Geopolitics

Venezuela’s stability is deteriorating rapidly along the lines of our projections in recent years. Regime failure is at this point a high probability and poses immediate risks to global oil production. Our conviction is high because of the unprecedented combination of internal and external factors working against the regime: Economic collapse: Economic collapse has translated into total social collapse, as indicated by the large-scale emigration from the country (Chart 1). The current mass protests are the largest ever and are gaining momentum, while the opposition movement is coalescing into a single force against the regime as a whole for the first time. Political illegitimacy: What remained of the Maduro administration’s political legitimacy has eroded with his decision to ignore the results of the 2015 election and rig the election of 2018. The President of the National Assembly, Juan Guaidó, has declared himself President of the Republic based on an interpretation of the Venezuelan constitution and his leadership of the democratically elected National Assembly.1 International opposition: The erosion of Maduro’s legitimacy is reinforced by a rapidly changing international environment, with several countries becoming more assertive in opposing the regime. The United States and Colombia, on January 23, formally recognized Guaidó as president. They are joined by Canada and several other Latin American states, including Brazil, which is taking a more confrontational posture under the newly inaugurated President Jair Bolsonaro. This marks a rare coordination of North and South American states in pursuing a harder policy toward Venezuela. U.S. intervention: The United States, in particular, is taking a more interventionist stance through tighter sanctions. Indeed a limited U.S. military intervention is one of our top five geopolitical “Black Swans” for this year. Such an intervention could be further motivated by President Donald Trump’s need to distract from his domestic woes (Chart 2). His weak popular approval is comparable to that of President Ronald Reagan at this stage in Reagan’s first term, when he intervened in the small island state of Grenada. Venezuela is not Grenada, but the U.S. is also not considering outright invasion. Trump is facing a serious risk of becoming a “lame duck” due to the fall in his popularity amid the government shutdown and gridlock in Congress. A foreign policy response to a humanitarian crisis is an obvious way for him to try to increase his influence over the remainder of his term. Moreover, the U.S. diplomatic and defense establishment may agree on the need to reinforce the Monroe Doctrine against anti-democratic politics and growing Chinese (and Russian) influence in Venezuela. Chart 1 Chart 2Trump May Distract From His Woes Trump May Distract From His Woes Trump May Distract From His Woes What remains is to see whether the U.S. adds force (tougher sanctions) to its more aggressive diplomatic posture, and whether the Venezuelan opposition remains mobilized and unified in rejecting anything except a transition to a new government. The U.S. is already considering expanding sanctions, including a likely deathblow that would involve sanctioning Venezuelan oil imports and the export of diluents necessary to process Venezuela’s heavy sour crude. Within Venezuela, the opposition’s momentum and the role of the National Bolivarian Armed Forces will be decisive: so far there are small signs of fracture (Table 1), but no sign of a substantial turn against the Maduro regime.Sufficient popular pressure can create a “tipping point,” however, after which the military and security forces are no longer effective in executing the government’s writ and the socio-political situation declines beyond the ability of the regime to stay in power. Persistent large-scale protests concentrating on Maduro’s departure and/or a split in the security forces could precipitate the final stage of transition to a new interim government in the short to medium term. Table 1Military Insurgencies Have Been Small And Unsuccessful … So Far Venezuelan Production Near Collapse Venezuelan Production Near Collapse Impact On The Oil Market In this context, we are raising the likelihood of a collapse of that state to an 80% probability, from our prior assessment (33%). We use the word “collapse” to stand for Venezuela’s production falling to 250k b/d to feed domestic refineries, from ~ 1mm b/d at present. In our simulation of how a collapse could affect oil prices, we make the following assumptions based on recent history – i.e., the run-up to the re-imposition of U.S. sanctions against Iranian oil exports. These assumptions are driven by our prior belief that the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which we’ve dubbed OPEC 2.0, and the Trump administration will attempt to hold Brent crude oil prices at or below $80/bbl in the event of a collapse in Venezuela’s oil production. Here are our assumptions: Venezuela collapses next month; OPEC 2.0 responds with a one-month lag, and increases production by 500k b/d in March 2019. If Brent spot prices trade to $85/bbl, OPEC 2.0 raises production an additional 100k b/d. If prices continue to rise toward $100/bbl, OPEC 2.0 adds another 300k b/d to global supply. Further increases lead to the U.S. Strategic Petroleum Reserve (SPR) releasing 100k b/d as needed to reduce Brent prices to $80/bbl or less. If spot Brent prices rise toward $100/bbl, we assume there will be 200k b/d of demand destruction globally. Chart 3 shows how Brent and WTI prices would evolve per these assumptions. Because Venezuela’s production has fallen so much, we believe the collapse of that country’s oil industry can be managed by OPEC 2.0, and, if necessary, via U.S. SPR releases. Of course, a similar trajectory likely would occur in the event Venezuela’s oil industry collapses later.2 Chart 3A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses In our simulation, the Brent spot price trades to $85/bbl in December 2019, and OPEC 2.0 adds an additional 100k b/d to global supply. Prices continue to rise, and we assume OPEC 2.0 member states release a combined 300k b/d in March 2020. The U.S. release 100k b/d of SPR in 2020. In addition, we do see demand destruction of 200k b/d in 2020, as prices reach close to $100/bbl. With all of this, prices are contained and start decreasing in mid-2020. Of course, whether these surges can be maintained indefinitely – i.e., until Venezuela comes back on line, or comparable crude grades can be shipped south from Canada – is an open question. Even so, there is no doubt that the leaders of OPEC 2.0 silenced more than a few critics by means of their 4Q18 production surge. KSA stands out in this regard, taking its November 2018 production over 11mm b/d from ~ 10mm b/d in 1H18 (Table 2). Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Venezuelan Production Near Collapse Venezuelan Production Near Collapse As a practical matter, we have no way of knowing how OPEC 2.0 or the U.S. SPR would respond to a collapse in Venezuela’s oil industry. In these simulations, we’re making a call on how and when OPEC 2.0 might choose to release its spare capacity once again, as they did in the run-up to the U.S.’s Iran oil export sanctions last year (Chart 4). Chart 4 As the members of OPEC 2.0 – mostly KSA, when it’s all said and done – dig deeper into spare capacity, less is available to meet another unplanned outage – e.g., Libya or Nigeria lose significant barrels to civil unrest. That is, we are sure, a discussion OPEC 2.0 is and will be having among its members, and with the U.S. SPR. The global oil market still is exposed to a sharp loss of Iranian barrels on top of the loss of Venezuela’s supplies in the event that country’s oil industry collapses. This argues strongly for an extension of the waivers granted by the Trump administration in November for anywhere from 90 to 180 days, depending on how the Venezuela situation evolves. These waivers expire at the end of May. This would require us to change our balances assessment, should it occur.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   Footnotes 1 Please see Articles 233, 333, 350 of the Venezuelan constitution. The domestic and international legal debate is beside the point: the effective power of the people, the security forces, and the international community will determine the outcome. 2 For more information on global supply and demand balances, and our most recent oil price forecasts, please see “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone,” published by BCA Research’s Commodity & Energy Strategy today. It is available at ces.bcaresearch.com.  

Highlights After this week’s drama, the Brexit political process remains extremely complex, but the probability of a hard Brexit is still below 10%. No easy compromise will come through as Brexit suffers a fundamental contradiction: balancing the desire to maximize British sovereignty versus minimizing the pain of leaving the common market. While cross-party talks will prove unfruitful, an extension of the Article 50 deadline is very likely. A new referendum is the most probable solution to the current impasse, but it will likely require a new election. The pound is cheap, but volatility will stay elevated. Buying the pound versus the euro on politically induced drawdowns remains the optimal strategy to gain exposure. Long-term GBP/USD calls are also attractive. The dollar cyclical bull market is intact, but the greenback correction is likely to deepen, especially against growth-sensitive currencies, the AUD in particular. Feature Theresa May’s soft Brexit deal has suffered the largest defeat since 1924 for a bill submitted by a sitting government. The proposed EU Withdrawal Agreement was voted down by 432 members of Parliament, including a whopping 118 members of the Conservative Party. This suggests that both hard Brexit and Bremain Tories voted against May. What lies at the heart of this historic collapse? The fundamental problem is that a soft Brexit is incompatible with the principal demand of Brexit voters: Sovereignty. Any relationship entailing continued access to EU institutions and markets will require two elements that reduce sovereignty: Paying an access fee and accepting the acquis communautaire of the EU without having a say in how it is formulated.1 We do not see how this impasse will be overcome. The financial community’s preferred option – that Prime Minister May breaks ranks and appeals to the Labour Party for a super-soft “Norway Plus” option – is a fantasy. First, the Labour Party smells blood and will likely oppose any deal. Second, a Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.2 Members of Parliament may also be getting cold feet due to the shifting poll numbers, which have slowly but steadily increased the gap between those who think that Brexit was the right choice and those who think it was the wrong choice to just under double digits (Chart I-1). This gap reveals that the U.K. public is having second thoughts, no doubt influenced by the incoherent process itself, but also by the combination of geopolitical factors that have changed the appeal of “going it alone.” Chart I-1A Serious Case Of Bregret A Serious Case Of Bregret A Serious Case Of Bregret First, the EU is no longer mired in an epic migration crisis, as it was in the months before the referendum (Chart I-2). Second, terrorist attacks committed by home-grown Islamic State adherents have abated in continental Europe, whereas they seemed to be a monthly affair ahead of the June 2016 vote. Third, the U.K.’s main ally, the United States, which is often cited as a key post-Brexit partner, has elected a president who is unpopular in the U.K. (Chart I-3), putting the “special relationship” in doubt. Chart I-2The Refugee Crisis Is Over The Refugee Crisis Is Over The Refugee Crisis Is Over   Chart I-3 Since the fateful referendum in 2016, the world has become less stable. As such, voters in the U.K. are no doubt wondering whether leaving the EU really would entail greater sovereignty – or whether “going it alone” would mean having to take the fait accompli of large powers such as the U.S., China, and Russia – whose values they share even less than those of their fellow Europeans across the Channel. Sovereignty, in other words, does not operate under Newtonian laws, but is rather relative to one’s vantage point. In short, Brexit cannot be resolved merely with an extension of the negotiating period. Furthermore, our high-conviction view is that even if it were possible to pass the withdrawal agreement today by promising an even softer exit, the process will ultimately fail when, in two- or three-years’ time, Westminster pushes to vote on implementing such an arrangement. Investors should remember that there is another vote waiting after the transition period. In the meantime, we see the following options as a way to resolve the current impasse (Diagram I-1): Chart I- Article 50 extension: The EU is on record stating that it would agree to extend the Article 50 deadline, currently set at March 29. The EU can do so with a unanimous vote of the EU Council. If there is one thing that the Euro Area crisis has taught investors, it is that deadlines are set in policy and legislation, not in stone. London can extend Article 50 with a simple legislative act, amending the March 29 deadline set in the EU Withdrawal Act (passed in June 2018). The EU is on record stating that it would be simple to extend the current negotiating period until July, when a new European Parliament (EP) would sit in its first session. Any extension beyond July would require U.K. members of European parliament (MEPs) to sit in the legislative body, as the country would remain part of the EU. This would mean that the U.K. would have to hold EP elections. We think this is a minor technicality. But it would be highly embarrassing for PM May if she had to organize EP elections a few months from now, especially if it galvanized the Bremain movement to turn out en masse and send Europhile MEPs to Strasbourg. The bigger question is what the extra time would accomplish. Given the size of the loss for the government on its Brexit bill, we think that both Labour Party members and Bremain supporters have been emboldened and will hold out for either a new election or a new referendum, or in case of Labour Party members, both.   New referendum: A new referendum would require an Article 50 extension. The rules for referendums are set out in the Political Parties, Elections, And Referendums Act of 2000. Westminster would have to pass legislation, which would then have to be considered by the Electoral Commission. The process would very likely go beyond March. The easiest path to a new referendum is through a Labour Party victory in an early election. For PM May to reverse her longstanding policy and call a new referendum, we would need another round of negotiations to fail. As such, it is difficult to see PM May concede to a second referendum, at least not until late in 2019.   A new election: Even though the January 16 vote of no confidence against the government failed, PM May could decide that she needs an early election. Why would she take this route? Because it could give her a political mandate with which to pursue renewed negotiations with the EU and her version of soft Brexit. Under the terms of the Fixed Term Parliaments Act, May would need two-thirds of all MPs in the House of Commons to approve a new election. Current polls show that the election would be too close to call (Chart I-4). We think May would stand a good chance of renewing her mandate by painting Opposition Leader Jeremy Corbyn as too left-leaning and as indecisive on Brexit. Chart I-4An Election May Not Provide A Clear Answer An Election May Not Provide A Clear Answer An Election May Not Provide A Clear Answer One option not on the table is another leadership challenge to PM May. She already survived the challenge in December and is therefore safe from a new one for 12 months. These rules could of course be changed or PM May could simply resign, but we do not expect either option. Simply put, a change of leadership in the Conservative Party is unlikely as hard Brexit supporters cannot get a majority of Tory MPs to support them, while soft Brexit MPs continue to support May. Could a no-deal Brexit occur? Technically, yes. According to the EU Withdrawal Act, the U.K. will leave the EU on March 29. As such, with no further legislative acts, the U.K. could “sleepwalk” into a hard Brexit. However, we believe that the probability of this is under 10%. There is not even close to a majority in Westminster for a hard Brexit. We estimate that, at most, only 10% of 650 MPs in the House of Commons favor a hard Brexit. As such, the government would certainly win a large majority for a piece of legislation that extends the deadline. And, according to the European Court of Justice ruling in December, London could stop the Article 50 process unilaterally, without EU approval. If the probability of hard Brexit is below 10%, isn’t the pound a screaming buy at this point? After all, if the probability of a major dislocation in the economic relationship between the U.K. and the continent is so low, it also means the probability that the Bank of England maintains as easy a monetary policy as its current one is minimal. Our low-conviction answer to this question is yes, the pound is indeed attractive. The reason why buying the pound is a low-conviction view is that one of the three alternative scenarios listed above could have mixed implications for the British economy as well as U.K. assets and the pound: A new election that produces a Labour government. Corbyn’s legislative agenda is the most left-leaning that Europe has seen since François Mitterrand. He is also on record stating that he would pursue his own negotiations with Brussels. Corbyn’s government would therefore prolong the uncertainty of Brexit while enacting an ambitious left-wing agenda. Ultimately, he may reverse both of these positions: succumbing to pressure to call a new referendum while moderating his economic policy. However, as was the case with Mitterrand in the early 1980s, it would require a deep market riot to force him to do so, which means that closing one’s eyes and buying the pound at these levels is not for risk-averse investors. Bottom Line: The political battle for Brexit is far from over. The risk of a hard Brexit has receded considerably to a less than 10% probability, but volatility will continue due to the inherent conflict between the desire to maximize British sovereignty and the objective to minimize economic pain. While cross-party talks are unlikely to yield any decisive changes, an extension of the Article 50 deadline is likely. A new referendum is the most probable end game of this saga, but it will probably require a new election. While the pound is an attractive long-term play, GBP pairs will continue to suffer from politically induced volatility. Investment Implications In September, we argued that the geopolitical risk premium in the GBP was too low in the face of the uncertainty ahead. Moreover, we recognized that the pound was cheap on many long-term metrics, limiting its downside potential. As a result, instead of shorting GBP outright, we recommended investors buy GBP-volatility, a view that panned out well for us. We closed this recommendation in mid-November, when Cabinet Ministers McVey, Raab, and Vara resigned from the government. Since that time, GBP volatility has receded as investors have increasingly agreed with our assessment that the probability of a hard Brexit is very low. However, the political reality in London continues to suggest that the GBP will trade in a volatile fashion, even if its long-term attractiveness remains alive. Hence, we continue to recommend investors use dips in the GBP to slowly begin moving capital into sterling. Practically, we have expressed this view by selling EUR/GBP. EUR/GBP trades toward the top end of its historical distribution (Chart I-5) and is likely to sell off violently on any whiff that a resolution of any kind is coming. Furthermore, since British interest rates are higher than in the euro area, investors are paid to wait while shorting this cross. Chart I-5EUR/GBP Is A Coiled Spring EUR/GBP Is A Coiled Spring EUR/GBP Is A Coiled Spring The pound is particularly cheap against the U.S. dollar (Chart I-6). As a result, buying GBP/USD offers the most attractive long-term potential. However, the intermediate-term hurdles for this position are greater than those present in selling EUR/GBP. First, long cable offers a negative carry of 1.89%, thus buying GBP/USD means that investors are paying to take on a lot of volatility. Second, our negative intermediate-term outlook for the global economy implies a strong dollar over the coming six to nine months, creating risks for GBP/USD holders while helping the profile of selling EUR/GBP (Chart I-7). Finally, since Brexit risks are weighing on the euro as well as the pound, if a hard Brexit were indeed to materialize, GBP would suffer much deeper losses against the dollar than against the euro. Chart I-6Lot Of Value In Cable Lot Of Value In Cable Lot Of Value In Cable   Chart I-7Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling This inherent conflict in GBP/USD between potentially large long-term gains but heightened short-term risk suggests that the best way to play cable is to buy long-term call options on this pair. As Chart I-8 shows, the implied volatility on 2-year GBP/USD options is elevated, but has been much higher in the past. Additionally, the implied volatility on these long-term options is abnormally low relative to that offered by 3-month options (Chart I-8, bottom panel), suggesting they are comparatively cheap. Thus, since the long-term outlook for cable is much more attractive than the short-term one, favoring long-term options as a vehicle to gain exposure to GBP/USD makes sense. It is a risky bet only deserving of a small portfolio allocation. Chart I-8Long-Term Call Options On Cable Are Attractive Long-Term Call Options On Cable Are Attractive Long-Term Call Options On Cable Are Attractive Bottom Line: Only investors with either long-term horizons or a deep capacity to handle volatility should begin garnering some exposure to the pound. Selling EUR/GBP when the pound weakens in response to political shocks remains the best vehicle to do so. While buying cable offers more attractive long-term potential returns than selling EUR/GBP, it is a riskier bet over a six- to nine-month horizon. Nonetheless, investors wanting to get some pound exposure via buying GBP/USD should allocate funds to 2-year GBP/USD call options. Short-Term Risks For The Greenback As we argued last week, continued downside in global growth as well as U.S. interest rate markets having already priced in a year-long pause by the Fed together point to continued upside for the dollar. However, we also highlighted that the dollar currently possesses significant tactical downside, especially against commodity currencies. Five reasons underpin our cautious tactically view: First, the dollar is currently over-owned. Both net speculative positions in the dollar and sentiment toward the DXY are near bullish extremes (Chart I-9). The dollar is a momentum currency, hence the progressive deterioration in our favored momentum signal for the greenback – the crossover of the one-month and six-month moving averages – suggests that the dollar could soon experience a momentum-induced liquidation. Chart I-9If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers Second, the most recent BAML Investor survey not only showed that investors are more pessimistic on global growth than at any point in the past decade, but also that a trade war was highest on the list of concerns. Today, the probability of a truce in Sino-U.S. trade relations is growing. A declining trade-war risk should temporarily support assets levered to global growth and hurt the defensive U.S. dollar. Moreover, a consequence of the warm-up between Beijing and Washington has been a weakening USD/CNY. Historically, a strengthening RMB is associated with rebounding commodity currencies (Chart I-10). Chart I-10A Strong CNY Points To Stronger Commodity Currencies A Strong CNY Points To Stronger Commodity Currencies A Strong CNY Points To Stronger Commodity Currencies Third, global growth could also temporarily positively surprise beaten-down expectations. Today, the highly mean-reverting Citi Economic Surprise Index is very stretched to the downside, suggesting scope for a reversal (Chart I-11). With Chinese fiscal stimulus building up, and the recent pick-up in the six-month Chinese credit impulse, a temporary bout of positive economic surprises is a growing risk for dollar bulls. Chart I-11There Is Scope For Economic Surprises To Rebound There Is Scope For Economic Surprises To Rebound There Is Scope For Economic Surprises To Rebound Fourth, our China Investment Strategy service’s Market-Based China Growth Indicator has rebounded (Chart I-12). This further reinforces the risk that global growth could positively surprise abysmal expectations. Chart I-12Markets Signalling A Pause In The Economic Slowdown Markets Signalling A Pause In The Economic Slowdown Markets Signalling A Pause In The Economic Slowdown Fifth, gold prices have rebounded significantly, implying an improvement in the global liquidity backdrop (Chart I-13). Since tightening global liquidity was a contributor to the deterioration in non-U.S. growth, rebounding gold prices also confirm that the slowdown in international economic activity may take a breather. Chart I-13Gold As A Liquidity Gauge Gold As A Liquidity Gauge Gold As A Liquidity Gauge Altogether, these five factors suggest that the corrective episode in the countercyclical dollar may deepen. Because Chinese reflation and a truce in Sino-U.S. tensions lie at the crux of the potential for positive economic surprises, the growth-sensitive currencies like the AUD, the CAD and EM currencies should outperform, especially vis-à-vis the yen. In this environment, Scandinavian currencies should also rise versus the euro. EUR/CHF is set to benefit from this backdrop. For the time being, we continue to view any weakness in the dollar as a correction, not the end of the bull market. Ultimately, the respite in the Chinese economy is likely to prove transitory. The six-month credit impulse is improving, but the 12-month credit impulse is not, even when fiscal stimulus is taken into account (Chart I-14). Since the noise-to-signal ratio is much greater in the six-month impulse than in the 12-month one, we believe that only once the longer-term credit impulse rebounds will Chinese economic activity form a durable bottom. Moreover, Chinese exports are beginning to suffer from a payback period after having been artificially supported by front-running ahead of the trade sanctions. As things stand today, the recent weakness in Chinese export growth looks set to worsen (Chart I-15). This will cause yet another shock to Chinese growth, one likely to percolate to domestic demand. Once it does, global industrial activity should soften again, creating a strong support for the dollar. Chart I-14China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... Chart I-15 ...And Exports Are Set To Become A Significant Drag ...And Exports Are Set To Become A Significant Drag ...And Exports Are Set To Become A Significant Drag Bottom Line: Cyclically, fundamentals remain supportive for the greenback. However, the tactical picture shows that the dollar should correct further, especially against growth-sensitive currencies like the AUD, which could rally to 0.75. This view is because the dollar’s momentum is deteriorating sharply, the yuan is rising on the back of a growing likelihood of a trade truce, global economic surprises have room to brighten, China is implementing some reflationary efforts, and global liquidity is improving at the margin.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1 The acquis communautaire refers to the collection of accumulated legislation, legal acts, and judicial decisions that constitute the body of the EU law. 2 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions.

Highlights After this week’s drama, the Brexit political process remains extremely complex, but the probability of a hard Brexit is still below 10%. No easy compromise will come through as Brexit suffers a fundamental contradiction: balancing the desire to maximize British sovereignty versus minimizing the pain of leaving the common market. While cross-party talks will prove unfruitful, an extension of the Article 50 deadline is very likely. A new referendum is the most probable solution to the current impasse, but it will likely require a new election. The pound is cheap, but volatility will stay elevated. Buying the pound versus the euro on politically induced drawdowns remains the optimal strategy to gain exposure. Long-term GBP/USD calls are also attractive. The dollar cyclical bull market is intact, but the greenback correction is likely to deepen, especially against growth-sensitive currencies, the AUD in particular. Feature Theresa May’s soft Brexit deal has suffered the largest defeat since 1924 for a bill submitted by a sitting government. The proposed EU Withdrawal Agreement was voted down by 432 members of Parliament, including a whopping 118 members of the Conservative Party. This suggests that both hard Brexit and Bremain Tories voted against May. What lies at the heart of this historic collapse? The fundamental problem is that a soft Brexit is incompatible with the principal demand of Brexit voters: Sovereignty. Any relationship entailing continued access to EU institutions and markets will require two elements that reduce sovereignty: Paying an access fee and accepting the acquis communautaire of the EU without having a say in how it is formulated.1   We do not see how this impasse will be overcome. The financial community’s preferred option – that Prime Minister May breaks ranks and appeals to the Labour Party for a super-soft “Norway Plus” option – is a fantasy. First, the Labour Party smells blood and will likely oppose any deal. Second, a Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.2  Members of Parliament may also be getting cold feet due to the shifting poll numbers, which have slowly but steadily increased the gap between those who think that Brexit was the right choice and those who think it was the wrong choice to just under double digits (Chart I-1). This gap reveals that the U.K. public is having second thoughts, no doubt influenced by the incoherent process itself, but also by the combination of geopolitical factors that have changed the appeal of “going it alone.” Chart I-1A Serious Case Of Bregret A Serious Case Of Bregret A Serious Case Of Bregret First, the EU is no longer mired in an epic migration crisis, as it was in the months before the referendum (Chart I-2). Second, terrorist attacks committed by home-grown Islamic State adherents have abated in continental Europe, whereas they seemed to be a monthly affair ahead of the June 2016 vote. Third, the U.K.’s main ally, the United States, which is often cited as a key post-Brexit partner, has elected a president who is unpopular in the U.K. (Chart I-3), putting the “special relationship” in doubt. Chart I-2The Refugee Crisis Is Over The Refugee Crisis Is Over The Refugee Crisis Is Over   Chart I-3 Since the fateful referendum in 2016, the world has become less stable. As such, voters in the U.K. are no doubt wondering whether leaving the EU really would entail greater sovereignty – or whether “going it alone” would mean having to take the fait accompli of large powers such as the U.S., China, and Russia – whose values they share even less than those of their fellow Europeans across the Channel. Sovereignty, in other words, does not operate under Newtonian laws, but is rather relative to one’s vantage point.   In short, Brexit cannot be resolved merely with an extension of the negotiating period. Furthermore, our high-conviction view is that even if it were possible to pass the withdrawal agreement today by promising an even softer exit, the process will ultimately fail when, in two- or three-years’ time, Westminster pushes to vote on implementing such an arrangement. Investors should remember that there is another vote waiting after the transition period.  In the meantime, we see the following options as a way to resolve the current impasse (Diagram I-1): Chart I- Article 50 extension: The EU is on record stating that it would agree to extend the Article 50 deadline, currently set at March 29. The EU can do so with a unanimous vote of the EU Council. If there is one thing that the Euro Area crisis has taught investors, it is that deadlines are set in policy and legislation, not in stone. London can extend Article 50 with a simple legislative act, amending the March 29 deadline set in the EU Withdrawal Act (passed in June 2018). The EU is on record stating that it would be simple to extend the current negotiating period until July, when a new European Parliament (EP) would sit in its first session. Any extension beyond July would require U.K. members of European parliament (MEPs) to sit in the legislative body, as the country would remain part of the EU. This would mean that the U.K. would have to hold EP elections. We think this is a minor technicality. But it would be highly embarrassing for PM May if she had to organize EP elections a few months from now, especially if it galvanized the Bremain movement to turn out en masse and send Europhile MEPs to Strasbourg. The bigger question is what the extra time would accomplish. Given the size of the loss for the government on its Brexit bill, we think that both Labour Party members and Bremain supporters have been emboldened and will hold out for either a new election or a new referendum, or in case of Labour Party members, both.    New referendum: A new referendum would require an Article 50 extension. The rules for referendums are set out in the Political Parties, Elections, And Referendums Act of 2000. Westminster would have to pass legislation, which would then have to be considered by the Electoral Commission. The process would very likely go beyond March. The easiest path to a new referendum is through a Labour Party victory in an early election. For PM May to reverse her longstanding policy and call a new referendum, we would need another round of negotiations to fail. As such, it is difficult to see PM May concede to a second referendum, at least not until late in 2019.   A new election: Even though the January 16 vote of no confidence against the government failed, PM May could decide that she needs an early election. Why would she take this route? Because it could give her a political mandate with which to pursue renewed negotiations with the EU and her version of soft Brexit. Under the terms of the Fixed Term Parliaments Act, May would need two-thirds of all MPs in the House of Commons to approve a new election. Current polls show that the election would be too close to call (Chart I-4). We think May would stand a good chance of renewing her mandate by painting Opposition Leader Jeremy Corbyn as too left-leaning and as indecisive on Brexit. Chart I-4An Election May Not Provide A Clear Answer An Election May Not Provide A Clear Answer An Election May Not Provide A Clear Answer One option not on the table is another leadership challenge to PM May. She already survived the challenge in December and is therefore safe from a new one for 12 months. These rules could of course be changed or PM May could simply resign, but we do not expect either option. Simply put, a change of leadership in the Conservative Party is unlikely as hard Brexit supporters cannot get a majority of Tory MPs to support them, while soft Brexit MPs continue to support May. Could a no-deal Brexit occur? Technically, yes. According to the EU Withdrawal Act, the U.K. will leave the EU on March 29. As such, with no further legislative acts, the U.K. could “sleepwalk” into a hard Brexit. However, we believe that the probability of this is under 10%. There is not even close to a majority in Westminster for a hard Brexit. We estimate that, at most, only 10% of 650 MPs in the House of Commons favor a hard Brexit. As such, the government would certainly win a large majority for a piece of legislation that extends the deadline. And, according to the European Court of Justice ruling in December, London could stop the Article 50 process unilaterally, without EU approval. If the probability of hard Brexit is below 10%, isn’t the pound a screaming buy at this point? After all, if the probability of a major dislocation in the economic relationship between the U.K. and the continent is so low, it also means the probability that the Bank of England maintains as easy a monetary policy as its current one is minimal. Our low-conviction answer to this question is yes, the pound is indeed attractive. The reason why buying the pound is a low-conviction view is that one of the three alternative scenarios listed above could have mixed implications for the British economy as well as U.K. assets and the pound: A new election that produces a Labour government. Corbyn’s legislative agenda is the most left-leaning that Europe has seen since François Mitterrand. He is also on record stating that he would pursue his own negotiations with Brussels. Corbyn’s government would therefore prolong the uncertainty of Brexit while enacting an ambitious left-wing agenda. Ultimately, he may reverse both of these positions: succumbing to pressure to call a new referendum while moderating his economic policy. However, as was the case with Mitterrand in the early 1980s, it would require a deep market riot to force him to do so, which means that closing one’s eyes and buying the pound at these levels is not for risk-averse investors. Bottom Line: The political battle for Brexit is far from over. The risk of a hard Brexit has receded considerably to a less than 10% probability, but volatility will continue due to the inherent conflict between the desire to maximize British sovereignty and the objective to minimize economic pain. While cross-party talks are unlikely to yield any decisive changes, an extension of the Article 50 deadline is likely. A new referendum is the most probable end game of this saga, but it will probably require a new election. While the pound is an attractive long-term play, GBP pairs will continue to suffer from politically induced volatility. Investment Implications In September, we argued that the geopolitical risk premium in the GBP was too low in the face of the uncertainty ahead. Moreover, we recognized that the pound was cheap on many long-term metrics, limiting its downside potential. As a result, instead of shorting GBP outright, we recommended investors buy GBP-volatility, a view that panned out well for us. We closed this recommendation in mid-November, when Cabinet Ministers McVey, Raab, and Vara resigned from the government. Since that time, GBP volatility has receded as investors have increasingly agreed with our assessment that the probability of a hard Brexit is very low. However, the political reality in London continues to suggest that the GBP will trade in a volatile fashion, even if its long-term attractiveness remains alive. Hence, we continue to recommend investors use dips in the GBP to slowly begin moving capital into sterling. Practically, we have expressed this view by selling EUR/GBP. EUR/GBP trades toward the top end of its historical distribution (Chart I-5) and is likely to sell off violently on any whiff that a resolution of any kind is coming. Furthermore, since British interest rates are higher than in the euro area, investors are paid to wait while shorting this cross. Chart I-5EUR/GBP Is A Coiled Spring EUR/GBP Is A Coiled Spring EUR/GBP Is A Coiled Spring The pound is particularly cheap against the U.S. dollar (Chart I-6). As a result, buying GBP/USD offers the most attractive long-term potential. However, the intermediate-term hurdles for this position are greater than those present in selling EUR/GBP. First, long cable offers a negative carry of 1.89%, thus buying GBP/USD means that investors are paying to take on a lot of volatility. Second, our negative intermediate-term outlook for the global economy implies a strong dollar over the coming six to nine months, creating risks for GBP/USD holders while helping the profile of selling EUR/GBP (Chart I-7). Finally, since Brexit risks are weighing on the euro as well as the pound, if a hard Brexit were indeed to materialize, GBP would suffer much deeper losses against the dollar than against the euro. Chart I-6Lot Of Value In Cable Lot Of Value In Cable Lot Of Value In Cable   Chart I-7Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling This inherent conflict in GBP/USD between potentially large long-term gains but heightened short-term risk suggests that the best way to play cable is to buy long-term call options on this pair. As Chart I-8 shows, the implied volatility on 2-year GBP/USD options is elevated, but has been much higher in the past. Additionally, the implied volatility on these long-term options is abnormally low relative to that offered by 3-month options (Chart I-8, bottom panel), suggesting they are comparatively cheap. Thus, since the long-term outlook for cable is much more attractive than the short-term one, favoring long-term options as a vehicle to gain exposure to GBP/USD makes sense. It is a risky bet only deserving of a small portfolio allocation. Chart I-8Long-Term Call Options On Cable Are Attractive Long-Term Call Options On Cable Are Attractive Long-Term Call Options On Cable Are Attractive Bottom Line: Only investors with either long-term horizons or a deep capacity to handle volatility should begin garnering some exposure to the pound. Selling EUR/GBP when the pound weakens in response to political shocks remains the best vehicle to do so. While buying cable offers more attractive long-term potential returns than selling EUR/GBP, it is a riskier bet over a six- to nine-month horizon. Nonetheless, investors wanting to get some pound exposure via buying GBP/USD should allocate funds to 2-year GBP/USD call options. Short-Term Risks For The Greenback As we argued last week, continued downside in global growth as well as U.S. interest rate markets having already priced in a year-long pause by the Fed together point to continued upside for the dollar. However, we also highlighted that the dollar currently possesses significant tactical downside, especially against commodity currencies. Five reasons underpin our cautious tactically view: First, the dollar is currently over-owned. Both net speculative positions in the dollar and sentiment toward the DXY are near bullish extremes (Chart I-9). The dollar is a momentum currency, hence the progressive deterioration in our favored momentum signal for the greenback – the crossover of the one-month and six-month moving averages – suggests that the dollar could soon experience a momentum-induced liquidation. Chart I-9If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers Second, the most recent BAML Investor survey not only showed that investors are more pessimistic on global growth than at any point in the past decade, but also that a trade war was highest on the list of concerns. Today, the probability of a truce in Sino-U.S. trade relations is growing. A declining trade-war risk should temporarily support assets levered to global growth and hurt the defensive U.S. dollar. Moreover, a consequence of the warm-up between Beijing and Washington has been a weakening USD/CNY. Historically, a strengthening RMB is associated with rebounding commodity currencies (Chart I-10). Chart I-10A Strong CNY Points To Stronger Commodity Currencies A Strong CNY Points To Stronger Commodity Currencies A Strong CNY Points To Stronger Commodity Currencies Third, global growth could also temporarily positively surprise beaten-down expectations. Today, the highly mean-reverting Citi Economic Surprise Index is very stretched to the downside, suggesting scope for a reversal (Chart I-11). With Chinese fiscal stimulus building up, and the recent pick-up in the six-month Chinese credit impulse, a temporary bout of positive economic surprises is a growing risk for dollar bulls. Chart I-11There Is Scope For Economic Surprises To Rebound There Is Scope For Economic Surprises To Rebound There Is Scope For Economic Surprises To Rebound Fourth, our China Investment Strategy service’s Market-Based China Growth Indicator has rebounded (Chart I-12). This further reinforces the risk that global growth could positively surprise abysmal expectations. Chart I-12Markets Signalling A Pause In The Economic Slowdown Markets Signalling A Pause In The Economic Slowdown Markets Signalling A Pause In The Economic Slowdown Fifth, gold prices have rebounded significantly, implying an improvement in the global liquidity backdrop (Chart I-13). Since tightening global liquidity was a contributor to the deterioration in non-U.S. growth, rebounding gold prices also confirm that the slowdown in international economic activity may take a breather. Chart I-13Gold As A Liquidity Gauge Gold As A Liquidity Gauge Gold As A Liquidity Gauge Altogether, these five factors suggest that the corrective episode in the countercyclical dollar may deepen. Because Chinese reflation and a truce in Sino-U.S. tensions lie at the crux of the potential for positive economic surprises, the growth-sensitive currencies like the AUD, the CAD and EM currencies should outperform, especially vis-à-vis the yen. In this environment, Scandinavian currencies should also rise versus the euro. EUR/CHF is set to benefit from this backdrop. For the time being, we continue to view any weakness in the dollar as a correction, not the end of the bull market. Ultimately, the respite in the Chinese economy is likely to prove transitory. The six-month credit impulse is improving, but the 12-month credit impulse is not, even when fiscal stimulus is taken into account (Chart I-14). Since the noise-to-signal ratio is much greater in the six-month impulse than in the 12-month one, we believe that only once the longer-term credit impulse rebounds will Chinese economic activity form a durable bottom. Moreover, Chinese exports are beginning to suffer from a payback period after having been artificially supported by front-running ahead of the trade sanctions. As things stand today, the recent weakness in Chinese export growth looks set to worsen (Chart I-15). This will cause yet another shock to Chinese growth, one likely to percolate to domestic demand. Once it does, global industrial activity should soften again, creating a strong support for the dollar. Chart I-14China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... Chart I-15 ...And Exports Are Set To Become A Significant Drag ...And Exports Are Set To Become A Significant Drag ...And Exports Are Set To Become A Significant Drag Bottom Line: Cyclically, fundamentals remain supportive for the greenback. However, the tactical picture shows that the dollar should correct further, especially against growth-sensitive currencies like the AUD, which could rally to 0.75. This view is because the dollar’s momentum is deteriorating sharply, the yuan is rising on the back of a growing likelihood of a trade truce, global economic surprises have room to brighten, China is implementing some reflationary efforts, and global liquidity is improving at the margin.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1 The acquis communautaire refers to the collection of accumulated legislation, legal acts, and judicial decisions that constitute the body of the EU law. 2 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 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 Recent data in the U.S. has been mixed: Core inflation came in line with expectations at 2.2%. Meanwhile, initial jobless claims outperformed expectations, coming it at 216 thousand. Finally, the ISM Non-manufacturing survey also surprised negatively, coming in at 57.6. DXY has been flat since the beginning of the year. After falling through the end of 2018 and the start of 2019, the dollar has staged a small recovery, managing to be flat year to date. We believe that while the greenback could experience tactical weaknesses in the coming three months, our cyclical outlook for the dollar remains positive. After all, the Fed will be able to deliver more hikes than the markets currently anticipates, and global growth remains soggy. Report Links: So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro are has been negative: Industrial production yearly growth surprised negatively, coming in at a 3.3% contraction. Moreover, headline inflation also underperformed expectations, coming in at 1.6%. Finally, the Markit Composite PMI also surprised to the downside, coming in at 51.1. EUR/USD has been flat since the beginning of the year. We are positive on EUR/USD on a tactical basis, given that China could be experiencing a temporary rebound, and given that the fall in the dollar and bond yields at the end of 2018 improved financial conditions around the world. These factors should be positive for the euro over the next 3-months. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Domestic Goods prices yearly growth underperformed expectations, coming in at a 1.5%. Moreover, overall household spending also underperformed expectations, coming in at a 0.6% contraction. However, bank lending yearly growth outperformed expectations, coming in at 2.4%. USD/JPY has fell at the beginning of the year but then managed to recover a bit. We are bearish on the yen on a tactical basis, given that the easing of financial conditions that started in late 2018 should continue to help risk assets. Consequently, safe havens like the yen should remain under pressure on a 3-month horizon. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Core inflation came in above expectations, coming in at 1.9%. However, industrial production surprised negatively, coming in at a 1.5% contraction. Finally, retail price growth also surprised to the downside, coming in at 2.7%. GBP/USD has risen by 2% since the beginning of the year. The low probability of a hard Brexit will support the pound, however, as the British political situation remain extremely fluid, GBP will continue to experience elevated volatility. Nonetheless, we believe that the best vehicle to play the strength in the pound is to short EUR/GBP. This cross is now trading at the upper range of its historical distribution, and therefore, any good news coming out of Britain could make it sell off violently. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been mixed: Retail sales month-on-month growth outperformed expectations, coming in at 0.4%. However, the trade balance for November also surprised negatively, coming in at 1.925 million. Finally, building permits month-on-month growth also surprised to the downside, coming in at -9.1%. AUD/USD has risen by 2.6% since the beginning of the year. We are positive on the AUD on a tactical basis, given that the current fall in the dollar and yields have eased monetary conditions and have provided a reflationary force helping risk assets. Moreover, the warming in Sino-U.S. relations and the recent strength in the yuan is adding another tailwind behind growth sensitive currencies like the Aussie. That being said, we are still bearish on the AUD on a cyclical timeframe, as the dual forces of Chinese deleveraging and Fed tightening should resume later this year. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 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 Recent data in New Zealand has been negative: Gross domestic product yearly growth came in below expectations, coming in at 2.6%. Moreover, electronic card retail sales month on month growth declined further from last month to -2.3%. NZD/USD has risen by 1.1% since the beginning of the year. While we are positive on the kiwi on a 3-month basis, as Chinese growth has started to rebound temporarily and global financial conditions have eased, we nonetheless prefer the AUD to the kiwi over this timeframe. That being said, the NZD will most likely depreciate against the dollar on a cyclical timeframe, as both the Fed and China reinitiate their tightening campaigns. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been positive: Seasonally adjusted housing starts growth came in above expectations, coming in at 213 thousand. Moreover, the unemployment rate surprised positively, coming in at 5.6%. Finally, the net change in employment also surprised to the upside, coming in at 9.3 thousand. USD/CAD has plunged by 2.5% since the beginning of the year. We are bullish on the CAD on a tactical basis, as oil prices should continue to rise on the back of tighter supply from OPEC. Moreover, the fall in yields which had led to easier financial conditions should continue to put upward pressure on commodity currencies like the Canadian dollar, a currency that very much enjoy falling risk-asset volatility. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation underperformed expectations, coming in at 0.7%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 96.3. However, the SVME Purchasing Manager’s Index outperformed expectations, coming in at 57.8. EUR/CHF has risen 0.5% since the beginning of the year. We are bullish on EUR/CHF as global financial conditions are easing. Moreover, disappointing Swiss inflation and economic data highlight that the SNB remain unable to achieve its target. To achieve growing prices, Switzerland will need a weaker currency. Therefore, the SNB will pull all the necessary levers to put a natural floor under this cross. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Headline inflation outperformed expectations, coming in at 3.5%. Moreover, core inflation also surprised positively, coming in at 2.1%. Finally, retail sales growth also surprised to the upside, coming in at 0.9%. USD/NOK has fallen by 1.3% since the beginning of the year. We are bearish on USD/NOK on a tactical time horizon, as global financial conditions are easing while oil prices are also rising. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been mixed: Consumer confidence underperformed expectations, coming in at 96.4. However, retail sales month-on-month growth outperformed expectations, coming in at 0.8%. Finally, headline inflation came in line with expectations, coming in at 2%. USD/SEK has risen by 1.6% since the beginning of the year. On a long-term basis, we like the SEK. Not only is the krona exceptionally cheap, but also, strong inflationary pressures in Sweden should eventually force the Riksbank to tighten monetary policy. Despite these structural positives for the SEK, the cyclical outlook is much more tenuous as this currency historically responds most poorly among G10 currencies to dollar strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. economy is slowing in a completely predictable manner. With inflationary pressures largely dormant, the Fed can afford to stay on hold for the next few FOMC meetings. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. A bearish stance towards U.S. Treasurys is warranted over a 12-month horizon. As long as the Fed is hiking rates in response to above-trend GDP growth rather than accelerating inflation, risk assets will fare well. Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Brexit fears are overdone. Stay long the pound versus the euro. We were stopped out of our short AUD/JPY trade for a gain of 10%. Feature A Predictable Slowdown Investors are misunderstanding the nature of the current slowdown in the United States and much of the world. Completely predictable slowdowns, such as this one, rarely morph into recessions. Real U.S. GDP rose at a blistering 3.8% average annualized pace in Q2 and Q3 of 2018. There is no way that sort of growth rate could have been sustained. Financial conditions also tightened sharply in Q4, which has inevitably weighed on growth. Given the stock market rout, it is actually surprising that the economy has not weakened more than it has. The New York Fed GDP Nowcast points to growth of 2.5% in Q4 of 2018 and 2.1% in Q1 of 2019. This is still above the Fed’s long-term estimate of potential GDP growth of 1.9%. Most of the slowdown has been concentrated in the manufacturing sector, but even there, the bloodletting may be ending. The latest Philadelphia Fed survey — arguably the most important of the regional Fed manufacturing reports — showed an uptick in activity, with the new orders component hitting the highest level since last July. Despite the tightening in financial conditions, bank lending to the business sector has accelerated over the past three months (Chart 1). The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 2). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 3). Chart 1Credit Is Still Flowing To U.S. Businesses Credit Is Still Flowing To U.S. Businesses Credit Is Still Flowing To U.S. Businesses Chart 2Little Sign Of A Looming Credit Crunch Little Sign Of A Looming Credit Crunch Little Sign Of A Looming Credit Crunch Chart 3Capex Plans Still Solid Capex Plans Still Solid Capex Plans Still Solid The labor market remains healthy, as evidenced by ongoing strong payroll growth and low initial unemployment claims. Faster wage growth is boosting consumer spending. Holiday sales rose by 5.1% from a year earlier according to the Mastercard SpendingPulse report, the fastest growth in six years. The Redbook same-store index tells a similar story (Chart 4). Chart 4Same-Store Sales Are Robust Same-Store Sales Are Robust Same-Store Sales Are Robust The housing market struggled for much of 2018, but the recent stabilization in mortgage rates should help matters (Chart 5). Notably, mortgage applications for purchase have surged to their highest levels since 2010 (Chart 6). Homebuilder confidence improved in January, mirroring the rally in homebuilder shares (Chart 7). We are long homebuilders versus the S&P 500, a trade that is up 5.3% since we recommended it on November 1, 2018. Chart 5aThe U.S. Housing Sector Will Stabilize (I) The U.S. Housing Sector Will Stabilize (I) The U.S. Housing Sector Will Stabilize (I) Chart 5BThe U.S. Housing Sector Will Stabilize (II) The U.S. Housing Sector Will Stabilize (II) The U.S. Housing Sector Will Stabilize (II) Chart 6A Positive Signal For U.S. Housing A Positive Signal For U.S. Housing A Positive Signal For U.S. Housing Chart 7U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Government Shutdown: A Near-Term Hit To Growth The government shutdown poses a near-term risk to the U.S. economy. If it lasts until the end of March, it will shave about 1.7% off Q1 GDP based on White House estimates. While this represents a potentially significant hit to the economy, the effect is likely to be completely reversed once the shutdown ends. Moreover, the drag to growth from the shutdown pales in comparison to the overall stance of fiscal policy. According to the IMF, the cyclically-adjusted budget deficit is set to reach 5.7% of GDP this year, up from 3.2% of GDP in 2015. There is also a reasonable chance that any deal to end the shutdown will involve a commitment to increase spending beyond currently budgeted levels. This would increase the overall amount of fiscal stimulus the economy is receiving. Taking The Pulse Of Global Growth The slowdown in growth has been deeper and more protracted outside the United States. Nevertheless, rays of sunshine are emerging. Our global Leading Economic Indicator diffusion index, which measures the proportion of countries with rising LEIs compared to those with falling LEIs, has bottomed. The diffusion index leads the global LEI by a few months (Chart 8). Chart 8The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize As is increasingly the case, the fate of the Chinese economy will be critical in determining when global growth begins to reaccelerate. The latest Chinese activity data has been disappointing, with this week’s downright awful export figures being the latest example. That said, credit growth may be starting to stabilize, as evidenced by stronger-than-expected loan growth for December. With credit growth now running only slightly above nominal GDP growth, the need for the authorities to maintain their deleveraging campaign has diminished. In an encouraging sign, the Market-Based China Growth Indicator developed by our China Investment Strategy service has been moving higher (Chart 9). Chart 9Encouraging Sign For The Chinese Economy Encouraging Sign For The Chinese Economy Encouraging Sign For The Chinese Economy A revival in Chinese growth would aid trade-sensitive economies such as Japan and Germany. The former saw a decline in economic momentum in the second half of 2018, exacerbated by typhoons and an earthquake in Hokkaido. With the consumption tax set to increase from 8% to 10% in October, the Bank of Japan will need to maintain its yield curve control regime at least until 2020. This could weigh on the yen. With that in mind, we tightened the stop on our short AUD/JPY trade two weeks ago and subsequently exited the position with a gain of 10%. The German economy has taken it on the chin recently. Real GDP contracted in the third quarter and barely grew in the fourth quarter. The economy should rebound in 2019 as external demand improves. The drag on growth from the decline in automobile assemblies following the introduction of new emission standards should also turn into a modest tailwind as production resumes. In addition, fiscal policy is set to turn more stimulative, while robust wage growth, lower oil prices, and rising home prices should support consumption. Elsewhere in Europe, the Italian economy should recover as bond yields come down from their highs and confidence improves following the resolution of the impasse with the EU over budget targets. The modest easing in Italy’s fiscal policy of about 0.5% of GDP in 2019 should also benefit growth. It is too early to quantify the effect on the French economy from the “yellow vest” protests. France is no stranger to protests of this sort, so our guess is that the impact on the economy will be minimal. President Macron’s pledge to loosen fiscal policy in hopes of placating the protestors should also support demand. Brexit: A “No Deal” Outcome Looks Less Likely The Brexit saga could end in one of three ways: 1) A “no deal” where the U.K. leaves the EU with no alternative in place; 2) A “soft Brexit” involving an agreement to form a permanent customs union or some sort of “Norway plus” arrangement; 3) A decision to reverse the results of the original referendum and stay in the EU. In thinking about which of these three outcomes is most likely, one should keep the following in mind: Any course of action that the U.K. takes must have the support of the British parliament. A no deal outcome does not have parliament’s support. Not even close. Thus, it will not happen. This leaves options 2 and 3. This publication has argued since the day after the Brexit vote that the European establishment, following the example of the Irish and Danish referendums over various EU treaties, will keep insisting on do-overs until it gets the result it wants. If one referendum is good, two is even better – it’s twice as much democracy! The betting markets seem to be coming around to our view. As we go to press, PredictIt shows a one-in-three chance that a new referendum will be called by March 31 (Chart 10). Polling trends suggest that if another referendum were held, the remain side would probably prevail (Chart 11). Chart 10 Chart 10 Chart 11U.K.: A Change Of Heart? U.K.: A Change Of Heart? U.K.: A Change Of Heart? In some sense though, it does not matter for investors whether the original referendum is reversed or a soft-Brexit deal is reached. Either outcome would be welcomed by markets. We continue to advocate buying GBP/EUR. My colleague Dhaval Joshi, BCA’s Chief European strategist, also recommends that equity investors purchase the FTSE 250 index, which comprises from the 101st to the 350th largest companies listed on the London Stock Exchange. Unlike its large-cap counterpart, the FTSE 100, the FTSE 250 index is more geared to what happens in the U.K. than in the rest of the world. Investment Conclusions Global inflation remains subdued, which gives central banks the luxury of taking a wait-and-see approach to tightening monetary policy. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. Given that the market is no longer pricing in any Fed hikes, a bearish stance towards U.S. Treasurys is warranted over a 12-month horizon (Chart 12). Outside of Japan, bond yields will also rise in the major developed economies. Chart 12Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected We downgraded global equities in June as our leading indicators began to point to slower growth ahead, but upgraded them back to overweight after stocks plunged following the December FOMC meeting. The rally over the past three weeks has reversed deeply oversold conditions and our tactical MacroQuant model is once again flagging some near-term risk to stocks. Nevertheless, if the global economy avoids a recession this year, as we expect, equities should fare well over a 12-month horizon. The MSCI All-Country World index is trading at a modest 13.6-times forward earnings (Chart 13). Profit estimates have been revised down meaningfully, suggesting that the bar for upward earnings surprises is now quite low. Chart 13A Lot Of Bad News Already Discounted? A Lot Of Bad News Already Discounted? A Lot Of Bad News Already Discounted? Risk assets can tolerate higher rates as long as tighter monetary policy is the result of stronger growth. What risk assets cannot withstand is a stagflationary environment where growth is slowing but the Fed is hiking rates in order to bring down inflation. That is not the situation today, but could be the situation next year. Bottom line: Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 14 Tactical Trades Strategic Recommendations Closed Trades

Highlights Buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit. For equity investors the best play is a FTSE Small Company Index ETF and/or U.K. REITS. Beaten-down banks, industrials and materials can continue their recent countertrend outperformances. This necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Go overweight industrials versus utilities as a tactical trade. Feature Chart of the WeekWere It Not For Brexit, U.K. Interest Rates Would be 1 Percent Higher Were It Not For Brexit, U.K. Interest Rates Would be 1 Percent Higher Were It Not For Brexit, U.K. Interest Rates Would be 1 Percent Higher Please join me for a webcast today at 10.00 AM EST (3.00 PM GMT, 4.00 PM CET, 11.00 PM HKT) when I will be elaborating on some of the ideas in this report as well as other major investment themes. For those of you who cannot participate live, the webcast will also be available as a playback. Were it not for the psychodrama called Brexit, the pound would be trading at $1.50 rather than at $1.28. We can say this with utmost confidence because ‘cable’ is very closely tracking the difference in 2-year interest rates in the U.K. versus the U.S. Absent the Brexit shenanigans, U.K. interest rates would be around 1 percent closer to those in the U.S., implying that pound/dollar would be around 15 percent higher ( Chart I-2 and Chart I-3 ). Chart I-2Absent The Brexit Discount On U.K. Interest Rates... Absent The Brexit Discount On U.K. Interest Rates... Absent The Brexit Discount On U.K. Interest Rates... Chart I-3...The Pound Would Be At $1.50 The Pound Would Be At $1.50 The Pound Would Be At $1.50 Explaining Brexit’s Impact On U.K. Interest Rates And The Pound The difference in U.K. versus U.S. interest rates usually tracks the difference in their inflation rates, in effect equalizing real interest rates in the two economies. But the Brexit referendum in 2016 forced the Bank of England into an ‘emergency monetary policy’ mode, whereby interest rates were left depressed relative to the inflation fundamentals, and U.K. real interest rates collapsed. Applying the BoE’s pre-Brexit reaction function to the current inflation dynamics, U.K. interest rates – and therefore the pound – would be in a completely different ballpark. After all, U.K. and U.S. core inflation rates and unemployment rates are virtually identical ( Chart of the Week  ). It follows that the pound’s trajectory will be higher in any negotiated Brexit – or indeed ‘no Brexit’ – which avoids a complete and overnight no-deal divorce. The simple reason is that a transition period lasting several years that continues to give the U.K. access to the EU single market will allow the BoE to revert to its pre-Brexit monetary policy reaction function. But any workable alternative to a no-deal Brexit must satisfy two conditions: the way forward must be acceptable to the EU27; and it must command a majority in the U.K. parliament. From the perspective of investors, what this way forward turns out to be – Common Market 2.0, permanent customs union, second referendum, or general election – does not really matter. What matters is that a parliamentary majority exists for a course of action that avoids no-deal. The investment strategy is to buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit . In this event, do not buy the FTSE100. Whenever the pound strengthens, the weaker translation of the FTSE100 companies’ dollar-denominated earnings tends to weigh down this large-cap index. A better play is the FTSE250 mid-cap index ( Chart I-4 ), but for equity investors t he best play is a FTSE Small Company Index ETF and/or U.K. REITS ( Chart I-5 ). Chart I-4A Negotiated Brexit Would Favour The FTSE250... A Negotiated Brexit Would Favour The FTSE250... A Negotiated Brexit Would Favour The FTSE250... Chart I-5...And U.K. Small Companies ...And U.K. Small Companies ...And U.K. Small Companies Europeans Are Celebrating Lower Oil Europeans will be celebrating the near halving of the crude oil price from its $86 high just three months ago. The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. After all, Europeans have to do the school run and stay warm in winter, irrespective of the oil price. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending ( Chart I-6 ). A second transmission mechanism is via credit creation: higher inflation, through its implication for tighter monetary policy, lifts bond yields and depresses credit impulses; lower inflation does the opposite, it depresses bond yields and lifts credit impulses. The upshot is that higher oil weighed on European growth in 2018 while lower oil should boost growth in early 2019. Chart I-6Inflation Is Likely To Plunge, Boosting Real Incomes Inflation Is Likely To Plunge, Boosting Real Incomes Inflation Is Likely To Plunge, Boosting Real Incomes Compelling proof comes from the oscillations in the euro area economy. For several years, these growth oscillations have perfectly and inversely tracked oscillations in the oil price ( Chart I-7 ). The economic implication is that the recent collapse in energy prices should engineer some sort of growth rebound in the euro area. The investment implication is that such a growth rebound will support the classically cyclical equity sectors – banks, industrials and materials – because of their very high operational leverage to economic growth. Chart I-7Euro Area Growth Oscillations Inversely Track Oil Price Oscillations Euro Area Growth Oscillations Inversely Track Oil Price Oscillations Euro Area Growth Oscillations Inversely Track Oil Price Oscillations Profit is a small number created from the difference between two large numbers: sales minus the cost of generating those sales. But the dominant cost – the wage bill – tends to be quite sticky. Hence, if a company’s sales are highly sensitive to the economy, the power of operational leverage means that a small change in GDP can have a dramatically large proportional impact on profit. This is a simple principle, but it turns out to be an excellent explanation for the Eurostoxx50 earnings per share (eps) cycle. Because the index is dominated by the classically economic-sensitive sectors, Eurostoxx50 eps growth has a very high operational leverage to changes in euro area GDP growth, potentially as high as 50 times over short periods such as six months ( Chart I-8 ). In contrast the less cyclical S&P500 has an operational leverage to economic growth of less than 10 ( Chart I-9 ). Chart I-8Eurostoxx50 Profits Growth Is Highly Geared To Economic Growth Eurostoxx50 Profits Growth Is Highly Geared To Economic Growth Eurostoxx50 Profits Growth Is Highly Geared To Economic Growth Chart I-9S&P500 Profits Growth Is Less Geared To Economic Growth S&P500 Profits Growth Is Less Geared To Economic Growth S&P500 Profits Growth Is Less Geared To Economic Growth On the expectation that euro area growth will rebound modestly in early 2019, the beaten-down banks, industrials and materials can continue their recent countertrend outperformances. And this necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Explaining The ‘Unexplainable’ Moves In Markets During the recent Christmas holiday period, financial markets experienced sharp moves with no explainable catalyst. Such reversals leave many strategists and analysts scratching their heads in bewilderment, wondering: what was the catalyst for that reversal? The answer is there was no fundamental catalyst; the market reversed because liquidity dried up . But to explain why liquidity dried up and markets ‘unexplainably’ reversed, we first need to understand what creates market liquidity in the first place. Market liquidity is the ability to convert cash into an investment quickly and in volume without affecting its price. But for an investor to convert a large amount of cash into an investment without affecting its price, another investor must be willing to do the exact opposite – convert a large amount of the investment into cash at the given price. Therefore, market liquidity comes from a disagreement about the attractiveness of an investment at that given price. Investors disagree about the attractiveness of an investment at a given price because investors with different time horizons interpret the same facts and information very differently. Hence, a market remains stable when it possesses investors with many different time horizons. The reason is that when a day-trader experiences a ‘six-sigma’ price move, an investor with a longer investment horizon, for example 65 days, will step in and stabilize the market. The longer-term investor will do so because, within his investment horizon, the day-trader’s six-sigma price move is not unusual. As long as another investor has a longer trading horizon than the investor experiencing an extreme event, the market will stabilize itself. Therefore, the market’s liquidity and stability are maximized when its participants possess a variation of investment horizons, say, both the 1 day horizon and the 65 day horizon. The corollary is that the market’s liquidity and stability disappear when its participants no longer possesses this healthy variation in horizons. In technical terms, this occurs when the market’s 65-day fractal dimension collapses to its lower bound. Without a shadow of a doubt, this is what happened to the S&P500 on Christmas Eve and triggered a 5 percent market rebound on Boxing Day ( Chart I-10 ). And this is now what is happening to the relative performance of industrials versus utilities, which is also in the process of a similar liquidity-triggered rebound ( Chart I-11 ). Chart I-10A Liquidity Shortage Triggered A Sharp Rebound In The S&P500 A Liquidity Shortage Triggered A Sharp Rebound In The S&P500 A Liquidity Shortage Triggered A Sharp Rebound In The S&P500   Chart I-11Expect A Liquidity-Triggered Rebound In Industrials Versus Utilities Expect A Liquidity-Triggered Rebound In Industrials Versus Utilities Expect A Liquidity-Triggered Rebound In Industrials Versus Utilities   Fractal Trading System* This week we note that the strong rally in the Indian rupee versus the Pakistan rupee has reached a point where an imminent liquidity shortage could trigger a countertrend move. Go short the Indian rupee versus the Pakistan rupee with a profit target of 3 percent, and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Short Indian rupee versus Pakistan rupee Short Indian rupee versus Pakistan rupee The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com   Dhaval Joshi , Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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 - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights So What? Our “Black Swan” risks for the year reveal several potential wars. Why? While we think it is premature to expect armed conflict over Taiwan, an outbreak of serious tensions is possible. Russia and Ukraine may have a shared incentive to go renew hostilities this year. Saudi Arabia has received a “blank cheque” from Donald Trump, so it may continue to be provocative. Everyone has forgotten about the Balkans … but tensions are building. A “Lame Duck” Trump could stage a military intervention in Venezuela. Feature Over the past three years, we have compiled a list of five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s list of “Ten Surprises for 2018,” we do not assign these events a “better than 50% likelihood of happening.”1 Instead, we believe that the market is seriously underpricing these risks by assigning them only single-digit probabilities when the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Furthermore, some of our events below are obscure enough that it is unclear how exactly to price them. But before we get to our list of the five things that keep us up at night,2 a quick note on the question for financial markets in 2019: Will the economic policy divergence between the U.S. and China continue? At the moment, momentum is building behind the narrative that both the U.S. and China have decided to reflate. In anticipation of this narrative switch, we closed our long DM / short EM equity trade on December 3, 2018 for a 15.70% return (originally opened on March 6, 2018). How sustainable is the EM outperformance relative to DM? Will the rest of the world “catch up” to U.S. growth momentum, thus hurting the U.S. dollar in the process? The global central bank – the Fed – is already expected to “back off,” even though members of the FOMC have simply pointed out that they remain data-dependent. Granting our BCA House View that the U.S. economy remains in decent health, U.S. economic data will continue to come in strong through the course of the year. This means that there is scope for a hawkish Fed surprise for the markets, given that the interest rate market already has dovish expectations, anticipating 4.33 basis points and 16.74 basis points of cuts over the next 12 and 24 months respectively (Chart 1). Chart 1 Meanwhile, the global demand engine – China – may disappoint in its reflationary efforts. We refer to China as the “global demand engine” because the combined imports and capex of China and other emerging markets dwarf that of the U.S. and EU (Chart 2 and Chart 3).3 Chinese imports alone make up $1.6 trillion, constituting 23% of the $7 trillion total of EM imports and about half of EM investment expenditures. Given that large swaths of EM are high-beta to the Chinese economy, the EM-plus-China slice of the global demand pie is leveraged to Beijing’s reflationary policies. Chart 2EM/China Imports Are Much Larger Than U.S.'s And EU's Combined EM/China Imports Are Much Larger Than U.S.'s And EU's Combined EM/China Imports Are Much Larger Than U.S.'s And EU's Combined Chart 3EM/China Capex Is As Large As U.S.'s And EU's Combined EM/China Capex Is As Large As U.S.'s And EU's Combined EM/China Capex Is As Large As U.S.'s And EU's Combined Chinese policymakers have gestured toward greater support for the economy. The communiqué published following the Central Economic Work Conference (CEWC) in December called for a broad stabilization of aggregate demand as a focus of macro policy over the course of 2019. The language was still not very expansionary, but Beijing has launched stimulus despite relatively muted communiqués in the past. The massive stimulus of early 2016, for instance, followed a mixed CEWC communiqué in December 2015. So everything depends on the forthcoming data. Broad money and credit growth improved marginally in December, while the State Council announced that local government bond issuance could begin at the start of the year rather than waiting until spring. Meanwhile, a coordinated announcement by the People’s Bank of China, the Ministry of Finance, and the National Development and Reform Commission declares that a larger tax cut is forthcoming – that is, in addition to the roughly 1% of GDP household tax cuts that went into effect starting late last year. Monetary policy remains very lax with liquidity injections and additional RRR cuts. Before investors become overly bullish, however, we would note that Chinese policymakers are focusing their reflationary efforts on fiscal spending and supply-side reforms like tax cuts. The problem with the latter is that household tax cuts will not add much to global demand, given that consumer goods make up just 15% of China’s imports (Table 1). The vast majority of Chinese imports stem from the country’s capital spending. Table 1China’s Consumer-Oriented Stimulus Will Boost Different Imports Than Past Stimulus Five Black Swans In 2019 Five Black Swans In 2019 Fiscal spending, meanwhile, is as large as the overall credit origination in the Chinese economy (Chart 4). But without a revival in credit growth, more spending will mainly serve to stabilize the economy, not light it on fire. It is likely that part of the fiscal pump-priming will be greater issuance of local government bonds. However, even the recently announced 1.39 trillion RMB quota for new bonds this year is not impressive. And even a 2 trillion RMB increase would only be equivalent to a single month of large credit expansion (Chart 5). Chart 4China: Credit Origination Is As Large As Government Spending China: Credit Origination Is As Large As Government Spending China: Credit Origination Is As Large As Government Spending   Chart 5 As such, tactically nimble investors could profit from a reflationary narrative that sees both the global central bank – the Fed – and the global fiscal engine – China – turning more dovish and supportive of growth. However, we agree with BCA’s Emerging Markets Chief Strategist Arthur Budaghyan, who is on record saying that “Going Tactically Long EM Is Akin To Collecting Pennies In Front Of A Steamroller.” The bottom line for investors is that 2019 is the first year in a decade where the collective intention of policymakers – across the world – is to prepare for the next recession, rather than to prevent a deflationary relapse. This cognitive shift may be slight, but it is important. The Fed and Beijing are engaged in a macroeconomic game of chicken. Each camp is trying to avoid having to over-reflate at the end of the cycle. For the Fed, the goal is to have room to cut rates sufficiently when the recession finally hits. For China, the goal is to ensure that its leverage does not get out of hand. Into this uncertain macroeconomic context we now insert the five Black Swans for 2019. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months; Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk; Geopolitical: We must be able to identify the risk scenario through the lens of BCA’s geopolitical methodology. Genuinely unpredictable events – such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe – do not make the cut. Black Swan 1: China Goes To War With Taiwan One could argue that a military conflict between China and Taiwan in 2019 should not technically qualify for our list, as there has been chatter in the media about such an outcome. Indeed, our recent travels across Asia revealed that clients are taking a much greater interest in our longstanding view – since January 2016 – that Taiwan is the premier geopolitical Black Swan. We established this view well before President Trump won the election and received a congratulatory call from Taiwanese President Tsai Ing-wen, breaking diplomatic practice since 1979. Now, at the beginning of 2019, the exchange of barbs between the Chinese and Taiwanese presidents has raised tensions anew (Chart 6).4 Chart 6Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Nonetheless, Taiwan makes the cut here because we doubt that most of our global clients take the issue seriously. Furthermore, we are concerned that – with fair odds of a U.S.-China trade truce lasting through 2019 – cross-strait tensions could fall out of sight. The basis of our view is that there is a unique confluence of political developments in Beijing, Washington, and Taipei that is conducive toward a diplomatic or military incident that could escalate tensions: Taiwan’s pro-independence Democratic Progressive Party (DPP), in addition to taking the presidency in 2016, won control of the legislature for the first time ever (Chart 7). This means that domestic political constraints on President Tsai Ing-wen’s administration are lower than usual. Tsai has angered Beijing by seeking stronger relations with the U.S. and refusing to endorse the 1992 Consensus, which holds that there is only “One China” albeit two interpretations. China’s General Secretary Xi Jinping has removed term limits and placed greater emphasis on the reunification of Taiwan. Xi has consolidated power domestically and has pursued a more aggressive foreign policy throughout his term, including in the South China Sea, where greater naval control would enable China to threaten Taiwan’s supply security. Xi’s blueprint for his “New Era” includes the reunification of China, and some have argued that there is a fixed timetable for reunification with Taiwan by 2050 or even 2035.5 Some recent military drills can be seen as warnings to Taiwan. U.S. President Trump called the One China Policy into question at the outset of his term in office (only later reaffirming it), and has presided over an increase in U.S. strategic pressure against China, such as the trade war and freedom of navigation operations, including in the Taiwan Strait. Trump’s National Security Adviser John Bolton and Assistant Defense Secretary Randall Schriver are seen as Taiwan hawks, while the just-concluded Republican Congress passed the Taiwan Travel Act and the Asia Reassurance Initiative Act (ARIA), which imply an upgrade to the U.S. commitment to Taiwan’s democracy and security.6 Chart 7 These three factors suggest that, cyclically, there is larger room than usual for incidents to occur that initiate a vicious cycle of tensions. The odds of a full-fledged war are still very low – the U.S. has reaffirmed the One China Policy in its recent negotiations with Beijing, which seem to be progressing, while China has not changed its official position on Taiwan. Beijing’s reunification timetable still has a comfortable 30 years to go. The Chinese economy has not collapsed, so there is no immediate need for Beijing to dive headlong into a nationalist foreign policy adventure that could bring on World War III. However, the odds of diplomatic incidents, or military saber rattling, that then trigger a dangerous escalation and a multi-month period of extremely elevated tensions are much higher than the market recognizes. This is because the U.S. and China may still see strategic tensions flare even if they make progress on a trade deal, while a failure on the trade front could spark a spillover into strategic areas. Any cross-strait incident would be relevant to global investors – and not just Taiwanese assets, which would suffer the brunt of economic sanctions – because the slightest increase in the odds of a full-scale war would be extremely negative for global risk appetite. Over the next 12 months, we would mostly expect Beijing to eschew high-profile provocations. The reason is that President Tsai is unpopular and the recent local elections in Taiwan saw her DPP lose seats to the more China-friendly Kuomintang (Chart 8). An aggressive posture could revive the DPP ahead of the January 2020 presidential election, the opposite of what Beijing wants.7 Chart 8 On the other hand, Beijing could decide to ignore the 1996 precedent and choose outright military intimidation. Or it could attempt to meddle in Taiwan’s domestic politics, as it has been accused of doing in the recent local elections.8 Meanwhile, the U.S. and Taiwan are the more likely instigators of an incident over these 12 months, knowingly or not. Washington and Taipei have a window of opportunity to achieve a few concrete objectives while Presidents Tsai and Trump are still in office – which cannot be guaranteed after 2020. A similar window of opportunity caused a market-relevant spike in China-South Korea tensions back in 2015-17, when the United States, seeing that the right-wing Park Geun-hye administration was falling out of power, attempted to rush through the deployment of the Terminal High Altitude Area Defense (THAAD) missile system in South Korea. As a result, China imposed economic sanctions on its neighbor (Chart 9). Chart 9China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Something similar could transpire over the next year if the U.S. sends a high-level official – say, Bolton, or Secretary of State Mike Pompeo, or even Vice President Mike Pence – to hold talks in Taiwan. Or if the U.S. stages a major show of force in the Taiwan Strait, as it threatened in October, or U.S. naval vessels call on Taiwanese ports. The U.S. could also announce bigger or better arms packages (Chart 10), such as submarine systems, which have been cleared by the Department of State. Given the elevated U.S.-China and China-Taiwan tensions overall, such an incident could cause a bigger escalation than the different participants expect – and even more so than the market currently expects. Chart 10U.S. Arms Sales To Taiwan Could Provoke Beijing U.S. Arms Sales To Taiwan Could Provoke Beijing U.S. Arms Sales To Taiwan Could Provoke Beijing Bottom Line: Cyclically, the period between now and the inauguration of the next Taiwanese president in May 2020 brings heightened risk of a geopolitical incident. Depending on what happens in 2020, tensions could rise or fall for a time. Yet structurally, as Sino-American strategic distrust continues to build, Taiwan will continually find itself at the center of the storm. Black Swan 2: Russia And Ukraine Agree To Go To War Tensions are mounting between Russia and Ukraine in the run-up to the March 31 Ukrainian presidential election. Incumbent President, Petro Poroshenko, has been trailing in the polls for a year. His rival is the populist Yulia Tymoshenko, who has been leading both first-round and second-round polling. Both Poroshenko and Tymoshenko have, at various points in their careers, been accused of being pro-Russian. Poroshenko’s business interests, as with most successful Ukrainian businesspeople, include considerable holdings in Russia. Tymoshenko, on the other hand, was imprisoned from 2011 to 2014 for negotiating a gas imports contract with Russia that allegedly hurt Ukrainian interests. With the most pro-Russian parts of Ukraine either cleaved off (Crimea) or in a state of lawlessness (Donetsk and Luhansk), the median voter in the country has become considerably more nationalist and anti-Russian. It therefore serves no purpose for any politician to campaign on a platform of normalizing relations with Moscow. In this context, the decision by the Patriarchate of Constantinople – the first-among-equals of the Christian Orthodox churches – to grant autocephaly (sovereignty) to the Orthodox Church of Ukraine in January is part of the ongoing evolution of Ukraine into an independent entity from Russia. This process could create tensions, particularly as parts of the country continue to be engaged in military conflict (Map 1). From Moscow’s perspective, the autocephaly grants Ukraine religious – and therefore some semblance of cultural – independence from Russia. This solidifies the loss of a 43-million person crown jewel from the Russian sphere of influence. Chart Moscow is also not averse to stoking tensions. Although President Putin’s mandate will last until 2024, his popularity is nearly at the lowest level this decade. Orthodox monetary and fiscal policy, along with pension reforms, have sapped his political capital at home. In 2014, tensions over Ukraine spurred nationalist sentiment in Russia, rapidly increased popular support for both Putin and his government (Chart 11). Putin may calculate that another such recapitalization may be needed. Chart 11Non-Negligible Risk Of Russian Aggression Non-Negligible Risk Of Russian Aggression Non-Negligible Risk Of Russian Aggression The danger is therefore that domestic politics in both Ukraine and Russia may create a window of opportunity for a skirmish this quarter. Perhaps something akin to the naval tensions around the Kerch Strait that ultimately cost President Putin a summit with President Trump at the G20 meeting in December. While these incidents may benefit both sides domestically, and may even appear carefully orchestrated, they could also get out of hand in unpredictable ways. Bottom Line: While both Kiev and Russia may see a short-termed conflict as domestically beneficial, such an outcome could have unforeseen consequences. At the very least, it could sap already poor business confidence in neighboring Europe, as it did in 2014-2015. Black Swan 3: Saudi Arabia With A Blank Cheque One of the greatest geopolitical blunders of the twentieth century was Berlin’s decision to give its ally Austro-Hungary a “blank cheque.” Austro-Hungary was an anachronism at the turn of the century – a multiethnic empire held together by allegiance to a royal family. As such, the ideology of nationalism represented an existential threat, particularly given that 60% of the empire’s population was neither Austrian nor Hungarian. Following the assassination of its crown prince Archduke Franz Ferdinand by a pan-Slavist terrorist in Sarajevo, Vienna decided that a total destruction of Serbia was necessary for geopolitical and domestic political reasons. Today, Saudi Arabia is in many ways an anachronism itself. It is the world’s last feudal monarchy. Its leaders understand the risks and have begun an ambitious and multifaceted reform effort. Unlike Austro-Hungary, Saudi Arabia has learned to embrace nationalism. Riyadh is using the war in Yemen, as well as targeted actions against its own royal family and the religious establishment, to build a modern nation-state. The problem is that, much as nationalism was an ideological kryptonite for Vienna, democratic Islamism is an existential problem for Riyadh and its peers among the Gulf monarchies. Neighboring Qatar, a tiny peninsular kingdom enjoying an oversized geopolitical influence due to its natural gas wealth, has supported various groups across the Middle East that believe that democracy and conservative Islam are compatible. Turkey and Qatar have often cooperated in this effort, as the ruling Justice and Development Party (AKP) of Turkey has served as a model for many such Islamist parties in the region. Why Qatar hitched its geopolitical wagon to democratic Islamism is not clear. Perhaps its leaders felt that it was the only option unclaimed by an energy-rich sponsor. Regardless, Qatar’s support of the Muslim Brotherhood and other such groups has clearly irked Saudi Arabia and other Gulf monarchies, enough for them to kick Qatar out of the Gulf Cooperation Council (GCC). In 2017, with the pro-Saudi Trump administration ascendant in the White House, Riyadh felt emboldened enough to break off all diplomatic relations with Qatar and impose an economic blockade. Since 2014, another dynamic has emerged in the region that raises further concerns: a scramble for material resources brought on by the end of +$100 per barrel oil prices. Saudi public expenditures have been steadily rising since 2008, both due to population growth, social welfare spending in the wake of Arab Spring rebellions, and astronomical defense spending to counter the rising influence of Iran. And yet, 2014 saw oil prices plunge to decade lows in a matter of months. Saudi Arabia’s fiscal breakeven oil price has doubled, in a decade, from under $40 per barrel to $83 per barrel in 2018 (Chart 12). Meanwhile, Qatar’s GDP is a quarter of that of Saudi Arabia, even though its population is less than 2% of Saudi Arabia’s. Chart 12Saudi Arabia Has A Fiscal Problem Saudi Arabia Has A Fiscal Problem Saudi Arabia Has A Fiscal Problem Rumors that the U.S. Defense Secretary James Mattis prevented a Saudi invasion of Qatar in 2018 have largely been dismissed by the mainstream media. But should they be? If allegedly “rogue elements” of the Saudi intelligence establishment can dismember a journalist in a consulate, why couldn’t “rogue elements” of its military stage a coup – or an outright invasion – in neighboring Qatar? Such an outcome would truly be extraordinary, but so was the annexation of Crimea in 2014. Meanwhile, President Trump offered an extraordinary level of support for Riyadh by issuing what we can only refer to as a “blank cheque” following Khashoggi’s murder. In the November 20 statement, President Trump essentially created a new policy doctrine of standing with Saudi Arabia “no matter what.”9 Two weeks later, Riyadh “thanked” the U.S. President by slashing the OPEC oil output by 1.2 million barrels per day. From this dynamic, it appears that Washington has made a similar strategic blunder in 2018 that Berlin did in 1914. A weakened, stressed, and threatened ally has been given a “blank cheque” by its stronger ally. Such a sweeping offer of support may lead to unintended consequences as the weaker ally feels that its material and geopolitical constraints can be overcome. In Saudi Arabia’s case, that could mean a more aggressive policy towards Qatar, or perhaps Iran. Particularly now that the White House has seen several realist members of the Trump cabinet – such as Mattis and former Secretary of State Rex Tillerson – replaced by Iran hawks and Trump loyalists. Bottom Line: A combination of less independent-minded cabinet members in the White House and a clear “blank cheque” from President Trump to Saudi Arabia could cause geopolitical risk to re-emerge in the Middle East. In the near term, this could increase the geopolitical risk premium on oil prices – as measured by the residual in Chart 13. Chart 13 Black Swan 4: The Balkans Become A Powder Keg … Again Bismarck famously said in 1888 – 26 years before the outbreak of the Great War, that “one day the great European War will come out of some damned foolish thing in the Balkans.” The Balkans are far less geopolitically relevant today than in the early twentieth century. They are also exhausted following a decade-long Yugoslav rigor mortis in the 1990s which yielded at least three regional wars and now six (or seven, depending who is counting) independent states. The problem is that tensions have not disappeared. Two frozen conflicts remain. First, Bosnia and Herzegovina is a sovereign country made up of two political entities, with the Serb-dominated Republika Srpska agitating for independence and aligning with Russia. Second, tensions between Serbia and Kosovo took a turn for the worse late last year as Kosovo imposed an economic embargo on trade with Serbia and called for the creation of a military. Has anything really changed over the course of the decade? We think there are three causes for alarm: Tensions between Russia and the West have become serious, with both camps looking to score tactical and strategic wins across the globe. With the Syrian Civil War all but over, a new battleground may emerge. While Republika Srpska is essentially an outright ally of Russia, Serbia continues to try to straddle the fine line between an EU enlargement candidate and geopolitical neutrality. However, this high-wire act is becoming untenable as… Enlargement fatigue sets in the EU. There is no doubt that the EU enlargement process froze Balkan conflicts. Countries like Serbia and Kosovo have an incentive to be on their best behavior so long as the prospect of eventual EU membership remains. But in the current environment of introspection, the EU may not have enough of a coherent geopolitical vision to deal with the Balkans without a crisis. The global economic cycle may be ending, leading to a global recession in the next 12-to-24 months. While our BCA House View remains that the next recession will be a mild one in the U.S., we think that EM and, by extension, frontier markets could be the eye of the storm in the next downturn. As investors abandon their “search for yield” in riskier geographies, they could exacerbate poor governance, political tensions, and geopolitical cleavages that have been frozen in place by the last economic cycle. Finally, U.S. policy towards the Balkans is unclear. In the past, the U.S. asked all countries in the region to accept the status quo and prepare for EU integration. But with the U.S. now adopting an antagonistic view towards the EU bloc, it is unclear what Washington’s message to the Balkans will be. After all, Trump has personally encouraged all other world leaders to don their own version of the “America First” slogan. The only problem in a place like the Balkans is that “Serbia first” – or Croatia and Kosovo first – is unlikely to go down smoothly in the neighborhood, given the last twenty – or even hundred – years. Bottom Line: The powder keg that is the Balkans has not been dried for decades. However, several tailwinds of stability are gone, replaced with macro headwinds. A renewed conflict on Europe’s doorstep could be the next great geopolitical crisis. If this were to occur, we would bank on greater European integration, especially in terms of military and foreign policy. However, it could also mark the first break in U.S.-EU foreign policy if the two decide to pick opposing sides in the region. Black Swan 5: Lame Duck Trump For our final Black Swan, we are sticking with one of our 2018 choices: a “Lame duck” presidency. “Lame duck” presidents – leaders whose popularity late in their terms have sunk so low that they can no longer affect policy – are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.10 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents can seek relevance abroad. President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains strong (Chart 14), his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 15). Now there is also a Democrat-led House of Representatives to stymie his domestic policy and launch independent investigations into both his administration’s conduct and his personal finances and dealings. Chart 14 Chart 15 We would also add the Senate to the list of problems for President Trump. The electoral math was friendly towards the Republicans in 2018, with Democrats defending 10 Senate seats in states that President Trump won in 2016. In 2020, however, two-thirds of the races will be for Republican-held seats. As such, many Republican senators may begin campaigning early by moving away from President Trump. What kind of adventures would we expect to see President Trump embark on in 2019? Last year, we identified “China-U.S. trade war,” “Iran jingoism,” and “North Korea” as potentials. In many ways, 2018 was the year when all three mattered. Going forward, however, we think that trade war and the Middle East might take a backseat. First, the bear market in equities has raised the odds of a recession. As such, the potential cost of pursuing the trade war further has been increased. So has an aggressive policy towards Iran that dramatically boosts oil prices. Furthermore, President Trump has signaled that he is willing to withdraw from the Middle East, calling for a full withdrawal from Syria and telegraphing one from Afghanistan. Instead, we see President Trump potentially following in the footsteps of previous U.S. administrations and finding relevance in Latin America. A military intervention in Venezuela, to ostensibly support a coup against the current regime, would find little opposition domestically. First, there is no doubt that Venezuela has become a genuine humanitarian disaster. Second, its oil output is on a downward spiral already, with only 1 million b/d of production at risk due to a potential military conflict (Chart 16). Third, the new Bolsonaro administration in Brazil may even support an intervention, as well as neighboring Colombia. This is a change from the last twenty years, in which Latin American countries largely stuck together, despite ideological differences, in opposition to U.S. interference in the continent’s domestic affairs. Chart 16On A Downward Spiral On A Downward Spiral On A Downward Spiral Finally, even the anti-Trump U.S. foreign policy establishment may support an intervention. Not only is there the issue of human suffering, but Russia and China have used Venezuela as an anchor to build out influence in America’s sphere of influence. Furthermore, the potential promise of Venezuela’s eventual energy production is another reason to consider an American intervention (Chart 17). Chart 17 Bottom Line: American presidents rarely decide to go softly into that good night. It is very difficult to see President Trump become irrelevant. With tensions with China carrying a high economic cost and military interventions in the Middle East remaining politically toxic in the wake of Iraq and Afghanistan wars, perhaps President Trump will decide to go “retro,” in the sense of a throwback Latin America intervention.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Please see, Blackstone, “Byron Wien Announces Ten Surprises For 2018,” dated January 2, 2018, available at blackstone.com. 2 A shoutout to another doyen of the financial industry, Alastair Newton! 3 Please see BCA Emerging Markets Strategy Special Report, “Deciphering Global Trade Linkages,” dated September 27, 2018, available at ems.bcaresearch.com. 4 Please see “Highlights of Xi’s speech at Taiwan message anniversary event,” China Daily, January 2, 2019, available at www.chinadaily.com.cn; and “President Tsai Issues Statement On China’s President Xi’s ‘Message To Compatriots In Taiwan,’” Office of the President, Republic of China (Taiwan), January 2, 2019, available at english.president.gov.tw. 5 Please see Xi Jinping, “Secure a Decisive Victory in Building a Moderately Prosperous Society in All Respects and Strive for the Great Success of Socialism with Chinese Characteristics for a New Era,” section 3.12, October 18, 2017, available at www.xinhuanet.com; and Deng Yuwen, “Is China Planning To Take Taiwan By Force In 2020?” South China Morning Post, July 20, 2018, available at beta.scmp.com. 6 Please see United States, H.R. 535, Taiwan Travel Act, 115th Congress (2017-18), available at www.congress.gov and S. 2736, Asia Reassurance Initiative Act of 2018, 115th Congress (2017-18), available at www.congress.gov. 7 This is precisely what occurred when China chose missile tests in 1995-96 and drove voters toward the very candidate, Lee Teng-hui, that Beijing least desired. The popular Taipei Mayor Ko Wen-je may run for president in 2020, and Beijing may see him as preferable to President Tsai. He has spoken of China and Taiwan as being part of the same family and he has held city-to-city talks between Shanghai and Taipei despite the shutdown in direct talks between Beijing and Taipei. 8 Please see Andrew Sharp, “Beijing likely meddled in Taiwan elections, US cybersecurity firm says,” Nikkei Asian Review, November 28, 2018, available at asia.nikkei.com. 9 Please see “Statement from President Donald J. Trump on Standing with Saudi Arabia,” The White House, dated November 20, 2018, available at whitehouse.org. 10 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him, while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the “surge” of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014.   Geopolitical Calendar