Geopolitics

Highlights So What? More downside to CNY/USD ahead. Why? The trade war is spilling into political and military arenas, making it harder to de-escalate and negotiate a trade deal. Official U.S. and Chinese rhetoric is increasingly antagonistic, reflecting once-in-a-generation policy shifts toward a new Cold War. Tensions will not subside after the U.S. midterm election - neither the U.S.-Mexico-Canada agreement nor any quick deals with Japan and the EU will speed up U.S.-China negotiations. Feature Clients know that BCA's Geopolitical Strategy has been alarmist on U.S.-China relations since we started as a service in 2012.1 This structural view is based on the long-term decline of U.S. power relative to China and the emergence of global multipolarity.2 However, the rise of General Secretary Xi Jinping in 2012 and President Donald Trump in 2016 have reinforced our view that "Sino-American conflict is more likely than you think."3 This includes military as well as economic conflict. Setting aside the risk of war, a geopolitical "incident" of some kind is becoming increasingly likely. As the two sides engage in brinkmanship, the probability of a miscalculation or provocation rises, and the probability of a grand new compromise falls. For investors, the takeaway is supportive of Geopolitical Strategy's current stance: long U.S. dollar, long U.S. stocks relative to DM, and long DM stocks relative to EM. We expect CNY/USD to fall further as markets question the ability to discount trade uncertainties via tariff rates alone (Chart 1). We continue to recommend a "safe haven" hedge of Swiss bonds and gold. Chart 1CNY/USD Has More Downside CNY/USD Has More Downside CNY/USD Has More Downside The risk is that China could respond to U.S. pressure by stimulating its economy aggressively. So far, the "China Play Index," devised by our Foreign Exchange Strategy, does not signal reflation. Nor do Chinese domestic infrastructure stocks relative to global, which our China Investment Strategy watches closely (Chart 2). Chart 2Small Stimulus Thus Far Small Stimulus Thus Far Small Stimulus Thus Far Trade Tensions Are Spilling Over A corollary of our view that U.S.-China tensions are secular and strategic in nature - i.e., not limited to the U.S. trade deficit - is the view that trade tensions will spill over into strategic areas, exacerbating those tensions and generating negative outcomes for investors exposed to the U.S.-China economic partnership.4 This strategic spillover is now taking shape. Since President Trump went forward with the second round of tariffs - 10% on $200 billion worth of imports, to ratchet up to 25% on January 1, 2019 - a series of negative events have taken place in U.S.-China relations (Table 1), culminating in the USS Decatur incident on September 30. Table 1Trade War Spills Into Strategic Areas A Global Show Of Force? A Global Show Of Force? The Decatur, an Arleigh Burke-class guided-missile destroyer, was conducting operations in the Spratly Islands in the South China Sea when it sailed within 12 nautical miles of Gaven and Johnson Reefs, which China claims as sovereign islands. At around 8:30am that Sunday morning, a Luyang-class destroyer from China's People's Liberation Army Navy "approached within 45 yards of Decatur's bow, after which Decatur maneuvered to prevent a collision," according to the U.S. Pacific Fleet spokesman. This was not an unprecedented incident in itself, but it came very close to a collision that could easily have resulted in a shipwreck, a full-blown U.S.-China crisis, and a global risk-off event in financial markets. The Decatur sailed close to the Chinese-claimed reefs because it was conducting a "Freedom of Navigation Operation" (FONOP) to assert the international right of free passage. A major point of contention between China and the U.S. (and between China and most of its neighbors and the western world) is that China claims outright sovereignty over about 80% of the South China Sea, including the Spratly Islands. In July 2016, the International Court of Arbitration ruled that none of the contested rocks and reefs in the sea qualify as islands and hence that they are not entitled to 12 nautical miles of "territorial" sea. China rejects this ruling and asserts sovereignty over the maritime features and much of the sea itself.5 In Diagram 1 we illustrate how a FONOP works based on a similar operation last year. The U.S. has conducted these operations for decades, but in late 2015 it began a series of FONOPs focusing on countering China's excessive claims in the South China Sea.6 This was also a way of opposing China's construction, reclamation, and "militarization" of the reefs under its possession. Diagram 1What Is A 'Freedom Of Navigation Operation'? A Global Show Of Force? A Global Show Of Force? It is not remotely a surprise that this year's trade tensions came close to exploding in the South China Sea. It is the premier geographic location of U.S.-China strategic friction: a hub for international trade; a vital supply route for all major Asian economies; and the primary focus of China's attempt to rewrite global rules (Diagram 2).7 The Appendix updates our list of clashes in this area. Diagram 2South China Sea As Traffic Roundabout A Global Show Of Force? A Global Show Of Force? The takeaway is that, far from capitulating to the Trump administration's trade demands, China is taking a more aggressive stance - and it is doing so outside the trade context. The U.S., for its part, has not diminished the significance of this incident, as it has often done on similar occasions.8 Instead, Vice President Mike Pence gave a remarkable speech at the Hudson Institute on October 4 in which he highlighted the Decatur, among a range of other "predatory" Chinese state-backed actions, to make a comprehensive case that China is a geopolitical rival seeking to undermine the United States and specifically the Trump administration.9 Pence's comments reflect a decision to "go public" with a shift in national strategy that has been developing in recent years, beginning - albeit tepidly - even in the Obama administration. A similar shift is underway in China - and has accelerated with the U.S.'s implementation of tariffs. Official Communist Party rhetoric increasingly characterizes the U.S. as an enemy whose real intention is to "contain" China's rise and has recently called for Chinese "self-reliance" in the face of U.S. sanctions.10 The two sides are bracing for conflict and are now seeking to mold public opinion more actively. Bottom Line: Investors should take note: markets were 45 yards away from a significant correction! The U.S.-China trade tensions are spilling outside of economic relations into political and military domains, as we expected. The South China Sea remains a hot zone that could be the setting of a geopolitical incident as tensions mount. What Is A Show Of Force? Notably, the U.S. military is said to be considering a "global show of force" during an unspecified week in November in order to deter China from its current policy trajectory. If this occurs, it will be market-relevant as it will be seen as a provocation by China and other U.S. rivals. A "show of force" is a formal military operation conducted by a nation with the purpose of demonstrating that it has both the will and the ability to use force in defense of its interests. It is fundamentally a political action, even though it utilizes military resources. The declared intention is to demonstrate resolve and prevent or deter an undesirable course of action by a rival state.11 Nevertheless, it is the equivalent of a dog baring its teeth and should not be taken lightly, especially when conducted by one major power against another. The U.S. holds shows of force fairly frequently. Over recent decades it has been the third most common type of operation for U.S. forces.12 However, for most of the past several decades, the U.S. conducted very few operations in the Asia Pacific not pertaining to the Vietnam War, and these were usually of limited length and intensity. They were often shows of force to deter North Korea from various acts of terrorism and sabotage. China was rarely involved - there was, for example, no U.S. deployment during the Tiananmen crisis. Nevertheless there are a few highly relevant precedents: By far the most important exception is the Third Taiwan Strait Crisis in 1996. This was a major show of force - and one whose shadow still hangs over the Taiwan Strait. In July 1995, Beijing launched a series of missile tests and military exercises, hoping to discourage pro-independence sentiment and dissuade the Taiwanese people from voting for President Lee Teng-hui - who was rightly suspected of favoring independence - ahead of the 1996 elections. The United States responded on March 1, 1996 by deploying two aircraft carriers, USS Nimitz and USS Independence, and various warships to the area. The Nimitz even sailed through the strait. Tensions peaked ahead of the Taiwanese election on March 23, 1996 - in which voters went against China's wishes - and the show of force concluded after 48 days on April 17. Of course, tensions simmered for years afterwards. The Taiwan incident was the only operation involving China in the 1990s, and the first to do so since a minor contingency operation upon the Chinese invasion of Vietnam in 1979. It is generally deemed successful in demonstrating U.S. commitment to Taiwan's security - but it also spurred a revolution in Chinese military affairs, such that China is today in a far better position to attack Taiwan than ever before.13 The market effects were pronounced: Chinese and Taiwanese equities sold off. American stocks were unaffected (Chart 3). Chart 3Naval Shows Of Force Can Rattle Markets Naval Shows Of Force Can Rattle Markets Naval Shows Of Force Can Rattle Markets The second major exception was the Hainan Island Incident, or EP-3 Incident. On April 1, 2001 a Chinese jet struck a U.S. EP-3 ARIES II signals reconnaissance plane in the skies over the South China Sea. The U.S. plane landed on China's island province of Hainan, where its crew was detained and interrogated for 10 days while their aircraft was meticulously disassembled. Ultimately the U.S. issued a half-hearted apology and the crew was released. This was a much smaller show of force than the third Taiwan crisis. The U.S. Navy positioned three destroyers in the area for two days. Chart 4A South China Sea Incident Helped Kill The Bull Market A South China Sea Incident Helped Kill The Bull Market A South China Sea Incident Helped Kill The Bull Market This incident marked the peak of the cycle in U.S. equities ex-tech (Chart 4). In China, both A-shares and H-shares experienced volatility before selling off in subsequent months (Chart 5, top panel). Chart 5Volatility And Selloffs Amid Asian Shows Of Force Volatility And Selloffs Amid Asian Shows Of Force Volatility And Selloffs Amid Asian Shows Of Force The Cheonan and Yeonpyeong Island incidents occasioned a show of force. On March 26, 2010 a North Korean miniature submarine conducted a surprise torpedo attack against the Cheonan, a South Korean Corvette, sinking it and killing 46 sailors. The U.S. intended to respond by positioning the USS George Washington in the Yellow Sea, but was intimidated from doing so by China's fiercely negative diplomatic reaction. Instead it deployed the carrier to the Sea of Japan. Later that year, however, after North Korea shelled Yeonpyeong Island and killed four South Koreans, the U.S. responded with a beefed up version of regular military drills, including the George Washington, for four days in the Yellow Sea. This incident is significant in showing how aggressively China will oppose demonstrations of American naval power in its near abroad. Unlike in 1996, China is today much better positioned to react to U.S. naval action in its neighborhood. If Beijing was so resistant to a U.S. show of force against North Korea in the wake of a North Korean attack, it will be even more resistant to a U.S. display of might in China's nearby waters aimed at China in response to what China views as a defense of maritime-territorial sovereignty. Chinese A-shares sold off, while H-shares were somewhat more resilient, during this episode (Chart 5, second panel). Fire and Fury: The United States' latest significant show of force occurred in 2017 when the navy positioned three aircraft carrier strike groups in the region to deter North Korean nuclear and missile tests and belligerent rhetoric against the United States. This action ultimately led to Chinese enforcement of sanctions and North Korean capitulation to U.S. demands. Chinese stocks only briefly sold off during this episode (Chart 5, third panel). However, the U.S. 10-year Treasury yield fell during the peak of tensions in the summer. So what about the global show of force that the U.S. is considering in November? Details on the specific operation under consideration are scant because they fall under a "classified proposal," written by members of the U.S. Navy's Pacific Command and only partially leaked to the press (apparently to coincide with Vice President Pence's speech).14 The proposal is still being discussed by the Joint Chiefs of Staff and the Intelligence Community, so nothing is final. From the information that is publicly available, it is highly significant that the proposed show of force is supposed to be "global" in range. It would reportedly involve a "series" of military missions on "several fronts," including the South China Sea, the Taiwan Strait, an unspecified area near Russia, and the west coast of South America. It would also involve multiple military services - the navy, the air force, the marines, and potentially cyber and space capabilities. While the various missions would reportedly be "concentrated" and "focused," implying that the U.S. wants to manage the escalation of tensions carefully, the locations that have been named are extremely sensitive. A show of force in the Taiwan Strait and South China Sea would be provocative enough. A simultaneous show of force against both China and Russia in today's context would be truly extraordinary.15 In short, if the report is accurate, the U.S. is contemplating a rare and provocative display of its global power projection capabilities. Why would the U.S. stage such a grand demonstration merely because of a taunt by a Chinese ship? The Decatur incident is only the proximate cause. Washington is in the midst of attempting a very dangerous "two-front war" against China and Iran, the latter of whom faces oil sanctions from November 4.16 Moreover, this is a "three-front war" if today's historically bad relations with Russia are taken into account. Indeed, the U.S. may well be responding to the joint show of force by Russian President Vladimir Putin and Chinese President Xi in their own large-scale military exercises in September, in which Chinese soldiers participated in a Russian drill outside the auspices of the Shanghai Cooperation Organization for the first time.17 As such, we would not put any stock in the idea that a sudden drop-off in geopolitical tensions, with China or anyone else, will occur after the U.S. midterm election on November 6. Rather, investors should expect an increase in geopolitical risk. There is no combination of midterm election results in which Trump will be forced to pull back on his "Maximum Pressure" doctrine. The proposal is not final, and the idea alone is a low-level threat that could be used in negotiations. But under the circumstances, we think it more likely than not that the U.S. will go forward with it. Ultimately, the U.S. proposal epitomizes our mega-theme of multipolarity. The U.S. is in relative decline and is reasserting itself with a muscular national security policy, particularly against China and Iran but also against Russia. However, its actions are highly unlikely to cause a change in China's behavior now that Beijing has determined that the U.S. is seeking Cold War-style strategic containment. Instead, China will hasten its efforts to become self-reliant and to deter U.S. aggression in its near abroad. Global economic policy uncertainty, and trade policy uncertainty, are likely to increase, not decrease, in such an environment. Saber-rattling and supply-chain risk will weigh on EM Asia in particular. Bottom Line: The U.S. government is contemplating an extraordinary "global show of force" that could involve a series of joint military operations across the globe. The chief focus is China, but the unknown array of operations could also target Russia or Iran. We think such operations are plausible and will increase global economic uncertainty. We would expect them to create volatility in global markets, adding to jitters over China tariffs (supply-chain risks) and Iranian sanctions (oil prices). How Will China Retaliate? China does not have the ability to respond proportionately to the U.S. - it cannot hold a global show of force of its own. Because its own shows of force will appear diminutive next to American fireworks, it may not react immediately. Beijing is more likely to respond by changing its policies to address the underlying increase in antagonism with the United States and improve its national security. We would classify its potential responses into two main groups: the low road and the high road. The low road consists of policies meant to confront the U.S. directly and forcefully. In our view, these policies bring significant costs that will make China reluctant to embrace them fully: Raise the stakes in the South China Sea: China could go for broke and deploy the full range of military assets in the islands that it has repurposed. This would provoke an even larger international naval response from the U.S. and its allies.18 Remove sanctions on North Korea: China could reverse sanctions enforcement on North Korea (Chart 6) and undermine President Trump's signature foreign policy overture. The problem is that China would then provide the U.S. with a pretext for an even greater military presence in Northeast Asia. Chart 6China Could Reverse Sanctions Enforcement China Could Reverse Sanctions Enforcement China Could Reverse Sanctions Enforcement Flout sanctions on Iran: China could subsidize Iran (Chart 7) in the hopes of helping to create a huge American distraction comparable to the second Iraq war. But this confrontation would threaten China with an oil shock and economic dislocation, an even greater conflict with the U.S., and the risk of regime change in Iran.19 Chart 7China Could Flout Iran Sanctions China Could Flout Iran Sanctions China Could Flout Iran Sanctions Punish U.S. companies: China could raise the pressure on U.S. companies doing business on its territory. The problem is that the U.S. has already demonstrated, through the ZTE affair this year, that it can inflict devastating reprisals against the tech champions on whom China's economic future depends (Chart 8). Chart 8U.S. Could Punish Chinese Tech Firms U.S. Could Punish Chinese Tech Firms U.S. Could Punish Chinese Tech Firms Thus China is most likely to take the "high road," i.e. seeking alternatives to the United States throughout the rest of the world: Chart 9China's Market Is Its Biggest Advantage China's Market Is Its Biggest Advantage China's Market Is Its Biggest Advantage Import more goods: China's greatest strength in winning friends is that its domestic demand remains relatively robust (Chart 9). China can substitute away from the U.S. by shifting to other developed markets. Emerging markets are becoming more connected with China and less so with the U.S. (Chart 10). Chart 10China's Trade Ties Grow, Ex-U.S. China's Trade Ties Grow, Ex-U.S. China's Trade Ties Grow, Ex-U.S. Maintain outward investment: China's outward investment profile is expanding rapidly (Chart 11), but there is potential for a negative political backlash - as has occurred in Malaysia.20 China will need to focus on improving relations with those countries where it expands investment, including in the Belt and Road Initiative (BRI).21 Chart 11China's Outward Investment Strategy: Priorities Over The Past Decade A Global Show Of Force? A Global Show Of Force? Court U.S. regional allies: Relations with South Korea have already improved; Shinzo Abe of Japan is soon to make a rare state visit to China; and trilateral trade talks between these three have revived for the first time since 2015 (Chart 12). Both the Philippines and Thailand currently have governments that are friendly to China. Beijing will need to ensure that its growing trade surpluses do not get out of whack. Chart 12Can China Court U.S. Allies? Can China Court U.S. Allies? Can China Court U.S. Allies? Sign multilateral trade pacts: China is trying to position itself as a leader of free trade. This is a tough sell, but a successful completion of negotiations on the Regional Comprehensive Economic Partnership (RCEP) will generate some momentum. This Asia Pacific trade grouping is far larger in terms of total imports than its more sophisticated rival, the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the latter being shorn of U.S. participation (Chart 13). Chart 13RCEP Is Bigger Than CPTPP RCEP Is Bigger Than CPTPP RCEP Is Bigger Than CPTPP Play nice in the South China Sea: Now that the U.S. is proposing to push back against Chinese militarization of the islands, it makes sense for China to take a conciliatory approach. It is proposing joint energy exploration with the Philippines and others at least as long as offshore activity is depressed (Chart 14). China might also try to settle a diplomatic "Code of Conduct" for the sea with its neighbors. Chart 14A Reason For China To Play Nice A Reason For China To Play Nice A Reason For China To Play Nice The most important consequence is an alliance with Russia, whether formal or not. The security agenda of these two powers is increasingly aligned with their robust economic partnership (Chart 15).22 The differences and distrust between them cannot override their need to guard themselves against a more assertive United States. Chart 15Embrace Of Dragon And Bear Embrace Of Dragon And Bear Embrace Of Dragon And Bear Bottom Line: China's "high road" strategies are its best options when more aggressive options have higher risks of undermining China's own long-term interests. But an alliance with Russia is quickly becoming inevitable. Investment Implications A global show of force targeting China's "core interests" in Taiwan and the South China Sea will make trade negotiations even more difficult. China is not going to offer concessions when facing U.S. military intimidation in addition to tariffs.23 Investors should watch closely for any signs that nationalist protests and boycotts of U.S. goods are developing in China. Such a movement would not be allowed to continue for long without the Communist Party condoning it. A boycott would mark a form of retaliation that is much more impactful than tariffs. A deterioration in cultural ties is also in the cards. The United States is reported to be considering restrictions on Chinese student visas after intelligence assessments of non-traditional technological and intellectual property theft via graduate students in advanced programs such as artificial intelligence and quantum computing.24 U.S. markets remain insulated today, as in the last big rupture in U.S.-China relations in 1989, so we continue to expect U.S. equities to outperform Chinese (and global) stocks amid trade tensions and saber-rattling. Chart 16Last U.S.-China Crisis Prompted Stimulus... Last U.S.-China Crisis Prompted Stimulus... Last U.S.-China Crisis Prompted Stimulus... However, an important takeaway from the 1989 episode is that China stimulated the economy (Chart 16). This time we think stimulus will remain lackluster, reflecting Xi's need to keep overall leverage contained (Chart 17). But conflict escalation with the U.S. is clearly the biggest risk to this view. Chart 17...But Stimulus Muted Thus Far ...But Stimulus Muted Thus Far ...But Stimulus Muted Thus Far One oft-discussed retaliatory option is that China could sell off its vast $1.17 trillion holdings of U.S. treasuries. Rapidly dumping them is not effective, but slowly tapering is precisely what China has been doing since 2011 (Chart 18). This will accelerate its need to invest in real assets abroad and to purchase alternative reserve currencies, such as the euro, pound, and yen. Chart 18China Weans Itself Off Treasuries China Weans Itself Off Treasuries China Weans Itself Off Treasuries Ultimately, the significance of Vice President Pence's speech is that the U.S. now views China as both a great power and a threat to U.S. supremacy. This raises the potential for a large share of the $33 billion in cumulative U.S. direct investment in China since 2006 to become, effectively, stranded capital (Chart 19). If that is indeed the case, it would mean that investors in S&P 500 China-exposed companies would have to take note and re-rate their investments. Companies with significant investment in China may have to make capital investments in alternative supply-chain options, leading to a significant hit to their profit margin. Chart 19Stranded Capital In China? A Global Show Of Force? A Global Show Of Force? Other countries in Europe and the rest of Asia stand to benefit from the U.S. getting squeezed out of China's market, unless and until the new Cold War forces them to choose sides. Their choice is by no means a foregone conclusion, underscoring that China's policy response will be to seek better bonds with its neighbors and non-U.S. partners. Over the longer term, we think that our mega-theme of multipolarity will produce the bifurcation of capitalism. Within each sphere of influence globalization will continue to operate, but between spheres, or in the border areas, it will become a much less tidy affair. In addition to our recommendations above on page 2, we are reinitiating our short U.S. S&P 500 China-exposed stocks relative to the broad market. These companies have sold off heavily in recent months but the negative backdrop suggests that there is farther to go. Housekeeping On a separate note, BCA's Geopolitical Strategy is closing our long U.S. high-tax rate basket relative to S&P 500 trade for a gain of 8.26%. This was a play on the Trump tax cuts that we initiated in April 2017. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, and "The Looming Conflict In The South China Sea," May 29, 2012, available at gps.bcaresearch.com. 8 Comparable incidents in December 2013, August 2014, May 2016, December 2016, August 2017, and March 2018 did not receive such a high-level response from U.S. leaders, reflecting both the seriousness of the Decatur incident and the administration's sense of political expediency amidst the trade conflict and midterm election cycle. 9 Pence criticized Chinese President Xi by name for allegedly breaking his word on the militarization of the Spratly Islands. He suggested that China's outward investment should be understood in strategic rather than economic terms, implying that the Belt and Road Initiative is a Soviet-style plan to organize a "bloc" of nations under Chinese hegemony. And he hinted at a new defense of the Monroe Doctrine in his criticism of China's recent assistance to the collapsing socialist regime in Venezuela. Please see the White House, "Remarks by Vice President Pence on the Administration's Policy Toward China," dated October 4, 2018, available at www.whitehouse.gov. 10 The Trump administration's key document is Secretary of Defense James Mattis, "Summary of the 2018 National Defense Strategy of the United States of America," Department of Defense, 2018, available at dod.defense.gov. For the Xi administration, see Orange Wang and Zhou Xin, "Xi Jinping says trade war pushes China to rely on itself and 'that's not a bad thing,'" South China Morning Post, dated September 26, 2018, available at www.scmp.com; and the Information Office of the State Council, "The Facts and China's Position on China-US Trade Friction," September 2018, available at www.chinadaily.com. 11 For this discussion of shows of force please see W. Eugene Cobble, H. H. Gaffney, and Dmitry Gorenburg, "For the Record: All U.S. Forces' Responses to Situations, 1970-2000 (with additions covering 2000-2003)," Center for Strategic Studies, May 2005, available at www.dtic.mil. 12 See footnote 11 above. 13 Please see William S. Murray, "Asymmetric Options for Taiwan's Defense," Testimony before the U.S.-China Economic and Security Review Commission, June 5, 2014, available at www.uscc.gov. 14 Please see Barbara Starr, "US Navy proposing major show of force to warn China," dated October 4, 2018, available at www.cnn.com. 15 Even the South American location implies that Chinese, Russian, and Iranian influence on that continent is now deemed meaningful enough to require a reassertion of the Monroe Doctrine. Over the past decade, the U.S. has tended to regard these activities as limited, but now that may be changing. 16 Please see BCA Geopolitical Strategy Special Report, "2019: The Geopolitical Recession?" dated October 3, 2018, available at gps.bcaresearch.com. 17 Please see "Russia Holds Massive War Games, As Putin And Xi Tout Ties," Radio Free Europe, Radio Liberty, September 11, 2018, available at www.rferl.org. 18 Australia, Japan, and the U.K. have already begun enforcing freedom of navigation alongside the U.S. 19 The U.S. could also impose secondary sanctions on China for non-compliance. State-owned energy firm Sinopec, for instance, was said to be reducing imports of crude from Iran by half in the month of September. Our Commodity & Energy Strategy notes that Chinese refiners, like other Asian refiners, are preparing to run more light-sweet crude from the U.S. in the future, which gives a good yield in high-value-added products like gasoline. So far China has not imposed retaliatory tariffs on these imports from the U.S. Please see Chen Aizhu and Florence Tan, "China's Sinopec halves Iran oil loadings under U.S. pressure: sources," Reuters, dated September 28, 2018, available at uk.reuters.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 21 Please see BCA Emerging Markets Strategy Special Report, "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?" dated September 13, 2017, available at ems.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, and "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 23 Xi Jinping's refusal to meet with Secretary of State Mike Pompeo over the past weekend, and decision to visit North Korea for the first time in his term, underscores this point. 24 Please see Demetri Sevastopulo and Tom Mitchell, "US considered ban on student visas for Chinese nationals," Financial Times, dated October 2, 2018, available at www.ft.com. Appendix Notable Clashes In The South China Sea (2010-18) A Global Show Of Force? A Global Show Of Force? Notable Clashes In The South China Sea (2010-18) (Continued) A Global Show Of Force? A Global Show Of Force? Notable Clashes In The South China Sea (2010-18) (Continued) A Global Show Of Force? A Global Show Of Force?

Jair Bolsonaro, an ex-army captain and a right-leaning, law-and-order candidate has won a surprising victory in the first round of the Brazilian presidential election (Chart I-1). Bolsonaro came within striking distance of 50%, but did not cross that threshold, which means that the second round will go ahead on October 28. Given that he only needs another 4% to gain a majority of votes, his victory in the second round is now the most likely outcome by far. Importantly, the results of the congressional election similarly saw a swing to the right in both legislative houses. Chart I-1Bolsonaro Outperformed In The First Round Brazil: A Regime Shift? (Special Report) Brazil: A Regime Shift? (Special Report) What are the prospects for pro-market structural reforms amid this apparent regime shift in Brazilian politics? How should investors be positioned over the coming months? In the short term, a Bolsonaro presidency will boost business and market sentiment. This is mainly due to the right-leaning balance of parties in Congress and hence Bolsonaro's ability to form a majority coalition. This should lead to an outperformance of Brazilian assets relative to EM on expectations of reforms being passed and implemented. BCA's Emerging Markets Strategy service recommends upgrading Brazil to an overweight within EM equity, credit, and local fixed-income portfolios. However, in the longer term, we expect that Bolsonaro's presidency will still be constrained on social security reforms. It is still not clear if Brazil's median voter is demanding the kind of policies touted by Bolsonaro's economic advisors. Given Bolsonaro's populism, he may not be willing to expend his political capital on painful and unpopular reforms. In light of this, investors with a 2-5 year horizon should be wary of increasing their absolute exposure to Brazilian assets. Private investors looking for long-term exposure to Brazil should be especially concerned about Bolsonaro's anti-democratic, pro-military inclinations. A New Political Regime... Bolsonaro outperformed expectations in the first round by winning 46% of the popular vote, soundly beating his main rival Fernando Haddad of the left-wing Worker's Party. Polls over the past few weeks had seen him pegged at around 30%. Yet, Sunday night's results showed Bolsonaro beating all pollsters' expectations and nearly gaining the victory in the first round. Table I-1First Round Turnout Was Low In Contrast To Pass Elections Brazil: A Regime Shift? (Special Report) Brazil: A Regime Shift? (Special Report) Notably, and in contrast to previous elections, overall turnout for the first round was low, standing at just 79% (Table I-1). This played into Bolsonaro's hands. Even though there will be strategic voting in the second round - and our expectation is that most left-leaning voters will switch to Haddad, the remaining left-wing candidate - Haddad's chances look slim. He needs a mass wave of Lula supporters to turn out for the vote. The fact that they did not in the first round bodes ill for him. Thus, Bolsonaro stands at strong odds of becoming Brazil's next president. Attention will turn to the mandate that Bolsonaro will receive over the next four years. In our view, the factors below will be key: Short-term constraints have fallen off: The surprising surge in right-leaning parties at the congressional level suggests that President Bolsonaro will have no immediate legislative constraints to his agenda. He will be free to pursue his policy preferences relatively unimpeded. Chart I-2Chamber Of Deputies Results Brazil: A Regime Shift? (Special Report) Brazil: A Regime Shift? (Special Report) This is due to both legislative houses shifting towards the right, giving Bolsonaro a mandate to form a majority right-wing government for the first time since 1998 (Chart I-2). So far, 63% of seats in the lower house have gone to center-right and right-wing parties (according to our back-of-the-envelope calculation). If all of these parties joined into a coalition it would represent a historically strong mandate. Markets will surely interpret this as a positive development. However, not all of these parties will necessarily join Bolsonaro. Moreover, reforms requiring a constitutional amendment, such as the all-important reform of Brazil's unsustainable pension system, would require a supermajority of 308 out of 513 seats (60%) in the lower house. Historically, this has proven difficult, and it will be especially tricky for a president with no executive experience, little legislative record, and who denounces the use of pork-barrel spending.1 Otherwise, Congress can ultimately be cajoled into following Bolsonaro. As such, for the first time since Lula's first election (2002 to 2006), the Brazilian president is well-positioned to pursue his agenda. Bolsonaro will likely initiate some easy supply-side policies like cutting corporate taxes and red tape for businesses. Besides, business sentiment could surge due to the emergence of a business-friendly government. Hence, Bolsonaro has some short-term, easy "boosters" before the long-term challenges resurface. Long-term constraints uncertain: Despite the above, the pace of reforms will be slow given that Bolsonaro is, in the end, a populist who will want to maintain power above all. We continue to doubt Bolsonaro's willingness and ability to pursue social security reforms. We suspect that the vast majority of his voters chose to cast their ballot due to his law-and-order agenda that included a focus on battling crime and corruption. His economic advisor, Paulo Guedes, spent more time touting his reformist credentials in foreign financial publications than on the campaign trail. As such, it is difficult to conclude that Bolsonaro actually has a strong mandate for painful pension reforms. Polls ahead of the election suggest that only 4% of the public wants pension reforms (Chart I-3). Chart I-3Brazil's Population Is Not Open To Fiscal Austerity Brazil: A Regime Shift? (Special Report) Brazil: A Regime Shift? (Special Report) Chart I-4The J-Curve Of Structural Reform Brazil: A Regime Shift? (Special Report) Brazil: A Regime Shift? (Special Report) That said, we are open-minded and willing to be proved wrong. If Bolsonaro supports very dramatic reforms in his first 12 months in office, when his political capital is strongest, he could pull through despite the likely opposition from the median voter. As our J-Curve Of Structural Reform suggests, Bolsonaro can survive the "danger zone" if he pushes ahead with painful reforms right away (Chart I-4). He will start with sufficient political capital to do so. For long-term investors, the chief question is this: Is Bolsonaro a Brazilian Ronald Reagan or merely a Brazilian Rodrigo Duterte? Judging from everything he himself - not his advisors - has said in the past and on the campaign trail, we would bet on the latter. ...But The Same Economic Problems Brazil is getting a new government, but the macro economic challenges remain the same. Namely, ballooning public debt, still high interest rates and an unsustainable pension system (Chart I-5). As discussed above, it is not evident that Bolsonaro will strive to enact major cuts in the social security system that would be very unpopular. Apart from pensions and privatization, other choices to tackle the unsustainable public debt dynamics include reducing interest rates and boosting nominal growth (Chart I-6). Bolsonaro's economic team has repeatedly discussed the need to reduce high interest rates. Chart I-5Much Needed Pension Reform! Much Needed Pension Reform! Much Needed Pension Reform! Chart I-6Brazil's Macro Distortions Brazil's Macro Distortions Brazil's Macro Distortions   Chart I-7The Real Is Still At Risk Of Depreciation The Real Is Still At Risk Of Depreciation The Real Is Still At Risk Of Depreciation Rapid and large interest rate cuts by the central bank will help to service the public debt given that 96% of public debt is in local currency. Yet, lower interest rates could put pressure on the currency to depreciate - the interest rate differential between Brazil and the U.S. is at all-time lows (Chart I-7). Meanwhile, a weaker currency is needed to increase nominal growth. Notably, extremely low inflation and weak nominal growth have worsened the nation's public debt dynamics in recent years. Overall, lower policy rates and currency devaluation are required to reflate Brazil out of a public debt trap. If the exchange rate stabilizes in the short run as foreign investors come back to Brazil, the central bank will reduce interest rates considerably. Lower borrowing costs in combination with a sharp rise in business confidence and existing pent-up investment demand will propel capital spending, employment and overall growth. In short, these are necessary conditions for Brazilian markets to outperform their EM peers, i.e., for relative outperformance. As to absolute performance, it also depends on the outlook for global markets. In a complete global risk-off mode (the odds of which are considerable at the moment) - in which EM currencies and risk assets continue rioting and U.S. share prices drop - it will be difficult for Brazilian risk assets to rally meaningfully. That said, they will still outperform their EM peers. In the long run, pursuing policies of lower-than-needed interest rates and, hence, of chronic currency depreciation appears to be more palatable to Bolsonaro's populist credentials than difficult structural reforms. Therefore, investors who look to commit long-term capital to Brazil should mind the exchange rate. Populist policies favoring nominal growth in the long run lead to chronic currency depreciation. Bottom Line: Bolsonaro's election and his initial policies will be cheered by markets and will help Brazilian markets to outperform their EM peers for now. However, Bolsonaro is a populist and in the long term will choose economic policies that favor high nominal growth and, thereby, warrant chronic currency depreciation. Investment Recommendations Chart I-8Overweight Brazilian Assets Relative To EM Overweight Brazilian Assets Relative To EM Overweight Brazilian Assets Relative To EM In terms of market recommendations, we have the following: For EM dedicated portfolios, we recommend upgrading Brazil to overweight within the equity, credit, and local currency bonds universes (Chart I-8). BCA's Emerging Market Strategy service is taking a 14% profit on its structural short BRL versus USD position. Also, we are closing the short BRLMXN and short BRLARS trades with a 12% gain and a 5.7% loss, respectively. We also recommend closing the short Brazilian bank stocks trade initiated on May 16, 2018, as its return is now flat due to the recent rebound over the past few days. Absolute performance of Brazilian risk assets is contingent on global financial markets sentiment and at the moment odds of global risk off are considerable. This could cap the rally in Brazilian risk assets for now. Long-term investors should realize that timing Brazilian markets in general, and the exchange rate in particular, will be critical to protect gains. We believe that the path of least resistance for Bolsonaro and his team will be to depreciate the currency and engender nominal GDP growth in order to inflate away the country's public debt. This is a smart strategy for which they have a political mandate. But it will be a death-knell for foreign investors with major positions in the country.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 In late 1998, for instance, even President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999.  

Highlights So What? Go long Brent / short S&P 500. The risk of a recession in 2019 is underappreciated. Why? The likelihood is increasing of a geopolitically-induced supply-side shock that pushes crude prices above $100 per barrel in the coming 6-12 months. Oil supply disruptions in Iran, Iraq, and Venezuela represent the primary source of risk. Historically, the combination of Fed rates hike and an oil price spike has preceded 8 out of the last 9 recessions. Also... A recession in 2019, ahead of the 2020 election, would set the stage for a confrontation between Trump and the Fed, adding fuel to market volatility. Feature Geopolitical tensions are brewing from the Strait of Hormuz to the Strait of Malacca. As we go to press, news is breaking that a Chinese naval vessel almost collided with the USS Decatur as the latter conducted "freedom of navigation" operations within 12 nautical miles of Gaven and Johnson reefs in the Spratly Islands. Given the trade tensions between China and the U.S., this alleged maneuver by the Chinese vessel suggests that Beijing is not backing off from a confrontation. Our view remains that Sino-American trade tensions can get a lot worse before they get better. The latest incident, which builds on a series of negative gestures recently in the South China Sea, suggests that both sides are combining longstanding geopolitical tensions with the trade war. This will likely encourage brinkmanship and further degrade U.S.-China relations. Yet China-U.S. tensions are not the only concern for investors in 2019. Another crisis is brewing in the Middle East, with the potential to significantly increase oil prices over the next 12 months. U.S. households may have to deal with a double-whammy next year: higher costs of imported goods as the U.S.-China trade war rages on and a significant increase in gasoline prices. In this report, we discuss this dire outlook. The Folly Of Recession Forecasting In mid-2017, BCA Research published two reports, one titled "Beware The 2019 Trump Recession" and another titled "The Timing Of The Next Recession."1 Both argued that if the Federal Reserve kept raising rates in line with the FOMC dots, then monetary policy would move into restrictive territory by early 2019 and increase the likelihood of recession thereafter. We subsequently adjusted the timing of our recession forecast to 2020 or beyond, based on a more positive assessment of the U.S. economy. In this report, we explore a risk to the BCA House View on the timing of the next recession. As BCA's long-time Chief Economist Martin Barnes has said, predicting recessions is a mug's game. There have been eight recessions in the past 60 years (excluding the brief 1980-81 downturn) and the Fed failed to forecast all of them (Table 1). Table 1Fed Economic Forecasts Versus Outcomes 2019: The Geopolitical Recession? 2019: The Geopolitical Recession? The Atlanta Fed produces a recession indicator index which is designed to highlight the odds of recession based on trends in recent GDP data. At the moment, the indicator is at a historically sanguine 2.4%. Unfortunately, low readings are not a reliable cause for optimism. The 1974-75, 1981-82, and 2007-09 recessions were all severe and the Atlanta Fed's recession indicator had a low reading of 10%, 1.6%, and 7.7%, respectively - just as the recession was about to begin (Chart 1). Chart 1The Market Is Not Expecting A Recession The Market Is Not Expecting A Recession The Market Is Not Expecting A Recession The 1974-75 recession is instructive, given the numerous parallels with the current environment: Energy Geopolitics: The 1973 oil crisis caused a massive spike in crude prices. This point is especially pertinent since the 1973 oil embargo is widely viewed as an important contributor to the 1974-75 recession. Real short rates had risen and the yield curve had inverted long before oil prices spiked, so recession was almost inevitable even without the oil price move. But the oil spike made the recession much deeper than otherwise. Protectionism: President Nixon imposed a 10% across-the-board tariff on all imports into the U.S. in 1971 to try to force trade partners to devalue the U.S. dollar. Dislocation: Competition from newly industrialized countries - Japan and the East Asian tigers in particular - laid waste to the steel industry in the developed world. Polarization: President Nixon polarized the nation with both his policies and behavior, leading to his resignation in 1974. Given the exogenous and geopolitical nature of oil supply shocks, today's recession indicators are missing a critical potential headwind to the economy. A geopolitically induced oil-price shock could create more pain than the economy is able to handle. Why An Oil Price Shock? America's renewed foray into the politics of the Middle East will unravel the tenuous equilibrium that was just recently established between Iran and its regional rivals. The U.S.-Iran détente that produced the signing of the 2015 Joint Comprehensive Plan of Action (JCPA) created conditions for a precarious balance of power between Israel and Saudi Arabia on one side, and Iran and its allies on the other side. This equilibrium led to a meaningful change in Tehran's behavior, particularly on the following fronts: The Strait of Hormuz: Tehran ceased to rhetorically threaten the Strait as soon as negotiations began with the U.S. (Chart 2). Since then, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities remain unchanged.2 Iraq: Iran directly participated in the anti-U.S. insurgency in Iraq. Tehran changed tack after 2013 and cooperated closely with the U.S. in the fight against the Islamic State. In 2014, Iran acquiesced to the removal of the deeply sectarian, and pro-Iranian, Prime Minister Nouri al-Maliki. Bahrain and the Saudi Eastern Province: Iran's material and rhetorical support was instrumental in the Shia uprisings in Bahrain and Saudi Arabia's Eastern Province in 2011 (Map 1). Saudi Arabia had to resort to military force to quell both. Since the détente with the U.S. in 2015, Iranian support for Shia uprisings in these critical areas of the Persian Gulf has stopped. Chart 2Geopolitical Crises And Global Peak Supply Losses 2019: The Geopolitical Recession? 2019: The Geopolitical Recession? Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate 2019: The Geopolitical Recession? 2019: The Geopolitical Recession? Put simply, the 2015 nuclear deal traded American acquiescence toward Iranian nuclear development in exchange for Iran's cooperation on a number of strategically vital regional issues. By unraveling that détente, President Trump is upending the balance of power in the Middle East and increasing the probability that Iran retaliates. Since penning our latest net assessment of the U.S.-Iran tensions in May, Iran has already retaliated.3 Our checklist for "kinetic" conflict has now risen from zero to at least 15%, if not higher (Table 2). We expect the probability to rise once the U.S. starts implementing the oil embargo in November. This will dovetail our Iran-U.S. decision tree, which sets the subjective probability of kinetic action by the U.S. against Iran at a baseline of 20% (Diagram 1). Table 2Will The U.S. Attack Iran? 2019: The Geopolitical Recession? 2019: The Geopolitical Recession? Diagram 1Iran-U.S. Tensions Decision Tree 2019: The Geopolitical Recession? 2019: The Geopolitical Recession? Bottom Line: The premier geopolitical risk to investors in 2019 is that President Trump's maximum pressure tactic on Iran spills over into Iraq, causing a loss of supply from the world's fifth-largest crude producer.4 We expect the U.S. oil embargo against Iran to remove between 1 million and 1.5 million barrels per day from the market. In addition, the loss of Iraqi production due to sabotage could be anywhere between 500,000 and 3.5 million barrels per day. Added to this total is the potential loss of Venezuelan exports due to the deteriorating situation there. When our commodity team combines all of these factors, they generate a worst-case scenario where the price of crude rises to $110 per barrel in 2019 or higher (Chart 3). And this scenario assumes that EMs do not reinstitute energy subsidies (and therefore their consumption falls faster than if they do reinstitute them). Chart 3Worst-Case Scenario Propels Oil Price Toward 0/Barrel Worst-Case Scenario Propels Oil Price Toward $110/Barrel Worst-Case Scenario Propels Oil Price Toward $110/Barrel The Ayatollah Recession We believe that the midterm election is a dud from an investment perspective, no matter the outcome. However, the election does matter as a hurdle that, once cleared, will allow President Trump to renew his "maximum pressure" tactic against China, Iran, and perhaps domestic tech corporations.5 Iran is a critical risk in this strategy. If President Trump applies maximum pressure on Iran, then a reduction in crude exports from Iran, Iranian retaliation in Iraq, and the simultaneous loss of Venezuelan supplies could combine to increase the likelihood of U.S. recession in 2019. Readers might recall that no sitting president has gotten re-elected during a recession. Why would Trump pursue a policy that risks his re-election chances in 2020? Surely he would deviate from his maximum pressure tactic if faced with the prospect of a recession. However, it is folly to assume that policymakers are perfectly rational, or fully informed. American presidents are some of the most unconstrained policymakers in the world, given both the hard power of the United States and the constitutional lack of constraints on the president when it comes to national security. Trump may believe, for instance, that the 660 million barrels of crude in America's Strategic Petroleum Reserve can offset the impact of sanctions against Iran.6 Or he may believe that he can force OPEC to supply enough oil to offset the Iranian losses. The problem for President Trump is that Iran is not led by idiots. Iranian policymakers understand that the best way to reduce American pressure is to induce an oil price spike in the summer of 2019 that hurts President Trump's re-election chances, forcing him to back off. As such, sabotaging Iraqi oil exports, which mainly transit through the port of Basra - a city highly vulnerable to Shia-on-Shia violence that is already a risk to the country's stability - would be an obvious target. An oil price spike would serve as a negotiating tool against the U.S., and the additional revenue would help replace what Iran loses due to the embargo. Tehran and Washington will therefore play a game of chicken throughout 2019, and there is a fair probability that neither side will swerve. President Trump may be making the same mistake as many predecessors have made, assuming that the Iranian regime is teetering at a precipice and that a mere nudge will force the leadership to negotiate. Oil price shocks and recessions have a historical connection. In a recent report, our commodity strategists highlighted that a spike in oil prices preceded 10 out of the past 11 recessions in the U.S. since 1945 (Table 3). Admittedly, not all spikes were followed by recession. The combination of an oil price spike and Fed rate hikes has produced a recession 8 out of 9 times.7 If oil prices rose to $100 per barrel in the coming 6-12 months, there will be several negative macro consequences. In particular, gasoline prices will rise back toward $4 per gallon (Chart 4). Retail gasoline prices have already increased by more than 50% since they bottomed in February 2016. So how much more upside can the U.S. private sector take? Table 3History Of Oil Supply Shocks 2019: The Geopolitical Recession? 2019: The Geopolitical Recession? Chart 4A Source Of Pressure For Consumers A Source Of Pressure For Consumers A Source Of Pressure For Consumers The Household Sector Consumer confidence is currently near all-time highs, which tends to signal that the path of least resistance is flat or down (Chart 5). Household gasoline consumption has already declined in response to higher oil prices since the middle of 2017. Given that gasoline demand is relatively inelastic, consumers may already be near their minimum consumption level. Chart 5Nearing All-Time Highs Nearing All-Time Highs Nearing All-Time Highs Instead, households will experience a decline in their disposable income. This will come on the back of both higher gasoline prices and an increase in the prices of other goods and services, as the oil spike spills across sectors. U.S. households - and most likely those in other markets - are stretched to the limit already. A recent Fed survey found that 40% of U.S. households do not have the funds needed to meet an unexpected $400 cost in any given month.8 Such an unexpected expense would require them to either sell possessions, borrow, or cut back on other purchases. Chart 6Most Americans Cannot Cut Saving To Spend Most Americans Cannot Cut Saving To Spend Most Americans Cannot Cut Saving To Spend Left with few other options, households would react to their lower disposable income by reducing demand for other goods and services. This dent in consumer spending would bring down aggregate demand, leading to slower employment growth and even less income and spending. Households could save less to maintain their current purchasing levels, given the recent rise in the savings rate (Chart 6). But this is unlikely. Although the household savings rate has increased in recent years, we have previously argued that a material part of the increase was driven by small business-owner profits. These owners have much higher levels of income than the median consumer. For Americans living paycheck-to-paycheck, it would be difficult to reduce a savings rate that is already close to, or below, zero. Higher oil prices will also hurt growth in Europe and Japan, economies that are already struggling to gain economic momentum after grappling with a weaker growth impulse from China. In addition, EM economies that took the opportunity to reform their oil subsidies amid lower oil prices post-2014 will have to grapple with a much larger shock to consumers than usual. The Corporate Sector In theory, what consumers lose from rising oil prices, producers of crude can gain in stronger revenue. This is especially important in the U.S. as domestic energy production has increased significantly over the past 10 years. Nonetheless, the oil and gas extraction sector accounts for just 1.1% of GDP and 0.1% of total employment. The marginal propensity to spend out of every dollar of income is lower for producers than consumers. Moreover, if consumer confidence fell and consumer spending weakened, non-energy capex would decline as businesses reassessed household demand and held off from making investment decisions. Small business confidence is at record highs, and as with consumer confidence, vulnerable to downward revisions (Chart 7). Chart 7Dizzying Heights Dizzying Heights Dizzying Heights Chart 8Only One Way To Go (Down) Only One Way To Go (Down) Only One Way To Go (Down) Profit margins remain at a highly elevated level and also have only one way to go (Chart 8). If high oil prices should combine with rising borrowing costs and upward pressure on wages (which could develop in this macro environment) the result would be a triple hit to margins (Chart 9). Of course, rising wages would give consumers some offset to higher oil prices, so the question will be the net effect of all variables. And if the dollar bull market continues, as our FX team believes it will, the combination of higher oil prices and a strong USD would hurt U.S. companies with international exposure. The debt load held by the U.S. corporate sector would turn this bad dream into a nightmare. Many American companies have spent the past 10 years increasing leverage to buy back equity (Chart 10). Companies with high debt would need to revise down their profit expectations, with potentially devastating consequences. Elevated debt levels also increase the likelihood of financial market stress if bond investors get worried and spreads begin to widen significantly. Chart 9Rising Pressures On Earnings? Rising Cost Pressures On Earnings Rising Cost Pressures On Earnings Chart 10Large Corporate Debts Large Corporate Debts Large Corporate Debts According to all measures, U.S. stocks are at or near their all-time valuation peaks. Investors have also priced in a significant amount of optimism for profit growth (Chart 11). These expectations would be subject to quick revision if our oil shock scenario plays out. In other words, investor expectations for profit margins are not sufficiently factoring the triple hit of higher oil prices, higher interest rates, and higher wages. Chart 11The Market Has High Hopes The Market Has High Hopes The Market Has High Hopes An additional geopolitical risk on the horizon for 2019 is the creeping "stroke of pen" risk from potential regulation of technology enterprises. This is unrelated to an oil price spike (other than that it would be an effect of U.S. policy) but could nonetheless combine with rising energy prices to sour investors' mood.9 Bottom Line: An oil price spike above $100 would produce negative consequences for the U.S. household and corporate sectors. Given the supply-side nature of the price shock, it would not be accompanied by the usual decline in USD, and could therefore hurt the foreign profits of U.S. corporations as well. If investors must also deal with mounting regulatory pressures on FAANG stocks, they could face a perfect storm. Given the high probability of such an oil price shock, why isn't a 2019 recession BCA's House View, rather than merely a risk to it? Because it is difficult to say how high oil prices need to rise to cause a recession. For example, 1973 both marked a permanent move up in oil prices and saw oil prices triple. In 2019 terms, that would mean an oil price above $200, a far less probable scenario than $100-$110. Nevertheless, the combination of elevated oil prices and the price impact on consumer goods of the U.S.-China trade war could combine to create a nightmare scenario for consumers. But it is impossible to gauge the level of both required to push the U.S. into a recession. Second, there are many ways in which today's macro environment is different from that in 1974. In the 1970s the inventory cycle was a key factor in the business cycle, with excesses building up ahead of recessions, forcing output cutbacks as demand weakened. That is no longer the case in today's world of just-in-time inventory management. Also, inflation was a much bigger problem back then, requiring tougher Fed action. On the other hand, debt burdens were much lower. Investment Implications To be clear, none of the usual recession indicators that BCA Research uses are flashing red at this time. The point of this analysis is to illustrate a credible, exogenous scenario that cannot be revealed through the usual data-driven recession forecasting methods. What happens if a recession does occur ahead of the 2020 election? How would President Trump react to a recession induced by his foreign policy adventurism in the Middle East? By doing what every other president would do: finding someone else to blame. In this case, we would put high odds on the Federal Reserve becoming the target of President Trump's fury. Ahead of 2020, the Fed and its independence may very well become an election issue.10 This could spell serious trouble for the Fed, which is at a massive disadvantage when it comes to explaining to voters why central bank independence is so important. The Fed had great difficulty managing public opinion regarding its extraordinary measures to combat the Great Recession - its attempts at public outreach largely failed. Compare the number of Trump's Twitter followers to that of the Fed's (Chart 12). Chart 12The Fed's PR Abilities Are Limited 2019: The Geopolitical Recession? 2019: The Geopolitical Recession? Though most of our clients and colleagues will probably disagree, we do not see central bank independence as a static quality. It was bestowed upon central banks by politicians following widespread inflation fears throughout the 1970s and 1980s, although in the U.S. the current tradition goes back to the 1951 Treasury Accord that restored the independence of the Fed. Our colleague Martin Barnes penned a report on the politicization of monetary policy in 2013.11 His conclusion is that political meddling in monetary affairs is less pernicious than economic performance. The Fed will incur Trump's ire, in other words, but it will be its failure to generate economic growth that causes a break in independence. We are not so sure. The next recession is likely to be a mild one for Main Street given the lack of real economic bubbles. But given the slow recovery in real wages over the past decade and the general angst of the populace towards governing elites, even a mild recession that merely reminds voters of 2008-2009 could produce deep anxiety and significant public reactions. Further, the idea of "independent," non-politically accountable institutions is going out of style. President Trump - and other policymakers in the developed world - have specifically targeted the "so-called experts" and "institutions." President Trump has attacked America's foreign policy architecture, NATO, the WTO, and a slew of supposedly outdated norms and practices for being "out of touch" with the electorate. This policy has served him well thus far. If our nightmare scenario of an oil price-induced recession plays out, the immediate implication for investors will be a sharp downturn in risk assets. As such, we are recommending that investors hedge their portfolios with a long Brent / short S&P 500 trade. Alternatively we would recommend going long U.S. energy / short technology stocks. A longer-term, and perhaps even more pernicious implication, would be the end of the era of central bank independence and a full politicization of the economy. Laissez-faire capitalist system would give way to dirigisme. In the process, the U.S. dollar and Treasuries would be doomed. Jim Mylonas, Global Strategist Daily Insights & BCA Academy jim@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 3 Please see BCA Research Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018 and "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "A Story Told Through Charts: The U.S. Midterm Election," dated September 19, 2018, available at gps.bcaresearch.com. 6 The Strategic Petroleum Reserve currently covers 100 days of net crude imports, or 200 days of net petroleum imports, and can be tapped for reasons of political timing as well as international emergencies. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge," dated September 13, 2018, available at bcaresearch.com. 8 Please see the U.S. Federal Reserve, "Report on the Economic Well-Being of U.S. Households in 2017," May 2018, available at federalreserve.gov. 9 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com. 10 Please see BCA Daily Insights, "Politics And Monetary Policy," dated August 22, 2018, and "The Battle Of The Press Conferences: Trump Versus Powell," dated September 27, 2018, available at dailyinsights.bcaresearch.com. 11 Please see BCA Special Report, "The Politicization Of Monetary Policy: Should We Care?" dated April 15, 2013, available at bca.bcaresearch.com. Geopolitical Calendar

Highlights The presidential race between Haddad and Bolsorano will be very tight. At present, we put slightly higher odds on Haddad winning by a small margin in the second round. A Haddad victory would lead to a continuation of stress in financial markets. The prospects of Lula's release and populist policies will lead to further downside in Brazilian assets Bolsorano's victory in the second round will likely lead to a tradeable rally in Brazil's financial markets. For now continue underweighting Brazilian equities and credit and continue shorting the BRL. We will consider whether to upgrade Brazil after the outcome of the elections becomes clearer. Feature Chart 1Potential Roadmaps For Equities Relative Performance Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Brazil's upcoming general elections will be among the closest in recent history. Current polls show a tight race between right-wing candidate Jair Bolsonaro and left-wing candidate Fernando Haddad. A victory by Bolsonaro may spark a short-term rally in Brazilian assets on the expectation of structural reforms. On the other hand, a Haddad victory and return of the Worker's Party to power would be quite negative for financial markets. The upside of this election, regardless of outcome, is that a new government with a new mandate will be formed, restoring a semblance of legitimacy for the first time since the impeachment of President Dilma Rousseff in 2016. The downside is that this mandate will be weak, the odds of a "pro-market" government are uncertain, and Congress will be fragmented. Much-needed yet painful social security reforms will face an uphill battle, with potentially another market riot needed to motivate policymakers and legislators to enact social security reforms. On the macroeconomic front, Brazil does not have a lot of room and time for maneuver. Without drastic measures to cut the budget deficit or boost nominal GDP, public debt will most likely spiral out of control. Due to the current state of polarization, we cannot have a high conviction view on the election outcome until after the congressional elections on October 7. That said, the macro forces remain negative for EM overall and Brazil in particular. Barring Bolsorano's victory in the second round, there is little reason for Brazilian risk assets to rally (Chart 1). An Anti-Establishment Victory? Media attention has centered on Bolsonaro of the Social Liberal Party. He is the frontrunner in the first round of the race, despite his controversial rhetoric and overt sympathies with Brazil's military dictatorship of the past. In polling for the second round, his considerable lead has shrunk, as he is now neck and neck with the other contenders (Chart 2). Bolsonaro is a serious candidate not because of any overarching, international "Trumpian" narrative, but because Brazil itself is ripe for an anti-establishment electoral outcome: With Lula out of the race, the combined "right-wing" and "left-wing" vote is close in the first round (Chart 3). Chart 2Second-Round Polls Very Tight Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 3A Tight Race Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? The country is still in the throes of a political crisis and a historic recession (Chart 4). The major political parties have been discredited. Years of slow economic growth have resulted in extremely low levels of public trust in government (Chart 5). Chart 4Brazil In The Wake Of A Historic Recession Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 5Low Growth Countries Suffer From Lack Of Trust In Their Government Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? This is prompting voters to seek a "change in direction" and/or a "protest vote," from which Bolsonaro is apparently benefiting. There is even a sizable audience for Bolsonaro's authoritarianism and nostalgia for military rule. Brazilians are disillusioned with democracy - with 67% of respondents in a Pew Research poll saying they are "not satisfied" with democracy, compared to a global median of 52%.1 Almost a third of educated Brazilians favor military rule, and that number is as high as 45% among the uneducated (Chart 6).2 Bolsonaro's net approval is less negative than other candidates. In fact, only former Presidents Lula and Rousseff have higher net approval (Chart 7). This is a serious risk to Bolsonaro's likeliest rivals, Fernando Haddad of the Worker's Party and Ciro Gomes of the Democratic Labor Party. Bolsonaro's stabbing at a rally on September 6 has not taken him out of the race. His social media support has become an important tool to reach out to his fan base. Chart 6Brazilian Voters Harbor Some Authoritarian Tendencies Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 7Net Approvals Advantage Bolsonaro Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? However, there are two key reasons why Bolsonaro is not the favorite to win the election: First, Brazil's two-round electoral system works against Bolsonaro because it enables left-leaning voters to vote strategically in favor of the "least bad option," i.e. the available left-of-center candidate, in the second round. Thus while polling shows Bolsonaro very close to each of his potential opponents in the second round, his final opponent will receive a boost that will not be fully accounted for until after the first round eliminates other left-wing contenders. Recent polls suggest that Haddad stands to benefit much more than Bolsonaro from the "migration" of votes after the first round, as left-wing supporters team up against Bolsonaro in the second round (Table 1). Second, with Lula disqualified from the race, Lula supporters are now in the process of switching to support Haddad. Lula has carried a high approval rating of around 35%-40% for over a year, well above all other candidates. In our "poll of polls" (average of various polls) Haddad has risen rapidly in the one month since Lula's disqualification became clear, so that he is now at equal odds with Bolsonaro (see Chart 2 above). A few polls even suggest Haddad is ahead of Bolsonaro in the second round (Chart 8).3 Table 1Second Round Migration##br## Polls Advantage Haddad Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 8Haddad Is Ahead##br## In These Polls Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? To elaborate on this last point: First, about 59% of Lula's supporters say they will shift to Haddad (Chart 9), which should be enough to position him as one of the top two contenders in the first round of voting. Only 4% of Lula supporters will shift to right-of-center candidate Alckmin- a share that is overpowered by the 71% of the Lula vote that will go to left-leaning candidates. Second, the number of undecided and "blank" Lula voters is high at 18%. These voters - if they vote - will mostly go to Haddad, and then Gomes. From the above we can conclude that Haddad will face Bolsonaro in the second round runoff. Because of strategic voting, Haddad will be favored to win the Presidency. A major risk to the left-wing candidate in the second round is that as many as 18% of Lula voters may stay home and not vote. This would mean that Haddad could lose the final vote due to low turnout.4 Overall voter turnout has been falling slightly since 2006 (from 83.3% to 80.7% in 2014) and the disillusionment of voters could result in still lower turnout in 2018. This would favor Bolsonaro, whose supporters are the most likely to vote, whereas Haddad's are the least likely, according to surveys. The profile of the most likely voters favors Bolsonaro (Table 2).5 Chart 9Lula's Migration Vote Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Table 2Voter Profile Of Each Candidate Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? As a consequence, we give Bolsonaro 40%-50% odds of winning the presidency, with the possibility of downgrading his probability to a flat 40% if the rise in Haddad's polling continues at the current pace. Strategic voting imposes a handicap on Bolsonaro, making it hard for him to increase his odds above 50%. The lower net approval for Haddad and Gomes, and the risk that Lula voters will fail to transfer in full force to Haddad, suggests that Bolsonaro has a fair chance of winning the second round. Elections are a Bayesian process and we will update our probabilities as more information comes in. In particular, it is important to see if Haddad exceeds expectations in the October 7 first round. Bottom Line: Given strategic voting in the second round and the momentum behind Haddad, the odds of a left-wing victory in the Brazilian election are 50%-60%. However, this is a low-conviction view. Bolsonaro's odds of winning are closer to 40%-50%, particularly if Lula voters stay home. The New Government's Mandate Will Be Weak No matter who wins, there will be at least one positive takeaway for Brazilian risk assets: a new government will be elected with a fresh mandate to lead the country. The Brazilian state has suffered from a crisis of legitimacy over the past few years. A countrywide anti-corruption campaign and economic depression has led to a general loss of confidence. The latter was further exacerbated by the impeachment of President Rousseff and paralysis of the interim government of Michel Temer. Hence this election will clear the air and give a new government the chance to tackle the country's economic and political problems. However, this clearly positive factor will be overwhelmed by negative factors as the election unfolds and in the aftermath: No first round winner: As outlined above, none of the candidates are likely to win a simple majority of the vote in the first round on October 7. This has been the norm in recent elections, but it precludes the possibility that the current crisis will be matched by a leader with a strong personal mandate, like Cardoso in the 1990s. A close election may lead to contested results: The current second-round polling suggests the outcome will be close. The losing side may challenge the results, a controversy that could cause significant political uncertainty for weeks or months. Bolsonaro has already suggested that he can only lose if the Worker's Party rigs the election. Congress will be fractured: Brazil's Congress is always fractious; with numerous parties and coalitions cobbled together by presidents whose own party has a relatively small share of seats (Chart 10). The upcoming president may even have a weaker congressional base than usual. The erstwhile dominant parties, the PDMB and the PSDB, are less popular than they once were and have put forward lackluster presidential candidates, suggesting they will not win large numbers of seats. The Worker's Party, with a large support base in recent decades, was at the epicenter of the impeachment crisis and suffered huge losses in the municipal elections of 2016, also suggesting it will not win as many seats.6 Meanwhile Bolsonaro's Social Liberal Party is starting from a low base (it currently has only eight out of 513 seats in the lower house and none in the senate). Hence, no party is in a position to sweep Congress, or even come close to a majority, ensuring high diffusion of power, horse-trading, and unstable, ad hoc coalitions. Such coalitions have been a hallmark of Brazilian politics and may even be more unstable this time around. Chart 10ABrazil's Parliament Is Fractious Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 10BBrazil's Parliament Is Fractious Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? No more pork: Given the focus on fiscal austerity and corruption, the next president of Brazil will struggle to command as much "pork-barrel spending" - politically-motivated fiscal handouts to individual congress members - to grease the wheels of politics. President Lula and President Cardoso both relied on pork to ensure passage of key legislation in the 1990s and early 2000s. Polarization: Polarization will remain high as a result of the economic crisis. If Haddad wins, we expect that he will pardon President Lula, despite his assertions to the contrary, and create ill-will among the roughly 52% of the population that views Lula as corrupt. If Bolsonaro manages a victory, he will face intense opposition and resistance from civil society and possibly a left-of-center Congress. Historically, a governing coalition with a majority of seats eventually emerges from Brazil's fragmented Congress. However, periods of political crisis - and transitions from one leading party to the next - often require more time to form such coalitions. It took Lula two years, from 2002-04, to form a majority coalition during his first term in office, according to research by Taeko Hiroi of the University of Texas at El Paso (Chart 11). Chart 11Historical Profile Of Governing Coalitions Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Bottom Line: The formation of a new government with a new mandate is positive but it will not bestow as much political capital as the market expects: in all likelihood the new president's mandate will be weak and Congress will, at least initially, be divided. Will Reforms Be Reactive Or Proactive? What are the likely market reactions from the different election scenarios? And will policymakers be proactive or reactive in their pursuit of any structural reforms? While we cannot rule out a knee-jerk rally if Bolsonaro wins, the length and breadth of the market reaction will depend on the government's political capital (e.g. popular margin of victory and strength in Congress) and willingness to be proactive about structural reforms. On the left, both Haddad and Gomes are "populist," left-leaning, candidates whose victory would exacerbate the selloff. Haddad's vice-presidential candidate and coalition partner is Manuela D'Avila, from the Brazilian Communist Party (PCdoB). Their platform states that the solution to low economic growth is expansionary fiscal and monetary policies, such as a removal of the cap on government spending and a reduction in interest rates. Meanwhile the Gomes campaign has denied that Brazil has a pension deficit.7 Neither Haddad nor Gomes faces the IMF-imposed constraints that Lula faced when he took power in 2002. The market pressure surrounding his election in 2002 and the IMF proposals at that time essentially forced Lula to continue his predecessor Cardoso's reforms. Compared to 2002-03, today's profile of Brazilian share prices suggests that more downside is warranted (see Chart 1, page 1). Hence, we believe more market turmoil would be necessary to force Haddad or Gomes to adopt any difficult and unpopular fiscal reforms. We believe that both could be capable of executing reforms if pressed by the market, but a market riot is needed first. On the other hand, a Bolsonaro victory would likely trigger a meaningful rally on the expectation of pro-market reforms. Bolsonaro's economic advisor Paulo Guedes, a University of Chicago economics PhD holder, is a supply-side reformer who has proposed to privatize state-owned assets, enact tax and pension reforms, and scale back the bureaucracy. Crucially, Bolsonaro's camp wants to use the proceeds from privatization to repurchase public debt and buy time before reforming the pension system. Hence, in the eyes of many investors, Bolsonaro represents a market-friendly candidate despite his tough talk and anti-establishment tendencies. The problem is that Guedes has spent far more time giving interviews to the financial press than campaigning on draconian structural reforms. As such, it is not clear that Bolsonaro's economic team's promises jive with the desires of the median voter in the country. Bolsonaro, meanwhile, will likely be limited in forming a coalition in the Chamber of Deputies.8 The ability to form and maintain alliances in the Chamber of Deputies is a key constraint for any Brazilian president, especially from a smaller party. Obstructionism is common.9 Even large parties with strong alliances have fallen into gridlock, most obviously in attempting structural reforms. In late 1998, for instance, President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999. In short, it will be difficult for the new president to implement reforms at the beginning of his term even though, as noted above, Brazilian presidents tend to cobble together a coalition over time. It should be noted that Bolsonaro's authoritarian tendencies and desire to rewrite the 1988 constitution - a partisan Pandora's Box - could result in a further deterioration of Brazilian governance (Chart 12). This would push up the risk premium on assets over the long run, though in the short run Bolsonaro may be positively received by financial markets. Bottom Line: Bolsonaro would likely want to be a proactive structural reformer, but he would also be constrained at first due to his small party base in Congress and need to form a coalition. In addition, the days of liberally soothing partisan battles with pork-barrel spending are over. Brazil is both fiscally constrained and increasingly sensitive to corruption. Moreover, fiscal austerity would come with a negative hit to growth in the short term. It is not clear whether Bolsonaro will be able to form a Congressional coalition that can push through the painful part of the "J-Curve" of structural reform (Diagram 1). Chart 12Brazilian Governance Set To Fall Further Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Diagram 1The J-Curve Of Structural Reform Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? On the other hand, neither Haddad's nor Gomes's platforms are market-friendly. Neither is likely to attempt structural reforms proactively. The market would have to sell off further, as in 2002, to pressure them into such policies. At that point, however, they might ultimately have a better ability to push legislation through Congress than Bolsonaro due to their ability to form larger coalitions amongst leftist parties. Either way Brazilian risk assets have further downside from where they stand today. A market riot is likely necessary to galvanize the population's support for painful structural reforms. That support currently does not exist. What Is At Stake? Chart 13The Achilles Heel Of The Brazilian Economy Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Brazil's public debt is out of control. Weak nominal GDP growth and high borrowing costs are increasing the public debt burden. This debt stems in large part from a sizable social security deficit that will continue expanding without the above-mentioned reforms (Chart 13). Thus, the next president will face a dilemma: implement austerity to satisfy creditors or increase spending to satisfy voters. A close look at voter preferences suggests that top priorities are improving health services and raising the minimum wage, while pension reform is at the bottom of the list (Chart 14). This reinforces our view that the left-of-center candidates are likely to be the closest to the median voter, and that fiscal austerity is not forthcoming. However, voters are also demanding that inflation be controlled, taxes be cut, and jobs be created - all of which could result in support for right-of-center candidates. Two possibilities to stabilize or reduce the debt load are: (1) restoring a primary budget surplus by enacting social security cuts and/or (2) privatizing state assets to raise fiscal revenues. In Europe throughout the early 2000s, peripheral countries with large public debt imbalances ran large primary budget deficits, just as Brazil has been running (Chart 15, top panel). Portugal, Ireland, Italy, Greece, and Spain stabilized their debt-to-GDP ratios by cutting social spending and capping fiscal expenditures (Chart 15, bottom panel). This will prove challenging as Brazil's pension system is one of the most generous in the world, with retirement ages of 54 and 52 for men and women, respectively, and a much lower contribution period relative to other countries. Furthermore, replacement rates for both men and women are 61%, or 10 percentage points above the OECD average and over 15 percentage points above other countries' reformed pension systems.10 Finally, the dependency ratio will continue to increase, as rising life expectancy and a declining working-age population remain structural headwinds for years to come.11 In our conversations with clients, the reality of Brazil's aging demographics usually comes as a complete surprise. Chart 14Brazil's Population Is ##br##Not Open To Fiscal Austerity Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 15Eurozone Debt Crisis Resulted ##br##In Lower Spending And Stable Debt Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Therefore, social security reforms require outright cuts in spending, rather than soft caps on the budget balance. The present soft cap on government expenditures is not adequate to stabilize or reduce government debt levels. Could privatization help stabilize public debt dynamics? The privatization program during the 1990s under the Collor, Franco, and Cardoso governments led to the sale of $91 billion (around R$ 100 billion or 9% of GDP) worth of assets from 107 state-owned enterprises over the course of a decade. Presently, in order to re-balance the primary deficits of R$93 and R$79 billion for 2018 and 2019 respectively, the government would be required to frontload the sale of large state-owned entities, such as Petrobras or Banco do Brasil. This will prove challenging, since the sale of state-owned enterprises requires legislative approval. In fact, over the past two years, under interim President Temer, the government has struggled to sell its assets such as Electrobras. Even assuming that a Brazilian government under Bolsonaro conducts large-scale asset sales, previous privatization programs have failed to yield targeted sums and have required a longer time to implement than originally expected. Overall, privatization is not a feasible option to reduce high debt levels in Brazil in the short run. Bottom Line: Stabilizing or reducing the public debt as a share of GDP will be challenging under the current set of preferences set by voters. Moreover, demographic headwinds and structural constraints embodied in Brazil's two-tier legislative system will slow down the process of privatization and pension reform. The market is forward-looking and will cheer attempts to enact supply-side reforms in the short run, should they emerge, despite long-term uncertainties. The key questions are (1) whether the election produces a proactive Bolsonaro regime or a reactive left-wing regime (2) whether coalition formation - in Bolsonaro's case - or exogenous market pressure - in Haddad's case - are sufficient to initiate reforms in a timely manner in 2019. Amidst a broad EM selloff driven by external factors as well as Brazil's and other EM's internal fundamentals, we expect the markets to be largely disappointed in 2019. The evolution of the political context throughout the year will then determine when and if a buying opportunity emerges. Investment Implications In the late 1990s, faced with high foreign debt levels, a large current account deficit, and weak nominal growth, the Brazilian central bank devalued the real by 66% in January 1999 (Chart 16). This led to a rebound in nominal growth which helped the country relieve itself from built up excesses. In today's context, a weaker currency and lower interest rates are required to boost nominal GDP and contain Brazil's public debt as a share of GDP. There are already signs that the central bank is easing liquidity amid currency depreciation - which stands in contrast of the recent past (Chart 17). More liquidity provisioning by the central bank will cause the real to depreciate further. In light of this, we recommend that investors continue shorting the currency versus the U.S. dollar. Furthermore, due to our expectation of further deceleration in global growth stemming from China and a strong dollar, investors should expect more downside in broader EM and Brazilian share prices in U.S. dollar terms. With respect to the outcome of the elections, investors should continue underweighting Brazilian equities and credit in their respective portfolios for now (Chart 18). Chart 16Brazil Needs A Weaker Currency To##br## Boost Nominal Growth Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 17A New##br## Paradigm Shift? Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 18Sovereign Credit Spreads Will##br## Continue Widening Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? We will consider whether an upgrade of Brazil is warranted after electoral outcomes become known. Particularly, the balance of the parties in Congress and the new president's coalition formation options will dictate the relative performance of Brazilian equities and credit over the next 6-12 months. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see, Wike, R. et al., "Globally, Broad Support for Representative and Direct Democracy", October 16th, 2017, available at http://www.pewglobal.org/2017/10/16/many-unhappy-with-current-political-system/ 2 In addition to the Pew Research data cited in Chart 5, please see Dora Saclarides, "Do Brazilians Believe In Democracy?" InoVozes, The Wilson Center, November 21, 2017, available at www.wilsoncenter.org. 3 Please see "Brazil: Vox Populi Poll Gives Haddad Lead In Presidential Race," Telesur, September 13, 2018, available at www.telesurtv.net, & Data Poder 360 poll from September 21st, available at: https://www.poder360.com.br/datapoder360/datapoder360-bolsonaro-tem-26-e-haddad-22-os-2-empatam-no-2o-turno/ 4 Please see, BTG Pactual September 15-16 poll, page 18. The Polls states that 57% of Lula voters would "not vote at all" while 41% would vote for Haddad. While turnout will improve for the second round, this is a risk to Haddad. 5 A poll by Empiricus Research and Parana Pesquisas p56 shows that 89.5% intend to vote (which is unrealistic), and that 95.7% of Bolsonaro voters intend to vote while 91.6% of Haddad voters intend to vote. 6 "The PT lost four of the five state capitals it had run, including Sao Paulo, the country's economic powerhouse where the leftist party was born. The PT lost two-thirds of the municipalities it won in 2012, dropping to 10th place from third in the number of mayors controlled by each party." Please see Anthony Broadle, "Brazil parties linked to corruption punished in local elections," Reuters, October 2, 2016, available at www.reuters.com. 7 Gomes has, however, admitted the need for some adjustments to the retirement age and public sector worker privileges, which suggests that he could be brought to pursue structural reforms under the right circumstances. https://todoscomciro.com/en_us/pnd/ciro-gomes-previdencia-social/ 8 Bolsonaro's legislative experience is also surprisingly thin. As a congressional representative for 27 years, he has only passed two laws, after presenting a total of 171 bills and one amendment to the constitution. Only three of these bills presented were of economic nature. It is unclear whether he has what it takes to galvanize the legislature in pursuit of tricky reforms. 9 Please see BCA Geopolitical Strategy Special Report, "Separating The Signal From The Noise," dated September 10, 2014, available at gps.bcaresearch.com. 10 A replacement rate is the percentage of a worker's pre-retirement income that is paid out by a pension program upon retirement. 11 Ratio measuring number of dependent zero to 14 and over the age of 65 to total working age population

Highlights The risk of unplanned oil-production outages is rising. One or more such events will severely test OPEC 2.0's spare capacity in a supply-constrained market (Chart of the Week).1 As things now stand, OPEC 2.0 spare capacity - if it is available - and a likely U.S. SPR release of 500k b/d in 1Q19 will not cover expected production losses, if markets are hit with another unplanned outage from Libya or Iraq.2 Demand destruction via higher prices will have to balance markets. Oil markets are tightening (Chart 2). Falling supply and stable demand will produce a 1mm b/d physical deficit into 1H19, forcing continued OECD inventory draws (Chart 3). The dominant scenario in our forecast includes a supply shock arising from lost Iranian and Venezuelan exports, which triggers price-induced demand destruction. We raised the odds of Brent prices hitting $100/bbl by 1Q19, and our 2019 forecast to $95/bbl on the back of these factors. Unplanned outages would lift prices higher. Energy: Overweight. The long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls we recommended last week are up an average 33.8%, as of Tuesday's close. Base Metals: Neutral. Our foreign-exchange strategists expect the USD to correct further. This will be bullish for copper, which is up ~ 10% since Sept. 11. Precious Metals: Neutral. The USD correction will support gold in the short term. Technically, gold appears to be forming a pennant, which could be short-term bullish. Ags/Softs: Underweight. Corn prices are benefiting from strong exports, according to USDA data. Accumulated exports for the current crop year are up 27% vs last year in the week ending Sept. 13. Chart of the WeekUnplanned Oil-Production Outage Risks Up, OPEC 2.0's Spare Capacity Down Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Chart 2Physical Oil Deficit Returns##BR##To Oil Market Next Year Physical Oil Deficit Returns To Oil Market Next Year Physical Oil Deficit Returns To Oil Market Next Year Chart 3Fundamentals Support##BR##Strong Prices Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Feature Oil markets are approaching a moment of truth. OPEC 2.0's spare capacity likely will be put to the test in 1Q19, as Iranian export volumes continue to fall, and other threats to production - Venezuelan losses, and increasing sectarian tension in Iraq and Libya - come to the fore. As the Chart of the Week demonstrates, spare capacity in the traditional OPEC states is low and falling: The U.S. EIA's most recent estimate of OPEC spare capacity is 1.7mm b/d this year and 1.3mm next year, well below the 2.3mm b/d average of 2008 - 2017. For its part, Russia - the other putative leader of OPEC 2.0 - likely only has ~ 200k b/d of spare capacity to ramp. On a relative basis, OPEC spare capacity is even more stretched: This year, the EIA expects it to average 1.7% of global demand. By next year, it is expected to fall to 1.3%, or ~ 1.3mm b/d. This will be lower than the spare capacity reported for 2008 (1.6%), when OPEC (mostly KSA) found itself struggling to meet surging EM demand, and well below the 2.6% average for 2008 - 2017. Spare capacity is very close to levels last seen in 2016, when low prices resulted in supply destruction. In the wake of the oil-price rout of 2014 - 16, capex collapsed as did maintenance spending needed to keep production steady y/y. This can be seen in the relentless decline in OPEC production ex GCC and the stagnation in other states unable to grow output (Chart 4 and Chart 5). Indeed, as prices hit their nadir in 1Q16, sovereign wealth funds (SWFs) in OPEC and non-OPEC states were being liquidated to cover gaping holes in producers' fiscal accounts. This partly explains the growing incidence of unplanned outages, and our contention OPEC spare-capacity claims are highly suspect (Chart of the Week). Chart 4OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports Chart 5Outside Of A Very Few Regions, Oil Production Has Struggled Outside Of A Very Few Regions, Oil Production Has Struggled Outside Of A Very Few Regions, Oil Production Has Struggled U.S. Remains Adamant On Shutting Down Iran's Exports The Trump administration's goal is to reduce Iranian oil exports to zero via the sanctions it will impose beginning November 4 from ~ 2.5mm b/d back in April, when the U.S. sanctions were announced. However, as the EIA data indicates, achieving this goal would leave markets seriously short oil. Indeed, the Washington-based Center for International Strategic Studies (CSIS) noted in late August, "realistically, there is simply not enough readily available spare oil production capacity in the world to replace the loss of all Iranian barrels (some 2.4 mm b/d), coupled with the potential for further reductions in Venezuela, Libya, Nigeria, and elsewhere."3 Our modeling includes 1.25mm b/d of lost Iranian and Venezuelan exports, continued y/y losses in non-core OPEC (Chart 4), constrained U.S. production growth, and stagnate supply growth outside a handful of states able to lift their output (Chart 5). We do not believe OPEC 2.0 spare capacity is sufficient to cover these losses and one or two additional unplanned outages in Iraq or Libya, or anywhere for that matter. In addition, a 500k b/d release of U.S. SPR after the price goes above $90/bbl in 1Q19 will contain the supply shock we expect slightly, but will not completely reverse it. We have long believed KSA's ability to maintain production above 10.5mm b/d for an extended period is suspect, despite its claims it can ramp to its capacity of 12mm b/d.4 We are carrying KSA's current production at 10.4mm b/d in our balances estimates, roughly the level it self-reported to OPEC last month. To be clear, we are not saying KSA's production cannot be increased - perhaps to 10.7mm b/d - but we are dubious it can get to its claimed 12mm b/d capacity, or that it can sustain 10.7mm b/d indefinitely. It is important to note any short-term increase in OPEC 2.0's production will come out of spare capacity available to meet unplanned outages, or deeper-than-expected Venezuelan losses next year. Lastly, unplanned outages in a market already stretched by tighter supply will accelerate the rate of demand destruction via higher prices. This also would accelerate the arrival of a U.S. recession brought about by an oil-price shock, all else equal.5 Iran's Hand Is Strengthening You'd never know it from the declarations of President Trump and U.S. Treasury Secretary Steve Mnuchin - both of whom are adamant in their professed desire to see Iranian oil exports fall to zero - but the U.S. has been attempting to engage Iran in treaty discussions to limit the country's ballistic-missile capabilities and nuclear-development program.6 Not surprisingly, Iranian officials have shown no interest in such discussions. This is a remarkable turn of events, but not unexpected. At some point, it likely became apparent to the Trump administration the global oil markets are on a trajectory for significantly higher prices, as our analysis and forecasts indicate. It also likely is apparent to administration officials that oil prices - and gasoline prices, in particular, which matter most to U.S. voters - will be surging just as the 2020 presidential campaign gets underway next summer. Along with our colleague Marko Papic, who runs BCA's Geopolitical Strategy, we believe that, from a game-theoretic perspective, the approach from the U.S. actually strengthens Iran's hand. Given its history with the previous round of sanctions, and the economic hardships they imposed, the government in Iran likely believes it can ride out 12 to 18 months of renewed sanctions. It is not unrealistic to entertain the possibility Iranian politicians take the bet that sharply higher gasoline prices in the U.S. by 2H19 will give Democrats in U.S. presidential and congressional races - which kick off next summer - a powerful issue with which to campaign against President Trump and the GOP. Bottom Line: There is a non-trivial chance that OPEC 2.0 spare capacity will prove insufficient to cover the losses in Iranian and Venezuelan exports we foresee in the very near term. Should this prove to be the case, the odds that Brent crude oil prices exceed our $95/bbl forecast for next year are high. We believe Iran's political hand could be strengthened, if it rebuffs overtures by the Trump administration to negotiate a treaty to replace the executive agreement with former U.S. president Obama that limited its nuclear program. We recommended getting long Brent call spreads last week to position for the higher prices we are forecasting for next year. Specifically, we recommended getting long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls. As of Tuesday's close, these positions were up 33.8% on average vs their opening levels last Thursday. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Upside Risks Dominate BCA's Oil Price Forecast," published by BCA Research's Commodity & Energy Strategy October 26, 2017, and "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. Both are available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed in November 2016, following the price collapse brought on by OPEC's market-share war launched in November 2014. Please see last week's Commodity & Energy Strategy lead article, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. In that article we note that, in addition to the highly visible export losses in Iran due to U.S. sanctions and continued deterioration in Venezuelan production, the EIA reduced its estimate of U.S. production growth by 201k b/d in 2019, and the IEA reduced its estimate of Brazilian output this year by 260k b/d. 3 Please see "Whither the Oil Market? Headlines and Tariffs and Bears, Oh My..." published by csis.org August 29, 2018. We are closely following a just-proposed workaround to U.S. sanctions on Iranian oil exports made by the High Representative of the EU, Federica Mogherini, at the UN General Assembly meeting in New York on Tuesday. Ms. Mogherini proposed setting up a special-purpose vehicle that would allow importers in the EU, China and Russia to continue purchasing Iranian oil crude. The SPV would transact in euros, yuan, and roubles, so as to avoid processing transactions through the Society for Worldwide Interbank Financial Telecommunication SWIFT system in Brussels. The SWIFT system is dominated by USD transactions, and the U.S. Treasury has high visibility into transactions made using the system, given USD-denominated transaction like oil purchases and sales must ultimately be cleared through a U.S. bank or intermediary. Iran already takes yuan for its oil, and this mechanism would allow it to purchase goods and services denominated in these currencies. If technical details of the proposed system can be worked out, the SPV could facilitate increased Iranian exports under the U.S. sanctions regime. This would cause us to lower our estimate of lost exports from that country from our baseline assumption of 1.25mm b/d. Please see "Why India Will Struggle to Join Iran's Sanctions Busters," published by bloomberg.com on September 26, 2018. 4 We are not the only ones dubious of KSA's ability to ramp production. Please see "Can Saudi Arabia pump much more oil," published by reuters.com July 1, 2018. 5 In our House view, a recession in the U.S. does not arrive until 2H20. We have argued an oil-supply shock, particularly during a Fed tightening cycle, typically presages a recession in the 6 - 18 months following the shock. Please see Commodity & Energy Strategy lead article, "Odds of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. 6 Please see "U.S. seeking to negotiate a treaty with Iran," published September 19, 2018, by reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Trades Closed in 2018 Summary of Trades Closed in 2017 Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect

Highlights So What? President Trump is treating the midterm election as a hurdle. Once cleared, he will restart "Maximum Pressure" policy towards China and Iran that will induce market volatility. The outcome of the election, however, has only a marginal investment relevance. Why? A Democrat-held Congress will not have the votes to overturn President Trump's signature economic policies: tax cuts, deregulation, and stimulus. Removal from power requires 67 votes in the Senate, out of the reach for Democrats. President Trump will pursue aggressive foreign and trade policies, regardless of the midterm outcome. As such, the midterm outcome is a non-diagnostic variable. Also... Rising stroke-of-pen risk, combined with President Trump's unorthodox foreign and trade policies, will likely intensify following the midterm election. Therefore, it is difficult to "buy on (midterm-related) dips," despite our call that the election does not matter. Feature Should investors care about the upcoming midterm election? The answer is yes, but marginally. A gridlocked Congress, our most likely outcome, is historically less positive for equities than an electoral outcome that results in a unified executive and legislature (Chart 1). The reality, however, is that economic and monetary variables are overwhelmingly more important for investors than politics.1 Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of gridlock and reduced uncertainty in the 12-months following presidential and midterm elections.2 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 1A Unified Congress Is A Boon For Stocks A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Table 1A Divided Government Is Marginally Negative For Stocks A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of the timeframe, but only just. Could 2018 be different? Given the extraordinary level of polarization - captured in Chart 2 by the difference in presidential approval by party identification - this time could, indeed, be different. But, we do not think it will be. As we discussed last week,3 Democrats in Congress would not be able to impact the three crucial pillars of the Trump Reflation Trade: De-regulatory agenda: The executive branch is in charge of the deregulatory agenda, which investors should note kindled corporate animal spirits on day 1 of the Trump presidency (Chart 3). Chart 2Presidential Approval Variance Signals Peak Polarization Presidential Approval Variance Signals Peak Polarization Presidential Approval Variance Signals Peak Polarization Chart 3Trump's Mere Election Stoked Animal Spirits Trump's Mere Election Stoked Animal Spirits Trump's Mere Election Stoked Animal Spirits Tax cuts: Without 67 votes in the Senate, the Democrats cannot overturn a presidential veto that is certain to be used on any tax-hikes as long as President Trump is in power. They won't even get to the 60 votes necessarily to invoke cloture and thus avoid a Republican filibuster on tax, immigration, or other policy reforms. Fiscal policy: We see no chance of the Democratic Party becoming the party of fiscal discipline ahead of the 2020 election. Voters are not demanding budget discipline, despite the obvious rise in budget deficits (Chart 4), so why would the Democratic Party nail itself to the fiscal conservative cross over the next two years? What of the impeachment risk? There is no empirical evidence that impeachment proceedings have any impact on U.S. equity markets.4 And we would fade any concerns that an impeachment push would cause President Trump to seek relevancy abroad with aggressive foreign and trade policies because we expect him to do so regardless of the midterm outcome! Nonetheless, we do think that investors are in for a mild surprise this November (Chart 5). First, the data suggests that Democrats will have a wave election. In fact, we are raising our probability of a Democratic House victory to 70%, largely in line with current expectations. Second, we are also raising our call on the Senate to a "too-close-to-call." Essentially, we think that the Democratic Party may be able to pick up a Senate seat, which would be an extraordinary outcome given that they are defending 26 seats out of the 35 in contention.5 While such an electoral surprise may not have immediate investment implications in 2018 and 2019, it could have implications beyond 2020. The Senate electoral math significantly changes in 2020, with Republicans currently set to defend 21 seats out of 33 in contention (a number that could grow due to retirements). A Democratic sweep of U.S. institutions in 2020 could significantly alter the long-term earnings outlook in the U.S., especially if America's center-left party swings further to the left by then. Such an outcome would put an end to the two-decade long divergence in profits and wages as share of the total economy (Chart 6). But more on that at a later point. In this report, we focus on the upcoming election itself. Chart 4Voter Fiscal Preferences Are Not Fixed Voter Fiscal Preferences Are Not Fixed Voter Fiscal Preferences Are Not Fixed Chart 5Our Senate Call Is Out Of Consensus Our Senate Call Is Out Of Consensus Our Senate Call Is Out Of Consensus Chart 6What Is Not Sustainable Will Stop What Is Not Sustainable Will Stop What Is Not Sustainable Will Stop Midterm Election: The Twenty Charts To Watch History is stacked against the Republican Party. Chart 7 shows that the president's party has lost, on average, 24 seats since the 1950 midterm election. Only Clinton in 1998 - at the top of an epic bull market and with an approval rating of 66% (!) - and Bush Jr. in 2002 - following a once-in-a-generation terrorist attack on the U.S. homeland - managed to eke out positive gains. Even in those Goldilocks conditions, Clinton's Democrats only picked up a paltry five seats in the House (none in the Senate), while Bush's GOP gained two Senate and eight House seats. Chart 7Midterm Elections Normally Spell Doom For The President's Party A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Polls suggest that this time will not be different. Both the congressional generic ballot (Chart 8) and President Trump's popularity - at just 39% - (Chart 9) are signaling a wave election for the Democrats. Chart 8Polling Gives Dems The Advantage Polling Gives Dems The Advantage Polling Gives Dems The Advantage Chart 9President Trump Is A Drag On The GOP... A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election But what about the roaring economy? Astonishingly, economic performance has a negative correlation with electoral outcomes in congressional elections (Chart 10)! This data point is so counterintuitive that it must be wrong. At the very least, history suggests that there is no clear relationship between the economy and congressional returns. Chart 10...Whereas The Economy Is Unlikely To Provide A Tailwind A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election The economy only matters when things are going wrong. Current polls, in other words, are already pricing in a solid economic context, with the Democratic lead over the Republicans having narrowed from double-digits since the economy began roaring in January (Chart 11). At this point, however, it is highly unlikely that two more months of solid economic performance will have much of an effect on voter preferences. In fact, the importance of the economy, jobs, and budget deficits to voters has been declining since 2014 (Chart 12). Chart 11The Economy Is Already Baked In The (Polling) Cake The Economy Is Already Baked In The (Polling) Cake The Economy Is Already Baked In The (Polling) Cake Chart 12Voters Care Less About Economic Issues A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election In addition, investors should remember that voter experience of the economic recovery is highly polarized. During Obama's presidency, Republican voter consumer sentiment and expectations were at recession levels. Magically, on November 8, 2016, both Republicans and Democrats changed their sentiment (Chart 13). Independent voters are, unsurprisingly, somewhere in the middle. Chart 13Voters Cannot Agree On Economic Performance Anyway Voters Cannot Agree On Economic Performance Anyway Voters Cannot Agree On Economic Performance Anyway Primary election turnouts are confirming that the economy is not the primary driver of voter enthusiasm. Democrats have seen 8.9 million more voters vote in the 2018 primaries, compared to the 2014 midterm election. Meanwhile, GOP voters - who are presumably more enthused about the economy - have only seen a pickup of 3.8 million new primary voters. The pattern of primary voting is similar to the one in 2010, when the Tea Party revolt energized the Republican base in opposition to President Obama. In 2010, Republicans increased primary turnout in 186 congressional districts compared to the 2006 election. Satisfied with President Obama's win in 2008, Democrats only increased the primary turnout in 35 districts. As a result, the GOP picked up 63 House seats and gained control of the lower chamber of Congress. This time around, the numbers foreshadow a similar wave, but in favor of the left. Democrats have seen their turnout increase in 123 electoral districts, compared to the 2014 election. This includes 20 of the most competitive races this year. Republicans, meanwhile, have seen an increase in enthusiasm in only 19 congressional districts this year. The death knell for Republicans in the House of Representatives, in our view, will be the abnormally large number of retirements (Chart 14). Incumbency has a powerful effect in congressional races. On average, incumbents easily win over 90% of their races for the House (Chart 15). Chart 14Double More GOP Retirements This Year A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Chart 15Incumbents Normally Carry The Day Incumbents Normally Carry The Day Incumbents Normally Carry The Day The average margin of victory for the Republican representatives not running for re-election in the 42 electoral districts in 2016 was 28.3%6 (Table 2). This sounds like too high of a hurdle for Democrats to leap over. However, that is precisely what Democratic candidates have done in the House and Senate special elections in 2017 and 2018. The average GOP lead in those races is down from 29.2% in 2016 to just 8.5% today, a 20.7% swing (Table 3). This math explains why the Cook Political Report, the premier U.S. election forecasting consultancy, sees the number of competitive Republican-held seats more than doubling in 2018 (Chart 16), whereas the number of competitive Democratic-held seats has collapsed. Table 2Republicans Not Seeking Re-Election In 2018 A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Table 3Non-Incumbent Republicans Lost 20% Advantage In Special Elections A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Our Senate model is similarly flashing red for the Republican Party. Despite an overwhelming structural advantage in the 2018 cohort - having to only defend nine seats - our model is predicting that the Democrats will hold all their Senate seats and pick up one (in Nevada) (Chart 17). Chart 16Number Of GOP Seats At Risk Has More Than Doubled! A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Chart 17Our Senate Model Is Generous To The Democrats A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.7 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. The results of our "beta" model, expressed as a margin of victory by the Republican candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate. Highly concerning for President Trump and the GOP is that the Democratic Senate candidates have a healthy lead in three out of the four contested Midwest races (Chart 18), suggesting that Trump's crossover appeal to blue-collar voters is not working when he is not the candidate (or perhaps, even more alarming for the GOP, when Hillary Clinton is not his opponent). The only tight Midwest election is in Indiana, where Democratic incumbent Joe Donnelly's lead is within the margin of error. Another concern for the Republicans is that the Democrats have largely fielded centrist candidates in the House and Senate races. For example, former Tennessee Governor (2003-2011), Phil Bredesen, is a conservative Democrat currently leading in the polls against his Republican opponent. Democratic candidates for election in Republican-held Arizona and Nevada are similarly centrists and thus competitive (Chart 19). Furthermore, in the 42 seats where Republicans are fielding non-incumbents, our research suggests that Democrats only fielded 14 left-wing/progressive candidates.8 Despite the media's focus on left-wing/progressive candidates - such as Alexandria Ocasio-Cortez in the Bronx or Ayanna Pressley in Boston - the vast majority of Democratic candidates in the non-coastal U.S. have been centrists. This means that GOP candidates will have very few "lay-ups" in November. Putting it all together, we would give Democrats a 70% chance of picking up the necessary 23 seats to take over the House. In the Senate, the next two months will determine the outlook for GOP candidates. Investors should fade the message from the current polling - and thus our model - as voters have paid very little attention to local races before Labor Day. However, if the current trajectory in the congressional generic poll and Trump's popularity holds until November, the likelihood of a GOP hold in the Senate will fall. For President Trump, a result where he loses the House and the Senate would be a political disaster. Should investors prepare for the volatility of impeachment in that case? The midterm election is a non-diagnostic variable. The Senate requires 67 votes to convict the president and thus remove him from power. A 50 +1 majority will not help Democrats get to that level any more than a 50 -1 minority would. They will need Republican Senators to join them in the impeachment endeavor. For that to happen, Republican voters will have to lose confidence in President Trump in droves, as they once did in President Nixon. As Chart 20 clearly illustrates, we are nowhere near that point today. Chart 18The Midwest: Is The Trump Magic Gone? A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Chart 19The Sun-Belt: No Place To Hide For The GOP? A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Chart 20Trump Is Not Nixon (Yet) A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Investment Implications: Much Ado About Nothing Putting it all together, this year's midterm election has a good chance of dominating the news flow by producing a shocking electoral surprise. In the immediacy of an outcome that hands the control of the entire Congress to the fired-up Democrats, it would be smart to bet on a brief risk asset pullback. However, the Democrats will not be able to unravel any of President Trump's main economic policies. In fact, investors may be presented with higher odds of an infrastructure plan and even of an immigration deal, if President Trump faces reality and comes to the middle ground on some of his demands (as President Clinton did after his disastrous 1994 midterm election). As for impeachment and the risk of President Trump "seeking relevancy abroad," our high conviction view is that he will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. In fact, President Trump has explicitly threatened an increase of the tariff rate to 25% by the end of the year in order to put more pressure on Beijing. The increase in the tariff rate would be a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election date. This is not a coincidence, but a product of White House design. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not.9 Given the potential impact on domestic gasoline prices, the White House has decided to coincide the pressure on Tehran with the end of the election season. The midterm election, therefore, is important only in terms of timing. Once it is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes (and we agree) led to a breakthrough in North Korea policy. Unfortunately for the markets, we do not expect that the maximum pressure tactic will work as smoothly with Iran and China.10 The final risk to markets is the creeping "stroke of pen" risk from potential regulation of technology enterprises. Joseph Simons, the Trump appointed new chair of the Federal Trade Commission, recently said that "the broad antitrust consensus that has existed... for about 25 years is being challenged... the U.S. economy has grown more concentrated and less competitive."11 His comments have dovetailed the threat to FAANG stocks that exists from a shift in U.S. anti-trust enforcement, one that would take the anti-trust practice away from the consumer-friendly approach of the "Chicago School."12 Chart 21FAANG Stocks + Microsoft Have Dramatically Outperformed... FAANG Stocks + Microsoft Have Dramatically Outperformed... FAANG Stocks + Microsoft Have Dramatically Outperformed... Table 4...Generating 50% Of The 2018 S&P 500 Return! A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election This is a big risk for the ongoing bull market as the reason why the S&P 500 has performed well is due to the performance of a few (enormous) technology stocks that have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history (Chart 21 and Table 4). And yet the one thing that a plurality of Democrats and Republicans seem to agree with is that major tech companies should be regulated (Chart 22). Privacy advocates - who tend to lean left or libertarian - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs post midterm election. In fact, it is the one thing that Trump, and his supporters may (Chart 23), have in common with a potentially left-leaning Congress. Chart 22Majority Of Americans Want Tech Regulated A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election Chart 23Conservatives Distrust Tech Companies A Story Told Through Charts: The U.S. Midterm Election A Story Told Through Charts: The U.S. Midterm Election How should investors play the midterm election? It is tough to say. We do not think the Democrats' takeover of Congress will be a catalyst for the markets. However, there are a slew of concerning geopolitical developments that will accelerate post-election, some specifically because President Trump will become more aggressive following the electoral hurdle. As such, we would be cautious. While it may serve investors well to "buy on dips" related to the fear of a "Socialist" takeover of Congress, it will be difficult to disassociate such hysteria from genuinely bearish narratives emanating from the Middle East, with trade policy, or stroke of pen risks looming over FAANG stocks. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 2 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 3 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 We are counting Senators Angus King (Maine) and Bernie Sanders (Vermont) as "Democrats" in this tally as they both caucus with the Democratic Party and generally vote very much in line with their left-leaning peers. 6 Excludes Pennsylvania due to redistricting in early 2018, and OK-01, as the candidate ran unopposed. 7 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincident index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 8 This number is largely our judgement call based on the statements from the Democratic primary winners. However, the fact that there is no unified progressive movement - akin to the 2010 Tea Party revolution - confirms our view. 9 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 11 Please see Diane Bartz, "Trump's antitrust enforcer considers shifting up a gear," dated September 13, 2018, available at reuters.com. 12 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com.

Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close GOP Trails In Polls, But It Is Still Close GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Chart 4... Even Those That Produce Gridlock Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Markets Can Rally Through Impeachment... Markets Can Rally Through Impeachment... Chart 5B...Despite Volatility ...Despite Volatility ...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Nobody Is Paying Attention To Iranian Supply Risk! Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Chart 9Two Hedges We Recommend Two Hedges We Recommend Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Abnormal Moves Around The Brexit Vote... Abnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk ...Make It Hard To Spot Geopolitical Risk ...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... No Geopolitical Risk Embedded... No Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling ...In Today's Pound Sterling ...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Policy Uncertainty Index Muted Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling A Liability For Sterling A Liability For Sterling Chart 15Theresa May's Tenuous Grip Theresa May's Tenuous Grip Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Fade Any Short-Term Rebound Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Out-Of-Sample Testing Of Model (I) Out-Of-Sample Testing Of Model (I) Chart 20 Out-Of-Sample Testing Of Model (II) Out-Of-Sample Testing Of Model (II) Geopolitical Calendar