Geopolitics

Highlights The dollar rally is set to continue. The dollar tends to perform best when real rates are rising and above r-star. We are entering this environment and raising our DXY target to 98. Moreover, the rest of the world is likely to be more vulnerable to higher U.S. rates than the U.S. itself. Not only does the Federal Reserve set the cost of capital for the world, debt excesses are more prevalent outside the U.S. than in it. Additionally, the U.S. is less impacted by slowing global industrial activity than the rest of the world. Relative growth dynamics will therefore flatter the greenback. Italy is weighing on the euro, and any deterioration in the pricing of Italian risk will further hurt the common currency. However, EUR/USD does not even need Italian drama to depreciate. Relative growth and inflation are enough to push the euro toward 1.12. Feature The beginning of the year was a tough time for the dollar, with the DXY plunging nearly 4% from January 1 to February 15th. However, soon after Valentine's day, the market became enamored with the greenback, prompting the USD to rally a hefty 6%. Now that the dollar has hit our target of 94, it is time to pause and ask a simple question: can the U.S. currency rally further, or is it time to bail on the rally? While we do think the secular trend for the greenback is down, we also believe the current rebound has further to run. We are revising our DXY price target to 98. Essentially, we are entering a window where both U.S. monetary policy and the global growth backdrop will give the dollar an additional boost. The Over And Under On R-Star Table I-1Fed And The Dollar: Where We Stand ##br##Matters As Much As The Direction This Time Is NOT Different This Time Is NOT Different A common market lore is that the dollar tends to appreciate in anticipation of rising rates, but once the Fed actually begins to increase rates, the dollar weakens. There is some truth to this assertion. The 1994 and 2004 experiences do bear these facts. Moreover, the DXY fell 8.5% after the ill-fated December 2015 hike, and fell more than 11% as the Fed hiked rates through 2017. However, these kinds of simple heuristics can be deceiving. Where we stand in the hiking process matters just as much. In other words, it is not only whether interest rates are rising that counts, but whether or not they are rising above the neutral rate, or r-star. This distinction makes all the difference. As Table I-1 illustrates, the heuristic holds true when the Fed begins lifting rates but the real fed funds rate is below r-star. In this environment, the average annual return of the DXY since 1973 has been -5%, and the dollar has generated negative returns 75% of the time. However, the picture changes drastically if the real fed funds rate rests above the r-star. In this environment, the DXY rises alongside the fed funds rate, generating average annual gains of 4.7% 70% of the time. These results have been robust, independent of what was expected in interest rates futures. When the fed funds rate is falling, it is difficult to generate any strong views, as neither the expected returns nor the batting averages are statistically different from the expected outcomes of coin tosses. Chart I-1We Are Entering The Dollar-Bullish##br## Part Of The Fed Cycle We Are Entering The Dollar-Bullish Part Of The Fed Cycle We Are Entering The Dollar-Bullish Part Of The Fed Cycle Interwoven behind this picture is global growth. We have long argued that global growth is a key determinant for the dollar: When it is strong, the dollar weakens; when it is weak, the dollar strengthens.1 Essentially, when the fed funds rate rises but is still below r-star, global growth is improving, often even more so than U.S. growth, leading to a soggy greenback. When the fed funds rate moves above r-star, we tend to see hiccups around the world, essentially because the global cost of capital starts to rise, hurting the most vulnerable places. This helps the dollar. Sometimes, the most vulnerable country to higher U.S. interest rates happens to be the U.S., in which case the dollar does not respond positively to rising rates, even if they are above r-star. This is exactly what happened between 2005 and 2006. Today, we are entering an environment where the dollar is likely to receive a fillip from the Fed. As Chart I-1 illustrates, the real fed funds rate is about to punch above the Laubach-Williams estimate for r-star. It is true that the LW measure for r-star is only an estimate of this crucial but unobservable concept, and that it is subject to revisions, but the Fed is set to increase rates at least four times over the next 12 months, which in our view will definitely push the fed funds rate above realistic estimates of r-star. As a result, we should anticipate the dollar to rally further. Bottom Line: When we think about the Fed and the dollar, rising interest rates are not enough to boost the greenback. Actually, if U.S. real rates rise but are still below the neutral rate of interest, this generally results in very poor dollar performance, like what transpired in 2017 and the first month of 2018. If, however, the fed funds rate is both rising and above the neutral rate, the dollar rallies. We are entering this environment. Why Is This Time NOT Different? If one were to make the argument that the dollar will not rally as the fed funds rate moves above the neutral rate - which has happened in 30% of past occurrences - one needs to make the case that the U.S. is more vulnerable to higher U.S. rates than the rest of the world. We do not want to make this bet. First, there does not seem to be any obvious imbalances in the U.S. economy right now. Historically, periods of vulnerability in the U.S. have been preceded by an elevated share of cyclical sectors as a percentage of GDP. This was particularly obvious last cycle, when cyclical sectors represented 28% of GDP in 2006, and residential investment was particularly out of norm, at almost 7% of GDP (Chart I-2). Today, cyclical sectors represent 24.3% of GDP, in line with the average of 25.4% since 1960. Moreover, while there are rampant fears that the U.S. current account deficit will blow up, at the moment - thanks to decreasing oil imports - it only stands at -2.5% of GDP, much narrower than the levels that prevailed in 2006 (Chart I-3). Second, the key ingredient that would generate vulnerability in the U.S. is not present, but it is visible around the world: too fast a pace of debt accumulation. Not only do debt buildups make financial systems and economies illiquid, if the accretion is built swiftly it raises the probability of a misallocation of capital. After all, investing is a time-consuming activity, and if done too quickly chances are that due diligence was not very diligent. Today, it is true that there has been a deterioration in the quality of the corporate sector debt in the U.S., but nonetheless, the U.S. private sector has curtailed its debt load, and has been rather reluctant to re-lever. In the rest of the G-10, debt loads are as elevated as ever, and in fact are hitting record highs in Canada, Australia, and the Scandinavian economies. In EM and China, not only are debt levels elevated, they have also been rising briskly (Chart I-4). The vulnerabilities are therefore outside the U.S. and not in the U.S Chart I-2No Cyclical Imbalances In The U.S. No Cyclical Imbalances In The U.S. No Cyclical Imbalances In The U.S. Chart I-3Better External Balance As Well Better External Balance As Well Better External Balance As Well Chart I-4Debt: U.S. Robust, RoW Not So Much Debt: U.S. Robust, RoW Not So Much Debt: U.S. Robust, RoW Not So Much Third, global growth is facing an important headwind emanating from China. The Chinese economy has been in the process of slowing, and continues to do so: Leading the charge have been efforts by Chinese policymakers to diminish the pace of debt accumulation. As Chart I-5 illustrates, not only has the Chinese credit impulse rolled over, but the decline in working capital of small financial intuitions suggests that more pain is in the pipeline. Real estate activity is slowing down. The prices of newly built units in the main cities are contracting on an annual basis, and in second-tier cities price appreciation is slowing. As a result, construction activity is also downshifting. The growth of industrial profits has slowed considerably, hitting a 14-month low. Railway traffic, electricity production and excavator sales are all decelerating sharply. The Li-Keqiang index is also slowing and, according to our leading index based on credit activity, is set to continue to do so (Chart I-6). Unsurprisingly, Chinese import growth is also slowing significantly, implying that China is not providing as much of a shot in the arm for the rest of the world as it did 12 months ago (Chart I-6, bottom panel). Chart I-5Chinese Policy Tightening In Action Chinese Policy Tightening In Action Chinese Policy Tightening In Action Chart I-6The China Syndrome The China Syndrome The China Syndrome EM economies are particularly exposed to these dynamics. As we like to put it when we talk to our clients, if EM economies were a security, Chinese activity would drive cash flow growth, while U.S. monetary policy dictates the cost of capital. This is especially true today, as a record amount of EM-ex-China exports go to China, while USD-debt as a percentage of EM GDP, reserves and exports is at multi-decade highs (Chart I-7). This analogy suggests that EM economies are therefore the most vulnerable corner of the world to higher U.S. rates: Not only is their indebtedness high, but they are also facing a potent headwind from China. Hence, we expect EM financial conditions to deteriorate further, with negative implications for EM growth. However, EM have been the most dynamic contributor to global growth and global trade. This implies that if EM growth conditions deteriorate, so will global trade and global industrial activity (Chart I-8). As we have highlighted before, the U.S. is normally insulated from these dynamics as commodity production, manufacturing and exports represent a relatively low share of gross value added in what is fundamentally a domestically driven economy. Through this aperture, the relative resilience of the U.S. to the recent decline in global growth is unsurprising. To the contrary, we can expect this current bout of growth divergence to stay in place for much of 2018 (Chart I-9). Chart I-7EM Have A Lot Of Dollar Debt EM Have A Lot Of Dollar Debt EM Have A Lot Of Dollar Debt Chart I-8Weak EM Equals Weak Global IP Weak EM Equals Weak Global IP Weak EM Equals Weak Global IP Chart I-9Global Growth Divergences Global Growth Divergences Global Growth Divergences As a result, global growth dynamics are likely to buttress the bullish implications for the dollar of a Fed lifting rates above r-star. As Chart I-10 shows, slowing global growth is good for the dollar. This is likely to be especially true this time around as investors have yet to purge their overhang of short-dollar bets (Chart I-11). Moreover, as we highlighted five months ago, from a stylistic perspective, the dollar is the epitome of momentum currencies within the G-10.2 The indicator that has empirically best captured the momentum-continuation behavior of the dollar is the gap between the 1-month moving average and the 6-month moving average. Currently, this indicator is flashing an unabashedly bullish signal for the USD (Chart I-12). Chart I-10The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart I-11Still Short The Dollar This Time Is NOT Different This Time Is NOT Different Chart I-12Momentum Currrently Favors The Dollar Momentum Currrently Favors The Dollar Momentum Currrently Favors The Dollar Bottom Line: This time will not be different, and the dollar should rise as the Fed pushes interest rates above r-star. The U.S. private sector has not experienced any material debt buildup in recent years, and is less vulnerable to higher rates than emerging markets. Since the U.S. is less sensitive to EM growth than other advanced economies, the U.S. is relatively insulated from any EM slowdown, explaining why the U.S. economy is not slowing like the rest of the world is right now. This is a positive backdrop for the dollar. Euro Weakness: More Than Just Italy The euro's weakness through the recent dollar rally has been particularly striking. Recent developments in Italy have supercharged this weakness, as investors are once again questioning the commitment of Italy to staying in the euro area - an assessment that is weighing on Italian assets (Chart I-13). However, Marko Papic argues in BCA's Geopolitical Strategy service that Italy is not on the verge of leaving the euro area.3 However, the Five-Star movement / Lega Nord coalition wants to challenge the EU's Stability and Growth Pact 3% limit on budget deficits. As Dhaval Joshi argues in BCA's European Investment Strategy service, Italy has a fiscal multiplier greater than one, and thus more spending is likely to help the Italian economy over the coming year - whether or not the now-infamous issuance of mini-BOTs are involved.4 And to be honest, the Italian economy needs all the help it can get (Chart I-14). Chart I-13Markets Are Worried About Italy Markets Are Worried About Italy Markets Are Worried About Italy Chart I-14Italian Economy Has Yet To Heal Italian Economy Has Yet To Heal Italian Economy Has Yet To Heal However, it remains to be seen how much Italy will be able to open the fiscal spigot. Much depends on the willingness of the bond market to finance this intended profligacy. So far, the move in Italian BTPs has been small, but any repeat of 2010-2012 will prevent the coalition government from implementing its desired spending plans. Such a confrontation between the bond market and Italian politicians could cause a sharp decline in the euro. To be clear, it is highly unlikely that the coalition will be able to increase the deficit by the EUR100bn planned in its manifesto. To note, Rob Robis has downgraded Italian bonds to underweight in BCA's Global Fixed Income Strategy service.5 While Italian risks have exacerbated the weakness in the euro, ultimately the weakness in the common currency simply reflects the greater shock to European growth resulting from a slowing China. As Chart I-15 illustrates, European growth tends to underperform U.S. growth when Chinese monetary conditions are tightened, or when China's marginal propensity to consume - as approximated by the growth rate of M1 relative to M2 - declines. We are currently facing this environment. Chart I-15AChina's Deceleration Is Filtering Into Europe (I) China's Deceleration Is Filtering Into Europe (I) China's Deceleration Is Filtering Into Europe (I) Chart I-15BChina's Deceleration Is Filtering Into Europe (II) China's Deceleration Is Filtering Into Europe (II) China's Deceleration Is Filtering Into Europe (II) In addition, not only is European growth falling behind the U.S., but the European economy is also feeling the pinch from the tightening in financial conditions vis-à-vis the U.S. that ensued following the furious euro rally of 2017. In response to these combined shocks, European core inflation is now weakening relative to the U.S., which normally portends to a weakening euro over the course of the subsequent six months (Chart I-16). Since investors have yet to clear their massive long bets on the euro, we think the euro will need to flirt again with fair value before being able to stage a durable rally (Chart I-17). While the euro's fair value is currently 1.12, we will re-evaluate the situation once EUR/USD moves below 1.15. Despite the upbeat picture we have painted for the dollar, the greenback still faces potent structural headwinds, which means that we cannot be too careful and need to approach any dollar rebound with a great deal of care, always keeping an eye open for potential risks to the dollar. Chart I-16Relative Inflation And The Euro Relative Inflation And The Euro Relative Inflation And The Euro Chart I-17More Downside In EUR For Now More Downside In EUR For Now More Downside In EUR For Now Bottom Line: Italian political developments are currently hurting the euro. The euro will suffer further if the bond market ends up rioting, unwilling to finance the coalition's deficit-busting proposals. While such dynamics would precipitate a sharp and violent fall in the euro, EUR/USD does not need Italian misadventures to weaken further. The euro continues to trade at a premium to its fair value, and the euro area is feeling the pain of a slowing China deeper than the U.S. is. Therefore, European growth and inflation are likely to weigh further on the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "More Than Just Trade Wars", dated April 6 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, titled "Some Goods News (Trade), Some Bad News (Italy)", dated May 23, 2018, available at gps.bcaresearch.com 4 Please see European Investment Strategy Special Report, titled "Italy Vs Brussels: Who's Right?", dated May 24, 2018, available at eis.bcaresearch.com 5 Please see Global Fixed Income Strategy Weekly Report, titled "Is It Partly Sunny Or Mostly Cloudy?", dated May 22, 2018, available at gfis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The U.S. economy continues to perform well with the Manufacturing and Services PMI coming in at 56.6 and 55.7, respectively, beating expectations. However, the dovish Fed minutes were the highlight of this week. While inflation seems to finally be making a comeback, members of the FOMC opined that it was "premature to conclude that inflation would remain at level around 2 percent". This implies a higher possibility of the Fed's pursuit towards a more "symmetric" inflation target, indicating that the Fed doesn't want to raise rates more aggressively than what is implied it the current dot forecasts. The 2-year yield fell by 7.1 bps, while the 10-year fell by 6.9 bps on the news. Furthermore, the Fed has become increasingly cautious in its communications in the face of a flattening yield curve. Despite these potential negatives, the dollar continues to appreciate as global growth softens. This rally could run further as European and EM data continues to disappoint. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Is King Dollar Facing Regicide? - April 27, 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 This week was negative across the board for the euro area. French, German and overall euro area Manufacturing, Services and Composite PMIs all underperformed expectations. In addition to lackluster economic data, the eurosceptic M5S-Lega coalition is now putting the Brussels to the test. As expected, the BTP-Bund spread spiked to just below 2%, near levels that last prevailed in early 2017, and the euro has been suffering as a result of this. While the ECB's QE program is scheduled to end in September, the current situation is a threat and may necessitate a lower euro to ease monetary conditions. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: The Nikkei Manufacturing PMI came in below expectations, coming in at 52.5. This measure also decreased from last month's reading. Annualized gross domestic product growth for Qtk surprised to the downside, coming at -0.6%. Moreover, machinery orders yearly growth also surprised negatively, coming in at -2.4%. After rising by more than 2% the last couple weeks, USD/JPY has come back below 110 recently. We believe that the yen will most likely be amongst the best performing G-10 currencies, given that an environment of declining global growth and rising risk normally supports the yen. However, on a longer term basis, the yen is likely to see downside, given that the BoJ will not allow an appreciating yen from derailing the economy. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen's Mighty Rise Continues... For Now - February 16, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been negative: Headline and core inflation both surprised to the downside, coming in at 2.4% and 2.1% respectively. They also both decreased from last month's number. Industrial Production yearly growth also underperformed expectations, coming in at 2.9%. Finally, Halifax house price yearly growth also surprised negatively, coming in at 2.2%. GBP/USD has gone down by nearly 1.5% these past few weeks, dragged down by the euro's weakness. Overall, we remain bearish on cable, given that inflation should continue to surprise to the downside in the U.K, as a result of the appreciation of the pound last year. On the other hand inflation in the U.S. should outperform, as a result of the decreased excess capacity and tight labor market. This will force the Fed to raise rates more than the BoE, putting downward pressure on the pound. 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 has been mixed recently: Westpac Consumer Confidence was negative in May, at -0.6%; The Wage Price Index annual growth remain unchanged at 2.1%, also in line with expectations; The unemployment rate picked up to 5.6% from 5.5%, however, the participation rate also increased by 0.1% to 65.6%; Employment grew by 22,600, with full-time employment at 32,700 and part-time contracting by 10,000; Governor Lowe spoke in Sydney this week at the Australia-China Relations Institute, citing Australia increased dependence on the second largest economy in the world, and the "bumpy" journey along the path of financial reform that China is likely to experience. This is likely to bring increased volatility to an Australian economy already replete with excess capacity. The RBA is unlikely to raise interest rates any time soon. 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 Recent data in New Zealand has been positive: Both exports and imports surprised to the upside, coming in at 5.05 billion and 4.79 billion respectively. Additionally, the trade balance also outperformed expectations, coming in at -3.78 billion dollars. Finally, the Producer Input Price Index quarterly growth also surprised positively, coming in at 0.6%. The kiwi has declined by more than 1.5% this past weeks. Overall we continue to be bearish on NZD/USD, given that we expect the current environment of heightened volatility to persist. That being said, we are bullish on the NZD against the AUD, as Australia is much more exposed to a slowdown in the Chinese industrial cycle and as the Australian economy exhibits more signs of slack than New Zealand's. 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 The Canadian dollar has managed to remain flat despite the recent broad-based selloff of commodity currencies against the greenback. Canada's inflation has been in line with the BoC's target. Furthermore, a resilient labor market and robust wage growth point to favorable domestic demand conditions and greater inflationary pressures in the coming quarters. External factors such as a favorable oil market, relative to metals, have helped the CAD against other commodity currencies, despite this week's weakness. Going forward, these variables are likely to continue to support the loonie against the likes of the Aussie or the Kiwi. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been negative: The Producer Price index underperformed expectations, coming in at 2.7%. Moreover, headline CPI inflation also underperformed expectations, coming in at 0.8%. EUR/CHF has declined by almost 2% these past weeks. We continue to be bearish on this cross, given that an environment of continued risk aversion should hurt the euro, while giving a boost to safe heavens like the franc. Italy's political tumult only adds credence to this argument. However, on a long term basis we are positive on EUR/CHF, given that the SNB will maintain an extremely easy monetary policy, much more so than the ECB, in order to prevent an appreciating franc which would derail its objective of ever reviving inflation in Switzerland. 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 Recent data in Norway has been positive: Headline CPI inflation outperformed expectation, coming in at 2.4%. Meanwhile, core CPI inflation came in line with expectations, at 1.3%. USD/NOK has been relatively flat in the month of May. Overall rising U.S. real rates relative to Norway should lift USD/NOK, even amid rising oil prices. That being said, the krone is likely to outperform other commodity currencies like the AUD or the NZD. This is because oil is less sensitive to China than other commodities, and the black gold is supported by a friendlier supply backdrop, especially as tensions in the Middle East are once again rising and Venezuela is circling down the drain. NOK should continue to appreciate against the EUR as well. 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 While Swedish producer prices annual growth picked up to 4.9% from 4% in April - suggesting a resurgence in inflationary pressures, labor market conditions softened as the unemployment rate climbed to 6.8% from 6.5%. The Riksbank also released a commentary on household debt, citing a "poorly functioning housing market" and a "tax system not being well designed from a financial stability perspective" as reasons for the current predicament. There was also emphasis placed on the uncertainty of house prices going forward. While these factors are present, resurgent inflation will ultimately prompt the Riksbank to hike, albeit cautiously, in order to avoid having to raise rates too violently down the road, which could cause serious harm to a Swedish economy afflicted by considerable internal imbalances. 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

Feature The prospect of a 5S-Lega government in Italy is unnerving some analysts and commentators. Italy's sovereign debt-to-GDP ratio is already one of the highest in the world. A seemingly endless economic stagnation is constraining GDP, and now the populists are proposing policies that would increase the deficit, lifting sovereign debt even higher. Feature ChartFiscal Thrust Has Driven Italy's ##br##Growth In Recent Years Fiscal Thrust Has Driven Italy's Growth In Recent Years Fiscal Thrust Has Driven Italy's Growth In Recent Years The suggested cures to Italy's high sovereign debt-to-GDP ratio divide into two opposing camps. One camp - Italy's populists - wants to boost GDP, the ratio's denominator. The other camp - Brussels - wants to rein in sovereign debt, the ratio's numerator. Who's right? It is not a simple choice. Growth and debt are not independent variables. It is impossible to boost growth quickly without a positive credit impulse from some part of the economy. Equally, reducing government borrowing can have a devastating impact on growth (Chart I-2). Therefore, to resolve the conflict between Italy's populists and Brussels, we need to understand the specific relationship in Italy between government debt, GDP, and their interaction: the fiscal multiplier. Chart I-2The Fiscal Multiplier Is High ##br##When The Private Sector Or Banks Are Financially Unhealthy Italy Vs Brussels: Who's Right? Italy Vs Brussels: Who's Right? Italy Is Right, Brussels Is Wrong Imagine that government debt starts at 130 and GDP starts at 100. Imagine also that each unit of government borrowing to spend lifts GDP by one unit, meaning the fiscal multiplier equals one. Under these assumptions, three units of fiscal thrust would lift debt to 133 and lift GDP to 103, reducing the debt-to-GDP ratio to 129%. Conversely, three units of fiscal drag would reduce debt to 127 and reduce GDP to 97, paradoxically increasing the debt-to-GDP ratio to 131% and making the austerity strategy entirely counterproductive. Critics will snap back that these two assumptions appear inconsistent. When sovereign indebtedness is already high, at say 130% of GDP, it seems implausible that the fiscal multiplier could also be high: the government has already done its useful borrowing to spend and, at the margin, additional borrowing is likely to be 'fiscally irresponsible'. This criticism would be valid if the government was the only part of the economy that could borrow. But it isn't. Whether the fiscal multiplier is high or low also depends on what is happening in the private sector (Chart I-3). Chart I-3The Fiscal Multiplier Is Low ##br##When The Private Sector And Banks Are Financially Healthy Italy Vs Brussels: Who's Right? Italy Vs Brussels: Who's Right? Fiscal multipliers become very high when there is a breakdown in the ability of households and firms to borrow and/or a breakdown in the ability of banks to lend. After such a breakdown, credit flows to the private sector remain depressed however low (or negative) interest rates go. Specifically, this happens after a severe economic trauma when large numbers of households and firms are simultaneously repairing their badly damaged balance sheets and/or when banks are insolvent. If the one and only engine of demand - government spending - then cuts out, the economy can enter a prolonged stagnation. Under such conditions, thrift reinforces thrift: one unit of fiscal drag can trigger an additional private sector spending cut, magnifying the impact of the original cut. In other words, the fiscal multiplier can exceed one and reach a level as high as two according to several academic and empirical studies.1 During and immediately after the global financial crisis, fiscal multipliers surged. Through 2009-12, fiscal thrust had a very strong explanatory power for GDP growth; across 14 major economies, the regression slope of 1.5 confirms a high average fiscal multiplier. In other words, each unit of fiscal thrust boosted GDP by 1.5 units; and each unit of fiscal drag depressed GDP by 1.5 units.2 Another way to see this is to observe that in the global financial crisis the economies that had the largest fiscal thrusts tended to experience the least severe recessions. The annual fiscal thrust in the U.S., U.K. and France equalled 2% of GDP; in Spain it equalled 3%.3 By contrast, Germany and Italy had negligible fiscal thrusts, and they suffered the worst recessions. But by 2012, households and firms around the world were willing to borrow again, and banks were sufficiently recapitalised to lend. Hence, fiscal multipliers slumped: fiscal thrust no longer had any explanatory power for GDP growth (Charts I-4 - I-7). Chart I-4Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The U.S. Post 2012: No Connection Between Fiscal Thrust And Growth In The U.S. Post 2012: No Connection Between Fiscal Thrust And Growth In The U.S. Chart I-5Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The U.K. Post 2012: No Connection Between Fiscal Thrust And Growth In The U.K. Post 2012: No Connection Between Fiscal Thrust And Growth In The U.K. Chart I-6Post 2012: No Connection Between ##br##Fiscal Thrust And Growth In The Germany Post 2012: No Connection Between Fiscal Thrust And Growth In The Germany Post 2012: No Connection Between Fiscal Thrust And Growth In The Germany Chart I-7Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The France Post 2012: No Connection Between Fiscal Thrust And Growth In The France Post 2012: No Connection Between Fiscal Thrust And Growth In The France There was one glaring exception to this trend: alas, poor Italy. Trapped in the EU's inflexible and misguided fiscal compact, and without an outright crisis, the Italian government could not recapitalise the dysfunctional banks. Although the solvency of the banks has improved in the past year, the evidence strongly suggests that fiscal thrust remains the main driver of the Italian economy (Feature Chart). On this evidence, the best economic policy for Italy right now is not to adhere slavishly to the misguided one-size-fits-all EU fiscal compact. The best policy is to use fiscal thrust intelligently to boost growth. We conclude that, on this specific point, Italy's populists are right and Brussels is wrong. Italy Needs Growth Italian BTPs offer a yield premium over German bunds as a compensation for two possible risks. One risk is a haircut or, more euphemistically, a 'restructuring'. But the likelihood of such a restructuring is very low. Putting aside the damage it would do to Italy's international standing, the simpler explanation is that it would kill the Italian banking system. As a rule of thumb, a bank's investors start to get nervous about its solvency when equity capital no longer covers its net non-performing loans (NPLs). In this regard, the largest Italian banks now have €165 billion of equity capital against €130 billion of NPLs, implying excess capital of €35 billion. The banks also hold around €350 billion of Italian government bonds (Chart I-8). Chart I-8Italian Banks Own 350 Billion Euro Of Italian Government Bonds Italy Vs Brussels: Who's Right? Italy Vs Brussels: Who's Right? So a mere 10% haircut on these BTPs could cripple the banking system and send the economy into a new tailspin. Meaning, it is in nobody's interest to restructure Italian bonds. The more likely risk to BTP holders - albeit still small - is redenomination out of the euro and into a reinstated lira. In which case the yield premium on BTPs ought to equal: (The likely loss on being paid in liras rather than deutschmarks) multiplied by (the annual probability of Italy leaving the euro) The first of these terms captures Italy's competitiveness shortfall versus Germany, which will change quite gradually. The second term captures a political risk, as leaving the euro would require a mandate from the Italian people. This means that the second term is very sensitive (inversely) to the popularity of the euro in Italy. It follows that a policy that kick starts growth and improves living standards - thereby boosting the popularity of the euro amongst the Italian people - is also a good policy for Italian bonds, banks, sustainable growth in Italy, and therefore for the euro itself. Bear in mind that Italy's structural deficit, at just 1%, is nowhere near the double-digit percentage levels that reliably signal the onset of a sovereign debt trap (Table I-1). Table I-1Italy's Structural Deficit Has Almost Disappeared Italy Vs Brussels: Who's Right? Italy Vs Brussels: Who's Right? Given Italy's high fiscal multiplier, we conclude once again that Italy's populists are right and Brussels is wrong. Some Investment Considerations Italian assets rallied strongly at the start of the year and certainly did not discount an election outcome in which the unlikely bedfellows 5S and La Lega formed a government. Therefore, from a technical perspective, the rally was extended and ripe for a pullback. A further consideration for Italy's MIB is that it is over-weighted to banks, so a sustained outperformance from the stock market requires a sustained outperformance from global banks, which we do not expect to start imminently. So in the near term, we prefer France's CAC to Italy's MIB. We have also opened a tactical pair-trade: long Poland's Warsaw General Index, short Italy's MIB. However, later this year, we expect both our credit impulse (cyclical) indicator and fractal dimension (technical) indicator to signal a better entry point into banks, into the Italian equity market and for BTP yield spread compression. Italy's structural deficit, at 1%, is amongst the lowest in the world, so Italy has plenty of 'fiscal space'. Moreover, fiscal stimulus can deliver bang for its buck because Italy appears to have a high fiscal multiplier. This differentiates Italy from other major economies, and makes the EU's one-size-fits-all fiscal compact entirely counterproductive for the euro area's third largest economy. This means that policies that push back against Brussels on this specific point might finally permit Italy to escape its decade-long growth trap. And therefore, somewhat paradoxically, they will enable the yield premium on 10-year Italian BTPs versus 10-year French OATs ultimately to compress. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, please see: When Is The Government Spending Multiplier Large? Christiano, Eichenbaum and Rebelo, Northwestern University. 2 Even removing the outlier data point that is Greece, the best-fit line has a slope of 1.1. And the r-squared explanatory power remains significant at 0.5. 3 Through 2008-9.

Highlights China-U.S. trade détente goes against our alarmist forecast, prompting us to reassess the view; We do not expect the truce to last long, as China has not given the U.S. what we believe the Trump administration wants; Instead, we see the truce lasting until at least the completion of the North Korea - U.S. summit, at most early 2019; Market is correct to fret about Italy, as the populist agenda will be constrained by the bond market in due course; Stay long DXY, but close our recommendations to short China-exposed S&P 500 companies. Feature Our alarmist view on trade wars appears to be in retreat, or at least "on hold," following the conclusion of the latest trade talks between U.S. and Chinese officials. Global markets breathed a sigh of relief on Monday, after a weekend of extremely positive comments from President Trump's advisers and cabinet members. Particularly bullish were the comments from Trump's top economic adviser, Larry Kudlow, who claimed that China had agreed to reduce its massive trade surplus with the U.S. by $200 billion (Chart 1). Chart 1China, Not NAFTA, Is The Problem China, Not NAFTA, Is The Problem China, Not NAFTA, Is The Problem The official bilateral statement, subsequently published by the White House, was vague. It claimed that "there was a consensus" regarding a substantive - but unquantifiable - reduction in the U.S. trade deficit.1 The only sectors that were mentioned specifically were "United States agriculture and energy exports." China agreed to "meaningfully" increase the imports of those products, which are low value- added commodity goods. With regard to value-added exports, China merely agreed that it would encourage "expanding trade in manufactured goods and services." The two sides also agreed to "attach paramount importance to intellectual property protections," with China specifically agreeing to "advance relevant amendments to its laws and regulations in this area." Subsequent to the declaratory statement, China lowered tariffs on auto imports from 25% to 15%. It will also cut tariffs on imported car parts, to around 6%, from the current average of about 10%. Is that it? Was the consensus view - that China would merely write a check for some Boeings, beef, and crude oil - essentially right? The key bellwether for trade tensions has been the proposed tariffs on $50-$150 billion worth of goods, set to come in effect as early as May 21. According to Treasury Secretary Steven Mnuchin, this tariff action is now "on hold." Mnuchin was also supposed to announce investment restrictions by this date, another bellwether that is apparently on hold. This is objective evidence that trade tensions have probably peaked for this year.2 On the other hand, there are several reasons to remain cautious: Section 301 Investigation: Robert Lighthizer, the cantankerous U.S. Trade Representative who spearheaded the Section 301 investigation into China's trade practices that justified the abovementioned tariffs and investment restrictions, immediately issued a statement on Sunday dampening enthusiasm: "Real work still needs to be done to achieve changes in a Chinese system that facilitates forced technology transfers in order to do business in China." In the same statement, Lighthizer added that China facilitates "the theft of our companies' intellectual property and business know-how." In other words, Lighthizer does not appear to be excited by the prospect of trading IP and tech protection for additional exports of beef and crude oil. Political Reaction: The reaction from conservative circles was less than enthusiastic, with both congressional officials and various Trump supporters announcing their exasperation with the supposed deal over the weekend.3 The Wall Street Journal claimed that China refused to put a number - such as the aforementioned $200 billion - in the final statement.4 The implication is that Beijing won this round of negotiations. But President Trump will not want to appear weak. If a narrative emerges that he "lost," we would expect President Trump to pivot back to tariffs and confrontation. Support for free trade has recently rebounded among Republican voters but remains dramatically lower among them than among Democrats (Chart 2). As such, it is a salient issue for the president politically. Chart 2Support For Free Trade Recovering, ##br##But Republicans Still Trail Democrats Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 3China Already ##br##Imports U.S. Commodities... Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Investment Restrictions: Senator Cornyn's (Texas, Republican) bill to strengthen the Committee on Foreign Investment in the United States (CFIUS) process continues to move through the Senate.5 The Foreign Investment Risk Review Modernization Act Of 2017 (FIRRMA) is currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs and should be submitted to a vote ahead of the November election. Congress is also looking to pass a bipartisan bill that would prevent President Trump from taking it easy on Chinese telecommunication manufacturer ZTE. Chart 4U.S. Commodity Export Growth Is Solid Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 5... But Impedes Market Access For Higher Value-Added Goods Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Beef And Oil Is Not Enough: The U.S. already has a growing market share in China's imports of commodities and crude materials, although it could significantly increase its exports in several categories (Chart 3). As the Chinese people develop middle-class consumption habits, the country was always going to import more agricultural products. And as their tastes matured, the U.S. was always going to benefit, given the higher quality and price point of its agricultural exports. In fact, China's imports of U.S. primary commodity exports have been increasing faster than imports of U.S. manufacturing goods (Chart 4). As such, the statement suggests that the U.S. and China have opted for the easiest compromises (commodities) to grant U.S. greater market access; the U.S. may have fallen short on market access for value-added manufacturing (Chart 5). In addition, there was little acknowledgment of the American demands that China cease forced tech transfers, cut subsidies for SOEs, reduce domestic content requirements under the "Made in China 2025" plan, and liberalize trade for U.S. software and high-tech exporters (Chart 6). Given these outstanding and unresolved issues, there are three ways to interpret the about-face in U.S. trade demands: Geopolitical Strategy is wrong: One scenario is that we are wrong, that the Trump administration is not focused on forced tech transfers and IP theft in any serious way.6 On the other hand, if that is true, the U.S. is also not serious about significantly reducing its trade deficit with China, since structurally, IP theft and non-tariff barriers to trade of high-value exports are a major reason why China has a massive surplus. Instead, the U.S. may only be focused on reducing the trade deficit through assurances of greater market access - a key demand as well, but one that could prove temporary or un-strategic, especially if access is only granted for commodities.7 If this is true, it suggests that President Trump's demands on China are transactional, not geopolitical, as we asserted in March.8 Midterms matter: Another scenario is that President Trump does not want to do anything that would hurt the momentum behind the GOP's polling ahead of the November midterms (Chart 7). The administration can always pick up the pressure on China following the election, given that 2019 is not an election year. Trump's political team may believe that Beijing concessions on agriculture, autos, and energy will be sufficient to satisfy the base until then. By mid-2019, the White House can also use twelve months of trade data to assess whether Beijing has actually made any attempt to deliver on its promises of increased imports from the U.S. Chart 6China's High-Tech Protectionism Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 7Republicans Are Gaining... Republicans Are Gaining... Republicans Are Gaining... North Korea matters: Along the same vein as the midterms, there is wisdom in delaying trade action against China given the upcoming June 12 summit between President Trump and North Korean Supreme Leader Kim Jong-un in Singapore. President Trump's approval ratings began their second surge this year following the announced talks (Chart 8), and it is clear that the administration has a lot of political capital invested in the summit's success. Recent North Korean statements, suggesting that they are willing to break off dialogue, may have been the result of the surprise May 8 meeting between Chinese President Xi Jinping and Kim, the second in two months. As such, President Trump may have had to back off on the imposition of tariffs against China in order to ensure that his summit with Kim goes smoothly. At this point, it is difficult to gauge whether the decision to ease the pressure against China was due to strategic or tactical reasons. We expect that the market will price in both, easing geopolitical risk on equity markets. However, if the delay is tactical - and therefore temporary - then the risk premium would remain appropriate. We do not think that we are wrong when it comes to U.S. demands on China. These include greater market access for U.S. value-added exports and services (not just commodities), as well as a radical change in how China awards such access (i.e., ending the demand that technology transfers accompany FDI and market access). In addition, China still massively underpays for U.S. intellectual property (IP) rights and has been promising to do more on that front for decades (Chart 9). Given that China has launched some anti-piracy campaigns, and given its recent success in other top-down campaigns like shuttering excess industrial capacity, it is hard to believe that Beijing could not crack down on IP theft even more significantly. Chart 8...Thanks To Tax Cuts And Kim Jong-un ...Thanks To Tax Cuts And Kim Jong-un ...Thanks To Tax Cuts And Kim Jong-un Chart 9What Happened To ~$100 Billion IP Theft? Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Furthermore, U.S. demands on China are not merely about market access and IP. There is also the issue of aggressive geopolitical footprint in East Asia, particularly the South China Sea. The U.S. defense and intelligence establishment is growing uneasy over China's pace of economic and technological development, given its growing military aggressiveness. In fact, over the past two weeks, China has: Landed the Xian H-6K strategic bombers capable of carrying nuclear weapons on disputed "islands" in the South China Sea; Installed anti-ship cruise missiles, as well as surface-to-air missiles, on three of its outposts in disputed areas. Of course, if we are off the mark on our view of Sino-American tensions, it would mean that the Trump administration is willing to make transactional economic concessions for geopolitical maneuvering room. In other words, more crude oil and LNG exports in exchange for better Chinese positioning in vital sea and air routes in East Asia. We highly doubt that the Trump administration is making such a grand bargain, even if the rhetoric from the White House often suggests that the "America First" agenda would allow for such a strategic shift. Rather, we think the Trump administration, like the Obama administration, put the South China Sea low on the priority list, but will focus greater attention on it when is deemed necessary at some future date. Bottom Line: Trade tensions between China and the U.S. have almost assuredly peaked in a tactical, three-to-six month timeframe. While still not official, it appears that the implementation of tariffs on $50-$150 billion worth of imports from China, set for any time after May 21, is now on hold. As such, a trade war is on hold. We are closing our short China-exposed S&P 500 companies versus U.S. financials and telecoms, a trade that has returned 3.94% and long European / short U.S. industrials, which is down 2% since inception. This greatly reduces investment-relevant geopolitical risk this summer and makes us far less confident that investors should "sell in May and go away." Our tactical bearishness is therefore reduced, although several other geopolitical risks - such as Iran-U.S. tensions, Italian politics, and the U.S. midterm election- remain relevant.9 We do not think that Sino-American tensions have peaked cyclically or structurally (six months and beyond). The Trump Administration continues to lack constraints when it comes to acting tough on China. As such, investors should expect tensions to renew either right after the summit between Trump and Kim in early June or, more likely, following the November midterm elections. Italy: The Divine Comedy Continues Since 2016, we have noted that Italy remains the premier risk to European markets and politics.10 There are two reasons for the view. First, Italy has retained a higher baseline level of Euroskepticism relative to the rest of Europe (Chart 10). While support for the common currency has risen in other member states since 2013, it has remained between 55%-60% in Italy. This is unsurprising given the clearly disappointing economic performance in Italy relative to that of its Mediterranean peers (Chart 11). Chart 10Italy Remains A Relative Euroskeptic Italy Remains A Relative Euroskeptic Italy Remains A Relative Euroskeptic Chart 11Lagging Economy Explains Cyclical Euroskepticism Lagging Economy Explains Cyclical Euroskepticism Lagging Economy Explains Cyclical Euroskepticism Italy's Euroskepticism, however, is not merely a product of economic malaise. Chart 12 shows that a strong majority of Europeans are outright pessimistic about the future of their country outside of the EU. But when Italians are polled in that same survey, the population is increasingly growing optimistic about the option of exit (Chart 13). The only other EU member state whose citizens are as optimistic about a life outside the bloc is the U.K., where population obviously voted for Brexit. Chart 12Europeans Are Pessimists About EU Exit... Europeans Are Pessimists About EU Exit... Europeans Are Pessimists About EU Exit... Chart 13...But Italians Are More Like Brits ...But Italians Are More Like Brits ...But Italians Are More Like Brits Furthermore, Italian respondents have begun to self-identify as Italian only, not as "European" also, which breaks with another long-term trend in the rest of the continent (Chart 14) and is also reminiscent of the U.K. The second reason to worry about Italy is its economic performance. Real GDP is still 5.6% below its 2008 peak, while domestic demand continues to linger at 7.9% below its pre-GFC levels (Chart 15). As we posited at the end of 2017, the siren song of FX devaluation would become a powerful political elixir in the 2018 election, as populist policymakers blame Italy's Euro Area membership for the economic performance from Chart 15.11 Chart 14Italians Feel More Italian Italians Feel More Italian Italians Feel More Italian Chart 15Italian Demand Never Fully Recovered Italian Demand Never Fully Recovered Italian Demand Never Fully Recovered Is the Euro Area to blame for Italy's ills? No. The blame lies squarely at the feet of Italian policymakers, who flubbed efforts to boost collapsing productivity throughout the 1990s and 2000s (Chart 16). There was simply no pressure on politicians to enact reforms amidst the post-Maastricht Treaty convergence in borrowing costs. Italy punted reforms to its educational system, tax collection, and corporate governance. Twenty years of complacency have led to a massive loss in global market share (Chart 17). Chart 16Italy Has A Productivity Problem Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 17Export Performance Is A Disaster Export Performance Is A Disaster Export Performance Is A Disaster While it is difficult to prove a counterfactual, we are not sure that even outright currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 18 illustrates. The incoming populist government is unfortunately coming to power with growing global growth headwinds (Chart 19), with negative implications for Italy (Chart 20). These are likely to act as a constraint on plans by the Five Star Movement (M5S) and Lega coalition to blow out the budget deficit in pursuit of massive tax cuts, reversals of pension reforms, minimum wage hikes, and a proposal to increase spending on welfare. Our back-of-the-envelope calculation sees Italy's budget deficit growing to over 7% in 2019 if all the proposed reforms were enacted, well above the 3% limit imposed by the EU on its member states. Chart 18Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Chart 19Tepid Global Growth... Tepid Global Growth... Tepid Global Growth... Chart 20...Is Bad News For Italy ...Is Bad News For Italy ...Is Bad News For Italy How would the EU Commission react to these proposals, given that Italy would break the rules of the EU Stability and Growth Pact (SGP)? We think the question is irrelevant. The process by which the EU Commission enforces the rules of the SGP is the Excessive Deficit Procedure (EDP), which would take over a year to put into place.12 First, the Commission would have to review the 2019 budget proposed by the new Italian government in September 2018. It would likely tell Rome that its plans would throw it into non-compliance with SGP rules, at which point the EU Commission would recommend the opening of a Significant Deviation Procedure (SDP). If Italy failed to follow the recommendations of the SDP, the Commission would then likely throw Italy into EDP at some point in the first quarter of 2019, or later that year.13 And what happens if Italy does not conform to the rules of the EDP? Italy would be sanctioned by the EU Commission by forcing Rome to make a non-interest-bearing deposit of 0.2% GDP.14 (Because it makes perfect sense to force a country with a large budget deficit to go into an even greater budget deficit.) Even if Rome complied with the sanctions, the punishment would only be feasible at the end of 2019, most likely at the end of Q1 2020. The point is that the above two paragraphs are academic. The Italian bond market would likely react much faster to Rome's budget proposals. The EU Commission operates on an annual and bi-annual timeline, whereas the bond market is on a minute-by-minute timeline. Given the bond market reaction thus far, it is difficult to see how Rome could be given the benefit of the doubt from investors (Chart 21). Investors have been demanding an ever-greater premium on Italian bonds, relative to their credit rating, ever since the election (Chart 22). Chart 21Uh Oh Spaghettio! Uh Oh Spaghettio! Uh Oh Spaghettio! Chart 22Bond Vigilantes Are Coming Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) As such, the real question for investors is not whether the EU Commission can constrain Rome. It cannot. Rather, it is whether the bond market will. Rising borrowing costs would obviously impact the economy via several transmission channels, including overall business sentiment. But the real risk is Italy's banking sector. Domestic financial institutions hold 45% of Italian treasury bonds (BTPs) (Chart 23), which makes up 9.3% of all their assets, an amount equivalent to 77.8% of their capital and reserves (Chart 24). Foreign investors own 32%, less than they did before the Euro Area crisis, but still a significant amount. Chart 23Foreign Investors Still Hold A Third Of All Italian Debt Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 24Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of a euro area breakup of 20% over the subsequent five years (Chart 25).15 What would happen if the populists in Rome followed through with their fiscal plans by September 2018 by including them in the 2019 budget? The bond market would likely begin re-pricing a similar probability of a Euro Area breakup, if not higher. In the process, Italian bonds could lose 20%-to-30% of their value - assuming that German bunds would rally on risk-aversion flows - which would result in a potential 15%-to-25% hit to Italian banks' capital and reserves. With the still large overhang of NPLs, Italian banks would be, for all intents and purposes, insolvent (Chart 26). Chart 25In 2011, Italian Spreads Signal Euro Break-Up In 2011, Italian Spreads Signal Euro Break-Up In 2011, Italian Spreads Signal Euro Break-Up Chart 26Italian Banks Still Carry Loads Of Bad Loans Italian Banks Still Carry Loads Of Bad Loans Italian Banks Still Carry Loads Of Bad Loans The populist government in Rome may not understand this dynamic today, but they will soon enough. This is perhaps why the leadership of both parties has decided to appoint a relatively unknown law professor, Guiseppe Conte, as prime minister. Conte is, according to the Italian press, a moderate and is not a Euroskeptic. It will fall to Conte to try to sell Europe first on as much of the M5S-Lega fiscal stimulus as he can, followed by the Italian public on why the coalition fell far short of its official promises. If the coalition pushes ahead with its promises, and ignores warnings from the bond market, we can see a re-run of the 2015 Greek crisis playing out in Italy. In that unlikely scenario, the ECB would announce publicly that it would no longer support Italian assets if Rome were determined to egregiously depart from the SGP. The populist government in Rome would try to play chicken with the ECB and its Euro Area peers, but the ATM's in the country would stop working, destroying its credibility with voters. In the end, the crisis will cause the populists to mutate into fiscally responsible Europhiles, just as the Euro Area crisis did to Greece's SYRIZA. For investors, this narrative is not a reassuring one. While our conviction level that Italy stays in the Euro Area is high, the scenario we are describing here would still lead to a significant financial crisis centered on the world's seventh-largest bond market. Bottom Line: Over the next several months, we would expect bond market jitters concerning Italy to continue, supporting our bearish view on EUR/USD, which we are currently articulating by being long the DXY (the EUR/USD cross makes up 57.6% of the DXY index). Given global growth headwinds, which are already apparent in the European economic data, and growing Italian risks, the ECB may also turn marginally more dovish for the rest of the year, which would be negative for the euro. Our baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals. We expect that Italy will eventually flirt with overt Euroskepticism, but this would happen after the next recession and quite possibly only after the next election. If we are wrong, and the current populist government does not back off, then we could see a global risk-off due to Italy either later this summer, or in 2019. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Joint Statement of the United States and China Regarding Trade Consultations," dated May 19, 2018, available at whitehouse.gov. 2 President Trump later tweeted that the announced deal was substantive and "one of the best things to happen to our farmers in many years!" 3 The most illustrative comment may have come from Dan DiMicco, former steel industry CEO and staunch supporter of President Trump on tariffs, who tweeted "Did president just blink? China and friends appear to be carrying the day." 4 Please see Bob Davis and Lingling Wei, "China Rejects U.S. Target For Narrowing Trade Gap," The Wall Street Journal, dated May 19, 2018, available at wsj.com. 5 Please see "S. 2098 - 115th Congress: Foreign Investment Risk Review Modernization Act Of 2017," dated May 21, 2018, available at www.govtrack.us. 6 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018; and "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 12 Please see, The Treaty on the Functioning of the European Union, "Excessive deficit procedure (EDP)," available at eur-lex.europa.eu. 13 Have you been missing the European alphabet soup over the past three years? 14 The EU Commission can also suspend financing from the European Structural and Investment Funds (ESIF), but Italy has never participated in a bailout and thus could not be sanctioned that way. 15 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com.

Highlights Copper has been stuck in the $2.90-$3.30/lb trading range since late August, 2017. Offsetting supply- and demand-side effects are keeping us neutral: Concerns over restrictions on China's scrap imports and possible industrial action in Chile, along with continued worries over a slow-down in China will keep prices range-bound until we see a fundamental catalyst on one side of the market. Our updated balances model shows a physical surplus in 2018, followed by a deficit in 2019. Energy: Overweight. Rising crude oil prices and steepening backwardation in Brent and WTI, to a lesser extent, will be supportive of our energy-heavy S&P GSCI recommendation, as we expected. The position is up 17.1% since it was initiated on December 7, 2017. Base Metals: Neutral. Our updated balances model points to a physical surplus in the copper market by year end (see below). Precious Metals: Neutral. A stronger USD and higher real rates are pressuring precious metals lower. Our long gold and silver positions are down 1.8% and 0.8%, respectively, over the past week. Ags/Softs: Underweight. The USDA expects Brazil to surpass the U.S. as the world's largest soybean producer in the upcoming crop year, for the first time in history. Nevertheless - and despite U.S.-Sino trade tensions - the report also predicts record U.S. exports of the bean in the 2018/19 crop year. Feature Chart of the WeekStuck In A Trading Range Stuck In A Trading Range Stuck In A Trading Range Copper on the COMEX averaged $3.12/lb since the beginning of the year - slightly higher than our $3.10/lb expectation published in January (Chart of the Week).1 Fears of a slowdown in China -suggested by weaker readings of the Li Keqiang Index - as well as a stronger dollar have been headwinds to further upside. On the flip side, upcoming contract renegotiations at Escondida, China's ongoing environmental efforts, and global PMI readings above the 50 boom-bust line have kept bulls interested in the red metal. Our estimate of the refined copper balance is for a physical surplus this year (Chart 2). Strong demand from Asia, and to a lesser extent North America, will support a moderate pickup in consumption this year. This will be met by greater refined output - a ramp in primary refined output will more than offset the expected decline in secondary production (i.e. refined copper produced from the scrap metal). Upside risk to this outlook comes from supply-side disruptions at the ore mines - particularly in Chile - and at refined levels. The biggest downside risk remains China's growth trajectory: If policymakers are unable to manage the transition to sustainable, consumer- and services-led growth in the market that accounts for 50% of global demand, prices will fall. Longer term, our models point to a physical refined-copper deficit on the back of stronger consumption growth vis-à-vis output growth. The key to a breakout - up or down -lies in the evolution of financial and fundamental factors. On the financial side, the USD has been edging higher since mid-April. Absent an upward copper price catalyst, a continuation in the USD's path will prevent the metal from booking strong gains. On the fundamental side, we expect copper markets to be in surplus this year. However, downside risks from a greater-than-expected slowdown in China could easily tilt the balance. Ongoing Chinese tightening of scrap copper imports will resist sharp moves to the downside. Chart 2Updated Balances: Expect A Refined Copper Surplus This Year Copper: A Break Out, Or A Break Down? Copper: A Break Out, Or A Break Down? Any of these factors may emerge as a catalyst for a breakout or a breakdown in the copper market this year. Yet for now our model is pointing to a physical surplus and we are comfortable with our neutral outlook. We expect near term prices to trade in the $2.90 to $3.15/lb range. Nevertheless, the evolution of these known unknowns may tilt our balances to either side. A break lower would be reason to sell, while a break above the upper bound would support an outlook for higher prices. Geopolitical Risks On The Horizon Political tensions are spilling into the copper market, threatening supplies, and bringing with them the prospect of higher prices. This is not without reason: Supply-side shocks to mined output have historically been a source of upside risk to prices. Foremost among the potential shocks is labor action at the Escondida mine in Chile, the world's largest. June 4 is the deadline for contract renegotiations to begin. These talks will follow last year's contract renewal efforts, which led to a 44-day strike, a 63% y/y decline in the mine's copper output in 1Q17, and eventually, an 18-month contract extension. As the world's largest mine, Escondida accounts for 1.27mm MT out of the 22mm MT of world capacity, and contributes ~5% of global supply. Efforts to lock in an advance deal ended late last month to no avail.2 Nevertheless, Escondida's production in 1Q18 has been exceptional - more than triple the same period last year. Furthermore, copper was among the metals that caught a bid last month amid fears of further rounds of U.S. sanctions on Russian companies. Russian oligarch Vladimir Potanin has a 33% stake in Norilsk, one of the world's largest copper mines - accounting for 388k MT of output last year. While sanctions against Potanin have not been announced, he was named in the U.S. Section 241 Foreign Asset Control filing, suggesting that he may be targeted in future sanctions, putting Norilsk's future at risk, à la Rusal. While fears of U.S. sanctions on Russia appear to have eased, the risk of such action on global copper supply was a tailwind to the copper market last month. In addition to the upside from these potential supply-side shocks, ongoing environmental reform efforts in China remain a theme in metals markets globally. In the case of the red metal, restrictions on Chinese access to "foreign waste" will curtail scrap shipments going forward. World secondary refined production from scrap accounts for almost 20% of global refined copper. China produces more than half of the world's secondary refined copper. This means that China's secondary output makes up 10% of all world refined copper production (Chart 3). Chart 3China's Secondary Output Important To Refined Copper Supply... Copper: A Break Out, Or A Break Down? Copper: A Break Out, Or A Break Down? As such, scrap copper imports play an important role in China - they act as a buffer against high prices, rising when prices lift, and dwindling in times of low prices. Among the measures implemented to gain more control over scrap markets in China are the following: 1. For the period between May 4 and June 4, the Chinese customs inspection firm - China Certification and Inspection Group North America - announced it would suspend the issuance of export certificates for scrap material shipments, including scrap copper.3 The aim of the suspension is to inspect the waste material and ensure it complies with China's new environmental regulations. In general China imports 15% of its copper scrap from the U.S. - purchasing more than 500k MT of scrap copper from the U.S. last year (Chart 4). Since the U.S. is China's top supplier of scrap copper, this specific initiative and China's ongoing efforts for environmental reform could be consequential to secondary refined output. 2. This move comes in addition to ongoing restrictions on imported solid waste. Starting in 2019, Category 7 scrap copper imports - i.e., solid waste, which account for ~20% of all scrap - will be banned.4 Since the beginning of the year, import licenses were granted only to scrap end-users and, since March 1, hazardous impurity levels in scrap copper imports were limited to 1% by weight. A Metal Bulletin report late last month estimated import quotas for scrap copper were 84% lower so far this year.5 As such, Jiangxi Copper - the largest copper refinery in the world - estimates that these restrictions will culminate in a 500k MT decline in scrap copper imports this year. In fact, scrap copper imports have already been falling significantly, with Chinese purchases down 40% y/y in 1Q18. The near-term implication of these restrictions on China's scrap copper imports would be to raise imports of refined copper, or of ores and concentrates. Scrap copper displaced from these restrictions will likely be diverted to other countries where they will be refined and shipped to China for final consumption. While an eventual move by Chinese companies to Southeast Asian countries in a bid to set up processing facilities there would eliminate the long term price impact, there may be some upside to prices during the transition phase. As such, China's imports of copper ores and concentrates, and of the refined metal, have been strong. During the first four months of the year, imports of ores and concentrates were up almost 10% y/y, while inflows of the refined metal are 15% above last year's levels (Chart 5). Chart 4...But Scrap Imports Are Restrained ...But Scrap Imports Are Restrained ...But Scrap Imports Are Restrained Chart 5China's Copper Imports Still Going Strong China's Copper Imports Still Going Strong China's Copper Imports Still Going Strong As these policy measures have been known to the public for quite some time, we suspect they are already priced into markets, and do not foresee further upside risk arising from this source. Nevertheless, their impact will remain significant, given that limited ability to produce scrap copper, which will restrict supply, will keep the market resistant to significant downward price pressure. Moderate Consumption Growth This Year Our updated balances model does not include any significant changes to our demand outlook from our January estimate. This is consistent with our consumption estimates for other industrial commodities that share strong co-movement properties with copper demand. We expect lower global consumption and growth than what's being projected by the International Copper Study Group (ICSG) and the Australian Department of Industry, Innovation and Science in its Resources & Energy Quarterly report. While China will remain the world's major copper consumer, a slowdown in its economy remains the foremost demand-side concern for us this year. DM economies appear to be comfortably perched at an above trend level. Fiscal stimulus in the U.S. and solid growth figures from the rest of the world will help keep demand in DM economies supported (Table 1). Table 1Strong Global Growth Will Support##BR##Copper Consumption Copper: A Break Out, Or A Break Down? Copper: A Break Out, Or A Break Down? However, Chinese demand growth remains vulnerable to a slowdown. As we outlined in our March 29 Weekly Report, while there are fundamental reasons to be concerned about Chinese growth going forward, there are no signs of alarm just yet.6 Manufacturing PMIs have come down in recent months, but they remain above the 50 boom-bust mark. That said, it is worth pointing out that the most significant indicator of the Chinese economy we track - the Li Keqiang index -has also been slowing as of late. We continue to expect the government to be able to pull off the managed slowdown it has embarked on. However, we are alert for any sign the Chinese economy is sharply decelerating, as it would lead us to revise our consumption forecast. A Surplus...At Least This Year Our demand and supply expectations lead us to call for a surplus of refined copper this year. Further out, we expect consumption growth to outpace production next year. The upward adjustment in our balance to a surplus since January is a result of upside revisions to supply amid a stable consumption growth path (Chart 6). Copper inventories remain elevated (Chart 7). While current levels of inventories are not a predictor of future price movements, they do indicate there is sufficient cushion in the market to withstand near-term supply disruptions. Chart 6Solid Production Path Amid Stable Consumption;##BR##Surplus Will Emerge Solid Production Path Amid Stable Consumption; Surplus Will Emerge Solid Production Path Amid Stable Consumption; Surplus Will Emerge Chart 7Inventories Will Cushion##BR##Against Supply Shocks Inventories Will Cushion Against Supply Shocks Inventories Will Cushion Against Supply Shocks Of course, along with other commodity markets, copper prices remain vulnerable to USD movements. In fact, the red metal's performance over the past month is especially impressive given the relative strength in the USD as of late. BCA expects the USD will appreciate in the coming months. Absent fundamental changes - i.e. supply- or demand-side shocks - copper markets will likely be restrained from staging a break-out rally by a stronger USD going forward. Bottom Line: Fundamental and financial risks to the copper market are slightly skewed to the downside this year. We expect a physical surplus to emerge by year-end, given slightly higher output and slower demand growth as China slows. On the downside, prices are vulnerable to a stronger USD and muted demand growth in China. On the upside, they are supported by supply-side concerns, chiefly at the Escondida mine and due to restrictions on China's imports of scrap copper. Stay neutral the red metal. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see p.11 of BCA Research's Commodity & Energy Strategy Weekly Report titled "Stronger USD, Slower China Growth Threaten Copper," dated January 25, 2018, available at ces.bcaresearch.com. 2 Please see "Union at BHP's Escondida copper mine in Chile says no advance deal likely," dated April 24, 2018, available at reuters.com. 3 Please see "China to suspend checks on U.S. scrap metal shipments, halting imports," dated May 4, 2018, available at reuters.com. 4 Please see "China scrap metal firms face pressure from import curbs: official", dated April 26, 2018, available at reuters.com and BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 5 Please see "FOCUS: China's copper scrap import quotas down 84% so far this year," dated April 23, 2018, available at metalbulletin.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in Summary of Trades Closed in

Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? EM Breakdown? EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Global Growth On A Knife Edge Global Growth On A Knife Edge Chart 4German Data... German Data... German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Is Erdogan In Trouble? Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Chart 24Voters Want Governance Improvements Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.

Highlights At just under 3-in-10 odds, the probability Brent crude oil prices will exceed $80/bbl by year-end is now more than double what it was at the beginning of the year, following President Trump's announcement he would withdraw the U.S. from the 2015 Joint Comprehensive Plan of Action (JCPOA), and re-impose all economic sanctions against Iran (Chart of the Week). Chart of the WeekProbability Brent Exceeds $90/bbl Is Understated By Markets Feedback Loop: Spec Positioning & Oil Price Volatility Feedback Loop: Spec Positioning & Oil Price Volatility We believe these odds are too low. Indeed, we think the odds of Brent prices ending above $90/bbl this year are higher than the 1-in-8 chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. We also expect sharper down moves going forward, as news flows become noisier. Speculators have loaded the boat on the long side, and they will be exquisitely sensitive to any unexpected softening in fundamentals - e.g., a supply increase or the whiff of lower demand - given their positioning (Chart 2). Chart 2Specs Have Loaded the Boat##BR##Getting Long Brent and WTI Exposure Specs Have Loaded the Boat Getting Long Brent and WTI Exposure Specs Have Loaded the Boat Getting Long Brent and WTI Exposure Our research indicates that spec positioning in the underlying futures can, under some circumstances, dominate the evolution of oil options' implied volatility, the markets' key gauge of risk and the essential component of option pricing. As new risk factors arising from Trump's decision emerge, we expect option implied volatility to increase, as the frequency of spec re-positioning increases. Energy: Overweight. We are getting long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectation. We also recommend getting long Aug/19 $75 Brent calls vs. short Aug/19 $80/bbl calls. We already are long Dec/18 $65/bbl Brent calls vs. short $70/bbl calls expiring at the end of Oct/18, which are up 74.2% since they were recommended in Feb/18. Rising vol favors long options positions. The new positions will put on at tonight's close. Base Metals: Neutral. Refined copper imports in China grew 47% y/y in March. For the first four months of 2018 they are up 15% y/y. Imports of copper ores and concentrates were up 9.7% y/y in the January - April period. Precious Metals: Neutral. We remain strategically long gold and tactically long spot silver. A stronger USD continues to weigh on both. Ags/Softs: Underweight. The USDA's weekly Crop Progress report indicates farmers in the U.S. are catching up in their spring planting, converging toward averages for this time of year. Nevertheless, the condition of winter wheat remains a concern. Feature The wild swings in crude oil prices following President Trump's decision not to waive nuclear-related sanctions against Iran - down ~ 2% after Trump's announcement Tuesday, then up more than 2.5% the following morning - resolved one of the more important "known unknowns" ahead of schedule - to wit, would the U.S. re-impose nuclear-related sanctions against Iran, or continue to waive them.1 Ahead of Trump's announcement this week, speculators clearly were building long positions in Brent and WTI, as seen in Chart 2. Among other things, stout fundamentals, which we have been highlighting, and a possible tightening of supply on the back of the re-imposition of U.S. sanctions were obvious catalysts for building the bullish positions. We find specs do not Granger-cause oil prices, and typically these traders are reacting to fundamental news.2 This is consistent with other research into this topic.3 In other words, we find specs essentially follow the fundamentals, they don't lead them, and, as a result, the level of oil prices largely is explained by supply, demand and inventories. Based on the Granger-causality tests and our fundamental modeling, we believe oil markets are, to a very large extent, efficient in the sense that prices reflect most publicly available information.4 This is not to say, however, that the role of speculation can be dismissed as trivial to price formation. Spec Positioning Matters For Implied Volatility In Oil Our most recent research, building on earlier work on speculation in oil markets, finds that the concentration of speculators on the long side or the short side of the market actually does play a significant role in how volatility evolves (Chart 3, bottom panel).5 Other factors are important to the evolution of volatility, as well - i.e., U.S. financial conditions, particularly the stress in the system as measured by the St. Louis Fed's Financial Stress Index; EM equity volatility; and y/y percent changes in WTI oil prices themselves (Chart 3). But spec positioning clearly dominates: In periods of rising or elevated volatility, it explains most of the change in WTI option implied volatilities (Chart 4). This can push volatility higher when it occurs. However, on the downside, this does not hold - Working's T Index is not material to the evolution of implied volatility when uncertainty about future oil prices is low or decreasing. Chart 3Key Variables##BR##Explaining Volatility Key Variables Explaining Volatility Key Variables Explaining Volatility Chart 4Spec Positioning Dominates##BR##Evolution of WTI Implied Volatility Spec Positioning Dominates Evolution of WTI Implied Volatility Spec Positioning Dominates Evolution of WTI Implied Volatility Working's T Index and implied volatility are independent of price direction - they are directionless, therefore they cannot be used to forecast prices.6 These variables tend to increase when the quality of information available to the market deteriorates - i.e., when it becomes more difficult to form expectations about future oil prices. This is, we believe, an attractive time for informed speculators to enter the market and use their information to make profits. We find two-way Granger-causality between WTI implied volatility and Working's T, when the annual change in excess speculation is one-standard deviation above or below its mean. This means the more specs are concentrated on one side of the market in the underlying futures - long or short - the more influence their positioning has on volatility, and that the higher volatility is the more specs are drawn to the market. Given that specs' beliefs are different, this means there is a rising number of long or short spec contracts relative not only to specs on the other side of the market, but also to long and short hedgers. Why Speculation Is Important Prices do not suddenly manifest themselves in markets fully aligned with fundamentals. They are made efficient by hedgers off-loading risk based on their marginal costs, and speculators uncovering information that is material to the level at which prices clear markets. The goal of speculation is to buy low and sell high. Hedging and speculation are both done in the presence of noise, or pseudo-information that has no real connection with where markets clear.7 Information is to noise as substance is to a void. Noise can look like information, as Black (1986) notes, and people can trade on it, but they will lose money and eventually go out of business. Information, on the other hand, is costly, as Grossman and Stiglitz (1980) point out. To incentivize someone (a speculator) to gather it and feed it into prices via the market clearing - i.e., buying and selling based on information - they have to be able to make a profit. Speculators supply the liquidity necessary for trading - and, most importantly, hedging - to occur. Successful speculators make profits. Therefore, the information on which they trade is more often germane to the market-clearing process than not. To be successful they have to be willing to buy when prices are low, expecting them to go higher, and to sell when prices are high, expecting them to go lower. As Paul Samuelson wryly observed, "Is there any other kind of price than 'speculative' price? Uncertainty pervades real life and future prices are never knowable with precision. An investor is a speculator who has been successful; a speculator is merely an investor who last lost his money."8 Known Unknowns Will Keep Vol Elevated Chart 5BCA's Oil Price Forecast Unchanged,##BR##Following Trump's Iran Announcement BCA's Oil Price Forecast Unchanged, Following Trump's Iran Announcement BCA's Oil Price Forecast Unchanged, Following Trump's Iran Announcement In the wake of Trump's announcement, the fundamental and geopolitical landscape has been re-cast, creating additional "known unknowns", particularly re how the U.S. will implement the renewed sanctions and the timing of these moves. Among the new known unknowns, which can only be resolved with the passage of time, are: The precise timing and extent of the re-imposed sanctions on the part of the U.S., which will evolve over the next 90 to 180 days. Demand-side implications of higher prices, particularly in EM economies where policymakers used the low prices following OPEC's 2014 - 16 market-share war to eliminate fuel subsidies, which prevented high prices from being experienced by their citizens. The supply-side implications of higher prices on U.S. shale production - does production and investment, including pipeline take-away capacity, take another leg higher? The Kingdom of Saudi Arabia's (KSA) ability to raise output, given the Kingdom said it would be raising output in the event Iranian volumes are lost to export markets. The fate of the Saudi Aramco IPO, and how the re-imposition of sanctions by the U.S. on Iran affects the royal family's decision on whether to float 5% of the company publicly. Will production in distressed states in- and outside of OPEC be negatively affected by increasing geopolitical risk?9 Among the "known unknowns," Iran's next moves rank high, as do responses to such moves by the U.S. and its allies. The U.S. and its Gulf allies clearly view Iran as a threat and, with the re-imposition of sanctions against Iran, are confronting it. Iran has a similar view vis-à-vis the U.S. and its Gulf allies. Left to be determined: Does Iran increase its level of direct action against KSA, upping the ante, so to speak, in its ongoing proxy wars with the Kingdom? Is Gulf production threatened? Are U.S. - European relations threatened by Trump's action? Thus far, European leaders have indicated they remain committed to the sanctions deal Trump walked away from. What would it take for OPEC 2.0 to restore actual production cuts we estimate at 1.1 to 1.2mm b/d to the market? What would it take to trigger a release of the U.S. Strategic Petroleum Reserve (SPR), estimated at just under 664-million-barrel, which could be released to the market at a rate of 500k to 1mm b/d? These known unknowns are not causing us to change our price forecast for this year - $74/bbl for Brent and $70/bbl for WTI, based on our fundamental modeling (Chart 5). However, we do think price risk is to the upside in both markets, given the elevated geopolitical tensions in the market. We continue to expect more frequent prices excursions to and through $80/bbl for the balance of the year, particularly for Brent. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We lay out some of these "known unknowns" in BCA Research's Commodity & Energy Strategy Weekly Report "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published April 19, 2018. In addition to the Iran issues, which have been resolved, Venezuela looms large. Oil production declined by 900k b/d between December 2015 and March 2018, with half of that occurring in the past six months. We are carrying Venezuela's current production at ~ 1.5mm b/d, although other estimates have it lower. With the country moving closer to collapsing as a functioning state, the risk to its oil output and exports is high. 2 Granger-causality refers to an econometric test developed by Clive Granger, the 2003 Nobel laureate in economics. It determines whether past values of one variable can be said to predict, or cause, the present value of another variable. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, available at ces.bcaresearch.com. See also the International Energy Agency's "Oil: Medium-Term Market Report 2012;" and "The Role of Speculation in Oil Markets: What Have We Learned So Far?" by Bassam Fattouh, Lutz Kilian and Lavan Mahadeva, published by The Oxford Institute For Energy Studies. Also, see "Speculation, Fundamentals, and The Price of Crude Oil," by Kenneth B. Medlock III, published by the James A. Baker III Institute for Public Policy at Rice University, August 2013. 4 This is the semi-strong form of market efficiency. For a discussion of how markets impound information in prices, please see Eugene Fama's Noble lecture, "Two Pillars of Asset Pricing," which was reprinted in the June 2014 issue of The American Economic Review (p. 1467). 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking." Formally, Working's T Index looks like this: Feedback Loop: Spec Positioning & Oil Price Volatility Feedback Loop: Spec Positioning & Oil Price Volatility 6 Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 7 Please see Black, Fischer (1986), "Noise," in the Journal of Finance, 41:3; and Grossman, Sanford J., and Stiglitz, Joseph E. (1980), "On the Impossibility of Informationally Efficient Markets," in the June issue of the American Economic Review. 8 Please see Samuelson, Paul A. (1973), "Mathematics Of Speculative Price," in the January 1973 SIAM Review, 15:1. 9 Please see "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published by BCA's Energy Sector Strategy on May 9, 2018, which discusses these production risks in depth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Feedback Loop: Spec Positioning & Oil Price Volatility Feedback Loop: Spec Positioning & Oil Price Volatility Trades Closed in 2018 Summary of Trades Closed in 2017 Feedback Loop: Spec Positioning & Oil Price Volatility Feedback Loop: Spec Positioning & Oil Price Volatility

Highlights The grand U.S.-China strategic negotiation is focused on Korea and trade - only Korea is seeing good news; The trade war is expanding to include investment - and Chinese capital account liberalization is the silver bullet; Capital account openness has mixed benefits for EMs, yet the risks are dire. China's policymakers will move only gradually; If Trump demands faster liberalization, a full-blown trade war is more likely; Favor DM equities over EM. Feature The American and Chinese economies have diverged for years (Chart 1), threatening to remove the constraint on broader strategic disagreements. Amidst the uncertainty, a grand U.S.-China negotiation is taking place, focused on two primary dimensions: Korea and trade. Chart 1Economic Constraint To Conflict Erodes Economic Constraint To Conflict Erodes Economic Constraint To Conflict Erodes On the Korea front, the news is mostly positive.1 The leaders of North and South Korea have held their third summit, promising an end to hostilities and a new beginning for economic engagement and possibly denuclearization. They are laying the groundwork for U.S. President Donald Trump to meet North Korean leader Kim Jong Un sometime this month, or in June. From China's point of view, the North Korean developments are mostly positive. A belligerent North Korea provides the U.S. and its allies with a reason to build up their military assets in the region, which can also serve to contain China. A calmer North Korea removes this reason and, over the long run, holds out the potential for the reduction of U.S. troops in South Korea. On net, China has benefited from the opening up of the formerly reclusive Vietnamese and Myanmar economies and stands to do the same if North Korea follows suit. On U.S.-China trade, however, the news is not so good.2 The two countries have just seen another high-level embassy conclude without progress, all but ensuring that relations will get worse before they get better. Investors should prepare for the U.S. to take additional punitive measures and for China to retaliate in kind. The U.S. Treasury Department is on the verge of imposing landmark new restrictions on Chinese investment by May 21 or sooner. Congress, separate from the Trump administration and in a notable sign of bipartisan unity, is considering legislation that would do the same. This is independent from Trump's impending tariffs on $50-$150 billion worth of Chinese goods, which could also come as early as May 21. In other words, the U.S.-China economic conflict is rotating from trade to investment. Hence, in this report, we take a look at the "Holy Grail" of American demands on China: capital account liberalization. So far the Trump administration has not pushed its demands this far. That is a good thing, because China is not willing to move quickly on this front. Rapid and complete opening to global capital flows is a "red line" for China, so it is an important indicator of whether the two great powers are heading toward a full-blown trade war. The Uncertainties Of Capital Account Liberalization A country's capital account covers foreign direct investment (FDI), portfolio investment, cross-border banking transactions, and other miscellaneous international capital flows. Since the 1960s, especially since 1989, developed market economies in the West have encouraged the free flow of capital across national borders (Chart 2). As with the free flow of goods, services, and labor, the flow of capital promised integrated markets and more efficient uses of resources. Just as freer trade would lower prices, spur competition, and improve efficiency and innovation, so would the unfettered movement of capital. Trading partners could use savings to invest in each other's areas of productive potential that lacked funds. In this sense, capital flows were nothing but future trade flows: today's cross-border investment would be tomorrow's production of freely tradable goods.3 The laissez-faire, Anglo-Saxon economies promoted capital account liberalization for several reasons. First, economic theory and practice supported free trade as a means of increasing wealth, and free trade requires some degree of capital liberalization. Furthermore, liberalization played to the advantage of London and New York City, as international financial hubs, and both the U.S. and the U.K. sought to expand their role as providers of global reserve currencies.4 The European Community also sought freer capital flows due to the fact that the creation of the common market, at minimum, required it for trade financing. In the 1980s, France's bad experience with capital controls led it to adopt a more laissez-faire approach, prompting a convergence across Europe to the Anglo-Saxon model. Capital account liberalization joined free trade, fiscal conservatism, and deregulation as part of the "Washington Consensus" orthodoxy. Major economies were encouraged to liberalize their capital accounts if they wanted to join the OECD, like Japan, or if they sought economic and financial assistance from the IMF (Table 1).5 And yet the empirical evidence of the benefits of capital account liberalization is surprisingly mixed. There is not a clear causal connection between free movement of capital and improved macroeconomic variables like higher rates of growth, investment, or productivity. Relative to other kinds of international liberalization - of labor markets, for example - capital account liberalization is likely to bring small gains to growth rates (Table 2). Chart 2Global Capital Flows Expand China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Table 1Capital Account Liberalization: A Timeline China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Table 2Economic Benefits Of Open Borders China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks We can illustrate this point simply by showing that emerging market economies with more open capital accounts, whether defined by the IMF's Capital Account Openness Index or by the ratio of direct and portfolio capital flows to GDP, do not necessarily have higher potential GDP growth or productivity (Chart 3 A&B). A change in openness also does not correlate with a change in growth potential or productivity. Chart 3AEM Capital Openness Not Obviously Correlated With Potential Growth (1) China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 3BEM Capital Openness Not Obviously Correlated With Potential Growth (2) China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks This conclusion can be reinforced by looking at portfolio investment. Portfolio investment is usually one of the last types of investment to be deregulated. Hence a large ratio of portfolio investment to GDP is a proxy for capital liberalization. However, emerging markets that rank high in this regard do not record higher potential growth, productivity, or capital productivity contributions to GDP growth (Chart 4). Chart 4EM: Larger Foreign Stock Inflows Not Correlated With Capital Productivity China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks While the benefits of capital account liberalization are debatable, the risks are dire. It has contributed to, if not caused, a number of financial crises in recent decades. Latin America saw a series of such crises from 1982-89. Mexico's peso crisis of 1994 also owed much of its severity to destabilizing capital flows. Japan opened its capital account in 1979 and over the succeeding decade experienced a rollercoaster of massive capital influx, culminating in the property bubble and financial crash of 1990. Thailand, South Korea, and other Asian countries suffered the Asian Financial Crisis of 1997-98 as a result of premature and poorly sequenced liberalization. All of these countries faced different financial and economic circumstances, and the crises had different causes, but what they shared in common was a relatively recent openness to large inflows and outflows of global capital that triggered or exacerbated currency moves and liquidity shortages.6 This is not to say that there are not benefits to capital account liberalization, or that the benefits never outweigh the costs. The major multilateral global institutions continue to believe that capital account liberalization is optimal policy, if only because the richest, freest, best governed, and most advanced economies have all liberalized. Capital account openness is positively correlated with "rule of law" governance indicators. And back-of-the-envelope exercises such as those shown above suggest that developed market economies do see higher potential growth and capital productivity as a result of capital account liberalization, at least up to a point (Charts 5A & 5B). Chart 5ADM: Capital Openness Is Correlated With Potential Growth (1) China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 5BDM: Capital Openness Is Correlated With Potential Growth (2) China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks While a number of countries have experienced financial and economic crises after opening their capital accounts, studies have shown that the causal connection is not always clear (the crisis did not necessarily stem from capital account liberalization).7 The removal of barriers to entry or exit of capital does not have a unidirectional effect but can exacerbate capital flows when times are good or bad. Moreover, some research shows that countries are more likely to suffer financial crises from capital controls than from the removal of them.8 And it is very difficult for countries with open current accounts (free trade) to enforce rigid capital controls anyway, since the distinction between capital flows covering trade transactions and other capital flows is difficult in practice to enforce, resulting in leakage. Because of the link between trade and capital, no country has ever fully and permanently reversed liberalization.9 The academic debate rages on, but from a political point of view, two things are clear. First, the best practices of the most advanced countries suggest that capital account liberalization is optimal policy. Second, policymakers in less open economies are faced with uncertainty and a range of views from economic advisers, orthodox and unorthodox. In the wake of crises in recent decades, this uncertainty has made them less inclined over the years to trust to economic orthodoxy or the "Washington Consensus" when making critical decisions about capital flows. Rather, opening is likely when economic problems call for a change in tack, while capital controls are likely when flows are considered excessive or destabilizing. Bottom Line: Capital account liberalization is the best practice among advanced economies but the risk-reward ratio for policymakers in EMs and partly closed economies is likely skewed to the downside. China's Stalled Capital Account Liberalization Chart 6China's Fear Of Capital Flight China's Fear Of Capital Flight China's Fear Of Capital Flight In recent years China's policymakers have struggled with the problem of capital account liberalization. In the aftermath of the global financial crisis they announced that they would speed up the process. In 2015 they pledged to complete it by 2020, only to re-impose capital controls when financial turmoil that year prompted large capital outflows (Chart 6). In 2017 President Xi Jinping claimed that the country remains committed to gradual liberalization. We have argued that his administration would ease these controls later rather than sooner, in order to pursue tricky domestic financial reforms first.10 As we have seen (Chart 3 above), China lies on the low end of the IMF's "Capital Account Openness" index, which ranks countries across the world based on six economic indicators and 12 asset classes. By this measure, China is slightly more open than India - a notoriously hermetic economy - and less open than the Philippines. China's closed capital account is also clear from its international investment position. China has fewer international assets and liabilities, as a share of output, than the U.S., Japan, Europe, or South Korea (Charts 7A & 7B). China's international assets are largely the result of its government's $3.1 trillion in foreign exchange reserves, as well as outward FDI. As for its liabilities, China has opened up to FDI more so than portfolio investment or other capital flows. This is because FDI is long-term capital that tends to be more closely tied to real production; it is difficult to unwind it in times of crisis. China allows inward and outward FDI to gain knowhow, technology, and natural resources. It is more closed, however, to short-term capital flows, such as dollar-denominated bank debt, currency speculation, and portfolio investment. Typically it is these short-term flows that are most destabilizing, especially when countries are newly open to them. Chart 7AChina Has Fewer Foreign Assets, Mostly Official Forex Reserves China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 7BChina Has Fewer Foreign Liabilities, Mostly FDI China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Western economies, however, stand to benefit if China opens up to these shorter-term capital flows. They have a comparative advantage in financial services and thus can rebalance their relationships with China if it gives its households and corporations more freedom to manage their wealth in foreign currencies and assets. It is logical that China's FDI and portfolio investment in western countries would rise if Chinese investors were allowed to go abroad, simply because the latter would wish to diversify their portfolios for the first time. China's neighbors and trade partners would receive a windfall of new investments. Meanwhile they would gain new investment opportunities, as private capital would be able to venture into China, and flee out of it, more easily.11 Western countries are also increasingly agitating for China to loosen its inward capital restrictions. Despite China's openness to FDI relative to other capital flows, it is still one of the world's most restrictive countries in which to invest long-term capital (Chart 8). China's heavy restrictions have granted monopolies to Chinese companies, depriving foreigners of the fruits of China's growth. This is especially important as China moves into consumer- and services-oriented growth. Western countries have a comparative advantage in high-end consumer goods and services relative to low-end goods and manufacturing in general, where they have largely lost out to Chinese competition in recent decades. Chart 8China Is Highly Restrictive Toward Foreign Direct Investment China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks China, too, stands to benefit from freer capital flows, and policymakers believe there is a self-interest in liberalizing. But Beijing has repeatedly demonstrated that it wants to move very gradually because of the skewed risk-reward assessment. China's harrowing experience with capital flight in 2014-16 has vindicated this policy.12 It is not necessarily capital account opening per se that causes destabilizing capital outflows - it is also the macro and financial environment. And China has all the hallmarks of an economy that could suffer a crisis from premature liberalization, including: Large macro imbalances (Chart 9); An immature and shallow financial system (Chart 10); Lack of information transparency; Weak rule of law. Chart 9China Has Macro Imbalances China Has Macro Imbalances China Has Macro Imbalances Chart 10China's Financial System Is Shallow China's Financial System Is Shallow China's Financial System Is Shallow Bottom Line: It is guaranteed that China will not pursue capital account liberalization rapidly. It will continue to take small steps, and ultimately "two steps forward and one step back" if necessary to maintain overall stability. Will China Liberalize? By the same logic, why should China liberalize at all? The 2014-16 crisis not only revealed the dangers of too-rapid opening but also the dangers of an inflexible currency and draconian capital controls. When Chinese authorities devalued the yuan in August 2015, they made the capital flight (and global panic) worse. Since then, by imposing strict capital controls, China's leaders have signaled to domestic and foreign investors (1) that they are unwilling to allow global capital flows to discipline their fiscal or monetary policies (a negative sign for China's macro fundamentals), and (2) that they may deny investors the rights of their property or even confiscate it.13 This is why China has made important policy changes since the 2014-16 crisis. First, it has maintained a more flexible "managed float" of the RMB, allowing it to trade more freely along with a basket of currencies that belong to major trading partners and abandoning the dollar peg. Various measures of the exchange rate - offshore deliverable forwards, spot rates, and the exchange rate at interest rate parity - have converged, revealing an exchange rate that is more market-oriented, i.e. less heavily managed by the People's Bank of China (Chart 11).14 This process is being pursued with the long-term interest of rebalancing the economy - making it more flexible and less fixed to an export-led manufacturing model. It is also necessary in order to internationalize the yuan, which is a long and rocky road but, it is hoped, will eventually reduce foreign exchange risk to China's economy (Chart 12). One of the main reasons that governments, including China, have maintained closed capital accounts is to control exchange rates. As currencies float more freely, the economy becomes better able to withstand large or volatile capital flows. At the same time, the yuan will never be a global reserve currency if China never opens the capital account. Chart 11The RMB Is Floating A Bit More Freely The RMB Is Floating A Bit More Freely The RMB Is Floating A Bit More Freely Chart 12The RMB Is Going Global ... Slowly The RMB Is Going Global ... Slowly The RMB Is Going Global ... Slowly Second, while tight capital controls remain in place, Beijing is pursuing long-delayed reforms to the financial sector and fiscal and legal systems to allow for better financial regulation, supervision, and transparency. For instance, the new central bank Governor Yi Gang's reported desire to genuinely liberalize domestic deposit interest rates will prepare China's banks for greater competition with each other, and hence ultimately to greater competition from abroad. This in turn will improve allocation of capital across the economy. Another example is the expansion of the domestic and offshore bond markets - and gradual formalization of the local government debt market - in order to deepen the financial sector.15 These reforms are desirable in themselves but also necessary for eventual capital account liberalization, as countries with deep domestic financial markets have less vulnerability to new surges of foreign inflows or outflows. Naturally, the reform process is taking place on China's timeline. Since Beijing stresses overall stability above all else, it is gradual. But we would expect the Xi administration to continue with piecemeal opening measures through the coming years, so that by 2021, the capital account is materially more open than it is today. As for full liberalization, it is beyond our forecasting horizon. Xi's goal of turning China into a "modern socialist country" by 2035 is not too late of a timeframe to consider, given the potential for serious setbacks. But such delayed progress raises the prospect of a clash with the U.S. A risk to this view is that China backslides yet again on the internal reforms, making it impossible to move to the subsequent stage of opening up to international flows. Vested financial and non-financial corporate interests often oppose capital account liberalization. State-controlled companies, for instance, will gradually have to compete more intensely for capital that comes from better disciplined domestic banks, all while watching small and medium-sized rivals gain market share due to the newfound access to foreign capital, which makes them more competitive.16 Backsliding will, again, antagonize the West. Bottom Line: China is preparing to open its capital account further, as we are in the "two steps forward" phase following Xi Jinping's political recapitalization in 2017. A New Front In The U.S.-China Trade War The U.S. has long argued that China maintains excessive capital controls that violate the conditions of China's accession to the World Trade Organization in 2001.17 The following statement, from one of the U.S. government's annual reports on China's compliance with the WTO, was written before the Trump administration took office and is typical of such reports and of the overall U.S. position: Although China continues to consider reforms to its investment regime ... many aspects of China's investment regime, including lack of a substantially liberalized market, maintenance of administrative approvals and the potential for a new and overly broad national security review system, continue to cause foreign investors great concern ... China has added a variety of restrictions on investment that appear designed to shield inefficient or monopolistic Chinese enterprises from foreign competition.18 The Trump administration's own reports on China's WTO compliance have amplified such criticisms.19 Remember that it was partly China's lack of WTO compliance that the Trump administration highlighted as justification for the sanctions announced in March under Section 301 of the 1974 Trade Act. In particular, the administration argues that U.S.-China investment relations are not fair or reciprocal, i.e. that the U.S. does not have as great of investment access in China as vice versa (Chart 13). Even in FDI, where China is relatively open and the bilateral sums are fairly reciprocal, the U.S. share is smaller than that of comparable developed economies, such as Japan and Europe (Chart 14). While it is not a foregone conclusion that this is the result of discriminatory policies, the U.S. argues that it suffers from unfair practices. What is clear is that China designates a number of sectors "strategic," excluding them from foreign investment, and places caps on foreign ownership. The two countries tried but failed to conclude a bilateral investment treaty under the Obama administration, which was meant to resolve this problem and stimulate private capital flows. China also has not implemented a nationwide foreign investment "negative list," which it has promised since 2013.20 A negative list would explicitly designate sectors that are off-limits to foreign investment and thus implicitly liberalize investment in all others. Chart 13The U.S. Wants Investment Reciprocity China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 14The U.S. Wants More Investment Access China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks The U.S. is also demanding greater reciprocity for its banks to lend to Chinese borrowers. China is well-known for heavily restricting foreign bank access, with foreign loans accounting for only 2.75% of total. The U.S. grants much larger market access to Chinese lenders than vice versa (Chart 15). While there are perfectly good reasons for U.S. banks to hold a smaller share of China's total cross-border bank loans than European banks and comparable Asian banks (U.S. banks focus on their large domestic market while European and Japanese banks are bigger international lenders), nevertheless the Americans will see their smaller market share as evidence that American market access can go up (Chart 16). Chart 15The U.S. Wants Banking Reciprocity China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 16The U.S. Wants More Banking Access China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Thus the silver bullet for the Trump administration would be to demand accelerated, full capital account liberalization from Beijing. This would address the above problems of investment access while also constituting a larger demand for China to hasten structural reforms that would favor American interests. This is why American officials have urged China to liberalize during high-level bilateral dialogues in the past - while knowing that the reform itself was of such significance that China would only move gradually.21 Chart 17Is The RMB Undervalued? Is The RMB Undervalued? Is The RMB Undervalued? So far the Trump administration has not demanded that China accelerate capital account liberalization, perhaps knowing that it would be a non-starter for China.22 One reason may be the expectation that the RMB could depreciate. True, the yuan is roughly at fair value in real effective terms, after a 7.4% appreciation since Trump's inauguration. However, China's 2014-16 capital flight episode suggests that, under the circumstances of a rapid opening of the capital account, outflow pressure could resume and the currency could fall. This would, at least for a time, drive down CNY/USD, contrary to Trump's oft-repeated desire that the currency appreciate. Trump adheres to a view that the RMB is structurally undervalued, as illustrated here by the IMF's purchasing power parity model, which suggests that it should rise by 45% against the greenback (Chart 17). Given Trump's rhetoric, it may not be far-fetched to suggest that Trump is disinclined to push for capital account liberalization and would rather see China maintain its current "managed" system in order to manage the CNY/USD even further upward. The broader point, however, is that previous U.S. administrations have pushed for faster capital account liberalization, and the Trump administration could eventually follow suit. This would mark a major escalation in the standoff, since China possibly cannot, and certainly will not, deliver such a momentous structural change on a timeline imposed by a foreign power. Bottom Line: Rapid capital account liberalization represents China's "red line" in the trade talks. If Trump pushes his demands this far, then he will be seen as threatening China's stability and will be rebuffed. This is a pathway to a full-blown trade war. Investment Conclusions Capital account liberalization is by no means the only indicator for gauging whether the U.S. and China are heading toward a full-blown trade war. As things stand, Trump will soon impose Section 301 tariffs, China will retaliate, and Trump will retaliate to the retaliation. This is our definition of a trade war. Not only is Trump threatening tariffs on $50-$150 billion worth of imports. He is now demanding that China reduce the U.S.'s trade deficit by $200 billion, or 53% of the total, twice as much as earlier. To give an indication of how significant such a change would be for China over the long haul, Table 3 provides a very simple scenario analysis of what would happen to China's trade surplus, current account surplus, and GDP growth rate if the U.S. reduced its bilateral trade deficit by 10%, 33%, or 50%. It shows that if the deficit fell by 33%, Trump's initial goal, then China's current account balance would fall to less than one percent of GDP, and GDP growth would slow down to 6.24% for the year. Table 3Scenario Analysis: Trump Slashes U.S. Trade Deficit With China China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Table 4 takes the worst-case scenario for China, in which the U.S. cuts the deficit by 50%, while oil prices average $90/bbl due to oil price shocks from unplanned production outages in Iran (where Trump is re-imposing sanctions), or Venezuela or others, amid a very tight global oil market.23 China's current account surplus would go negative, while GDP growth would fall to 5.32%! Table 4Scenario Analysis: Trump Slashes Deficit, Oil Prices Soar China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks These scenarios are significant because they are not very far-fetched. Instead, they show how easily China could undergo a symbolic transition into a "twin deficit" country - a country with an estimated 13% budget deficit and a negative current account balance. Such a development would not necessarily have immediate concrete ramifications. But it would, if it became a trend, mark a turning point in which China begins exporting rather than importing global wealth. It would cause global investors to scrutinize the country in different ways than before and to question the status and long-term trajectory of China's traditional buffers against financial and economic challenges: the country's large national savings and foreign exchange reserves. These scenarios are merely suggestive and meant to show the gravity of Trump's threats and the seriousness with which Xi will take them. In the current U.S.-China trade conflict, if China allows the CNY/USD to weaken - the logical way of alleviating tariff impacts - then it will be depreciating the currency in Trump's face: conflict will intensify. It is not clear how long the conflict will last or how bad it will get, so investors would be wise to hedge their exposure to stocks along the U.S.-China value chain, favoring small caps and domestic plays in both countries. BCA's Geopolitical Strategy recommends staying long DM equities relative to EM equities. We are short Chinese technology stocks outright, and short China-exposed S&P 500 stocks. By contrast, BCA's China Investment Strategy service continues to recommend that investors stay overweight Chinese stocks excluding the technology sector (versus global ex-tech stocks) over the coming 6-12 months with a short leash. As highlighted in this report, the near-term risks to China from the external sector are clearly to the downside, which supports the decision of the China Investment Strategy team to place Chinese stocks on downgrade watch for Q2.24 This watch remains in effect for the coming two months, a period during which we hope fuller clarity on the U.S.-China trade dispute and the pace of decline in China's industrial sector will emerge. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 Please see Barry Eichengreen, "Capital Account Liberalization: What Do Cross-Country Studies Tell Us?" World Bank Economic Review 15:3 (2001), 341-65. Available at documents.worldbank.org. 4 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Is King Dollar Facing Regicide?" dated April 27, 2018, available at gps.bcaresearch.com. 5 Please see Jeff Chelsky, "Capital Account Liberalization: Does Advanced Economy Experience Provide Lessons for China?" World Bank Economic Premise 74 (2012), available at openknowledge.worldbank.org. 6 Please see Donald J. Mathieson and Liliana Rojas-Suarez, "Liberalization of the Capital Account: Experiences and Issues," International Monetary Fund, March 15, 1993, available at www.imf.org; Ricardo Gottschalk, "Sequencing Trade and Capital Account Liberalization: The Experience of Brazil in the 1990s," United Nations Conference on Trade and Development and United Nations Development Programme Occasional Paper (2004), available at unctad.org; see also Sarah M. Brooks, "Explaining Capital Account Liberalization In Latin America: A Transitional Cost Approach," World Politics 56:3 (2004), 389-430. 7 Please see Peter Blair Henry, "Capital Account Liberalization: Theory, Evidence, and Speculation," Federal Reserve Bank of San Francisco Working Paper 2007-32 (2006); see also Eichengreen in footnote 1 above. 8 Please see Reuven Glick, Xueyan Guo, and Michael Hutchison, "Currency Crises, Capital-Account Liberalization, and Selection Bias," The Review of Economics and Statistics 88:4 (2006), 698-714, available at www.mitpressjournals.org. 9 Please see M. Ayhan Kose and Eswar Prasad, "Capital Accounts: Liberalize Or Not?" International Monetary Fund, Finance and Development, dated July 29, 2017, available at www.imf.org. 10 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 11 This western interest in Chinese capital account liberalization exists entirely aside from any of the aforementioned capital flight pressures from Chinese investors, which could reignite again. Foreign countries would welcome such inflows to some extent but not to the point that they become destabilizing at home or abroad. 12 The earliest rumored deadline for capital account liberalization was the seventeenth National Party Congress of the Communist Party in 2007. Please see Derek Scissors, "Liberalization In Reverse," The Heritage Foundation, May 4, 2009, available at www.heritage.org. 13 Eichengreen highlighted these points with regard to the literature and observations on capital account liberalization across a range of countries. They are highly relevant to China today. 14 Please see BCA China Investment Strategy Weekly Report, "Has The RMB Gone Too Far?" dated February 1, 2018, available at cis.bcaresearch.com. 15 Please see BCA China Investment Strategy Weekly Report, "Embracing Chinese Bonds," dated July 6, 2017, available at cis.bcaresearch.com. 16 Raghuram G. Rajan and Luigi Zingales, "The Great Reversals: The Politics of Financial Development in the Twentieth Century," Journal of Financial Economics 69 (2003), 5-50, available at faculty.chicagobooth.edu. 17 China did not commit to fully liberalizing the capital account as part of its WTO accession agreements, but rather the U.S. cites China's use of capital controls as a means of violating other WTO commitments regarding market access, subsidization, etc. At the time China joined the WTO, it was widely believed that its commitments would include gradual liberalization. For instance, the State Administration of Foreign Exchange lifted capital controls imposed during the Asian Financial Crisis in September 2001. Please see Lin Guijun and Ronald M. Schramm, "China's Foreign Exchange Policies Since 1979: A Review of Developments and an Assessment," China Economic Review 14:3 (2003), 246-280, available at www.sciencedirect.com. 18 U.S. Trade Representative, "2015 Report To Congress On China's WTO Compliance," December 2015, available at ustr.gov. 19 U.S. Trade Representative, "2017 Report To Congress On China's WTO Compliance," January 2018, available at ustr.gov. 20 Please see U.S. Department of State, "2012 U.S. Model Bilateral Investment Treaty," available at www.state.gov. See also U.S. Department of the Treasury, "Joint U.S.-China Economic Track Fact Sheet of the Fifth Meeting of the U.S.-China Strategic and Economic Dialogue," July 12, 2013, available at www.treasury.gov. 21 See, for instance, U.S. Department of the Treasury, "2015 U.S.-China Strategic and Economic Dialogue Joint U.S.-China Fact Sheet - Economic Track," June 6, 2015, available at www.treasury.gov. 22 However, Michael Pillsbury, director of the Center for Chinese Strategy at the Hudson Institute and an adviser on Trump's transition team, has argued that the Trump administration's endgame is to implement the well-known World Bank and China State Council Development Research Center report, China 2030, which full-throatedly endorses capital account liberalization. Please see Robert Delaney, "Donald Trump's trade endgame said to be the opening of China's economy," South China Morning Post, April 3, 2018, available at www.scmp.com. For the report, see "China 2030: Building a Modern, Harmonious, and Creative Society," 2013, available at www.worldbank.org. 23 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 24 Please see BCA China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight," dated March 28, 2018, available at cis.bcaresearch.com.

Highlights Despite recent softness in the data, Swedish growth will remain robust over the next 6-12 months, supported by loose monetary conditions and solid export demand. Inflation has climbed back to the Riksbank 2% target, and additional increases are likely over the next 6-12 months. Though debt levels are high, households are relatively healthy given strong wealth, solid disposable income and elevated saving rates. Swedish politics will not substantively impact the markets. If the Moderate Party comes to power, it is unlikely to make significant policy departures from the Social Democrats. Swedish banks' capital levels are elevated, particularly compared to their EU peers. Still, the massive exposure to domestic real estate suggests that banks could not withstand a meaningful decline in house prices. The uninterrupted, long-term surge in Swedish house prices suggests that a bubble has formed. A strong supply-side response has softened prices as of late, but a massive correction is not imminent given robust economic growth and very accommodative monetary policy. Negative interest rates are inconsistent with the robust growth Sweden is experiencing. Going forward, strong growth momentum, rising inflation and a tight labor market will force policymakers to raise rates earlier, and by more, than markets expect. Sweden government debt will underperform global developed market peers over the next 6-12 months. Feature Chart 1Watch What They Do,##BR##Not What They Say Watch What They Do, Not What They Say Watch What They Do, Not What They Say Sweden is a country that has been very frustrating to figure out for investors and analysts alike over the past few years. The economy has been performing very well, with real GDP growth averaging around 3% since 2013, well above the OECD's estimate of potential GDP growth of 2.2%. Over that same period, the unemployment rate has fallen from 8% to 6.5% while inflation has risen from 0% to 2%. These are the types of developments that would normally lead an inflation targeting central bank like the Riksbank to contemplate a tightening of monetary policy. Yet while the Riksbank has been projecting significant increases in policy rates and bond yields every year for the past few years, it has actually delivered additional interest rate cuts, bringing the benchmark repo rate down into negative territory in 2014 and keeping it there to this day (Chart 1). In this Special Report, we examine Sweden's economic backdrop, upcoming elections and the health of the financial system to determine the likely future path of Swedish interest rates. We conclude that investors should not fear an imminent collapse of the Swedish housing bubble or a shock outcome in the September general election. A shift in direction for monetary policy, however, is likely later this year, with the Riksbank set to become more hawkish in response to an economy that no longer requires ultra-loose monetary conditions. This has bearish strategic implications for Swedish fixed income, and could finally place a floor under the beleaguered krona. Economy: Sustained Growth Outweighs Potential Risks After experiencing slowing growth momentum in 2016, Sweden's economy made a solid recovery in 2017. Real GDP growth came in at 3.3% on a year-over-year basis in Q4/2017, following on the strong prints earlier in the year. The Riksbank believes that GDP growth will slow slightly in 2018 due to some softening in consumer spending and business investment. However, real consumption has remained resilient and should be supported by the continued recovery in wages. Capital spending has also been robust and industrial confidence remains in an uptrend. While both the OECD leading economic indicator and manufacturing PMI have pulled back in recent months, both are coming off elevated levels. The PMI remains well above the 50 line, suggesting that strong growth momentum remains intact (Chart 2). The National Institute of Economic Research's economic tendency survey bounced back in April on the back of manufacturing and construction strength, with readings for the survey having been above 100 (signifying growth stronger than normal) every month since April 2015. One important factor helping support above-trend growth is fiscal policy, which has become modestly stimulative after two years of major fiscal drag in 2015 and 2016. As an export-oriented country, Sweden is highly levered to the state of the global economy. Export growth remains supported by continued strong global activity, low unit labor costs and recent krona weakness. Real exports expanded at a 4.7% rate (year-over-year) at the end of 2017 and the outlook is bright given firming growth in Sweden's largest export partners and the considerable depreciation of the krona. This is confirmed by our export model, which is signaling a pickup in export growth through the rest of the year before moderating slightly in 2019 (Chart 3). Chart 2Swedish Growth Cooling Off A Bit,##BR##But Remains Strong Swedish Growth Cooling Off A Bit, But Remains Strong Swedish Growth Cooling Off A Bit, But Remains Strong Chart 3Export Growth##BR##Will Remain Solid Export Growth Will Remain Solid Export Growth Will Remain Solid Healthy employment growth has driven Sweden's unemployment rate to 6.5%, more than one full percentage point below the OECD's estimate of the full-employment NAIRU1 rate (Chart 4). The spread between the two (the unemployment gap) has not been this low in nearly two decades. During the last period when unemployment was below NAIRU in 2007-08, wage growth surged to over 4%. However, Swedish wage growth has been subdued following the 2008 financial crisis, has been the case in most developed countries, even as unemployment continues to fall. Currently, annual growth in average hourly earnings is now displaying positive upward momentum, both in nominal terms (+2.5%) and, even more importantly for consumer spending, in real terms (+0.9%). A tightening labor market will support additional wage increases in the coming months. Importantly, Swedish wages are also influenced by wages in countries that are export competitors. For example, they have closely tracked German wages in recent years. The strong wage increases coming out of the latest round of German labor union negotiations is therefore a positive sign for Swedish wage growth.2 In addition, there is scope for more improvement as the unemployment rate is still above its pre-crisis level. Sweden has experienced a large inflow of immigration over the last decade and the unemployment rate for non-EU-born residents is approximately four times higher than the national figure. The government is stressing education and skill-building programs to address this issue and speed up the integration process. To the extent that these programs are successful, there is scope for a decline in the immigrant unemployment rate that can pull the overall national unemployment rate even lower - as long as the economy continues to expand and the demand for labor remains robust. A rising trend in domestic price pressures from the labor market can extend the recent uptrend in Swedish inflation. Inflation has been steadily rising since the deflation scare at the end of 2013, driven by consistent above-trend economic growth which has soaked up all spare capacity in the Swedish economy (Chart 5). The latest print on headline CPI inflation was 1.9%, while CPIF inflation (the Riksbank's preferred measure that is measured with fixed interest rates) sits right at the central bank's 2% target. Market-based inflation expectations have eased a bit on the year, though most survey-based measures have remained firm. Chart 4Wage Pressures Intensifying Wage Pressures Intensifying Wage Pressures Intensifying Chart 5Inflation Back To Target, May Not Stop There Inflation Back To Target, May Not Stop There Inflation Back To Target, May Not Stop There Rising oil prices have lifted inflation and BCA's commodity strategists believe that there is some additional upside given high demand and declining inventories, suggesting additional inflationary pressure ahead. In addition, even though core prices have historically been weak in the summer months, our Swedish core CPI model suggests that inflationary pressures will continue to build over the next six months, primarily due to booming resource utilization (bottom panel). Additionally, inflation should remain supported by a weaker krona, which has declined 8.5% year-to-date despite robust domestic fundamentals. The real trade-weighted index (TWI) peaked in 2017 and is now at a post-crisis low. These depressed levels suggest the currency can rise without derailing export growth. Going forward, the Riksbank expects the krona to gradually appreciate, based on projections from the April 2018 Monetary Policy Report (MPR).3 However, the currency has closely tracked the real policy rate (Chart 6) and thus could continue to fall below the Riksbank's projected path if our base case scenario of inflation rising further before the Riksbank starts hiking rates plays out - providing an additional boost to inflation from an even weaker krona. While the cyclical economic story in Sweden still looks solid, there remains a significant potential structural headwind in the form of high household debt. Mortgage borrowing has propelled the debt-to-income ratio to over 180% and the debt-to-GDP ratio to over 80%, making Swedish households some of the most indebted in the developed world (Chart 7). The Riksbank projects that debt-to-income will reach 190% by 2021 and its financial vulnerability indicator is at a post-crisis high. While we are certainly not understating the risks associated with such a massive debt load, we do not view this as an imminent threat to the economy. Chart 6VERY Loose Monetary Conditions##BR##In Sweden VERY Loose Monetary Conditions In Sweden VERY Loose Monetary Conditions In Sweden Chart 7Swedish Households Can##BR##Manage High Debt Swedish Households Can Manage High Debt Swedish Households Can Manage High Debt Swedish households' financial situation is better than it appears, with wealth three times larger than liabilities. Additionally, disposable income, which suffers under Sweden's high tax rates, should receive a boost this year from the increase in child allowance and lower taxes on pensioners. Importantly, the Swedish personal saving rate has been trending upward since the financial crisis and currently is one of the highest in the developed world at 9.6%. In addition, while about 70% of Swedish mortgages are variable rate, consumers are prepared for higher interest rates. Survey data shows household expectations on rates are in line with the National Institute of Economic Research's forecast. Outside of a negative growth shock or a substantial and rapid rise in interest rates, which is not our base case, Swedish high household debt levels should not pose a risk to the current economic expansion. Bottom Line: Despite recent softness in the data, Swedish growth will remain robust over the next 6-12 months, supported by loose monetary conditions and solid export demand. Inflation has climbed back to the Riksbank 2% target, and additional increases are likely over the next 6-12 months. Though debt levels are high, households are relatively healthy given strong wealth and elevated saving rates. Politics: Moderating On All Fronts Sweden has become something of a poster child for a country where immigration policy has become unhinged. In the U.S., Sweden's struggle to integrate recent arrivals, particularly its large asylum population, is a frequent feature on right-wing news channels and websites. The narrative is that Sweden is overrun with migrants and that, as a result, anti-establishment and populist parties will be successful in the upcoming elections on September 9th. This view is based on some objective truths. First, Sweden genuinely does struggle to integrate migrants. As BCA's Chief Global Strategist, Peter Berezin, has showed, Sweden is one of the worst performers when it comes to integrating immigrants into its labor force (Chart 8) and in educational attainment (Chart 9).4 Peter posits that the likely culprit is the country's generous welfare state, which discourages migrants from participating in the labor force and perhaps creates a self-selection process where migrants and asylum seekers looking to enter Sweden are those most likely to abuse its generous public support system.5 Chart 8Immigrants Have Trouble##BR##Integrating Into The Labor Force Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore Chart 9Immigrants Have Trouble##BR##In Swedish Education Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore Second, the country's premier populist party - the Sweden Democrats - is relatively successful in the European context. Its ardently anti-immigrant policy has helped the party go from just 2.9% of the vote in 2006, to 12.9% in 2014. For much of 2017, Sweden Democrats have polled as the second most popular party in the country, behind the ruling Social Democrats (Chart 10). Chart 10Anti-Establishment Party Polling Well Anti-Establishment Party Polling Well Anti-Establishment Party Polling Well At the same time, the pessimistic narrative is old news and misses the big picture. In Europe, the anti-establishment parties are moving to the center on investment-relevant matters - such as EU integration - while the establishment parties are adopting the populist narratives on immigration. BCA's Geopolitical Strategy described this process in a recent Special Report that outlined how political pluralism - as opposed to the party duopoly present in the U.S. - encourages such a political migration to the center.6 Sweden is a dramatic case of increasing political pluralism. As such, its political evolution is relevant to the thesis that investors should not fear pluralism because the anti-establishment will migrate to the center while the establishment adopts anti-immigrant rhetoric. This is precisely what has been happening in Sweden for the past six months. First, the ruling Social Democrats - traditionally proponents of migration in the country - have called for tougher rules on labor migration, a major departure from party orthodoxy. Second, Sweden Democrats have seen an exodus of right-wing members, including the former leader, as the party moves to the middle ground on all non-immigration-related issues. This opens up the possibility for Sweden Democrats to join the pro-business Moderate Party in a coalition deal after the election. Should investors fear the upcoming election? Our high conviction view is no. There are three general conclusions we would make regarding the election: Anti-asylum policies will accelerate. All parties are becoming more anti-immigrant in Sweden as the public turns against the country's liberal asylum policies. This is somewhat irrelevant, however, as the influx of asylum seekers into Europe has already dramatically slowed due to better border enforcement policies by the EU (Chart 11). Meanwhile, the pace of migration to Sweden from other EU countries will not moderate, given that the country is part of the continental Labor Market. This is important as EU migrants make up 32% of total migrants into Sweden and tend to be more highly educated and much better at participating in the labor market. Euroskepticism is irrelevant: There is absolutely no support for exiting the EU, with Swedes among the most ardent supporters of remaining in the bloc. Less than a third of Swedes are optimistic about a life outside the EU, for example (Chart 12). As such, the pace of migration will only moderate in so far as the country accepts less refugees going forward. There will be no break with the EU Labor Market and no "Swexit" referendum on the investable time horizon. Chart 11Asylum Flows Are Slowing Asylum Flows Are Slowing Asylum Flows Are Slowing Chart 12Swedes Are Europhiles Swedes Are Europhiles Swedes Are Europhiles The Moderate Party is not a panacea: The pro-business, center-right, Moderate Party is often seen as a panacea for investors. It is true that the party's rise to power, in 1991, coincided with a severe financial crisis and that it was under its leadership that reform efforts began in earnest. However, the Social Democrats already initiated reforms ahead of their 1991 loss and accelerated structural changes well past Moderate Party rule, which ended in 1994. Some of the deepest cuts to the country's social welfare programs were in fact undertaken under Prime Minister Göran Persson, who was either the finance or prime minister between 1994 and 2006. Bottom Line: Swedish politics will not substantively impact the markets. Sweden Democrats are shifting to the center on non-immigration issues. Meanwhile, moderate parties are becoming more anti-immigrant. While there are no risks, we would also not expect major tailwinds. If the Moderate Party comes to power, it is unlikely to make significant policy departures from the Social Democrats. Banks: In Good Shape... For Now Chart 13Sweden's Banks Are In Excellent Shape Sweden's Banks Are In Excellent Shape Sweden's Banks Are In Excellent Shape Swedish banks have been generating solid earnings growth, far outpacing their EU peers, as net interest margins are at multi-year highs and funding costs are low (Chart 13). Solid domestic economic growth has helped boost lending volumes. Non-performing loans have been in a downtrend since 2010 and have stabilized at very low levels. While we expect lending volumes to stay strong and defaults to remain low over the medium term given robust economic growth, we are more cautious on the earnings front. Our base case is that the Riksbank will finally embark on the beginning of a monetary tightening cycle at the end of 2018, and banks will likely struggle to maintain the current solid pace of earnings growth with a policy-driven flattening of the Swedish yield curve. Sweden has stricter capital requirements than their EU peers and, as such, the banks are far better capitalized. Both the aggregate Liquidity Coverage Ratio, a measure of short-term liquidity resilience, and the Net Stable Funding ratio are above Basel Committee requirements and have steadily increased over the past few quarters. The ratio of bank equity to risk-weighted assets paints an overly sanguine picture given that banks use internal models to calculate risk weights and are likely underestimating the risk associated with their massive mortgage exposure. Still, our preferred metric, the ratio of tangible equity to tangible assets, has remained firmly at elevated levels. Sweden's banking system has long been dominated by four major banks (Nordea, SEB, Svenska Handelsbanken and Swedbank). However, Nordea, Sweden's only global systemically important bank, is planning to move its headquarters to Finland later this year. The move will drastically reduce the size of Sweden's national bank assets from 400% of GDP to just under 300%. Nordea has clashed with Sweden's government over higher taxes and increased regulation and the relocation is projected to save €1.1 billion over the long run. Importantly, Nordea will be overseen by the European Banking Union. Overall, we believe this lowers the risk to the Swedish banking system given the reduction in banking assets. More importantly, Swedish authorities will no longer be financially responsible for future problems that could develop at Nordea. Bottom Line: Swedish bank earnings growth has been solid, but will come under pressure once the Riksbank begins to raise rates this year. Capital levels are elevated, particularly compared to their EU peers. Still, the massive exposure to domestic real estate suggests that banks could not withstand a sharp or prolonged decline in house prices. Housing: The Beginning Of The End? House prices in Sweden have been in an uninterrupted, secular uptrend due to low interest rates, robust demand, a structural supply shortage and considerable tax incentives for home ownership. While many of its EU counterparts had significant housing corrections over the last decade, the Swedish market escaped relatively unscathed. In fact, the last meaningful decline was during the 1990s crisis, when house prices fell close to -20%. Chart 14The Overheated Housing Market##BR##Has Cooled Off The Overheated Housing Market Has Cooled Off The Overheated Housing Market Has Cooled Off Swedish authorities believe that the bubbling housing market poses the greatest risk to the Swedish economy, given the sheer magnitude of the uptrend and the Swedish banking sector's massive exposure (Chart 14). Valuation metrics indicate that housing is overvalued and, as such, the current five-month decline has prompted concerns that a meaningful correction may be underway. However, the recent pullback was a result of a strong supply-side response that began in 2013, specifically the construction of tenant-owned apartments. Last year had the most housing starts since 1990. That new supply is still insufficient to meet expected demand, however, and Swedish policymakers are implementing a 22-point plan to both increase and speed up residential construction. Swedish regulators have introduced multiple macroprudential measures over the past few years in order to both cool demand and boost household resilience. These include placing a cap on the size of mortgages (85% of the value of a home), raising banks' risk weight floors7 and multiple adjustments to amortization requirements. Data suggests that these policies have affected consumer behavior by both decreasing the amount of borrowing and causing buyers to purchase less expensive homes. Additionally, the government has recently approved legislation that will boost the ability of the financial regulator (Finansinspektionen) to act in the event of a potential downtown. The policy measures to cool the housing market have been fairly effective, with house prices now down -4.4% on a year-over-year basis (middle panel). However, economic history teaches us that asset bubbles never deflate peacefully. We are concerned over a structural horizon, but we believe that a massive correction is unlikely over the next year. Economic growth will like remain robust and monetary policy is very accommodative. It will take multiple rate hikes before monetary conditions are restrictive, thereby drastically weakening demand and prompting a sustained reversal in the house price uptrend. Bottom Line: The uninterrupted, long-term surge in Swedish house prices suggests that a bubble has formed. A strong supply side response has softened prices as of late, but a massive correction is not imminent given robust economic growth and very accommodative monetary policy. Monetary Policy: Riksbank On Hold, But Not For Long At the most recent monetary policy meeting in late-April, the Riksbank decided to keep the benchmark repo rate at -0.5%, further exercising caution after prematurely raising rates in 2010-2011. The Riksbank acknowledged that economic growth was "strong", but also maintained that inflation was "subdued" and monetary conditions needed to remain stimulative to ensure that inflation would sustainably stay at the 2% target. They revised their projected path for the repo rate downward, with the first hike now only coming at the end of this year. Even after that liftoff, however, the Riksbank plans to continue reinvesting redemptions and coupon payments from its government bond portfolio, accumulated during its quantitative easing program that ended last December, for "some time". Chart 15Our New Riksbank Monitor##BR##Is Calling For Rate Hikes Our New Riksbank Monitor Is Calling For Rate Hikes Our New Riksbank Monitor Is Calling For Rate Hikes In recent years, the Riksbank has moved the repo rate alongside the ECB's policy rate, in order to protect export competitiveness by preventing an unwanted appreciation of the krona. However, the fundamentals do not justify this. Inflation is in a clear uptrend and has recovered to the Riksbank's target, while euro area inflation is still well below the ECB's target. Additionally, Swedish growth has been outpacing that of the euro area, and relative leading indicators suggest this will continue. While the ECB continues to emphasize that it has no plans to raise interest rates anytime soon, it is now far more difficult for the Riksbank to justify keeping its policy rates below zero as the ECB is doing. It is one thing to have negative interest rates and a cheap currency when there is plenty of economic slack and inflation is well below target. It is quite another to have those same loose policy settings when the output gap is closed, labor markets are at full employment and inflation is at target. This can be seen by the reading from our new Riksbank Central Bank Monitor (Chart 15). The BCA Central Bank Monitors are composite indicators designed to measure cyclical growth and inflation pressures that can influence future monetary policy decisions. A reading above zero indicates that policymakers are facing pressures to raise interest rates. We have Monitors for most developed markets, but we had not yet built the indicator for Sweden. Currently, the Riksbank Monitor is in "tight money required" territory, as it has been since late-2015. Though the Monitor has been primarily being driven upward by the growth component, the inflation component is also above the zero line. Forward interest rate pricing in the Swedish Overnight Index Swap (OIS) curve indicates that markets are not expecting the Riksbank to begin hiking rates until July 2019. Only 95bps of hikes are priced by March 2020, suggesting that the market expects a very moderate start to the tightening cycle once it begins. Given the still-positive growth and inflation backdrop, we expect that the Riksbank will begin to hike earlier - likely by year-end as currently projected by the central bank - and by more than currently discounted by markets. Bottom Line: Negative interest rates are inconsistent with a robust Swedish economy that is operating with no spare capacity. Going forward, strong growth momentum, rising inflation and a tight labor market will force policymakers to raise rates earlier, and by more, than markets expect. Investment Implications With the market not priced for the move in Riksbank monetary policy that we expect, investors can position for that shift through the following recommended positions (Chart 16): Chart 16How To Position For##BR##Higher Swedish Interest Rates How To Position For Higher Swedish Interest Rates How To Position For Higher Swedish Interest Rates Underweight Swedish bonds within a global hedged fixed income portfolio. Swedish government debt has been a star performer since the beginning of 2017, outperforming the Barclays Global Treasury Index by 101bps (currency-hedged into U.S. dollars). Global yields have risen over that period while Swedish yields have remained fairly flat. This trend is unlikely to continue, moving forward. The Riksbank ended the net new bond purchases in its quantitative easing program last December, removing a powerful tailwind for Swedish debt performance. If the Riksbank begins to hike rates by year-end, as it is projecting and we expect, then interest rate convergence will begin to undermine the ability for Sweden to continue its impressive run of fixed income outperformance. Enter a Sweden 2-year/10-year government bond yield curve flattener. As the Riksbank begins to shift to a more hawkish tone over the coming months, markets will begin to reprice not only the level of Swedish interest rates but the shape of the Swedish yield curve. That means not only higher bond yields but a flatter curve, as too few rate hikes are currently priced at the short-end. Growth is robust, inflation is at target and the unemployment rate is well below NAIRU. With their mandates met, the Riksbank will be forced to act more aggressively. Importantly, there is no flattening currently priced into the Swedish bond forward curve, thus there is no negative carry associated with putting on a flattener now. Short 2-year Sweden government bonds vs. 2-year German government bonds. The yield spread between the Swedish and German 2-year yield is only 5bps, well below its long-run average of 27bps. Relative fundamentals suggest that the Riksbank will no longer be able to shadow the actions of the ECB (negative policy rates) as it has over the past few years. Growth in Sweden is likely to outpace that of the euro area once again in 2018. Swedish inflation is already at the Riksbank target while euro area inflation continues to undershoot the ECB benchmark. Also, the currencies have moved in opposite directions since 2017, with the Euro Area trade-weighted index (TWI) rising by 7% and Sweden TWI falling by 6%, suggesting that Sweden can better handle tighter monetary policy. With the ECB signaling that it is in no hurry to begin raising interest rates (even after it ends its asset purchase program at the end of the year, as we expect), policy rate differentials will drive the 2-year Sweden-Germany spread wider over the next 12-18 months, with no spread move currently priced into the forwards. Patrick Trinh, Associate Editor patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Non-Accelerating Inflation Rate Of Unemployment 2 https://www.reuters.com/article/us-germany-wages/german-pay-deal-heralds-end-of-wage-restraint-in-europes-largest-economy-idUSKBN1FP0PD 3 https://www.riksbank.se/globalassets/media/rapporter/ppr/engelska/2018/180426/monetary-policy-report-april-2018 4 Please see BCA Global Investment Strategy Special Report, "The Future Of Western Democracy: Back To Blood," dated November 18, 2016, available at gis.bcaresearch.com. 5 Please see BCA Global Investment Strategy Special Report, "The End Of Europe's Welfare State," dated June 26, 2015, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Should Investors Fear Political Plurality," dated November 29, 2017, available at gps.bcaresearch.com. 7 25% of the value of a mortgage loan must be included when banks calculate their required regulatory risk-weighted capital levels.

Highlights Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Inside The Beltway Inside The Beltway Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Inside The Beltway Inside The Beltway Chart 3GOP Retirements Are Unprecedented Inside The Beltway Inside The Beltway Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Inside The Beltway Inside The Beltway Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Inside The Beltway Inside The Beltway Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Inside The Beltway Inside The Beltway Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment U.S. To Restrict Chinese Investment U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Inside The Beltway Inside The Beltway Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Is This Enough To Stay Trump's Hand On Tariffs? Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Iranian Geopolitical Risk About to Shoot Up Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Inside The Beltway Inside The Beltway Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range Oil Prices Can Make Runs Into $80/Barrel Range Oil Prices Can Make Runs Into $80/Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Reserve currencies are built on a geopolitical and macroeconomic foundation. For the U.S. Dollar, these foundations remain in place, but cracks are emerging. Relative decline in American power, combined with a loss of confidence in the "Washington Consensus" at home, are eroding the geopolitical foundations. Meanwhile, threats to globalization, a slower pace of petrodollar recycling, and stresses in the Eurodollar system are eroding the macroeconomic foundations. The Renminbi is not an alternative to King Dollar, but the euro remains a potential challenger in the coming interregnum years that will see the world transition from American hegemony... to something else. In the long run, we envision a multipolar currency regime to emerge alongside a multipolar geopolitical world order. Feature In this report, BCA's Geopolitical and Foreign Exchange strategies join efforts with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research) to examine the conditions necessary for the decline of a reserve currency. Specifically, we seek to answer the question of whether the U.S. dollar is at the precipice of such a decline. With President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. After all, King Dollar has fallen by 9.7% since President Trump's inauguration on January 20, while alternatives of dubious value, such as a slew of cryptocurrencies, have seen a rally of epic proportions (Chart 1). Professor Barry Eichengreen, a world-renowned international economics historian,1 has recently penned an insightful paper proposing a link between the robustness of military alliances and currency reserve status.2 According to the analysis, reserve currency status reflects both economic fundamentals - safety, liquidity, network effects, and economic conditions - and geopolitical fundamentals. In the case of close U.S. military allies, such as South Korea and Japan, the choice of the dollar as store of value is explained far more by the geopolitical links to the U.S., rather than the importance of the dollar for their economies. The authors warn that if the U.S. "withdraws from the world," the impact could be as large as an 80 basis points rise in the U.S. long-term interest rate. Intriguingly, some of what Professor Eichengreen posits could happen has already happened. For example, the share of foreign holdings of U.S. Treasuries by military allies has already declined by a whopping 25% (Chart 2). And yet the demand for King Dollar assets was immediately picked up by non-military allies, proving the resiliency of greenback's status as the reserve currency. Chart 1Is Trump Guilty Of Regicide? Is Trump Guilty Of Regicide? Is Trump Guilty Of Regicide? Chart 2Geopolitics Is Not Driving Demand For Treasuries Geopolitics Is Not Driving Demand For Treasuries Geopolitics Is Not Driving Demand For Treasuries When it comes to global currency reserves, the U.S. dollar continues to command 63%, roughly the same level it has commanded since 2000 (Chart 3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart 4). The Chinese renminbi remains largely ignored as a global reserve currency and its use across markets and geographies appears to have declined since the imposition of full capital controls in October 2015 (Chart 5). Chart 3Dollar Remains King Dollar Remains King Dollar Remains King Chart 4The Euro Is The Only Serious Competitor To The King Dollar... Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? Chart 5...The Renminbi Is Not Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? However, some cracks in the foundation are emerging. A recent IMF paper, penned by Camilo E. Tovar and Tania Mohd Nor,3 uses currency co-movements to determine which national currencies belong to a particular reserve currency bloc.4 Their work shows that the international monetary system has already transitioned from a bi-polar system - consisting of the greenback and the euro - to a multipolar one that includes the CNY (Chart 6). However, the CNY's influence does not extend beyond the BRICS and is scant in East Asia, the geographical region that China already dominates in trade (Chart 7), albeit not yet geopolitically (Map 1). Chart 6Renminbi Does Command A Large Currency ''Bloc''... Renminbi Does Command A Large Currency '''Bloc'''... Renminbi Does Command A Large Currency '''Bloc'''... Chart 7...But Despite China's Dominance Of East Asia... ...But Despite China's Dominance Of East Asia... ...But Despite China's Dominance Of East Asia... Map 1...Renminbi's "Bloc" Is Not In Asia! Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? Our conclusion is that the geopolitical and economic tailwinds behind the greenback's status as a global reserve currency are shifting into headwinds. This process, as we describe below, could increase the risk of a global dollar liquidity shortage, buoying the greenback in the short term. In the long term, however, a transition into a multipolar currency arrangement could rebalance some of the imbalances created by the collapse of the Bretton Woods System and is not necessarily to be feared. The Geopolitical Fundamentals Of A Reserve Currency Nothing lasts forever and the U.S. dollar will one day join a long list of former reserve currencies that includes the Ancient Greek drachma, the Roman aureus, the Byzantium solidus, the Florentine florin, the Dutch gulden, the Spanish dollar, and the pound sterling. All of the political entities that produced these reserve currencies have several factors in common. They were the geopolitical hegemons of their era, capable of controlling the most important trade routes, projecting both hard and soft power outside of their borders, and maintaining a stable economy that underpinned the purchasing power of their currency. Table 1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table 1Insights From History: What Makes A Reserve Currency? Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? Geopolitical Power As Eichengreen posits, geopolitical fundamentals are essential for reserve currency status. Military power is necessary in order to defend one's national and commercial interests abroad, compel foreign powers to yield to those interests, and protect allies in exchange for their acquiescence to the hegemonic status quo. An important modern world example of such "gunboat diplomacy" was the 1974 agreement between the U.S. and Saudi Arabia.5 In exchange for dumping their petro-dollars into U.S. debt, Riyadh received an American commitment to keep the Saudi Kingdom safe from all threats, both regional (Iran) and global (the Soviet Union). It also received special permission to keep its purchases of U.S. Treasuries secret. Chart 8The Exorbitant Privilege In One Chart Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? As with all the empires surveyed in Table 1, allies and vassal states were forced to use the hegemon's currency in their trade and investment transactions as a way of paying for the security blanket. To this day, there is no better way to explain the "exorbitant privilege" that the dollar commands. Chart 8 illustrates that the U.S. enjoys positive net income despite a massively negative net international investment position. It is true that the U.S.'s foreign assets are skewed toward foreign direct investment and equities, investments that have higher rates of returns than the fixed-income liabilities the U.S. owes to the rest of the world. But the U.S.'s positive net income balance has been exacerbated by the willingness of foreigners to invest their assets into the U.S. for little compensation, something illustrated by the fact that between 1971 and 2007, the ex-post U.S. term premium has been toward the lower end of the G10. Additionally, as foreigners are also willing holders of U.S. physical cash, the U.S. government has been able to finance part of its budget deficit with instruments carrying no interest payments. This is what economists refer to as seigniorage, a subsidy to the U.S. government equivalent to around 0.2% of GDP per annum (or roughly $39.5 bn in 2017). In essence, American allies are paying for American hegemony through their investments in U.S. dollar assets, and this lets the U.S. live above its means. But ultimately, the quid pro quo is perhaps as much geopolitical as economic. There is one, non-negligible, cost for U.S. policymakers. The greenback tends to appreciate during periods of global economic stress due to its reserve currency status.6 This means that each time the U.S. needs a weak dollar to reflate its economy, the dollar moves in the opposite direction, adding deflationary pressures to an already weak domestic economy. Compared to the benefits, which offer the U.S. a steady-stream of seigniorage income and low-cost financing, the cost of reserve currency status is acceptable. Economic Power Chart 9U.S. Naval Strength Still Supreme... U.S. Naval Strength Still Supreme... U.S. Naval Strength Still Supreme... Aside from brute force, an empire is built on commercial and trade links. There are two reasons for this. First, trade allows the empire to acquire raw materials to fuel its economy and technological advancement. Second, it also gives the "periphery" a role to play in the empire, a stake in the world system underpinned by the hegemonic core. This creates an entire layer of society in the periphery - the elites enriched by and entrenched in the Empire - with existential interest in the status quo. For the past five centuries, commercial dominance has been underpinned by naval dominance. As the Ottoman Empire and the Ming Dynasty closed off the overland routes in the fourteenth and fifteenth centuries, Europeans used technological innovation to avoid the off-limits Eurasian landmass and establish alternative - and exclusively naval - routes to commodities and new markets. This has propelled a succession of largely naval empires: Portuguese, Spanish, Dutch, French, British, and finally American. Several land-based powers tried to break through the nautical noose - Ottoman Turks, Sweden, Hapsburg Austria, Germany, and the Soviet Union - but were defeated by the superiority of naval-based power. Dominance of the seas allows the hegemonic core to unite disparate and far-flung regions through commerce and to call upon vast resources in case of a global conflict. Meanwhile, the hegemon can deny that commerce and those resources to land-locked challengers. This is how the British defeated Napoleon and how the U.S. and its allies won World War I and II. The U.S. remains the supreme naval power (Chart 9). While China is building up its ability to push back against the U.S. navy in its regional seas (East and South China Seas), it will be decades before it is close to being able to project power across the world's oceans. While the former is necessary for becoming a regional hegemon, the latter is necessary for China to offer non-contiguous allies an alternative to American hegemony. Bottom Line: The foundation of a global reserve currency status is geopolitical fundamentals. The U.S. remains well-endowed in both. American Hegemony - From Tailwinds To Headwinds Chart 10...But Overall Hegemony Is In Decline ...But Overall Hegemony Is In Decline ...But Overall Hegemony Is In Decline The U.S. is already facing a relative geopolitical decline due to the rise of major emerging markets like China (Chart 10). This theme underpins BCA Geopolitical Strategy's view that the world has already transitioned from American hegemony to a multipolar arrangement.7 In absolute terms, the U.S. still retains the hard and soft power variables that have supported the USD's global reserve status and will continue to do so for the next decade (which is the maximum investment horizon of the vast majority of our clients). However, there are three imminent threats to the status quo that may accentuate global multipolarity: Populism: The global hegemon could decide to withdraw from distant entanglements and institutional arrangements. In the U.S., an isolationist narrative has emerged suggesting that America's status as the consumer and mercenary of last resort is unsustainable (Chart 11). President Obama was elected on the promise of withdrawing from Iraq and Afghanistan; his administration also struck a major deal with Iran to reduce American exposure to the Middle East. Donald Trump won the presidency on an even more isolationist platform and he and several of his advisors have voiced such a view over the past 15 months. The appeal of isolationism could resurface as it is a potent political elixir based on a much deeper rejection of globalization among the American public than the policy establishment realized (Chart 12). Chart 11Trump Is Rebelling Against The Post-Cold War System Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? Chart 12Americans Are Rebelling Against The Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? Return of the land-based empire: While the U.S. remains the preeminent naval power, its leadership in military prowess could be wasted through a suboptimal grand strategy. The U.S. has two geopolitical imperatives: dominate the world's oceans and ensure the disunity of the Eurasian landmass.8 Eurasia has sufficient natural resources (Russia), population (China), wealth (Europe), and geographical buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia would have no need for a navy as it would become a superpower by default. Why would America's European allies abandon their U.S. security blanket for an alliance with Russia and China? First, stranger shifts in alliance structure have occurred in the past.9 Second, because a mix of U.S. mercantilism and isolationism could push Europe into making independent geopolitical arrangements with its Eurasian peers, even if these arrangements were informal. The advent of the cyber realm: Finally, the advent of the Internet as a new realm of great power competition reduces the relative utility of hard power, such as a navy. Great empires of the past struggled when confronted with new arenas of conflict such as air and submarine. New technologies and new arenas can yield advantages in traditional battlefields. Today, the U.S. must compete for hegemony in space and cyber-space with China, Russia, and other rivals. In these mediums, the U.S. does not have as great of a head start as it has in naval competition. Bottom Line: The U.S. remains the preeminent global power. However, its status as a hegemon is in relative decline. Domestic populism, suboptimal grand strategy, and the advent of cyber and outer-space warfare could all accelerate this decline on the margin. The Economic Fundamentals Of U.S. Dollar Reserve Status One unique aspect of the U.S. dollar as a reserve currency is that it is a fiat currency, i.e. paper money limited in supply only by policy. Throughout human history, most dominant currency reserves were based on commodities that were rare or difficult to acquire, like silver or gold.10 When the U.S. dollar was decoupled from gold prices in 1971, it became the only recent example of a global reserve currency backed by nothing but faith (the pound was for most of its period of dominance backed by gold). Money serves three functions in the economy. It is a means of payment, a unit of account, and a store of value. The last comes into jeopardy when the reserve currency has to supply the world with more and more liquidity, also known as the "Triffin dilemma". By definition, as the global reserve currency, the USD has to be plentiful enough for the global economy and financial system to function adequately. The U.S. government must constantly supply dollars to this end. Chart 13 illustrates the timeline of global dollar liquidity, which we define as the total U.S. monetary base in circulation (U.S. monetary base plus holdings of U.S. Treasury securities held in custody for foreign officials and international accounts). The world has seen an ever-expanding U.S. dollar monetary base since 1988. Only during periods where the price of money (i.e. the Federal funds rate) has increased, has the money creation process slowed. Now that the expansion of the global USD monetary base is slowing, overall dollar liquidity is as important as the price, if not more (Chart 14). Chart 13Global Dollar Liquidity... Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? Chart 14...Drives Global Asset Prices ...Drives Global Asset Prices ...Drives Global Asset Prices The constant increase of dollar liquidity has made the greenback the "lubricant" of today's global financial system. There are three major forces at work beneath this condition: Recycling of petrodollars into the global financial system; Globalization and the build-up of - mainly USD-denominated - FX reserves; Deregulation of the Eurodollar system.11 Petrodollars Commodity exporters, mainly oil producers, sell their products in exchange for U.S. dollars. In addition, most Middle Eastern producers recycle their profits into U.S. dollars due to the liquidity and depth of U.S. capital markets. By 1980, the majority of oil producers were trading in U.S. dollars and were similarly investing their surpluses into the U.S. financial system in the form of U.S. government debt securities. The growth in petrodollars has allowed the world's dollar monetary base to grow substantially. This was both enabled by direct issuance of U.S. debt securities funded by petrodollar purchases and also through the Eurodollar system whereby banks outside the U.S. held large deposits of surplus dollar earnings from Middle East oil producers. Globalization The contemporary wave of globalization began in the mid-1980s, when it became evident that the Soviet Union was in midst of a deep economic malaise. This prompted the new Soviet Premier Mikhail Gorbachev to launch perestroika ("restructuring") in 1985, throwing in the proverbial towel in the contest between a statist planned economy and a free market one. Alongside the rise in global trade, financial globalization rose at a very rapid pace as cross-border capital flows more than doubled as a percentage of global GDP from 1990 onward. In the U.S., the economic boom of the 1990s was the longest expansion in history, with growth averaging 4% during the period. The U.S. trade deficit ballooned, providing the world with large amounts of dollar liquidity in the process. The flipside of the massive current account deficit was the accumulation of FX reserves in Europe and Asia, largely denominated in U.S. dollars. These insensitive buyers of U.S. debt indirectly financed the U.S. trade deficit, and also indirectly fuelled the debt super cycle and asset inflation as the "savings glut" compressed the world's risk-free rate and term premium. In other words, financial globalization combined with excess international savings morphed into a global quid pro quo. The world economy needed liquidity to finance growth and capital investment. In a system where the greenback stood at the base of any liquidity build up, this meant that the world needed dollars to finance its development. The world was thus willing to finance the U.S. current account deficit at little cost. The Eurodollar System The Eurodollar system was originally a payment system introduced after World War II as a result of the Marshal Plan. Because global trade was dominated by the U.S. - the only country that retained the capacity to produce industrial goods - foreigners had to be able to access U.S. dollars where they were domiciled in order to buy capital goods. The U.S. current account deficit played a role in growing that Eurodollar market. While a lot of the dollars supplied to the rest of the world through the U.S. current account deficit ended up going back to the U.S. via its large capital account surplus, a significant portion remained in offshore jurisdictions, providing an important fuel for the Eurodollar markets. In fact, more than two-thirds of U.S.-dollar claims in the Eurodollar market can be traced back to U.S. entities. After this original impetus, the Eurodollar market grew by leaps and bounds amid a number of regulatory advantages introduced in the 1980s. These changes in regulations not only deepened the participation of European and Japanese banks in the offshore markets, it also allowed U.S. banks to shift capital to Europe, harvesting a lower cost of capital in the process.12 The next growth phase in the Eurodollar system came with the evolution of shadow banking, in which credit was created off balance sheet by lending out collateral more than once, thus enabling banks to obtain higher gearing. This process is known as "re-hypothecation." In the U.S. there was a limit to which banks were allowed to gear collateral, which was not the case in Europe. Hence, to take advantage of this regulatory leniency, global banks grew further through the offshore market, causing an additional expansion in the Eurodollar market.13 Ultimately, this implies that over the past 30 years, the growth of the Eurodollar system has mainly been a consequence of the architecture of the international financial system. Headwinds To Dollar Liquidity The forces contributing to the extraordinary growth in dollar liquidity have begun to fade. In brief: Protectionism and populism: A slowdown in global trade has occurred for a number of structural, non-geopolitical reasons, especially if one controls for the recovery of energy prices (Chart 15).14 This slowdown implies a slower accumulation of international FX reserves and a reduction of the "savings glut." If protectionism were to compound the effects - by shrinking the U.S. trade deficit - the result for global dollar liquidity would be negative. The consequence would be a certain degree of "quantitative tightening" of global dollar liquidity. Energy prices: Despite the recovery in energy prices, oil producers continue to struggle to rein in their budget deficits. Deficits blew out during the high-spending era buoyed by high oil prices (Chart 16). Today, oil producing countries have less oil revenues to spend on the Treasury market, as their cash is needed at home. Meanwhile, the U.S. is slowly moving towards partial energy independence, further shrinking its trade deficit. Chart 15Global Trade Growth Has Moderated Global Trade Growth Has Moderated Global Trade Growth Has Moderated Chart 16Petrodollars Are Scarce Petrodollars Are Scarce Petrodollars Are Scarce Eurodollar system: The monetary "plumbing" has become clogged since 2014 after the Fed stopped growing its balance sheet and sweeping Basel III bank regulations took effect. The cost of acquiring U.S. dollars in Eurodollar markets currently stands at a premium. This extra cost cannot be arbitraged away due to the restrictive capital rules imposed under Basel III, which have raised the cost of capital for banks. This can be seen in the persistent widening of USD cross-currency basis-swap spreads and more recently, in the rise of the Libor-OIS spread (Chart 17). The introduction of interest on excess reserves by the Federal Reserve is further draining dollars from the Eurodollar system. The velocity of dollar usage in international markets is unlikely to return to the pace experienced from 1995 to 2008, when the shadow banking system grew rapidly. To complicate matters, dollar-denominated debt issued outside of the U.S. by non-U.S. entities such as banks, governments, and non-financial corporations has grown substantially. This could exacerbate the scramble for dollars in case of a global shortage. For example, the stock of outstanding dollar debt issued by foreign nonfinancial corporations currently stands at US$10 trillion (Chart 18). Chart 17Mounting Stress In The Eurodollar System Mounting Stress In The Eurodollar System Mounting Stress In The Eurodollar System Chart 18Foreign Dollar Debt Is At $10 Trillion Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? Why is the Eurodollar system so important? Today is the first time in the world's history that this much debt has been accumulated in the global reserve currency outside of the country that issues that currency. The Eurodollar system is thus a key source of liquidity for global borrowers. It is also necessary to ensure that these borrowers can access U.S. dollars when the time comes to repay their USD-denominated obligations. Chart 19Eurodollar Stress Produces FX Volatility Eurodollar Stress Produces FX Volatility Eurodollar Stress Produces FX Volatility The U.S. trade deficit is effectively the source of the growth of the monetary base in the Eurodollar system, and the stock of dollar-denominated debt issued by non-U.S. entities is the world's broad money supply. With the money multiplier in the offshore USD markets having fallen in response to the regulatory tightening that followed the Great Financial Crisis, broad USD money supply in the Eurodollar system will be hyper sensitive to any decline in the U.S. current account deficit. Less global imbalances would therefore result in a further increase in USD funding costs in the international system, and potentially into a stronger U.S. dollar as well, making this dollar debt very expensive to repay. This raises the likelihood of a massive short-squeeze in favour of the U.S. dollar, challenging the current downward trajectory in the U.S. dollar, at least in the short term. Another consequence of a higher cost of sourcing U.S. dollars in the Eurodollar market tends to be rising FX volatility (Chart 19). An increase in FX volatility should represent a potent headwinds for carry trades. This, in turn, will hurt liquidity conditions in EM economies. Hence, EM growth may be another casualty of problems in the Eurodollar system. Thus, the risks associated with U.S. protectionism go well beyond the risks to global trade. If severe enough, protectionism can threaten the plumbing system of the global economy. Bottom Line: The global economy has been supplied with dollar-based liquidity through the Eurodollar market. At the base of this edifice stands the U.S. trade-deficit, which was then magnified by the issuance of U.S. dollar-denominated debt by non-U.S. entities. This system is becoming increasingly tenuous as Basel III regulations have increased the cost of capital for global money-center banks, resulting in a downward force on the money multiplier in the offshore dollar funding system. In this environment, the risk to the system created by protectionism rises. If Trump and his administration can indeed scale back the size of the U.S. trade deficit, not only will the growth of the U.S. dollar monetary base be broken, but since the monetary multiplier of the Eurodollar system is also impaired, the capacity of the system to provide the dollars needed to fund all the liabilities it has created will decline. This could result in a serious rise in dollar funding costs as well as a tightening of global liquidity that will hurt global growth and result in a dollar short squeeze. This implied precarious situation raises one obvious question: Could we see the emergence of another reserve asset to complement the dollar, alleviating global liquidity risk? If Something Cannot Go On Forever, It Will Stop A global shortage of dollars is not imminent but could result from the forces described above. Even so, it is unlikely that the U.S. dollar faces any sudden end to its role as the leading global reserve currency. However, the world is unlikely to abide by a system that limits its growth potential either. The demise of the Bretton Woods system is important to keep in mind. The Bretton Woods system tied the supply of global liquidity to the supply of U.S. dollars. Initially this was not a problem as the U.S. ran a trade surplus. But it became a significant issue when the rest of the world began to question the U.S. commitment to honouring the $35/oz price commitment amidst domestic profligacy and money printing. Ultimately, the system broke down for this very reason. The strength of the global economy, along with the size of the U.S. current account deficit, was creating too many offshore dollars. Either the global money supply had to shrink, or gold had to be revalued against the dollar. The unpegging of the dollar from gold effectively resulted in the latter. However, the 1971 Smithsonian Agreement that replaced the gold standard with a dollar standard retained the dollar's hegemony. There was simply no alternative at the time. Chart 20Reserve Currency Status ##br##Can Diminish Quickly Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? Today, it is unlikely that the global economy will stand idle in the face of a potentially sharp tightening of global liquidity conditions. We posit that this rising dollar funding costs will be the most important factor to decrease the importance of the dollar in the global financial system. Since the demand for the USD as a reserve currency is linked to its use as a liability by banks and financial systems outside of the U.S., if the USD gets downgraded as a source of financing by global banks, the demand for the greenback in global reserves will decline.15 As the share of dollars in foreign reserve coffers decreases, the dollar will likely depreciate over time as it will stop benefiting from the return-inelastic demand from reserve managers. Profit-motivated private investors will demand higher expected returns on dollar assets in order to finance the U.S. current account deficit. Despite this important negative, the dollar will still be the most important reserve asset in the world for many decades. After all, the decline of the pound as the global reserve asset in the interwar period was a gradual affair. Nonetheless, the share of reserves concentrated in USD assets as well as the share of international liabilities issued in USD will decrease, potentially a lot quicker than is thought possible. For example, Eichengreen has shown that the pound sterling's share of non-gold global currency reserves fell from 63% in 1899 to 48% in 1913, just 14 years later (Chart 20). It is instructive that this pre-World War I era coincides with today's multipolar geopolitical context. It similarly featured the decline of a status quo power (the U.K.) and the emergence of a rising challenger (the German Empire). What are the alternatives to the dollar? Obviously, the euro will have a role in this play. The euro today only represents 20% of global reserve assets, and considering the size of the Euro Area economy as well as the depth of its capital markets, the euro's place in global reserves has room to increase. In fact, the share of euros in global reserves is 15% smaller than that of the combined continental European national currencies in 1990 (see Chart 4). The CNY can also expect to see its share of international reserves increase. While China does not have the same capital-market depth as the Euro Area, it is gaining wider currency. The One Belt One Road project is causing many international projects to be financed in CNY and China's economic and military heft is still growing fairly rapidly. Nevertheless, China's closed capital account continues to weigh against the CNY's position. As Chart 21 illustrates, there is a relationship between a country's share of international global payments and inward foreign investment. Essentially, investors want to know that they can do something (buy and sell goods and services) with the currency that they use to settle their payments. In particular, they want to know that they can use the currency in the economy that issues it. As long as it keeps its capital account closed, China will fail to transform the CNY into a reserve currency. Chart 21A Reserve Currency With A Closed Capital Account? Forget About It! Is King Dollar Facing Regicide? Is King Dollar Facing Regicide? This means that for at least the next five years, the renminbi's internationalization will be limited. If U.S. protectionism is severe enough, China's economic transition is less likely to be orderly and capital account liberalization could be delayed further. In terms of investment implications, this suggests that for the coming decade, the euro is likely to benefit from a structural tailwind as global reserve managers increase their share of euro reserves. The key metric that investors should follow to gauge whether or not the euro is becoming a more important source of global liquidity is not just the share of euros in global reserves, but also the amount of foreign-currency debt issued in euros by non-euro area entities in the international markets. Chart 22Are We Nearing A Global Liquidity Event? Are We Nearing A Global Liquidity Event? Are We Nearing A Global Liquidity Event? In all likelihood, before the world transitions toward a unit of account other than the USD, tensions will grow severe, as they did in the late 1960s. It is hard to know when these tensions will become evident. This past winter, the USD basis-swap spread began to widen along with the Libor-OIS spread, but while the Libor-OIS spread remains wide, basis-swap spreads have normalized. Nonetheless, by the end of this cycle, we would expect a liquidity event to cause stress in global carry trades and EM assets. It is important that investors keep a close eye on basis-swap and Libor-OIS spreads to gauge this risk (Chart 22). Additionally, the more protectionist the U.S. becomes, the larger the diversification away from the dollar by both global reserve managers and international bond issuers could become. This is because of two reasons: First, if the U.S. actually manages to pare down its trade deficit, this will accentuate the decline in the supply of base money in the international system. Second, rising trade protectionism out of the White House gives the world the impression that economic mismanagement is taking hold of the U.S., raising the spectre of stagflation. Finally, the next global reserve asset does not have to be a currency. After all, for millennia, that role was fulfilled by commodities such as gold, silver, or copper. Thus, another asset may emerge to fill this gap. At this point in time it is not clear which asset this may be. Bottom Line: A severe liquidity-tightening caused by a scarcity of U.S. dollars would create market tumult around the world. We worry that such a risk is growing. However, it is hard to envision the global economy falling to its knees. Instead, the global system will likely do what it has done many times before: evolve. This evolution will most likely result in new tools being used to increase the global monetary base. At the current juncture, our best bet is that it will be the euro, which will hurt the USD's exchange rate at the margin on a secular basis. This brings up the very important question of whether the euro is politically viable. We have turned to this question many times over the past seven years. Our high conviction view is still that the euro will survive over the foreseeable time horizon.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist Mathieu Savary, Vice President Foreign Exchange Strategy Mehul Daya Consulting Editor Neels Heyneke Consulting Editor 1 And an erstwhile member of BCA's Research Advisory Board. 2 Please see Eichengreen, Barry et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org. 3 Please see Tovar, Camillo and Tania Mohd Nor, 2018 "Reserve Currency Blocks: A Changing International Monetary System?," IMF Working Paper WP/18/20, Washington D.C. 4 The authors are essentially examining the extent to which national currencies are anchored to a particular reserve currency. 5 Please see David Shapiro, The Hidden Hand Of American Hegemony: Petrodollar Recycling And International Markets, New York: Columbia University Press. Also, Andrea Wong, "The Untold Story Behind Saudi Arabia's 41-Year Secret Debt," The Independent, dated June 1, 2016, available at independent.co.uk. 6 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," February 1, 2017, available at gps.bcaresearch.com. 9 Entente cordiale being particularly shocking at the time it was formalized in 1904. Other examples of ideologically heterodox alliances include the USSR's alliance first with Nazi Germany and then with Democratic America during World War II; the notorious alliance of Catholic France with Muslim Turks against its Christian neighbors throughout the seventeenth and eighteenth centuries; or Greek alliances with the Carthaginians against Rome in the third century BC. 10 Another exception to this rule was the Yuan Dynasty, established by Mongol ruler Kublai Khan, which issued fiat money made from mulberry bark. In fact, the mulberry trees in the courtyard at the Bank of England serve as a reminder of the origins of fiat money. 11 Eurodollar system simply refers to U.S. dollars that are outside the U.S. 12 Firstly, the absence of Regulation Q in offshore markets meant that regulatory arbitrage was possible, i.e. there was no ceiling imposed on interest rates on deposits at non-U.S. banks. Then, in the late 1990s, the Eurodollar system had another jump start with the amendment to Regulation D, which meant that non-U.S. banks were exempted from reserve requirements. 13 European banks specifically, but also U.S. banks with European branches, were aggressive buyers/funders of exotic derivatives products, such as CDO, MBS, SIVS. Most of these activities were off-balance sheet and took place in the Eurodollar system because a number of regulatory arbitrages existed. This is one of the main reasons that the Federal Reserve's bailout programs were largely focused towards foreign banks. The Fed's swap lines were heavily used by foreign central banks in order to clean up the operations of their own financial institutions. 14 Please see BCA Global Investment Strategy Special Report, "Why Has Global Trade Slowed?," dated January 29, 2016, available at gis.bcaresearch.com. 15 Shah, Nihar, "Foreign Dollar Reserves and Financial Stability," December 2015, Harvard University. 16 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011; "No Apocalypse Now?," dated October 31, 2011; "The Draghi 'Bait And Switch," dated January 9, 2013; "Europe: The Euro And (Geo)politics," dated February 11, 2015; "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016; "After BREXIT, N-EXIT?," dated July 13, 2016; "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades