Geopolitics

Highlights Rising non-OPEC production and the Trump administration's successful efforts at jawboning OPEC into increasing oil production - including a not-so-subtle threat that American protection of the Cartel's Gulf Arab producers would be withheld if production weren't ramped - will keep oil prices under pressure in 2H18. Markets could become chaotic in 2019: Iran's capacity to close the Strait of Hormuz - discussed below in this Special Report written jointly by BCA's Commodity & Energy Strategy and Geopolitical Strategy - cannot be dismissed. An extended closure of the Strait - our most dire scenario - could send prices on exponential trajectories: In one simulation, above $1,000/bbl. We are keeping our forecast for 2H18 Brent at $70/bbl, unchanged from June, and lowering our 2019 expectation by $2 to $75/bbl. We expect WTI to trade $6/bbl below Brent. Rising geopolitical uncertainty will widen the range in which oil prices trade - i.e., it will lift volatility. Energy: Overweight. We are moving to a tactically neutral weighting, while maintaining our strategic overweight recommendation. We are closing our Dec18 Brent $65 vs. $70/bbl call spread but are retaining long call-spread exposures in 2019 along the Brent forward curve. Base Metals: Neutral. Contract renegotiations at Chile's Escondida copper mine are yet to be resolved. The union rejected BHP's proposal late last week, and threatened to vote for a strike unless substantial changes were made. Failure to reach a labor deal at the Escondida mine led to a 44-day strike last year, and an extension of the contract. This agreement expires at the end of this month. Precious Metals: Neutral. Increasing real rates in the U.S. and a stronger USD are offsetting safe-haven demand for gold, which is down 10% from its 2018 highs of $1360/oz. Ags/Softs: Underweight. The Chinese agriculture ministry lowered its forecast for 2018/19 soybean imports late last week to 93.85 mm MT from 95.65 mm MT. This is in line with its adjustment to consumption this year, now forecast at 109.23 from 111.19 mm MT. Tariffs are expected to incentivize Chinese consumers to prefer alternative proteins - e.g., rapeseed - and to replace U.S. soybean imports with those from South America. Feature U.S. President Donald Trump jawboned OPEC Cartel members - particularly its Gulf Arab members - into raising production. This was accompanied with a none-too-subtle threat implying continued U.S. protection of the Gulf Arab states was at risk if oil production were not lifted.1 OPEC, particularly KSA, responded by lifting production and pledging to keep it at an elevated level. In addition, non-OPEC production growth has been particularly strong this year, and will remain so. These combined production increases will contribute to a modest rebuilding of inventories in 2H18, as markets prepare for the loss of as much as 1 MMb/d of Iranian oil exports beginning in November (Chart of the Week). Chart of the WeekOECD Inventory##BR##Depletion Will Slow OECD Inventory Depletion Will Slow OECD Inventory Depletion Will Slow Chart 2Global Balances Will Loosen,##BR##As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Estimated 2H18 total OPEC production rose a net 130k b/d, led by a 180k b/d increase on the part of KSA, which will average just under 10.6 MMb/d in the second half of the year. Non-OPEC production for 2H18 was revised upward by 180k b/d in our balances models - based on historical data from the U.S. EIA and OPEC - led by the U.S. shales, which were up close to 700k b/d over 1Q18 levels. This led to a combined increase in global production of 310k b/d in 2H18. With demand growth remaining at 1.7 MMb/d y/y for 2018 and 2019, we expect the higher output from OPEC and non-OPEC sources to loosen physical balances in 2H18 (Chart 2 and Table 1).2 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic In and of itself, increased production will reverse some of the depletion of OECD inventories targeted by OPEC 2.0 in its effort to rebalance the market. All else equal, this would be bearish for prices. However, we are keeping our price forecast for 2H18 unchanged from last month - $70/bbl for Brent in 2H18 - and lowering our expectation for Brent to $75/bbl in 2019. This adjustment in next year's expectation reflects our belief that this round of increased production by OPEC 2.0 arguably is being undertaken specifically to rebuild storage ahead of the re-imposition of export sanctions by the U.S. against Iran. Re-imposing sanctions unwinds a deal negotiated by the U.S. and its allies in 2015, which relaxed nuclear-related sanctions against Iran in exchange for commitments to scale back its involvement across the Middle East in the affairs of Arab states with restive Shia populations.3 The re-imposition of sanctions by the U.S. against Iran has set off a round of diplomatic barbs and thrusts on both sides. President Trump declared he wanted Iran's oil exports to go to zero, which was followed by Iran's threat to close the Strait of Hormuz. This set oil markets on edge, given that close to 20% of the world's oil flows through the Strait on any given day.4 Geopolitics Reasserts Itself In The Gulf Oil prices will become increasingly sensitive to geopolitical developments, particularly in the Gulf, now that the U.S. and its allies - chiefly KSA - and Iran and its allies are preparing to square off diplomatically, and possibly militarily. This will lead to a wider range in which oil will trade - i.e., we expect more significant deviations from fundamentally implied values, as markets attempt to price in highly uncertain outcomes to political events.5 Tensions around the Strait of Hormuz - discussed below - will remain elevated post-sanctions being re-imposed, even if we only see threats to traffic through this most-important oil transit. Chart 3 shows that in periods when the error term of our fundamental econometric model increases, it typically coincides with higher implied volatilities. Specifically, the confidence interval around our fundamental-based price forecast widens in times of heightened uncertainty and volatility. The larger the volatility, the larger the squared deviation between our fitted Brent prices against actual prices.6 This indicates the probability of ending 2H18 exactly at our $70/bbl target is reduced as mounting upside - e.g. faster-than-expected collapse in Venezuelan crude exports, rising tensions around the Strait of Hormuz or larger-than-expected Permian pipeline/production bottlenecks - and downside - e.g. escalating U.S.-Sino trade war tensions, increasing Libyan and Nigerian production - risks push the upper and lower bounds around our forecast further apart. Chart 3Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range This directly translates into a wider range in which prices will trade - uncertainty is high, and, while it is being resolved, markets will remain extremely sensitive to any information that could send prices on an alternative path (Chart 4). Chart 4Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Risks related to a closure of the Strait are not accounted for in our forecasts. However, given the magnitude of the risks implied by even the remote possibility of a closure, we expect markets will put a risk premium into prices. In an attempt to frame out price estimates from a short (10-day) and long (100-day) closure, we provide some cursory simulation results below.7 Can Iran Close The Strait Of Hormuz? The Strait of Hormuz, through which some 20% of global oil supply transits daily, is the principal risk that will keep markets hyper-vigilant going forward.8 A complete closure of the Strait of Hormuz (Map 1) would be the greatest disruption of oil production in history, three times more significant than the supply loss following the Islamic Revolution in 1979 (Chart 5). By our estimate, a 10-day closure at the beginning of 2H19 could pop prices by ~ $25/bbl. A 100-day closure could send prices above $1,000/bbl in our estimates. Map 1Iran Threatens Gulf Shipments Again U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Chart 5Geopolitical Crises And Global Peak Supply Losses U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic So, the question naturally arises, can Iran's forces close the Strait? Iran's ability is limited by structural and military factors, but it could definitely impede traffic through the globe's most crucial energy chokepoint. There are two scenarios for the closure of the Strait: (i) Iran does so preemptively in retaliation to crippling economic sanctions; or (ii) Iran does so in retaliation to an attack against its nuclear facilities. Either scenario is possible in 2019, as the U.S. intends to re-impose sanctions against Iranian oil exports on November 9, a move that could lead to armed conflict if Iran were to retaliate (Diagram 1).9 Diagram 1Iran-U.S. Tensions Decision Tree U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic SCENARIO I - Preemptive Closure In the past, Tehran has threatened to preemptively close the Strait of Hormuz whenever tensions regarding its nuclear program arose. The threats stopped in mid-2012, as U.S. and Iranian officials engaged in negotiations over the country's nuclear program. However, on July 4 of this year, Iran's nominally moderate President Hassan Rouhani pledged that Tehran would retaliate to an oil export embargo by closing the Strait. Rouhani's comments were reinforced on July 5 by the commander of Iran's elite Revolutionary Guards, whose forces patrol the Strait, Mohammad Ali Jafari. Could Iran actually impede traffic through the Strait of Hormuz?10 Yes. Our most pessimistic scenario posits that Iran could close the waterway for about three or four months. This is based on three military capabilities: mines, land-based anti-ship cruise missiles (ASCM), and a large number of small boats for suicide-like attack waves. In our pessimistic scenario, we assume that Iran would be able to deploy about 700 mines and threaten the Strait by firing only one anti-ship cruise missiles (ASCM) operated via land-based batteries or ship per day, in order to prolong the threat.11 In that way, Iran could draw out the threat indefinitely. The length of closure is based on how long it would take the U.S. naval assets in the region to clear the mines, establish a Q-route - corridor within which the probability of hitting a mine is below 10% - and locate ASCM radars and batteries. The pessimistic scenario is unlikely to occur because of several countermeasures that the U.S. and its regional allies could employ - anti-mine operations, meant to clear a so-called Q route allowing safe passage of oil tankers under U.S. naval escort; punitive retaliation, which would inflict punitive damage on Iran's economy and infrastructure; and, lastly, Iran would not want to risk exposing its radar-guided anti-ship missiles to U.S. suppression of enemy air-defense (SEAD) operations that seek and destroy radars. Despite Iran's growing capability, we still posit that its forces would only be able to close the Strait of Hormuz for between three-to-four months. However, the more likely, "optimistic," scenario is that the closure itself lasts 7-10 days, while Iran then continues to threaten, but not actually close, the Strait for up to four months. It would be worth remembering that the U.S. has already retaliated against a potential closure, precisely 30 years ago. Midway through the Iran-Iraq war, both belligerents began attacking each other's tankers in the Gulf. Iran also began to attack Kuwaiti tankers after it concluded that the country was assisting with Iraq's war efforts. In response, Kuwait requested U.S. assistance and President Ronald Reagan declared in January 1987 that tankers from Kuwait would be flagged as American ships. After several small skirmishes over the following year, the USS Samuel B Roberts hit a mine north of Qatar. The mine recovered was linked to documents found by the U.S. during an attack on a small Iranian vessel laying mines earlier in 1987. The U.S. responded by launching Operation Praying Mantis on April 18, 1988. During the operation, which only lasted a day, the U.S. navy seriously damaged Iran's naval capabilities before it was ordered to disengage as the Iranians quickly retreated. Specifically, two Iranian oil platforms, two Iranian ships, and six gunboats were destroyed. The USS Wainwright also engaged two Iranian F-4s, forcing both to retreat after one was damaged. From this embarrassing destruction of Iran's naval assets, the country realized that conventional capabilities stood little chance against a far superior U.S. navy. As a result, Iran has strengthened its asymmetrical sea capabilities, such as the use of small vessels, and has made evident that the use of mines would be integral to its engagements with foreign navies in the Gulf. However, the switch to asymmetrical warfare means that Iran would likely threaten, rather than directly close, the Strait. From an investment perspective, the threat to shipping would have to be priced-in via higher insurance rates. According to research by the University of Texas Robert S. Strauss Center, the insurance premiums never rose above 7.5% of the price of vessel during the 1980s Iran-Iraq war and actually hovered around 2% throughout the conflict. Rates for tankers docking in Somali ports, presumably as dangerous of a shipping mission as it gets, are set at 10% of the value of the vessel. A typical very large crude carrier (VLCC) is worth approximately $120 million. Adding the market value of two million barrels of crude would bring its value up to around $270 million at current prices. If insurance rates were to double to 20%, the insurance costs alone would add around $30 per barrel, $15 per barrel if rates stayed at the more reasonable 10%. This is without factoring in any geopolitical risk premium or direct loss of supply of Iran's output due to war. Bottom Line: Iran's military capabilities have increased significantly since the 1980s when it last threatened the shipping in the Strait. Iran has also bolstered its asymmetric capabilities since 2012, while the U.S. has largely remained the same in terms of anti-mine capabilities. If Iran had the first-mover advantage in our preemptive closure scenario, the most likely outcome would be that it could close the Strait for up to 10 days and then threaten to close it for up to four months in total. SCENARIO II - Retaliatory Closure A retaliatory closure is possible in the case of a U.S. (or Israeli) attack against Iran's nuclear facilities. Following from the military analysis of a preemptive closure, we can ascertain that a retaliatory closure would be far less effective. The U.S. would deploy all of its countermeasures to Iranian closure tactics as part of its initial attack. If Iran loses its first-mover advantage, it is not clear how it would lay the mines that are critical to closing the Strait. Iran's Kilo class submarines, the main component of a covert mine-laying operation, would be destroyed in port or hunted down in a large search-and-destroy mission that would "light up" the Strait of Hormuz with active sonar pings. The duration of the closure could therefore be insignificant, even non-existent. The only potential threat is that of Iran's ASCM capability. Iran would be able to use its ASCMs in much the same way as in the preemptive scenario, depending on the rate of fire and rate of discovery by U.S. assets. Bottom Line: It makes a big difference whether Iran closes the Strait of Hormuz preemptively or as part of a retaliation to an attack. The U.S. would, in any attack, likely target Iran's ability to retaliate against global shipping in the Persian Gulf. As such, Tehran's asymmetric advantages would be lost. Putting It All Together - Can Iran Close The Strait? Our three scenarios are presented in Table 2. Iran has the ability to close the Strait of Hormuz for up to three-to-four months. That "pessimistic" scenario, however, is highly unlikely. The more likely scenarios are the "preemptive optimistic" and retaliatory scenarios. Table 2Closing The Strait Of Hormuz: Scenarios U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Assessing the price implications of these scenarios is extremely difficult. Even though the "preemptive optimistic" and the "retaliatory" scenarios are short-lived, up to 20% of the world's daily demand would be removed from the market in the event the Strait of Hormuz was closed. Of course, the U.S. would release barrels from its 660mm-barrel Strategic Petroleum Reserve (SPR) - likely the full maximum of 30 million barrels authorized under law, released over 30 days for a 1 MMb/d release - and Europe would also release ~ 1 MMb/d or so from its crude and product stocks. China likely would tap its SPR as well for 500k b/d. In addition, there is ~ 2 MMb/d of spare capacity in OPEC, which could be brought on line in 30 days (once the Strait is re-opened), and delivered for at least 90 days. How and when a closure of the Strait of Hormuz occurs cannot be modeled, since, as far as prices are concerned, so much depends on when it occurs, and its duration. For this reason, and the extremely low probability we attach to any closure of the Strait, we do not include these types of simulations in our analysis of the various scenarios we include in our ensemble. That said, it is useful to frame the range implied by the scenarios above. We did a cursory check of the impact of scenarios 1 and 2 above, in which we assume 19 MMb/d flow through the Strait is lost for 10 days and 100 days due to closure by Iran in July 2019. We assume this will be accompanied by a 2 MMb/d release from various SPRs globally. In scenario 1, the 10-day closure of the Strait lifts price by $25/bbl, and is resolved in ~ 2 months, with prices returning to ~ $75/bbl for the remainder of the year. In scenario 2, the Strait is closed for 100 days, and this sends prices to $1,500/bbl in our simulation. This obviously would not stand and we would expect the U.S. and its allies - supported by the entire industrialized world - would launch a powerful offensive to reopen the Strait. This would be extremely destructive to Iran, which is why we give it such a low probability. Bottom Line: While the odds of a closure of the Strait of Hormuz are extremely low - to the point of not being explicitly modeled in our balances and forecasts - framing the possible outcomes from the scenarios considered in this report reveals the huge stakes involved. A short closure of 10 days could pop prices by $25/bbl before flows are restored to normal and inventory rebuilt, while an extended 100-day closure could send prices to $1,500/bbl or more. Because the latter outcome would result in a massive offensive against Iran - supported by oil-consuming states globally - we view this as a low-probability event. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 President Trump's tweets calling for higher oil production have consistently been directed at the original OPEC Cartel, as seen July 4: "The OPEC monopoly must remember that gas prices are up & they are doing little to help. If anything, they are driving prices higher as the United States defends many of their members for very little $'s. This must be a two way street. REDUCE PRICING NOW!" Since the end of 2016, we have been following the production and policy statements of OPEC 2.0, the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 We will be exploring the rising risks to our demand projections in future research. Still, we are in broad agreement with the IMF's most recent assessment of global economic growth, which remains at 3.9% p.a. Please see "The Global Expansion: Still Strong but Less Even, More Fragile, Under Threat," published July 16, 2018, on the IMF's blog. 3 We discuss this at length in the Special Report we published with BCA's Geopolitical Strategy on June 7, 2018, entitled "Iraq Is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. 4 In an apparent recognition of what it would mean for world oil markets if Iran's exports did go to zero - particularly with Venezuela so close to collapse, which could take another 800k b/d off the market - U.S. Secretary of State Mike Pompeo announced waivers to the sanctions would be granted, following Trump's remarks at the beginning of July. See "Pompeo says US could issue Iran oil sanctions waivers" in the July 10, 2018, Financial Times. The Trump administration, however, is keeping markets on their toes, with Treasury Secretary Steven Mnuchin telling the U.S. Congress, "We want people to reduce oil purchases to zero, but in certain cases, if people can't do that overnight, we'll consider exceptions." See "Iran sues US for compensation ahead of re-imposition of oil sanctions," published by S&P Global Platts on July 17, 2018, on its spglobal.com/platts website. 5 Technically, this means the confidence interval around the target is now wider, which implies high probability of going above $80/bbl as well as the probability of going under $70/bbl. Still, the 2019 risks are skewed to the upside, in our view. 6 Given that our model is based solely on a variety of fundamental variables - i.e. supply-demand-inventory - the deviations can be interpreted as movements in the risks premium/discount. 7 This exercise does not include any estimate of oil flows through KSA's East-West pipeline, and possible exports therefrom. The rated capacity of the 745-mile line is 5 MMb/d, possibly 7 MMb/d. KSA's Red Sea loading capacity and the capacity of the Suez Canal and Bab el Mandeb under stress - i.e., the volumes either can handle with a surge of oil-tanker traffic - is not considered either. 8 This is the U.S. EIA's estimate. The EIA notes that in 2015 the daily flow of oil through the Strait accounted for 30% of all seaborne-traded crude oil and other liquids. Natural gas markets also could be affected by a closure: In 2016, more than 30% of global liquefied natural gas trade transited the Strait. Please see "Three important oil trade chokepoints are located around the Arabian Peninsula," published August 4, 2017, at eia.gov. 9 We encourage our clients to read our analysis of potential Iranian retaliatory strategies, penned by BCA's Geopolitical Strategy team. 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 Analysis of Iran's military strategy and U.S. counterstrategy used in this paper relies on research from three heavily cited papers. Eugene Gholz and Daryl Press are skeptical of Iran's ability to close the Strait in their paper titled "Protecting 'The Prize': Oil and the National Interest," published in Security Studies Vol. 19, No. 3, 2010. Caitlin Talmadge gives Iran's capabilities far more credit in a paper titled "Closing Time: Assessing the Iranian Threat to the Strait of Hormuz," published in International Security Vol. 33, No. 1, Summer 2008. Eugene Gholz also led a project at the University of Texas Robert S. Strauss Center for International Security and Law that published an extensive report titled "The Strait of Hormuz: Political-Military Analysis of Threats to Oil Flows." 11 In the Strauss Center study, the most likely number is 814 mines, if Iran had a two-week period to do so covertly. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Trades Closed in 2018 Summary of Trades Closed in 2018 U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic

Highlights President Trump is a prisoner of his own mercantilist rhetoric - there is more trade tension and volatility to come; China's depreciation of the RMB can go further - and will elicit more punitive measures from Trump; Gasoline prices are a constraint on Trump's Maximum Pressure campaign against Iran, but only until midterm elections are done; Brexit woes are keeping us short GBP/USD, but Theresa May has discovered the credible threat of new elections - we are putting a trailing stop on this trade at 2%; The EU migration "crisis" is neither a real crisis nor investment relevant. Feature General Hummel: I'm not about to kill 80,000 innocent people! We bluffed, they called it. The mission is over. Captain Frye: Whoever said anything about bluffing, General? The Rock, 1996 As BCA's Geopolitical Strategy has expected since November 2016, the risk of trade war poses a clear and present danger for investors.1 The U.S. imposed tariffs of 25% on $34 billion of Chinese goods on July 6, with tariffs on another $16 billion going into effect on July 20. President Trump announced on July 10 that he would levy a 10% tariff on an additional $200 billion of Chinese imports by August 31 and then on another $300 billion if China still refused to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than China exported to the U.S. last year (Chart 1)! Chart 1President Trump Magically Threatens ##br##Even Non-Existent China Imports Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Table 1Market's Couldn't Care##br## Less About Tariffs Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? The S&P 500 couldn't care less. Trade-related events - and other geopolitical crises - have thus far had a negligible impact on U.S. equities (Table 1). If anything, stocks appear to be slowly climbing the geopolitical wall of worry since plunging to a low of 2,581 on February 8, which was before any trade tensions emerged in full focus (Chart 2A and Chart 2B).2 Chart 2AStocks Climbing The 'Wall Of Worry' On Trade Tensions... Stocks Climbing The 'Wall Of Worry' On Trade Tensions... Stocks Climbing The 'Wall Of Worry' On Trade Tensions... Chart 2B...And On Military Tensions ...And On Military Tensions ...And On Military Tensions Speaking with clients, the consensus appears to be that President Trump is "bluffing." After all, did he not successfully create a "credible threat" amidst the tensions with North Korea, thus forcing Pyongyang to stand down, change its bellicose rhetoric, free U.S. prisoners, and freeze its nuclear device and ballistic tests? This was a genuinely successful application of his "Maximum Pressure" tactic and he did not have to fire a shot!3 Yes, but the Washington-Pyongyang 2017 brinkmanship caused 10-year Treasuries to plunge 35bps from their July 7 peak to their September 7 low.4 Our colleague Rob Robis - BCA's Chief Fixed Income Strategist - assures us that this move in Treasuries last summer was purely North Korea-related, which suggests that not all investors were relaxed and expecting tensions to resolve themselves.5 President Trump may be bluffing on protectionism, on Iran, and on the U.S.'s trade and geopolitical relationship with its G7 allies. However, we should consider two risks. The first is that his opponents might not back down. Yes, we agree with the consensus that China will ultimately lose a trade war with the U.S. It is a trade surplus country fighting a trade war with its chief source of final export demand (Chart 3). Chart 3China Has More To Lose Than The U.S. China Has More To Lose Than The U.S. China Has More To Lose Than The U.S. Forecasting when China backs down, however, is difficult. If Beijing backs down in 2018, investors betting on stocks ignoring trade risks will be proven correct. We do not see this happening. Instead, we expect Beijing to continue using CNY depreciation to offset the impact of tariffs, likely exacerbating the ongoing USD rally in the process, and eventually putting pressure on U.S. corporate earnings in Q3 and Q4. China does not appear to be panicking about the threat of a 10% tariff. In fact, Beijing may decide to double-down on its structural reform efforts, which have negatively impacted growth in the country thus far, blaming President Trump's protectionist policies for the pain. The other question is whether the U.S. political context will allow President Trump to end the trade war. Our clients, colleagues, and friends in the financial industry seem to have collective amnesia about the "trade truce" orchestrated by Treasury Secretary Steven Mnuchin on May 20. The truce lasted merely a couple of days, with the U.S. ultimately announcing on May 29 that the tariffs on $50 billion of Chinese imports would go forward. President Trump may have wanted to present the Mnuchin truce as a big victory ahead of the midterm elections. His tweets the next day were triumphant.6 However, once the collective American establishment (Congress, pundits, and even Trump's ardent supporters in the conservative media) got hold of the details of the deal, they were shocked and disappointed.7 Why? The American "median voter" is far more protectionist than the political establishment has wanted to admit. Now that this public preference has been elucidated, President Trump himself cannot move against it. He is a prisoner of his own mercantilist rhetoric. President Trump may be dealing with a situation similar to the one General Hummel faced in the iconic mid-1990s action thriller The Rock. Hummel, played by the steely Ed Harris, holed up in Alcatraz with VX gas-armed M55 rockets, threatening to take out tens of thousands in San Francisco unless a ransom was paid by the Washington establishment. Unfortunately for Hummel, the psychotic marines he brought to "The Rock" turned against him when he suggested that the entire operation was in fact a bluff. As such, we reiterate: Whoever said anything about bluffing? China: Beware Beijing's Retaliation Since 2017, we have cautioned investors that Beijing was likely to retaliate to the imposition of tariffs by weakening the CNY/USD.8 June was the largest one-month decline in CNY/USD since the massive devaluation in 1994 (Chart 4). BCA's China Investment Strategy has shown that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar.9 Chart 5 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have reflected the strength in the U.S. dollar until very recently. However, CNY/USD has fallen over the past few days by a magnitude in excess of what would be expected given movements in the greenback, implying that the very recent weakness is likely policy-driven. Chart 4The Biggest One-Month Yuan Drop Since 1994 The Biggest One-Month Yuan Drop Since 1994 The Biggest One-Month Yuan Drop Since 1994 Chart 5The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies BCA's Foreign Exchange Strategy has pointed out that currency depreciation is also a way to stimulate the economy in the face of the central government's ongoing deleveraging policy.10 Not only does a weaker CNY dull the impact of Trump's tariffs, it also insulates China against a slowdown in global trade volumes (Chart 6). Moreover, China's current account fell into deficit last quarter (Chart 7). A weaker RMB helps deal with this issue, but the PBoC may be forced to cut Reserve Requirement Ratios (RRRs) further if the deficit remains in place, forcing the currency even lower. Chart 6China Needs A Buffer Against Slowing Trade China Needs A Buffer Against Slowing Trade China Needs A Buffer Against Slowing Trade Chart 7Supportive Conditions For A Lower CNY Supportive Conditions For A Lower CNY Supportive Conditions For A Lower CNY There is no silver lining in this move by Beijing. Evidence that China is manipulating its currency would be a clear sign of an outright, full-scale trade war between the U.S. and China. On one hand, a falling RMB will improve the financial position of China's exporters. On the other hand, it may invite further protectionist action from the U.S., including a threat by the White House to increase the tariff levels on the additional $500 billion of imports from the current 10% rate, or to enhance export restrictions on critical technologies, or to add new investment restrictions. Several of our clients have pointed out that China does not want a trade war, that it cannot win a trade war, and that it is therefore likely to offer concessions ahead of the U.S. midterm election. We agree that China is at a disadvantage.11 But we also reiterate that the concessions have already been offered, in mid-May following the Mnuchin negotiations with Chinese Vice Premier Liu He. China and the U.S. may of course resume negotiations at any time, but it will likely take months, at best, to arrange a deal that reverses this month's actual implementation of tariffs. We think that the obsession with "who will win the trade war" is misplaced. Of course, the U.S. will "win." The problem is that what the Trump administration and what investors consider a "victory" may be starkly different: victory may not include a rip-roaring stock market. In fact, President Trump may require a stock market correction precisely to convince his audience, including those in Beijing, that his threats are indeed credible. Bottom Line: President Trump's promise of a 10% tariff on $500 billion of Chinese imports can easily be assuaged by a CNY/USD depreciation. If we know that Beijing is depreciating its currency, so does the White House. The charge against Beijing for currency manipulation could occur as late as the Treasury Department's semiannual Report to Congress in October, or informally via a presidential tweet at any time before then. While the formal remedies against a country deemed to be officially engaged in currency manipulation are relatively benign in the context of the ongoing trade war, we would expect President Trump to up the pressure on China regardless. Iran: Can Midterm Election Stay President Trump's Hand? We identified U.S.-Iran tensions in our annual Strategic Outlook as the premier geopolitical risk in 2018 aside from trade concerns.12 We subsequently argued that President Trump's application of "Maximum Pressure" against Iran would likely exacerbate tensions in the Middle East, add a geopolitical risk premium to oil prices, and potentially lead to a military conflict in 2019 (Diagram 1).13 Diagram 1Iran-U.S. Tension Decision Tree Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? The Brent crude oil price has come off its highs just below $80/bbl in late May and appears to be holding at $75/bbl. Is the market once again ignoring bubbling U.S.-Iran tensions or is there another factor at play? We suspect that investors are placing their hopes on White House pressure on producers to bring massive amounts of crude online to offset the impact of "Maximum Pressure" on Iran. First, Trump tweeted in April that "OPEC is at it again," keeping oil prices artificially high. He followed this with another tweet at the end of June, directly requesting that Saudi Arabia increase oil production by up to 2 million b/d so that he may continue to play brinkmanship with Tehran. Second, the Libyan media leaked that President Trump sent letters to the representatives of Libya's warring factions, imploring them to restart oil exports or face international prosecution and potential U.S. military intervention.14 The pressure on the Libyan authorities appears to have worked, with the Tripoli-based National Oil Corporation (NOC) ending its force majeure, a legal waiver on contractual obligations, on the ports of Ras Lanuf, Es Sider, Zueitina, and Hariga. Third, Secretary of State Mike Pompeo signaled on July 10 that the U.S. would consider granting waivers to countries seeking to avoid being sanctioned for buying oil from Iran. On July 15, however, the administration clarified the comment by stating that it would only grant limited exceptions based on national security or humanitarian efforts. The White House is realizing that, unlike its brinkmanship with North Korea, "Maximum Pressure" on Iran comes with immediate domestic costs: higher gasoline prices (Chart 8). The last thing President Trump wants to see is his household tax cut trumped by the higher cost of gasoline. Chart 8How Badly Do Americans Want A New Iran Deal? How Badly Do Americans Want A New Iran Deal? How Badly Do Americans Want A New Iran Deal? Chart 9Iran Is Not Yet At Peak North Korean Levels Of Threat Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Applying Maximum Pressure on Iran is tricky. Politically, the upside is limited for President Trump. First, a majority of Americans (62%) do not want to see the U.S. withdraw from the deal, and do not consider Iran to be as critical of a threat as North Korea (Chart 9). That said, 40% believe that Iran is a "very serious" threat - up from just 30% in October, 2017 - and 62% of Americans believe that "Iran has violated the terms" of the nuclear agreement. These are numbers that President Trump can "work with," but not if gasoline prices rise to consumer-pinching levels. As such, the question is whether we should stand down from our bullish oil outlook given President Trump's active role in eking out new supply. We should, if there were supply to be eked out. BCA's Commodity & Energy Strategy believes that global supply capacity will not be sufficient to keep prices below $80/bbl in the event that Venezuela collapses in 2019 or that Iranian export losses are greater than the 500,000 b/d we are currently projecting.15 The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year, to fall to just over 1 mm b/d next year (Chart 10). Our commodity strategists believe that the idle and spare capacity of KSA, Russia, and other core OPEC 2.0 states that can actually increase production would be taxed to the extreme to cover losses of Iranian exports, especially if the losses reached 1 mm b/d. In fact, many secondary OPEC 2.0 producers are struggling to produce at their 2017-2018 production quota, suggesting that lack of investment and natural depletion have already taken their toll (Chart 11). Chart 10Global Spare Capacity##br## Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Chart 11OPEC 2.0's Core Producers Would##br## Struggle To Replace Lost Exports OPEC 2.0's Core Producers Would Struggle To Replace Lost Exports OPEC 2.0's Core Producers Would Struggle To Replace Lost Exports Could President Trump back off from the threat of brinkmanship with Iran due to the risk of rising oil prices? Yes, absolutely. We have argued in the past that President Trump appears to be an intensely domestically-focused president. We also see little logic, from the perspective of U.S. interests broadly defined or President Trump's "America First" strategy specifically, in undermining the Obama-era nuclear agreement. As such, domestic constraints could stay President Trump's hand. On the other hand, these constraints would have the greatest force ahead of the November 2018 midterm and the 2020 general elections. This gives President Trump a window between November 2018 and at least the early summer of 2020 to put Maximum Pressure on Iran. As such, we think that investors should fade White House attempts to shore up global supply. Once the midterm election is over, the pressure will fall back on Iran. What about Iran's calculus? Tehran has an interest in dampening tensions ahead of the midterms as well. However, if the U.S. actually enforces sanctions, as we expect it will, we are certain that Iran will begin to ponder the retaliatory action we describe in Diagram 1. In fact, Iran's population appears to be itching for a confrontation, with an ever-increasing majority supporting the restart of Iranian nuclear facilities in response to U.S. withdrawal from the JCPOA nuclear agreement (Chart 12). Iranian officials have also already threatened to close the Straits of Hormuz as we expected they would. Chart 12Iranians Supported Ending Nuclear Deal If The U.S. Did (And It Did!) Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Bottom Line: Between now and November, U.S. policy towards Iran may be much ado about nothing. However, we expect the pressure to rise by the end of the year and especially in 2019. Our subjective probability of armed conflict remains at an elevated 20%, by the end of 2019. This is four times greater than our probability of kinetic action amidst the tensions between the U.S. and North Korea. Brexit: Has Theresa May Figured Out How Credible Threats Work? We have long argued that a soft Brexit is incompatible with Euroskeptic demands for increased sovereignty (Diagram 2). And, indeed, sovereignty was one of the main demands - if not the main demand - of Brexit voters ahead of the referendum. A large percent, 32% of "leave" voters, said they would be willing to vote "stay" if a deal with the EU gave "more power to the U.K. parliament," an even greater share than those focused on migration (Chart 13). As such, since March 2016, we have expected the U.K. Conservative Party to split into factions regardless of the outcome of the vote on EU membership.16 Diagram 2The Illogic Of ##br##Soft Brexit Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Chart 13Sovereignty Topped The##br## List Of Brexit Voter Concerns Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? U.K. Prime Minister Theresa May has fought against the inevitable by inviting notable Euroskeptics into her cabinet and by trying to pursue a hard Brexit in practice. The problem with this strategy is that it won't work in Westminster, where a whopping 74% of all members of parliament, and 55% of all Tory MPs, declared themselves as "remain" supporters ahead of the 2016 referendum (Chart 14). Given that the House of Commons has to approve the ultimate U.K.-EU deal, a hard-Brexit deal is likely to fail in Parliament. While such a defeat would not automatically bring up an election, May would be essentially left without any political capital with which to continue EU negotiations and would either have to resign or call a new election. Chart 14Westminster MPs Support Bremain! Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Theresa May therefore has two options. The first is to trust the political instincts of David Davis and Boris Johnson and try to push a hard Brexit through the House of Commons. But with a slim majority of just one MP, how would she accomplish such a feat? Nobody knows, ourselves included, which is why we shorted the GBP as long as May stubbornly listened to the Euroskeptics in her cabinet. However, it appears that May has finally decided to ditch her Euroskeptic cabinet members and establish the "credible threat" of a new election. While May has not uttered the phrase directly, she hinted at a new election when she suggested that "there may be no Brexit at all." The message to hard-Brexit Tory rebels is clear: back my version of Brexit or risk new elections. From an economic perspective, retaining some semblance of Common Market membership is obviously superior to the hard-Brexit alternative. It is so superior, in fact, that Boris Johnson himself called for it immediately following the referendum!17 From a political perspective, it is also much easier to persuade less than two-dozen committed Tory Euroskeptics that a new election would be folly than it is to convince half of the party that the economic risks of a hard-Brexit are inconsequential. The switch in May's tactic therefore warrants a cautionary approach to our current GBP/USD short. The recommendation is up 5.55% since February 14. However, the GBP could be given a tailwind if investors sniff out fear amongst hard Brexit Tories. We still believe that downside risks exist in the short term. First, there is no telling if the EU will accept the particularities of May's Brexit strategy. In fact, the EU may want to make May's life even more difficult by asking for more concessions. Second, Euroskeptic Tories in the House of Commons may be willing martyrs, rebelling against May regardless of the economic and political consequences. Bottom Line: We are keeping our short GBP/USD on for now, which has returned 5.55% since February 14, but we will tighten the stop to just 2%. We think that Theresa May has finally figured out how to use "credible threats" to cajole her party into a soft Brexit. The problem, however, is that she still needs Brussels to play ball and her Euroskeptic MPs to act against their ideology. Europe: Will The Immigration Crisis End The EU? Chart 15European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over No. There is no migration crisis in the EU (Chart 15). Despite the posturing in Europe over the past several months, the migration crisis ended in October 2015. As we forecast at the time, Europe has since taken several steps ovet the succeeding years to increase the enforcement of its external borders, including illiberal methods that many investors thought beyond European sensibilities.18 Today, EU member states are openly interdicting ships carrying asylum seekers and turning them away in international waters. Chancellor Angela Merkel has become just the latest in a long line of policymakers to succumb to her political constraints - and abandon her preferences - by agreeing to end the standoff with her conservative Bavarian allies. Merkel has agreed to set up transit centers on the border of Austria from where migrants will be returned to the EU country where they were originally registered, or simply sent across the border to Austria. The idea behind the move is to end the "pull" that Merkel inadvertently created by openly declaring that Germany was open to migrants regardless of where they came from. Why wouldn't migrants keep coming to Europe regardless? Because if the promise of a job and a legal status in Germany or other EU member states is no longer available, the cost - in treasure, limb, and life - of the journey through the Sahara and unstable states like Libya, and the Mediterranean Sea will no longer make sense. As Chart 15 shows, potential migrants are capable of making the cost-benefit calculation and are electing to stay put. Bottom Line: The EU migration crisis is not investment-relevant. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see the Appendices for the detailed description of events. 3 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," June 8, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 5 BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 6 His tweets in the immediacy of the deal suggest that this was the case. He tweeted, immediately following Mnuchin's Fox News appearance, "China has agreed to buy massive amounts of ADDITIONAL Farm/Agricultural Products - would be one of the best things to happen to our farmers in many years!" He then tweeted again, suggesting that his deal was superior to anything President Obama got, "I ask Senator Chuck Schumer, why didn't President Obama & the Democrats do something about Trade with China, including Theft of Intellectual Property etc.? They did NOTHING! With that being said, Chuck & I have long agreed on this issue! Trade, plus, with China will happen!" His third tweet suggested that the deal being negotiated was indeed a big compromise, "On China, Barriers and Tariffs to come down for first time." All random capitalizations are President Trump's originals. 7 We reacted to the truce by arguing that it would not "last long." It lasted merely three days! Please see BCA Geopolitical Strategy Weekly Report, "Some Good News (Trade), Some Bad News (Italy)," dated May 23, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. 10 Please see BCA Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World," dated June 29, 2018, available at fes.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 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. 14 Please see "Trump's letter to rivals allegedly results in resumption of oil exports in Libya," Libyan Express, dated July 11, 2018, available at libyanexpress.com. 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf," dated July 5, 2018, available at ces.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 17 Johnson stated right after the referendum that "there will continue to be free trade and access to the single market." Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 18 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. Appendix Appendix 2A Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Appendix 2B Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Appendix 2B (Cont.) Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Geopolitical Calendar

Dear Client, Geopolitical analysis is a fundamental part of the investment process. BCA’s Chief Geopolitical Strategist, Marko Papic, will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Highlights The U.S. and China have now acted on their threats and imposed tariffs; A full-blown trade war is expected, as President Trump retaliates to China's retaliation; The Tiananmen Square incident, the third Taiwan Strait Crisis, and the Hainan Island incident are previous U.S.-China clashes worth comparing to today's conflict - they point to more trouble ahead; Trade tensions are already spilling out into strategic tensions in China's near seas. It is too soon to buy Chinese or China-exposed equities. Feature On July 6, President Donald Trump imposed a 25% tariff on $34 billion worth of Chinese imports, to expand to $50 billion on July 20. China responded with tariffs of its own on the same amount (Chart 1). Trump has since threatened to slap a 10% tariff on $200 billion worth of goods, and potentially additional tariffs on another $300 billion. Beijing is refusing to negotiate under duress. Trade tensions have already spilled into the military realm, with scuffles occurring from the coast of Africa to the Taiwan Strait.1 BCA's Geopolitical Strategy has long maintained that U.S.-China relations are in a structural, not merely cyclical, decline.2 One of the most striking illustrations of this thesis has been the divergence of the two economies since the global financial crisis. The Chinese exporter has fallen in importance to China's economy while the U.S. consumer has been taking on less debt (Chart 2). Previously, a close economic dependency - dubbed "Chimerica" by prominent commentators - limited the two countries' underlying strategic distrust. Today, strategic distrust is aggravating economic divisions. Chart 1U.S.-China Trade Hit By Tariffs The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 2Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over How significant is the current rupture in U.S.-China relations? A brief look at the three major crisis points of the 1980s-2000s reinforces our structural assessment: the current conflict has the potential to become the biggest conflict in U.S.-China relations since the early Cold War. Judging by previous crises, it could last two years or more and involve extensive economic sanctions and military saber-rattling. The disruption to global markets could be much greater than in the past due to China's greater heft on the world stage. Crisis #1: Tiananmen Square, 1989-91 The first major crisis in modern U.S.-China relations was also the worst to date. It is therefore the model against which to compare today's fraying relationship. It centered on the suppression of the Tiananmen Square protests in 1989 by the Communist Party and People's Liberation Army (PLA). Throughout the 1980s, China struggled to manage the rapid economic and social consequences of opening up to the outside world. The release of pent-up demand in an inefficient, command-style supply system resulted in rising bouts of inflation that spurred popular unrest (Chart 3). Meanwhile, student activism and democratic sentiment emerged in the political climate of glasnost across communist regimes. These forces coalesced into the large-scale demonstrations at Tiananmen Square, Beijing, and other cities, in the spring of 1989. In response, the ruling party declared martial law and ordered the PLA to break up the demonstrations on June 3-4. The United States responded with a series of sanctions intended to punish and isolate China's leaders. President George H. W. Bush halted arms exports, other sensitive exports, most civilian and military dialogue, development aid, and support for multilateral bank lending to China.3 The other G7 countries joined with their own restrictions on exports, aid, and loans. China's economy slowed sharply to a 4% growth rate from above 10% for most of the decade. Meanwhile the government expanded the crackdown on domestic dissent. Exports to China clearly suffered from the crisis (Chart 4). Chart 3China's Reform Era Sparked Inflation China's Reform Era Sparked Inflation China's Reform Era Sparked Inflation Chart 4Trade Suffered From Tiananmen Incident Trade Suffered From Tiananmen Incident Trade Suffered From Tiananmen Incident Ultimately, however, the U.S. and its allies proved unwilling to sustain the pressure. While multilateral lending dropped off, direct lending continued (Chart 5). China was also allowed to retain its Most Favored Nation (MFN) trading status. The G7 began removing some of the sanctions as early as the following year. The inflow of FDI recovered sharply (Chart 6). Only a few of the sanctions had a lasting effect.4 Chart 5Multilateral Lending Cut Off After Tiananmen The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 6FDI Recovered From Tiananmen Quickly The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis The relevance of Tiananmen today is that when faced with domestic instability, China's ruling party took drastic measures to ensure its supremacy. This included weathering the pain of the combined G7 trade sanctions at a time when China's economy was small, weak, and slowing. By comparison, today's trade war also threatens domestic stability - through unemployed manufacturing workers rather than pro-democracy students. Yet it does not involve a united front against China from the West (the Trump administration is simultaneously slapping tariffs on the G7!). Moreover, China's economy is far larger and more influential than in 1989. This gives it a greater ability to retaliate and to deter a conflict that is all the more consequential for global economies and markets (Table 1). As for the market impact, mainland China did not have functional stock markets until 1990-91, but Hong Kong-listed stocks collapsed during the Tiananmen protests and did not fully recover for a year (Chart 7). Today, tariffs are a more direct and lasting threat to corporate earnings than the Tiananmen fallout and it is not clear how far the cycle of retaliation will go. The implication for investors is that Chinese and China-exposed equities are not yet a buy, despite the 10% and 13% selloff in A-shares and H-shares in recent weeks. Table 1China Much Bigger Today Than In Previous U.S.-China Clashes The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 7Tiananmen Hit Hong Kong Stocks Tiananmen Hit Hong Kong Stocks Tiananmen Hit Hong Kong Stocks Finally, the 1980s-90s marked the heyday of U.S.-China economic engagement and the Bush White House was eager to get on with business (even the Bill Clinton White House proved to be the same). By contrast, the Washington establishment today is united in demanding a tougher stance on China. The two countries are now "peers" locked in a struggle that goes beyond trade to affect long-term national security.5 Rebuilding trust will require painstaking negotiations that may take months; more economic and financial pain may be necessary to force cooperation. Bottom Line: The Tiananmen incident has long provided the basic framework for a rupture in U.S.-China relations, as it involved an official diplomatic cutoff along with a serious blow to Chinese growth rates and foreign trade and investment. Circumstances are even more dangerous today, as China is in a better position to stare down U.S. pressure and the U.S. is more desirous of a drawn-out confrontation. This is a bad combination for risk assets. It is too early to buy into the selloff in Chinese and China-related equities. Crisis #2: The Taiwan Strait, 1995-96 From the end of the Chinese Civil War in 1949 and beginning of the Korean War in 1950, the United States undertook to defend the routed Chinese nationalists on their island refuge of Taiwan. Fighting occasionally broke out over control of the small coastal islands across the strait from Taiwan, most notably in the two "Taiwan Strait Crises" of 1954-55 and 1958. An uneasy equilibrium then developed that lasted until the third Taiwan Strait Crisis in 1995-96. The third crisis arose in the aftermath of Taiwan's democratization. China's economy was booming, it was seeking to modernize its military, and the U.S. was increasing arms sales to Taiwan (Chart 8). 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 with a show of force on behalf of its informal ally, eventually deploying two aircraft carriers, USS Nimitz and USS Independence, and various warships to the area. The Nimitz sailed through the strait. Tensions peaked ahead of the Taiwanese election on March 23, 1996 - in which voters went against China's wishes - and simmered for years afterwards. Chart 8Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Chart 9Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks The military and diplomatic standoff had a pronounced negative impact on financial markets. Both mainland and Taiwanese stock markets sold off and were suppressed for months afterwards (Chart 9). Our measure of the Taiwanese geopolitical risk premium - which utilizes the JPY/USD and USD/KRW exchange rates as proxies - shows that risks reached a peak during this period (Chart 10). As with Tiananmen, however, U.S. stocks were insulated from the crisis. Chart 10Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Over the long run, China's saber-rattling promoted pro-independence sentiment and Taiwanese identity, factors that are proving to be political risks once again in 2018 (Chart 11). China has held provocative military drills and imposed discrete sanctions as a result of pro-independence election outcomes in 2014-16 (Chart 12). Local elections on November 24 this year could serve as a lightning rod for provocations, especially if pro-independence politicians, which currently hold all branches of government, continue to win.6 Chart 11Beijing's Saber-Rattling Was Counter-Productive The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 12Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Further, the Trump administration has upgraded Taiwan relations and its trade war with China is already spilling over into Taiwan affairs. The decision to send the destroyers USS Mustin and Benfold through the Taiwan Strait on July 7-8 should be seen in the context of trade tensions. A new aircraft carrier transit is being openly discussed. These are negative signs that warrant caution toward both mainland and Taiwanese equities. Bottom Line: The Third Taiwan Strait Crisis marked the biggest spike in military tensions between the U.S. and China in recent memory and had a markedly negative impact on regional risk assets. It is a worrying sign that the U.S.-China trade war is becoming intermeshed with cross-strait political tensions. We continue to view Taiwan as the potential site of a "Black Swan" event, especially if this November's local election goes against Beijing's wishes.7 Crisis #3: Hainan Island, 2001 Lastly, the "Hainan Island Incident" marks another point of tension in U.S.-China relations. 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, between Hainan and the contested Paracel Islands. The U.S. plane landed on the southern island, where its crew was detained and interrogated for 10 days while their aircraft was meticulously disassembled. The U.S. issued a half-hearted apology and the crew was released. The Chinese pilot went missing in the crash and was later declared killed in action. The incident fed into already sour feelings between Washington and Beijing. Just two years earlier, the U.S. government had "botched" an attack on a federal Yugoslav target in Belgrade, striking the Chinese embassy and killing three Chinese civilians.8 Thus, at the turn of the century, China was angry about U.S. military interventionism, while the U.S. was wary of China's military modernization. But this period of tensions was ultimately overshadowed by the September 11 terrorist attacks later that year, which prompted the U.S. to turn its attention to the Middle East and the war on terrorism. We highlight the Hainan incident for a simple reason: the South China Sea is a much more fiercely contested space today than it was in 2001. This is not only because global trade traffic has multiplied to around $4.14 trillion in the sea (Diagram 1). It is also because China has attempted to enforce its sovereignty claims over most of the sea by building up military assets there over the past several years.9 The U.S. has begun to push back by conducting "freedom of navigation" exercises that directly challenge China's maritime-territorial claims. Diagram 1South China Sea As Traffic Roundabout The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis In fact, China's entire maritime periphery - from the South China Sea to the Taiwan Strait to the East China Sea - has become a zone of geopolitical risk. The risk stems from China's attempts to establish a sphere of influence - and the American, Japanese, and other Asian nations' attempts to contain China's rise. A Hainan incident today would have a much bigger impact on the market than in 2001, when China's share of global GDP, imports, and military spending was roughly one-third of what it is today (see Table 1 above). And while a diplomatic crisis of this nature could easily cause global stocks to fall, the greater danger to the marketplace is that a military incident occurs. That would jeopardize global trade and growth, and the geopolitical fallout would be more difficult to contain. Bottom Line: U.S.-China strategic tensions came to a head in the South China Sea in 2001, but quickly subsided.. Today both the risk of a miscalculation and the economic stakes are greater than in the past. China's maritime periphery is thus an additional source of geopolitical risk at a time of U.S.-China trade war. Investment Conclusions: Then And Now What the three examples above have in common is that they occurred during the springtime of U.S.-China relations after the rise of Deng Xiaoping and China's "reform and opening up" policy. In each case, thriving trade and corporate profits provided an impetus for Washington and Beijing to move beyond their difficulties. The political elite across the West also believed that economic engagement would nudge China toward fuller liberalization and eventually even democracy. Today, however, the economic logic of a U.S.-China détente has been replaced by strategic rivalry, as the two economic systems are diverging. The U.S. is growing fearful of China's technological prowess, while China fears having its access to technology unplugged.10 As we have highlighted before, President Trump is virtually unconstrained on trade policy as well as on foreign policy and national security. And while he faces congressional resistance to his tariffs on G7 allies, Congress is actually egging him on in the fight against China - as seen with the Senate's vote to re-impose, against Trump's will, sanctions on Chinese telecommunications company ZTE.11 The kerfuffle over Trump's attempted trade deal with China in May was highly illuminating: Trump attempted to sign off on a deal with China to get a "quick win" ahead of the midterms. Secretary of Treasury Steve Mnuchin called it a "truce" and top economic adviser Larry Kudlow promoted it on talk shows. But the deal was rebuffed by Congress, which is demanding resolution to the thornier problems of forced tech transfer and intellectual property theft that Trump's own administration prioritized. Hence this trade war can go farther than even Trump intended. In other words, Trump's protectionist rhetoric on China has been so successful that it now constrains his actions. The U.S. engaged in a similar trade war with Japan in the 1980s and succeeded in reducing Japan's share of the American market and in forcing Japan to invest long-term capital in the U.S. The Trump administration presumably wants to repeat this process and achieve a similar outcome (Chart 13). The intention is not necessarily to destabilize China, but to change the composition of the U.S.'s Asia trade, and hence the distribution of Asian power, and to re-capture Chinese savings via American hard assets. Chart 13The U.S. Hopes To Replicate Japan Trade War The U.S. Hopes To Replicate Japan Trade War The U.S. Hopes To Replicate Japan Trade War Chart 14The U.S. Seeks To Redistribute Asian Trade The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis If China's exports to the U.S. are taxed, both it and other manufacturing nations will have to invest more in other developing Asian economies. The latter can gradually make their manufacturing sectors more efficient, but cannot pose a strategic threat to the United States (Chart 14). However, Japan ultimately capitulated to U.S. tariff pressure because the two countries were Cold War allies with a clear national security hierarchy. By contrast, China and the U.S. are antagonists without a clear hierarchy. Beijing perceives U.S. actions as part of its strategy to contain China's rise. The Southeast Asian countries that stand to benefit from the transformation of international supply chains are also the ones that will eventually become most exposed to U.S.-China conflicts.12 As highlighted above, China is not likely to shrink from the fight that the U.S. is bringing. Given that we expect diplomacy to remain on track in North Korea,13 the result is that Taiwan and the countries around the South China Sea are the likeliest candidates for geopolitical risk events in Asia that disrupt markets this year or next. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 For Taiwan, please see Section II below. For Africa, please see Ryan Browne, "Chinese lasers injure US military pilots in Africa, Pentagon says," CNN, May 4, 2018, available at www.cnn.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, and Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 The institutions affected included the multilateral development banks and other U.S. and international development agencies. Please see Dianne E. Rennack, "China: U.S. Economic Sanctions," Congressional Research Service, October 1, 1997, available at congressionalresearch.com 4 Arms and certain high-tech exports remained under restriction for years after the event, both from Europe and the U.S. China is still unable to receive funding from the U.S. Overseas Private Investment Corporation or exports of items on the U.S. Munitions List. 5 Please see BCA Geopolitical Strategy Special Report, "Italy, Spain, Trade Wars... Oh My!" dated May 30, 2018, available at gps.bcaresearch.com. 6 Or if the pro-independence third party or the anti-establishment candidates win. 7 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 8 There is an extensive debate over the Belgrade embassy bombing. It can be summarized by saying that although the U.S. apologized for the mistake, the U.S. suspected Chinese collaboration with the Yugoslav government, while China maintains its innocence. 9 We have tracked the South China Sea closely since 2012. Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, and "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. Appendix Returns Following Crises In U.S.-China Relations Returns Following Crises In U.S.-China Relations The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Open Trades & Positions Open Tactical Recommendations* The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Open Strategic Recommendations* The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis

Highlights Systemic, data-driven, political analysis is a "must-have" (and "nice to have" too!); Investment-relevant political analysis has to be data driven; Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on "beating the spread," not predicting the match winner; Focus on policymaker constraints, not their preferences; The median voter is the price maker in the political marketplace. Feature Since the launch of our Geopolitical Strategy service in 2012, BCA Research has made a simple proposition to financial professionals: political analysis is a vital tool in the investor toolbox. It may not be the most important tool, or the one used most frequently. But a toolbox without it is incomplete. At this year's BCA Investment Conference - taking place in Toronto from September 23-25 - I will lead a seminar that will introduce the attendees to the method and philosophy the Geopolitical Strategy team employs to generate geopolitical alpha. As an introduction to the seminar, this note focuses on five frequent myths about geopolitical forecasting. Myth Number 1: Getting Geopolitics Right Is A "Nice To Have, Not A Must Have" Some investors remain skeptical about the value of geopolitical analysis. The holdouts most frequently respond with a variation of "this analysis is a nice to have, but it is not a must have." In other words, investment-focused political analysis is seen as ancillary to the investment decision-making process. A tool to be used when an exogenous event threatens one's strategic decisions. Another way to put it is to say "we will call you when something blows up." Table 1Geopolitical Crises And SPX Returns Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Please don't. No need. If something does "blow up," just close your eyes and buy risk assets. Table 1 lists the major geopolitical crises since the Second World War. While the average peak-to-trough decline during a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis.1 To illustrate this trend, we have grafted the average S&P 500 return following past geopolitical crises on to the current equity bull market (Chart 1). The picture is encouraging and shows the market often grinds higher even if something does "blow up." BCA's Geopolitical Strategy takes a different approach to political analysis. We seek to understand the market-relevant interplay between global policy decisions. Rather than reacting to things "blowing up," we look to proactively predict the path of fiscal, monetary, and government policy. Take our fundamental view in 2018 that the resynchronization in global growth - the dominant market narrative in 2017 - would be interrupted by de-synchronization between U.S. and Chinese policy. The U.S. economy often dictates global monetary conditions given the dollar's status as the global reserve currency. However, China often influences global fiscal policy given its oversized contribution to global growth (Chart 2). In 2017, we argued with high conviction that U.S. fiscal policy would turn stimulative, thus encouraging the Fed to hike rates at a faster pace than investors expected.2 We also argued that Chinese policymakers would continue to double-down on growth-constraining structural reforms.3 The interplay of these two views would weigh on global growth, supercharge the U.S. economy relative to the rest of the world, and pull the U.S. dollar higher (Chart 3). Chart 1Buy Risk If Something Blows Up Buy Risk If Something Blows Up Buy Risk If Something Blows Up Chart 2China Makes The World Go Round Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Chart 3Political Analysis Predicted This Would Happen Political Analysis Predicted This Would Happen Political Analysis Predicted This Would Happen We relied minimally on economic data in making this strategic market call. In fact, for much of 2017, economic data was not supporting our out-of-consensus view. There were few indications of a slowdown in China and the U.S. dollar kept facing headwinds. Instead, we relied on a high conviction view that politics would be stimulative to growth in the U.S. and restrictive to Chinese growth.4 This allowed us to: Recommend a high-conviction "Long U.S. Dollar Index (DXY)" view on January 31, 2018 - up 5.90% since initiation; Recommend a "Long Developed Markets Equities / Short Emerging Markets Equities" view on March 6, 2018 - up 12.09% since initiation; Recommend a "Long Indian Equities / Short Brazilian Equities" view on March 6, 2018 - up 36.40% since initiation; Recommend that clients overweight U.S. equities relative to Europe and Japan in January 2018; Highlight in April that U.S. equities would face headwinds this summer and investors should be tactically cautious. These views have now become the House View of BCA Research as a whole.5 Prescient political analysis is indeed a "nice to have." Myth Number 2: Political Data Is Useless The second-most frequent claim by geopolitical Luddites is that political data is of poor quality and thus systematic research is impossible. Our favorite two examples of this shortcoming are the Brexit referendum and the 2016 U.S. election, which polls supposedly "got wrong." But the polls did not get Brexit and President Trump's election wrong, the pundits did. If anything, the polls were showing the Brexit camp comfortably ahead throughout June 2016. It was only once MP Jo Cox was tragically murdered on June 16, a week ahead of the vote, that the polls favored the "Stay" vote. But on the day of the vote, the "Stay" camp was ahead by only 4%, well within the statistical "margin of error."6 That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit occurring, in other words, should have been a lot higher than the 30% imbued by the betting markets (Chart 4). We made a case for alarm early in 2016 based on a fundamental analysis of the British electorate.7 Chart 4AOnline Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Chart 4B... Not The Polls ... Not The Polls ... Not The Polls Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory despite her slim poll lead on the day of the election. What modelers missed is the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for President Obama, and the presence of third-party challengers. We addressed these, as well as Trump's successful "White Hype" strategy, early on in the electoral process.8 The truth is that there is an incredible wealth of political data, but investors are not familiar with it because we have become over-professionalized in our own discipline. Polling agencies, political science academics, non-governmental organizations, all provide investors with an incredible array of historical data. Some of it is of poor quality, some of it is solid. But dismissing it all outright in favor of punditry, op-eds, and the whispers of "wise old men," is folly. More recently we relied on a Pew Research survey that began in 1976 to correctly forecast that there are very few genuine fiscal conservatives in America (Chart 5). This was a critical part of our forecast, last year, that the members of the Freedom Caucus - ideologically allied with the precepts of the Tea Party revolution - would vote in favor of a massively profligate tax cut. In fact, it was Freedom Caucus members who first supported President Trump's plan to pass non-revenue neutral tax cut. Chart 5Data Told Us That America's Fiscal Conservatism Is Optional Data Told Us That America's Fiscal Conservatism Is Optional Data Told Us That America's Fiscal Conservatism Is Optional Another notable example is our long-held assertion that the world is multipolar and thus more likely to face paradigm shifts in terms of security and trade policy (Chart 6).9 To drive this point home, we have relied on our Geopolitical Power Index (GPI). To construct our GPI, we enhanced the classic National Capability Index (NCI), which was originally created by political scientists in 1963 for the Correlates of War project. Chart 6BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Political data is all around us. Just because it is not served on a platter - or accessible on a Bloomberg Terminal - does not make it useless. Myth Number 3: One Cannot Predict Politics In sports betting, gamblers are not trying to predict the outcome of a game. To be a successful gambler, one has to be agnostic to the ultimate winner. In other words, you cannot be a fan and a gambler at the same time. Instead, the goal is to "beat the spread" or choose an "over/under" on the "line" set by the casino. This is precisely what we do for a living. We do not forecast politics. We try to "beat the spread" on political outcomes set by the ultimate bookie, the market. Take our Brexit forecast. In March of 2016, we argued the probability of Brexit was closer to 50% than the 30% that was priced-in by the currency markets. Did we actually forecast that Brexit would happen? No. We argued a week ahead of the vote that Bremain would win a tight referendum. Swing and a miss, right? Wrong. Our clients do not pay us to make political forecasts. They expect us to make market forecasts. We correctly forecasted that the U.K. currency, gilts, and equity markets were not pricing in the higher-than-expected odds of a Brexit outcome. Occasionally both our political and market calls will be correct. For example, we had an extremely high conviction view that Marine Le Pen would not be able to win the French election in 2017.10 The combination of Brexit and the U.S. presidential election had bid up the probability of an anti-establishment outcome in France. Investors were imbuing an extremely erroneous conditional relationship between political outcomes in those two Anglo-Saxon countries and France. But our net assessment, made in early 2016, was that populist outcomes were far more likely in laissez-faire economies than in continental Europe, where expensive social welfare states acted as political social shock absorbers.11 Generating geopolitical alpha is the art of finding overstated and understated geopolitical risks in capital markets. Therefore, whether predicting politics is possible is an irrelevant question. The fact is capital markets are constantly pricing geopolitical risk. We believe it is our job to unearth when the market is mispricing these risks. Myth Number 4: ______ (INSERT POLITICIAN NAME) Is Unpredictable Several of our clients have pointed out that trying to forecast President Trump's policies is impossible. He is erratic, emotional, and bound to make gross errors in judgement. Another set of clients believes, with a high conviction, he is a deal-making businessman obsessed with the performance of the equity market. Yet a third group holds both views at the same time! What do we think? Nothing. We have no view on President Trump's preferences. We are indifferent and aloof of them. The fundamental precept of our method is that constraints are the superior predictor of human behavior, rather than preferences. Preferences are optional and subject to constraints. Constraints are neither optional nor subject to preferences. This is not just a neat mantra we repeat at the onset of every meeting with a prospective client. As Lee Ross and Richard Nisbett discuss in their classic of social psychology, The Person and the Situation, the context and the situation are often more important than the person themselves. In other words, what (if anything) you had for breakfast matters more for whether you were grumpy this morning than your personality traits, education, religion, and usual disposition.12 The policy path of least resistance will be bound by constraints. When faced with rigid and material constraints, predicting policymaker action is easy and our conviction is high. Take the behavior of the Greek leaders in 2015. We had a high conviction view that their political, economic, financial, and geopolitical constraints would force Athens to accept the EU's loan conditionality. In the "Game of Chicken" between Prime Minister Alexis Tsipras and Chancellor Angela Merkel, the former was riding a tricycle, while Frau Merkel was behind the wheel of a Mercedes Benz G-Wagen (Diagram 1). We therefore assigned an extremely low probability of "Grexit" even following the Greek electorate's rejection of bailout conditionality in the June 2015 referendum.13 Diagram 1ARegular Game Of Chicken Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Diagram 1BGreece Versus Euro Area 2015 Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting On the other hand, policymaker optionality increases when constraints are low. Following President Trump's victory in November 2016, we penned a report that correctly forecast the next 18 months of his presidency by purely focusing on what aspects of executive power were poorly bound by constraints.14 We particularly pointed out the U.S. Congress has given up its constitutional power over tariffs through successive legislative acts (Table 2). Table 2Trump Lacks Legal Constraints On Trade Issues Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting When constraints on policymakers are low - as is the case with Trump and protectionism - investors are tempted to fall back on preference-based forecasting. This is folly. Nobody knows what Trump really wants. No private sector institution has the necessary human intelligence (HUMINT) that would produce a statistically significant forecast of President Trump's behavior. As such, when constraints are unclear or low, investors should prepare for volatility at best, downside risks at worst. Myth Number 5: Politicians Are Price Makers The most important constraint to policymakers is the public - particularly in a democracy, but not exclusively. The public can revolt through the ballot box, tweets, or with pitchforks. As such, policymakers drain their political capital by pursuing policies that are not aligned with the "median voter." The "Median Voter Theory" is one of the few genuine theories of political science.15 It argues that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Empirical work since the 1950s has both confirmed and challenged the theory, but the fact that every U.S. presidential election concludes with a mad dash to the "center" proves it has merits. That said, the median voter is not always a centrist. First, there are multiple political issues on which there exists a median voter. The job of a successful politician is to identify the most salient issue of the day and then gauge where the median voter sits on that issue. President Trump successfully identified "the issue" of the 2016 election globalization and where the American median voter sits on the topic. The American median voter is far less supportive of globalization and free trade than was previously assumed (Chart 7). By focusing on trade, President Trump forced his opponent, Secretary Clinton, and subsequently members of his pro-business, pro-free trade, Republican Party, to swing against globalization. Chart 7America Belongs To The Anti-Globalization Bloc Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting To this day, investors continue to believe that the median voter will come to the rescue of globalization and free trade. The conventional view is that U.S. voters will revolt once the price of T-shirts, toaster ovens, and toys go up 10-15% at the local Walmart store. We vociferously disagree. The median voter is far less supportive of globalization. And ultimately, it is the median voter who sets the price in the political marketplace, policymakers are merely price takers. As such, investors should focus on the preferences of the median voter as they form the constraint matrix that policymakers have to navigate. Putting It All Together Investment-relevant political analysis is not a science. Data is of varying quality, theory is rarely foolproof, and confidence intervals are wide. However, investing is not a science either. If it were, finance and economics PhDs would be, on average, significantly wealthier than their less educated counterparts in the financial industry (they are not).16 Investors should not throw up their hands and ignore politics altogether just because of the disciplinary limitations of geopolitical analysis. By tweaking some key precepts of political science to fit the necessities of the financial industry, we have developed a set of "best practices" - if not exactly a scientific method - through which we have made geopolitical analysis investment-relevant. Ultimately, the key to sober and investment-relevant geopolitical analysis begins with the right state of mind. The job of an investor is not to predict what should happen or who will emerge victorious. Our job is much simpler: find inefficiencies in the market's pricing of geopolitical events and trends, and generate geopolitical alpha. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17 2018, available at gps.bcaresearch.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 6 Given that the Brexit referendum was a "one off" and without precedent, the margin of error should have been wide to begin with. 7 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 12 Please see our book review of this seminal work in our February 2014 Monthly Report. Lee Ross and Richard Nisbett, The Person and the Situation - Essential Contributions of Social Psychology, (London: Pinter & Martin, 2011). 13 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 15 The Median Voter Theory was in fact first posited by economist Harold Hotelling in his 1929 article "Stability in Competition." His en passant comment in an article otherwise focused on business decision-making remains prescient today. Please see "Stability in Competition," Economic Journal 39 (1929), pp. 41-57. For subsequent treatments of the concept in political science, please see Duncan Black, "On The Rationale of Group Decision-Making," Journal of Political Economy 56 (1948), pp. 23-34; and Anthony Downs, An Economic Theory of Democracy (New York: Harper Collins, 1957). 16 Please see The Economist, "Why doing a PhD is often a waste of time," dated December 27, 2016, available at economist.com.

Highlights Systemic, data-driven, political analysis is a "must-have" (and "nice to have" too!); Investment-relevant political analysis has to be data driven; Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on "beating the spread," not predicting the match winner; Focus on policymaker constraints, not their preferences; The median voter is the price maker in the political marketplace. Feature Since the launch of our Geopolitical Strategy service in 2012, BCA Research has made a simple proposition to financial professionals: political analysis is a vital tool in the investor toolbox. It may not be the most important tool, or the one used most frequently. But a toolbox without it is incomplete. At this year's BCA Investment Conference - taking place in Toronto from September 23-25 - I will lead a seminar that will introduce the attendees to the method and philosophy the Geopolitical Strategy team employs to generate geopolitical alpha. As an introduction to the seminar, this note focuses on five frequent myths about geopolitical forecasting. Myth Number 1: Getting Geopolitics Right Is A "Nice To Have, Not A Must Have" Some investors remain skeptical about the value of geopolitical analysis. The holdouts most frequently respond with a variation of "this analysis is a nice to have, but it is not a must have." In other words, investment-focused political analysis is seen as ancillary to the investment decision-making process. A tool to be used when an exogenous event threatens one's strategic decisions. Another way to put it is to say "we will call you when something blows up." Table 1Geopolitical Crises And SPX Returns Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Please don't. No need. If something does "blow up," just close your eyes and buy risk assets. Table 1 lists the major geopolitical crises since the Second World War. While the average peak-to-trough decline during a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis.1 To illustrate this trend, we have grafted the average S&P 500 return following past geopolitical crises on to the current equity bull market (Chart 1). The picture is encouraging and shows the market often grinds higher even if something does "blow up." BCA's Geopolitical Strategy takes a different approach to political analysis. We seek to understand the market-relevant interplay between global policy decisions. Rather than reacting to things "blowing up," we look to proactively predict the path of fiscal, monetary, and government policy. Take our fundamental view in 2018 that the resynchronization in global growth - the dominant market narrative in 2017 - would be interrupted by de-synchronization between U.S. and Chinese policy. The U.S. economy often dictates global monetary conditions given the dollar's status as the global reserve currency. However, China often influences global fiscal policy given its oversized contribution to global growth (Chart 2). In 2017, we argued with high conviction that U.S. fiscal policy would turn stimulative, thus encouraging the Fed to hike rates at a faster pace than investors expected.2 We also argued that Chinese policymakers would continue to double-down on growth-constraining structural reforms.3 The interplay of these two views would weigh on global growth, supercharge the U.S. economy relative to the rest of the world, and pull the U.S. dollar higher (Chart 3). Chart 1Buy Risk If Something Blows Up Buy Risk If Something Blows Up Buy Risk If Something Blows Up Chart 2China Makes The World Go Round Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Chart 3Political Analysis Predicted This Would Happen Political Analysis Predicted This Would Happen Political Analysis Predicted This Would Happen We relied minimally on economic data in making this strategic market call. In fact, for much of 2017, economic data was not supporting our out-of-consensus view. There were few indications of a slowdown in China and the U.S. dollar kept facing headwinds. Instead, we relied on a high conviction view that politics would be stimulative to growth in the U.S. and restrictive to Chinese growth.4 This allowed us to: Recommend a high-conviction "Long U.S. Dollar Index (DXY)" view on January 31, 2018 - up 5.90% since initiation; Recommend a "Long Developed Markets Equities / Short Emerging Markets Equities" view on March 6, 2018 - up 12.09% since initiation; Recommend a "Long Indian Equities / Short Brazilian Equities" view on March 6, 2018 - up 36.40% since initiation; Recommend that clients overweight U.S. equities relative to Europe and Japan in January 2018; Highlight in April that U.S. equities would face headwinds this summer and investors should be tactically cautious. These views have now become the House View of BCA Research as a whole.5 Prescient political analysis is indeed a "nice to have." Myth Number 2: Political Data Is Useless The second-most frequent claim by geopolitical Luddites is that political data is of poor quality and thus systematic research is impossible. Our favorite two examples of this shortcoming are the Brexit referendum and the 2016 U.S. election, which polls supposedly "got wrong." But the polls did not get Brexit and President Trump's election wrong, the pundits did. If anything, the polls were showing the Brexit camp comfortably ahead throughout June 2016. It was only once MP Jo Cox was tragically murdered on June 16, a week ahead of the vote, that the polls favored the "Stay" vote. But on the day of the vote, the "Stay" camp was ahead by only 4%, well within the statistical "margin of error."6 That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit occurring, in other words, should have been a lot higher than the 30% imbued by the betting markets (Chart 4). We made a case for alarm early in 2016 based on a fundamental analysis of the British electorate.7 Chart 4AOnline Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Chart 4B... Not The Polls ... Not The Polls ... Not The Polls Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory despite her slim poll lead on the day of the election. What modelers missed is the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for President Obama, and the presence of third-party challengers. We addressed these, as well as Trump's successful "White Hype" strategy, early on in the electoral process.8 The truth is that there is an incredible wealth of political data, but investors are not familiar with it because we have become over-professionalized in our own discipline. Polling agencies, political science academics, non-governmental organizations, all provide investors with an incredible array of historical data. Some of it is of poor quality, some of it is solid. But dismissing it all outright in favor of punditry, op-eds, and the whispers of "wise old men," is folly. More recently we relied on a Pew Research survey that began in 1976 to correctly forecast that there are very few genuine fiscal conservatives in America (Chart 5). This was a critical part of our forecast, last year, that the members of the Freedom Caucus - ideologically allied with the precepts of the Tea Party revolution - would vote in favor of a massively profligate tax cut. In fact, it was Freedom Caucus members who first supported President Trump's plan to pass non-revenue neutral tax cut. Chart 5Data Told Us That America's Fiscal Conservatism Is Optional Data Told Us That America's Fiscal Conservatism Is Optional Data Told Us That America's Fiscal Conservatism Is Optional Another notable example is our long-held assertion that the world is multipolar and thus more likely to face paradigm shifts in terms of security and trade policy (Chart 6).9 To drive this point home, we have relied on our Geopolitical Power Index (GPI). To construct our GPI, we enhanced the classic National Capability Index (NCI), which was originally created by political scientists in 1963 for the Correlates of War project. Chart 6BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Political data is all around us. Just because it is not served on a platter - or accessible on a Bloomberg Terminal - does not make it useless. Myth Number 3: One Cannot Predict Politics In sports betting, gamblers are not trying to predict the outcome of a game. To be a successful gambler, one has to be agnostic to the ultimate winner. In other words, you cannot be a fan and a gambler at the same time. Instead, the goal is to "beat the spread" or choose an "over/under" on the "line" set by the casino. This is precisely what we do for a living. We do not forecast politics. We try to "beat the spread" on political outcomes set by the ultimate bookie, the market. Take our Brexit forecast. In March of 2016, we argued the probability of Brexit was closer to 50% than the 30% that was priced-in by the currency markets. Did we actually forecast that Brexit would happen? No. We argued a week ahead of the vote that Bremain would win a tight referendum. Swing and a miss, right? Wrong. Our clients do not pay us to make political forecasts. They expect us to make market forecasts. We correctly forecasted that the U.K. currency, gilts, and equity markets were not pricing in the higher-than-expected odds of a Brexit outcome. Occasionally both our political and market calls will be correct. For example, we had an extremely high conviction view that Marine Le Pen would not be able to win the French election in 2017.10 The combination of Brexit and the U.S. presidential election had bid up the probability of an anti-establishment outcome in France. Investors were imbuing an extremely erroneous conditional relationship between political outcomes in those two Anglo-Saxon countries and France. But our net assessment, made in early 2016, was that populist outcomes were far more likely in laissez-faire economies than in continental Europe, where expensive social welfare states acted as political social shock absorbers.11 Generating geopolitical alpha is the art of finding overstated and understated geopolitical risks in capital markets. Therefore, whether predicting politics is possible is an irrelevant question. The fact is capital markets are constantly pricing geopolitical risk. We believe it is our job to unearth when the market is mispricing these risks. Myth Number 4: ______ (INSERT POLITICIAN NAME) Is Unpredictable Several of our clients have pointed out that trying to forecast President Trump's policies is impossible. He is erratic, emotional, and bound to make gross errors in judgement. Another set of clients believes, with a high conviction, he is a deal-making businessman obsessed with the performance of the equity market. Yet a third group holds both views at the same time! What do we think? Nothing. We have no view on President Trump's preferences. We are indifferent and aloof of them. The fundamental precept of our method is that constraints are the superior predictor of human behavior, rather than preferences. Preferences are optional and subject to constraints. Constraints are neither optional nor subject to preferences. This is not just a neat mantra we repeat at the onset of every meeting with a prospective client. As Lee Ross and Richard Nisbett discuss in their classic of social psychology, The Person and the Situation, the context and the situation are often more important than the person themselves. In other words, what (if anything) you had for breakfast matters more for whether you were grumpy this morning than your personality traits, education, religion, and usual disposition.12 The policy path of least resistance will be bound by constraints. When faced with rigid and material constraints, predicting policymaker action is easy and our conviction is high. Take the behavior of the Greek leaders in 2015. We had a high conviction view that their political, economic, financial, and geopolitical constraints would force Athens to accept the EU's loan conditionality. In the "Game of Chicken" between Prime Minister Alexis Tsipras and Chancellor Angela Merkel, the former was riding a tricycle, while Frau Merkel was behind the wheel of a Mercedes Benz G-Wagen (Diagram 1). We therefore assigned an extremely low probability of "Grexit" even following the Greek electorate's rejection of bailout conditionality in the June 2015 referendum.13 Diagram 1ARegular Game Of Chicken Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Diagram 1BGreece Versus Euro Area 2015 Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting On the other hand, policymaker optionality increases when constraints are low. Following President Trump's victory in November 2016, we penned a report that correctly forecast the next 18 months of his presidency by purely focusing on what aspects of executive power were poorly bound by constraints.14 We particularly pointed out the U.S. Congress has given up its constitutional power over tariffs through successive legislative acts (Table 2). Table 2Trump Lacks Legal Constraints On Trade Issues Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting When constraints on policymakers are low - as is the case with Trump and protectionism - investors are tempted to fall back on preference-based forecasting. This is folly. Nobody knows what Trump really wants. No private sector institution has the necessary human intelligence (HUMINT) that would produce a statistically significant forecast of President Trump's behavior. As such, when constraints are unclear or low, investors should prepare for volatility at best, downside risks at worst. Myth Number 5: Politicians Are Price Makers The most important constraint to policymakers is the public - particularly in a democracy, but not exclusively. The public can revolt through the ballot box, tweets, or with pitchforks. As such, policymakers drain their political capital by pursuing policies that are not aligned with the "median voter." The "Median Voter Theory" is one of the few genuine theories of political science.15 It argues that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Empirical work since the 1950s has both confirmed and challenged the theory, but the fact that every U.S. presidential election concludes with a mad dash to the "center" proves it has merits. That said, the median voter is not always a centrist. First, there are multiple political issues on which there exists a median voter. The job of a successful politician is to identify the most salient issue of the day and then gauge where the median voter sits on that issue. President Trump successfully identified "the issue" of the 2016 election globalization and where the American median voter sits on the topic. The American median voter is far less supportive of globalization and free trade than was previously assumed (Chart 7). By focusing on trade, President Trump forced his opponent, Secretary Clinton, and subsequently members of his pro-business, pro-free trade, Republican Party, to swing against globalization. Chart 7America Belongs To The Anti-Globalization Bloc Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting To this day, investors continue to believe that the median voter will come to the rescue of globalization and free trade. The conventional view is that U.S. voters will revolt once the price of T-shirts, toaster ovens, and toys go up 10-15% at the local Walmart store. We vociferously disagree. The median voter is far less supportive of globalization. And ultimately, it is the median voter who sets the price in the political marketplace, policymakers are merely price takers. As such, investors should focus on the preferences of the median voter as they form the constraint matrix that policymakers have to navigate. Putting It All Together Investment-relevant political analysis is not a science. Data is of varying quality, theory is rarely foolproof, and confidence intervals are wide. However, investing is not a science either. If it were, finance and economics PhDs would be, on average, significantly wealthier than their less educated counterparts in the financial industry (they are not).16 Investors should not throw up their hands and ignore politics altogether just because of the disciplinary limitations of geopolitical analysis. By tweaking some key precepts of political science to fit the necessities of the financial industry, we have developed a set of "best practices" - if not exactly a scientific method - through which we have made geopolitical analysis investment-relevant. Ultimately, the key to sober and investment-relevant geopolitical analysis begins with the right state of mind. The job of an investor is not to predict what should happen or who will emerge victorious. Our job is much simpler: find inefficiencies in the market's pricing of geopolitical events and trends, and generate geopolitical alpha. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17 2018, available at gps.bcaresearch.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 6 Given that the Brexit referendum was a "one off" and without precedent, the margin of error should have been wide to begin with. 7 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 12 Please see our book review of this seminal work in our February 2014 Monthly Report. Lee Ross and Richard Nisbett, The Person and the Situation - Essential Contributions of Social Psychology, (London: Pinter & Martin, 2011). 13 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 15 The Median Voter Theory was in fact first posited by economist Harold Hotelling in his 1929 article "Stability in Competition." His en passant comment in an article otherwise focused on business decision-making remains prescient today. Please see "Stability in Competition," Economic Journal 39 (1929), pp. 41-57. For subsequent treatments of the concept in political science, please see Duncan Black, "On The Rationale of Group Decision-Making," Journal of Political Economy 56 (1948), pp. 23-34; and Anthony Downs, An Economic Theory of Democracy (New York: Harper Collins, 1957). 16 Please see The Economist, "Why doing a PhD is often a waste of time," dated December 27, 2016, available at economist.com.

Highlights If the EU27 pours cold water on Theresa May's much-hyped Brexit proposals, the immediate uncertainty around Brexit would increase. But a longer-term outcome that keeps the U.K. either in a protracted transition to exit, or attached to the EEA or EFTA would be benign for the U.K. economy. For U.K. gilts relative to other government bonds, it means bullish near-term, but bearish long-term. For the pound, it is the opposite: caution near-term, but scope for long-term appreciation, especially versus the dollar. Neutral FTSE100 in a European or global equity portfolio, given its large overweight to the technically extended oil and gas sector. The global 6-month credit impulse is still in a mini-downswing, which corroborates our successful underweight stance to the classical cyclical sectors. The dollar's recent rally is technically extended to a point which usually signals a tradeable reversal in the DXY. Feature Last week, we highlighted a surprising fact: wages in Europe and the U.S. are now growing at exactly the same pace, 2.7%. We also pointed out that wage growth in the euro area is running slightly lower than the EU28 average - which necessarily means that in a major European economy outside the euro area, wage growth is running considerably higher. That major European economy is the U.K. Chart of the WeekThe Pound Is A Function Of Relative Monetary Policy The Pound Is A Function Of Relative Monetary Policy The Pound Is A Function Of Relative Monetary Policy Absent Brexit, U.K. Interest Rates Would Be Much Higher U.K. wages are growing at 3.7% (Chart I-2). Total labour costs, which include other compensation such as employer pension contributions, are rising even faster, at 4.4%, a sharp acceleration from a year ago.1 Meanwhile, the unemployment rate is at a forty year low of 4.2% (Chart I-3). To put all of this into context, the U.K. metrics are broadly equal to, or more extreme than those in the U.S. where the Federal Reserve has already hiked the policy interest rate seven times! Chart I-2U.K. Wages Are Growing ##br##Faster Than In The U.S. U.K. Wages Are Growing Faster Than In The U.S. U.K. Wages Are Growing Faster Than In The U.S. Chart I-3The U.K. Unemployment Rate##br## Is As Low As In The U.S. The U.K. Unemployment Rate Is As Low As In The U.S. The U.K. Unemployment Rate Is As Low As In The U.S. You might think that the Bank of England would be emulating the Fed. Acknowledging "a tight labour market and gradually mounting pay pressure" Monetary Policy Committee member Andy Haldane did change his vote to a hike at the June 21 meeting. Yet the votes to remove ultra-accommodation remain in a minority of three to six. The BoE policy interest rate is still at 0.5%, only a fraction above its effective lower bound. And the tightening expected in the next couple of years remains very modest (Chart I-4). Why? Chart I-4Expectations For U.K. Rate ##br##Hikes Remain Subdued Expectations For U.K. Rate Hikes Remain Subdued Expectations For U.K. Rate Hikes Remain Subdued The BoE explains: "The main challenge continues to be to assess the economic implications of the United Kingdom withdrawing from the European Union and to identify the appropriate response to that changing outlook... ...those economic implications would be influenced significantly by the expectations of households, firms and financial markets about the United Kingdom's eventual relationships with the European Union and other countries, and the transition to them." The U.K./EU Relationship Has Only Three Possible Shapes Two years have passed since the U.K. voted to leave the EU, and the tomes that have been written on Brexit could have filled the British Library several times over. Yet on the crucial issue of what the U.K./EU relationship will look like, what we know today is little different to what we knew on the morning of June 24 2016. Just as then, we can say that the EU27 sees only three options for the long-term relationship between the U.K. and the EU. Stay in the EU. Plug into an off-the-shelf association, either the European Economic Area (EEA) or European Free Trade Association (EFTA), which already establishes the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland. Become a 'third country' to the EU like, for example, Ukraine and Turkey. The first option, to stay in the EU, is politically impossible for the U.K. unless and until a second referendum overturned the result of the first referendum - a not inconceivable, but distant possibility. The second option, to join the EEA or EFTA, is impossible until the U.K. government exorcises the hard Brexiters within its ranks who regard this endpoint as 'Brino' (Brexit in name only). Nevertheless, this - or something equivalent - is the most likely ultimate outcome once it becomes clear that what is on offer in the third option is a considerably worse deal for the U.K., both politically and economically. Becoming a third country necessarily involves a hard border. For the U.K. this creates an insoluble trilemma: the U.K./EU land border between Northern Ireland and the Irish Republic; the Good Friday peace agreement requiring the absence of any physical border within Ireland; and the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea (which would require a border between Northern Ireland and the rest of the U.K.). The U.K. government might suggest a solution: leave the EU single market for services and free movement of people, but commit to stay in the single market for goods by aligning U.K. tariffs and regulations with the EU. The U.K. government would argue that this would abrogate the need for customs checks and a hard border within Ireland. The problem with this is that the distinction between goods and services has become increasingly blurred. For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. It follows that the EU27 will almost instantaneously reject such a division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people. The rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy. Hence, the U.K. government's much hyped and lofty Brexit proposals risk getting a cold shower. The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland indefinitely remaining in the EU single market - an outcome that will be politically unpalatable. Meanwhile, the many U.K. firms which depend directly or indirectly on borderless EU supply chains for their livelihoods will fear a substantial disruption to their trade - an outcome that will be economically unpalatable. To mitigate these political and economic risks of becoming a third country to the EU, the U.K. would almost certainly need the safety net of a protracted transition period, which might become a never-ending 'rolling contract'. Throughout which, the U.K. would have to adhere almost fully to EU laws and regulations, an arrangement which a clear majority of the U.K. parliament supports (Figure I-1). Figure I-1Survey Of U.K. Members Of Parliament: ##br##Which Of These Would You Consider To Be Acceptable As Part Of A Transition Agreement? Crunch Time For Britain Crunch Time For Britain Then the reality might dawn: is it really worth going through a long transition to become a third country? Why not just attach to the EEA or EFTA instead? Although bereft of a seat at the EU top table, the carrot of EEA membership is that its Treaty Articles 112-114 enable a 'temporary brake' on the freedom of movement in particular economic sectors, satisfying a key demand of Brexit voters. The Investment Implications: Distinguish Near-Term From Long-Term If the EU27 pours cold water on Theresa May's much-hyped Brexit proposals, the immediate uncertainty around Brexit would increase. However, in the longer term any outcome that keeps the U.K. either in a protracted transition to exit or eventually attach to the EEA or EFTA would be benign for the U.K. economy and comfort the BoE. Hence, it is important to distinguish the near-term and long-term outlooks for U.K. investments. For U.K. gilts relative to other government bonds, it means bullish near-term, but bearish long-term (Chart I-5). Chart I-5Brexit Risks Have Constrained The BoE ##br##And Held Down U.K. Bond Yields Brexit Risks Have Constrained The BoE And Held Down U.K. Bond Yields Brexit Risks Have Constrained The BoE And Held Down U.K. Bond Yields For the pound, it is the opposite: caution near-term, but scope for long-term appreciation, especially versus the dollar (Chart of the Week). For the FTSE100 relative to other major equity indexes, there is another consideration: the FTSE100 is very overweight the oil and gas sector, whose outperformance appears technically extended. Hence, within a European or global equity portfolio, we recently downgraded the FTSE100 from overweight to neutral (Chart I-6). Chart I-6The FTSE100's Overweight To Oil And Gas##br## Drives Its Relative Performance The FTSE100's Overweight To Oil And Gas Drives Its Relative Performance The FTSE100's Overweight To Oil And Gas Drives Its Relative Performance We finish with two important charts outside the U.K.: The global 6-month credit impulse is still in a mini-downswing, which corroborates our successful on-going underweight stance to the classical cyclical sectors (Chart I-7). Chart I-7Underweight Cyclicals Whenever The Global 6-Month Credit Impulse Is In A Mini-Downswing Underweight Cyclicals Whenever The Global 6-Month Credit Impulse Is In A Mini-Downswing Underweight Cyclicals Whenever The Global 6-Month Credit Impulse Is In A Mini-Downswing Finally, the dollar's recent rally is technically extended to a point which usually signals a tradeable reversal in the DXY (Chart I-8). Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 As measured by Eurostat on a harmonized basis. Fractal Trading Model* As just discussed, this week's recommended trade is to position for a tradeable reversal in the trade-weighted dollar. Set a 2% profit target with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 Short Trade-Weighted Dollar Short Trade-Weighted Dollar The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The not-so-veiled threat to Gulf Arab oil shipments through the critically important Strait of Hormuz by Iran's President Rouhani earlier this week was a response to the ramping up of maximum pressure by the Trump administration, which is demanding importers of Iranian crude reduce volumes to zero. This was a predictable first step toward what could become a chaotic oil pricing environment (Map 1).1 Map 1Iran Threatens Gulf Shipments Again Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Oil prices surged on reports of the Iranian threat Tuesday morning, sold off, and recovered later in the day. Pledges from the Kingdom of Saudi Arabia (KSA) to lift production to as much as 11mm b/d this month - a record high - were all but ignored by the market. The threat to safe passage through the Strait of Hormuz - where ~ 20% of global supply transits daily - raises the spectre of military confrontation between the U.S. and Iran, and their respective allies. The growing risks from tighter supply - markets could lose as much as 2mm b/d of Iranian and Venezuelan exports as things stand now - now must be augmented by the likelihood of a Gulf conflict. Energy: Overweight. We remain long call spreads along the Brent forward curve and the S&P GSCI, as we expect volatility, prices and backwardation to move higher. These recommendations are up 34.6% since they were recommended five months ago. Base Metals: Neutral. Treatment and refining charges are higher following smelter closings. Metal Bulletin's TC/RC index was ~ $80/MT at end-June, up ~ $3 vs end-May. Precious Metals: Neutral. Gold traded below $1,240/oz over the past week, but recovered above $1,250/oz as geopolitical tensions rise. Ags/Softs: Underweight. The USDA expects U.S. farm exports in 2018 will come in at $142.5 billion, the second-highest level on record, according to agriculture.com. Feature Oil pricing could become chaotic, as U.S. policy measures aimed at Iran are countered by responses that are not altogether unexpected. In addition to limited spare capacity, and increased unplanned production outages, markets now must discount the likelihood of renewed armed conflict (short of all-out war) in the Gulf between the U.S. and Iran, and their respective allies. To appreciate the significance of President Rouhani's not-so-veiled threat to deny safe passage through the Strait of Hormuz to oil tankers carrying Gulf Arab states' exports, one need only consider that some 20% of the world's oil supply flows through this narrow passage on any given day.2 The response of the president of Iran to U.S. policy - nominally directed at denying Iran the capacity to develop nuclear weapons, but arguably meant to force the existing regime from power - is a predictable next step in the brinkmanship now being played out between these long-standing rivals.3 Following the lifting of nuclear-related sanctions in 2015, Iran's production rose ~ 1mm b/d from 2.8mm b/d to 3.8mm b/d. We expect 500k b/d of Iran's exports will be lost to the market by the end of 1H19, as a result of sanctions being re-imposed November 4. Other estimates run as high as 1mm b/d being lost if the U.S. succeeds in getting importers to drastically reduce purchases. The ire of the U.S. also is directed at Venezuela, where the loss of that country's ~ 1mm b/d of exports would become all but certain, if, as U.S. Secretary of State Mike Pompeo pressed for last month, U.S. trade sanctions against the failing state are imposed.4 We estimate Venezuela's production is down close to 1mm b/d since end-2016, and will average ~ 1.07mm b/d in 2H18 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf BCA's Ensemble Forecast Includes Extreme Events In our updated balances modeling, our base case front-loaded the OPEC 2.0 production increase announced by the coalition at its end-June meeting in Vienna. Core OPEC 2.0's 1.1mm b/d increase (1H19 vs 1H18) is offset by losses in the rest of OPEC 2.0 amounting to ~ 530k b/d in 2H18, and ~ 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels. We assume Iran's exports fall 200k b/d by the end of this year, and another 300k b/d by the end of 1H19, resulting in a total loss of 500k b/d by 2H19. Global supply rises ~ 2mm b/d this year and next, averaging 99.9mm b/d and 101.7mm b/d, respectively, in our estimates. The bulk of this growth is provided by U.S. shale-oil output, which we estimate will rise by 1.28mm b/d this year, and 1.33mm b/d next year. On the demand side, we expect global growth to remain strong, powered as always by stout EM consumption. That said, rising trade frictions, signs the synchronized global growth that powered EM oil demand could move out of synch, and divergent monetary policies at systematically important central banks could take some of the wind out of our consumption-forecast sails (Chart of the Week). That said, if a supply-side event results in a sharp upward price move, we would expect demand growth to adjust lower in fairly short order. This is because many EM states removed or reduced oil-price subsidies in the wake of the prices collapse following OPEC's declaration of a market-share war in late 2014, which leaves consumers in these state more directly exposed to higher prices than in previous cycles. Our base case is augmented with three scenarios. In our simulations, the Venezuela collapse is met by OPEC 2.0's core producers lifting production another 200k b/d, which takes its total output hike to 1.2mm b/d in 2019. OPEC 2.0 does not respond to the lower-than-expected U.S. shale growth contingency we're modeling, which is brought on by pipeline bottlenecks in the Permian Basin. Our scenarios are: A reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks (Scenario 2, Chart 2); Venezuela production collapses to 250k b/d from current levels of ~ 1.07mm b/d, which allows it to support domestic refined product demand and nothing more (Scenario 3, Chart 2); Both of these occurring simultaneously in the Oct/18 - Sep/19 interval (Scenario 4, Chart 2). Chart of the WeekTight Supply, Strong Demand##BR##Remain Supportive of Prices Tight Supply, Strong Demand Remain Supportive of Prices Tight Supply, Strong Demand Remain Supportive of Prices Chart 2BCA's Scenarios Include##BR##Production Losses In Venezuela, Iran BCA's Scenarios Include Production Losses in Venezuela, Iran BCA's Scenarios Include Production Losses in Venezuela, Iran The Stark Reality Of Low Spare Capacity Chart 3Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Our scenario analyses - particularly Scenarios 3 and 4 - illustrate the stark reality confronting oil markets: Spare capacity will not be sufficient to keep prices below $80/bbl in the event Venezuela collapses, or if Iranian export losses are greater than the 500k b/d we currently are modeling. The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year. This will fall to just over 1mm b/d next year (Chart 3).5 As things stand now, idle and spare capacity of KSA, Russia and core OPEC 2.0 states that actually can increase production would be taxed to the extreme to cover losses of Iranian exports, if some of the higher levels projected by analysts - i.e., up to 1mm b/d - are realized (Chart 4). KSA's maximum sustainable capacity is believed to be ~ 12mm b/d; officials have indicated production will be raised to close to 11mm b/d in July, then likely held there. This record level of production will test KSA's production infrastructure, and would leave the Kingdom with 1mm b/d of spare capacity. Russia is believed to have ~ 400k b/d of spare capacity; it likely will restore ~ 200k b/d of production to the market over the near future, leaving 200k b/d as spare capacity. If just the two high-loss events described above are realized - i.e., Iran export losses come in at 1mm b/d instead of the 500k b/d we expect, and Venezuela's 1mm b/d of exports are lost because the state collapses - global inventory draws will accelerate until enough demand is destroyed via higher prices to clear the market at whatever level of supply can be maintained (Chart 5). Approaching that point, we would expect OECD strategic petroleum reserves (SPRs) to be released.6 Chart 4OPEC 2.0's Core Producers Would Be##BR##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 5A Supply Shock Would Draw##BR##Crude Inventories Sharply A Supply Shock Would Draw Crude Inventories Sharply A Supply Shock Would Draw Crude Inventories Sharply Chart 6Falling Net Imports Implies##BR##Current SPR Could Be Too Large Falling Net Imports Implies Current SPR Could Be Too Large Falling Net Imports Implies Current SPR Could Be Too Large It is difficult to forecast the price at which markets would clear if we get to the state described above. However, it is worthwhile noting that OPEC spare capacity in 2008 stood at 1.4mm b/d, or 2.4% of global consumption. The 1.8mm b/d of OPEC spare capacity EIA estimates is now available to the market represents 1.8% of daily consumption globally. By next year, the EIA's estimated 1mm b/d of OPEC spare capacity will represent a little over 1% of global daily consumption. It was in this economic setting that WTI and Brent breached $150/bbl in mid-2008, just before the Global Financial Crisis tanked the world economy.7 Bottom Line: Into the mix of tightening global supply and limited spare capacity, oil markets now confront higher odds of armed conflict in the Gulf once again. Oil pricing will remain volatile, and could become chaotic as brinkmanship raises the level of uncertainty in markets. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Rouhani says U.S. pressure to stop Iranian oil may affect regional exports," published by uk.reuters.com July 3, 2018. We explore the Trump administration's maximum pressure in a Commodity & Energy Strategy Special Report published June 7, 2018, entitled "Iraq is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. We are using the term chaotic in the sense of "... sensitive dependence on initial conditions or 'the butterfly effect'" described in "Weak Emergence" by Mark A. Bedau (1997), which appears in Philosophical Perspectives: Mind, Causation, And World, Vol. 11, J. Tomberlin, ed., Blackwell, Malden MA. 2 The U.S. EIA calls the Strait of Hormuz "the world's most important oil chokepoint" in its "World Oil Transit Chokepoints," published by the U.S. EIA July 25, 2017. By the EIA's estimates, 80% of the crude oil transiting the strait is bound for Asian markets, with China, Japan, India, South Korea and Singapore being the largest markets. 3 Please see "Mattis's Last Stand Is Iran," published by Foreign Policy June 28, 2018, on foreignpolicy.com. The essay describes the state of play within the Trump administration vis-à-vis Iran. President Trump's third national security advisor, John Bolton, has stated the goal of the administration's policy is not regime change, but denial of the capacity to develop nuclear weapons. However, Bolton repeatedly called for regime change in Iran prior to being tapped as the national security advisor, and has advocated going to war with Iran to prevent it from developing a nuclear weapons capability, in a New York Times op-ed published March 26, 2015, entitled "To Stop Iran's Bomb, Bomb Iran." 4 Please see "Pompeo calls on OAS to oust Venezuela," published by CNN Politics June 4, 2018. 5 OPEC 2.0 is the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. On June 22, 2018, the coalition agreed to raise production 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman, and Qatar. The other core members of OPEC 2.0 are believed to have close to 300k b/d of spare capacity. Other estimates put the spare capacity as high as 3.4mm b/d. The ex-KSA estimates are pieced together by using the International Energy Agency's estimates for core OPEC and Citicorp's estimates for Russia. Please see "Russia's OPEC Deal Dilemma Worsens as Idled Crude Capacity Grows," published by bloomberg.com May 16, 2018. 6 In just-completed research, our colleague Matt Conlan writes the U.S. SPR, at ~ 660mm barrels, can cover more than 100 days of net U.S. crude imports (Chart 6). This coverage will rise to 140 days of net crude imports by the end of 2019. Please see "American Energy Independence And SPR Ramifications," published by BCA Research's Energy Sector Strategy July 4, 2018. 7 Please see the discussion of demand beginning on p. 228 of Hamilton, James D. (2009), "Causes And Consequences Of The Oil Shock Of 2007 - 08," published by the Brookings Institute. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Trades Closed in 2018 Summary of Trades Closed in 2017 Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf

Highlights Andrés Manuel López Obrador (AMLO) will most likely win the upcoming presidential election; His rising popularity has increased the likelihood that his left-wing party MORENA wins the lower Chamber of Congress; That said, his agenda is more "nationalist" than outright socialist; Moreover, there is no evidence that the Mexican median voter has abandoned their long-held centrist outlook; While the election and NAFTA renegotiations represent serious headwinds to Mexican assets, dedicated EM investors should stay overweight across all asset classes. Feature "I believe it is time to say that neither Chavismo... nor Trump... yes Mexicanism." Andrés Manuel López Obrador, March 2018 Mexican voters go to the polls on July 1 to elect a new president and Congress. The leading candidate for President, Andrés Manuel López Obrador (also known as AMLO), is likely to win. Our aggregate poll-of-polls shows that AMLO now has a 25% lead against his two challengers, Ricardo Anaya of the center-right National Action Party (PAN) and José Antonio Meade Kuribreña of the centrist (formerly center-left, now also center-right) Institutional Revolutionary Party (PRI). At this point, it is safe to call the presidential election for AMLO (Chart 1). A win for López Obrador will be an unprecedented political event in modern Mexican history. Although the roots of the PRI - Mexico's long-time ruling party - lie in labor, anti-Catholic, and socialist politics, no outwardly left-wing leader has won a national election since Plutarco Elías Calles in 1924. Over the past two decades, the main line of political competition in Mexico has been between the centrist PRI and center-right PAN, which ruled Mexico from 2000 to 2012 under the presidencies of Vicente Fox and Felipe Calderón. The outgoing President Enrique Peña Nieto shifted PRI towards the center-right to compete with PAN. In some way, this makes sense given that the median Mexican voter has traditionally been center, if not center-right, on economic policies (Chart 2). However, by shifting PRI so far to the right, Nieto has left space on the left for AMLO and his new party, the National Regeneration Movement (MORENA). Chart 1AMLO Is The Next President Of Mexico... A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Chart 2...But Mexicans Are Not Left-Wing A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Chart 3MORENA Can Win A Majority... A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO What should investors expect from AMLO and MORENA? First, much will depend on whether MORENA will be able to garner a majority in Congress - both the Senate and the Chamber of Deputies. Polls are starting to show that the left-wing MORENA is surging and that there is a chance that it captures a majority (Chart 3). Second, there is a major question regarding what MORENA actually stands for, politically and economically. We argue that AMLO and MORENA's rise has more to do with the ongoing drug war and corruption problems and less with the economy. As such, the Mexican median voter will remain a constraint against overly left-leaning policy. Meanwhile, the judicial branch and the market itself will retain an important role in disciplining AMLO's most left-leaning tendencies. We do not expect AMLO to veer towards socialism, but rather to remain pragmatic in his decision making. We believe him when he says that he will neither emulate Hugo Chavez of Venezuela nor Donald Trump of the U.S. Can AMLO Dominate Mexico? The short answer to the critical question is that yes, AMLO can dominate Mexican politics. Given current polling, political constraints to the AMLO presidency may be weak. For the first time in twenty years, a Mexican president may not face pluralism in Congress. BCA's geopolitical methodology focuses on constraints over preferences. Investors often focus on policymaker preferences - largely because the media reports on them enthusiastically - but what generates geopolitical alpha are constraints. This is because preferences are ephemeral, optional, and subject to constraints. Constraints, on the other hand, are real, material, not optional, and definitely not subject to preferences. For most of his career, AMLO has campaigned on a policy platform that harkens to traditional left-wing Latin American politics. Before we examine his commitment to those policies, we would have to ask whether constitutional and legislative constraints will allow AMLO and MORENA to dominate Mexican politics. The Mexican constitution designates Congress as the primary legislative body. This includes power to promulgate laws, levy taxes, declare war, and regulate trade.1 The Mexican president can veto legislation, but the veto can be overturned by a two-thirds majority. In 2011, President Felipe Calderon ended the practice of a "pocket veto," which allowed presidents to kill legislation by simply refusing to sign them. Were AMLO to face an opposition-led Congress, he would have two strategies. First would be to veto - or threaten to veto - legislation and force Congress to work with him. Given current polling, it is unlikely that Congress would have a two-thirds majority to overturn AMLO's vetoes. However, this strategy would ensure that the constitutional reforms passed under Nieto remain in place, as the president would struggle to pass his own agenda. Second would be to try to bring one of the opposition parties on board with his legislative agenda, which would ensure its passage but also ensure that the resultant legislation was modified. Lower House - The Chamber Of Deputies What are the chances that AMLO can operate with a MORENA majority? There has not been a governing majority in the Mexican Chamber of Deputies since 1994 (Chart 4), with the share of votes by the largest party normally coming in under 40% (Chart 5). According to our calculations, based on previous elections, a party would need to get at least 42% of the vote share to achieve a majority (Chart 6). Chart 4...Breaking With Recent Tradition Of Pluralism A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Chart 5Can MORENA Be First To 40% In Two Decades? A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Chart 642%: The Magic Number For The Chamber Of Deputies A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Chart 7AMLO Can Lift MORENA Fortunes A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Can AMLO lift the fortunes of MORENA? Yes. According to our calculations, the relationship between the vote share for the presidential candidate and his party is strong (Chart 7). The coefficient is around 1, so 1% vote share for the presidential candidate means 1% vote share for his respective party (or parties, if they are in a coalition). Given that AMLO is currently polling at 47% in the latest polls, it is conceivable that MORENA - along with its coalition partners the left-wing Labor Party and socially conservative Social Encounter Party - could win a majority in the Chamber of Deputies. We would assign this scenario, given current polling, a 70% probability (Table 1). Especially given that, in Mexico, polls tend to underestimate the performance of the winning candidate (Chart 8). Table 1MORENA Is Set For A Majority In The Chamber Of Deputies A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Chart 8Polling Tends To Underestimate Winning Candidate A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Upper House - The Senate What about the Mexican Senate? Electoral rules make it more difficult for the dominant party to win the upper chamber because they guarantee representation for the party that comes in second in state-by-state races. MORENA is currently leading in the polls in 19 out of 32 Mexican states and trailing as second in another five. The electoral system awards two Senate seats to the outright winner of each state. The second-placed party gets one seat. The remaining thirty-two senators are distributed based on the party's national vote, irrespective of the state-specific elections. As such, MORENA is likely to capture, at minimum, around 56 seats in the Senate, were it to garner around 40% of the overall vote.2 This would be nine short of the 65-seat majority in the upper chamber. To win those extra nine seats, the hurdles are considerable. Even if we give MORENA victories in every state in which it is currently trailing and raise its national vote to 50%, it still comes one short of the 65-seat majority (Chart 9). Chart 9MORENA Will Face A Tougher Path In The Senate A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Our forecast for a MORENA-held Senate is therefore considerably lower than for the Chamber of Deputies. At this moment, the Senate is a "too-close-to-call" election. Much will depend on whether MORENA and AMLO can get more than 50% of the vote on July 1 and whether MORENA translates some specific state races into wins. The left-wing MORENA sits on the edge of a majority, but state-by-state polling in Mexico is woefully poor and thus the variability of the final result is great. Winning the Senate will require a genuine "wave" election that Mexico has not seen in years. If AMLO's party fails to win the majority in the Senate, the chamber will remain a hurdle to him throughout his six-year term as Mexico does not elect Senators in midterm elections. Judicial - Supreme Court Of Justice The final branch of government that can impose checks on the executive is the Mexican Supreme Court, officially referred to as the Supreme Court of Justice of the Nation. The Supreme Court has 11 judges who are appointed for 15 years. Given the current roster of judges on the Court, the new president of Mexico will have the opportunity to appoint only three new members of the Court over the next six years of his mandate. President López Obrador would have the first opportunity to do so already in late 2018, with another in 2019, and final one in 2021. And that only holds if MORENA has a majority in the Senate, as the president has to rely on a Senate vote to ultimately appoint his preferred court picks. This is important because the president of Mexico can call a referendum on his own. López Obrador and MORENA have in the past called for a referendum on energy reforms. Frequent appeals to voters on policy matters is also a fundamental thesis of the MORENA manifesto. According to the 2014 Mexican Federal Law of Popular Consultation, reforms can be called by the president, one third of either chamber plus a majority of the other, or support of at least 2% of voters through a mail-in campaign. As such, the hurdle for calling a referendum in Mexico is extremely low, giving AMLO the potential route to avoid an intransigent Congress. This is where the Supreme Court comes in. The 2014 law prohibits referenda on any issue of human rights, national security, elections, or fiscal matters. This means that the ability of the president and Congress to call referendums is limited to largely non-investment relevant issues. In 2014, for example, the Supreme Court ruled that a referendum on energy reforms was unconstitutional and therefore could not be held. Given the current composition of the Court, and limited ability of AMLO to change it, it is unlikely that the Court would do AMLO's or MORENA's bidding in the future. Bottom Line: The Mexican president is constrained by the constitution to take Congress's lead on promulgating laws. However, AMLO's surging popularity makes it possible that his left-wing MORENA wins the lower Chamber of Congress. Forecasting the Senate election is much more difficult, where the election is currently too-close-to-call. Overall, AMLO has a very good chance of winning the majority in both chambers, making him potentially the first president since Ernesto Zedillo to control Congress (Zedillo famously lost PRI's legislative majority in the 1997 midterm election). Despite possible control of both Chambers of Mexican Congress, there is no way that AMLO will be able to capture the judicial branch during his limited, six-year, term in office. As such, the fear that AMLO will rule via popular referendums is overstated. However, if his MORENA captures Congress, AMLO will be able to pass laws through the legislative chamber and will not need to rule via referendum anyway.3 How Left Is The Mexican Left? Chart 2 (on page 2) suggests that Mexicans have traditionally seen themselves as centrist on economic matters. Why would this have changed, in such a dramatic fashion, so as to give both AMLO and the upstart MORENA a potential electoral sweep on July 1? Is the economy in such dire straits that voters are willing to contemplate an economic paradigm shift in 2018? Chart 10Misery Index Is Inconclusive Misery Index Is Inconclusive Misery Index Is Inconclusive Chart 11Central Bank Induced Pain Central Bank Induced Pain Central Bank Induced Pain The short answer is no. The unemployment rate has been steadily declining under Nieto, although inflation surged over the past two years as the peso collapsed and is only now showing signs of easing (Chart 10). To fight inflation, the central bank tightened monetary policy, contracting consumer spending and capital expenditure in the process (Chart 11). Both are now showing signs of tepid recovery as hawkish monetary policy takes a backseat. However, fiscal and monetary tightening - combined with surging inflation - caused weak real wage growth for the past three years (Chart 12). Economic performance has therefore been tepid, not disastrous. The problem is that Nieto promised real change, ushering in his term with several major economic reforms that culminated in the 2013 energy reforms. These reforms, however, have been followed by disappointing economic results while the persistent ills of corruption and violence have actually gotten worse. These two ills, which have plagued Mexico for decades, are the real game changer in the coming election. After a peak in 2011, drug-related deaths dropped off. However, there has been a major increase in drug-related homicides over the past two years, with a record 29,168 in 2017 (Chart 13). Year 2018 is on track to be the deadliest year ever, on pace for 32,000 deaths. Since President Calderon launched the drug war in 2007, more than 210,000 drug-related homicides have occurred in the country. Chart 12Real Wages In A Downturn Since 2016 Real Wages In A Downturn Since 2016 Real Wages In A Downturn Since 2016 Chart 13Drug-War Deaths Are Rising Again A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO In December 2017, AMLO proposed giving amnesty for drug cartel kingpins, saying he wanted dialogue. The proposal caused outrage in the international and domestic press but has clearly not dented his popularity. At the time of his comments, AMLO was up just 7% on his opponents, with the gap today at 25%! Jorge Castañeda, campaign chief of Ricardo Anaya - the torchbearer of Calderon's center-right PAN that initiated the drug war - recently suggested that his candidate would ditch the "totally useless" 12-year war on drugs. This means that AMLO's initial comment has forced his opponents to similarly adjust their views on the drug war. Merely voicing tough rhetoric and doubling down on more security-oriented policies does not return political dividends anymore. It would appear that AMLO's focus on the drug war and general corruption has struck a nerve with the Mexican "median voter." Polls show that both issues are the most salient with Mexican voters (Chart 14). Corrupt leaders, drug cartel violence, and crime score higher than income inequality, immigration, employment, healthcare, and education. Rising prices do make the list of major problems but they are normally ubiquitous as a concern in emerging markets. This is not to say that Mexican voters do not want economic change. Rather, we are pointing out that AMLO's popularity is not merely a show of support for his economic policies. He and the newly launched MORENA have an incorruptible image in a country plagued by corruption and offer new solutions to the scourge of the drug war that two mainstream parties - the PRI and the PAN - have spent over a decade fighting with limited success. Chart 14Security & Corruption Dominate The Election A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO In terms of actual economic policy proposals, AMLO's and MORENA's bark may be worse than their bite. There are three critical policy proposals where we expect considerable moderation following the election: Referendums: As we pointed out above, AMLO has promised a new referendum on the 2013 energy reforms. MORENA's manifesto argues that the use of referendums would prevent the continued hijacking of institutions by oligarchies. In other words, the message is that investors should prepare for a constant stream of referendums. However, this will only be possible in non-investment relevant fields, given the role of the Mexican Supreme Court in the process as discussed above. Energy reforms: The likely pick for the Energy Secretary, Rocío Nahle, has been a vociferous opponent of Nieto's energy reforms. However, he has since toned down the rhetoric and has focused on a MORENA proposal to build two state-run refineries in order to curb imports of refined petroleum products from the U.S. (Chart 15). Several of AMLO's key economic advisers - such as Alfredo Romo and Abel Hibert - have suggested that reversal of energy reforms will not be on the table. Nonetheless, AMLO's administration is likely to stall private auctions once he comes to power, given that it is a featured electoral promise. However, it is not clear that this would set the stage for a curbing of foreign investments in other areas. In fact, AMLO's opposition to domestic oligopolies could specifically benefit foreign investors by breaking up entrenched economic interests. Industrial policy: AMLO and his economic advisers - including the likely finance and economic ministers Carlos Manuel Urzúa Macias and Graciela Márquez Colín - appear to be in favor of an activist government industrial policy. This return to the "import substitution" model may appear to be a step back in Mexico's economic development. However, if it is combined with fiscal prudence, as AMLO and his advisors promise, and a pro-investor outlook, which they still have to prove, the policy may not be a major risk for financial markets. Investors should also look to the issue of NAFTA renegotiations for a lead on how AMLO intends to govern. He has been a vociferous critic of the trade deal for years. However, nearly 70% of Mexicans support the trade deal. This has forced AMLO to modify his view towards NAFTA. He has promised to renegotiate the deal with President Trump, although he has complained about the renegotiation process taking place ahead of the Mexican elections by the outgoing government. In addition, AMLO's track record as mayor of Mexico City (2000-2006) does not raise any red flags. During that period, the city saw its municipal debt decline, foreign investment surge, and good amount of infrastructure projects implemented. Granted, his term coincided with a global bull market, but he did not have an overt anti-business bias despite his perpetual left-wing rhetoric. Bottom Line: López Obrador and his left-wing MORENA could represent an economic paradigm shift in Mexico. However, his brand of economics is more "nationalist" than left-wing; more "Mexicanism" than outright socialism. Opposition to foreign investment in the energy sector is a clear red flag for investors, but it does not extend to any other sector of the economy, at least not rhetorically in the election campaign. As such, it is a vestige of Mexican history, where the capture of state energy resources was a crucial pillar of the country's independence and sovereignty movement. Meanwhile, there is no evidence that the Mexican median voter has abandoned their long-held centrist outlook. Seven out of ten Mexican voters support NAFTA, while a plurality still supports globalization - at a much higher clip than their neighbors to the north (Chart 16)! AMLO and MORENA's success in the election is therefore due to their strident anti-corruption stance and due to the failures of the previous PRI and PAN administrations to effectively deal with the ongoing drug war. This means that, were AMLO to deviate too much into left-wing economic policies, the electorate would act as a constraint. Chart 15Refined Petroleum##br## Imports Will Fall Refined Petroleum Imports Will Fall Refined Petroleum Imports Will Fall Chart 16Mexicans Are More Supportive Of ##br##Globalization Than Americans A Mexican Standoff - Markets Vs. AMLO A Mexican Standoff - Markets Vs. AMLO Investment Conclusions Tactically speaking, Mexican elections and NAFTA renegotiations represent serious headwinds to Mexican assets. There is a high probability that MORENA wins both the Chamber of Deputies (70%) and the Senate (50%, too-close-to-call). We do not think that this scenario is priced in by the market at the moment. Meanwhile, NAFTA renegotiations have stalled and could result in a failure. As we argued last year, the probability of abrogation of the deal is at 50%, higher than what the market thinks.4 This is because President Trump has no constraints - either legal or political - to withdrawing from the deal.5 Particularly if he intends to renegotiate bilateral deals with Canada and Mexico after the midterms. AMLO, however, will face three constraints in governing even if he were to gain a majority in both Chambers of Congress: Judicial branch: There is no way for AMLO to stack the Mexican supreme court with left-leaning, loyalist, judges. As such, his plan to use referendums to rule will fail. Median voter: The median voter in Mexico is certainly not thrilled with the economic performance of the country, but long-term polling suggests that Mexicans remain committed to a free market economy and even to globalization. We suspect that AMLO's and MORENA's stellar rise is therefore a product of government corruption, the dominance of oligopolies, and the ongoing drug-war, which has definitively failed. Correctly identifying the basis for AMLO's and MORENA's success is crucial as it suggests that there is a limit to how far left AMLO can take the country before imperiling his political capital. Mexican midterm elections, due in 2021, are an important constraint if he loses the faith of the median voter. The market: The Mexican peso will be the vehicle by which the market expresses its displeasure with any future government policies. A downleg in the peso could be non-trivial, especially given the current broad-based upturn in the U.S. dollar. As a result, inflation will remain elevated and real incomes depressed. Bank of Mexico will have to respond by maintaining tight monetary policy or tightening policy further with negative ramifications for growth. This is not a scenario that AMLO will want, as it would imperil his control of the Chamber of Deputies ahead of the 2021 midterms. Therefore, financial markets will act as a major constraint on AMLO adopting left-wing or populist policies. Given AMLO's track record as mayor of Mexico City, his mix of centrist economic advisors, and a penchant for reversing previous rhetoric (such as on NAFTA and the energy reforms), we suspect that he is well aware of the above constraints. The focus of the administration will likely be on corruption and the drug war, while energy reforms will get a token review early in his presidency. Considering the headline risks, however, investors may take time to buy into this view. As such, we do not recommend holding Mexican assets on an absolute basis. On a relative basis to other emerging market economies, Mexico does have several cyclical advantages over its peers. The Mexican economy has already been going through the natural path of adjustment - demand retrenchment - following monetary and fiscal tightening during the past couple of years. This stands in contrast to many other emerging markets economies which have avoided harsh medicine in recent years. Yet presently, with their currencies plummeting, these developing nations will have no choice but to tolerate domestic demand retrenchment themselves. While most emerging markets are leveraged to China and metals, Mexico is more exposed to U.S. domestic demand and oil. In line with our view that U.S. growth will do much better than that of China, Mexican exports to the U.S., which represents 30% of Mexican GDP, will remain strong, benefitting the nation's growth and balance of payments. Consequently, our view is that Mexican risk assets will outperform their EM peers in the next 6-12 months: Chart 17MXN Is A Positive Carry Trade Relative To EM MXN Is A Positive Carry Trade Relative To EM MXN Is A Positive Carry Trade Relative To EM Chart 18Mexican Peso Is Cheap Mexican Peso Is Cheap Mexican Peso Is Cheap First, the Mexican peso is attractive. For the first time in many years, Mexican short term interest rates are above the majority of EM economies, even among high yielding emerging markets like South Africa and Brazil (Chart 17), making the Mexican peso a positive carry trade relative to its EM counterparts. More importantly, the Mexican peso is cheap. As illustrated on Chart 18, according to the real effective exchange rate based on unit labor cost, the Mexican peso is well below its historic mean in absolute terms. Second, local currency bond yields and USD sovereign spreads are elevated and offer great value relative to their respective EM benchmarks (Chart 19). Even if AMLO favors some left-wing policies, Mexico's local bonds' and credit markets' relative pricing already reflect this and are unlikely to underperform much versus their EM peers. Third, Mexico's bourse has dramatically underperformed the EM overall index since 2016 and a lot of bad news in relative terms might already be priced in. In addition, consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of the overall EM market cap. EM consumer staples have massively underperformed the EM benchmark since early 2016 (Chart 20 top panel) and odds are that this sector will outperform in the next 12 months as defensives outperforms cyclicals. This will bode well for Mexico's relative performance in common currency terms versus the EM equity benchmark which seems to be forming a major bottom (Chart 20 bottom panel). Chart 19Local Currency And Dollar Bonds Offer Value Local Currency And Dollar Bonds Offer Value Local Currency And Dollar Bonds Offer Value Chart 20Mexican Equites Are A Defensive Play Mexican Equites Are A Defensive Play Mexican Equites Are A Defensive Play Bottom Line: Headline risk from NAFTA renegotiations and Mexican election could cause tactical downside to the country's FX, equity, and bond markets. However, these may present buying opportunities for longer-term investors given the combination of our political and macroeconomic views. Dedicated EM investors should overweight Mexican equities, local currency bonds as well as sovereign credit relative to their EM benchmarks. Currency traders should stay long MXN versus an equally-weighted basket of BRL and ZAR. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Please see Section III of the Constitution of Mexico, available at OAS.org. 2 We get this number if MORENA wins the 19 states where it is currently leading, giving it 38 assured Senate seats. In addition, Morena is trailing as second-placed in the polls in another five states, giving it an additional five seats. Finally, we assume that MORENA wins 40% of the vote, giving it an additional 12 seats (40% of 32 would be 12.8). This combines for a grand total of 56 seats, nine seats short of a 65-seat majority. 3 Modifying the constitution, however, still requires two-thirds of Congress, which MORENA has no mathematical chance of winning. 4 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com.

Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos America Profits From Chaos America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform U.S. Assets Outperform U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 8Trump's Tariffs On China Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue Downside Risks Continue Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 11Car Imports? What Imports? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 16Bremain On The Rise Bremain On The Rise Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar

Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Markets Are Positioning Themselves For Higher Inflation Markets Are Positioning Themselves For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... U.S. Sectoral Performance Suggests Investors Have Already Bet On Higher Inflation... U.S. Sectoral Performance Suggests Investors Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio ...So Does The Stock-To-Bond Ratio ...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Money Has Flown Into Resources Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bond Market Positioning Is Still Very Short Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction Global Growth Is Losing Traction Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs More Weakness In LEIs More Weakness In LEIs Chart I-9Global Liquidity Tightening Global Liquidity Tightening Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World China Not Yet Set To Bail Out The World China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation The Dollar Likes Lower Global Inflation The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Inflation Is In The Price Inflation Is In The Price Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound NOK/SEK Suffers If Inflation Bets Are Unwound NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Anarchy In The U.K. Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten The Credit Impulse Has Bitten The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth U.K. Exports Are Slowing Because Of Global Growth U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Investors Are Well Aware Of Britain's Problems Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens EUR/GBP Sags When EUR/USD Weakens EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth A Crucial Support To Growth A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Cable Will Not Avoid The Downward Pull Of A Strong Dollar Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Inflation Is In The Price Inflation Is In The Price Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc Inflation Is In The Price Inflation Is In The Price However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable EUR/CAD Is Still Vulnerable EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Wave Pattern Not Completed Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades