Elections

Highlights Geopolitics will not spoil the stock rally yet; European election risks remain overstated; In China, look beyond the National Party Congress; China's reforms could re-launch in 2018 ... ... But India's reforms are gaining momentum now. Feature The global economy continues to surprise to the upside, with the latest round of global purchasing managers' indices (PMIs) confirming that the business cycle continues to accelerate (Chart 1). In the context of firming global growth, the Fed's decision to hike rates may not produce as violent of a reaction from the dollar as last year, giving way to further upside in stocks. And while investors continue to fret about valuations, U.S. stocks are expensive only relative to history, not relative to competing assets, as our colleague Lenka Martinek of the U.S. Investment Strategy service points out (Chart 2).1 Chart 1Because I'm Happy Because I'm Happy Because I'm Happy Chart 2U.S. Stocks Pricey By History, Not Peers U.S. Stocks Pricey By History, Not Peers U.S. Stocks Pricey By History, Not Peers What geopolitical news could break up the party over the next six months? Europe: As we argued three weeks ago, the European electoral calendar is unusually busy (Table 1).2 However, we have also posited in our 2017 Strategic Outlook that Europe will be a red herring this year, allowing risk assets to "climb the wall of worry."3 The first test of this thesis comes today, with the Dutch general elections taking place. The polls suggest that the Dutch electorate is not following the populist trend of the Brexit referendum and U.S. election (Chart 3), but rather in the footsteps of the little noticed Austrian presidential election in December, which saw the populist presidential candidate defeated. Dutch Euroskeptics, who have led the polling throughout the last twelve months, are bleeding support as election day approaches. Meanwhile, in France, Marine Le Pen is struggling to keep momentum going with only a month and a half to the first round. Thus far, our thesis on Europe is holding. Table 1Busy Calendar For Europe This Year China Down, India Up? China Down, India Up? Chart 3Dutch Euroskeptics Are An Overstated Threat China Down, India Up? China Down, India Up? The U.S.: Investors will finally get to put numbers to President Trump's rhetoric when the White House announces its budget on March 16. As we argued last week, President Trump is who we thought he was: an economic populist looking to shake up America's status quo. That suggests he will err on the side of greater deficits and large middle-class tax cuts. We do not think Congress will bar his way, as it has rarely restrained a Republican president from profligacy (Chart 4). We could be wrong, but it is unclear if a more fiscally responsible budget would be negative for the markets. On one hand, it may disappoint optimistic growth projections, but on the other, it would mean that the Fed would have no reason to err on the side of more rate hikes in 2017. Meanwhile, while we continue to fear protectionism's impact on the market, it is unlikely that the Trump White House will focus on trade when so many domestic priorities are looming this summer. Russia: As we argued in a Special Report with the Emerging Markets Strategy group last week, Russia may be entering a low-beta paradigm - escaping from its close embrace with oil prices - due to the combination of orthodox monetary policy, modest structural reforms, and growing confidence in its geopolitical predicament.4 This is not the time for President Putin to rattle nerves in the West. He does not want to give Europe and the U.S. a reason to cooperate. We therefore expect Russia's geopolitical risk premium to continue to decline, a boon for European risk assets (Chart 5). Chart 4Budgets: Republican Presidents##br## Get What They Want China Down, India Up? China Down, India Up? Chart 5Russia's Calm##br## Is Europe's Profit Russia's Calm Is Europe's Profit Russia's Calm Is Europe's Profit From a tactical perspective, we believe that the confluence of geopolitical forces supports our continued overweight of developed-market equities versus those of emerging markets. Within developed markets, the BCA House View is to prefer euro-area equities due to overstated geopolitical risks and favorable valuations relative to the U.S. equity market. BCA's Global Investment Strategy has pointed out that euro-area equities are one standard deviation undervalued relative to the U.S., when one applies U.S. sector weights to them (Chart 6). In addition, BCA's U.S. Bond Strategy service believes that Treasury yields have more room to rise, with growth putting upward pressure on inflation and the Fed in a rate-hike cycle. This makes sense to us given that no major geopolitical risk is materializing and considerable upside risk exists in U.S. growth due to Trump's populist policies. Chart 6European Stocks Still A Buy Relative To U.S. European Stocks Still A Buy Relative To U.S. European Stocks Still A Buy Relative To U.S. In what follows, we take a break from poring over geopolitical risks in Europe and the U.S. and focus on emerging markets. Since January, very few investors have asked us about EM politics, save for the occasional question about Brazil. However, the two Asian giants - China and India - are both a source of risk: the first a downside, left-tail risk and the second an upside, right-tail risk. China: What Comes After The Party Congress This Fall? Since 2013, we have been outspoken in our low expectations for China's structural reforms.5 This view was confirmed with a series of stimulus efforts that displaced reforms, including the local government debt swap program in 2014 and extensive fiscal and monetary easing in 2015 and especially 2016.6 The upside of weak reforms was better-than-expected growth in the short run, as stimulus took effect. Indeed, China has pulled off a remarkable economic turnaround since early last year: infrastructure and housing investment have increased, the weaker yuan has boosted exports, and the global recovery in commodity prices has helped producer prices to recover, easing deflationary pressures (Chart 7). Chart 7Deflationary Pressures Easing Deflationary Pressures Easing Deflationary Pressures Easing Chart 8Stimulus Dropped Off Stimulus Dropped Off Stimulus Dropped Off Accordingly, Chinese policymakers, who are attempting to strike a balance between stimulus and restructuring, have begun leaning against the economy's gathering momentum. Government spending has collapsed now that a 6.5% GDP growth "floor" has been established (Chart 8). A new round of property market regulatory tightening began last fall, though it has had little impact so far. Also, the People's Bank of China has begun draining some liquidity (Chart 9). Signals coming out of the "Two Sessions" over the past two weeks, namely the National People's Congress, suggest that the Chinese leadership is content with the current state of affairs. Policymakers set their growth targets for 2017 a little lower than last year's targets and a little higher than last year's actual performance (Table 2).7 It is a line so thin that it is almost imperceptible. They do not want significant change. Chart 9PBoC Draining Liquidity PBoC Draining Liquidity PBoC Draining Liquidity Table 2China's Economic Targets For 2017 China Down, India Up? China Down, India Up? This stance fits with a deeper desire to keep the economy on an even keel during a pivotal year for Chinese politics. The legislative session took place under the shadow of the Communist Party's impending 19th National Party Congress - the "midterm" meeting of the party that happens every five years and features extensive promotions, rotations, and retirements for the party leadership. This year's congress promises to be especially influential because of Xi Jinping's ascendancy and the fact that around 70% of the upper tier of leaders will be replaced. Chart 10, which we have been showing clients over the past year to dampen expectations of stimulus, reveals that the party congress is not normally an excuse to throw open the floodgates of credit and government spending. Rather, it is a reason to avoid anything that might rock the boat, whether stimulus or reform. Chart 10Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Thus while government spending has declined, it should be expected to rise again if growth slows down too much for too long. There may be a period of slowdown and market jitters before the leaders reach for the fiscal lever again, but the "Socialist Put" remains in place. Meanwhile, we are not surprised that structural reforms continue to suffer. It is not that China has eschewed all reforms but rather that its reforms have focused on centralizing power for the ruling party and alleviating some outstanding social grievances. These are positive in themselves but they do not address the key concerns of foreign investors relating to economic openness, financial stability, and the role of the state. The recent imposition of capital controls and a host of non-tariff barriers in the name of "state security" exemplify a negative trend. The delayed rollout of the property tax is also a sign of Beijing's proclivity to delay policies that may be financially risky.8 And Beijing has only tentatively attempted to cut back state-owned enterprises. Simply put, a push to overhaul any significant sector or sub-sector does not fit Beijing's priorities at the moment. However, if growth, debt, or asset prices should climb too rapidly, then we expect countermeasures to tamp them down. Even on the geopolitical front - where we have a high conviction view that tail risks to financial markets are higher than the market perceives them to be, both in China and the broader Asia Pacific - there have been some signs of the U.S. and China playing ball on a shared desire for "stability," at least for the moment.9 While we expect a negative geopolitical shock, the market will only believe it when it sees it. All of the above suggest that China will focus on "maintaining stability" this year even more than usual due to the party congress. This is clearly bullish, especially given improving U.S. and global growth. However, the mantra of "stability" and "party congress" should not prevent investors from looking beyond October or November of this year. Chart 11China Needs More##br## Credit For Same Growth China Down, India Up? China Down, India Up? Chart 12China Gets Old ##br##Before It Gets Rich China Gets Old Before It Gets Rich China Gets Old Before It Gets Rich Even assuming that China experiences no significant internal or external economic shocks from now until this fall, it is important to remember that China's growth potential is still slowing for structural reasons. Productivity is collapsing and credit dependency is rising (Chart 11). The slowdown stems from deep shifts such as the end of the debt supercycle in the U.S. (weak external demand), the tipping point in Chinese demographics (higher dependency ratio) (Chart 12), and the extremely rapid build-up in corporate debt (Chart 13). Chart 13Corporate Debt Skyrockets Corporate Debt Skyrockets Corporate Debt Skyrockets Chart 14As Good As It Gets As Good As It Gets As Good As It Gets This is what leads our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, to surmise that China is at the peak of its current economic mini-cycle. This is "as good as it gets," as he shows in Chart 14. Barring a situation in which Xi somehow fails to consolidate power at the party congress, the market impact will depend on which of two scenarios follows: First scenario: Xi achieves a dominant position in all party and state organs, yet 2018 sees a continuation of the current pattern of mini-cycles of stimulus, lackluster reform, and foreign policy aggressiveness. Xi implicitly deems the strategic cost of reform too great, as we argued he would do over the past four years, and dedicates his stint in office to the accumulation of power. Perhaps a successor will be able to use these powers to enact painful reforms in the mid-2020s; that is not Xi's immediate concern. This is short-term bullish for global and Chinese growth, long-term bearish for Chinese assets. Second scenario: Xi achieves a dominant position and uses his power to reinvigorate the country's stalled reforms. Hints of big measures emerge in the wake of the party congress in November or December, and January 2018 begins with a bang. This would necessarily mean that Xi accepts slower growth, or even that he imposes it through tighter fiscal policy, real credit control, SOE failures, and aggressive overcapacity cuts. However, Chinese productivity would begin to recover. This is short-term bearish for Chinese and global growth. However, it is the most bullish outcome for the long-term performance of Chinese assets. In China's current state - with capital controls newly reinstituted (Chart 15), Xi lauding the "central role" of SOEs in development, and Xi's administration still focused on purging the party and controlling the media - the second scenario admittedly seems far-fetched. Chart 15Are Capital Controls Working? Are Capital Controls Working? Are Capital Controls Working? Moreover, Xi seems averse to risky experiments at home that could weaken the country in the face of unprecedented strategic threats from the United States and Japan. Nevertheless, a 2018 reform push should not be dismissed out of hand. Why? Because an overbearing state, credit excesses, and weak productivity really do threaten the sustainability of the Chinese economy and hence the Communist Party's grip on power. Xi must keep them in check, as the current gestures toward tighter policy indicate. The government has overseen a massive monetary and credit expansion to protect the country from faltering external demand since 2008. As the current account surplus has declined, the country's massive savings have built up at home in the form of debt (Chart 16).10 Yet the investment avenues are restricted by the role of the state. As a result, the inefficient state-supported sector is getting propped up while the shadow financial sector grows wildly and creates murky systemic risks that are difficult to monitor and control. The PBoC has undertaken further extraordinary actions to keep financial conditions loose (Chart 17). Chart 16Savings Invested At Home Savings Invested At Home Savings Invested At Home Chart 17PBoC Lends A Helping Hand PBoC Lends A Helping Hand PBoC Lends A Helping Hand What signposts should investors watch for to see which path Xi will take after the party congress? Jockeying ahead of the party congress: The latest NPC session saw some political maneuvering. Several sixth generation leaders made appearances and spoke to media.11 Xi's supposed favorite, Chen Min'er, Party Secretary of Guizhou, distinguished himself by cutting reporters short at a press conference. Meanwhile former President Hu Jintao appeared publicly alongside his apprentice, Hu Chunhua, Party Secretary of Guangdong. Elite party gatherings in the summer, especially any retreat at Beidaihe, should be watched closely for any clues of who may be up and who down, and what general policy trajectory may be forthcoming. Xi's future: First, will Xi Jinping and Li Keqiang establish clear successors for their top two positions in 2022?12 A failure to do so will suggest that Xi intends to stay in power beyond his de facto term limit of 2022. This would mean that Xi will prioritize his own future over painful structural reforms. On the other hand, a clear commitment to a leadership transition in five years may re-focus the Xi-Li administration towards their initial commitment to economic restructuring. National Financial Work Conference: This conference is held every five years, usually connected with a major new financial reform or regulatory push, and due sometime in 2017. The government is looking into serious changes to financial regulation - including the creation of a super-ministry to house the various regulatory agencies. This, or the broader attempt to ensure adequate capitalization of banks, could be behind the delay. New central banker: Central bank governor Zhou Xiaochuan, in office since 2002, may step down this fall. He could be replaced with another technocrat to little fanfare, but his exit introduces the opportunity for shaking up the PBoC regime as a whole. Other new officials: A slew of other appointments and reshuffles will take place this year as a generation of leaders born before the Revolution retires. A new director of the state economic planner, the National Development and Reform Commission, was just named, while late last year a new finance minister took his post. These officials have yet to make their mark. Their statements should be watched closely for any shifts in economic policy emphasis. Time frames for reforms: The market is still waiting for concrete proposals and time frames for major reform initiatives, particularly opening up to foreign competition and restructuring state-owned enterprises. Overcapacity cuts have also had mixed results. We do not expect major advances on big structural reforms this year due to the party congress, but details that can be gleaned about the process and timetables could be important. Bottom Line: Watch for signs of a renewed reform drive after the nineteenth National Party Congress. Xi is not going to reverse what he has done so far. And China is not going to become a market economy on the ideal western model. But a pivot point could be in the cards next year for China to pursue some pro-efficiency reforms that it has already set out for itself in a more resolute way. Xi's decision to stay in power beyond 2022 would be bearish for reforms as it would incentivize the current "Socialist Put" model of policymaking over a genuine paradigm shift. India: What Comes After Modi's Big Win? Prime Minister Narendra Modi has won a crushing victory in India's most populous state, Uttar Pradesh, positioning himself, his Bharatiya Janata Party (BJP), and National Democratic Alliance (NDA) coalition very well for the 2019 general elections. Policymaking is going to become easier for the ruling party - though there are still serious political and economic constraints. We have been long Indian equities relative to EM equities since the "Modi wave" began with Modi's victory in the Lok Sabha or lower house in 2014.13 The end of the commodity bull market signaled an opportunity for India, which imports about a third of its energy. The decline of global trade also heralded the outperformance of domestic demand-driven economies like India. Further, Modi's sweeping victory held out the promise for a reform agenda of tighter monetary and fiscal policy that would reduce inflation and make room for private investment to grow. This would make Indian risk assets attractive, especially relative to other EMs, which were at that time either lagging at reforms or failing to undertake them entirely. Since then we have seen Modi rack up a key legislative victory - the passage of the Goods and Services Tax, in the process of implementation - and engineer a surprise "demonetization" effort late last year to increase bank deposits, bring the country's gray markets into the open, and flush out crime and corruption.14 The ruling coalition's gains in Uttar Pradesh and a few other state elections this year are a striking vindication of popular support after this highly unconventional and controversial maneuver.15 Uttar Pradesh is the most important of these elections. It was slated to be a grand testing ground for Modi well before demonetization. It is the most populous Indian state, with about 200 million people, and the third largest state economy (producing about 10% of GDP). It is the second-poorest state, with a GDP per capita of about $730, it has the highest proportion of "scheduled castes" (untouchables), and ranks around the middle of states in terms of the Hindu share of population - all challenges for the landed, pro-business, Hindu nationalist BJP (Map 1). Politically, aside from its inherent heft in population and centrality, Uttar Pradesh sends the most representatives of any state to India's upper house (31 seats), the Rajya Sabha, where Modi lacks a majority. It is thus a key source of federal power and an important state ally. Map 1Modi's Saffron Wave Takes The Indian Core China Down, India Up? China Down, India Up? Given the above, it is hugely bullish that Modi's BJP romped to a historic victory in the state election, winning 312 out of 403 seats (about 39.7% of the vote), up from 47 seats previously. His coalition rose to 324 seats total (Chart 18). The BJP now has the largest majority of any party in the state since 1980. These results were not anticipated. A close election was predicted and opinion polls had BJP winning 157 seats, short of the 202 needed for a majority. This was only slightly ahead of its closest rival, an alliance made up of the local Samajwadi Party and its national partner, the left-leaning Indian National Congress (INC). Exit polls even suggested that the Samajwadi-INC coalition had edged ahead of the BJP. The immediate takeaway is that Modi will have better luck governing Uttar Pradesh itself now that the state government is on his side. Individual states hold the key to reform in India because of the country's size and socio-economic disparities. The state will now be expected to implement Modi's policies faithfully and push approved policies forward on its own. The second takeaway is that while Uttar Pradesh will not give Modi control of India's upper house of parliament, the Rajya Sabha, it will give him a better position there. The BJP has 56 seats in the upper house (fewer than the INC's 59), and the ruling coalition has 74, out of a total of 250. The coalition needs 52 seats for a simple majority. Uttar Pradesh will deliver 10 seats at most by the 2019 general election. Modi would have to win almost every seat of the 56 non-allied seats coming open between now and 2019 in order to win the upper house by that time (Chart 19). That is unlikely, but Modi is moving in the right direction and an upper-house majority cannot be ruled out in the long run. Chart 18Modi's Big Win In Uttar Pradesh China Down, India Up? China Down, India Up? Chart 19Modi's National Position Improves China Down, India Up? China Down, India Up? Of course, Modi has already shown with the Goods and Services Tax that he can pass very difficult legislation through the upper house without controlling a majority there. This achievement last year was perhaps an even greater surprise than the victory in Uttar Pradesh, which reinforces it. Modi also has a secret weapon: in case of a national emergency, however defined, he can call a joint session of parliament, where his coalition would carry the day. This is now more likely because it is the Indian president who is responsible for calling a joint session, and Modi is now more likely to get his candidate into that position due to the win in Uttar Pradesh. President Pranab Mukherjee, who is affiliated with the INC, will step down on July 25. Though Modi does not have all the votes in the electoral college to choose the president outright, smaller parties may fall in line now that the BJP has so much national momentum.16 Controlling the presidency will also give Modi greater influence over constitutional obstacles and gradually over the legal system. Separately, in August, Modi's alliance will be able to choose the vice president as well. More broadly, the Uttar Pradesh election marks a victory for Modi's style of appealing to voter demand for greater economic development as a general priority over longstanding religious and caste grievances that frequently determine electoral outcomes in state elections. This is a hugely significant indication for India's economic structural reform and nation building. Bottom Line: Modi's victory in Uttar Pradesh is proof that for all of India's sprawling inefficiencies, its political system is capable of responding to the large public demand for economic development. Do not underestimate reform momentum now. Modi's political capital remains high. Investment Conclusions The conventional wisdom has for decades been that China is better at reforming its economy because of its authoritarian regime, whereas India democratized too early and has thus lagged at reforms. We have never agreed with this simplistic view of economic reforms. Structural reforms are always and everywhere painful. As such, they require political capital. As our "J-Curve of Structural Reforms" posits, reforms deplete political capital as the pain spreads through the economy and opposition mounts among both the elite and the common man (Chart 20). Eventually, the government is faced with a "danger zone" in which the pain of reforms lingers, the benefits remain beyond the horizon, and all political capital is exhausted. Many leaders chose to water down the reforms, or back off from them altogether, at this point. Chart 20The J-Curve Of Structural Reform China Down, India Up? China Down, India Up? On the surface, authoritarian regimes have massive political capital with which to burst through the danger zone of reform. But this assumption is not entirely correct. In China's case, the political capital for reform came after disastrous performances by the "conservative" political forces. Reformers in China were buoyed by the failures of the "Cultural Revolution" (which ended in 1976) and the 1989 Tiananmen Square protests. Each political and social crisis gave the reformers an opening - following a consolidation period - to pursue controversial economic reforms at the expense of "conservative" forces. The fruit of these reform efforts has been the growth of China's middle class. And while this middle class expects reforms in the delivery and quality of public services, it is not interested in seeing a slowdown in economic growth, no matter how temporary or healthy it may be. As such, Chinese leaders are faced with a significant hurdle to their reform preference: how to convince the public that a slowdown is needed in order to restructure the economy. We are unsure whether the upcoming party congress will make a difference. However, we can see a scenario where President Xi decides to pursue market-friendly reforms because he sees an increase in his political capital. In particular, he may feel that he has cemented his personal dominance over his intra-party rivals and that the aggressive foreign and trade policy emanating from the Trump White House gives him a foil to blame for any downturn in growth. Reform would also be a return to Xi's original agenda, and would conform to the playbook of former president Jiang Zemin, whose precedents Xi has followed in some other areas. Given Xi's modus operandi, a post-consolidation reform drive would be executed relatively effectively and would therefore present short-term risks to Chinese and hence global growth, despite the long-term improvement. Markets are definitely not expecting such a policy pivot at the moment. China bulls are content with the current reforms, while China bears see no chance of the Xi administration changing tack. While we are just beginning to see the potential for a turn in Chinese policymaking towards reforms, India is a much clearer example of a reformist administration. Modi will feel empowered by the Uttar Pradesh election, a political recapitalization of sorts. Foreign investment will likely continue cheering Modi's ongoing revolution (Chart 21). The question now is whether Modi intends to use the infusion of political capital for genuine reforms. After all, the economy is not looking up (Chart 22). Chart 21Foreign Investors Cheer On Modi Foreign Investors Cheer On Modi Foreign Investors Cheer On Modi Chart 22Indian Economy Still Weak Indian Economy Still Weak Indian Economy Still Weak The evidence is mixed. First, Modi has not maintained strictness on fiscal spending and the budget deficit is creeping back to where it was when he took over the reins (Chart 23). Rising government spending along with higher commodity prices suggest that inflation will continue making a comeback (Chart 24). Poor food production is also driving up inflation. And higher spending and inflation pose a key threat to the sustainability of the reform agenda, since rising government bond yields will crowd out private investment. Chart 23Losing Budgetary Discipline? Losing Budgetary Discipline? Losing Budgetary Discipline? Chart 24Inflation Makes A Comeback Inflation Makes A Comeback Inflation Makes A Comeback Second, the RBI will be less likely to pursue a tighter monetary policy with both political influence and weak growth pressing on it. Moreover, Indian stocks are not all that cheap. In 2014, valuations were favorable and the backdrop included cheap commodities, fiscal prudence, and Modi's electoral success. Today, India is trading at its historical mean relative to EM (Chart 25), but using the equal sector weighted P/E ratio, by which India was very cheap back in 2014, India is at a 52% premium now (Chart 26). Chart 25Indian Stocks Trading##br## At Mean Against EM Indian Stocks Trading At Mean Against EM Indian Stocks Trading At Mean Against EM Chart 26Indian Stocks Pricey##br## Versus EM Sector-Weighted Indian Stocks Pricey Versus EM Sector-Weighted Indian Stocks Pricey Versus EM Sector-Weighted We are therefore taking this opportunity to close our long India / short EM trade for a 28% gain (since May 2014). We will reassess Modi's structural reform priorities in future research and gauge whether a new entry point is warranted. We remain optimistic on India in the long run as Modi certainly has the political capital for reforms. The question is whether he plans to use it. Meanwhile, we remain skeptical about China's long-term trajectory. To become fully optimistic about Chinese risk assets in absolute terms, we need to see the Xi administration chose short-term pain for long-term gain. For the time being, China continues to repress its structural problems rather than deal with them head on, relying on minimal openness, high and rising leverage, and state-owned banks and companies. India may be lagging in its reform effort, but it has at least established market reforms as a priority. And the Modi administration has built political capital through the slow and painful democratic process. Over the long term, India's approach is more sustainable. If President Xi wastes the opportunity afforded to him by the upcoming party congress, we suspect that China will face a much higher probability of left-tail economic risks than India over the long term. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "How Expensive Are U.S. Stocks?," dated March 13, 2017, available at usis.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 3 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. 4 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. 5 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and "China: The Socialist Put And Rising Government Leverage" in Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA China Investment Strategy, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 8 Please see Chong Koh Ping, "No plans for NPC to discuss property tax," Straits Times, March 5, 2017, available at www.straitstimes.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. 11 China's leadership is typically referred to in terms of "generations," with Mao Zedong and his peers the first generation, Deng Xiaoping and his cohort the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth. The fifth generation was born in the early 1950s, the sixth generation was born in the early 1960s. 12 Xi may tweak retirement norms to let close allies, like Wang Qishan, the anti-graft attack dog, stay on the Politburo Standing Committee. This might also suggest that Xi himself intends to overstay his age limit in 2022. 13 Please see Geopolitical Strategy Special Report, "Long Modi, Short Jokowi," dated August 28, 2014, available at gps.bcaresearch.com, and Emerging Markets Strategy Special Report, "Long Indian / Short Indonesian Stocks," dated July 30, 2014, available at ems.bcaresearch.com. 14 Please see "India: Demonetization And Opportunities In Equities," in Emerging Markets Strategy Weekly Report, "EM: Untenable Divergences," dated December 21, 2016, available at ems.bcaresearch.com. 15 Though the mixed results also indicate persistent regional differences. Modi's coalition won seats in Uttarakhand and Manipur but lost them in Goa and Punjab. Gujarat, Modi's home state, will hold elections later this year. Himachal Pradesh will also vote this year and will be a subsequent testing ground. 16 Please see Gaurav Vivek Bhatnagar, "BJP Sweep in UP Will Impact Decision on President, Rajya Sabha Numbers," The Wire, March 12, 2017, available at https://thewire.in/116044/bjp-sweep-will-impact-decision-president/

Highlights We discuss three "battles" that will shape the investment landscape in the euro area over the remainder of the decade. Battle #1: Reflation Versus Deleveraging - Reflation will triumph over the next 12 months. For the time being, this justifies an overweight position in euro area equities. Beyond then, the outlook is likely to darken. Battle #2: Hawks Versus Doves - The doves will win. Germany will reluctantly accept an overheated economy and higher inflation. Stay short the euro. Battle #3: Globalists Versus Populists - Marine Le Pen will lose this year's election, but Europe's populist parties will finally gain the upper hand by the end of the decade. Buy gold as a long-term hedge. Feature Market Update Global equities are technically overbought in the short term, but the longer-term cyclical (12-month) trend remains to the upside. Chart 1 illustrates the "reflation trade" in a nutshell. The Citigroup global economic and inflation surprise indices have surged and now stand at their highest combined level in the 14-year history of the series. While tracking estimates for Q1 U.S. GDP growth have fallen, this is mainly because of negative contributions from government spending, net exports, and inventories. Taken together, these three factors have shaved about 1.4 percentage points off of Q1 growth according to the Atlanta Fed's GDPNow model (Chart 2). Private final domestic demand is still growing at a reasonably robust 2.6% pace, and forward-looking indicators such as the ISM indices suggest that this number could rise over the next few quarters. Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Underlying U.S. Growth Is Still Healthy Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny As such, it is not too surprising that U.S. equities have had little trouble digesting the prospect of a March Fed rate hike. The market is still pricing in less than three rate increases this calendar year. Four hikes would not be out of the question. Investors should remain positioned for a stronger dollar and higher Treasury yields. We continue to favor higher beta developed markets such as the euro area and Japan over the U.S. on a currency-hedged basis. The Battle For Europe History is often shaped by great battles. Sometimes these are of the military variety. But often they transcend physical conflict, pitting competing ideas, interests, and trends against one another. In the remainder of this week's report, we discuss three economic and political battles that will determine Europe's fortunes over the next 12 months and beyond. Battle #1: Reflation Versus Deleveraging The euro area grew faster than the U.S. in 2016, the first time this has happened since 2008. While the U.S. is likely to resume pole position in 2017, we still expect the euro area economy to expand at an above-trend pace. That should be enough to keep unemployment on a downward trajectory. The euro area economic surprise index remains in positive territory. The composite PMI rose to 56 in February - the highest level since April 2011 - with the forward-looking "new orders" component hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart 3). In addition, private-sector credit growth has sped up to the fastest pace since the 2008-09 financial crisis (Chart 4). All this is good news for the region. Investors should overweight euro area equities on a currency-hedged basis over the next 12 months. Chart 3Euro Area Growth Holding Up Well Euro Area Growth Holding Up Well Euro Area Growth Holding Up Well Chart 4Euro Area: Accelerating Private-Sector ##br##Credit Growth Euro Area: Accelerating Private-Sector Credit Growth Euro Area: Accelerating Private-Sector Credit Growth Beyond then, things look murkier. The ECB's Bank Lending Standards survey showed a modest tightening in lending standards for business loans in Q4 of 2016 (Chart 5). Private-sector debt levels also remain elevated across the region, which is likely to dampen credit demand (Chart 6). Both of these factors suggest that loan growth could begin to moderate later this year. Chart 5Slight Tightening In Lending Standards ##br##For Business Loans And Mortgages In Q4 Of 2016 Slight Tightening In Lending Standards For Business Loans And Mortgages In Q4 Of 2016 Slight Tightening In Lending Standards For Business Loans And Mortgages In Q4 Of 2016 Chart 6Still A Lot Of Debt Still A Lot Of Debt Still A Lot Of Debt If the positive impulse from rising credit growth does begin to fade, GDP growth will fall off. Whether that proves to be just another run-of-the-mill "mid-cycle slowdown" or something more nefarious will depend on the policy response. On the fiscal side, the period of extended austerity has ended. The fiscal thrust in the euro area turned positive last year, the first time this has happened since 2010. The European Commission is advising member states to loosen fiscal policy further this year, but the governments themselves are targeting a modest tightening (Chart 7). With a slew of elections slated for this year, budget overruns will be hard to avoid. Nevertheless, barring a significant economic slowdown, no major European economy is likely to launch a large fiscal stimulus program anytime soon. Thus, while fiscal policy will not be a drag on growth, it will not provide much of a tailwind either. Chart 7European Commission Recommending Greater Fiscal Expansion Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny This puts the ball back in the ECB's court. As we discuss next, monetary policy is likely to stay highly accommodative. That should help extend the cyclical recovery into 2018. Battle #2: Hawks Versus Doves Jean Claude Trichet's decision to raise rates in 2011 would have gone down as the most disastrous blunder the ECB ever made, were it not for his even more disastrous decision to raise rates in 2008. Mario Draghi has gone out of his way to avoid repeating the mistakes of his predecessor. Nevertheless, the risk is that the improving growth backdrop instills a false sense of complacency. There is no doubt that Draghi has become more confident about the economic outlook. The ECB revised up its growth and inflation projections for 2017-18 at this week's meeting and signaled that it was unlikely to extend its targeted longer-term refinancing operations, or TLTROs. The ECB is also likely to further reduce the value of its monthly asset purchases in 2018 with a view towards phasing them out completely by the end of that year. It is possible that these steps could trigger a "taper tantrum" in European government debt markets of the sort the U.S. experienced in 2013. If that were to happen, we would see it as a buying opportunity. As Draghi stressed during his press conference, wage growth is anemic. Without faster wage growth, inflationary pressures will remain muted. Granted, euro area headline inflation reached 2.0% in February. However, this was mainly the result of base effects stemming from higher food and energy prices. Our expectation is that headline inflation will fall back close to 1% by the end of the year. This is where core inflation currently stands. One should also keep in mind that the trade-weighted euro has depreciated by 8% since mid-2014 (Chart 8). To the extent that a weaker euro has put upward pressure on import prices, this has caused core inflation to be higher than it would otherwise have been. In contrast, the trade-weighted U.S. dollar has appreciated by 24% over this period. Yet, despite the diverging path between the two currencies, core inflation in the euro area remains noticeably lower than in the U.S. This is true even if one excludes housing costs from the U.S. CPI in order to make it more comparable to the European estimate of inflation. Excluding shelter, U.S. core inflation is currently 43 basis points higher than in the euro area (Chart 9). The point is that the Fed is much further along the path to monetary policy normalization than the ECB. Chart 8A Stronger Dollar Has Restrained U.S. Inflation... A Stronger Dollar Has Restrained U.S. Inflation… A Stronger Dollar Has Restrained U.S. Inflation… Chart 9...Yet Core Inflation In The U.S. ##br##Is Still Higher, Even Excluding Housing ...Yet Core Inflation In The U.S. Is Still Higher, Even Excluding Housing ...Yet Core Inflation In The U.S. Is Still Higher, Even Excluding Housing If that were all to the story, it would be enough to justify the ECB's wait-and-see approach. But there is so much more. Start with the fact that the euro area's poor demographics, high debt levels, and dysfunctional institutions all imply that the neutral rate - the interest rate consistent with full employment - is lower there than in the U.S. How does one ensure that real rates can fall to a low enough level in the event of an economic slowdown? One solution is to target a higher inflation rate. If inflation is running at 1% going into a recession, it might be impossible to bring real rates down much below -1%. But if inflation is running at 3%, real rates can fall to as low as -3%. This implies that the ECB should actually target a higher inflation rate than the Fed. Then there are the internal constraints imposed by the common currency. Countries with flexible exchange rates can adjust to adverse economic shocks by letting their currencies depreciate. That is not possible within the euro area. If one or a few countries in the region are suffering while others are not, the unlucky ones have to engineer an "internal devaluation." This requires that wages and prices in the ill-fated countries decline in relation to those in the better-performing ones. However, if inflation is already low in the latter, outright deflation may be necessary in the former, something that only a deep recession can achieve. The travails experienced by the peripheral countries over the past eight years brought home this lesson in stark and painful terms. Will Germany accept higher inflation? There is little in its recent history to suggest that it won't. Mario Draghi was not the odds-on favorite to become ECB president. That job was supposed to go to Axel Weber, the former president of the Bundesbank. Weber met with Angela Merkel on February 10, 2011. During this meeting with the chancellor, he made it clear that he did not support the ECB's emergency bond buying. Merkel balked and so the next day Weber tendered his resignation. Six months after that, ECB board member and uber-hawk Jürgen Stark quit, leaving the ECB more firmly in the control of the doves.1 Chart 10Germans Turning Radically Europhile Germans Turning Radically Europhile Germans Turning Radically Europhile Merkel's preference for a less hawkish ECB leadership wasn't solely based on altruistic feelings towards her European compatriots. Politically, Merkel knew full well that Germany would be blamed for the breakup of the euro area. Economically, German taxpayers also stood to lose a lot from a breakup. It is easy to forget now, but Germany spent 8% of GDP during the global financial crisis on bailing out its own banks. All that effort would have been for naught if German banks had been forced to write off billions of euros in loans that they had extended to peripheral Europe. Critically, the demise of the euro would have also saddled German exporters with a much more expensive Deutsche Mark, thus blowing a hole through the country's gargantuan current account surplus. The calculus has not changed much over the last six years. Germany may not welcome higher inflation, but the alternative is much worse. If anything, the polls suggest that German voters have become even more Europhile since the euro crisis ended (Chart 10). This gives Draghi even more free rein. For investors, this implies that the ECB is unlikely to raise rates for the next two years, and perhaps not until the end of the decade. As inflation expectations across the euro area drift higher, real rates will fall. This will push down the value of the euro. We expect EUR/USD to approach parity over the course of this year. Battle #3: Globalists Versus Populists First Brexit, then Trump, and now Le Pen? The spread between French and German 10-year government bond yields briefly touched 68 basis points in February, the highest level since the euro crisis (Chart 11). While the spread has edged down since then, investors remain on edge. Betting markets are currently assigning a one-in-three chance that Le Pen will become president, close to the odds that they were giving Donald Trump before his surprise victory (Chart 12). Chart 11Investors Worried About The Coming ##br##French Election Investors Worried About The Coming French Election Investors Worried About The Coming French Election Chart 12Will Le Pen Rule? Wanna Bet? Will Le Pen Rule? Wanna Bet? Will Le Pen Rule? Wanna Bet? There is little doubt that populism is in a secular "bull market." However, that doesn't mean that every populist politician is going to win every single election. For all their faults, U.S. nationwide presidential election polls were not that far off the mark. The RealClearPolitics average had Clinton up by 3.2% going into the election. She won by 2.1 points. Where the polls fell flat was at the state level. They completely underestimated Trump support in the Rust Belt states of Pennsylvania, Ohio, Michigan, and Wisconsin. That's not an issue in France, where the presidential vote is tallied at the national level. Le Pen currently trails Macron by 26 percentage points in a head-to-head contest (Chart 13). It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. The only way that Le Pen could win is if one of the two leftist candidates drops out.2 However, given the animosity between Benoit Hamon and Jean-Luc Mélenchon, that is almost inconceivable. And even if that did occur, the odds would still favor Macron slipping into the final round. As such, investors should downplay risks of a populist uprising this year. Beyond then, things are likely to get messier. At some point, Europe will face another downturn, either of its own doing or the result of an external shock. Many voters have been reluctant to vote for populist leaders out of fear that the ensuing economic turmoil could leave them out of a job. But if they have already lost their jobs, that reason goes away. Chart 14 shows the strong correlation between unemployment in various French départements, and support for Marine Le Pen's National Front. If French unemployment rises, her support is likely to increase as well. The same goes for other European countries. Chart 13Macron Leads Le Pen By A Mile Macron Leads Le Pen By A Mile Macron Leads Le Pen By A Mile Chart 14Higher Unemployment Would Benefit Le Pen Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny In addition, worries about large-scale immigration from outside Europe will continue to work to the advantage of populist leaders. Recent immigrants and their children have sometimes struggled to integrate into European society. This has manifested itself in the form of low labor participation rates, poor educational achievement, elevated involvement in criminal activity, and high welfare usage. The problem has been especially acute in European countries with very generous welfare states (Chart 15). Chart 15Many Immigrants To Europe Are Lagging Behind Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny The reaction of establishment parties to mounting concerns about immigration has been completely counterproductive. Rather than acknowledging the problems, they have sought to censor uncomfortable "hatefacts" and stage show trials of populist leaders - such as the one Marine Le Pen will likely be subjected to for her alleged crime of tweeting graphic photos of terrorist atrocities. This strategy will backfire and the result will be a wave of populist victories towards the end of the decade. With that in mind, investors should consider buying some gold as a long-term hedge. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see BCA Geopolitical Strategy, “Europe: Game Was Changed A Long Time Ago,” in a Monthly Report, “Fortuna And Policymakers,” dated October 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, “Europe – Election Update, France,” in a Weekly Report, “Donald Trump Is Who We Thought He Was,” dated March 8, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Nothing in Trump's congressional address changes our outlook from November; Trump has reaffirmed his commitment to mercantilism; Investors should continue to favor small caps over large caps; We expect Trump to get his way on more spending, and a tax reform plan to pass by the end of the year; The Dutch election is a red herring, Le Pen's chances of winning are falling, but Italy remains a risk, especially in 2018; North Korea has evolved from a red herring into a black swan, stay short KRW/THB. Feature President Donald J. Trump delivered a reassuring speech last week. Sporting a magnanimous tone (and a new tie!) the president shocked the media by invoking a "new surge of optimism." Gone were the diatribes about "American carnage." Instead, President Trump implored Congress to work together to bring forth a major infrastructure program that would rival that of Eisenhower's interstate highway system, adopt a merit-based immigration system akin to Canada, and reform Obamacare in a way that would retain all its popular pillars. Trump concluded the speech by stating that "everything that is broken in our country can be fixed" and warning the polarized Congress that "true love for our people requires us to find common ground." After the speech, a narrative emerged in the media and financial press saying that Trump was a changed man. Should investors believe it? Not at all! There was simply nothing in the Trump speech that changes our outlook in November: that President Trump was elected on a populist platform and that he will be unconstrained on blowing out the U.S. budget and pursuing a mercantilist agenda.1 On everything else - from immigration reform to Obamacare - Trump may pursue a pragmatic set of policies. Or he may not. But what investors really care about is whether the Trump administration and Congress will: Get sweeping tax cut legislation done in 2017; Pass some infrastructure spending in 2017; Pursue protectionist policies. On all three counts, we believe that the answer is yes. Trump will get his way on both his pro-growth - anti-fiscal discipline - and mercantilist agendas. The timing is difficult to gauge, but we believe that we will see all three policy avenues aggressively pursued throughout the year and passed into law by the year's end. Trump's speech has only reinforced this view. Who Is Trump? Tax Cuts As we discussed in a recent report detailing the border adjustment tax (BAT) proposal, newly elected presidents rarely fumble on tax reform.2 Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In addition, the GOP knows that it must move fast if it wants to pass any tax cuts in 2017. President Trump is now the most unpopular president since polling began tracking the question (Chart 1). Chart 1Does President Trump Lack Political Capital? Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was However, Republican voters continue to support him at 88%. This means that the House Republicans are vulnerable both to a Democrat/Independent backlash against Trump in the midterm elections and a Trump supporter backlash in the Republican primaries. They need to pass major legislation that satisfies middle class concerns and ensure that they do not incur the wrath of the Trump voters in primary races. While it is unlikely that the Democrats could significantly eat into Republican majorities in the House of Representatives and the Senate, stranger things have happened.3 Adding fire under the GOP are two special Congressional Elections, in Georgia's sixth district and for Montana's "at large" seat, to be held in April and May respectively.4 Both were easily won in November by Republicans. A slippage by the Republicans in either would send shockwaves through Congress. There is therefore little time to waste. The Republicans know that they must strike while the iron is hot. We suspect that most representatives will abandon their demand for revenue-neutral tax reform to get any tax reform. That may mean adjusting House Speaker Paul Ryan's favorite revenue-raising proposal - the border adjustment tax (BAT) - so that it brings less revenue by exempting whole categories of imports from punitive corporate taxes. "Dynamic scoring" - an accounting method that considers the holistic impact of budget measures on revenues and thus deficits - will be used to make the "math" work and satisfy the procedural demand for budget responsibility.5 What about Obamacare? A narrative has emerged in the media that Republicans cannot work on tax reform while the issue of "repealing and replacing" the Affordable Care Act looms over their heads. We disagree. There are plenty of examples of the White House and Congress cooperating on multiple policy agendas at the same time. For example, the Obama White House used its majorities in Congress to push through a major fiscal stimulus, financial reform, and the controversial health care plan. Ronald Reagan also managed to enact comprehensive immigration and tax reform in 1986. Trump's congressional address made only one mention of government debt. But he did emphasize that his tax plan would provide "massive tax relief for the middle class." This implies that the election campaign's individual income tax proposals may have to be altered. Trump's and the GOP's plans from last year agreed that the individual income tax should be reduced from seven to three brackets, with the marginal rates at 12%, 25%, and 33%. This would have cut the top marginal rate from 39.6% to 33%, but would also have left a significant number of Americans with an increase, or no change, to their marginal tax rate.6 It is likely that this will have to change, potentially creating an even greater impact on the deficit. Bottom Line: We expect both corporate and individual tax reform by the end of 2017. We do not have clarity on how legislators will go from here to there, but we suspect that to get both passed, Republicans in Congress will err on the side of greater deficits. As such, investors should expect exemptions on many imports under the final BAT (weakening any USD spike) and likely greater middle class tax cuts than are currently priced in the market. Infrastructure Spending Trump's congressional address ended several weeks of silence from the Trump administration on infrastructure spending. Not only did Trump reference the Eisenhower interstate highway system as a model to emulate, but he also promised a considerable increase in military spending and the completion of the wall on the border with Mexico ahead of schedule. Trump referred back to the original $1 trillion price tag that he announced in the heat of the electoral campaign. This figure was revised down by Trump's transition team to a modest $550 billion, though the difference may only be due to time frame. Whatever the case, Trump is using the bigger number now. We continue to believe that GOP representatives will not obstruct Trump's spending priorities. First, "dynamic scoring" can be applied to both tax cuts and infrastructure spending to make anything look close to revenue neutral. Second, voters want infrastructure spending (Chart 2). It is in fact the only issue other than combating drug addiction that Republicans and Democrats deeply agree on (Chart 3). Chart 2Everyone Loves Infrastructure Spending Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 3Infrastructure Is Not A Partisan Issue Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Third, history is not on the side of deficit hawks. True, the national debt is higher today at $20 trillion than it has been for previous Republican administrations. However, it is not only an arithmetic fact that Republican administrations run large deficits (Chart 4), it is also a fact that they tend to get more than they ask from Congress. Chart 5 shows, with astonishing consistency, that Congress is only a check on Democratic presidents when it comes to the final size of appropriation bills, whereas Republican presidents always managed to get Congress to approve more funding than they asked for. Chart 4Fact: Republicans Run##br## Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Chart 5Budgets: Republican Presidents ##br##Get What They Want Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Bottom Line: It remains difficult to gauge the actual size or economic impact of Trump's government spending proposals. However, we expect that President Trump will get his way on more spending not only for defense, veterans, and the wall, but also for infrastructure. While the impact will be minimal in 2017, investors should see greater fiscal thrust in 2018. Mercantilism While the media focused on the magnanimous tone of Trump's speech last week, we saw little change in his commitment to mercantilism. We continue to believe that Trump is a populist protectionist and that he is serious about enacting mercantilist policies.7 Recent government appointments (Table 2) and statements from the Trump administration (Table 3) suggest that we are correct. Table 2Government Appointments That Certify That Trump Is A Protectionist Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In his speech, Trump invoked President Abraham Lincoln's words that "abandonment of the protective policy by the American Government [will] produce want and ruin among our people."8 He went on to call for "fair trade," contrasted explicitly with "free trade," and to suggest that he would support changing the U.S. corporate tax system to make U.S. exports more competitive. Trump also said on February 24, in a Reuters interview, that he thought that the border adjustment tax would boost exports and help keep jobs in the U.S.9 This should end the speculation - prompted by an early comment from Trump on the BAT - that the president and congressional GOP are irreconcilably at odds over the BAT. Table 3Protectionist Statements From The Trump Administration Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was While Trump has yet to endorse Ryan's BAT proposal officially, he does not oppose its protectionist aspects. As a reminder, the BAT is protectionist because of two key elements: The BAT would give a "rebate" on exports (implicitly or explicitly) that could be higher than the amount of tax due on foreign profits (Diagram 1). For all intents and purposes, this is a dirigiste government subsidy for export-oriented industries. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was The BAT would allow companies to write off wages and salaries as costs, just like under the current corporate income tax system. But under the value-added tax systems of the rest of the world wages are not deductible. In addition, Trump still retains a bevy of traditional tools like tariffs with which to go after potential trade rivals. As we have pointed out since November, there are few constraints on a U.S. president when imposing protectionist measures.10 Bottom Line: Donald Trump remains committed to a mercantilist agenda. Investors should expect him to live up to the hype at some point in 2017. Investment Implications If markets have been cheering Trump's pro-growth policies, in addition to improving global growth data, we suspect the stock-market party will continue. Investors can take from President Trump's March 1 speech a renewed commitment to a populist agenda that should cause government spending to increase, regulations to be cut, corporate and individual tax rates to fall, and the budget deficit to widen. Won't this pursuit of nominal GDP growth at any cost create conditions for inflation and eventually a recession? Yes, but the timing is difficult to gauge and much will depend on whether Donald Trump replaces the doves on the Fed governing board with hawks, as current conventional wisdom has it. We highly doubt that he would chose hawks, or policymakers committed to rules-based central banking, given his singular focus on reviving economic growth. But even a dovish Fed may move to raise interest rates aggressively given the slate of pro-growth policies being undertaken so late in the economic cycle. In the meantime, on a cyclical horizon, the party will continue and stocks will go higher. As we posited two weeks ago, many of our clients are cautious and tactically bearish, expecting a correction, but we cannot find a single structural bear. In this environment, where everyone expects to "buy on dips" following the correction that never seems to happen, it is hard for a correction to happen. But isn't protectionism and a trade war between the U.S. and China, or even the rest of the world, a risk to the rally? Not necessarily. First, the timing is uncertain. Second, the impact on economic growth is even more uncertain. Third, aside from any knee-jerk selloffs, protectionism will split sectors and stocks into winners and losers. Those with a greater share of revenues abroad will suffer due to potential retaliation from America's trade partners. Furthermore, much of Trump's policies will be dollar bullish - including tax cuts, greater government spending, and likely the BAT. As such, export-oriented sectors and companies will stand to suffer. We continue to believe that an overweight position in small caps will be a way to play the "Trump effect" on a strategic basis. Europe - Election Update Europe's election season is heating up, with the Dutch election just a week away and the first round of the French presidential election in just over a month. Here is a quick update on the key developments: The Netherlands According to the latest polls from the Netherlands, the Euroskeptic Party for Freedom (PVV) appears to be slipping (Chart 6). Just two months ago, the PVV was projected to capture around 35 seats, a number that has now fallen to around 25. Given that the Dutch parliament has 150 seats and that the PVV has no potential allies amongst the other 13 competitive parties, this election is largely a red herring. Should investors be worried about the Netherlands' role in European integration in the future? We don't think so. Support for the euro and the EU has not slipped in the Netherlands, at least not according to the data we have presented in these pages before.11 Instead, the PVV's support has risen due to the recent migration crisis. In fact, the number of asylum seekers has correlated almost perfectly with the PVV's support level since mid-2015 when the influx began (Chart 7). Given that the migration crisis is over (and we do not expect it to restart any time soon), we suspect that the PVV's support will moderate over the next electoral cycle. Chart 6Dutch Euroskeptics Are##br## An Overstated Threat Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 7Dutch Populists Are A##br## Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis France The French election continues to grab headlines in Europe. However, almost all the news is bad news for Marine Le Pen. First, François Bayrou, a notable centrist who captured 9.3% of the vote in the first round of the 2012 election and 18.6% in 2007, has decided not to contest the election and instead support Emmanuel Macron. Non-French media have not picked up on the significance of the endorsement. It is more important than Bayrou's 3-5% level of support in the polls suggests. While Bayrou is a centrist, he once belonged to the center-right, conservative movement and was a cabinet minister during Jacques Chirac's reign. As such, his endorsement will give Macron, a former Socialist Party minister, even more "cross-over appeal" for center-right voters in the second round against Le Pen. Chart 8Le Pen Is Facing Resistance Le Pen Is Facing Resistance Le Pen Is Facing Resistance Second, the rumored alliance between the far-left Jean-Luc Mélenchon and the left-wing candidate of the ruling Socialist Party, Benoît Hamon, has failed to materialize. Their potential alliance was one of the main concerns that many of our clients brought to us in recent meetings. Given current polling, such a marriage could have produced a singular left-wing candidacy that would have propelled either Mélenchon or Hamon into the second round. However, the alliance was always a long shot, as anyone who has followed French politics knows, given Mélenchon's staunch commitment to running on his own platform. And furthermore, arithmetically combining the polling of the two candidates makes no sense given that a singular platform would have forced compromises that would have led to serious defections by voters to other candidates. As such, the combined ticket's support level was always just a theoretical exercise. Third, the latest polls suggest that Le Pen's mini-rally has been arrested (Chart 8). She has failed to consistently break through the 40% percentile mark for the second round. Against Macron, her most likely opponent, she continues to trail by a 25-30% margin. The second-round election is on May 7, just two months away. Two months from November 8, Donald Trump trailed Hillary Clinton by just 5%. Italy Our main political concern in Europe remains Italy. Polls continue to show that Euroskeptics are gaining on the centrist parties (Chart 9). Most worryingly, Italians continue to gain confidence in life outside the EU. According to a poll that asks respondents whether they think "their country could better face the future outside of the EU," Italians are the most optimistic, next to the Brits and the historically Euroskeptic Austrians, about life outside the bloc (Chart 10). Chart 9Italian Establishment##br## Is Collapsing Italian Establishment Is Collapsing Italian Establishment Is Collapsing Chart 10AItalians Are Now The Only People In ##br##The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Chart 10BItalians Are Now The Only People In##br## The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits We therefore find the market's sanguine view on Italy to be myopic. Yes, the probability of an election in 2017 is declining. The ruling Democratic Party (PD) has set its leadership race for April 30, which rules out an election this summer, and former Prime Minister Matteo Renzi appears to have agreed to an election in February 2018.12 On a cyclical time horizon of 12 months, Italy is therefore not a major risk. However, once the election does take place, it could be source of considerable market volatility. At that point, investors would have to ask whether the election would take place under a new electoral law. If not, then the probability of a hung parliament would be considerable. Unless, that is, the Euroskeptic parties could form a coalition based solely on holding a referendum to leave the euro area. We doubt that the left-wing Five Star Movement (M5S) would be able to cooperate with the more staunchly Euroskeptic and right-wing Northern League and Brothers of Italy on this matter. Particularly since M5S has already begun to moderate on the issue of Euroskepticism. There is no point in speculating on an outcome of an election a year from now given that we are not even certain what electoral rules the contest would use. However, we do not think that investors should be sanguine because the likeliest outcome is governmental dysfunction. Chart 11SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent The one thing that may help Italy in 2018 is the outcome of the German election in September. The radically Europhile chancellor-candidate of the Social Democratic Party (SPD), Martin Schulz, has continued to do well in the polls against Angela Merkel (Chart 11). On a recent tour of highly sophisticated clients in New York we were surprised that only a handful were aware of Schulz's platform and background. Even if Schulz does not win, a renewed Grand Coalition between Merkel's Christian Democratic Union and the SPD would have to take into consideration his meteoric rise. The price for a renewed Grand Coalition could be the abandonment of Merkel's reticent leadership of the euro area. Investment Implications For now, our view that the markets will climb the wall of worry in Europe in 2017 is holding up. We suspect that investors will quickly refocus their attention on Italy once the French election is out of the way. One of the best gauges of euro area breakup risk has been the performance of French bonds versus German bonds relative to the performance of Spanish and Italian bonds versus German bonds. In our view, every time French spreads have correlated highly with Spanish and Italian spreads, the euro area faced existential threats. The shaded sections of Chart 12 largely conform to the political context in Europe over the past five years. In particular, it is interesting that French yields have decoupled from their Mediterranean peers ever since the ECB's "whatever it takes" announcement. Chart 12French Spreads Are Overstated French Spreads Are Overstated French Spreads Are Overstated Until right now, that is. We think the bond market is making a mistake. France is not a risk and euro area breakup risk over the next 12 months is essentially near zero. However, the probability of a major economy leaving the euro area over the next five years is going up. This is both because of the political situation in Italy and because Euroskeptics like Marine Le Pen could take over the mantle of the "official opposition" to the "centrist consensus" running Europe. If a country like Italy exits the euro area, would the currency union be doomed? It depends, largely on how that economy were to perform post-exit. In the ceteris paribus world of macroeconomics, a massive currency devaluation post-exit would be a clear and definitive positive. However, BCA's Geopolitical Strategy was created specifically to go beyond ceteris paribus analysis. And we doubt that the euro area exit would be undertaken by pragmatic policymakers capable of taking advantage of currency devaluation while reassuring both markets and EU member states that they would pursue orthodox economic policies. As a guide for what we think would happen to Italy, we would suggest our clients read our January 2016 report on the Greek future post euro area.13 In this think piece, we argue that Greece would not become a "land of milk and honey" after exiting, largely because the political context of exit would be turbulent and lead to populist policies that would devastate the economy. As such, we would stress that while the probability of an individual member state leaving the euro area is climbing - even one as important as Italy - it does not necessarily mean that the probability of euro area dissolution is climbing at the same rate. North Korea: No Longer A Red Herring A brief word about the Korean peninsula is in order after the four North Korean missile tests on March 6 and our report last week recommending that clients steer clear of South Korean assets.14 Simply put, the Korean peninsula is a source of real geopolitical risk right now, contrary to the status quo in which North Korea was largely a red herring. We have narrated this transition since last year,15 but it boils down to the following points: North Korea is finally "arriving" at the nuclear club: It is coming upon that horizon foreseen long ago in which it possesses the ability strike the United States with a nuclear missile, however crude. The American and Japanese defense establishments are becoming more concerned, and their public opinion can follow on command.16 Trump's policy looks to be more assertive, though that is not certain. U.S.-China relations have gone sour: The worsening of Sino-American tensions makes these two more suspicious of each other's motives and simultaneously increases economic and political pressure on both Koreas. Ironically, China is currently sanctioning both North and South Korea, the latter because it is hosting the U.S. THAAD missile defense system (Chart 13). The U.S., for its part, has been rushing THAAD, which it is just now rapidly deploying after the latest North Korean launches. North Korean internal stability is overrated: It is hard to argue that Kim Jong Un has not consolidated power impressively. But this consolidation has coincided with some loosening of internal economic control to help compensate for slower Chinese growth and worse Chinese relations. Gradual marketization threatens to undermine the regime from within, yet the standard playbook of belligerence threatens to provoke sanctions with real teeth from without, like China's proposed coal import ban for the rest of this year.17 Chart 13China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles Adding to the volatile mix, South Korea's right-of-center ruling party is collapsing, which affects the behavior of all the interested parties. The Constitutional Court is set to decide whether to uphold the president's impeachment as early as this week. Where is it all going? In the short term, markets will respond to the court case and elections. A ruling is expected immediately, but could take until June. A ruling ejecting the president would be positive for South Korean risk assets, as it would reduce the current extreme uncertainty. As to the long-term outlook, if everything were to happen according to the region's familiar patterns of rising and falling tensions, China's sanctions would force North Korea to offer de-escalation, a new left-wing government in South Korea would launch a bold new "Sunshine Policy" of engagement with the North, and the alignment of these three in favor of new diplomatic negotiations would drive Japan and the United States to give peace another chance despite their skepticism about the outcome. By 2018, a revival of something like the Six Party Talks, discontinued in 2009, would be on the horizon or even underway. The problem is that the usual cycle is less assured because of the North's improving capabilities and other factors above. Thus, until we see China verifiably enforce sanctions, North Korea step back from its provocations, and the Trump administration take a non-aggressive posture (with Japan following suit), the Korean peninsula will be at a heightened risk of producing geopolitical "black swan" events. Bottom Line: North Korea is shifting from a red herring to a potential black swan, at least until U.S.-China relations improve and lend some stability to the situation. Stay short KRW/THB. Marko Papic, Senior Vice President marko@bcaresearch.com Matt Gertken, Associate Editor mattg@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 Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 3 For example, the 2010 "Tea Party" revolution reversed the Democrat's majority in the House with one of the most sweeping victories merely 24 months following President Obama's 2008 victory, which itself was a lot more convincing than Trump's victory over Clinton. 4 Republican Ryan Zinke won the Montana seat but left it to become Trump's Secretary of Interior; Republican Tom Price won the Georgia seat but left it to become Secretary of Health and Human Services. 5 Dynamic-scoring, also known as macroeconomic modeling, is a favorite tool of Republican legislators when passing tax cut legislation. It allows policymakers to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. The same method could be used to pass "revenue-neutral" infrastructure spending, given that it too would produce higher economic growth and thus presumably higher government revenues. 6 Several income brackets would see no substantial tax cuts under the original tax cut plan proposed by the Trump campaign. Those making $15,000-$19,000 would see their tax rate increase from 10% to 12%. Those making $52,500-101,500 would see their rate stay the same at 25%, while those making $127,500-$200,500 would see their rate rise substantively, from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 President Trump failed to mention that the U.S. was - when Lincoln made the statement in 1846 - a developing economy. Nor did he mention that Lincoln made the statements not as a president but a representative. 9 Please see Holland, Steve, Reuters, "Exclusive: Trump says Republican border tax could boost U.S. jobs," dated February 24, 2017, available at reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 12 Renzi said on February 26 that "The elections are envisaged in February 2018. Fullstop." Please see Reuters, "Decision on early Italian elections up to PM Gentiloni: Renzi," dated February 26, 2017, available at reuters.com. 13 Please see BCA Geopolitical Strategy Special Report, "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, and "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 16 Please see Mark Landler, "North Korea Nuclear Threat Cited by James Clapper, Intelligence Chief," New York Times, February 9, 2016; Siegfried S. Hecker, "The U.S. Must Talk To North Korea," New York Times, January 12, 2017, available at www.nytimes.com. See also Jeff Seldin, "N. Korea Capable of Nuclear Strike at US, Military Leader Says," Voice of America, April 7, 2015, available at www.voanews.com. In 2013, Chairman of the Joint Chiefs of Staff General Martin Dempsey said that "in the absence of concrete evidence to the contrary, we have to assume the worst case, and that's ... why we're postured as we are today," quoted in "Hagel: North Korea Near 'Red Line,'" UPI, April 10, 2013, available at www.upi.com. 17 Enforcement is as yet unclear. Please see Leo Byrne, "North Korean cargo ship moves between Chinese, DPRK coal facilities," dated March 6, 2017, available at www.nknews.org.

Highlights Markets are facing large tail risks - both negative and positive; Donald Trump is a "Fat-Tail" president; European politics offer both a right-tail risk - German Europhile turn ... ... And a left-tail risk - Italian election and a shock in France; Investors should turn to the options market for opportunities. Feature "Stock market hits new high with longest winning streak in decades. Great level of confidence and optimism - even before tax plan rollout!" President Donald Trump "tweet" - February 16, 2017 Global stocks continue their tear as the market shrugs off President Trump's tweets, European Black Swans, saber-rattling in the South China Sea, and fears of de-globalization. Some of the optimism is backed by economic data, but mostly by the "soft data," or survey-based indicators (Chart 1).1 Chart 1Not Much Behind The Optimism Aside From Animal Spirits Not Much Behind The Optimism Aside From Animal Spirits Not Much Behind The Optimism Aside From Animal Spirits So, why the party? It's the Animal Spirits. The bears are in retreat ... or facing deportation! We think investors are betting that the combination of the Brexit referendum and election of Donald Trump has forced policymakers to take their heads out of the sand. The market believes that policymakers have heard the angry electorate whose message is that dithering over economic policies must stop. BCA has been in this camp since last summer, when our colleague Peter Berezin penned an optimistic missive titled "The Upside To Populism."2 The hope that urgency will translate to expediency is what we think has propelled the S&P 500 to one of its best post-election performances (Chart 2). Trump's market performance is in the 83rd percentile of post-election outcomes. As promised, Trump has delivered a win. Chart 2Trump Is Winning The S&P 500 Contest Trump Is Winning The S&P 500 Contest Trump Is Winning The S&P 500 Contest The danger is that the market is extrapolating from the Trump presidency all the "right-tail" or super-positive policy outcomes without accounting for any left-tail events. Trump is a "Fat-Tails" president, an unorthodox politician that could break the gridlock and deliver positive change, but whose brand of nationalist populism may also produce paradigm-shifting crises along the way. Several indicators suggest that caution is warranted. Our U.S. Equity Strategy colleagues offer two measures of complacency, the valuation-to-volatility ratio (Chart 3) and "Complacency-Anxiety Index" (Chart 4).3 Both are stretched and suggest that the market has never been as engrossed by the right-tail narrative as today. Given our constraints-based methodology, we are concerned by how certain the market appears. It seems to believe that all the wonderful things that Trump has promised will face no constraints, while his nationalism and mercantilism will be discarded. Chart 3Market Sees Only Right Tails Market Sees Only Right Tails Market Sees Only Right Tails Chart 4Complacency Reigns Complacency Reigns Complacency Reigns First, on the domestic front, Trump faces several mounting constraints: Political capital: Trump is an unpopular president (Chart 5), at least by the standards of his peers who enjoyed a post-election "honeymoon." This could affect his relationship with the GOP-controlled Congress that hardly warmed up to him in the first place. Precedent: Congress is struggling to produce Obamacare-replacement legislation, which the GOP had six years to prepare for. This bodes poorly for the timeliness of other legislation, like tax reform. Paying for stimulus: Republicans and the White House appear to be at odds over how to pay for the coming household and corporate tax cuts. The former want to pass the controversial border adjustment tax (BAT),4 while the Trump administration may not care how tax cuts are paid for. The BAT proposal is also facing opposition from major retailers and its legality under the WTO is still in question. Infrastructure: Spending on infrastructure, which is a no-brainer and has broad public support (Chart 6), has not seen a concrete plan despite Trump's emphasis on it during his inaugural address and campaign. Chart 5Trump's Approval Ratings Dismal A Fat-Tails World A Fat-Tails World Chart 6Everyone Loves New Roads A Fat-Tails World A Fat-Tails World In addition to the domestic political agenda, investors must deal with a packed European political calendar that we elucidated in last week's report5 (Table 1) and a potential U.S.-China trade war that could spill over into military tensions in the South China Sea.6 Table 1Busy Calendar For Europe This Year A Fat-Tails World A Fat-Tails World Investors may have been lulled into complacency by the February 10 phone call between presidents Xi and Trump. During the call, Trump committed to uphold the "One China" policy that has formed the bedrock of the Beijing-Washington rapprochement since 1972. A week later, on February 16, China suspended all imports of coal from North Korea - 50% of the country's entire export haul - until the end of the year. The move was a big nod to Donald Trump, a message by Beijing that China can play the role of an indispensable partner - if not outright ally - in the region. These moves have put fears of trade protectionism, our main candidate for a catalyst of a market correction, on the backburner. Investors can certainly be disappointed by smaller-than-expected tax cuts and tepid infrastructure spending, but such policy reversals will only encourage the Fed to stay easy and thus prolong the party. In the context of a synchronized global growth recovery - with both the global (Chart 7) and U.S. (Chart 8) economies looking decent - investors will not be deterred from bullishness merely by congressional intrigue. Chart 7Global Growth Looks Solid ... Global Growth Looks Solid ... Global Growth Looks Solid ... Chart 8... And So Does U.S. Growth ... And So Does U.S. Growth ... And So Does U.S. Growth The problem for investors is that the main two risks to global markets in 2017 have no set timeline. Last week, we pointed out that the main political risk in Europe is the Italian election whose date could be in autumn, or even as late as spring 2018. Today we add the French election to the list, where Marine Le Pen is mounting a furious rally on the back of rioting in the banlieue of Aulnay-sous-Bois. Similarly, Trump's mercantilism may remain dormant as he focuses on immigration, the "dishonest media," and cabinet appointees, even though it is very real. His administration is laser-focused on correcting a major perceived ill of the U.S. economy: the current account deficit. Therefore, investors should certainly welcome the Xi-Trump phone call, but the fact that the two leaders spent valuable time reaffirming a policy set 45 years ago should not be encouraging. In fact, the Trump administration has since asked the U.S. Trade Representative's office to consider changing how it calculates the U.S. trade deficit. According to the Wall Street Journal, Trump's White House is looking to exclude "re-exports" - goods imported into the U.S. merely so they can be assembled and then exported - from the calculation of U.S. exports.7 This would naturally balloon the U.S. trade deficit and give the Trump administration greater political ammunition - particularly against Mexico - for retaliation. Given solid global growth data, extremely positive surveys, and a market narrative still focused on the "Upside of Populism," it is tempting for investors to throw caution to the wind. Every time we encounter a bear in a client meeting or conference, we ask if he or she would "buy on dips" in case a correction happened. Their answer is almost universally "yes." It is difficult to see how a correction occurs in such an environment, where nobody actually expects a bear market. Although we are throwing in the towel with our two hedges - both the S&P 500 and Eurostoxx hedges have stopped out, we continue to stress that the market has priced in none of the left-tail risks that remain. We have a Fat-Tail President in the White House and an increasingly binary resolution to the euro area saga in the making in Europe. Fat Tails In Europe Since late 2016, we have suspected that Merkel's rule is unsustainable.8 However, while most investors fretted that Merkel would be replaced by a Euroskeptic, we considered that outcome extremely unlikely (at least in the current electoral cycle). For one, the refugee crisis that befell Europe would be short-lived, and indeed it is now over (Chart 9). For another, Germans are not Euroskeptics. What is astonishing is how quickly the German political establishment has realized and sought to profit from these facts. Instead of opposing Merkel with a cautious choice, the center-left Social Democratic Party (SPD) has turned to an unabashed Europhile, former President of the European Parliament Martin Schulz. Schulz is a relative unknown in Germany and was perceived by Merkel's coterie as a lightweight. On the surface, this made sense. Schulz has no university education and worked as a bookseller before becoming a politician. However, he knows EU politics extremely well, as he has been a member of the European Parliament since 1994. He has therefore heard every Euroskeptic argument on the continent and has learned to counter it emphatically. And he seems to understand the benefits that euro area membership has bestowed upon Germany, a view he appears to share with 80% of the German public, if the latest polls are to be believed (Chart 10)! Chart 9Migrant Crisis Waning Migrant Crisis Waning Migrant Crisis Waning Chart 10Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Thus far, Schulz's campaign has focused on three main lines of attack: the traditional SPD call for greater economic redistribution, general appeal for European solidarity, and blaming Merkel for the rise of populists. To everyone's surprise - other than folks who understand how Germany works - this has been a successful approach. In just three weeks, the SPD has gone from trailing Merkel's Christian Democratic Union (CDU) by double digits to leading in the polls for the first time since 2001 (Chart 11). What should investors make of Schulz's meteoric rise? For one, nobody should get too excited, as the election is still a long seven months away. However, the SPD's resurrection suggests that the German political marketplace has been demanding a genuinely pro- euro area political alternative to the overly cautious Angela Merkel for some time. In other words, Schulz has realized that the median voter in Germany is far more Europhile than the conventional wisdom and Merkel have thought. Again... Chart 10 says it all! Unfortunately for the euro, Germany's Europhile turn may be too little too late. Italy's election is a major risk. As with the threat of American mercantilism, Italian elections are a risk that we cannot properly time. Furthermore, polls remain extremely close in Italy, suggesting that the election could go either way between the establishment and Euroskeptic parties. At this point, the best outcome may be a hung parliament. Meanwhile, the ongoing unrest in the northeast suburb of Paris, Aulnay-sous-Bois, appears to have given Marine Le Pen some wind in her sails (Chart 12). She has closed her head-to-head polling gap against Francois Fillon and Emmanuel Macron to just 12% and 20% respectively. Our net assessment is that she is not going to win, but our conviction level is declining. Her subjective probability has climbed to well over 20% at this point. Chart 11Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Chart 12Le Pen Lags By 12-20% In Second Round A Fat-Tails World A Fat-Tails World Similar rioting in 2005 launched the political career of one Nicolas Sarkozy, who, as the country's Minister of Interior, took a hard line approach to the unrest, which launched him into the presidency. The lesson from Sarkozy's rise is important for two reasons. First, unrest in France's banlieues is politically relevant. These frequent bursts of violence support the National Front (FN) narrative that the integration of migrants has failed, that the country needs full control over its borders, and that the elites in Paris are not serious about law and order. The second lesson is that centrist, establishment politicians have no problem with being tough on crime, minorities, or immigrants. Sarkozy's rhetoric in 2007 mirrored much of the FN electoral platform. There is enough time, in other words, for Macron and Fillon to do the same in 2017. This will be particularly easy for Fillon, whose immigration policies already echo those of the FN. Chart 13ECB Policy Will Stimulate Core Europe ECB Policy Will Stimulate Core Europe ECB Policy Will Stimulate Core Europe Macron, however, could be in trouble in the second round. And at the moment, he is more likely to face Le Pen in the second round than Fillon. As we pointed out in last week's missive, Macron could struggle to get right-wing voters to support him in the second round. We still do not have a historical case where right-wing voters were the ones who swung against the FN. In both the 2002 presidential election and the 2015 regional elections, it was mostly left-wing voters who swung to the center-right to keep the FN out of power. Will French conservative voters come out and support a centrist candidate like Macron who may be perceived as "soft" on crime? Time will tell. His polling appears to be holding up well against Le Pen, but her momentum is now rising. Bottom Line: Europe faces its own version of Fat Tails in 2017. On the one hand, we expect the ECB to remain easier than consensus would have it, given the mounting political risks in the periphery. We expect the ECB to ignore the broad euro area economy and focus on the interest rates that the periphery - namely Italy - needs (very low for very long time) (Chart 13). When combined with a Europhile turn in Germany and a positive fiscal thrust as the EU Commission turns against austerity, we see a Goldilocks scenario for euro area assets over the short and medium term. We are betting that this right-tail risk will ultimately prevail. On the other hand, Italian elections could knock the train off the rails at any time. Due to the announced leadership race in the ruling Democratic Party (PD), the election will most likely have to take place after the summer. Or, it may have to be put off until Q1 2018. But whenever it is announced, it will become the risk to European and global assets. For now, we continue to recommend that clients remain overweight euro area equities. However, vigilance will be needed as the market climbs the wall of worry. Investment Implications - Trading Fat Tails In A Low-Vol World What should investors do in a world that is increasingly exemplified by our Fat-Tails thesis? Current levels of the VIX suggest that the market is not pricing in a potentially higher level of volatility, which we would intuitively expect to rise in a Fat-Tail world (Chart 14). On the other hand, current low levels of volatility may merely be the calm before the storm. Investors may be "frozen" by the high probability of both left- and right-tail outcomes and thus choosing to sit on the sidelines instead of committing to any one narrative. Chart 14Volatility Extremely Low Volatility Extremely Low Volatility Extremely Low One way to think about investing in this world is to turn to the options market. The options market is unique in that it allows investors to take a view on the dispersion of the expected returns of the asset against which the option is written.9 This is because one of the critical components of a call or put option's value is the expected volatility of returns for the asset underlying the option itself. Volatility is trading-market shorthand for the annualized standard deviation of expected returns for the underlying asset. Volatility is a calculated value, whereas the other components of an option's price - i.e. the underlying asset's price, the strike price, time to expiration, and interest rates - are known inputs. Volatility, like the price of the underlying asset, is "discovered" when a trade occurs. After an option trades and its premium is known, an option-pricing model - e.g., the Black-Scholes-Merton model - can be run backwards, so to speak, to see what level of volatility solves the pricing model for the value that cleared the market. This is known as the option's implied volatility, because it is the expected standard deviation of returns implied by the price at which the option clears the market. One reason investors and traders buy and sell options is to express a view on implied volatility. Option buyers who think the market is underestimating the likelihood of sharply higher returns can express this view by buying out-of-the-money options. This can arise for any number of reasons, but they all boil down to one essential point: option buyers think there is a higher probability that returns will be higher or lower during the life of an option than what is being priced in the options market.10 Option sellers, on the other hand, are expressing the opposite view. We believe the geopolitical tail risks we have discussed in this report are not being fully reflected in the options markets most sensitive to this information, among them the gold market. Our own assessment of these risks implies much fatter tails than we currently observe in out-of-the-money gold options. For this reason, we are recommending investors consider buying $1,200/oz gold puts and $1,300/oz gold calls expiring in either June or December of this year. This is a strategic recommendation. We leave it to investors to set their own stop-loss, if they are not comfortable foregoing the full premium paid to hold these options to expiry, possibly expiring worthless. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Robert Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Downside To Full Employment," dated February 3, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 6 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?," dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 7 "Please see William Mauldin and Devlin Barrett, "Trump Administration Considers Change In Calculating U.S. Trade Deficit," Wall Street Journal, February 19, 2017, available at www.wsj.com. 8 Please see Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 9 Call options give the buyer the right to go long an underlying asset at the price at which an option contract is struck - i.e. the option's strike price. Puts give option buyers the right to go short the underlying asset at the price at which the contract is struck. While an option buyer is not required to ever exercise an option, option sellers must take the other side of the deal if the buyer chooses to exercise. Option buyers pay a premium for the put or call they purchase. 10 This probability also can be expressed in terms of price levels, which allows investors to take an explicit view of the likelihood of a particular price being realized during the life of the option being purchased. Please see Bob Ryan and Tancred Lidderdale, "Energy Price Volatility and Forecast Uncertainty," published by the U.S. Energy Information Administration (2009), for a discussion of options markets and implied volatility. "Appendix II: Derivation of the Cumulative Normal Density for Futures Prices" beginning on p. 22 shows how to transform the returns distribution into a price distribution. It is available at https://www.eia.gov/outlooks/steo/special/pdf/2009_sp_05.pdf. Geopolitical Calendar

Dear Client, In addition to our regular Weekly Report, we sent you a Special Report on Wednesday prepared by my colleague Marko Papic, BCA's chief geopolitical strategist, assessing the election landscape in Europe this year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Global growth has accelerated, corporate earnings are rebounding, and leading indicators suggest that these positive trends will persist over the remainder of the year. This supports our cyclically bullish view on global equities. Looking further out, the impulse to growth from the easing in financial conditions that began in early 2016 will fade, setting the stage for a slowdown in 2018. If growth does falter next year, easier fiscal policy could provide an offsetting tailwind. However, there continues to be a large gap between what politicians are promising and what they can realistically deliver. What is different this time is that spare capacity is much lower than it was during previous mid-cycle slowdowns. Thus, while global bond yields could eventually dip, they remain in a secular uptrend. Feature The Elusive Correction We have been arguing since last fall that stronger global growth will help fuel a variety of reflationary trades.1 This part of our view has panned out nicely. What has surprised us is just how relentlessly the market has traded that view. With the exception of a few small wobbles, the S&P 500 has basically marched higher since the morning following the U.S. presidential election. Reflecting this development, the VIX fell to near record low levels earlier this week (Chart 1). The market's failure to take a breather has sabotaged our efforts to have our cake and eat it too - to maintain an overweight stance on global equities, while also profiting from the occasional correction. In contrast to our last three tactical hedges - which generated a cumulative return of 42% - our latest hedge is now down 9%. That's a lot of red ink. Out of pure risk management considerations, we will close this trade if the loss breaches 10%. Nevertheless, most indicators continue to warn of a looming correction. In particular, our U.S. equity strategists' new "Complacency-Anxiety" index is at an all-time high, suggesting that stocks have entered a technical overshoot phase (Chart 2).2 Chart 1VIX Is Near Record Lows VIX Is Near Record Lows VIX Is Near Record Lows Chart 2Complacency Reigns Complacency Reigns Complacency Reigns Cyclical Picture Still Solid In contrast to the short-term outlook, the 12-month cyclical picture for risk assets still looks reasonably good. Measures of current activity are rebounding as animal spirits begin to kick in (Chart 3). Falling unemployment and stronger wage growth are causing households to open their wallets. Against the backdrop of decreasing spare capacity, firms are reacting to this by increasing investment spending. Capital goods orders in the G3 economies have jumped higher in recent months, and capex intention surveys are pointing to further upside (Chart 4). Chart 3Current Activity Indicators Are Rebounding Current Activity Indicators Are Rebounding Current Activity Indicators Are Rebounding Chart 4An Upswing In Capex An Upswing In Capex An Upswing In Capex Corporate earnings have also accelerated on the back of faster economic growth. Consensus estimates call for global EPS to expand by 12% in local-currency terms this year, with the S&P 500 registering 10.4% growth, the STOXX Europe 600 gaining 14.3%, Japan's TOPIX adding 12.5%, and MSCI EM leading the pack at 16%. Outside the U.S., year-to-date earnings revisions have generally been positive, particularly in Japan and EM (in the U.S., 2017 EPS estimates have ticked down a modest 0.8%). BCA's in-house earnings models are consistent with this optimistic profit picture (Chart 5). What accounts for this fortuitous turn of events? A number of reasons help explain why growth accelerated in the second half of 2016: The drag on global growth from the plunge in commodity sector investment ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7 percent off the level of U.S. GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 6). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus, helping to reflate the economy. Global growth benefited with a lag from the easing in financial conditions that began in earnest in early 2016. Government bond yields fell to record low levels in July. In addition, junk bond spreads collapsed, dropping from a peak of 7.9% in February to 4.3% by year-end (Chart 7). Higher equity prices, particularly in a number of beaten down emerging markets, also helped. Chart 5Broad-Based Acceleration In Corporate Earnings Broad-Based Acceleration In Corporate Earnings Broad-Based Acceleration In Corporate Earnings Chart 6Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 7Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen How Much Longer? Chart 8Improvement In Global ##br##Leading Economic Indicators Improvement In Global Leading Economic Indicators Improvement In Global Leading Economic Indicators The key question for investors is how long the good times will last. Right now, most leading indicators that we follow are signaling that the expansion will endure for the remainder of this year (Chart 8). As we look towards 2018, however, things get murkier. Conceptually, it is the change in financial conditions that matters for growth. While the ongoing rally in global equities and continued narrowing in credit spreads has contributed to some easing in financial conditions since the U.S. presidential election, this has been partly offset by higher government bond yields. A stronger dollar has also led to an incremental tightening in the U.S., as well as in some emerging markets with high levels of U.S. dollar-denominated debt. As such, it is likely that the positive "impulse" to economic growth from the easing in financial conditions that took place last year will begin to dissipate towards the end of this year. Fiscal Policy To The Rescue? If growth does slow next year, easier fiscal policy could provide an offsetting tailwind. The fiscal thrust for developed economies turned positive in 2016, the first year this happened since 2010 (Chart 9). However, it remains to be seen whether this trend will continue. There is little support among Republicans in Congress for a big infrastructure program. It once seemed possible that Chuck Schumer and his fellow Democrats could find common ground with President Trump on this issue, but that is looking less likely with each passing day, given the level of vitriol in Washington. Broad-based tax cuts are a certainty, but the risk is that they will be coupled with cuts to government spending. Empirically, the latter have a larger "multiplier effect" on GDP than the former. To complicate matters, the introduction of a border adjustment tax - something to which we assign 50% odds - could generate significant near-term dislocations for the global economy.3 Meanwhile, much of Trump's regulatory agenda is in limbo. A repeal of Dodd-Frank is off the table. Senate Republicans do not have the 60 votes needed to scrap it. The Volcker rule is here to stay. On the other side of the Atlantic, the European Commission has recommended a further loosening in fiscal policy this year, but member states themselves are actually targeting somewhat smaller fiscal deficits (Chart 10). As is often the case, budgetary overruns are likely, but with the Greek bailout program now back on the ropes, Germany and a number of other countries may begin to dial up the austerity rhetoric. Chart 9Will Fiscal Policy Continue To Ease? The Reflation Trade Rumbles On The Reflation Trade Rumbles On Chart 10European Commission Recommending Greater Fiscal Expansion The Reflation Trade Rumbles On The Reflation Trade Rumbles On Uncertainty over the slew of European elections slated for this year could also weigh on business sentiment. Marine Le Pen is likely to place first in the initial round of the French presidential election, but faces an uphill battle in the subsequent runoff. Nevertheless, betting markets are assigning a one-in-three chance of Le Pen becoming president - similar to the odds they were assigning to a Brexit "yes vote" and a Trump victory (Chart 11). Italy also remains a risk, as my colleague Marko Papic, BCA's chief geopolitical strategist, discussed in this week's Special Report.4 Anti-euro sentiment is now stronger there than in any other major European economy (Chart 12). Chinese fiscal policy has already tightened significantly, with the year-over-year rate of change in government spending falling from a high of 25% in November 2015 to zero at present (Chart 13). So far the Chinese economy has held up well, but there is a risk that this may change. Despite Trump's backpedaling on the "One China" question, we expect the Trump administration to declare China a currency manipulator later this year. This will pave the way for higher tariffs on a variety of Chinese goods, which could lead to retaliatory measures by China. Chart 11Brexit, Then Trump... Is Le Pen Next? Brexit, Then Trump... Is Le Pen Next? Brexit, Then Trump... Is Le Pen Next? Chart 12Italy: Anti-Euro Sentiment Is A Risk Italy: Anti-Euro Sentiment Is A Risk Italy: Anti-Euro Sentiment Is A Risk Chart 13China: Fiscal Stimulus Is Fading China: Fiscal Stimulus Is Fading China: Fiscal Stimulus Is Fading Investment Conclusions Chart 14Diminished Slack In The Global Economy Diminished Slack In The Global Economy Diminished Slack In The Global Economy Global growth continues to be strong, and is likely to stay that way for the remainder of this year. However, there is a heightened risk that the global economy will falter in 2018. We remain cyclically overweight global equities and underweight government bonds, but are not dogmatic about this view. As the discussion above suggests, plenty of things could derail the reflation trade. If evidence begins to mount that a slowdown is coming earlier than we think, we will turn more bearish on stocks. Given that equities are technically overbought at present, we would not fault anyone for taking some money off the table. If growth does slow in 2018, does this mean that bond yields will fall back towards last year's lows? We don't think so. For one thing, a major deflationary commodity bust of the sort we endured in 2014-15 is not in the cards. In addition, there is less slack in the global economy now than there was last year, or for that matter, anytime since early 2008 (Chart 14). As we discussed in our Q1 Strategy Outlook, potential GDP growth is likely to remain structurally depressed across much of the world, owing to slower productivity and labor force growth.5 Lower potential growth means that excess capacity could continue to be absorbed even if growth slows somewhat from its current well-above trend pace. In the U.S., this absorption of excess capacity is nearly complete, with most labor market indicators suggesting that the economy is approaching full employment (Chart 15). In this vein, we would heavily discount the decline in average hourly earnings in January's employment report. Chart 16 shows that this was mainly driven by an anomalous drop in compensation in the financial sector. Broader measures continue to point to brewing wage pressures (Chart 17). We expect the Fed to raise rates three times this year, one more hike than the market is now pricing in. If this happens, the dollar is likely to strengthen modestly over the remainder of the year. Chart 15U.S. Economy Approaching ##br##Full Employment U.S. Economy Approaching Full Employment U.S. Economy Approaching Full Employment Chart 16Financial Sector Dragging ##br##Down Hourly Earnings In The U.S. Financial Sector Dragging Down Hourly Earnings In The U.S. Financial Sector Dragging Down Hourly Earnings In The U.S. Chart 17U.S.: Broad Measures Pointing ##br##To Rising Wage Pressures U.S.: Broad Measures Pointing To Rising Wage Pressures U.S.: Broad Measures Pointing To Rising Wage Pressures Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Bonds are universally unloved. The economic 'mini-upswing' is extended. 6-month bank credit impulses have rolled over. Europe is entering a period of high-impact political events. Equities are universally loved. If bond prices bounce back, Bank equities are losers and Real Estate equities are winners. Feature From time to time it is worth stepping out of the herd and asking: is the herd heading in the right direction? Given the seemingly universal dislike of high-quality government bonds, this week's report goes through five reasons why bonds could make a surprising comeback in the coming months.1 Chart of the WeekBrexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing Brexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing Brexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing 1. Bonds Are Universally Unloved The extent of herding in bonds is extreme on both a 65-day and 130-day basis (Chart I-2). The herd is a good metaphor for financial markets given the capacity for investor sentiment to move en masse. However, excessive herding is dangerous, because it destroys market liquidity. Chart I-2The Extent Of Herding In Bonds Is Extreme The Extent Of Herding In Bonds Is Extreme The Extent Of Herding In Bonds Is Extreme Liquidity - defined as the ability to buy or sell an investment in large volume without moving its price - requires healthy disagreement. After all, at today's price, if you sell a bond and I buy it from you, we are disagreeing about the attractiveness of the price. If many investors disagree on the attractiveness of the price, then there will be plenty of liquidity. The main reason for healthy disagreement and plentiful liquidity is that the market is usually split between short-term momentum traders and long-term value investors. If the price fluctuates downwards, the momentum trader interprets this as a strong sell-signal but the value investor sees it as an equally strong buying-opportunity. Hence, the two types of investor can trade with each other in large volume without moving the price (much). However, if the value investor flips to become a momentum trader and sells rather than buys, the price must fall until it attracts a bid from a deep value investor. If the deep value investor then also flips to become a momentum trader, the price must fall further until it attracts a bid from an even deeper value investor. And so on... As everybody in turn flips to the same view, the herd and the trend will get stronger and stronger. The tipping point comes when there is nobody left to flip and to join the herd. If a value investor then suddenly reverts to type and puts in a buy order, he will find that there are no sellers left. Liquidity has evaporated, and to replenish it might require a substantial reversal in the price. On both our 130-day and 65-day herding indicators, bonds appear vulnerable to such a reversal in the coming weeks. 2. The Economic 'Mini-Upswing' Is Extended Chart 1-3Major Economies Exhibit ##br##Very Clear 'Mini-Cycles' Major Economies Exhibit Very Clear 'Mini-Cycles' Major Economies Exhibit Very Clear 'Mini-Cycles' A typical business cycle lasts multiple years. But within this longer cycle, major economies exhibit very clear 'mini-cycles' whose upswings and downswings last 6-12 months (Chart I-3). As we demonstrated in Slowdown: How And When? 2 these mini-cycles result from the perpetual interplay between changes in bond yields, accelerations/decelerations in credit growth, and accelerations/decelerations in economic growth. The inception of the current mini-upswing coincided with last February's G20 meeting in Shanghai. At the start of 2016, global growth appeared to be stalling and financial markets were fragile. In response, a so-called 'Shanghai Accord' facilitated a synchronized stimulus in the major economies - either directly, or in the case of the U.S., a watering down of monetary tightening expectations. By spring last year, bond yields were forming a typical mini-cycle bottom. But in June, the Brexit shock sent yields sharply, but briefly, lower. Conversely, the Trump shock-victory in November accelerated the upswing in yields that was already well underway (Chart of the Week). Absent these two political shocks, 2016 produced a typical mini-upswing whose duration is now approaching 12 months - making it long in the tooth. Mini-upswings do not die of old age. But it would be highly unusual for the economy's credit-sensitive sectors not to feel a strong headwind now from the sharp upswing in bond yields. 3. 6-Month Bank Credit Impulses Have Rolled Over 6-month credit impulses have indeed rolled over in the major economies (Chart I-4 and Chart I-5), exactly as would be expected after a sustained upswing in bond yields. Chart I-46-Month Credit Impulses Have ##br##Rolled Over In Major Economies... 6-Month Credit Impulses Have Rolled Over In Major Economies... 6-Month Credit Impulses Have Rolled Over In Major Economies... Chart I-5... And ##br##Globally ... And Globally ... And Globally Now you could argue that the upswing in bond yields is simply a response to improved expectations for growth. The problem with that argument comes from the inter-temporal and geographical distribution of that potential growth pickup. U.S. fiscal stimulus and infrastructure spending is an uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Furthermore, this stimulus is unlikely to benefit Europe or other economies outside the U.S. Yet the recent rise in bond yields and weakening of credit impulses has occurred everywhere. Compared to Trump's intangible stimulus, the choke on credit-sensitive sectors is a certain headwind whose impact will be felt sooner and more universally. 4. Europe Is Entering A Period Of High-Impact Political Events The next few months will also see a sequence of potentially high-impact political events in Europe. The Netherlands and France hold elections in which disruptive populist politicians are likely to perform well, though probably not well enough to gain power. Meanwhile, Greece appears to be reneging on the terms and conditions of its latest bailout - whose next tranche of funds it needs to make a large debt repayment in July. Into this sensitive mix, add the start of the formal and potentially acrimonious divorce proceedings between the U.K. and the EU27, due to start by the end of March. To be clear, the probability of a shock outcome in any of these individual events is low. But the probability of a shock from at least one of these multiple events is not so low. If the probability of an individual shock is, let's say, 20% then the probability that the event goes smoothly is clearly 80%. Therefore, the probability that all four events go smoothly would be 0.8 to the power of 4, equal to 41%.3 Which means that the probability of at least one shock would be a significant 59%. Perhaps the probability of an individual shock in any of these four events is less than 20%. However, there are also other more nebulous sources of risk, such as the possibility of early elections in Italy, and a disruptive outcome. To reiterate, an individual risk might be low or very low. But the chance of at least one shock in the upcoming sequence of events must be close to evens. And this is the chance that high-quality government bonds will receive significant haven demand at some point in the coming months. 5. Equities Are Universally Loved High-quality government bonds are universally unloved, but mainstream equities have the opposite problem. They are universally loved. The extent of herding in equities is extreme on a 65-day basis (Chart I-6). Chart I-6The Extent Of Herding In Equities Is Extreme The Extent Of Herding In Equities Is Extreme The Extent Of Herding In Equities Is Extreme This perfect symmetry of herding behaviour suggests to us that if investors suddenly fall out of love with equities - even briefly - then unloved bonds would be the very likely beneficiaries. Pulling all of the five arguments above together, we conclude that the odds of a tactical retracement in high-quality government bond yields in the next 3-6 months are more than evens. And we would position accordingly. In this eventuality, stock market investors should note that the sector that might be most vulnerable is Bank equities (Chart I-7). Conversely, the sector that might be one of the biggest beneficiaries is Real Estate equities (Chart I-8). Chart I-7If Bond Prices Bounce Back, ##br##Bank Equities Are Losers... If Bond Prices Bounce Back, Bank Equities Are Losers... If Bond Prices Bounce Back, Bank Equities Are Losers... Chart I-8... And Real Estate ##br##Equities Are Winners ... And Real Estate Equities Are Winners ... And Real Estate Equities Are Winners Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Our analysis throughout uses the JP Morgan Global Government Bond Index as the best representation of the direction of high-quality government bonds, including those in Europe. 2 Published on February 2, 2017 and available at eis.bcaresearch.com 3 Strictly speaking, this assumes that all four events are independent - that is, the outcome of one does not influence the outcome of another. Fractal Trading Model There are no new trades this week. 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 European populism is a red herring in 2017; France is a buy, Le Pen is overrated; Merkel's demise would be an opportunity, not a risk; Yet Italy poses a real risk - elections will be crucial; Moreover, Euro breakup risk is rising over the long run. Feature Clients are nervous. Nationalist and Euroskeptic French presidential candidate Marine Le Pen continues to lead first-round polling in the elections. Meanwhile, one of her establishment opponents - François Fillon - is facing corruption charges while anti-police riots have flared up in the banlieue of Aulnay-sous-Bois, northeast of Paris. Everything seems to be falling in place for another "black swan" political outcome (Chart 1). With Brexit and President Trump's victory fresh in everyone's consciousness, it is unsurprising that Le Pen's election probability is more than double our own assessment of 15% (Chart 2). Chart 1Another Black Swan In The Making? Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe Chart 2Brexit/Trump Drive Up Bets On Le Pen Brexit/Trump Drive Up Bets On Le Pen Brexit/Trump Drive Up Bets On Le Pen In this analysis, we take our clients around Europe in under 3,000 words. There is a lot happening on the continent this year. Yet, as we argued in our Strategic Outlook, Europe is setting up to be a massive red herring for investors.1 For example, France is more likely to have a free-market revolution than a populist one! It could be the chief investment opportunity in developed markets over the next several years.2 We are also optimistic about the Netherlands and Germany, despite alarms about populism. As such, we are going to play devil's advocate in this analysis and push our sanguine view to its limit. Where does our bullish logic break down? The Netherlands We begin with the Netherlands, which is the first to hit a busy electoral calendar in 2017. General elections are set for March 15 and the Euroskeptic Party for Freedom (PVV) of Geert Wilders will win a plurality of seats in the House of Representatives. According to the latest polls, Wilders' PVV will capture about 30 out of the 150 seats in the Tweede Kamer, the largest of any party. However, it is not enough to form a majority (Chart 3). Chart 3Dutch Populists A Minority In Parliament Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe The problem for the centrist parties in the Netherlands is that there are too many of them. In Chart 3, we combine the center-left and center-right, pro-EU integration parties together. There are approximately ten such parties fighting over the pro-EU middle ground. None is expected to get to the 30-seat projected average of PVV. Given that the center-right and center-left parties split the establishment vote roughly in half (~60 seats each), it is likely that the Dutch pro-EU parties will need a cross-aisle "Grand Coalition" to produce a government. Coalitions take a long time to form in the Netherlands. In 2012, the process took 54 days, whereas in 2010 it took four months. The 2010 election is a good guide to this year's event, as it also produced a relatively complicated seat breakdown that ultimately forced the center-right to depend on PVV votes to govern. We suspect that the Netherlands will be deep into the coalition talks in the summer months, well after the French election is over. Investors take comfort in the fact that PVV cannot form an anti-EU/euro government on their own. This is true. We would also point out that the Dutch support the euro at a very high level (Chart 4) and that they surprisingly lack confidence in the country's future outside the EU (Chart 5). However, a "Grand Coalition" whose only purpose is to keep PVV out of government would cede the "opposition" ground to Wilders and his Euroskeptic government. And while this seems like a good idea today, while Europe's economic growth is rebounding and the migration crisis has abated (Chart 6), it could be a very bad idea once the next recession hits or the next geopolitical crisis reveals flaws in EU governance. Chart 4The Dutch Highly Approve Of The Euro... The Dutch Highly Approve Of The Euro... The Dutch Highly Approve Of The Euro... Chart 5...And See Little Future Outside The EU ...And See Little Future Outside The EU ...And See Little Future Outside The EU Chart 6Waning Migrant Crisis Undermines Populist Waning Migrant Crisis Undermines Populist Waning Migrant Crisis Undermines Populist France Constraints to a Le Pen victory in the upcoming presidential election - April 23 and May 7 - are considerable, and we expanded on them in our February 3rd Special Report "The French Revolution."3 Briefly, they are: Strong French support for the euro: Support appears to be inversely correlated with Le Pen's overall popularity, suggesting that her stance on the euro and EU creates a ceiling to her support level (Chart 7). Le Pen is weak in the polls: Le Pen continues to trail both centrist Emmanuel Macron and center-right François Fillon in the second-round polling, both by around 20% (Chart 8)! Comparing Le Pen's chances to those of Trump is a massive insult to the latter, given that Trump never trailed Clinton by more than 8% with three months to go. Bad omens for Le Pen's party: The December 2015 regional elections pose a troubling precedent for Le Pen and her National Front (FN). Her party was decimated in the two-round format, despite a slew of tailwinds at the time, including the largest terrorist attack in recent French history. Chart 7Le Pen Hobbled By Her Anti-Euro Stance Le Pen Hobbled By Her Anti-Euro Stance Le Pen Hobbled By Her Anti-Euro Stance Chart 8Le Pen Lags By ~20% In Key Second-Round Polls Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe So, how does Le Pen win? We can imagine a scenario where a combination of another terrorist attack, banlieue rioting, and perhaps a restart of the migration crisis inspires enough voters to vote for Le Pen. Further, given that relatively liberal Macron is likely to make it to the second round, center-right voters may stay home or even shift to Le Pen in case of such a toxic brew. One problem with recent French electoral history is that it is replete with examples of center-left and left-wing voters strategically voting against Le Pen, yet little evidence exists that French conservative voters are willing to do the same and cast their vote for a left-leaning candidate. As such, despite better polling than Fillon in the second-round head-to-head against Le Pen, Macron remains vulnerable. What happens if Le Pen wins the election? This depends on whether FN wins the legislative elections set for June 11 and 18 - also a two-round election. Polls for the legislative election are sparse and unreliable, but it would be a shock if FN won a majority, especially given its performance in the December 2015 regional elections. As such, President Le Pen would have to co-habitate with an opposition-led parliament. The president of France has a lot of power, but it is checked by the National Assembly, the lower house of the parliament. For example, Le Pen's choice for prime minister would have to command a majority in the National Assembly in order to govern. And a number of constitutional powers - appointing members of the government, calling a referendum, dissolving the National Assembly, or ruling by decree - require the consent of the prime minister and cabinet. She would not even have a veto power over laws passed by parliament, as the French president can only delay legislation. Le Pen would only be unconstrained in matters of defense and foreign policy, where she could pursue several unorthodox policies. However, France's EU membership is written into the constitution (Article 88-1). Modifying the constitution would require an act of parliament (and potentially also a referendum, depending on a majority in parliament). In addition, France's membership in the euro is a legal obligation of its membership in the EU - given that France did not opt-out of the monetary union as Denmark and the U.K. did during the negotiations of the Maastricht Treaty. As such, it is unclear how Le Pen would be able to get the country out of the euro without pursuing the same procedure as the U.K. under Article 50 of the Lisbon Treaty, for which she would need to change the French constitution. All that said, these constraints may not be clear to the market if she is elected. We suspect that global markets would panic. A market riot, in fact, would be necessary to force Le Pen into orthodox policy, as it did with the surprise 1981 victory by socialist-leaning François Mitterrand. However, Mitterrand did not reverse policy until after two currency devaluations in the first year of his presidency, with the possibility of an IMF program openly discussed in Paris. The volte-face came after two years of sustained market pressure. It is not clear that France, or Europe for that matter, has that much time to dither today. Spain A referendum on the independence of Catalonia is expected by September. A referendum has been the main goal of the pro-independence government since Catalan elections in September 2015. The government combines far-left and center-right nationalists in an ungovernable coalition whose only common goal is independence. Chart 9Catalans Want Autonomy, Not Independence Catalans Want Autonomy, Not Independence Catalans Want Autonomy, Not Independence News flash to the markets: Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 9). And as we argued in our net assessment of the issue in 2014, a surge in internal migration since the Second World War has diluted the Catalan share of the total population.4 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.5 Another 10% identify non-Iberian languages as their first language, suggesting that migrants will further dilute support for sovereignty, as they have done in other places (most recently: Quebec). According to the Spanish constitution, Catalonia does not have the legal right to call for an independence referendum. We suspect that the center-right government in Madrid will continue to deny the legitimacy of any referendum. Ironically, this will suppress the anti-independence turnout and hand the nationalists a victory in September. What then? A low-turnout vote, combined with no recognition from Madrid, means that the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. The globally recognized definition of sovereignty is the "monopoly of the legitimate use of physical force within a defined territory." To put it bluntly: the Catalan government has to take up arms in order for its referendum to be relevant to markets (beyond the inevitable knee-jerk reactions surrounding the vote). Without recognition from Spain, and with no support from EU and NATO member states, Catalonia cannot win independence with a referendum alone. Germany General elections are set for September 24, with investors concerned that Chancellor Angela Merkel may face a tougher-than-expected challenge from the center-left Social Democratic Party (SPD). The new SPD Chancellor candidate, Martin Schulz, is polling very well and has even overtaken Merkel in the head-to-head polls (Chart 10). Schulz's overtly Europhile position - he has been the European Parliament Speaker since 2012 - appears to be winning over voters. The CDU held on to a double-digit lead over the SPD right up until Schulz took over as the primary challenger to Merkel (Chart 11). Chart 10Schulz Now Leads Merkel For Chancellor Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe Chart 11Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival To some extent, CDU's drop in the polls was inevitable. It is correlated with a decline in Merkel's popularity (Chart 12). But we suspect there is more to it. Schulz's confidently pro-European attitude is a breath of fresh air for voters in Germany who have perhaps lost faith in Merkel's cautious approach to the euro crisis. Record-high support for the common currency in Germany suggests that we may be on to something (Chart 13). The German public is simply nowhere close to being as Euroskeptic as the financial media would have investors believe. And that is for good reason: euro area membership has clearly worked for Germany. Can Schulz and the Europhile SPD keep up the pressure on Merkel? Time will tell. But we take two messages from the polls. First, Euroskeptic parties are nowhere close to governing in Germany (Chart 14). Second, Merkel is a shrewd politician who has shamelessly pivoted on policy issues in the past. If Merkel senses that her lukewarm embrace of European integration can cost her the election, and that voters are buying Schulz's claim that she is to blame for the rise of populists in Europe, then she will pivot on Europe. This would be very bullish for markets as it would suggest that Berlin is ready and willing to apply fewer sticks and more carrots to its euro area peers. Chart 12Merkel's Popularity##br## In Decline Merkel's Popularity In Decline Merkel's Popularity In Decline Chart 13Germans See The Euro##br## As A Great Deal Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Chart 14There Is A Lot Of Daylight... ##br##Euroskeptic Parties Weak In Germany There Is A Lot Of Daylight... Euroskeptic Parties Weak In Germany There Is A Lot Of Daylight... Euroskeptic Parties Weak In Germany What if Schulz defeats Merkel and the SPD takes over the leadership of the grand coalition, or perhaps forms a coalition with left-leaning Greens and Die Linke? Is Merkel's demise not a risk to the markets? Most of our clients would see Merkel's retirement as a risk. We disagree. Investors are overstating Merkel's role as the "anchor" of euro area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent euro area fiscal backstop mechanism due to upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. Her handling of the migration crisis also left much to be desired, to put it kindly. The SPD has picked up on this line of criticism and Schulz has begun to blame Merkel's cautious approach and insistence on austerity for the populism sweeping Europe. Given that polls suggest that Germans are not really in favor of austerity, this is potentially a winning strategy (Chart 15). Chart 15Germans Are Not Obsessed With Austerity Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe We therefore believe that Merkel's demise is not being correctly priced by the markets. First, investors seem to believe that she will easily win another term. Second, those that fret about her future incorrectly price the downside risk. We actually see Merkel's retirement as an opportunity, not a risk. Whether the SPD takes over, or a more Europhile member of the CDU replaces an embarrassed Merkel as the leader of a grand coalition (Box 1), investors should contemplate what the continent will look like with a new Europhile chancellor. BOX 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Wolfgang Schäuble, Finance Minister (CDU): The bane of the financial community, Schäuble is seen as the least market-friendly option due to his hardline position on bailouts and the euro area. In our view, this is an incorrect interpretation of Schäuble's heavy-handedness. He is by all accounts a genuine Europhile who believes in the integrationist project. At 74 years old, he comes from a generation of policymakers who consider European integration a national security issue for Germany. He has pursued a tough negotiating position in order to ensure that the German population does not sour on European integration. Nonetheless, we doubt that he will choose to take on the chancellorship if Merkel retires. He suffered an assassination attempt in 1990 that left him paralyzed and he has occasionally had to be hospitalized due to health complications from this injury. As such, it is unlikely that he would replace Merkel, but he may stay on as Finance Minister and thus be as close to a "Vice President" role as possible in Germany. Ursula von der Leyen, Defense Minister (CDU): Most often cited as the likely replacement for Merkel, Leyen nonetheless is not seen favorably by most of the population. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has gone so far as to say that the refugee crisis and the debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who has handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière, Interior Minister (CDU): Maizière is a former Defense Minister and a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could be a compromise candidate between the Europhiles and Eurohawks within the CDU ranks. Though he has been implicated in scandals as defense minister, his popularity as interior minister is surging at the moment as a result of his declared intention to overhaul immigration policy and internal security. Julia Klöckner, Executive Committee Member, Deputy Chair (CDU): A CDU politician from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel. While she has taken a more right-wing stance on the immigration crisis, she has remained loyal to Merkel otherwise. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist." We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe, Minister of Health (CDU): Gröhe is a former CDU secretary general and very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier, Minister President of Hesse (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier's handling of Brexit will attract much scrutiny. He is a heavyweight within the CDU's leadership and a staunch Europhile. Fritz Von Zusammenbruch, Hardline Euroskeptic (CDU): Significantly, no such candidate exists! Greece The financial media have begun to fret about the ongoing negotiations between Greece and its euro area creditors over further aid to the country. Greece faces a €7bn euro repayment in July, by which time the funding must be released or the government will run out of cash. The problem is that the IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. Europeans are willing to turn a blind eye to the reality in Greece and project high growth and primary surpluses. The IMF is not. And yet both Germany and Finland have made their participation in the Greek rescue conditional on the IMF's involvement. Even if a crisis emerges, the likely outcome would be early elections in Greece. Prime Minister Alexis Tsipras is holding on to a three-seat majority in the parliament. This majority is at risk, especially in a repeat of the 2015 crisis. Investors should cheer new elections in Greece, not fret about them. Polling shows that the pro-euro and pro-EU New Democracy Party is polling well above SYRIZA, and would produce a stable, pro-reform government (Chart 16). And there is no longer any Euroskeptic alternative in Greece. Chart 16No More Euroskeptic Option In Greece No More Euroskeptic Option In Greece No More Euroskeptic Option In Greece Given Tsipras's limited choices and the upcoming German elections, we suspect that investors will not see a return of the Greek saga this year, at least not at the same level of intensity as two years ago. And is Greek debt sustainable? Yes, it is sustainable as long as the Europeans decide to pretend that it is sustainable. Italy Last but not least is Italy. Investors have recently received some clarity on the timing of the next election as former Prime Minister Matteo Renzi has called a new leadership race in the ruling Democratic Party (PD). Given that the party must hold an internal election sometime in the spring, it is unlikely that elections will occur by mid-June, as Renzi had hoped. The most likely date is therefore in autumn 2017, given that Italy shuts down in the summer. However, interim Prime Minister Paolo Gentiloni, along with a large minority of MPs, opposes Renzi's leadership and could see him defeated in the leadership race. If that happens, investors may be spared an election until closer to the formal due date of May 23, 2018. The election, whenever held, will be the main political risk for European markets in 2017. First, support for the common currency continues to plumb multi-decade lows in Italy (Chart 17), while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart 18). Second, rising negative sentiment towards the euro and the EU are reflected in very strong polling for Euroskeptic parties. Chart 19 shows that establishment parties are barely fending off the Euroskeptic challenge - and that is only because we include the Forza Italia of former Prime Minister Silvio Berlusconi in the pro-Europe camp. Meanwhile, the ruling PD and Euroskeptic Five Star Movement (M5S) are neck-and-neck in the disaggregated polls (Chart 20). Chart 17Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart 18Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Chart 19Euroskeptic Parties##br## Strong In Italy Euroskeptic Parties Strong In Italy Euroskeptic Parties Strong In Italy Chart 20Five Star Movement Rivals##br## Ruling Democratic Party Five Star Movement Rivals Ruling Democratic Party Five Star Movement Rivals Ruling Democratic Party What happens if M5S wins the election? Given the recent Supreme Court ruling on the electoral law, it is essentially impossible for any party to win the majority in the next election, at least with the current polling numbers. As such, M5S would have to break its electoral pledge not to form coalition governments and either form one or rule with an unstable minority. It is highly possible that M5S would use support from other Euroskeptic parties - such as the nationalist Lega Nord - to pass a law on a non-binding referendum on the euro. While the Italian constitution prohibits referenda on international treaties - and membership in the monetary union is such a treaty - a vote against the euro in a non-binding referendum would give M5S legitimacy in pursuing an Italian exit from the euro area. At such a point, we would expect that a severe market riot would be needed to push Italy away from the brink. Our assessment is that M5S would ultimately back off, as Greece did in 2015. However, Italians in 2017 are more Euroskeptic than Greeks were in 2015. Whereas Greeks saw euro membership as a key link to their membership in the Western club, Italians appear to be a lot more confident in their ability to survive euro exit. That said, M5S is not a single-issue party. Rather, it is a protest movement against government corruption and incompetence that is also moderately Euroskeptic. As such, it is not clear that it would risk an economic crisis and a potential popular revolt over an issue that has split the Italian electorate. Rather, we suspect that M5S would use the threat of euro exit to win concessions on fiscal spending from the rest of Europe. As we explained in our September 2016 net assessment of Italian politics, European integration is vital for Rome both politically and economically.6 While Italy would theoretically benefit from currency devaluation by exiting the euro, it would in practice lose access to the common market as its euro membership is legally tied to its EU membership. Politically, it would also be highly unlikely that the other euro member states would allow such a large economy to devalue against them. Investment Implications European markets remain in a sweet spot in 2017. Global growth is showing signs of improvement, the ECB will remain dovish relative to the Fed, the EU Commission is calling for more expansionary fiscal policy, and valuations continue to favor European plays over other developed market plays. Will politics spoil the party? Of the six risks we reviewed in this report, Italy is the one where the devil's advocate argument is most convincing. Polls in the country have shown no improvement in support for the euro despite the continent-wide resurgence in support (Chart 21). The other five risks will likely remain limited to fodder for the news media, allowing markets to climb the proverbial wall of worry in 2017, especially if Italian elections are pushed off into 2018. But even if the slew of elections returns pro-euro governments, long-term political risks are mounting in Europe. As we pointed out in 2013, there is a danger in relying on "Grand Coalitions" between the center-right and center-left to sustain European integration.7 Such a centrist consensus cedes the opposition ground to the Euroskeptics. If - or rather, when - a major recession or geopolitical crisis occurs, voters will no longer have a pro-establishment political alternative to turn to. As such, we agree with our market gauge of euro area breakup probability - which measures the probability of a common currency breakup over the next five years. It currently stands at 30.2% (Chart 22). Chart 21Italy Poses Chief Risk ##br##To European Integration Italy Poses Chief Risk To European Integration Italy Poses Chief Risk To European Integration Chart 22Euro Breakup##br## Risk Is Rising Euro Breakup Risk Is Rising Euro Breakup Risk Is Rising Thankfully for investors, neither a recession nor a geopolitical crisis is on the horizon in 2017. The migration crisis has ended, as we expected (Chart 23).8 Given the geographical proximity of the Middle East and North Africa to Europe, another refugee deluge is possible. We suspect it would require the collapse of new states, such as Algeria or Egypt, not merely the ongoing crises in Libya and Syria. However, with the Middle East still in flux, a recession on the five-year horizon, and the first anti-EU president in the White House, risks are beginning to stack up against European integration. Chart 23Migrant Crisis Waning Migrant Crisis Waning Migrant Crisis Waning The key question for 2017 is the same as it has been since 2010: what will Germany do? If the Europhile turn in German politics is real, then the assumptions that investors have taken for granted may be shifting. A Germany more willing to shoulder the cost of economic rebalancing via higher inflation and debt relief would be a game changer for markets. Pessimists will say that Germans would never accept such costs. But with a 3.9% unemployment rate, an 8.5% of GDP current account surplus, and a budget surplus, Germany is firing at all cylinders. Ultimately, the question for German voters is whether they are willing to bear the costs of regional hegemony. If they are, then Europe's economy and markets are about to enter a multi-year bull market. If they are not, then the centrist victories in 2017 may be the calm before the storm. As BCA's Geopolitical Strategy argued in our aforementioned Special Report on the French election, we recommend going long French industrials versus German industrials, to capitalize on reforms we think are likely after the election (whereas Germany has already reformed). We are also sticking with our long German consumers versus exporters trade, reflecting the robust German economy and persistently dovish ECB. Finally, by contrast with these bullish trades, we maintain our more bearish tactical trade of matching every €1 of euro area equity exposure with 40 cents of VIX term structure, since the latter will spike if and when the various headline political risks cause market flutters. BCA is cyclically overweight euro-area equities relative to the U.S. in currency-hedged terms. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see 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 Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 See footnote 2 above. 4 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 5 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat. 6 Please see Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 7 Please see Geopolitical Strategy Monthly Report, "Austerity Is Kaputt," dated May 8, 2013, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com.

Highlights The USD bull case is now well known by the market, but this is not strong enough a hurdle to end the dollar's run. The behavior of positioning, the U.S. basic balance of payments, interest rate expectations, and relative central bank balance sheets suggest we are entering the overshoot phase of the rally. Volatility will increase and differentiation on the dollar's pairs is becoming more important. Reflation plays are especially in danger, and the euro could be handicapped by political risk. The yen remains the preferred mean to play the ongoing dollar correction. Feature The dollar bull market has been echoing the path traced in the 1990s (Chart I-1). The key question for investors now is whether the dollar can continue to follow this road map or is the bull market over. The dollar bullish arguments are now well known by market participants, increasing the risk that purchases of the dollar might exhaust themselves. We review the indicators that worry us most and conclude that the dollar bull market could run further. However, as the dollar is now moving into overshoot territory, we expect that the volatility of the rally will only grow. Also, divergences in the dollar on its pairs are becoming more likely. We remain short USD/JPY, and explore the risks to the euro's near-term outlook. Signs Of An Overshoot? Sentiment The first factor that worries us about the future of the USD bull market is the near universality of the positive disposition of investors toward the dollar. However, two observations are in order. First, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-2). Second, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. Either way, the dollar can continue to climb despite this handicap. Chart I-1Will History Repeat Itself? Will History Repeat Itself? Will History Repeat Itself? Chart I-2In The 1990s, The Consensus Was Right In The 1990s, The Consensus Was Right In The 1990s, The Consensus Was Right This reflects the fact that currency markets can often fall victim to something called the "band-wagon" effect, where a strong trend attracts more funds and perpetuates itself. Chart I-3America Is Great Again, ##br##At Least According To Investors America Is Great Again, At Least According To Investors America Is Great Again, At Least According To Investors We think this is caused by two factors. Valuation signals in the currency market have a poor track record at making money on a less than 2-year basis. This means that such signals need to be extremely strong before investors act on them. The dollar being 10% overvalued does not fit this description, instead a 20% to 25% overvaluation would hit that mark. Also, a strong upward move in a currency attracts funds to that economy. This creates liquidity in that nation's banking sector, alleviating some of the economic pain created by a rising currency or the tighter monetary policy that often caused the currency in question to rise in the first place. Today, the U.S. economy fits this bill, as private investors are rapaciously grabbing U.S. assets (Chart I-3). The Basic Balance Of Payments We have been struggling with how to interpret a strong basic balance of payment position. On the one hand, an elevated basic balance suggests that there is buying out there supporting a nation's currency. On the other hand, a strong basic balance position, especially if not caused by a current account surplus, suggests that market participants have already implemented their purchases of that nation's currency's and assets. These investors thus need further positive shocks to buy even more of that currency in order to lift its exchange rate ever higher. Today, the basic balance of payments in the U.S. is at a record high of 3.8% of GDP, begging the question of how it can climb higher from here (Chart I-4). However, as the same chart reveals, each of the previous dollar bull markets ended a few years after the U.S. basic balance of payments had peaked. Thus, we currently continue to expect the dollar to strengthen even if the U.S. basic balance position were to deteriorate. Additionally, the euro area basic balance is very depressed today at -3.4% of GDP, despite a current account surplus of 3% of GDP. However, in 1999, the region's basic balance bottomed at -5.6% of GDP, and it took until 2002 before the euro could durably rally, at which point the euro area basic balance had move back near 0% of GDP. Therefore, we would need to see a marked improvement in the euro area's basic balance in order to buy and hold the euro on a 12-to-18 months basis. Interest Rate Expectations Investors have rarely been as convinced as they are today that the Fed will increase interest rates over the coming months. This implies that the room for disappointment is large. However, as Chart I-5 illustrates, this is still not a reason to begin betting on an end to the dollar cyclical bull market. An overshoot in the dollar is marked by a fall in expectations of interest rate hikes as the strong dollar hurts the economy, preventing the Fed from hiking as much as anticipated. Moreover, except in 1994, a decreasing prevalence of rising rate expectations has lead dollar bear markets by more than a year. This suggests that there is room for the dollar to strengthen even if markets downgrade their U.S. rates expectations. Chart I-4The Basic Balance##br## Is A Small Hurdle The Basic Balance Is A Small Hurdle The Basic Balance Is A Small Hurdle Chart I-5In An Over Shoot, The Dollar Can Rally ##br##Even If Investors Doubt The Fed In An Over Shoot, The Dollar Can Rally Even If Investors Doubt The Fed In An Over Shoot, The Dollar Can Rally Even If Investors Doubt The Fed Even when looked comparatively, the broad consensus of investors regarding the continuation of monetary divergences between the Fed and the ECB is not yet a hurdle for the dollar to continue beating the euro on a 12-18 months basis. Not only is EUR/USD currently trading in line with relative expectations, previous euro rallies have been preceded by a big upgrade of the expected path of policy in Europe relative to the U.S. We currently expect the ECB to go out of its way to telegraph that even if asset purchases get curtailed in the second half of 2017, this will in no way foretell an imminent increase in European rates. Meanwhile, the Fed is in a firm position to increase rates as U.S. slack has dissipated (Chart I-6). Moreover, the proposed fiscal stimulus of the Trump administration should create inflationary pressures in this environment, solidifying the Fed's resolve to hike rates further. Chart I-6The Fed Pass Toward Higher Rates In Being Cleared The Fed Pass Toward Higher Rates In Being Cleared The Fed Pass Toward Higher Rates In Being Cleared Balance Sheet Positions One indicator concerns us more than the others at this point in time. As we wrote two weeks ago, one factor that has propelled the dollar higher has been its relative scarcity. The limited supply of dollar in the offshore markets - courtesy of the meltdown in the prime money-market funds industry and the heavier regulatory burden on banks - has caused cross-currency basis swap spreads to widen, pushing the greenback higher.1 Chart I-7Balance Sheet Dynamics And##br## The Scarcity Of Dollars Balance Sheet Dynamics And The Scarcity Of Dollars Balance Sheet Dynamics And The Scarcity Of Dollars Currently, the cross-currency basis swap spreads are hovering near record lows. However, as Chart I-7 illustrates, the surplus of euros created by the ECB's balance-sheet expansion as the Fed stopped its own purchases had a role to play in this phenomenon. While we expect the ECB to stand pat on the interest rate front for the foreseeable future, a further tapering of asset purchases in the second half of 2017 and beyond is very likely. This could limit the widening in cross-currency basis swap spreads that has been so helpful to the dollar, especially if the Fed elects not to curtail the size of its balance sheet. Net Net Many indicators suggest that the potential for dollar buying may be on the verge of exhausting itself. However, when looked closer, while these factors are a cause for concern, they still do not preclude an overshoot in the dollar. In fact, if anything, they suggest that the dollar is only now beginning its overshoot phase, a leg of the bull market that historically begins to inflict deeper pain on the U.S. economy as the dollar gets ever more dissociated from its fundamentals. So What? While the above indicators do not yet point to an end of the bull market, they in no way suggest that the dollar cannot suffer episodic corrections. We believe we are in the midst of such an event. Can the correction last further? Yes. To begin with, while the heavy net long positioning in the dollar does not represent much of a cyclical hurdle to beat, it does still constitute an important tactical risk. Our models corroborate this view. DXY is only currently fairly valued based on our intermediate-term timing model. Historically, tactical corrections fully play out once this model is in cheap territory (Chart I-8). Moreover, our capitulation index paints a similar story. This indicator has corrected some of its overbought excesses but remains above levels suggestive of an oversold environment. To the contrary, the fact that this index is still below its 13-week moving average points to additional selling pressures on the USD (Chart I-9). Chart I-8The Dollar Tactical Correction Is Not Over The Dollar Tactical Correction Is Not Over The Dollar Tactical Correction Is Not Over Chart I-9Confirming The Dollar Tactical Downside Confirming The Dollar Tactical Downside Confirming The Dollar Tactical Downside However, other factors suggest that the dollar could strengthen on certain pairs. The outlook seems especially grim for the reflation plays like the commodity currencies. Our reflation gauge, based on the prices of lumber, industrial metals, and platinum, has moved upward exactly as the U.S. dollar has rallied, a short-lived phenomenon that happened in 2001, 2002, and 2009. In all these cases, the Fed was easing policy and U.S. rates were softening relative to the rest of the world (Chart I-10). We doubt this phenomenon can continue much longer, especially as the Fed is currently tightening policy and U.S. rates are rising relative to the rest of the world. Moreover, Chinese fiscal stimulus was crucial in supporting this divergence in both 2009 and 2016. However, Chinese government spending went from growing at a 25% annual rate in November 2015, to a near 0% rate now. Moreover, the PBoC has already increased rates twice on its medium-term facilities and has also stopped injecting liquidity in the interbank market despite recent upward pressures on the SHIBOR. This tightening could prove problematic for natural resources like coking coal, iron ore, or copper, commodities highly levered to the Chinese real estate market and of which China recently accumulated large inventories (Chart I-11). Chart I-10An Unusual Move An Unusual Move An Unusual Move Chart I-11Elevated Chinese Metal Inventories Elevated Chinese Metal Inventories Elevated Chinese Metal Inventories Additionally, on the back of the longest expansion in the global credit impulse in a decade, G10 economic surprises have become very perky. However, it will be difficult to beat expectations going forward. Not only have investors ratcheted up their global growth expectations, the recent increase in global interest rates limits the capacity of the credit impulse to grow further. In fact, the recent tightening in U.S. banks credit standards for consumer loans, the fall in the quit rates in the U.S. labor market, and the underperformance of junk bonds relative to Treasurys since late January only re-inforce this message. Sagging global growth, even if temporary, is always a problem for commodities and commodity currencies. The euro faces its own risk: France. Last week, along with our colleagues from BCA's Geopolitical Strategy service, we wrote that the chance of a Le Pen electoral victory is still extremely low and we would buy the euro on any sell-off caused by a rising euro-area breakup risk premium.2 Yet, we are not oblivious to the risk that before the second round of the election is over on May 7th, investors can continue to place bets that Marine will win and that France will exit the euro area. The recent widening of the OAT/Bund spread reflects these exact dynamics as François Fillon's hardship and Macron's love life have taken center stage. So real has been the perception of this risk that spreads on Italian and Spanish bonds have followed suit (Chart I-12). While we are inclined to lean against this move, it is a risk that investors may want to bet on or hedge against. At the current juncture, the euro is fully pricing in these developments, and no mispricing is evident. However, as our model based on real rates differentials, commodity prices, and intra-European spreads shows, if France spreads were to widen further, EUR/USD could suffer (Chart I-13). In fact, if French spreads retest their 2011 levels, the euro could fall toward parity. Chart I-12Le Pen Is Causing A Repricing ##br##Of The Euro Area's Breakup Chance Le Pen Is Causing A Repricing Of The Euro Area's Breakup Chance Le Pen Is Causing A Repricing Of The Euro Area's Breakup Chance Chart I-13The Euro Will Suffer If French ##br##Bonds Underperform Further The Euro Will Suffer If French Bonds Underperform Further The Euro Will Suffer If French Bonds Underperform Further Investors wanting to speculate on the French election but wanting to avoid taking on some USD exposure can do so by shorting EUR/SEK, a very profitable strategy when the euro crisis was raging (Chart I-14) or could short EUR/GBP, as interest rates expectations have begun to move against the common currency and in favor of the pound (Chart I-15). While EUR/CHF tends to weaken during times of euro-duress, it is currently trading close to the unofficial SNB floor and we worry that growing intervention by the Swiss central bank will limit any downside on this pair. The currency that is likely to benefit the most against the dollar remains the yen. Not only are investors still very short the yen, but based on our intermediate-term timing model, the yen remains very attractive (Chart I-16). Moreover, the recent large improvement In the Japanese inventory-to-shipment ratio only highlights that the Japanese economy has gathered momentum, decreasing the likelihood of an enlargement of the current set of ultra-stimulative measures from the BoJ. Chart I-14Short EUR/SEK: A Hedge Against Le Pen Short EUR/SEK: A Hedge Against Le Pen Short EUR/SEK: A Hedge Against Le Pen Chart I-15Downside Risk For EUR/GBP Downside Risk For EUR/GBP Downside Risk For EUR/GBP Chart I-16Yen: Biggest Winner If USD Corrects Yen: Biggest Winner If USD Corrects Yen: Biggest Winner If USD Corrects Additionally, any risk-off event caused by a correction of the reflation trade would benefit the yen. Falling commodity prices will hurt Japanese inflation expectations and lift real rate differentials in favor of the yen. A correction in the reflation trade would also put downward pressure on global bond yields, which means that due to the low yield-beta of JGBs, Japanese nominal interest rates spread would further contribute to a narrowing of real interest rate differentials in favor of the JPY. Finally, if investors begin to bet even more aggressively on a breakup of the euro area fueled by the perceived prospects of a Le Pen electoral victory, the vicious wave of risk aversion unleashed around the globe by such an event would likely support the yen beyond our expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please refer to the Foreign Exchange Strategy Weekly Report, "Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism", dated January 27, 207, available at fes.bcaresearch.com 2 Please refer to the Foreign Exchange/ Geopolitical Strategy Special Report, "The French Revolution", dated February 3, 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 As we highlighted in previous reports, DXY's losses extended no further than the 99-100 support range, and the index has rebounded since then. A key external driver of the USD is EUR, whose roll-over has coincided with the DXY's rebound. In the coming months, EUR/USD could display downside risk as markets price in election jitters. This could be bullish for the greenback. The budget plan is in discussion. Due in around a month, the tentative plan comprises tax cuts and defense spending mostly. While this is still speculative, this plan may be bullish for the dollar. Until then, it is likely that the DXY will follow in its seasonal trend and be largely unchanged with little upside this month. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 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 Two main factors are weighing on the euro this week. Firstly, Draghi continues to retain his dovish stance. He stated that there is still "significant degree of labour market slack", which is limiting wage growth, a key contributor to underlying inflation. Secondly, and more substantial, are politically-induced anxieties in the run up to the European elections. In particular, French elections have increased risk premia, forcing the 10-year OAT-Bund spread to reach early-2014 highs. Greek 2-year yields have also spiked above 10%. Volatility is likely to be elevated in the lead up to the French election and possibly through Italian elections. The longer-term outlook will remain dictated by the development of the ECB's monetary policy stance. Report Links: The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Then yen continues to rally, with USD/JPY already down by almost 5% this year. Uncertainty surrounding the European elections should help continue this trend, given that the yen should benefit from safe haven flows. Nevertheless, the outlook for the yen remains bearish on a cyclical basis, as the measures that the BoJ has taken, such as anchoring 10-year rates near 0, and switching to de facto price level targeting will eventually lower Japanese real rates vis-à-vis the rest of the world. The BoJ has taken these measures to kick start an economy plagued by deflation. Early returns from this policy are mixed: Machinery Orders grew by 6.7% YoY, outperforming expectations. However both housing starts growth and Nikkei Manufacturing PMI fell below expectations, coming at 3.9% and 52.7 respectively. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 On Wednesday, the U.K. House of Commons finally gave their approval to a bill authorizing the government to start exits talks with the European Union. The House of Lords will be the next hurdle that Brexit hopefuls will have to overcome. Although cable suffered from some volatility following the decision it has remained relatively unaffected. We continue to think that the pound has further upside, particularly against the euro, as the negative consequences of Brexit on the British economy are already well priced into cable. Furthermore, increasing uncertainty regarding the French elections should also be bearish for EUR/GBP. If the fear of a Le Pen presidency starts to increase, Brexit will become an afterthought as exiting the European Union takes on a completely different meaning if the integrity of the EU starts being put into question. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 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 RBA held rates at 1.5% this week on the basis of upbeat business and consumer confidence, and above-trend growth in advanced economies. This decision helped the AUD, as investors repriced dovish bets and interpreted a change in stance. While above-trend growth is possible, Chinese demand is particularly important for Australia. Last week, the PBoC silently tightened their 7-, 14-, and 28-day reverse repo rates by 10 bps each to help alleviate looming risks in the real estate market and general financial stability. This may signal an end to an easing cycle, which may limit demand growth going forward. Australia has its own financial worries. Household debt is at its highest ever, at 186% of disposable income, which would be catastrophic if rates are raised. Lowe also highlighted concerns about a strong AUD and its impact on Australia's economic transition. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 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 The RBNZ decided to keep interest rates unchanged at 1.75% in their monetary policy meeting this Wednesday. Additionally, as expected, Governor Graeme Wheeler stated that the RBNZ had shifted from having a dovish bias to a having neutral one. Nevertheless, the kiwi has depreciated sharply since the announcement, not only because Governor Wheeler highlighted that the currency "remains higher than is sustainable for balanced growth" but also because the RBNZ showed a cautious approach by stating that "premature tightening of policy could undermine growth and forestall the anticipated gradual increase in inflation". However, we believe that the RBNZ will turn more hawkish, as inflationary forces in the economy will eventually put upward pressure on rates. This will lift the NZD, particularly against the AUD. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Uncertainty has come up as a key issue in the Bank of Canada's headlights, as Poloz remains nervous about the future of U.S.-Canada relations. CAD has recently displayed some strength despite this uncertainty. It has appreciated against USD, AUD and NZD. This is likely due to a brightening perception of the Canadian economy with the Ivey PMI recording a reading above 50 for January, at 52.3, above the previous 49.3. Additionally, housing starts beat expectations, dampening housing market concerns. Exports have been strong, which has also fed into this appreciation. A rapidly appreciating currency would exacerbate trade concerns further and adversely affect the Canadian economy. Therefore, it is likely that the BoC remains tilted to the dovish side, which will generate downside for the CAD through rate differentials. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has reached its lowest level since August 2015. At around 1.065, this cross is hovering in the lower range of the implied floor set by the SNB. Increased uncertainty caused by the upcoming European elections cycle will continue to test this floor, as the increased odds of an Eurosceptic government in France will not only decrease the value of the euro but will also put upward pressure on the franc, given its safe haven status. Nevertheless, the SNB will do everything in its power to weaken its currency as the Swiss economy continues to be plagued by deflationary forces: After showing glimpses of a recovery last month Real retail sales contracted by 3.5% YoY, falling well short of expectations. The SVMI Purchasing Manager's Index also came below expectations coming in at 54.6. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 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 USD/NOK has rebounded after reaching 8.20, its lowest level since Trump got elected. Interestingly, the NOK has not been as correlated with oil prices since the start of 2017 as it has been in the past. This is a trend worth monitoring. The inflation picture remains complex, although core and headline inflation have deaccelerated slightly as of late, inflation expectations are at their highest level of the last 9 years. Additionally house prices are growing at nearly 20%, a pace not seen since before the 2008 crisis. The Norges Bank is now facing a tough dilemma between risking an inflation overshoot if they keep their dovish bias or raising rates in an economy where growth for employment, real retail sales and nominal GDP is still in negative territory. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 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 continues to duplicate the dollar's movements, rolling over slightly from the 7% appreciation it saw over a month and a half. A more accurate measure of the SEK's value, EUR/SEK, paints a similar picture. These movements have been more or less in line with the Riksbank's desired developments, as it indicates a deceleration in the pace of recent appreciation. However, we believe that the rebound in EUR/SEK is not likely to run further. Political turbulence is being priced into the euro. After sustaining near oversold levels, the rebound could be nothing more than momentum exiting from oversold territories. Nevertheless, it is likely that EUR/SEK will correct in the coming months due to European elections. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In this report, we outline our tactical, cyclical and long term views on French government bonds, linked to France's political situation, cyclical dynamics, and structural outlook. Tactical View: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds. Cyclical View: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Secular View: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Feature Chart 1Fade The France Spread Widening Fade The France Spread Widening Fade The France Spread Widening After the stunning political victories in the U.K. and U.S. last year, there has been considerable speculation as to which country will fall next to the "populist wave." With a major political party aiming to take the country out of the Euro Area, France has naturally popped up on investors' radar screens. While it is easy to draw a parallel from Brexit to Trump to a possible "Frexit", the political and economic realities in France are very different from those in the U.K. and U.S. The upcoming presidential election will not provide a similar surprise, but could impact the economy's long trajectory. Meanwhile, this economy should beat expectations in the next twelve months. In this Special Report, we lay out our views on France from a political, cyclical and structural perspective and introduce two French bond trade ideas to benefit in the short and medium term. Tactical View: No Political Shocker Ahead In the short term (3-6 months), the domestic political landscape will dictate a large part of France's bond market price action leading up to the two-round French presidential election in April and May. Lately, political uncertainty surrounding the election has had a clear negative impact on French government bond yields (Chart 1). The spread between the benchmark 10-year French OAT and German Bund has widened 46bps off of the 2016 lows and is now close to levels seen during the Global Financial Crisis in 2008-9. The spread is still well below the wides seen during the European debt crisis in 2011-12, when markets were pricing in a serious Eurozone break-up risk. The current more moderate level seems reasonable to us, as a significantly wider spread to compensate for the political risk of a potential "Frexit" is not required, given the long odds of a Trump/Brexit-like upset victory. Last week, our colleagues at the BCA Geopolitical Strategy and Foreign Exchange Strategy services published a joint Special Report updating their view on the election, and concluded that Le Pen's odds of victory now stand at 15%.1 Either Francois Fillon (who is currently embroiled in a corruption scandal) or Emanuel Macron will win the French presidency, both of whom are running on structural reform platforms that should be market friendly. Moreover, Marine Le Pen has only a long-shot possibility to win the French presidential election, for several reasons:2 Assuming Le Pen becomes one of the final two candidates in the run-off election after the first round of voting in April, her probability of winning is low, as she continues to trail her centrist opponents by a massive 20% in the polls. That lead would have to fall to 3-5%, within the margin of error of the polling data, before investors would have to worry seriously about a Le Pen victory. Le Pen's personal approval rating peaked in 2012 (Chart 2). It fell despite the European refugee crisis, multiple terrorist attacks in France, and sluggish economic growth over the past two years, all of which should have helped boost her popularity. The problem for Le Pen is that 70% of the French support the euro (bottom panel), and she is running on an explicit campaign promise to try and pull France out of the euro if she wins the presidency. Leaving the euro area would mean a redenomination cost for Baby Boomer retirees, higher interest rates, higher inflation, and a likely economic recession. Judging by the high level of support for the euro, we suspect that the French population understands these risks. Given BCA's relatively sanguine view of the true political risks of the French election, the recent spread widening represents a tactical trade opportunity to go the other way and position for French outperformance. A Le Pen defeat will cause French policy uncertainty to recede and French bond yields will converge back to German levels. Vanishing uncertainty and lower bond yields will further fuel the current economic recovery, as explained in the next section. Bottom Line: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds on a tactical basis (a trade we are adding to our Overlay Trades list on Page 20). Cyclical View: An Outperforming Economy Over the medium-term (6 to 12 months), the cyclical dynamics of French growth and inflation, as well as potential shifts in Euro Area monetary policy, will drive the evolution of French bond yields. On this basis, there is room for French yields to rise in absolute terms. Current pricing in the French forward curve has the 10-year government bond yield reaching 1.40% by the end of 2017, up 26bps from the current level. That yield target will be easily exceeded based on the budding upturns in French economic growth and inflation. A low growth hurdle to overcome The Bloomberg survey of economists currently pencils in a French GDP growth forecast of 1.3% in 2017, almost unchanged from 1.2% in 2016. That figure should be surpassed, in our view. The current situation component of the French ZEW economic sentiment survey has spiked recently but still sits far from previous peaks (Chart 3). As this unfinished economic cycle progresses, growth will drift inevitably higher. Chart 2Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Chart 3An Un-finished Cycle An Un-finished Cycle An Un-finished Cycle More specifically, the business sector could positively surprise in 2017. Business sentiment and industrial production already started to hook upward toward the end of 2016, and the December surge in the French Manufacturing PMI signals that the economy is accelerating. Even the previously lagging French service sector PMI has now caught up to the Euro Area average (Chart 4). This upturn looks very well supported. Firms' order books have been replenished, and corporations are now in a position to hike prices, indicating that pricing power has returned (Chart 5). This is a crucial development, it will allow for further increases in corporate profit margins, and, in turn, give them some leeway to lift wages, hire more workers and/or invest anew. Chart 4A Solid Economic Upturn A Solid Economic Upturn A Solid Economic Upturn Chart 5Improving Business Sector Outlook Improving Business Sector Outlook Improving Business Sector Outlook Moreover, business cycle dynamics should then boost consumption. An improving labor market has already translated into confidence-building momentum among households. Consumers' disposable income growth has risen steadily, while households' intentions to make important purchases have reached levels not seen since before the Global Financial Crisis (Chart 6). Also, labor slack is diminishing in France, with the number of job seekers falling for the first time in a decade (bottom panel). If French households remain upbeat, the broader economy should do well. Historically, the INSEE survey of households' assessment of the future economic situation has been closely linked to GDP growth. Advancing that series by three months clearly shows that France's growth is set to accelerate. Using a simple regression, growth could reach a 1.7% year-over-year pace in the first half of 2017 (Chart 7). Chart 6Better Fundamentals For French Consumers Better Fundamentals For French Consumers Better Fundamentals For French Consumers Chart 7GDP Will Beat Expectations GDP Will Beat Expectations GDP Will Beat Expectations One note of caution on this optimistic French economic outlook comes from capital spending. The elevated political uncertainties from the upcoming election, as well as the potential U.K.-E.U. Brexit negotiations, have left French firms less inclined to expand business through increased investments. However, robust activity in the housing market should support overall gross fixed capital formation, as housing permits sprang to life in 2016 (Chart 8). To ensure that this economic expansion gains momentum, ample credit growth will be paramount. This could be a potential headwind, as France's non-financial private sector credit has reached high levels, especially compared to its European peers (Chart 9). These excesses could act as a speed limit on the overall economy, at some point. Chart 8Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Chart 9Private Non-Financial Leverage: High Private Non-Financial Leverage: High Private Non-Financial Leverage: High However, in the current cycle, this doesn't seem to be the case. Both money and loan growth are accelerating after several years of weakness (Chart 10, top panel). The ECB's Bank Lending Survey, which shows slowly increasing demand for credit (middle panel) and no tightening of lending standards (bottom panel) will help fuel this trend.3 The central bank's loose overall monetary stance will keep this positive credit impulse alive over the course of the year, while also helping exports by keeping the Euro weak. Finally, on the fiscal side, the IMF projects France's cyclically-adjusted primary budget balance to go from -0.6% of potential GDP in 2016 to -0.7% in 2017, representing a fiscal thrust of +0.1% (Chart 11). This modest number will obviously not supercharge the current cycle, but does represent a big change from the years of austerity since the last recession. Chart 10A Positive Credit Impulse A Positive Credit Impulse A Positive Credit Impulse Chart 11No More Austerity No More Austerity No More Austerity Building inflationary pressure The Bloomberg consensus forecast calls for French consumer price inflation to reach 1.2% in 2017, a modest advance from the current rate of 0.7%. That level should be reached, and likely surpassed, as most inflation measures have already entered an expansionary phase (Chart 12). That trend should persist in 2017 for several reasons: First, French unemployment will soon fall below the non-accelerating inflation rate of unemployment (NAIRU), which typically results in a rise in French underlying CPI inflation soon afterward (Chart 13). Chart 12Inflation Moving Higher Inflation Moving Higher Inflation Moving Higher Chart 13France Is Close To Full Employment France Is Close To Full Employment France Is Close To Full Employment Second, current French inflation appears about half a percentage point too low relative to the unemployment rate, based on the Phillips curve relationship since 2000 (Chart 14). Chart 14Inflation Should Be Higher Our Views On French Government Bonds Our Views On French Government Bonds Third, our French CPI diffusion index is well off the cyclical lows and points towards higher underlying inflation in the months ahead (Chart 15).4 In sum, French inflation will follow, and likely exceed, the current consensus expectation of 1.2%. This is important to appreciate, as inflation was a more important driver of higher nominal bond yields, relative to the real yield component, last year (Chart 15, bottom two panels). There is more to come in 2017. How to position for this view? In terms of valuation, French government bonds still appear quite expensive. Our bond valuation indicator shows that yields remain well below fair value, even after the recent backup (Chart 16). Combine this with our optimistic view on French growth and inflation, and investors should move to reduce duration within the French component of hedged global bond portfolios. Today, we open a new position in our model fixed income portfolio: reducing the exposure in the longest duration (+10 years) bucket in France, and placing the proceeds in the 1-3 year France bucket. This combination will lower our overall French duration exposure by one full year. If yields finish the year higher than currently priced on the forward curve, as we expect, this position will contribute positively to the excess return versus our benchmark. Bottom Line: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher this year. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Chart 15Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Chart 16French Bonds: Still Expensive French Bonds: Still Expensive French Bonds: Still Expensive Secular View: A Structural Ceiling On French Yields In the very long run (5 to 10 years), structural considerations are needed to forecast bond yields. Ten years ago, the French forward yield curve was implicitly forecasting that the 10-year French bond yield would be close to 4% today. Currently standing at 1.13%, the market missed the mark by 287bps! The forwards are now priced for the 10-year bond yield to reach 2.84% in ten years, possibly making the same mistake of over-estimating future bond yields. To gauge a fair value of the 10-year bond yield, using nominal potential GDP growth has proved to be useful in the past. From 2004 to 2014, and before the deflationary shock experienced since, France's 10-year bond yield was indeed trading very close to growth in French nominal potential GDP (Chart 17, shaded portion). Chart 17Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields As inflation will most likely return to more "normal" levels in the next few years, the relationship between the two should be reestablished soon. If so, the current 2.84% level on the 10-year French government bond yield, 10-years forward should translate to a nominal potential growth rate of around 2.8% in ten years' time (Chart 17). This outcome would represent an 80bp increase in the rate of trend French nominal potential growth from current levels, which could be difficult to achieve, in our view. Lots of work to do... Most likely, France's nominal potential growth will only slowly grind lower. Faster potential growth could be achieved either through increasing demographic growth or improving productivity. Unfortunately, neither outcome appears imminent. Since the French working age population is already expanding at a very slow pace, and is projected to decelerate in the years ahead, productivity increases are the only candidate to improve potential growth. On that front, a lot needs to be done; many structural weaknesses in the French economy have to be addressed. For years, France has been plagued by weak productivity, which has constrained growth. Compared to its European peers, inefficient use of available capital has led to a loss of competitiveness through higher unit labor costs. Clearly, France needs to improve workers' skills to lift total factor productivity growth (Chart 18). This will become increasingly difficult as France now faces - more than ever - difficulty attracting and retaining talent due to the recent turmoil that has hit the country such as the terrible rise in terrorist attacks. At the source, the poor productivity performance in France is grounded in the overly protective employment system. Like other European countries, high employment costs have led to misallocation of capital, potentially affecting the optimal capital labor input mix and total factor productivity.5 Indeed, friction in the labor market is often cited as the source of the problem. We tend to agree. French workers work too few hours, even fewer than in the Peripheral European economies. As the divide between the unemployment rate of persons under and over 25 years old gets larger, resolving the growing generational disparities has become paramount. Plus, upward mobility opportunities are scant - not everyone gets an equal chance to rise in status in French society (Chart 19). Chart 18Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Chart 19Friction In The Labor Market Friction In The Labor Market Friction In The Labor Market Recent reforms have the potential to fix some problems. The Pacte de Responsabilité et Solidarité (PRS) and the Crédit d'impôt compétitivité emploi (CICE) should help reduce unit labor costs through a reduced labor tax wedge.6 The Macron Law could raise real GDP growth by 0.3 percent per year through 2020, according to the OECD. However, the effectiveness might be fleeting in some other cases. For example, studies by the IMF suggest that the El Khomri Law - aimed at making the labor market more flexible - might have little impact on overall French unemployment, potentially reducing it by only 0.14 percentage points.7 Meanwhile, France's enormous public sector continues to crowd out the private sector. At 54% of GDP, government expenditures are simply too big, forcing the government to tax profits at a whopping 63% rate. This leaves little space for national savings - which now sit at a lowly 21.4% of GDP - to increase (Chart 20). Additionally, France ranks 115th out 136 countries in the Global Competitiveness Report in terms of the burden of government regulation, which further constrains productivity-enhancing investments.8 In sum, boosting potential GDP growth will remain an uphill battle. Everyone agrees that reforms are necessary. But will they happen? ...and France still has a tough crowd to win over It is not impossible that the next president will have a serious structural reform agenda. For example, the most reformist presidential contender, Francois Fillon, has made these proposals in his campaign platform: Abandon the national limit on weekly hours worked and leave that decision to individual companies; Decrease corporate taxation; Allow companies to fire employees when undergoing structural/managerial changes; Extend the retirement age; Cut public spending; Reduce the size of the state by cutting government employees. From a structural perspective, these measures would surely be promising for the future, and would lift French potential GDP growth over time. However, in the populist world we live in, we are skeptical that the electorate will give him an unambiguous mandate of this sort. That kind of mandate usually comes after a crisis, not before. More pain might be needed. Chart 20France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector Chart 21"Silent Majority" Wants Reform Our Views On French Government Bonds Our Views On French Government Bonds Moreover, reforming France has always proved very challenging. As such, will Mr. Fillon (or Mr. Macron) really be able to comply with his campaign promises, if elected? Winning a majority at the parliamentary election would be a necessary precondition. Although every President has been given a parliamentary majority since 2002, the elections have not happened yet. Confronting the unions on these measures will prove difficult for the next French president. The latest labor market reform push unveiled last year was met with massive resistance. Surely, deregulation that makes it easier to fire workers will inevitably dissatisfy insiders that benefit from high barriers to entry for new employees. This obstacle will be difficult to remove. In any case, it has always been puzzling why things have to be this way in France. According to economists Yann Algan and Pierre Cahuc, one possible response might lie in the French tendency to distrust their fellow citizen. Their theory, introduced more than ten years ago, posits the following: ...the French people's lack of trust gets in the way of their ability to cooperate, which brings the State to regulate work relations in minute detail. By emptying social dialogue of its content, these interventions prevent the adoption of favorable reforms to improve the function of the job market. Distrust even induces a fear of competition, leading to the set-up of regulatory barriers-to-entry, that create rent-seeking which favors corruption and mutual distrust. The French social model fosters a truly vicious circle. Corporatism and state intervention undermine the mechanisms of solidarity, destroy social dialogue and reinforce mutual distrust - that which in turn feeds categorical demands and the constant call for regulation, and thereby favors the expansion of corporatism and state intervention.9 Of course, their angle on things could sound somewhat extreme. But it might also explain why the issues discussed ten or twenty years ago concerning France's predicament remain mostly the same today. There might be something else besides pure rational thinking at play behind the French citizenry's propensity to stiff-arm reforms. Nonetheless, if these authors are correct, true changes will continue to be hard to come by in France. Meaning this invisible hand of distrust will continue to lead potential GDP growth lower, and, as history dictates, will represent a ceiling on how high long-term French bond yields can ever rise. That said, maybe our view could prove to be too backward looking. The new report co-written by our Geopolitical Strategy and Foreign Exchange Strategy teams takes a more optimistic view on the chances of French economic reform. They argue that France's recent economic underperformance will motivate its citizens to demand real action from their politicians, as occurred in Australia during the mid-1980s and 1990s and Germany in the 2000s - episodes of real structural reform occurring without any dramatic crisis to prompt them. A desire to compete with Germany economically, combined with government spending excesses and protest fatigue, could be leading France to elect a pro-reform government. As the French polling data shows, there is a "silent majority" in France that would favor supply side reforms (Chart 21). Plus, even those that traditionally favor the status quo, like "blue collar" and "left leaning" employees, are opposing reforms by extremely narrow margins. Undoubtedly, our colleagues raise very good points. As such, we will be watchful to see if reforms gain a greater chance of meaningfully transforming France in the next few years. The onus will be on the reformers to change the system. Bottom Line: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/Foreign Exchange Strategy Special Report, "The French Revolution", dated February 3, 2017, available at gps.bcaresearch.com and fes.bcaresearch.com 2 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?", dated November 16, 2016, available at gps.bcaresearch.com 3 https://www.ecb.europa.eu/stats/pdf/blssurvey_201701.pdf?6c44eff3bac4b858969b9cb71bd4a8fa 4 The diffusion index is the percentage of sectors within the French Consumer Price Index that are growing faster than their 24-month moving average. This indicator leads underlying inflation by 10 months. 5 For further details on this idea, please see "Employment Protection Legislation, Capital Investment and Access to Credit: Evidence from Italy", available at https://ideas.repec.org/p/sef/csefwp/337.html 6 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44080.0 7 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44081. 8 http://www3.weforum.org/docs GCR2016-2017/05FullReport TheGlobalCompetitivenessReport2016-2017_FINAL.pdf 9 http://voxeu.org/article/france-price-suspicion and more on these authors theory on the impact of trust on economic development can be found here: http://econ.sciences-po.fr/sites/default/files/file/yann%20algan/HB_FinalVersion1.pdf The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Our Views On French Government Bonds Our Views On French Government Bonds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns