuring Next Year? Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chinese President Jiang Zemin launched these reforms after the party congress of 1997, just as his successor, Hu Jintao, attempted to launch similar reforms following the party congress of 2007. The latter got cut short by the Great Recession. The question now for Xi Jinping's administration is whether he will use his own midterm party congress to launch the reforms that he has emphasized: namely, deep overcapacity cuts and financial and property market stabilization through measures to mitigate systemic risks.16 Bottom Line: China may decide to use American antagonism as an "excuse" to launch a serious structural reform push following this fall's National Party Congress. Short-term pain, which is normal under a reform scenario in any country, could then be blamed on an antagonistic U.S. trade and geopolitical policy. While reforms in China are a positive in the long term, we fear that a slowdown in China would export deflation to still fragile EM economies. And given Europe's high-beta economy, it could also be negative for European assets and the euro. Europe's Divine Comedy Investors remain focused on European elections this year. The first round of the French election is just 11 days away and polls are tightening (Chart 18). Although Marine Le Pen is set to lose the second round in a dramatic fashion against the pro-market, centrist Emmanuel Macron (Chart 19), she could be a lot more competitive if either center-right François Fillon or left-wing Jean-Luc Mélenchon squeaks by Macron to get into the second round.17 Chart 18Melenchon's Rise: Comrades Unite! Melenchon's Rise: Comrades Unite! Melenchon's Rise: Comrades Unite! Chart 19Le Pen Cruisin' For A Bruisin' Le Pen Cruisin' For A Bruisin' Le Pen Cruisin' For A Bruisin' The risk of someone-other-than-Macron getting into the second round is indeed rising. However, Mélenchon's rise thus far appears to be the mirror image of Socialist Party candidate Benoît Hamon's demise. At some point, this move will reach its natural limits: not all Hamon voters are willing to switch to Mélenchon. At that point, the Communist Party-backed Mélenchon will have to start taking voters away from Le Pen. This is definitely possible, but would also create a scenario in which it is Mélenchon, not Le Pen, that faces off against a centrist candidate in the second round. As such, we see Mélenchon's rise primarily as a threat to Le Pen, not Macron.18 While we remain focused on the French election, we think that any market relief from that election - and the subsequent German one - will be temporary. By early next year, investors will have to deal with Italian elections. Unfortunately, there is absolutely no clarity in terms of who will win the Italian election. If elections were held today, the Euroskeptic Five Star Movement (M5S) would gain a narrow victory (Chart 20). However, it is not clear what electoral law will apply in the next election. The current law on the books, which the Democratic Party-led (PD) government is attempting to reform by next February, would give a party reaching 40% of the vote a majority-bonus. As Chart 20 illustrates, however, no party is near that threshold. As such, the next election may produce a hung parliament with no clarity, but with a Euroskeptic plurality. Meanwhile, the ruling center-left Democratic Party is crumbling. Primaries are set for April 30 and will pit former PM Matteo Renzi against left-wing factions that have coalesced into a single alliance called the Progressive and Democratic Movement (DP). For now, DP supports the government of caretaker PM Paolo Gentiloni, but its members have recently embarrassed the government by voting with the opposition in a key April 6 vote in the Senate. If Renzi wins the leadership of the Democratic Party again, DP members could formally split and contest the 2018 election as a separate party. The real problem for investors with Italy is not the next election, whose results are almost certain to be uncertain, but rather the Euroskeptic turn in Italian politics. First, aggregating all Euroskeptic and Europhile parties produces a worrying trend (Chart 21). And we are being generous to the pro-European camp by including the increasingly Euroskeptic Forza Italia of former PM Silvio Berlusconi in its camp. Chart 20Five Star Movement Set For Plurality Win Five Star Movement Set For Plurality Win Five Star Movement Set For Plurality Win Chart 21Euroskeptics Take The Lead Euroskeptics Take The Lead Euroskeptics Take The Lead Unlike its Mediterranean peers Spain and Portugal, Italian support for the euro is still plumbing decade lows -- no doubt a reflection of the country's non-existent economic recovery (Chart 22). It is difficult to see how Italians can regain confidence in European integration given that they are unwilling to pursue painful structural reforms. Chart 22Italian Economic Woes Hurt Euro Support Italian Economic Woes Hurt Euro Support Italian Economic Woes Hurt Euro Support The question is not whether Italy will face a Euroskeptic crisis, but rather when. It may avoid one in 2018 as the pro-euro centrists cobble together a weak government or somehow entice the center-right into forming a grand coalition. But even in that rosy scenario, such a government is not going to have a mandate for painful structural reforms that would be required to pull Italy out of its low-growth doldrums. As such, it is unlikely that the next Italian government will last its full five-year term. Bottom Line: Investors should prepare for a re-run of Europe's sovereign debt crisis, with Italy as the main event. We expect this risk to be delayed until after the Italian election in 2018, maybe later. However, it is likely to have global repercussions, given Italy's status as the third-largest sovereign debt market. Will Italy exit the euro? Our view is that Italy needs a crisis in order to stay in the Euro Area, as only the market can bring forward the costs of euro exit for Italian voters by punishing the economy through the bond market. The market, economy, and politics have a dynamic relationship and Italian voters will be able to assess the costs of an exit first hand, as yields approach their highs in 2011 and Italian banks face a potential liquidity crisis. Given that support for the euro remains above 50% today, we would expect that Italians would back off from the abyss after such a shock, but our conviction level is low.19 Housekeeping This week, we are taking profits on our long MXN/RMB trade. We initiated the trade on January 25, 2017 and it has returned 14.2% since then. The trade was a play on our view that Trump's protectionism would hit China harder than Mexico. Given the favorable conclusion to the Mar-a-Lago summit - and the likely easing of risks of a China-U.S. trade war in the near term - it is time to book profits on this trade. We still see short-term upside to MXN and investors may want to pair it by shorting the Turkish lira. We expect more downside to TRY given domestic political instability, which we expect to continue beyond the April 15 constitutional referendum. We see both the yes and no outcomes of the referendum as market negative. In addition, we are closing our short Chinese RMB (via 12-month non-deliverable forwards) trade for a profit of 5.89% and our long USD/SEK trade for a gain of 1.27%. Our short U.K. REITs trade has been stopped out for a loss of 5%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 For this negotiating sequence, please see BCA Geopolitical Strategy and The Bank Credit Analyst Special Report, "A Q&A On Political Dynamics In Washington," dated November 24, 2016, available at bca.bcaresearch.com, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 3 Trump loves to win. 4 Please see Federal Ministry of Finance, Germany, "Communique - G20 Finance Ministers and Central Bank Governors Meeting," dated March 18, 2017, available at www.bundesfinanzministerium.de. 5 Please see BCA China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. 6 The head of the Lithuanian central bank, Vitas Vasiliauskas, was quoted by the Wall Street Journal in early April stating that "it is too early to discuss an exit because still we have a lot of significant uncertainties." This was followed by the executive board member Peter Praet dampening expectations of even a reduction in the bank's bond-buying program and President Mario Draghi stating that the current monetary policy stance remained appropriate. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 8 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 9 Treasury Secretary John Connally was particularly protectionist, with two infamous mercantilist quips to his name: "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 10 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." 11 We highly recommend that our clients peruse Lighthizer's testimony to the U.S.-China Economic and Security Review Commission. Beginning at p. 29, he recommends three key measures: using the 1971 surcharge as a model (p. 31); going beyond "WTO-consistent" policies (p. 33); and imposing tariffs against China explicitly (p. 35). Please see Robert E. Lighthizer, "Testimony Before the U.S.-China Economic and Security Review Commission: Evaluating China's Role in the World Trade Organization Over the Past Decade," dated June 9, 2010, available at www.uscc.gov. 12 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. See also the recent Geopolitical Strategy and Emerging Market Equity Sector Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 14 Please see BCA's Commodity & Energy Strategy Special Report, "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015, available at ces.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "China: Is Beijing About To Blink?" in Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 16 At a meeting of the Central Leading Group on Financial and Economic Affairs, which Xi chairs, the decision was made to make some progress on these structural issues this year, but only within the overriding framework of ensuring "stability." The question is whether Xi will grow bolder in 2018. Please see "Xi stresses stability, progress in China's economic work," Xinhua, February 28, 2017, available at news.xinhuanet.com. 17 That said, the most recent poll - conducted between April 9-10 - shows that Mélenchon may be even more likely to defeat Le Pen than Macron. He had a 61% to 39% lead in the second round versus Le Pen. 18 In the second round, Macron is expected to defeat Mélenchon by 55% to 45%, according to the latest poll, conducted April 9-10. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com.

Highlights Global political risks are overstated, at least in 2017; Global rally in risk assets hinges on hard data, not politics; But Trump and the GOP can still pass tax reforms or cuts this year; The EU's guidelines on Brexit are benign, risks have peaked; The French presidential election remains harmless to markets. Feature Investors have a love/hate relationship with populism. On one hand, we fear what anti-establishment movements will mean for the twentieth-century institutions that have underpinned post-Cold War stability.1 On the other, markets have cheered populism and its ability to jolt policymakers out of their torpor, particularly on fiscal policy.2 This dichotomy of outcomes informs our investment theme for 2017, which holds that markets are navigating a "Fat-Tails World."3 The failure to repeal and replace the Affordable Care Act (ACA, "Obamacare") - which took us by surprise - reminded investors that President Trump will not have smooth sailing through the murky waters of congressional politics. Opposition to him has put into doubt the consensus view that populism is a political defibrillator that will shock policymakers into action. Instead of right-tail outcomes, markets are again fretting about left-tail risks: namely gridlock and obstructionism, but also protectionism, trade war, and competing nationalisms. In the long term, we are pessimists. We do not see how China and the U.S. will escape the dreaded "Thucydides Trap." We remain concerned that President Trump will grow frustrated with America's trade imbalances and strike out at friends and foes alike. But these are concerns for 2018 and beyond. In 2017, we believe that political risks remain overstated. In this weekly, we explain why. It's The Economy, Stupid! The global macro backdrop remains positive for the time being. Despite a very high global policy uncertainty index print, the market is responding to strong economic data (Chart 1), with the sum of the Citibank global economic- and inflation-surprise indexes rising to the highest level in the 14-year history of the survey.4 Chart 1Is Political Risk Overstated? Is Political Risk Overstated? Is Political Risk Overstated? Chart 2The Apex Of Globalization... Delayed? The Apex Of Globalization... Delayed? The Apex Of Globalization... Delayed? The global economic improvements are real. Chart 2 shows that PMI indexes in the developed world have reached their highest level since 2011, with global export volumes recovering from their multi-year doldrums. The Baltic dry index has gone vertical. Several other positive developments have caught our eye: Global Earnings: The global growth story has started to funnel down to company earnings, with a recovery in the net earnings-revisions ratio (Chart 3), which had been negative since 2011. Chart 3Strong Global Earnings Global Earnings Recovering Global Earnings Recovering Chart 4Godot Is Here! Return Of Capex Godot Is Here! Return Of Capex Godot Is Here! Return Of Capex U.S. Capex: The long-awaited capex recovery may finally be coming to the U.S., with real non-residential investment bottoming in 2016 (Chart 4). Manufacturing Renaissance: Global industrial production should have a solid year, at least judging by the strong leading economic-indicator print (Chart 5). Chart 5Industrial Renaissance Industrial Renaissance Industrial Renaissance Chart 6Consumers Are Elated Consumers Are Elated Consumers Are Elated Consumer Confidence: U.S. consumer confidence is at its highest level in 16 years (Chart 6), and should firm up from here, according to the BCA disposable-income indicator (Chart 7), and our expectation that Trump and the Republicans pass tax cuts.5 Chart 7Income Growth To Follow Income Growth To Follow Income Growth To Follow Chart 8Euro Area Is Doing Great Euro Area Is Doing Great Euro Area Is Doing Great European Renaissance: Data from the Euro Area remains bullish, despite the focus on political risk (Chart 8). BCA's real GDP growth models, introduced by The Bank Credit Analyst in their March report, corroborate the bullish view (Chart 9).6 Chart 9BCA's GDP Models Are Bullish BCA's GDP Models Are Bullish BCA's GDP Models Are Bullish The broad-based recovery in the data strongly suggest that the market's performance since the U.S. election is based on more than just a bet on Trump and his policies. Markets are responding to genuine improvements in the global economic outlook. Certainly there is something of a bet on the populists "getting it right," but hard data should continue to back up the optimism. How long can the party last? Our colleagues Martin Barnes and Peter Berezin have both recently warned of heightened recession risks in 2019.7 We are perhaps even less sanguine, observing dark clouds gathering for 2018. However, we will save that story for next week's missive. This week, we will provide our reasons for optimism about the remainder of this year. U.S.: Fade The Trumpocalypse S&P 500 fell 1.2% on March 21, the day that apparently sealed the fate of the Republicans' seven-year pledge to repeal and replace Obamacare. In our view, investors are overstating the conditional relationship between "repeal and replace" and the GOP's forthcoming tax bill. The most important political question for investors this year is simple: will the GOP blow out the budget deficit or focus on austerity? Getting the answer to this question right will go a long way in determining whether the impact on nominal GDP growth, inflation expectations, and thus the Fed's reaction-function is bullish for the S&P 500 and the U.S. dollar. This is the Trump trade: the idea that overarching reflation policy is swinging from monetary to fiscal. We still believe in Trump! That said, we acknowledge that comprehensive tax reform is tough - otherwise it would have occurred more recently than 1986.8 It is also true that the failure to repeal Obamacare will leave a few hundred billion dollars in the federal deficit that would have otherwise been available for tax cuts. Table 1 shows that the average time it takes to pass tax reform - from introduction of the bill to its signing by the president - is around five months. It is therefore not impossible, though assuredly difficult, for Congress to return from August recess this year and squeeze through a bill by Christmas Eve. TableMajor Tax Legislation And The Congressional Balance Of Power Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Chart 10Intra-Party GOP Polarization Falls##br## In Line With Last 80 Years Intra-Party GOP Polarization Falls In Line With Last 80 Years Intra-Party GOP Polarization Falls In Line With Last 80 Years Plus, Trump could always pivot away from tax reform and go after tax cuts, which are what Presidents Reagan and Bush did in 1981 and 2001. Both of these efforts took only one month to pass.9 From an economic perspective, the less ambitious option of tax cuts would be more flammable than tax reform, as it would merely increase the deficit and thus act as a more significant short-term stimulus. We see five reasons why the GOP will pass some form of tax legislation this year that will (1) add to the budget deficit, (2) lower household and probably corporate tax rates, and (3) likely include some provisions for infrastructure spending: Polarization is overstated: Intraparty ideological polarization is rising within the Republican Party, whereas it appears to be significantly declining in the Democratic Party (Chart 10).10 However, the move is not as significant as the media suggests. The average level of polarization within the GOP is well within the range of the past century. In fact, the GOP remains considerably less polarized than the Democrats were for most of the post-Second World War era. The data therefore suggests that while the GOP is indeed becoming more conservative (Chart 11), it is doing so uniformly. The measurable differences between the "Tea Party," represented in the House of Representatives by the Freedom Caucus, and the rest of the party are overstated. Chart 11Polarization Increasing Between, Not Within, The Two Parties Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Trump still has political capital: Despite a slump in national opinion polls, the president retains support among Republican voters (Chart 12). This means that he can threaten to campaign against Freedom Caucus representatives in the 2018 mid-term elections, as he did recently in an ominous tweet.11 Data suggest that voters would indeed follow Trump and dump the Freedom Caucus. Trump is very popular among Tea Party voters, even in Texas when put up against the state's Tea Party champion Senator Ted Cruz (Chart 13). Given that voter turnout in primary races in a mid-term election is below 10% for Republicans, a series of Trump rallies in Freedom Caucus districts could be sufficient to change the course of the election. Chart 12Republican Voters Support Trump Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Chart 13Trump Is A Threat To The Tea Party Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Chart 14Budget Deficits: Not As Hot Of A Priority Budget Deficits: Not As Hot Of A Priority Budget Deficits: Not As Hot Of A Priority Budget deficits are less relevant: Given the first two points, why did the Freedom Caucus oppose President Trump on health care? Because Obamacare and its replacement were both "big government programs," whereas these are "small government" Republicans. It was not because Freedom Caucus constituencies are laser-focused on lowering budget deficits! In fact, 22% fewer Republicans see reducing the budget deficit as the top policy priority as did in 2012, when the Tea Party was in full stride (Chart 14). Tax cuts are popular among Republican voters. Expanded budget deficits can be sold to them as a way to "starve the beast" of government.12 Institutional constraints to reform are overstated: "God put the Republican Party on earth to cut taxes." The famous quip from Washington Post columnist Robert Novak is a good guide for investors on tax reform. Many of our colleagues and clients tend to over-complicate their political analysis. Opposing tax reform and/or cuts will be political suicide for Republican legislators. And if budget deficits grow too much, the GOP can rely on two time-tested strategies to find "offsets" for tax cuts: Revenue Offsets: Republicans still have a handful of possibilities to raise revenues to offset the loss from cuts in tax rates even if they abandon the border adjustment tax (which they have not yet done). First, they can require companies to repatriate their offshore earnings, whose taxes are deferred. Second, they could engage in limited reform by closing some loopholes in the tax code. Third, they could let certain "tax extenders" expire at the end of the year as they are technically scheduled to do. Fourth, they could reduce the size of the tax cuts from the very ambitious plans outlined in their now outdated 2016 proposals. These decisions would be politically difficult, but that does not mean that all of them will fail. Crucially, the leader of the Freedom Caucus, Representative Mark Meadows (R-N.C.), now claims he would support tax cuts that are not fully offset by revenues. The Freedom Caucus appears to have expended most of its political capital on opposing the Obamacare replacement and is now tucking its tail between its legs! Dynamic Scoring: Republicans have emphasized macroeconomic feedback, i.e. the fact that tax cuts generate growth, which in turn generates tax revenues, defraying the initial revenue losses of the cuts. The Republicans will argue that static accounting methods make tax cuts seem more costly than they will be in reality. For instance, while it is true that President Bush's White House vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 15). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 16). Chart 15Bush Was Right, ##br##CBO Was Wrong! Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Chart 16Dynamic Scoring Will Offset About##br## 10% Of Revenues Lost To Tax Cuts Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Timing is flexible: The GOP have the option of making tax cuts retroactive and thus avoiding a huge market disappointment if tax cuts come later in the 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.13 Chart 17Republicans Are Not Deficit-Neutral Republicans Are Not Deficit-Neutral Republicans Are Not Deficit-Neutral Our high-conviction view remains that tax reform - or less ambitious tax cuts - is still coming this year. It is empirically false that Republicans care more about balancing the budget than about reducing the tax burden on individuals and corporates (Chart 17). Arguments to the contrary rely on the time-tested (and failed) analytical strategy of "this time is different." Of course, the timing and legislative process lack clarity (Diagram 1). Republicans still plan to use "budget reconciliation" to sneak through tax reform or cuts. This allows them to approve tax policy with a simple majority, i.e. to bypass any "points of order" or filibusters in the Senate that would raise the bar to a 60-vote supermajority. The rules of reconciliation require a bill to be deficit-neutral beyond the five- or ten-year window mapped out in Congress's preceding budget resolution (the latter, for FY2018, has not yet passed). But this means that a bill that blows out the budget deficit can still be passed as long as it has a "sunset clause" at the end of the 10-year period, as was the case with President Bush's tax cuts.14 We are also sanguine on the more immediate question of government funding. Congress has to agree to fund the government by April 28 - the expiration date of December's continuing resolution - in order to avoid a government shutdown. Democrats are threatening to sink the appropriations bills (or omnibus bill) if Republicans attach noxious "riders" to it, such as defunding Planned Parenthood or building Trump's border wall. We think the Democrats are bluffing. Furthermore, leading Republicans are already signaling that they will postpone their moves on the most toxic issues to avoid a shutdown that would make them look incompetent. Diagram 1U.S. Congressional Budget Timeline 2017 Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 What about the upcoming vote to confirm President Trump's pick for the Supreme Court, Judge Neil M. Gorsuch? Is there any investment relevance of the pick? We do not think so. Judge Gorsuch will replace Judge Antonin Scalia and thereby protect the slightly conservative tilt of the court. Investors should watch to see if enough Democrats in fact filibuster the nomination and if Republicans change Senate rules to override filibusters for Supreme Court nominations (the so-called "nuclear option"). If Democrats insist on goading Republicans into this rule change, then the odds of bipartisan compromise on legislative initiatives (such as an infrastructure package) will fall, relative to a situation where some Democrats endorse Gorsuch and Republicans uphold Senate norms. Bottom Line: The market no longer believes that corporate tax reform will happen. High tax-rate companies have given back all of their post-election equity gains (Chart 18). We think this selloff is a mistake. As our report this week attests, we base our view on a study of political, legislative, and constitutional constraints to tax reforms and cuts. We are highly skeptical of "this time is different" narratives that overstate the power of the Freedom Caucus. As a direct bet on our high conviction view, we recommend that investors go long the high tax-rate basket relative to the S&P 500. Chart 18How To Profit From Tax Reform How To Profit From Tax Reform How To Profit From Tax Reform Chart 19Brexit Political Risk Bottomed In January Brexit Political Risk Bottomed In January Brexit Political Risk Bottomed In January Brexit: Much Ado About Nothing? The market has ignored both the invocation of Article 50 by London on March 29 and the publication of the EU's negotiation "guidelines" on March 31.15 As we discussed in January, political tensions between the EU and the U.K. likely peaked before January 16. This was the day when the market fully priced in the rumors that the U.K. would seek to withdraw from the EU Common Market. Prime Minister Theresa May confirmed the rumors on January 17 with a key speech. We have been long the GBP since.16 Investors continue to fret that there are more risks to come, but the market agrees with our assessment. The GBP bottomed against the EUR on October 11 (just after the Conservative Party conference where PM May affirmed the government's commitment to the referendum result) and bottomed against the USD on January 16. It has rallied against both currencies since the latter date (Chart 19). Why? First, the EU guidelines on the Brexit negotiations do not appear to be aggressive. The EU has offered the U.K. a "transition period," for an indefinite time between the U.K.'s technical withdrawal (March 29, 2019) and the new cross-channel status quo (for example, a free trade agreement, FTA). This is significant given that financial media doubted whether any transitional deal would be on offer as recently as a week ago. Second, the EU has implied that it will at least begin talks on an FTA with the U.K. while the negotiations on withdrawal are still ongoing. This is not exactly what London asked for but it is close.17 This means that the EU will hold the U.K.'s liabilities to the bloc for ransom before it begins negotiating a post-membership deal, but it also means that the EU does not want to threaten a "status cliff" where the U.K. and EU fail to forge any deal and hence revert back to basic WTO tariffs. Third, a leaked copy of an EU parliamentary resolution on Brexit also suggests that a "transition period," in this case limited to three years, is in the offing.18 It also hints at what we have long argued, that the EU would treat the U.K.'s notice of withdrawal (triggering Article 50) as revocable, i.e. reversible. That said, some negatives are obvious from both documents: The EU parliamentary resolution insists that the City of London does not get special access to the EU's common market; Spain will get a veto on whether the final agreement applies to the territory of Gibraltar; The U.K. will have to settle its financial commitments to the EU; No "cherry picking" of common-market benefits will be allowed. These points do not surprise us. We have been pessimists on London's ability to retain access to the EU common market well before Brexit. And May's own speech on January 17 cited that London would not seek to "cherry pick" benefits from the common market. Our assessment remains that the EU is not out for blood. Or, as we put it in our January 25 note: Now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. May's January 17 speech was therefore a classic "sell the rumor, buy the news" moment. Of course, we expect further risks and crises, especially with the British press laser-focused on the issue. But much of the hysterics will be irrelevant. Take the issue of the dreaded "exit fee." The media has focused on the fee as if the EU is seeking to impose a blood tax on the U.K. Instead, the roughly €60 billion "fee" is merely the remaining portion of U.K.'s contribution to the 2014-2020 EU budget, plus other liabilities. The EU sets its budgets on a seven-year horizon and the U.K. is going to remain a member state until March 2019. Some British newspapers think that the U.K. can continue to live in an EU apartment for the remainder of its lease without paying rent! The fact of the matter is that the EU is a trading power focused on expanding its markets. It is not in the interest of core member states, especially the export-oriented powerhouses such as Germany, Sweden, and the Netherlands, to lose the U.K. as a trading partner. And it is certainly not in their interest to impose such painful retribution as to risk harming their own economies. What about the message that the EU would want to send to other member states? This is only important if the likelihood of exit by another EU member state is high. As we discussed immediately after the referendum, the risks of EU dissolution are grossly overstated.19 Recent elections in Austria and the Netherlands confirm our analysis, and we expect that French elections will as well. Yes, Italy is a risk to the EU, given that Euroskepticism is on the rise there. However, the EU has ample tools with which to dissuade the Italians from exiting - starting with a market riot that the ECB can induce at any time by reversing its offer to buy Italian debt. And it is doubtful that the EU can change Italian sentiment through punitive Brexit negotiations. What kind of a post-Brexit relationship should investors expect between the U.K. and the EU? There are three options: Customs union: The U.K. is not likely to accept a Turkish arrangement in which it belongs to the customs union but not the common market. That is because the customs union forces Turkey to apply the common EU tariff on all imports, while its exports do not benefit from other countries' trade deals with the EU. The U.K. wants more autonomy over trade, so this is unlikely to be the solution. The Turkish deal also excludes trade in services, which the U.K. will want to promote. Common market lite: The U.K. has a low-probability option of accepting the Norwegian or Swiss options of membership in the common market despite non-membership in the customs union. These options would allow only a few limits to the EU's demand of free movement of goods, services, people, and capital; they are currently non-starters because the U.K. is prioritizing curbs on immigration. It is possible that the U.K. could come around to something similar later, but it would require a shift in domestic politics, of which there is little evidence yet. Chart 20British Public Remains Divided On Brexit Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 FTA: The U.K. is more likely to have an FTA arrangement, comparable to the just-signed EU deal with Canada. This would give the U.K. more autonomy on trade deals with third parties, while keeping tariffs to a minimum and incurring no obligation of free movement of people. It would also likely be more robust than the Canadian deal because of the much higher level of existing integration. Still, the U.K.'s prized service sector would suffer, as FTAs rarely cover services adequately. In fact, one of London's long-standing problems with the EU itself was lack of implementation of the 2006 EU Services Directive, which was supposed to harmonize trade in services and reduce non-tariff barriers to trade. We place the probability of the U.K. reverting back to WTO rules on trade with the EU - the most adverse scenario - to zero. Why such a high-conviction view? The EU has a customs agreement with Turkey, a country that threatens Europe with a Biblical exodus of refugees once every fortnight. In comparison, the U.K. and the EU are geopolitical allies that cooperate on national security, foreign policy, climate change, and other issues. There is no way that investors will wake up in 2019 and find that the U.K. has a worse trade agreement with the EU than Turkey.20 It is not all smooth sailing for the U.K., however. Brexit is not an optimal outcome for the U.K. economy.21 Leaving the EU means a deep cut in its labor-force growth rate, service exports, and inward FDI flows, reducing the U.K.'s growth potential. That said, given that the transitional deal will likely extend the horizon of "final Brexit" to around 2022 - or even beyond - and that there is still a small chance of a total reversal of Brexit, it is very difficult to predict the final impact on the U.K. economy now. There is another option that investors should consider. With Scottish independence gaining steam,22 and political risks rising in Northern Ireland, perhaps the EU is trying to kill Brexit with kindness. Polls on the Brexit referendum remain tight (Chart 20), which suggests that the "Remain" camp could eventually regain the upper hand - particularly if the shock to household income from inflation persists (Chart 21). With the U.K.'s own union at risk, perhaps the Tory leadership will alter its exit strategy over the course of negotiations. Meanwhile, investors should remember that: Chart 21Bremain May Regain Popularity ##br##When Brexit Bites Bremain May Regain Popularity When Brexit Bites Bremain May Regain Popularity When Brexit Bites Chart 22British Public Not Divided On ##br##Current Leadership British Public Not Divided On Current Leadership British Public Not Divided On Current Leadership Article 50 is almost certainly revocable. This is a political issue, not a legal one, as we have long stressed, and as the EU parliament leak suggests. Theresa May has promised that the final deal with the EU will be put to a vote in parliament. The bearish view has assumed that a failure of the vote would cast the U.K. into the abyss of no trade relationship other than the WTO's general agreement on tariffs. But failure could also follow from a shift in politics in the U.K. that seeks to act on the revocability of Article 50 and rejoin the EU. We see no sign of such a shift at the moment (Chart 22), but two to five years is time enough for one to develop. The next U.K. election will take place by May 2020, unless the government engineers a special early election. That is only a year after Article 50's two-year withdrawal period ends. If political winds are changing direction, the EU's allowance of a transition period could widen the window for a relatively smooth reverse-Brexit. In other words, "Brexit still means Brexit," but there are various escape hatches if the public demurs. The Scottish referendum has put a new constraint on the Tories and the EU may have figured out that the best way to encourage the Brits to change their mind is to smother them with kindness. What indications would suggest that the U.K. is changing strategies or the EU turning aggressive? In the U.K., a move to hold early elections could suggest that Prime Minister May wants a mandate of her own. This could enable her to pursue her current strategy more resolutely, but it could also give her the flexibility to reverse it. A sudden loss of support for the Tories, or a surge in the polling in favor of "Bremain," could also trigger a change in the government's approach. A significant public concession by the government in the negotiations could also mark a pivot point. In the EU, the following actions would suggest that the Brexit strategy will become less benign (and that our sanguine view is wrong): stonewalling in the exit negotiations, a reversal of the "Barroso doctrine" in order to encourage Scottish independence, a decision to shorten or deny the transition period, a lack of seriousness in trade negotiations, a downgrading of security and defense relations, or a move to pry away Gibraltar, among others. Bottom Line: We maintain our view that the pound bottomed along with the political risk on January 16. Yes, Brexit is not an optimal outcome, but the EU appears to be willing to push off the final date of the break with the U.K. into the future. At some point, we expect the U.K.'s inward FDI to suffer as companies - especially banks - grapple with the reality of Brexit. However, given the negotiations and potential transitional deal of up to three years, that date could be anywhere from two to five years into the future. Update On France: Can We Worry Now? We have spent much ink this year explaining why populist Marine Le Pen is not going to win the two-round French election on April 23 and May 7.23 Polls continue to support our view, with Le Pen trailing Emmanuel Macron by 26% with 33 days to go to their likely second-round matchup (Chart 23). At this point in the U.S. election, candidate Trump trailed Secretary Hillary Clinton by only 5%. Even Francois Fillon appears to be rallying against Le Pen. Despite ongoing corruption allegations against him, Fillon is leading Le Pen in a hypothetical second-round matchup by 16%. Chart 23Le Pen Lags Both Her Rivals##br## In Key Second Round Le Pen Lags Both Her Rivals In Key Second Round Le Pen Lags Both Her Rivals In Key Second Round Chart 24Is American Midwest A Path To##br## Le Pen Presidency? Is American Midwest A Path To Le Pen Presidency? Is American Midwest A Path To Le Pen Presidency? Chart 25No Comparison Between ##br##Le Pen And Trump Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 A sophisticated New York client challenged our comparison of Trump's national polling against Clinton to that of Le Pen and her rivals. Instead, the client asked us to focus on the massive underperformance of the polls in the Midwest, where Trump surprised to the upside and beat long odds to win in Pennsylvania, Michigan, and Wisconsin (Chart 24). We agree that it is all about voter turnout, but again the numbers bear out Le Pen's weakness. She would have to perform six times better than Trump did in the Midwest to win the election (Chart 25). Chart 26Italy's Euroskeptics Much ##br##Stronger Than France's Italy's Euroskeptics Much Stronger Than France's Italy's Euroskeptics Much Stronger Than France's Chart 27The Market Is Missing ##br##The Italian Risks The Market Is Missing The Italian Risks The Market Is Missing The Italian Risks Chart 28Long French Bonds, Short Italian Long French Bonds, Short Italian Long French Bonds, Short Italian We are not dogmatic on the subject, we just refuse to agree with the lazy conventional wisdom that "polls are wrong." They are not. National polls got the U.S. election almost perfectly (the polls predicted a 3.2% Clinton victory and she won the popular vote by 2.1%). It is not our problem that pundits overestimated Clinton's strength, especially in the rustbelt states. Our own quantitative model gave Trump a 40% chance of winning the election on the night of the vote, roughly double the consensus view.24 We will therefore upgrade Le Pen's chances of winning when she starts making serious improvement in her second-round, head-to-head polling. Meanwhile, in Italy, the establishment continues to lose support to Euroskeptic parties (Chart 26). The media have not caught on to this risk, perhaps because they are feasting on negative news from France (Chart 27). The bond market has begun to price higher risks in Italy, with spreads between French and Italian bonds having risen 76 bps since January 2016 (Chart 28). However, they remain 296 bps away from their highs in 2012. We suspect that Italian bonds will see further underperformance relative to French bonds. Bottom Line: We continue to monitor risks in France due to the presidential elections. However, Le Pen remains behind both of her likely opponents by double digits in the second round. We remain long French industrial equities relative to their German counterparts as a play on expected structural reforms post-election. In addition, we are initiating a long French bonds / short Italian bonds recommendation due to our fear that Italy is the one and only risk to European integration in the short and medium term. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Investment Strategy Special Report, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. 6 Please see The Bank Credit Analyst, "March 2017," dated February 23, 2017, available at bca.bcaresearch.com. 7 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com. 10 Data for polarization analysis uses "nominate" (nominal three-step estimation), a multidimensional scaling method developed to analyze preference and choice. Researchers use the bulk of roll call voting in the U.S. Congress over its entire history. Our Chart 10 measures intra-party polarization along the "primary dimension," which is the liberal-conservative spectrum on the basic role of the government in the economy. 11 "The Freedom Caucus will hurt the entire Republican agenda if they don't get on the team, & fast. We must fight them, & Dems, in 2018!" @realDonaldTrump 12 The quote "starve the beast" is a proverbial phrase that has applied to taxes at least since the 1970s. Nowadays it refers to cutting taxes and revenue in an effort to force cuts in expenditures. While the quote is attributed to President Ronald Reagan, he never used it. Instead, he used the analogy of a child's allowance during his campaign in 1980: "If you've got a kid that's extravagant, you can lecture him all you want to about his extravagance. Or you can cut his allowance and achieve the same end much quicker." Subsequent Republican administrations have used similar rhetoric to justify tax cuts, including that of George W. Bush. 13 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 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 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. 14 Please see Megan S. Lynch, "The Budget Reconciliation Process: Timing Of Legislative Action," Congressional Research Service, October 24, 2013, available at digital.library.unt.edu, and Tax Policy Center, "What Is Reconciliation," Briefing Book, available at www.taxpolicycenter.org. See also David Reich and Richard Kogan, "Introduction to Budget 'Reconciliation,'" Center on Budget and Policy Priorities, November 9, 2016, available at www.cbpp.org. 15 Please see Council of the European Union, "Draft guidelines following the United Kingdom's notification under Article 50 TEU," dated March 31, 2017, available at bbc.co.uk. 16 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 17 The exact wording from the EU guidelines: "While an agreement on a future relationship between the Union and the United Kingdom as such can only be concluded once the United Kingdom has become a third country, Article 50 TEU requires to take account of the framework for its future relationship with the Union in the arrangements for withdrawal. To this end, an overall understanding on the framework for the future relationship could be identified during a second phase of the negotiations under Article 50. The Union and its Member States stand ready to engage in preliminary and preparatory discussions to this end in the context of negotiations under Article 50 TEU, as soon as sufficient progress has been made in the first phase towards reaching a satisfactory agreement on the arrangements for an orderly withdrawal." 18 Please see Daniel Boffey, "First EU response to article 50 takes tough line on transitional deal," The Guardian, March 29, 2017, available at www.theguardian.com. 19 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 20 No way. 21 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. 22 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, Special Report, "The French Revolution," dated February 3, 2017, Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com.

Highlights Either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though our preferred long euro expression is long euro/pound near term and long euro/yuan structurally). All three of the above are just one big correlated trade. Long-term equity investors should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. But near term, remain cautious on risk-assets. Feature On the face of it, the ECB has committed to leave interest rates where they are for a very long time. "The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases"1 But take a closer look at this commitment, and an extended period of time could mean as little as a year. As things stand, "the horizon of the net asset purchases" has only nine more months to run, and "well past" could justifiably mean just six months or less beyond that. Furthermore, at the last press conference Draghi emphasized that forward guidance "is an expectation" and that the probabilities of the ECB's expectations are constantly changing. Remember also that the ECB has three policy interest rates:2 the deposit rate (-0.4%), the repo rate (0%) and the marginal lending rate (0.25%) - and the ECB doesn't have to move all three in tandem. Indeed in 2015, the ECB cut the deposit rate before the other two rates (Chart I-2). So it is quite conceivable that the ECB could hike the deposit rate before the other two rates and as soon as a year or so from now. Chart of the WeekGermany/Sweden Combination Has Run A Good Race With The U.S. Germany & Sweden Combination Has Run A Good Race With The U.S. Germany & Sweden Combination Has Run A Good Race With The U.S. Chart I-2The ECB Could Hike Its Deposit Rate Early The ECB Could Hike Its Deposit Rate Early The ECB Could Hike Its Deposit Rate Early ECB council member Ewald Nowotny hinted as much in a Handelsblatt interview last week, saying that all interest rates wouldn't have to be increased simultaneously nor to the same extent. "The ECB could raise the deposit rate earlier than the prime rate." A Major Mispricing: ECB Versus Fed This neatly brings us to one of the most extreme pricings in financial markets at the moment. The expected difference between ECB looseness and Fed tightness two years ahead stands at a 20-year extreme (Chart I-3). Chart I-3An Extreme Pricing: ECB Versus Fed An Extreme Pricing: ECB Versus Fed An Extreme Pricing: ECB Versus Fed Yet the percentage of the euro area population in employment is at an all-time high (Chart I-4), while on an apples for apples comparison, there is no difference between economic growth, inflation, or inflation expectations in the euro area and the U.S.3 Moreover, Draghi points out that "the risks surrounding euro area growth relate predominantly to global factors." If these global risks do materialise, it would prevent both the ECB and the Fed hiking rates through 2018. But if these global risks do not materialise, allowing the Fed to continue hiking through 2018, is it really conceivable that the ECB just sits pat? We think not. On this basis, investors should either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though we prefer long euro/pound near term and long euro/yuan structurally). We say "either or" because all three positions are just one big correlated trade (Chart I-5). Chart I-4Percentage Of Euro Area Population In##br## Employment Near An All-Time High! Percentage Of Euro Area Population In Employment Near An All-Time High! Percentage Of Euro Area Population In Employment Near An All-Time High! Chart I-5Correlated Trade: Interest Rate Futures,##br## Bond Yield Spreads, Ans EUR/USD Correlated Trade: Interest Rate Futures, Bond Yield Spreads, And EUR/USD Correlated Trade: Interest Rate Futures, Bond Yield Spreads, And EUR/USD The French Election: "System 1" And "System 2" The looming risk to this big correlated trade takes the form of the upcoming French Presidential Election. Two data points do not make a trend, but some people are worried that the same dynamic that delivered shock electoral victories for Brexit and Donald Trump in 2016 could propel Marine Le Pen to the Elysée Palace in 2017. This worry is overdone. In explaining the Brexit and Trump shock victories, an important point has been understated. These days many voters care more about politicians' personalities than policies. Emotional appeal arguably matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Both the Brexit and Trump campaigns resonated strongly with emotional System 1. A lot of voters warmed to Boris Johnson, a leader of the Brexit campaign, and to Donald Trump. By contrast, the Bremain and Hillary Clinton campaigns tried to appeal mainly to cold rational System 2. But as Kahneman explains, when cold rational System 2 competes with emotional System 1, emotional System 1 almost always wins. In this regard, the dynamic of the French Presidential election is very different to the U.K.'s EU Referendum and the U.S. Presidential Election. Charles Grant, director of the Centre for European Reform, points out that "Emmanuel Macron's personality, and notably his charm, calm authority and courage may well (emotionally) appeal to more voters than Marine Le Pen's simplistic remedies and bitterness." Therefore, a final run off between Le Pen and Macron - as now seems highly likely - does not give us sleepless nights. But we would be concerned if the final run off were between Le Pen and the much less emotionally appealing François Fillon (Chart I-6 and Chart I-7). Chart I-6A Final Run Off Between Le Pen & Macron... A Final Run Off Between Le Pen & Macron... A Final Run Off Between Le Pen & Macron... Chart I-7...Does Not Give Us Sleepless Nights ...Does Not Give Us Sleepless Nights ...Does Not Give Us Sleepless Nights Incidentally, both Daniel Kahneman and Charles Grant will be speaking at our forthcoming New York Conference on September 25-26, and promise to provide fascinating investment insights from their areas of expertise. So book your places now! A Better Way To Invest In Europe: Germany And Sweden All of this might suggest that the Eurostoxx50 should outperform the S&P500. Not necessarily. Extreme economic and political tail-events aside, there is almost no connection between national or regional economic relative performance and stock market relative performance. As we demonstrated in the Fallacy Of Division,4 by far the biggest driver of Eurostoxx50 versus S&P500 performance is its sector skew. The Eurostoxx50 has a major 15% weighting to banks and a minor 7% weighting to tech. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 22% weighting to tech. Furthermore, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. So relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,5 or vice-versa. Everything else is largely irrelevant. But this begs the question: can a different combination of European markets neutralise the sector skew and thereby provide a fairer head-to-head contest with the tech-heavy S&P500? At first glance, the answer seems to be no. Europe simply does not have the same type of technology companies that the U.S. has. So no combination of European markets can match the S&P500 tech exposure. On the other hand, Europe is the world-leader in a different type of technology: innovative industrial equipment and materials. It turns out that a 50:50 combination of Germany (DAX) and Sweden (OMX) matches the exposure to European industrial equipment and materials with the exposure to American tech. At the same time, the DAX/OMX combination largely removes Europe's bank overweight. The upshot is that the DAX/OMX combination has run a very good race with the S&P500 through the past 10 years, while the Eurostoxx50 has failed to keep the pace (Chart of the Week). In effect, DAX/OMX versus S&P500 reduces to Siemens, Bayer and Atlas Copco versus Apple, Microsoft and Google (Chart I-8). Compared to the euro area banks, Europe's innovative industrial equipment and materials are a much better long-term match-up against U.S. tech (Chart I-9). Indeed, my colleague, Brian Piccioni, BCA Technology strategist, points out that Bayer is a good play on the revolutionary new genetic modification technology CRISPR-Cas9.6 Chart I-8DAX/OMX Vs. S&P500 = Siemens, Bayer & Atlas Copco ##br##Vs. Apple, Microsoft & Google DAX/OMX Vs. S&P500 = Siemens, Bayer & Atlas Copco Vs. Apple, Microsoft & Google DAX/OMX Vs. S&P500 = Siemens, Bayer & Atlas Copco Vs. Apple, Microsoft & Google Chart I-9European Innovative Industrial Equipment & Materials ##br##Is A Good Match-Up Against American Tech European Innovative Industrial Equipment & Materials Is A Good Match-Up Against American Tech European Innovative Industrial Equipment & Materials Is A Good Match-Up Against American Tech Investors who want a long-term equity exposure to Europe should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. Nevertheless, those who can fine-tune their timing should await a better entry-point for all risk-assets. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the ECB introductory statement to the press conference, March 9 2017. 2 The deposit rate (-0.4%) is the rate at which commercial banks park their excess liquidity; the repo rate (0%) is the usually quoted policy rate for the ECB's standard money market operations; and the marginal lending rate (0.25%) is the rate at which commercial banks borrow from the central bank, usually when they cannot access interbank funding. 3 Please see the European Investment Strategy Weekly Report 'Fake News In Europe' January 26, 2017 available at eis.bcaresearch.com 4 Published on March 9, 2017 and available at eis.bcaresearch.com 5 Listed as Alphabet. 6 Please see the Technology Strategy and Global Investment Strategy Special Report 'CRISPR-Cas9: Investment Implications' March 17, 2017 available at www.bcaresearch.com Fractal Trading Model* There are no new trades this week. We are expressing a tactical short position in equities through a short exposure to the Netherlands AEX. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Short AEX Short AEX * 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 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. 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 Trump's agenda has not derailed ... at least not yet; Europe remains a red herring ... as the Dutch showed; Turkey cannot restart Europe's immigration crisis; Supply-side reforms are still likely in France; The ECB will remain dovish for longer than expected; EUR/USD may rise in the short term, but it will relapse. Feature In this Weekly Report, we focus on the key questions regarding continental European politics. To begin, however, we will briefly address the U.S., since investors are starting to worry about whether President Donald Trump can get his legislative agenda through, given the recent testimony of FBI Director James Comey on the alleged interference of Russia in the U.S. election. There are three points to focus on in the U.S.: Chart 1Trump Not Dead To Republicans Yet Five Questions On Europe Five Questions On Europe The GOP base supports Trump: President Trump was always going to be a controversial president. Anyone who is surprised by it today clearly was not paying attention last year. In the long term, Trump's extraordinarily low popularity will be an albatross around his neck, draining his political capital. However, until the mid-term elections, his popularity with Republican voters is all that matters, and it remains strong (Chart 1). House Republicans have to worry that they could face pro-Trump challengers in primary elections in the summer ahead of the 2018 midterms. As such, as long as the Republican voters support Trump, he still has political capital. Republicans in Congress want tax reform: Budget-busting tax reform is not only a Trump policy, it is a Republican policy. We have already received plenty of signals from fiscal hawks in Congress that they intend to use "dynamic scoring," macroeconomic modeling that takes into account revenue-positive effects of tax cuts when assessing the impact on the budget, in order to justify cuts as revenue-neutral. Republicans are also looking at the repatriation of corporate earnings and a border adjustment tax to raise revenue. Obamacare delay may not mean much: We already pointed out before that the GOP intention to focus on Obamacare first, tax reform second, would get them in trouble.1 This is now playing out. Opposing the Obamacare replacement may make sense to small-government Tea Party members. Repeal, alone, is why they are in Congress in the first place, given the 2010 wave election. But opposing tax cuts - once justified by dynamic scoring as revenue neutral - will be much more difficult. The Tea Party is "small government" first, fiscal restraint second. In other words, if tax reform cuts taxes and reduces revenue available to Washington D.C., "temporary" budget deficits will be easy to swallow. This is not to say that the recent events have not hurt the chances of whopping tax cuts and infrastructure spending. In particular, we think that Congressional GOP members may take over the agenda if Trump loses any more political capital. And this will mean less budget-busting than Trump would have done. Also, tax reform was always going to be difficult as special interests and lobbyists were bound to get involved. Chart 2French Spreads Are Overstated French Spreads Are Overstated French Spreads Are Overstated In addition, the probability of an eventual Trump impeachment - were Republicans to lose the House, or grassroots Republicans to abandon him in droves - has risen. Investors can no longer ignore this issue, even though it was initially a liberal fantasy. However, all of these risks to the Trump agenda will likely spur the GOP in the House to focus on passing tax reform while they still have a majority in Congress and control of the White House. We still expect tax reform to be done this year - within the fiscal year 2018 reconciliation bill - as time now may truly be running out for Republicans. Europe, meanwhile remains a focal point in client meetings. Our view that Europe will be a geopolitical red herring in 2017 - and thus an investment opportunity - remains controversial. We will address Brexit and the new Scottish independence referendum in our report next week, to coincide with London's formal invocation of Article 50 of the Lisbon Treaty to initiate the exit proceedings. Popular support for independence in Scotland has been one of our measures of "Bregret" since last summer and it has just sprung back to life, which adds a new source of risk for investors. On the continent, investors are particularly concerned that the upcoming French election will follow the populist script from the U.K. and the U.S. last year. This worry has pushed French bond yield spreads over German bonds to the highest level since 2011, bringing French bonds into the same trend as peripheral bonds (Chart 2). Since the outbreak of the euro area's sovereign debt crisis, a tight correlation between French and Italian/Spanish bonds has signified systemic political risk. We disagree that political events represent a systemic risk to the euro area in 2017. This week, we address five critical questions inspired by challenges to our view presented by our clients in meetings and conference calls. Question 1: Is The Dutch Election Result Important? Few clients have asked for a post-mortem on the March 15 Dutch election, but many asked about the vote beforehand. It has come and gone with little fanfare. Financial media have brushed it aside as it does not fit the neat script of rising Euroskepticism on the continent. To recap, the Euroskeptic and populist Party for Freedom (PVV), led by Geert Wilders, gained five seats in the election (13% of the votes cast), bringing its total support to 20 in the 150-seat parliament. Despite the gains, however, the election was an unmitigated disaster for Wilders, as the PVV was polling strong for most of the campaign and was expected to win between 30 and 35 seats (Chart 3). In terms of its share of total votes, the PVV's performance in 2017 trails its performance in the 2010 general election and the 2009 and 2014 European Parliament elections. Not only did the PVV underperform the past year's polls, but also they only managed to eke out their fourth-best performance ever. Chart 3Dutch Euroskeptics Were Always Overrated Five Questions On Europe Five Questions On Europe Chart 4Austria Leans Euroskeptic... Austria Leans Euroskeptic... Austria Leans Euroskeptic... Chart 5...Yet Chose A Europhile President ...Yet Chose A Europhile President ...Yet Chose A Europhile President It is a mistake to ignore these results. They teach us three valuable lessons: Trend reversal: In April of last year we warned clients that the upcoming Brexit referendum and U.S. elections had a much higher chance of populist outcomes than the European elections in 2017.2 The basis for our controversial claim was the notion that European social-welfare states dampened the pain of globalization for the middle class. We now have two elections that confirm our view that European voters are just not as angry as their Anglo-Saxon counterparts. Aside from the Dutch, there is also the lesson from the similarly ignored Austrian presidential election last December. Despite Austria's baseline as a relatively Euroskeptic country (Chart 4), the right wing, populist candidate lost his solid lead in the last few weeks ahead of the election (Chart 5). Clients should not ignore Austria and the Netherlands, since both countries have a long tradition of Euroskepticism and their populist, anti-immigration parties are well established and highly competitive. If Euroskeptics cannot win here, where can they win? It's immigration, stupid: Investors should make a distinction between anti-immigrant and anti-euro sentiment. In both the Netherlands and Austria, it was anti-immigrant sentiment that propelled populist parties in the polls. However, as the migration crisis abated, their polling collapsed. This was clearest in the Netherlands, where asylum applications to the EU - advanced by six months - tracked closely with PVV polling (Chart 6). The distinction is highly relevant as it means that even if the populists had taken power, they would not necessarily have had enough political support to take their country out of the euro area. This is particularly the case in the Netherlands, where support for the euro remains high (Chart 7). Brexit is not helping: Much ink has been spilt in the media suggesting that Brexit would encourage voters in Europe to hold similar popular referendums. We disagreed with this assertion and now the evidence from Austria and the Netherlands supports our view.3 Chart 3 shows that the decline in the PVV's support sped up around the time of the U.K. referendum, suggesting that Brexit may even have discouraged voters from voting for the populist option. Geert Wilders was temporarily buoyed by the kangaroo court accusing him of racial insensitivity. But the sympathy vote quickly dissipated and PVV polling reverted back to the post-Brexit trend.4 Chart 6Dutch Populists Linked To Immigration Dutch Populists Linked To Immigration Dutch Populists Linked To Immigration Chart 7The Dutch Approve Of The Euro The Dutch Approve Of The Euro The Dutch Approve Of The Euro Bottom Line: The election in the Netherlands provides an important data point that should not be ignored. The populist PVV not only failed to meet polling expectations, it failed to repeat its result from seven years ago. Investors are ignoring how important the abating of the migration crisis truly was for European politics. Question 2: Can Turkey Restart The Immigration Crisis? The end of the migration crisis in Europe clearly played a major role in dampening support for the Dutch and Austrian populists. We expected this in September 2015, when we argued with high conviction that the migration crisis would prove ephemeral (Chart 8).5 How did we make the right call at the height of the influx of asylum seekers into Europe? Three insights guided us: Civil wars end: No civil war can last forever. Eventually, battle lines ossify into de facto borders between warring factions and hostilities draw to a close. The Syrian Civil War is still going, but its most vicious phase has ended. Civilians have either moved into safer zones or, tragically, have perished. Enforcement increases: The influx of 220,000 asylum seekers per month - the height of the crisis in October 2015 - was unsustainable. Eventually, enforcement tightens. This happened to the "Balkan route" as countries reinforced their borders and Hungary built a fence. Liberal attitudes wane: European attitudes towards migrants soured quickly as the crisis escalated. After the highly publicized welcoming message from Chancellor Angela Merkel, the tone shifted to one of quiet hostility. This significantly changed the cost-benefit calculus of the economic migrants most likely to be deported. Given that roughly half of asylum seekers in 2015 were not fleeing war, but merely looking for a better life, the change in attitude in Europe was important. Many of our clients are today worried that Turkey might deliberately restart the migration crisis as a way to punish Europe amidst ongoing Euro-Turkish disputes. The rhetoric from Ankara supports this concern: Turkish officials have threatened economic sanctions against the Netherlands, and accused Germany of supporting the July 2016 coup and the U.S. of funding the Islamic State. We call Turkey's bluff on this threat. First, the number of migrants crossing the Mediterranean collapsed well before the EU-Turkey deal was negotiated in March 2016. This puts into doubt Turkey's role in dampening the flow in the first place. Second, unlike in 2015, Turkey is now officially involved in the Syrian conflict, having invaded the country last August. By participating directly, Turkey can no longer tolerate the unfettered flow of migrants through its territory to Europe, a luxury in 2015 when it was a "passive" bystander. Today, migrants flowing through its territory are even more likely to be parties active in the Syrian war looking to strike Turkish targets for strategic reasons. Third, the Turkish economy is reliant on Europe for both FDI and export demand (Chart 9). If Turkey were to lash out by encouraging migration into Europe, the subsequent economic sanctions would devastate the Turkish economy and collapse its currency. Investment and trade with Europe make up the vast majority of its current account deficit. Chart 8Migration Crisis Well Past Its Peak Migration Crisis Well Past Its Peak Migration Crisis Well Past Its Peak Chart 9Turkey Depends On Europe Turkey Depends On Europe Turkey Depends On Europe Bottom Line: Turkey can make Europe's life difficult. However, the migration crisis did not end because of Turkey and therefore will not restart because of Turkey. Furthermore, Ankara has its own security to consider and will continue to keep its border with Syria closed and closely monitored. Question 3: Is A Supply-Side Revolution Still Possible In France? In February, we posited that a supply-side revolution was afoot in France.6 Since then, the Thatcherite candidate for presidency - François Fillon - has suffered an ignominious fall in the polls due to ongoing corruption scandals. This somewhat dampens our enthusiasm, given that Fillon's program was by far the most aggressive in proposing cuts to the size of the French state. Still, the new leading candidate Emmanuel Macron (Chart 10) is quite possibly the most right-wing of left-wing candidates that France has ever fielded. He quit the Socialist Party and has received endorsements across the ideological spectrum. In addition, his governing program is largely pro-market: Public expenditure will go down to 50% of GDP (from 57%) by 2022; Corporate taxes will be reduced from 33.3% to 25%; Regulation will be simplified for small and medium-sized businesses; Productive investment will be exempt from the wealth tax, which will focus solely on real estate; Exceptions to the 35-hour work week will be allowed at the company level. More important than Macron's campaign promises is the evidence that the French "median voter" is shifting. Polls suggest that a "silent majority" in France favors structural reform (Chart 11). Chart 10Macron's Huge Lead Over Le Pen Macron's Huge Lead Over Le Pen Macron's Huge Lead Over Le Pen Chart 11France: 'Silent Majority' Wants Reform Five Questions On Europe Five Questions On Europe As such, France may be ready for reforms and Emmanuel Macron could be France's Gerhard Schröder, a centrist reformer capable of pulling the left-wing towards pro-market reforms. What about the fears that Macron will not be able to command a majority in France's National Assembly? Macron's party En Marche! was founded less than a year ago and is unlikely to be competitive in the upcoming June legislative elections (a two-round election to be held on June 10 and 17). This will force Macron, should he win, to "cohabitate" with a prime minister from another party. Most likely, this will mean a prime minister from the center-right Republicans. For investors, this could be very positive. The French constitution gives the National Assembly most power over domestic affairs when the president cannot command a majority. This means that a center-right prime minister who receives his mandate from Macron will be in charge of domestic reforms. We see no reason why Macron would not be able to work with such a prime minister. In fact, the worse En Marche! does in the parliamentary election, the more likely that Macron will be perceived as non-threatening to the center-right Republicans. What if no party wins a majority in parliament? We think that Macron would excel in this situation. He would be able to get support from the right-wing of the Socialist Party and the centrist elements of the Republicans. And if the National Assembly fails to support his program, he could always call for a new parliamentary election in a year's time, given his presidential powers. In other words, investors may be unduly pessimistic about the prospect of reforms under Macron. Several prominent center-right figures - including Alain Juppé and Manuel Valls - have already distanced themselves from Fillon, perhaps opening up the possibility of a premiership under Macron. In addition, Macron himself has refused to accuse Fillon of corruption, a smart strategy given that he will need his endorsement in the second round against Le Pen and that he will likely need to cohabitate with the Republicans to govern. What of Marine Le Pen's probability of winning? At this point, polling does not look good for her. Not only is she trailing Macron by 22% in the second round, but she is even trailing Fillon by 11%. Nonetheless, we suspect that she will close the gap over the next month. Election momentum works in cycles and she should be able to bounce back, giving investors another scare ahead of the election. Bottom Line: Concerns over Emmanuel Macron's ability to pursue structural reforms are overstated. Yes, he is less ideal of a candidate than Fillon from the market's perspective, but no, we do not doubt that he would be able to cohabitate with a center-right parliament. That said, we cannot pass definitive judgment until the parliamentary election takes place in June. Question 4: Will Germans Want A Hawk In 2019? An Austrian member of the ECB Governing Council, Ewald Nowotny, spooked the markets by suggesting that Bundesbank President Jens Weidmann would be one of the two most likely candidates to replace Mario Draghi in 2019. Weidmann is a noted hawk who has opposed the ECB's easy monetary policy and even testified against Angela Merkel's government during the court case assessing the constitutionality of the ECB's Outright Monetary Transactions (OMT). The prospect of a Weidmann ECB presidency fits the narrative that Germans will want a hawk to replace Mario Draghi in 2019. The idea is that by 2019, inflation will be close to the ECB's target of 2% and Germans would be itching to beat it down. We have heard this view from colleagues and clients for some time. And we have disagreed with it for quite some time as well! As we pointed out in 2012, it was a German political decision to shift the ECB towards a dovish outlook.7 This is not to say that the ECB takes its orders from Berlin. Rather, it is that Chancellor Merkel had plenty of opportunities via personnel decisions to ensure that the ECB followed a more monetarist and hawkish line. For example, she could have signed off on former Bundesbank President Axel Weber, who was the leading candidate for the job in 2011. She refused when Weber signaled his opposition to the ECB's initial bond-buying program (the Securities Market Program). Mario Draghi was quickly tapped as the alternative candidate suitable to Berlin. Later in 2011, ECB Executive Board member Jürgen Stark resigned over opposition to the same ECB bond-buying program. Since Stark was the German member of the Executive Board, convention held that Berlin would propose his replacement. In other words, while Merkel had her pick of Germany's foremost economists, she picked her finance minister's deputy, Jörg Asmussen. Neither Draghi nor Asmussen have a strand of monetarist or inflation-hawk DNA between the two of them. ECB policy has not been dovish by accident but by design. While it is true that the ECB will inhabit a different macro environment in 2017-19 from the crisis of 2011-12, nevertheless we suspect that dovishness will continue beyond 2019 for two key reasons: German domestic politics: Germans are not becoming Euroskeptic, they are turning rabidly Europhile! If the polls are to be believed, Germans are now the most pro-euro people in Europe (Chart 12). Martin Schulz, chancellor-candidate of the center-left Social Democratic Party (SPD), is campaigning on an aggressive anti-populist, pro-EU platform. He has accused Merkel of being too reticent and of providing Europe's Euroskeptics with a tailwind due to her policies. The SPD's recent climb in the polls is stunning (Chart 13). But even if Schulz fails to win, Merkel will have to take into account his brand of politics if she intends to reconstitute the Grand Coalition with the SPD. It is highly unlikely that Schulz will sign off on a hawkish ECB president (or on the return of Finance Minister Wolfgang Schäuble for that matter). Italian risks: While we have been sanguine about this year's political risks, the Italian election slated for February 2018 is set for genuine fireworks. Euroskeptic parties have now taken a lead in the polls (Chart 14). While the election is still too close to call, and a lot of things can happen between now and then, we expect it to be a risk catalyst in Europe. The problem with Italy is that the election is unlikely to provide any clarity. A hung parliament will likely produce a weak, potentially minority government. Given Italy's potential GDP growth rate of about 0%, this means that a weak government will at some point have to deal with a recession, heightening political risks beyond 2018. Chart 12Germans Love The Euro Germans Love The Euro Germans Love The Euro Chart 13Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Chart 14Italian Elections: The Big Risk Italian Elections: The Big Risk Italian Elections: The Big Risk Bottom Line: Italy will hang over Europe like a Sword of Damocles for quite some time. The ECB will therefore be forced to remain dovish a lot longer than investors think. We see no evidence that Berlin will seek to reverse this policy. In fact, given the political paradigm shift in Germany itself, we suspect that Berlin will turn more Europhile over the next several years. Question 5: What Is The Big Picture For Europe? What explains the dogged persistence of support for European integration on the continent? Even in the case of Italy - where Euroskepticism is clearly on the rise - we would bet on voters supporting euro area and EU membership in a referendum (albeit with a low conviction). Why? In 2011, at the height of the euro area sovereign debt crisis, we elucidated our view on the long-term trajectory of European integration.8 We highly recommend that our clients re-read this analysis, as it continues to inform our net assessment of Europe. Our assertion in 2011 was that Europe is integrating out of weakness, not out of misplaced hope of strength. Much of the analysis in the financial community and media does not understand this point. It therefore rejects the wisdom of integration on the basis that Europhile policymakers are blinded by ambition. In our view, they are driven by necessity. As Chart 15 suggests, the average "hard power" of the five largest economies in the euro area (the EMU-5) is much lower than the average "hard power" of the BRIC states.9 European integration is therefore an attempt to asymptotically approach the aggregate, rather than the average, "hard power" of the EMU-5. Europe will never achieve the aggregate figure, as that will require a level of integration that is impossible. But the effort lies beneath European policymakers' goal of an "ever closer union." The truth of the matter is that European nation-states - as individual sovereign states - simply do not matter anymore. Their economic weight, demographics, and military strength relative to other nations are a far cry from when Europe dominated the world (Chart 16). Chart 15European Integration Is About Geopolitics... European Integration Is About Geopolitics... European Integration Is About Geopolitics... Chart 16...And Global Relevance ...And Global Relevance ...And Global Relevance If European countries seek to shape their geopolitical and macroeconomic environment, they have to act in unison. This is not a normative statement, it is an empirical fact. This means that everything from Russian assertiveness and immigration crises to energy policy and trade negotiations have to be handled as a bloc. But is this not an elitist view? To what extent do European voters think in such grand geopolitical terms? According to polling, they think this way more than most analysts are willing to admit! Chart 17 shows that most Europeans - other than the British and Italians - are "in it" for geopolitical relevance and security, and only secondarily for economic growth. Even in Italy, geopolitical concerns are more important than economic performance, although levels of both suggest that Italy is again the critical risk for Europe. We suspect that it is this commitment to the non-economic goals of European integration that sustains the political commitment of both elites and the general public to the European project. As Chart 18 suggests, European voters continue to doubt that their future will be brighter outside of the bloc. Chart 17Voters Grasp The EU's Purpose ... Five Questions On Europe Five Questions On Europe Chart 18...And Most Want To Stay In It ...And Most Want To Stay In It ...And Most Want To Stay In It Bottom Line: European integration is not just an economic project. Voters understand this - not in all countries, but in enough to sustain integration beyond the immediate risks. Given this assessment, it is not clear to us that the project would collapse even if Italy left. Investment Implications Given our political assessment, we continue to support the recommendation of our colleague Peter Berezin that investors overweight euro area equities in a global portfolio.10 As Peter recently elucidated, capital goods orders continue to trend higher, which is a positive for investment spending on a cyclical horizon - helping euro area assets (Chart 19). Furthermore, private-sector credit growth remains robust, despite political risks (Chart 20). Chart 19European Economy Looking Up European Economy Looking Up European Economy Looking Up Chart 20Credit Growing Well Despite Election Risk Credit Growing Well Despite Election Risk Credit Growing Well Despite Election Risk Over the next 6-12 months, we see EUR/USD rising, especially as the ECB contemplates tapering its bond purchases. We recommend a tactical long EUR/USD trade as a result. The euro could rise higher if the Trump administration disappoints the market on tax reform and infrastructure spending, policies that were supposed to supercharge the U.S. economy and prompt further Fed hawkishness. Over the long term, however, we doubt that the ECB will have the luxury of hawkishness. And we highly doubt that Berlin will rebel against dovish monetary policy. In fact, investors may be using the wrong mental map if they are equating Mario Draghi's taper with that of Ben Bernanke. While Bernanke intended to signal eventual tightening, Draghi will likely do everything in his power to dissuade the market from believing that interest rate hikes are inevitably coming soon. Therefore, we suspect that EUR/USD will eventually hit parity, after a potential rally in 2017. While this long-term depreciation may make sense from a political and macroeconomic perspective for Europe, it will likely set the stage for a geopolitical confrontation between the Trump Administration and Europe sometime next year. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 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 Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 4 The media has suggested that the PVV merely suffered because of the Turkey-Netherlands spat over Turkish political campaigning in the Netherlands. We see no evidence of this. First, the PVV's collapse in the polls predates the crisis by several weeks. Second, the crisis had all the hallmarks of a trap for the establishment. It is not the fault of incumbent Prime Minister Mark Rutte for adeptly capitalizing on the situation. 5 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 7 Please see "Draghi And Asmussen, Not The OMT, Are A Game Changer," in BCA Geopolitical Strategy Monthly Report "Fortuna And Policymakers," dated October 10, 2012, available at gps.bcaresearch.com. 8 Please see BCA Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 9 As measured by the BCA Geopolitical Power Index. 10 Please see BCA Global Investment Strategy Weekly Report, "Three Battles That Will Determine The Euro Area's Destiny," dated March 10, 2017, available at gis.bcaresearch.com.