Geopolitics

Special Report

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 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 Table 1Capital Account Liberalization: A Timeline Table 2Economic Benefits Of Open Borders 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) Chart 3BEM Capital Openness Not Obviously Correlated With Potential Growth (2) 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 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) Chart 5BDM: Capital Openness Is Correlated With Potential Growth (2) 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 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 Chart 7BChina Has Fewer Foreign Liabilities, Mostly FDI 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, 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 Chart 10China'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 Chart 12The 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 Chart 14The U.S. Wants More Investment Access 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 Chart 16The U.S. Wants More Banking Access 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? 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 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 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.

Special Report

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 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 Chart 3Export Growth##BR##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 Chart 5Inflation 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 Chart 7Swedish Households Can##BR##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 Chart 9Immigrants Have Trouble##BR##In Swedish Education 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 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 Chart 12Swedes 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 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 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 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 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? 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? Chart 3GOP Retirements Are Unprecedented 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 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 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 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 Chart 7Australian Fears About China To Rise Chart 8Is 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 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 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 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 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

Special Report

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? Chart 2Geopolitics 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 Chart 4The Euro Is The Only Serious Competitor To The King Dollar... Chart 5...The Renminbi Is Not 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''... Chart 7...But Despite China's Dominance Of East Asia... Map 1...Renminbi's "Bloc" Is Not In Asia! 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? 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 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... 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 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 Chart 12Americans Are Rebelling Against The 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... Chart 14...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 Chart 16Petrodollars 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 Chart 18Foreign Dollar Debt Is At $10 Trillion 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 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 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! 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? 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

Bank Credit Analyst

This month's Special Report is a joint effort by BCA's Geopolitical and Foreign Exchange strategists, along with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research). It is a companion piece to last month's Special Report, in which I discussed the short- and long-term outlook for the U.S. dollar from a purely economic perspective. This month's analysis takes a geopolitical perspective, focusing on the possibility that the U.S. dollar will lose its reserve currency status and weaken over the long term. I trust that you will find the Report as insightful as I did. Mark McClellan 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. 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 II-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 II-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 II-1Is Trump Guilty Of Regicide? Chart II-2Geopolitics Is Not Driving ##br##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 II-3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart II-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 II-5). Chart II-3Dollar Remains King Chart II-4The Euro Is The Only Serious Competitor To King Dollar... Chart II-5...The Renminbi Is Not 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 II-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 II-7), albeit not yet geopolitically (Map II-1). Chart II-6Renminbi Does Command A Large Currency 'Bloc'... Chart II-7...But Despite China's Dominance Of East Asia... Map II-1...Renminbi's 'Bloc' Is Not In Asia! 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 II-1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table II-1Insights From History: What Makes A Reserve Currency? 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 II-8The Exorbitant Privilege In One Chart As with all the empires surveyed in Table II-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 II-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. Chart II-9U.S. Naval Strength Still Supreme... Economic Power 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 II-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 II-10...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 II-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 II-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 II-12). Chart II-11Trump Is Rebelling Against The Post-Cold War System Chart II-12Americans Are Rebelling Against The 'Washington Consensus' 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 II-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 II-14). Chart II-13Global Dollar Liquidity... Chart II-14...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 II-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 II-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 II-15Global Trade Growth Has Moderated Chart II-16Petrodollars 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 II-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 II-18). Chart II-17Mounting Stress In The Eurodollar System Chart II-18Foreign Dollar Debt Is At $10 Trillion 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. 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 II-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. Chart II-19Eurodollar Stress Produces FX Volatility 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. 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. Chart II-20Reserve Currency Status ##br##Can Diminish Quickly 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 II-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 II-4 on page 25). 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 II-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 II-21A Reserve Currency With A Closed Capital Account? Forget About It! 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. 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 II-22). Chart II-22Are We Nearing A Global Liquidity Event? 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.

Bank Credit Analyst

Highlights Our base case outlook is unchanged. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, the cycle is well advanced and, given current valuations, the long-term outlook for returns in the major asset classes is far less appealing. The risk/reward balance is unfavorable. Investors should therefore separate strategy from forecast. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, which means that the FOMC will have to consider becoming outright restrictive in order to slow growth and raise the unemployment rate. The risks facing equities, EM assets and spread product will escalate at that point. The advanced stage in the cycle and our bias for capital preservation requires us to heed the recent warnings from our growth indicators and 'exit' timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. The implication is that we are tactically trimming risk asset exposure to benchmark. We expect to shift back to overweight once our indicators improve and/or the geopolitical tensions fade. This month we provide total return estimates for the major U.S. asset classes under our base case outlook and two alternative scenarios. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession in 2019. We also review the U.S. fiscal outlook, which is clearly unsustainable over the long-term. While we do not see a dollar crisis anytime soon, the prospect of large and sustained federal budget deficits supports the view that the dollar will continue on a long-term downtrend (although it is likely to buck the trend in the coming months). It also supports our view that the multi-decade Treasury bull market is over. U.S. consumers will not be particularly sensitive to rising borrowing rates, although there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Feature It was the summer of 2009. Risk assets were bombed out, investor sentiment was deeply depressed, business leaders were shell-shocked, the Fed was easing and some 'green shoots' of recovery were emerging. Plentiful economic slack also meant that there was a long potential runway for the economy and earnings to grow. Given that backdrop, it was appropriate to begin rebuilding risk portfolios and ride out any additional turbulence in the markets. Today's situation is almost the mirror image. The economic expansion is well advanced, there is little slack, the Fed is tightening, risk assets are expensive, and investor equity sentiment is frothy. The long-term outlook for returns in the major asset classes is underwhelming to say the least. Table I-1 updates the long-run return expectations we published in the 2018 BCA Outlook. Some technical adjustments make the numbers look a little better but, still, a balanced portfolio will deliver average returns over the long-term of only 3.8% and 1.8% in nominal and real terms, respectively. Table I-110-Year Asset Return Projections For stocks, the expected returns are poor by historical standards because we assume a mean-reversion in multiples and a decline in the profit share of total income. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or P-E ratios remain at historically high levels. Equities obviously would do better than our estimates in this case, but the point is that it is very hard to see returns in risk assets anywhere close to their 1982-2017 average over the long haul. On a two-year horizon, our base case outlook still sees decent equity returns. Nonetheless, the risk/reward balance has become quite unfavorable because the cycle is so advanced. It is therefore prudent to focus on capital preservation and be quicker to trim risk exposure when the outlook becomes cloudier. Losing Sleep Investors have cheered some easing in the perceived risk of a trade war in recent weeks. Nonetheless, a number of items have made us more nervous about the near term. First, our Equity Scorecard has dropped to one, well below the critical value of three that is consistent with positive equity returns historically (Chart I-1). Table I-2 updates our Exit Checklist of items that we believe are important for the equity allocation call. Five of the nine are now giving a 'sell' signal, pointing to at least a technical correction. Chart I-1Our Equity Scorecard Turned Negative Table I-2Exit Checklist For Risk Assets Moreover, we highlighted last month that global growth appears to be peaking (Chart I-2). Our Global Leading Economic Indicator is still bullish, but its diffusion index has plunged below zero. The Global ZEW index and our Boom/Bust indicator have fallen sharply and the global PMI index ticked down (albeit, from a high level). Industrial production in the major economies has eased. Korean and Taiwanese exports, which are a barometer of global industrial activity, have decelerated as well. Chart I-2Economic Indicators Have Softened While we expect global growth to remain at an above-trend pace for at least the next year, the peaking in some coincident and leading indicators is worrying nonetheless. Other items to keep investors up at night include the following: Loss Of Fed Put: With inflation likely to reach the Fed's target in the next couple of months, and policymakers worried about froth in markets, the FOMC will be less predisposed to ease at the first hint of economic softness (see below). Inflation Surge: There is a lot of uncertainty around estimates of the level of the unemployment rate that is consistent with rising wage and price pressures. Inflation could suddenly jump if unemployment is far below this critical level, leading to a blood bath in the bond market that would reverberate through all other assets. The fact that long-term inflation breakevens have surged along with the 10-year Treasury yield in the past couple of weeks is an ominous sign for risk assets. Neutral Rate: We agree with the Fed that the neutral fed funds rate is rising, but nobody knows exactly where it is at the moment. If the neutral rate is lower than the Fed believes, then the economy could suddenly stall as actual rates rise above the neutral level. Trade War: President Trump's popularity among Republican voters is rising, which gives him the ability to weather turbulence in the stock market while he 'gets tough' on trade. The fact that U.S. Treasury Secretary Mnuchin will visit China is a hopeful sign. Nonetheless, we do not believe that we have seen peak pessimism on trade because the President needs to placate his supporters in the mid-west that are in favor of protectionism. The summer months could be volatile as market confusion grows amidst a plethora of upcoming event risks.1 Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks (Bolton and Pompeo). Meanwhile, tensions in Syria are building with the potential for U.S. and Iranian forces to be directly implicated in a skirmish. Russia: Tensions between the West and Russia are also building again. Stroke Of Pen Risk: There is a rising probability that the current administration decides to up the regulatory pressure on Amazon. Other technology companies like Facebook and Google also face "stroke of pen" risks. On a positive note, first quarter earnings season is off to a good start in the U.S. Earnings have surprised to the upside by a wide margin, which is impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results to beat expectations. That said, a lot of good news is already discounted in the U.S. market. Chart I-3 highlights that bottom-up analysts' expected annual average EPS growth for the S&P 500 over the next five years has shot up to more than 15%, a level not seen since 1998! This is excessive even considering that the estimates include the impact of the tax cuts. History teaches that investors should be wary during periods of earnings euphoria. Chart I-3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Given these risks, market pricing and our checklist, we adjusted the tactical (3-month) House View recommendation on risk assets to benchmark in April. We see this shift as tactical, and expect to move back to overweight once our growth indicators bottom and the geopolitical situation calms down a little. Our base case outlook remains constructive for risk assets on a cyclical (6-12 month) view. Three Scenarios This month we consider two alternative scenarios to our base case outlook and provide estimates of how several key asset classes would perform between now and the end of 2019: Base Case: U.S. real GDP growth accelerates to 3.3% year-over-year by the end of 2018 on the back of fiscal stimulus and improving animal spirits in the corporate sector. Growth is expected to decelerate in 2019, but remain above trend. Profit margins are squeezed marginally by rising wage pressure. The recession we expect to occur in 2020 is beyond the horizon of this exercise. Optimistic Case: The multiplier effects of the fiscal stimulus could be larger than we are assuming if consumers decide to spend most of the tax windfall, and the corporate sector cranks up capital spending due to accelerated depreciation, the tax savings and repatriated overseas funds. We assume that real GDP growth is about a half percentage point higher than the base case in both 2018 and 2019. This is only modestly stronger than the base case because, given that the economy is already at full employment, the supply side of the economy will constrain growth. Even more margin pressure partially offsets stronger top line growth for corporations. Pessimistic Case: The fiscal multiplier effects turn out to be smaller than expected, compounded by the growth-sapping impact of a tariff war and a spike in oil prices due to tensions in the Middle East. The corporate and consumer sectors are more sensitive to rising interest rates than we thought (see below for more discussion of U.S. consumer vulnerabilities). Growth begins to slow toward the end of 2018, culminating in a recession in the second half of 2019. Margins are squeezed initially, but then rise as labor market slack opens up next year. This is more than offset, however, by declining corporate revenues. Chart I-4 presents the implications for S&P 500 EPS growth in the three scenarios, according to our top-down model. Four-quarter trailing profit growth comes in at a respectable 15% and 8½%, respectively, in 2018 and 2019 in our base case. The optimistic scenario would see impressive profit growth of 20% and 13%. Trailing EPS expands by 9% this year in the pessimistic case, but contracts by about the same amount next year. Chart I-4Three Scenarios For S&P 500 EPS Growth In order to use these EPS forecasts to estimate expected S&P 500 returns, we made assumptions regarding an appropriate 12-month forward P/E ratio (Table I-3). We also translated our trailing EPS forecasts into 12-month forward estimates based on historical cyclical patterns. The 12-month forward P/E ratio is 17 as we go to press (based on Standard and Poors figures). We assume the ratio is flat this year in the base case, before edging lower in 2019 due to rising interest rates. The forward P/E is assumed to edge up in the optimistic case in 2019, but then falls back in 2019 as rates rise. In the recession scenario, we conservatively assume that this ratio falls to 15 by the end of this year, and to 13 by the end of 2019. We incorporate a 2% dividend yield in all scenarios. Over the next two years, the S&P 500 delivers an 8% annual average return in our baseline, and 13% in the optimistic case. As would be expected, investors suffer painful losses of 13% this year and roughly 20% next year in the case of recession, as the drop in multiples magnifies the earnings contraction. Table I-4 presents total return estimates for the 10-year Treasury under the three scenarios. The bond will provide an average return of close to zero in our base case. It suffers heavy losses in 2018 if growth turns out to be stronger than we expect, because a faster acceleration in inflation would spark a sharp upward revision to the path of short-term rates. Long-term inflation expectations would rise as well. The 10-year yield finishes 2019 at 3.5% in the base case, and at 3.75% in the optimistic growth scenario. In contrast, total returns are hefty in the recession case as the 10-year yield drops back below 2%. Table I-3S&P 500 Return Scenarios Table I-410-year Treasury Return Scenarios We believe the risk/reward profile is less attractive for corporate bonds than it is for equities (Table I-5). Strong profit growth in the base and optimistic cases is positive for corporates, but this is offset by deteriorating financial ratios as interest rates rise in the context of high leverage ratios. We expect investment-grade (IG) spreads to widen modestly even in the base case, providing a small negative excess return. We see spreads moving sideways at best in our optimistic scenario, giving investors a small positive excess return of about 100 basis points. In the case of a recession, we could see the option-adjusted spread of the Barclay's IG index surging from 105 basis points today to 250 basis points. Excess returns would obviously be quite negative. Table I-5U.S. Investment Grade Corporate Bonds All of these projected returns are only meant to be suggestive because they depend importantly on several key assumptions. Still, we wanted to provide readers with a sense of the risks for returns around our base case outlook. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession. U.S. Fiscal Policy: Good And Bad News The probabilities attached to the baseline and optimistic scenarios are supported by the U.S. fiscal stimulus that is in the pipeline. The IMF estimates that the tax cuts and spending increases will provide a fiscal thrust of 0.8% in 2018 and 0.9% in 2019, not far from the estimates we presented last month (Chart I-5).2 This represents a powerful tailwind for growth for the next two years. We must turn to the Congressional Budget Office (CBO) projections to gauge the longer-term implications. On a positive note, the CBO revised up its estimate of the economy's long-run potential growth rate on account of the supply-side benefits of lower taxes and the immediate expensing of capital outlays. Faster growth over the long run, on its own, reduces the projected cumulative budget deficit over the 2018-2027 period by $1 trillion. However, this positive impact is swamped by the direct effect on the budget of the tax breaks and increased spending. The CBO estimates that the net effect of the fiscal adjustments will be a $1.7 trillion increase in the cumulative budget deficit over the next decade, relative to the previous baseline (Chart I-6). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart I-5U.S. Fiscal Stimulus Will Support Growth Chart I-6U.S. Federal Budget: A Lot More Red Ink The deficit situation begins to look better after 2020 because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which they extend the temporary provisions and grow the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 6% of GDP by 2022 and the federal debt-to-GDP ratio hits almost 110% of GDP in 2028. This is not a pretty picture and investors are wondering what it means for government bond yields and the dollar. We noted in the March 2018 Bank Credit Analyst that academic studies published before 2007 suggested that every percentage point rise in the government's debt-to-GDP ratio added roughly three basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade would lift the equilibrium long-term bond yields by 75 basis points. This estimated impact on yields should not be thought of as a default risk premium because there is no reason to default when the Fed can simply print money in the event of a funding crisis. Rather, a worsening fiscal situation could show up in higher long-term inflation expectations if investors were to lose confidence in the Fed's inflation target. Higher real yields could also come about through the 'crowding out' effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Deficits And The Dollar We discussed the potential debt fallout for the U.S. dollar from an economic perspective in the April 2018 Special Report. While the fiscal stimulus means that the U.S. twin deficits are set to worsen, the situation is not so dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding U.S. debt sustainability among international investors. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. Nonetheless, 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. This month's Special Report beginning on page 22 examines this issue. There is no evidence at the moment that the U.S. dollar is losing any market share and we do not foresee any sudden shifts away from the U.S. dollar as a reserve currency. However, cracks are beginning to form, especially with regard to the RMB. We also believe that the euro is likely to benefit from a structural tailwind as global reserve managers increase the share of the euro in their reserves. A trade war would accelerate the diversification away from the dollar. Chart I-7Economic Slack: U.S./Eurozone Comparison The conclusions of this month's Special Report support those of last month's analysis; the dollar will continue on its long-term downtrend, although there is still room for a counter-trend rally this year. We do not see much upside against the yen in the near term, but we expect some of the euro's recent strength to be unwound. A debate is raging within the halls of the European Central Bank regarding the amount of Europe's economic slack. On this we side with President Draghi, who believes that there is still plenty of excess capacity in the labor market. The Eurozone's unemployment rate has reached the level of full employment as estimated by the OECD. However, Chart I-7 shows various measures of hidden unemployment, including discouraged workers and those that have been out of work for more than a year. In all cases, the Eurozone appears to be behind the U.S. in terms of getting back to full employment. This, along with the recent softening in some of the Eurozone's economic data, will keep the ECB wedded to low interest rates even as it terminates the asset purchase program this autumn. Long-dated forward rate differentials are beginning to move back in favor of the dollar relative to the Euro. Dollar strength will also be at the expense of most of the EM currencies. The Long-Term Consequences Of Government Debt While it is somewhat comforting that the U.S. twin-deficits are unlikely to spark financial panic in the short- to medium term, the U.S. and global debt situations are not without consequences. The latest IMF Fiscal Monitor again sounded the alarm over global debt levels, especially government paper. The Fund argues that debt sustainability becomes increasingly questionable once the general government debt/GDP ratio breaches 85%. The IMF points out that more than one-third of advanced economies had debt above 85% in 2017, three times more countries than in 2000. And this does not include the implicit liabilities linked to pension and health care spending. The good news is that the IMF expects that most of the major economies will see a reduction in their general government debt/GDP ratios between 2017 and 2023. The big exception is the U.S., where the average deficit is expected to far exceed the other major countries (Charts I-8A and I-8B). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019! Including all levels of government, the IMF estimates that the U.S. debt/GDP ratio will rise by about nine percentage points, to almost 117%, between 2017 and 2023. Chart I-8AIMF Projections (I) Chart I-8BIMF Projections (II) U.S. fiscal trends are clearly unsustainable in the long-term. Taxes will have to rise or entitlement programs will have to be slashed at some point. The question is whether Congress administers the required medicine willingly, or is forced to do so by rioting markets. We do not believe that the dollar's 'day of reckoning' will happen anytime soon, but growing angst over the U.S. fiscal outlook supports our view that the multi-decade Treasury bull market is over. In the near term, the main threat to the global bond market is a mini 'inflation scare' in the U.S. Fed Will Soon Reach 2% Goal Chart I-9Inflation May Soon Reach The Fed's Target The 10-year Treasury yield is testing the 3% support level as we go to press. In part, upward pressure on yields likely reflects some calming of tensions regarding global trade and the news that the U.S. will hold face-to-face discussions with North Korea. Moreover, long-term inflation expectations have been rising in most of the major countries. Investors appear to be waking up to how strong U.S. inflation has been in recent months, driven in part by an unwinding of base effects that temporarily depressed the annual inflation rate. U.S. core CPI inflation has already quickened from 1.8% in February to 2.1% in March (Chart I-9). This acceleration will also play out in the core PCE deflator, the Fed's preferred inflation metric. Even if the core PCE deflator rises only 0.1% month-over-month in March, year-over-year core PCE inflation will increase to 1.85%. This would be above Bloomberg and Fed estimates for the end of the year. If the core PCE deflator rises 0.2% m/m in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will almost reach the Fed's 2% target. The FOMC will not be alarmed even if inflation appears set to overshoot the 2% target. Nonetheless, Fed officials will be forced to adjust the communication language because they can no longer argue that "accommodative" monetary policy is still appropriate. In other words, policymakers will have to openly admit that policy will have to become outright restrictive. The Fed's "dot plot" could then be revised higher. The policy risks facing equities, EM assets and spread product will escalate once it becomes clear that the FOMC is actively targeting slower economic growth and a higher unemployment rate. As for Treasurys, the surge in the 10-year yield to 3% has been quick and we would not be surprised to see another consolidation period. Eventually, however, we expect the yield to reach 3.5% before the bear phase is over. How Vulnerable Are U.S. Households? The ultimate peak in U.S. yields will depend importantly on the economy's sensitivity to rising borrowing costs. Our research on excessive borrowing in recent months has focussed on the U.S. corporate sector. Next month we will review corporate vulnerabilities in the Eurozone. But what about U.S. consumers? Overall debt as a ratio to GDP or personal income has fallen back to pre-housing bubble levels, underscoring that the household sector has deleveraged impressively (Chart I-10). Household net worth has surpassed the pre-Lehman peak and our "wealth effect" proxy suggests that the rise in asset prices and recovery in home values provide a strong tailwind for spending (Chart I-11). The proxy likely overstates the size of the tailwind due to the lack of cash-out refinancing. Chart I-10U.S. Consumers Have Deleveraged Chart I-11'Wealth Effect' Is A Tailwind The financial obligation ratio (FOR) - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades (Chart I-12). Chart I-13 shows a broader measure of the burden that households face when paying for essentials; interest payments, food, medical care and energy. These are all expenses that are difficult to trim. Spending on essentials has increased over the past couple of years to a little under 42% of disposable income due to rising interest rates and a continuing uptrend in out-of-pocket medical care costs. However, the ratio is below the post-1980 average level and has only risen back to levels that existed in 2011/12. From this perspective, it is difficult to believe that rising gasoline prices will dominate the benefits of the tax cuts on household spending. Chart I-12Past The Peak Of U.S. Consumer Credit Quality Chart I-13Spending On Essentials Is Not Onerous The labor market is clearly supportive for consumer spending. Wage growth has been disappointing so far in this recover, and real personal disposable income has slowed over the past year. Nonetheless, the economy continues to produce new jobs at an impressive pace, unemployment claims are close to all-time lows, and households are feeling confident about their future income and job prospects. Some market pundits have pointed to the falling household savings rate as a warning sign that consumers are 'tapped out' (Chart I-14). We are less concerned. The savings rate tends to decline during economic expansions and rises almost exclusively during recessions. All else equal, one could make the case that U.S. households should save more over their lifetimes. Nonetheless, a falling savings rate is consistent with strong, not weak, economic activity. That said, some signs have emerged that not all consumer lending in recent years has been prudent. Bank and finance company loan delinquency rates are rising, especially for credit cards and autos (Chart I-15). While the FOR is still low, it is rising and it tends to lead bank loan delinquency rates (Chart I-12). These trends usually occur just prior to a recession. Chart I-14Savings Rate Falls During Expansions Chart I-15Some Signs Of Excessive Lending There has also been an alarming surge in credit card charge-off rates, which have reached recession levels among banks that are outside of the top 100 (Chart I-15, top panel). Anecdotal evidence suggests that large banks offered lush cash rewards and points to attract higher-quality customers. Smaller banks could not compete on cash rewards, and instead had to loosen credit requirements for card issuance. The deterioration in the credit-quality composition of these banks' loan portfolios helps to explain why delinquencies have increased despite a robust labor market. The Fed's senior loan officer survey shows that expected delinquencies and charge-offs are rising even among large banks. One risk is that, while overall credit growth has been weak in this expansion, it has been concentrated in lower-income households. However, the Fed's Survey of Consumer Finances does not flag a huge problem. Various measures of credit quality have not deteriorated for lower income households since 2007 (latest year available; Chart I-16). Chart I-16Credit Quality For Lower ##br##Income U.S. Households The bottom line is that there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Nonetheless, the backdrop for consumer health has not deteriorated to the point where the U.S. household sector will be ultra-sensitive to higher interest rates on a broad scale. Investment Conclusions Our base case outlook is unchanged this month. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, one must separate strategy from forecast at this point in the cycle. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, while rising energy and base metal prices add to the broader inflationary backdrop. Strong global oil demand growth and the OPEC/Russia production cuts are draining global oil inventories and supporting prices. Sanctions against Iran and/or Venezuela that further restrict supply could easily send oil prices to more than US$80/bbl this year. Investors should remain overweight energy plays. The implication is that the Fed may have to tighten into outright restrictive territory. The advanced stage in the cycle and our bias for capital preservation requires us to heed the warnings from our indicators and timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. Thus, we are tactically trimming risk asset exposure to benchmark until our indicators improve and/or geopolitical tensions fade. Investors should also be more cautious in their equity sector allocation for the very near term. We continue to favor Eurozone stocks over the U.S. (currency hedged), since the threat from monetary tightening is greater in the latter market and we expect the dollar to appreciate. We are neutral on the Nikkei because the risk of a rising yen offsets currently-strong EPS growth momentum. Stay short duration within global bond portfolios, and remain underweight the U.S., Canada and core Europe (currency hedged). Overweight Australia and the U.K. The Aussie economy will continue to underperform, and the U.K. economy will not allow the Bank of England to hike rates as much as is currently discounted. Mark McClellan Senior Vice President The Bank Credit Analyst April 26, 2018 Next Report: May 31, 2018 1 For a list of these events, see Table 2 in the BCA Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 2 The fiscal thrust is the change in the cyclically-adjusted budget balance as a share of GDP. It is a measure of the initial impetus to real GDP growth, but the actual impact on growth depends on fiscal "multipliers". II. Is King Dollar Facing Regicide? This month's Special Report is a joint effort by BCA's Geopolitical and Foreign Exchange strategists, along with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research). It is a companion piece to last month's Special Report, in which I discussed the short- and long-term outlook for the U.S. dollar from a purely economic perspective. This month's analysis takes a geopolitical perspective, focusing on the possibility that the U.S. dollar will lose its reserve currency status and weaken over the long term. I trust that you will find the Report as insightful as I did. Mark McClellan 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. 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 II-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 II-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 II-1Is Trump Guilty Of Regicide? Chart II-2Geopolitics Is Not Driving ##br##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 II-3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart II-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 II-5). Chart II-3Dollar Remains King Chart II-4The Euro Is The Only Serious Competitor To King Dollar... Chart II-5...The Renminbi Is Not 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 II-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 II-7), albeit not yet geopolitically (Map II-1). Chart II-6Renminbi Does Command A Large Currency 'Bloc'... Chart II-7...But Despite China's Dominance Of East Asia... Map II-1...Renminbi's 'Bloc' Is Not In Asia! 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 II-1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table II-1Insights From History: What Makes A Reserve Currency? 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 II-8The Exorbitant Privilege In One Chart As with all the empires surveyed in Table II-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 II-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. Chart II-9U.S. Naval Strength Still Supreme... Economic Power 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 II-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 II-10...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 II-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 II-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 II-12). Chart II-11Trump Is Rebelling Against The Post-Cold War System Chart II-12Americans Are Rebelling Against The 'Washington Consensus' 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 II-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 II-14). Chart II-13Global Dollar Liquidity... Chart II-14...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 II-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 II-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 II-15Global Trade Growth Has Moderated Chart II-16Petrodollars 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 II-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 II-18). Chart II-17Mounting Stress In The Eurodollar System Chart II-18Foreign Dollar Debt Is At $10 Trillion 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. 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 II-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. Chart II-19Eurodollar Stress Produces FX Volatility 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. 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. Chart II-20Reserve Currency Status ##br##Can Diminish Quickly 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 II-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 II-4 on page 25). 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 II-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 II-21A Reserve Currency With A Closed Capital Account? Forget About It! 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. 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 II-22). Chart II-22Are We Nearing A Global Liquidity Event? 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. III. Indicators And Reference Charts A key divergence has emerged between the U.S. corporate earnings data and our equity-related indicators. The divergence supports our tactical cautiousness on risk assets. Forward earnings have soared on the back of the U.S. tax cuts and upgrades to the growth outlook. Earnings are beating expectations by a wide margin so far in the Q1 earnings season, which is reflected in very elevated levels for the net revisions ratio and net earnings surprises. However, the S&P 500 has failed to gain any altitude on the back of the positive earnings news, in part because bond yields have jumped. Our Monetary Indicator moved further into bearish territory, and our Equity Technical indicator is below its 9-month moving average and is threatening to break below the zero line (which would be another negative signal). Valuation has improved marginally, but is still stretched, according to our Composite Valuation Indicator. Our Speculation Indicator does not suggest that market frothiness has waned at all, although sentiment has fallen back to neutral level. It is also worrying that our U.S. Willingness-to-Pay indicator took a sharp turn for the worse in April. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Finally, our Revealed Preference Indicator (RPI) for stocks flashed a 'sell' signal in April. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. As for bonds, oversold conditions have emerged but valuation has not yet reached one standard deviation, the threshold for undervaluation. This suggests that there is more upside potential for Treasury yields. The U.S. dollar broke out of its recent tight trading range to the upside in April, although this has only resulted in an unwinding of oversold conditions according to our Composite Technical Indicator. The dollar is expensive on a PPP basis, but we still expect the dollar to rally near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Special Report

Highlights The Philippines is seeing a genuine inflation outbreak. The Duterte administration's policies favor "growth at all costs." "Charter change," or constitutional revision, will stoke political polarization, erode governance, and feed inflation. We are neutral on Philippine stocks and bonds within EM benchmarks for now but are placing the country on downgrade watch. Feature Chart 1Markets Sold On Duterte Election It has been nearly two years since Rodrigo "Roddy" Duterte - the Philippines' populist and anti-establishment president - was elected. On May 11, 2016, two days after the vote, BCA's Geopolitical Strategy and Emerging Markets Strategy published a joint report arguing that Duterte would "take the shine off" the economic structural reforms that had taken place under the outgoing administration of President Benigno Aquino.1 We downgraded the bourse from overweight to neutral within the EM universe. Financial markets have largely vindicated this view. Philippine stocks peaked against EM stocks three days before Duterte's inauguration and have continued to underperform since then. The Philippine peso has also suffered, both in real effective terms and relative to the weakening U.S. dollar (Chart 1). Is it time to buy then? No. Duterte's policies will continue to erode the country's governance and macro fundamentals, overheating the economy and subtracting from investment returns. Of course, the country is well insulated from any China or commodity shock, and this is an important advantage over other EMs in the medium term. Also, equity and currency valuations have improved relative to other EMs. Hence we recommend clients remain neutral Philippine stocks, currency, and credit versus the EM benchmark for now, and use any meaningful outperformance to downgrade the country to underweight within aggregate EM portfolios. An Inflation Outbreak One of the most reliable definitions of a populist leader is one who pursues nominal, as opposed to real, GDP growth. While policymakers can stimulate nominal growth through various policies, real growth over the long run depends on productivity and labor force growth, which are much harder to control. The only way policymakers can affect real growth is by undertaking structural reforms - which are often painful and unpopular in the short run. By contrast, faster nominal growth as a result of higher inflation can create the "money illusion" among the populace and bring political rewards, at least for a time.2 Higher nominal growth might initially please the public, but when inflation escalates it will reduce living standards. Moreover, an inflation outbreak will eventually necessitate major policy tightening and a growth downturn to reverse inflation. A comparison of a range of populist political leaders with orthodox (non-populist) leaders across Latin America, Central Europe, and Central Asia demonstrates that populists really do tend to achieve higher nominal growth relative to non-populists in the first two years of their rule (Chart 2). This finding has served BCA's Geopolitical Strategy well in predicting that U.S. President Donald Trump would blow out the federal budget through tax cuts and government spending in pursuit of faster growth.3 With stimulus taking effect while the output gap is closed, inflationary pressures are likely to rise higher than they otherwise would have done over the next 12-to-24 months.4 Chart 2Populists Pursue Nominal GDP Growth President Duterte of the Philippines also appears to fit this rubric. Like Donald Trump, he combines foul-mouthed eccentricity and personal risk-taking with a policy agenda of tax cuts, fiscal spending, and deregulation (Table 1).5 Yet unlike Trump, his infrastructure program - which is desperately needed in the Philippines, a laggard in this respect - is up and running, producing a large increase in capital expenditures and imports. The gap between nominal and real GDP growth - i.e. the inflation rate - looks likely to rise further. Table 1Duterte's Agenda Consists Of Drug War, Tax Cuts, And Big Spending Signs of an inflation outbreak are already evident. Chart 3 shows that both core and headline inflation measures are now rising sharply and have crossed the Bangko Sentral ng Pilipinas's (BSP) 3% inflation target by a wide margin, even rising above the 2%-4% target band. Further, local currency yields are rapidly ascending while the currency has been plunging against the weak U.S. dollar. These indicators suggest that the inflation outbreak that BCA's Emerging Markets Strategy warned investors about in October has now come to pass.6 The official explanation for the inflation spike this year is Duterte's tax reform bill, which took effect January 1 (and is the first of several such bills). The bill cuts taxes for households and raises excise taxes on a range of goods - from electricity, petroleum products, coal, and mining to sugary drinks and tobacco.7 The central bank has cited this law and its ramifications (including transportation costs and wage demands) as reasons for the inflation overshoot to be temporary. Yet Duterte's growth agenda and the BSP's simulative policies have created an environment ripe for inflationary pressures to build, namely by encouraging banks to expand their balance sheets and money supply (Chart 4). This has led to excessive strength in domestic demand. Chart 3An Inflation Outbreak Chart 4Stimulative Policies Further signs of a genuine inflation outbreak include: Twin deficits: both the current account and fiscal balances are negative in the Philippines, a significant development over the past two years (Chart 5). Further, the trade balance now stands at a nearly two-decade low of 9.5% of GDP (Chart 6). Worryingly, the current account has fallen into deficit despite the fact that remittances from Filipinos living abroad, which account for 9% of GDP, have been robust (Chart 6, bottom panel). Oil prices are surprising to the upside as global inventories drain and the geopolitical risk premium rises. This puts additional pressure on the current account balance and adds to inflationary pressures. Chart 5The Philippines Now Has Twin Deficits Chart 6Trade Deficit Worsens; Remittances The Saving Grace The Philippines' import bill is growing briskly, especially that of consumer goods (Chart 7, top panel). Meanwhile, overall export volumes and revenues of non-electronic/manufacturing exports are contracting (Chart 7, second panel). This is a sign that the Philippine economy is losing competiveness. Indeed, the third panel of Chart 7 shows that the country's global export market share is deteriorating. Wages are rising across many sectors (Chart 8). The imposition of excise taxes on electricity and fuel has prompted a wave of demands for higher wages from labor groups and provincial wage boards. Duterte is also said to be preparing a nationwide minimum wage law (to increase regional wages vis-à-vis the capital Manila) and an end to temporary employment contracts, which cover about 25% of the nation's workers and pay wages that are 33% lower on average. As wage growth outpaces productivity gains, unit labor costs are rising, eating into listed non-financial companies' profit margins (Chart 9). Chart 7Domestic Demand Surges While Competitiveness Falls Chart 8Wage Growth Is Strong On the fiscal front, the Duterte administration is pushing badly needed spending increases in infrastructure, health, and education. The investments amount to $42 billion over six years, or roughly 2% of GDP per year in new fiscal spending.8 While these investments will be beneficial in the long run as they augment both the hard and soft infrastructure of the nation, their size and timing needs to be modulated in real time to prevent them from creating excessive inflationary pressures in the short and medium run. This is difficult and the administration is likely to err on the side of higher spending that feeds inflation. Further, the administration's tax reform plan is unlikely to raise enough revenue to cover all the new spending. The first tax reform bill to pass through Congress cuts household tax rates for most brackets (with rates to fall further in 2023) and raises the threshold to qualify for income tax, thereby narrowing the tax base to 17% of the population. The value added tax (VAT) will also have its threshold increased. Corporate taxes will be cut next. Revenue shortfalls will add to the budget deficit. Loosening fiscal policy will foster higher inflation and will continue weighing on the currency. Despite the upside inflation surprise, the central bank has kept the policy rate at the record low level of 3% where it has been since 2014. It also cut reserve requirements in March, injecting liquidity into the system. Deputy Governor Diwa Guinigundo says that an inflation reading within the target band at the May 10 monetary policy meeting will increase the likelihood that no rate hikes will occur this year.9 The central bank explicitly views this year's high inflation as a passing phenomenon tied to the excise taxes. It may also have stayed its hand due to signs of waning momentum in certain segments of the economy such as autos and property construction, which are weakening (Chart 10). Chart 9Higher Labor Costs Eat Firm Margins Chart 10Central Bank Not Worried About Overheating But in light of the fiscal and credit trends outlined above, and given that the Philippine economy is domestically driven and insulated from the slowdown in global growth, we do not expect domestic growth to fall very far. Overall, the central bank has maintained accommodative monetary policy for too long and tolerated an inflation outbreak. At this stage, central bank independence thus becomes a critical question. The current governor, Nestor Espenilla, is a tough enforcer against financial crimes who may be willing to do what it takes to rein in inflation: his comments have been a mixture of hawkish and dovish. But he is also a Duterte appointee, and thus perhaps unwilling to counter a popular, and forceful, president. It is too soon to say that the BSP will fail in its duties, but it does have a reputation for dovishness that it has reinforced this year.10 This analysis points to a policy of "growth at all costs." Odds are that growth will remain fast, that the inflation outbreak will continue, and that the BSP has fallen behind the curve. Bottom Line: The Philippines is witnessing an inflation outbreak that is likely to continue. Credit growth is booming, fiscal policy is loose, and the central bank is behind the curve. This policy setup is negative for the currency and for stock prices and local bonds in the absolute. Cha-Cha: What Does It Mean? In the long run, Duterte's authoritarian leanings will weigh on the country's performance. Governance has declined since he took office, primarily because of his rampant war against drugs. The Drug War has officially led to the deaths of 6,542 people since July 1, 2016, according to the Philippine Drug Enforcement Agency.11 Human rights groups believe the actual tally is twice as high. Yet even if we exclude "political stability and absence of violence" from the Philippines' governance indicators, the country's score has declined under Duterte and is worse than that of its neighbors (Chart 11). And this score does not yet account for the fact that Duterte has imposed martial law on the southern island of Mindanao and is using his popularity (56% net approval, Chart 12) and supermajority in Congress (89% of seats in the House and 74% in the Senate) to push a constitutional rewrite that would give him even more extensive powers.12 Chart 11Even Excluding The Drug War, Philippine Governance Is Bad And Getting Worse Chart 12Duterte Is Popular (But Not That Popular) Like previous administrations, the Duterte administration wants to revise the 1987 Philippine constitution. There are three current proposals, each of which would change the government from a "unitary" to a "federal" system.13 Manila would remain the capital but the provinces would be incorporated into states or regions that would have their own governments and greater autonomy. The proposals differ in detail, but if and when congressmen and senators reconstitute themselves into a Constituent Assembly to rewrite the charter, they will have complete freedom, i.e. will not be limited to the specifics of these proposals. A popular referendum will be necessary to approve the results and could occur as early as May 13, 2019, when Senate elections will be held, or the summer afterwards.14 "Charter change" or Cha-cha is a perennial preoccupation in the country with three main drivers (Table 2). First, successive Philippine presidents try to revise the constitution so that they can stay in power longer than the single, six-year term limit. Second, provincial political forces seek to change the constitution to decentralize power. Third, economic reformers and business interests seek to remove protectionist articles embedded in the constitution, particularly limitations on private and foreign investment. Table 2History Of Cha-Cha In The Philippines In general, Manila is seen as a distant and unresponsive capital ruling over an extremely diverse and disparate archipelago. The centralized system is prone to corruption due to the pyramid-like patronage structure descending from a handful of elite, Manila-based, families at the top. Meanwhile the provinces lack autonomy and economic development. While the capital region only contains 13% of the population, it accounts for 38% of GDP. The central government has trouble raising resources - as indicated by a low tax revenue share of GDP compared to neighbors (Chart 13). It is at times incapable of providing essential services like security and infrastructure, particularly in far-flung provinces like Mindanao or parts of the Visayas where poverty, under-development, natural disasters, and militancy reign. The chief goal of those who want a federal system is to decentralize power in order to strengthen the provinces. They argue that reversing the role of central and regional fiscal powers will improve government effectiveness overall by bringing the government closer to the people it governs. Today, the central government controls about 93.7% of the revenues and 82.7% of the spending while local governments control about 6.3% and 17.3% respectively (Chart 14). Chart 13The Philippine Government Is Underfunded And Weak Chart 14The Philippine Government Is Heavily Centralized Under a federal system these roles would reverse. Local governments would gain greater powers to tax and spend within their jurisdictions, while also improving tax collection. This would enable them to improve public services while still providing the federal government with resources to pursue national goals. Better funded and more autonomous local governments would presumably be more responsive to public demands within their jurisdictions. This is especially the case given the country's population and geography, with 101 million people spread out over more than 7,000 islands. The result - say the proponents - would be better governance all around, including greater economic development across the regions. From this point of view, over the long run, Cha-cha appears to be a pro-market outcome. In particular, the proposed changes will probably include greater openness to foreign direct investment (FDI), easing restrictions on land ownership, utilization, and resource exploitation that have long been difficult to remove because of their constitutional status (a vestige of anti-colonial sentiment). The Philippines falls markedly behind its peers in attracting FDI (Chart 15). This change would likely have a positive impact on FDI and productivity, as the Philippines has long suffered from its closed, protectionist, and heavily regulated model.15 Chart 15The Problem With Constitutional Restrictions On Foreign Investment However, Cha-cha's opponents argue that the net effect will be negative for the business community and financial markets because of the drastic shift in the status quo. They argue that the 1987 constitution provides ample authority for decentralization but that Congress has refused to pass implementing legislation due to vested interests. As opposed to reforming the Local Government Code and other laws on the books, a total change of the government system would be controversial, expensive, and prone to expanding bureaucracy (as it would replicate the current national government institutions for each state/region in the new federal system). It would also be self-interested. Cha-cha would give Duterte additional powers to oversee the chaotic transition, and likely give him new powers in the aftermath as a result of the provisions themselves.16 Weighing both sides, we expect that charter change will require a massive political struggle and a long transition period in which economic uncertainty will spike. It will also give Duterte more arbitrary power and weaken central institutions and legal frameworks designed to keep him in check. While he insists that he will step down in 2022 according to existing term limits, Cha-cha could remove the constitutional limit on his time in office or allow him to resume as prime minister indefinitely. He would also have extensive powers of appointment and dismissal affecting the judiciary and other checks and balances. Is creeping authoritarianism market-negative? Not necessarily. Authoritarian governments in some cases have greater ability to make difficult, unpopular decisions that benefit national interests in the long run - including on macroeconomic policy. Singapore, Taiwan, and China are famous regional examples. Nevertheless, the Philippines is not Singapore or China - it is not a weak or non-existent democracy with a strong central government, but rather a strong democracy with a weak central government. It will not be easy for Duterte to seize ever-greater control if he should attempt to. He will eventually meet resistance from "people power" - mass protests from civil society such as those that overthrew dictator Ferdinand Marcos in 1986 and President Joseph Estrada in 2001. Such a movement may not develop in the short run, given his popularity, but the distance from here to there will involve political instability and a deterioration of monetary and fiscal management. To illustrate this process, consider the Philippines' record in the "Polity IV" dataset, which is a political science tool that provides a standardized measure of the quality of democracy in different regimes across the world.17 A time series of the Philippines' Polity scores illustrates the drastic collapse of governance under Marcos (Chart 16), who imposed martial law from 1972-81 and plunged the country into a morass of oppression, dysfunction, and corruption. This ended with the first People Power Revolution in 1986 and the promulgation of the 1987 constitution. Since then, Polity scores have improved markedly. Today the Philippines scores an eight, within the range of western democracies. The democratic era has been a boon for investors who have seen the Philippines improve its macroeconomic and business environment over this period. But Duterte is a Marcos-like figure who could reverse this process even if he does not drag the country all the way down into the worst conditions of the 1970s-80s. Could Duterte succeed in charter change where his post-Marcos predecessors have failed? Yes. He has a lot of political capital and is well situated to push for dramatic change. He is an anti-establishment political outsider - the first Philippine president from the deep south - elected amidst a wave of disenchantment over persistent, endemic problems like poverty, corruption, lawlessness, and lack of development. He has high public approval ratings and a supermajority in Congress (Chart 17). It is too early in the game to give firm probabilities on whether the constitutional changes will pass the necessary popular referendum in spring or summer 2019, but it is perfectly possible for Duterte to succeed judging by his standing today. Chart 16The Marcos Dictatorship Was Inflationary Chart 17Duterte's Legislative Supermajority What will be the economic effects? Aside from policy uncertainty, decentralization will be good for growth and inflation. Local leaders will have more tax money to spend and less central discipline. Pent-up demand for development in the provinces will be unleashed, with local political leaders likely to encourage credit expansion. In the context outlined above this change means higher inflation. Inflation rates in the provinces should start to climb toward those of the capital region, while those of the capital region would have no reason to fall amid the flurry of new activity. Hence investors interested in the Philippines must monitor the long and rocky road of charter change. They should look to see if the Congress and Senate do indeed merge into a Constituent Assembly (the quickest yet most controversial way of revising the constitution because it is the least constrained); what proposals look to be codified in the drafting of the constitution and assembly debates; if Duterte retains his popularity throughout the constitutional process; and whether the public is supportive of the proposals.18 Our rule of thumb is that a constitutional process focused on decentralization and removal of protectionist provisions would be market-positive in principle. However, if authoritarian provisions creep into the final text, they may reveal the market-negative priorities and a lack of constraints on policymakers in Manila. Bottom Line: Philippine governance will continue to decay under the Duterte administration. Revisions to the constitution will have pro-market aspects, and net FDI will probably continue to rise. But these positive aspects will be overweighed by the politically polarizing and destabilizing process of charter change itself. Moreover, decentralization will feed into the current credit boom and inflationary backdrop and could produce excesses. The U.S.-China Crossfire The Philippines is a strategically located island chain that frames the South China Sea (Diagram 1). It has been caught in great power struggles for centuries. The rising U.S. colonial power displaced the remnants of the established Spanish colonial power there in 1898; the rising Japanese empire displaced the established U.S. in 1941, only to be defeated by the U.S. and its allies in 1944. Diagram 1The South China Sea: Still A Risk Now China is the rising power in Asia and is applying pressure on America's visiting forces. The Philippines is again caught in the middle. It relies on the U.S. more than China economically and strategically, but China is rapidly catching up, as is clear in trade data (Chart 18). And China's newfound naval assertiveness must be taken seriously. Indeed, Duterte claims that Chinese President Xi Jinping threatened him with war if his country crossed China's red line in the South China Sea.19 Chart 18China Rivals U.S. In The Philippines Geopolitical risk has fallen since Duterte's election as a result of his pledge to improve relations with China and distance his country from the United States. This was a sharp reversal of Philippine policy. From 2010-16, the Aquino administration engaged in aggressive strategic balancing against China. The country was threatened by China's militarization of the Spratly Islands in the South China Sea and encroachment into Philippine maritime space and territory. The pro-American direction of Aquino's policy culminated in the signing of the Enhanced Defense Cooperation Agreement (EDCA), which granted the American military the right, for ten years, to rotate back into Philippine bases. In July 2016, the Permanent Court of Arbitration ruled in favor of the Philippines, against China, in a landmark case of international law. It held that the South China Sea "islands" were not islands at all and that China could not base territorial or maritime claims off them.20 This strategic balancing brought tensions with China to a near boiling point. However, the pot was taken off the fire when the Philippine public elected the outspokenly anti-American, pro-Chinese, and communist-sympathizing Duterte. Duterte immediately set about courting Chinese investment, calling for bilateral China-Philippine solutions in the South China Sea (such as joint energy development), and denouncing President Barack Obama, the West, and various international legal bodies.21 As a result, China has largely dropped its pressure tactics against the Philippines. It has been investing more in the country over time (Chart 19) and has recently proposed a range of new projects worth a headline value of $26 billion. In the short run, Duterte's policy is positive because it enables the country to extract economic and security benefits from both the U.S. and China. China has reduced its coercive tactics, while the U.S. under President Trump has taken an easy-going attitude both toward Duterte's human rights violations and his pro-China (and pro-Russia) leanings. Duterte, for his part, has not tried to nullify the 2014 military pact with the U.S., but rather reversed his claim that he would sever ties with the U.S. by asking for American counter-insurgency support during the 2017 Siege of Marawi. Eventually, however, the emerging U.S.-China "Cold War" could force Duterte to make unpopular choices that violate economic relations with China or security protections from the U.S. The Philippine public is largely pro-American and suspicious of China.22 Thus, if Duterte pushes his foreign policy too far, he will provoke a backlash. This could take the form of a revolt against Chinese investments in the economy - as Chinese companies will be eager to take advantage of greater FDI access, especially under constitutional reform. Or it could take the form of a revolt against Chinese encroachments in the South China Sea, which are bound to recur.23 Alternatively, if the Philippines takes China's side, the U.S. could threaten to cut off market access, remittances, or (less likely) military support. A rupture in U.S. or China relations could spark or feed into domestic opposition to Duterte over political or constitutional issues or trigger a tense U.S.-China diplomatic standoff with economic ramifications. This is something to monitor in case a conflict emerges such as that which occurred in 2012-14 at the height of Philippine-China tensions, or in South Korea in 2015-16. In both cases, China imposed discrete economic sanctions against American allies as a result of foreign policy moves they took in stride with the United States (Chart 20). Chart 19Chinese Investment Will Rise Under Duterte Chart 20China Imposes Sanctions In Geopolitical Spats Bottom Line: Geopolitical risks have abated over the past two years and should remain contained for the next few years, as China wishes to reward Duterte and his foreign policy. However, relations between the U.S. and China are getting worse, which puts the Philippines in the middle of the crossfire. The South China Sea remains a fundamental, not superficial, source of tension. Investment Conclusions Chart 21Stocks And Bonds Will Underperform This scenario is negative for financial markets and will cause stocks to fall and local bonds yields to rise in absolute terms (Chart 21). Philippine equities remain very expensive. At this point only policy tightening by the BSP can control inflation, but that, even if it were to occur (unlikely in our opinion), will be negative for growth and financial markets in the short-to-medium term. Relative to other EMs, Philippine financial markets have underperformed considerably for the past few years, and thus might experience a relative rebound. If so, it will not be due to Philippine fundamentals but to the fact that in other EMs, fundamentals are deteriorating and financial markets selling off. These markets have had a good run in the past two years and are vulnerable to the downside. In this context, it matters that the Philippines is not a major commodity exporter and not highly vulnerable to a Chinese growth slowdown. Oversold conditions relative to EM peers and lower commodity prices could allow the Philippine bourse and currency to outperform those peers for a time. We thus maintain neutral allocation on Philippine stocks and bonds within EM benchmarks for now but are placing it on downgrade watch. On the political side, President Duterte is making investments in the country that will improve the supply side, but his policies will feed inflation in the short term and erode governance in the long term. His push to reshape the political and governmental system will increase political risk at a rare moment when geopolitical risks have somewhat abated. The latter are significant, but latent, and could flare up significantly in the long run due to U.S.-China conflicts. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor Emerging Markets Strategy ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 2The "money illusion" is a concept in macroeconomics coined by economist Irving Fisher, who wrote a book of the same title in 1928, to describe the failure of economic actors to perceive fluctuations in the value of any unit of money. In other words, people tend to pay more attention to nominal than to real changes in money or prices. The concept is valid today, albeit subject to academic debate over its precise workings. 3 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, and Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, and "Two Tectonic Macro Shifts," dated January 31, 2018, available at ems.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 6 Please see "The Philippines: An Overheating Economy Requires Policy Tightening" in BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, available at ems.bcaresearch.com. 7 Please see Office of the Presidential Spokesperson, "A Guide To T.R.A.I.N. Tax Reform for Acceleration and Inclusion (Republic Act No. 10963," dated January 2018, available at www.pcoo.gov.ph, and Department of Finance, "The Tax Reform For Acceleration And Inclusion (TRAIN) Act," dated December 27, 2017, available at www.dof.gov.ph. 8 Please see the Philippine Department of Finance, "The Comprehensive Tax Reform Program: Package One: Tax Reform For Acceleration And Inclusion (TRAIN)," January 2018, available at www.dof.gov.ph. 9 At its March policy meeting the BSP decided to keep interest rates on hold despite a March inflation reading of 4.3%, above the top of the target range of 4%. For Guinigundo's comments about the May 10 meeting, please see "Philippines c. bank says monetary policy still data-driven, may hold rates," April 20, 2018, available at www.reuters.com. 10 The BSP has reportedly only surprised markets four times out of 84 scheduled monetary policy meetings over the past ten years. Please see Siegfrid Alegado, "Life Is Getting Harder For Philippine Central Bank Watchers," dated March 21, 2018, available at www.bloomberg.com. 11 Please see Rambo Talabong, "Duterte gov't tally: At least 4,000 suspects killed in drug war," dated April 5, 2018, available at www.rappler.com. 12 Duterte's personal popularity is overstated. He was elected in a landslide, but only received 39% of the popular vote. The Pulse Asia quarterly polls suggest his popularity and "trust" ratings have ranged from 78%-86% since his inauguration (currently 80%), but this falls to 60% if undecided voters and disapproving voters are netted out. The Social Weather Station polls, which we cite, show a 56% net approval rating, which is mostly in line with Duterte's predecessor President Aquino at this stage in his term. 13 There are currently three draft proposals. The first is Senate Resolution No. 10, filed by Senator Nene Pimentel; the second is House Resolution No. 08, filed by Representatives Aurelio Gonzales and Eugene Michael de Vera; the third is the ruling PDP Laban Party's proposal, from Jonathan E. Malaya at the party's Federalism Institute. 14 The funding to hold a referendum in 2018 does not exist nor are legislators ready. A "special budget" will coincide with the plebiscite, no doubt strictly to pay for the polling and not to grease the wheels of the "yes" vote! Please see Bea Cupin, "Charter Change timetable: Plebiscite in 2018 or May 2019, says Pimentel," I, February 2, 2018, available at www.rappler.com. 15 Please see Gary B. Olivar, "Update On Constitutional Reforms Towards Economic Liberalization And Federalism," American Chamber of Commerce Legislative Committee, dated September 27, 2017, available at www.investphilippines.info. 16 Please see Neri Javier Colmenares, "Legal Memorandum on Charter Change under the Duterte Administration: Resolution of Both Houses No. 8 Proposed Federal Constitution," December 4, 2017, available at www.cbcplaiko.org. 17 Please see the Center for Systemic Peace and Monty G. Marshall, Ted Robert Gurr, and Keith Jaggers, "Polity IV Project: Political Regime Characteristics and Transitions, 1800-2016," July 25, 2017, available at www.systemicpeace.org. 18 Local elections in May 2018 may also provide some indications of popular support, as well as the Senate elections in May 2019 (if the referendum is not simultaneous). 19 Please see Richard Javad Heydarian, "Did China threaten war against the Philippines?" Asia Times, dated May 23, 2017, available at www.atimes.com. 20 Please see BCA Geopolitical Strategy Special Report, "South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 21 He has since said the Philippines will leave the International Criminal Court, which it joined in 2014, and arrest any prosecutor of the court who comes to the Philippines to investigate the government and police handling of the drug war. Please see Rosalie O. Abatayo, "Arresting ICC prosecutor could get Duterte in more legal trouble, says lawyer," The Philippine Daily Inquirer, April 22, 2018, available at globalnation.inquirer.net. 22 Please see Jacob Poushter and Caldwell Bishop, "People In The Philippines Still Favor U.S. Over China, But Gap Is Narrowing," Pew Research Center, September 21, 2017, available at www.pewglobal.org. 23 At present the Association of Southeast Asian Nations is negotiating a long-awaited, albeit non-binding, "code of conduct" with China in the South China Sea that could be concluded as early as this or next year. However, South China Sea tensions could heat up again at any point due to Chinese encroachments, U.S. pushback, or other regional actions. Also, with oil prices set to increase rapidly, non-U.S./OPEC/Russia international offshore oil rigs could begin to increase again, renewing an additional source of tension in the sea.

Highlights Oil markets could get even tighter, depending on fundamental "known unknowns." Chart of the WeekEM Import Volumes Continue Expanding,##BR##Reflecting Rising Incomes And Oil Demand The largest of these unknowns are the evolution of Iranian and Venezuelan oil output. With the May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran fast approaching, and Venezuela's output in free fall, supply could contract dramatically. On the demand side, our short-term trade model is signaling EM imports continue to grow, which indicates continued income growth (Chart of the Week). EM growth drives oil demand growth. DM growth also will support commodity demand this year and next. The likelihood oil prices push toward - or exceed - $80/bbl this year is high. An extension of OPEC 2.0's production cuts into next year all but assures such excursions in 2019.1 Our forecast for 2018 remains at $74 and $70/bbl for Brent and WTI; we are leaving our 2019 forecasts at $67 and $64/bbl, respectively, but anticipate raising them as OPEC 2.0 forward guidance evolves. Energy: Overweight. Oil trade recommendations closed in 1Q18 were up an average 82%. The trades were initiated between Sep/17 and Jan/18. Base Metals: Neutral. LME aluminum's backwardation extends to end-2021, reflecting tighter physical markets. This supports our long S&P GSCI call, which is up 11.4% since Dec 7/17, when we recommended it. Precious Metals: Neutral. We are getting tactically long spot silver at tonight's close. Back-to-back physical deficits in 2016 and 2017, global income growth, and near-record speculative short positioning in COMEX silver - 79.8k futures contracts - are bullish. Ags/Softs: Underweight. Importers of U.S. sorghum into China now are required to post a 179% deposit with Chinese customs, according to Xinhuanet. The state-run news agency reported Ministry of Commerce findings of a surge in U.S. imports - from 317k MT in 2013 to 4.80mm MT in 2017 - which drove down local prices 31%, and "hurt local industries." Feature Our updated balances modeling indicates oil markets remain tight, and will continue to tighten this year, given our fundamental assumptions for supply and demand (Chart 2). We now estimate slightly lower crude oil production this year - 99.73mm b/d vs. our March estimate of 100.20mm b/d - with OPEC output at 32.12mm b/d, vs. 32.50mm b/d last month (Table 1). This is offset by non-OPEC supply growth, which continues to be led by rising U.S. shale-oil output (Chart 3). We expect production in the "Big 4" basins - Bakken, Permian, Eagle Ford and Niobrara - to average just over 6.44mm b/d this year, up 1.21mm b/d y/y, and 7.78mm b/d next year, up just over 1.34mm b/d. Chart 2Oil Markets Will Tighten Further Chart 3Lower OPEC Production Offset By U.S. Shales Table 1BCA Global Oil Supply - Demand Balances (mm b/d) We are leaving our consumption growth estimate for this year unchanged at 1.70mm b/d, bringing demand to 100.32mm b/d in 2018 on average, and raising our expectation for 2019 to 1.70mm b/d growth, which will take it to 102.00mm b/d on average (Chart 4). Global inventories will continue to drain on the back of these bullish fundamentals, falling somewhat more than we expected last month (Chart 5). We would note the trajectory of inventory growth likely will be altered once we have definitive 2019 production guidance from OPEC 2.0 - i.e., we expect some production cuts to be maintained next year, keeping inventories closer to end-2018 levels. These fundamentals leave our price forecasts unchanged at $74 and $70/bbl for Brent and WTI this year, and $67 and $64/bbl, respectively, next year (Chart 6). Again, we caution clients we fully expect to raise our 2019 forecast as OPEC 2.0 forward guidance evolves. Ministers of the coalition met this month in New Delhi and Riyadh, presumably to discuss institutionalizing their confederation.2 Chart 4Oil Demand##BR##Remains Stout Chart 5Bullish Fundamentals##BR##Drain Inventories Chart 6Price Forecast Unchanged,##BR##But Upside Risks Are Rising Once Again With "Known Unknowns"3 Supply-Side "Known Unknowns" A critical juncture in the evolution of the oil markets is fast approaching: The May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran, and a determination on whether the U.S. will impose sanctions directly against Venezuela's oil industry. We have no advance knowledge of what the administration will do, but the signaling from the Trump White House has us inclined to believe the Iran sanctions will not be waived this time around. Action against Venezuela also is difficult to predict, but, of late, markets are sourcing alternative crude streams against a growing likelihood such sanctions will be imposed.4 Approaching the deadline for waiving Iranian sanctions, we have Iranian crude production at ~ 3.85mm b/d in 2H18, and a little over 3.90mm b/d next year. Prior to sanctions being lifted in January 2016, Iran was producing 2.80mm b/d. It is difficult to determine what will happen if sanctions are not waived by the U.S. - critically, whether U.S. allies will support such a move - so it is difficult to determine how deeply Iranian production and exports will be affected, if at all. S&P Global's Platts service noted a former Obama administration official estimated as much as 500k b/d of Iranian exports could be lost to the market, should the sanctions be restored. Other estimates range as high as 1mm b/d.5 We are carrying Venezuelan crude production at 1.52mm b/d for March, and have it declining to just over 1.40mm b/d by December. Last year, production averaged just over 1.90mm b/d. The government of Nicolas Maduro has run the economy and the state oil company, PDVSA, into the ground. Inflation came in at 454% in 1Q18, leaving prices up 8,900% in the year ended in March, according to Reuters.6 Presently, oil workers are fleeing PDVSA in a "stampede," according to Reuters, leaving the company woefully short of experienced personnel.7 The company lacks the wherewithal to pay for basic additives (diluents) to make its crude oil marketable. It is possible some of the company's creditors in Russia or China will step in to take over operations, but so far nothing has been announced. Demand-Side "Known Unknowns" Our demand estimates are premised on continued global growth this year and next, consistent with the IMF's latest global economic assessment.8 The Fund expects global GDP growth of 3.9% this year and next, which we incorporate into our modeling. Aside from the usual litany of long-term economic ills plaguing DM and EM economies - high debt levels, aging populations, falling labor-force participation rates, low productivity growth, and the need for diversification among commodity-exporting EM economies - trade tensions have become a more prominent risk. The Fund notes increasing trade tensions - set off by the U.S. imposition of tariffs on aluminum and steel imports - have the potential to "undermine confidence and derail global growth prematurely." These tensions have been stoked by tit-for-tat tariff announcements by the U.S. and China over the past month or so. Our own research supports this concern, which we believe is particularly acute for EM economies, where income growth, trade and commodity demand are inextricably entwined. Continued EM trade growth is essential for commodity demand growth, particularly for oil: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000. These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes.9 EM growth accounts for slightly more than three-quarters of the overall oil-demand growth we expect this year and next - ~ 1.30mm b/d of the 1.70mm b/d of growth we are forecasting. While the odds of a full-blown trade war remain low, in our estimation, we could begin to see the erosion of confidence and the potential for growth to be derailed affecting investment, trade volumes and EM growth generally, which would be bearish for oil demand growth. That said, we share the view articulated by our colleagues in BCA's Global Investment Strategy last week: "Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now." "Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff ... . However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune."10 A Note On Permian Basis Differentials WTI - Midland differentials recently weakened considerably, as take away capacity out of the basin became strained (Chart 7). Weakness in the Light Houston Sweet differentials, which measure the spread between the producing and consuming markets for WTI produced in the Permian, traded as wide as -$9.00/bbl. This market has experienced similar such widening of the basis, which can be seen in the WTI-Midland vs. WTI - Cushing differentials, which widened considerably when Permian production increased (Chart 8).11 These basis blowouts typically incentivize additional pipeline capacity. Indeed, earlier this year, some 2.4mm b/d of new takeaway capacity had been proposed by pipeline operators.12 Once this capacity is online, we expect to see WTI exports from the Gulf increasing. Chart 7Growing Pains In The Permian:##BR##Takeaway Capacity Constraints Chart 8Permian Crude Oil Production##BR##Exceeded Takeaway In The Past Bottom Line: We are maintaining our $74 and $70/bbl prices forecasts for Brent and WTI in 2018, and expect to revise our 2019 forecasts of $67 and $64/bbl, respectively, once we get definitive forward guidance from OPEC 2.0. We continue to monitor supply-side risk - chiefly re Venezuela and Iran - and trade-war threats to the demand side, for any information that could cause us to substantially revise our forecasts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Member states pledged to remove 1.80mm b/d of production from the market, of which some 1.2mm b/d is believed to be actual production cuts, while the remainder is comprised of involuntary losses from Venezuela and other producers unable to offset decline curve losses. 2 Please see S&P Platts OPEC Guide of April 16, 2018, entitled "OPEC MAR CRUDE OIL PRODUCTION TUMBLES TO 32.14 MIL B/D, DOWN 250,000 B/D FROM FEB: PLATTS SURVEY," which reports on the OPEC 2.0 ministerial meetings this month in New Delhi and Riyadh. 3 "Known Unknowns" is a phrase popularized by Donald Rumsfeld, a former U.S. Secretary of Defence in the administration of George W. Bush, at a press conference. Please see the U.S. Department of Defence "News Transcript" of February 12, 2002, at http://archive.defense.gov/Transcripts/Transcript.aspx?TranscriptID=2636 4 Please see "A U.S. Ban On Crude Imports," published by vessel tracker KPLER April 13, 2018. 5 Please see "US foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts March 20, 2018. 6 Please see "Venezuela inflation 454 percent in first quarter: National Assembly," published by reuters.com on April 11, 2018. 7 Please see "Under military rule, Venezuela oil workers quit in a stampede," published by uk.reuters.com on April 17, 2018. 8 Please see "Global Economy: Good News for Now but Trade tensions a Threat," published on the Fund's blog April 17, 2018. 9 Please see "Trade Tensions Cloud Oil Outlook," in the March 8, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Is China Heading For A Minsky Moment?" in the April 13, 2018, issue of BCA Research's Global Investment Strategy. It is available at gis.bcaresearch.com. 11 LHS data is limited, as it only recently emerged as a benchmark for the Houston refining market. 12 Please see "Operators Race to Build Pipelines As Permian Nears Takeaway Capacity," in the March 2018 issue of Pipeline & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Midterm election is yet another geopolitical headwind to the markets this summer; A "lame duck" Trump could seek relevance abroad, with aggressive foreign and trade policy; Investors would be right to fret about a hard turn to the left by the Democratic Party; Democrats have 60% probability of taking the House and 45% probability of taking the Senate; On a cyclical horizon, midterm election will not undermine pro-business policies of the Trump administration, but may signal a paradigm shift over a more structural time horizon. Feature Geopolitical winds have turned from tailwinds to headwinds. This is as we expected last April, when we correctly forecast that geopolitical risks were overstated in 2017 but understated for 2018.1 This January we focused on several key risks for 2018: trade protectionism, Iran-U.S. geopolitical tensions, and a potential black swan risk in Taiwan.2 In our 2018 Strategic Outlook, we also pointed out that if Donald Trump becomes an early "lame duck" president, he will seek relevance abroad.3 It is therefore time to turn to the question of the upcoming midterm election, set to take place on November 6. For most of our clients, the midterm election is another volatile political event to add to an already long list (Table 1). True, the midterm election could produce a gridlocked Congress - which we recently showed quantitatively is marginally negative for the markets - and a potential push to impeach President Trump.4 However, this is not the worst of it. As November approaches, through a tumultuous summer full of headline risks, President Trump may double-down on his doctrine of "maximum pressure" - which objectively succeeded in the case of North Korea. This could produce more aggressive rhetoric and policy in the ongoing trade skirmish with China, further sanctions against Iran, and tensions with Russia. Table 1Protectionism: Upcoming Dates To Watch President Trump would not be the first U.S. president to seek relevance abroad, although he may be the earliest, and potentially the lamest, lame duck president in recent U.S. history.5 As such, the real risk is not the Democrats taking over the House, but rather how the Trump administration reacts to a sudden loss of legislative initiative. While a Democratic House would dramatically increase domestic political constraints on President Trump, there are few constitutional constraints on U.S. presidents when it comes to foreign policy. As such, the midterm election is market relevant, but not because Democratic Party control will be able to impact domestic policy. Investors should remember why markets cheered President Trump in the first place: Chart 1Trump: A Boon For Main Street And Wall Street Chart 2Easy Fiscal + Tight Money = Buy SPX Deregulation: Business confidence soared even before Donald Trump was inaugurated as president, especially among small businesses, while regulatory worries melted away (Chart 1).6 The executive branch controls the regulatory process, which means that the Democratic takeover of the House of Representatives, or even the Senate, will have little impact. Tax cuts: Fears that the Democrats will be able to reverse the tax cuts are overstated. Without a veto-proof majority in both chambers of Congress - two-thirds of the seats - the Democrats cannot regain legislative initiative or reverse President Trump's accomplishments. Table 2ADXY Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Table 2BSPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Fiscal policy: Markets are currently pricing in a rare mix of tightening monetary policy and stimulative fiscal policy, a bullish combination (Chart 2) that tends to boost both equities and the dollar (Table 2). While there is no need for fiscal profligacy at the current point in the cycle (Chart 3), we would think that investors would recoil at any sign of fiscal conservativism. But looking for austerity within the current Democratic Party - whose official party platform calls for universal health coverage, for example - is a mistake. Chart 3An Odd Time For Fiscal Profligacy As such, the Democratic Party's control of the House - or even the Senate, given that a filibuster-proof majority is out of reach in 2018 - is unlikely to reverse the policy and regulatory backdrop that has been so beneficial for equities over the past 18 months. Instead, the risks are twofold. First, that President Trump reacts to the coming electoral bloodbath well ahead of November with aggressive foreign and trade policy that plays to his base. Second, that markets begin pricing in impeachment risk. Although we do not think that impeachment would have a major or direct impact on earnings and the real economy, it could add to volatility and could imply higher odds of a Democratic win in 2020 (think Gerald Ford). This would present a scenario in which the Democrats would be more likely to reverse Trump's policies in 2020, thus increasing uncertainty. As such impeachment could start being priced in well ahead of the November election. We would therefore expect midterm-related volatility to rise before the election. The election itself could likely be a time to buy risk assets, provided that fundamentals, the macro backdrop, and geopolitical risks all combine into a bullish signal, as long as President Trump makes an effort to move to the middle and work with either a split Congress, or even a potentially Democratic-led legislature. These are all sources of uncertainty and therefore provide plenty of reasons for the markets to fret ahead of the election. Who Will Win The Midterm Election? It is too early to have a high conviction view on the midterm election, which is still over six months away. Betting markets give Democrats roughly 70% probability of winning the House and just 40% of winning the Senate (Chart 4). We roughly agree with those odds, but would give the Democrats a lower chance of winning the House and a slightly higher chance of winning the Senate. There are broadly five reasons why the Democratic Party has a very good chance of winning the House of Representatives in November: Chart 4GOP Odds Have Fallen, But Stabilized Chart 5GOP Trails In Polls, But Still Close Polling: The generic congressional ballot (Chart 5) has the Democrats up 6.7% on the Republicans. The generic ballot has a decent predictive track record. Basically, the party that is up tends to perform well in the election. Meanwhile, Trump's approval rating, despite its recent recovery in support, remains at the lower end of presidential approval ratings ahead of midterm elections, predicting a 35-seat loss for Republicans in the House (Chart 6). On the whole, the Democrats' polling advantage is modest-to-strong. True, it could unravel over the summer. But at current levels, it is still a respectable advantage. Chart 6Republican Presidents And Midterm Results Retirements: Republicans in the House and the Senate are retiring at an alarming pace, one never seen in the modern political context (Chart 7). We cannot overstate how important this is, especially given that there has been a 20% swing against non-incumbent Republicans in deeply conservative districts that have held special elections thus far (Table 3). Most worrying for the GOP is that, of the 42 Republicans who have announced retirement, 18 sit in seats that are not "solidly" held by the GOP.7 These are seats that only elected the Republican candidate by an average of at most 5% more than the overall Republican vote in the 2012 and 2016 election. Chart 7GOP Retirements Are Unprecedented Table 32017 Special Elections Are Ominous For The GOP History: Of the 18 midterm elections since World War II, the sitting president's party only retained congressional control four times (Chart 8). The only president to win congressional control during the midterm election was Bush Jr., an election that was held a year after the September 11 terrorist attack (i.e., an exception). Americans like checks and balances and abhor hubris. Redistricting: Gerrymandering - politically motivated redrawing of district electoral maps - has mainly favored Republicans over the past decade.8 It has also significantly reduced the number of competitive districts available to electoral swings (Chart 9). Recently, however, the Pennsylvania state Supreme Court invoked the state constitution and struck down the congressional map that favored the GOP. The Supreme Court of the U.S. then refused an emergency request from Pennsylvania Republicans to block the new, non-partisan map drawn by the state court. This decision followed several decisions in 2016-17 that saw congressional maps in North Carolina, Virginia, Texas, Wisconsin, and Alabama either thrown out or questioned. The changes will help the Democrats at the margin, potentially making the difference between a majority and a minority position in the House. Chart 8Trump Is ##br##Fighting History Chart 9Gerrymandering Reduces##br## Competitive House Seats Momentum: Shouldn't a strong economy and sub-4% unemployment rate help the Republicans in November? The simple answer is not much. Just as a strong economy and a 4.7% unemployment rate did not help the incumbent party and its candidate Secretary Hillary Clinton fend off the inexperienced challenger, Donald Trump, in 2016. Simply put, economics is relative and partisan. While Republican voters suddenly became very happy about the economy after Trump's election - having been miserable merely days before- it is now the Democrats who believe that the economy is in a downward spiral (Chart 10). It is therefore difficult to see how the current economic performance makes enough of a difference to swing voters away from the trends we describe above. Further supporting this view is the fact that economic issues, broadly defined, are declining in terms of relevance in the upcoming election (Chart 11).9 Chart 10Politics Trumps Data! Chart 11It's Not Necessarily The Economy The trend is clear: Republicans are in trouble when it comes to the House of Representatives (Chart 12). Democrats need to win only 25 seats in November and there are now 29 Republicans representing seats that The Cook Political Report, the expert political analysis shop when it comes to predicting individual House races, classifies as "toss-up or worse." Our call, at this point, is that the Democrats have a 60% probability of winning the House of Representatives. We hesitate to set our odds at the higher end, near where the betting markets are pricing it, as there is still a long time until the election. In addition, the Democrats' lead in the generic congressional ballot has halved from 13% since December. What about the Senate? We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.10 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. Our model is a work in progress and we will update our clients as it develops. The results of our "beta" model, expressed as a margin of victory by the GOP candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate (Chart 13).11 This is astonishing given that the Democrats are defending nine seats in "red states," whereas Republicans are only defending one seat in a "blue state" (Nevada). Basically, our model predicts that Republicans would lose Nevada and Tennessee. Meanwhile, of the five Senate races that are ranked as "toss ups" and that are currently held by Democrats, our model predicts that Republicans will only win Indiana. Given that current polling is highly unreliable, we would take all predictions of our model with a healthy dose of skepticism. Nonetheless, the results are surprisingly bullish for the Democrats. Chart 12The Number Of "At-Risk" GOP Seats Has Doubled Chart 13BCA Senate Model Says: Election Is Too Close To Call Our call, at this point, is that the Democrats have a 45% probability of winning the Senate; essentially the election is too close to call. This is higher than where the betting markets are pricing the election and an astonishing turnaround from 12 months ago, when most forecasts ignored Democrat chances in the Senate given how unfavorable the math was for their odds of winning. What does it all mean for the markets? Chart 14Midterm Elections Are A Boon For The S&P 500... Chart 15...But Really, It's All About The Fed Generally speaking, the market has performed very well following midterm elections during a Republican presidency (Chart 14). At closer inspection, however, it appears that this may have been because monetary policy has almost always been easy during these periods (Chart 15). As fate would have it, Republican presidents have been generally blessed with easy monetary policy. As such, we do not think that investors should take anything from this data. Table 4Democratic Primaries To Watch Rather than rely on uncertain empirical results, we would simply point out that the run-up to the midterm election, this coming summer, looks packed with geopolitical risks and uncertainty. President Trump is facing a potential defeat in Congress and will want to ensure that his base turns out for the election. This could mean doubling down on those parts of his policy agenda where the constitutional constraints are the weakest: foreign and trade policy. This is a recipe for more volatility. The midterm election is therefore a catalyst, if not the source, of near-term volatility. Furthermore, investors should carefully observe the results of key Democratic primary races (Table 4). Any sign that the Democratic Party is fielding left-wing candidates, as opposed to centrists, would have two implications. On one hand, it would lower our odds of the Democrats winning the House and definitely the Senate. On the other hand, it would increase the odds that the U.S. will have a political paradigm shift over the next electoral cycle. If the Democrats swing hard to the left and win the midterm election, the implications for investors would be hard to overstate. As a point of reference, investors should remember that Republicans swung hard to the right in 2010-14, presaging the rise of Trump. Yet these Republican victories took place in the face of long-term demographic and social headwinds, whereas comparable Democratic victories today would take place in the face of long-term demographic and social tailwinds. American policy can shift harder to the left over the coming decade than it did to the right over the past eight years.12 As Charts 16 and 17 show, the U.S. is at "peak inequality." As the example of France illustrates, income inequality does not necessarily go up. In the early 1960s, France had a larger share of the national income apportioned to the wealthy than the U.S. does today. Since then, it has fallen. In other words, societal decisions on wealth redistribution vary over time. The concern for investors would be if any Democratic party move to the far left is rewarded at the polls in November. If this were to happen, it would be appropriate to begin pricing in a significant decline in the share of national income that goes to corporate profits, if not yet a decline in social unrest. As Chart 17 illustrates, a significant decline in wealth concentration in France occurred right around the late 1960s. The May 1968 revolution was one of the most paradigm-shifting moments in France's post-World War II history. If the markets begin pricing in anything close to this degree of change in the U.S., the S&P 500 could enter a bear market. Chart 16GOP Tax Cuts: Same Old Story Chart 17Beware May 1968 Bottom Line: Our odds of the Democrats winning the House are 60%, below market expectations. Our odds of the Democrats winning the Senate are 45%, above market expectations. While we do not think that Democratic control of Congress, or just the House, will be negative for earnings on a cyclical time horizon, we do understand why investors would price in higher volatility. First, President Trump may respond to a loss of congressional control by seeking relevance abroad through hawkish foreign and trade policy. Second, investors may sense a paradigm shift occurring in the U.S. if left-wing Democrats start winning primary races and then go on to win the House. Is Impeachment A Risk? In a report titled Break Glass In Case Of Impeachment, we argued that investors should fade impeachment-related volatility.13 Equity markets are driven by earnings. As such, there has to be a direct relationship between political volatility and company earnings. Impeachment has rarely produced such a link. Chart 18 looks at market performance during the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974), and President Clinton's Lewinsky Affair (January 1998 to February 1999). Of the three, the Teapot Dome scandal did not result in impeachment proceedings, but only because President Harding died in office in 1923 - and neither his death nor the unfolding scandal prevented the stock market from "roaring" through the mid-1920s.14 Chart 18AVolatility Amid Three U.S. Scandals Chart 18BEquities Amid Three U.S. Scandals The market reaction to the Lewinsky Affair was also highly muted. Like the Teapot Dome incident, it occurred amidst one of the greatest bull markets in U.S. history. Of course, U.S. equities did fall 19% mid-way through the Clinton impeachment process, but this was more due to global risk factors than domestic politics. Watergate appears to have affected both equity markets and volatility. The S&P 500 fell 39% from February 7, 1973 - when the Senate established a select committee to investigate Watergate - until Nixon's resignation on August 9, 1974. That said, the scandal alone did not cause the correction; rather, it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, and a massive insurance fraud scandal. Writing in the summer of 1973, BCA remarked that while a speculative, "Watergate-inspired," attack on the dollar further contributed to some short-term capital outflow, but that the macro-fundamentals of the economy would ultimately persevere. Would today play out more like Teapot and Clinton, or Nixon? It will depend on the fundamentals. In the 1920s and the 1990s, fundamentals were solid and thus politics could not dent the ongoing bull market. In the early 1970s, macro fundamentals were terrible and thus politics accentuated the decline in the bear market. One thing that impeachment would not change, however, is policy. The U.S. is not Brazil. Impeachment will not lead to a 180 degree change in policy outcomes. Vice President Mike Pence is a Republican and is as pro-business as Trump. Given that the aggressive trade policy towards China has both public and establishment support, we would not expect any relief on the protectionism front. However, there would be a lot less tweeting, insults, and erratic foreign policy rhetoric aimed at both allies and rivals. The "maximum pressure" doctrine would likely be replaced by a more traditional policy of carrots and sticks. Most notably, we think this would minimize the risk of a proxy war with Iran in the Middle East. How likely is impeachment once Democrats take over the House? It depends. If President Trump fires Department of Justice Special Counsel Robert Mueller, the Democrats in the House of Representatives may get enough votes to impeach President Trump even without a House takeover! The question is whether impeachment would matter. As we outlined in our special report, impeachment is a political, not a legal, process. As such, the House of Representatives has a low bar for impeachment. It can essentially impeach the U.S. president for anything, including a debatable claim that he obstructed justice. The real question is whether the Senate would convict. To do so, the Senate must hold a trial and vote on whether to remove the president from office by a two-thirds majority (67 votes). Even if Democrats win the Senate, they would need over 15 Republican Senators to join them in removing a sitting U.S. president from office, which has never been done in American history. This could happen, but it would require the American public, particularly Republicans, to lose faith in President Trump. In particular, we have been advising clients to focus on Republican voters' support for Trump. If it dips well below 70%, we suspect that Senators could start switching sides. We are currently nowhere near these levels (Chart 19). What could change these levels of support? The Mueller special investigation is a big risk to President Trump even if one thinks that the charge of collusion with Russia is unfounded. President Bill Clinton was similarly investigated by an independent special investigator, Kenneth Starr. Starr initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky, an issue completely unrelated to the original investigation. In other words, once independent investigators start digging, there is no telling what skeletons they will exhume. We do not intend to "prosecute" claims against President Trump in this or any future report. But we can also envision a scenario where the Mueller investigation reveals enough evidence of malfeasance to shake GOP voter confidence in President Trump, leading to a potential scenario where he is removed from power. Would the market care at this point? We think the answer is yes. While removal of a U.S. president has no impact on earnings, it could have an impact on social stability. Political polarization is at its highest levels in the U.S. (Chart 20), and roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being" (Chart 21). Chart 19Impeachment: Not A Risk (Yet) Chart 20Polarization, As Inequality, Remains At Record Highs Chart 21"A Threat To The Nation's Well-Being?" Really?! We would fade any risk of a widespread, Red State rebellion. Since a change in Republican opinion is required for Senators to convict Trump, most of Trump's supporters will have already lost faith in him by the time he is removed from office. As we outlined in our Strategic Outlook, we doubt that many Trump voters would risk social unrest to defend their champion.15 Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). But convincing the markets may take time, and any sign of even minimal right-wing terrorism could create volatility and drawdowns. Bottom Line: Impeachment remains a headline risk to the markets. We continue to believe that impeachment will merely accentuate the impact of fundamentals on risk assets. However, fundamentals themselves are starting to look vulnerable, at least on a tactical horizon. As such, we are entering a six-month period where geopolitical, trade, and domestic political risks could pose headwinds to U.S. risk assets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017; "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, 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 President Clinton launched the largest NATO military operation at the time against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops into Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. Less dramatic, but still notable examples, are President George W. Bush ordering the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006, and President Barack Obama negotiating the Iranian nuclear deal after losing the Senate (and hence the entire Congress) to the Republicans in 2014. 6 Please see BCA Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism!" dated November 8, 2017, available at gps.bcaresearch.com. 7 We use The Cook Political Report methodology for reporting the characteristic of House seats. Seats are split into "toss-up or worse," "likely/lean," and "solid" based on their Partisan Voter Index (PVI) score. The Cook PVI measures how each district performs at the presidential level compared to the nation as a whole. A district with a D+2 PVI voted an average of two points more Democratic than the nation did as a whole in the last two presidential elections (2012 and 2016 for current PVI rating). The Cook Political Report defines a "swing seat" as one that falls between D+5 and R+5. A "solid Republican" seat would therefore be any seat with a PVI of R+5 or higher. A "solid Democrat" seat would therefore be any seat with a PVI of D+5 or greater. 8 This is not to say that Democrats have not redistricted for partisan reasons. California was famously redistricted in the 1980s. Most recently, former Maryland Governor Martin O'Malley admitted, during a court deposition, that he redrew the state's district borders specifically to increase the Democratic congressional majority in the state. Please see Amber Phillips, "Maryland's redistricting case reminds us: Both parties gerrymander. A lot." The Washington Post, dated March 28, 2018, available at washingtonpost.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "As Good As It Gets?" dated January 29, 2018, available at usis.bcaresearch.com. 10 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincidence index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 11 The U.S. Vice President, Republican Mike Pence, would cast the deciding vote in case of a 50-50 tie and therefore the Democrats require a pickup of two seats. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 14 "Teapot Dome" was for decades the largest corruption scandal in U.S. history. It involved President Warren G. Harding, his Secretary of the Interior, other officials, and a number of oil companies that were given extremely favorable leases to drill oil in federal land in Wyoming. Investigations and prosecutions lasted through 1927. 15 Please see BCA Geopolitical Strategy Strategic Outlook, "BCA Geopolitical Strategy 2017 Report Card," dated December 13, 2017, available at gps.bcaresearch.com.

Highlights Apart from rising geopolitical tensions, our main macro themes remain a growth slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Subsiding NAFTA risks argue for overweighting Mexican stocks within an EM equity portfolio. This is in line with our recent upgrade of Mexican local and U.S. dollar sovereign bonds as well as the peso's outlook versus their EM peers. A new trade: Fixed-income trades should bet on yield curve steepening in Mexico by paying 10-year swap rates and receiving 2-year rates. Close overweight Russian markets positions in the wake of escalating U.S. sanctions. Feature Before discussing Mexico and Russia, we offer an update on our thoughts on the overall market outlook. EM: Looking Under The Hood Investor sentiment remains buoyant on global risk assets, and the buy-on-dips mentality remains well entrenched. On the surface, investors are not finding enough reasons to turn negative on global or EM risk markets. Nevertheless, when looking under the EM hood, we see several leading and coincident indicators that are beginning to flash red. Not only do geopolitics and the U.S.-China trade confrontation pose downside risks, there are also several macro developments that are turning from tailwinds to headwinds for EM risk assets. Specifically: EM manufacturing and Asian trade cycles have probably topped out. The relative total return (carry included) of three equally weighted EM1 (ZAR, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has relapsed since early this year, coinciding with the rollover in the EM manufacturing PMI index (Chart I-1). This currency ratio is herein referred to as the risk-on/safe-haven currency ratio. Chart I-1Risk On / Safe-Haven Currency Ratio And EM Manufacturing PMI The risk-on/safe-haven currency ratio also correlates with the average of new and backlog orders components of China's manufacturing PMI (Chart I-2). The latter does not herald an upturn in this currency ratio at the moment. Share prices of global machinery, chemicals and mining companies have so far underperformed the overall global equity index in this selloff, as exhibited in Chart I-3. Chart I-2China's Industrial Cycle Has Rolled Over Chart I-3Global Cyclicals Have Underperformed, Though Not Tech Potential trade wars, the setback in technology stocks and a resurgence of volatility in global equity markets have recently dominated news headlines. Yet, the underperformance of China-exposed global sectors and sub-sectors signifies that beneath the surface Chinese growth is weakening. Meanwhile, global tech stocks have not yet underperformed much (Chart I-3, bottom panel), implying the selloff has not been driven by this high-flying sector. The combination of weakening global trade amid still-robust U.S. domestic demand bodes well for the U.S. dollar, at least against EM and commodities currencies. U.S. and EU imports account for only 13% and 11% of global trade, respectively (Chart I-4). Meanwhile, aggregate EM including Chinese imports account for 30% of world imports. Hence, global trade can slow even with U.S. and EU domestic demand remaining robust. We addressed the twin deficit issue in the U.S. in our February 21 report,2 and will add the following: If U.S. fiscal stimulus coincides with abundant global growth, the greenback will weaken. If on the contrary, the U.S. fiscal expansion overlaps with weakening global trade, U.S. growth will be priced at a premium and the U.S. dollar will appreciate especially against the currencies of economies where growth will fall short. The majority of EM exchange rates will likely be in the latter group. The relative performance of EM versus DM stocks correlates with the relative volume of imports between China and the DM (Chart I-5). The rationale is that EM countries and their publically listed companies are much more leveraged to China's business cycle than DM. The opposite is true for DM-listed companies. Our view is that China's industrial recovery and growth outperformance versus DM since early 2016 is about to end. This, if realized, should undermine EM equities and currencies versus their DM counterparts. Last week, we published a Special Report on the Chinese real estate market.3 We documented that despite a drawdown in housing inventories over the past two years, both residential and non-residential inventories remain very elevated. This, along with poor affordability and the implementation housing purchase restrictions for investors, will dampen housing sales, which in turn will lead to a contraction in property development and construction activity. Chart I-4Global Trade Is More Leveraged To EM Not DM Chart I-5EM Underperforms When Chinese Imports Lag DM Ones Combined with a slowdown in infrastructure investment due to tighter controls on local government finances, this poses downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies, and the primary reason we continue to maintain our negative stance on EM risk assets. Last but not least, it is widely believed that Chinese households are not indebted and that there is a lot of pent-up demand for household credit. Chart I-6 reveals that this conjecture is simply not true - the household debt-to-disposable income ratio has surged to 110% of disposable income in China. The same ratio is currently 107% in the U.S. Given borrowing costs in general and mortgage rates in particular are higher in China than in the U.S. (the mortgage rate is 5.2% in China versus 4.4% in the U.S.), interest payments on debt account for a larger share of households' disposable income in China than in America right now. In the U.S., the surprise on the macro front in the coming months will likely be both rising wage growth and core inflation. Chart I-7 highlights that average hourly earnings in manufacturing and construction have been accelerating. This underscores that wages are rising fast in these cyclical sectors. This will spread to other sectors sooner rather than later. Core inflation in America is rising and has already moved above 2% (Chart I-8). The rise is broad-based as all different core consumer price measures are rising and heading toward 2%. Chart I-6Chinese Households Are As Leveraged As Americans Chart I-7U.S. Wages Are Accelerating Chart I-8U.S. Core Inflation Is Above 2% While this does not entail that the U.S. is heading into runaway inflation, rising core inflation and wage growth will likely lead many investors to believe that the Federal Reserve cannot back off too fast from rate hikes, particularly when the U.S. fiscal thrust remains so positive, even if the drawdown in share prices persist. This may especially weigh on EM risk assets, where growth will be subsiding due to their links with Chinese imports. Bottom Line: Our main macro themes remain a slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Upgrade Mexican Equities To Overweight In our March 29 report,4 we upgraded our stance on the Mexican peso, local currency bonds and U.S. dollar sovereign credit from neutral to overweight. The main rationale was receding odds of NAFTA abrogation and the country's healthy macro fundamentals. In addition, we instituted a new currency trade: long MXN / short BRL and ZAR. Continuing with this theme, we today recommend upgrading Mexican stocks to overweight within an EM equity portfolio: The odds of NAFTA retraction are rapidly subsiding as the U.S. is shifting its focus to China. Hence, chances are that NAFTA negotiations will be completed this summer, and a deal will be signed off before Mexico's presidential elections on July 1st. A more benign outcome together with an early end to NAFTA negotiations will reduce uncertainty and the risk premium priced into Mexican financial markets. This will help the latter outperform their EM peers. A final note on Mexican politics: The leftist presidential candidate Andres Manuel Lopez Obrador has high chances of winning the presidential elections in July. Yet Our colleagues at BCA's Geopolitical Strategy service believe political risks are overstated.5 The basis is that Obrador will balance the left-leaning preferences of his electorate with the prudent policies needed to produce robust growth. While political uncertainty in Mexico is subsiding, it is rising in many other EM countries such as Russia, China and Brazil. In brief, geopolitical dynamics favor Mexico versus the rest of EM. We expect dedicated EM managers across various asset classes to rotate into Mexico from other EM countries. We outlined two weeks ago that a stable exchange rate will bring down inflation, opening a door for the central bank to cut interest rates no later than this summer. As local interest rate expectations in Mexico continue to subside both in absolute terms as well as relative to EM, Mexican share prices will outpace their EM peers (Chart I-9). Consistently, tightening Mexican sovereign credit spreads versus EM overall should also foster this nation's equity outperformance (Chart I-10). Chart I-9Relative Equity Performance Tracks Relative ##br##Local Bond Yields Chart I-10Relative Equity Performance Tracks Relative ##br##Sovereign Spreads Domestic demand growth has plunged following monetary and fiscal tightening in the past two years (Chart I-11). As both fiscal and monetary policy begin to ease, domestic demand will recover later this year. Chances are that share prices will sniff this out and begin their advance/outperformance sooner than later. Consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of overall EM market cap. Hence, Mexico's relative equity performance is somewhat hinged on the outlook for these two sectors in general and consumer staples in particular. EM consumer staple stocks have massively underperformed the EM benchmark since early 2016 (Chart I-12, top panel), and odds are this sector will outperform in the next six to 12 months as defensive sectors outperform cyclicals. This in turn heralds Mexico's relative outperformance versus the EM benchmark, which seems to be forming a major bottom (Chart I-12, bottom panel). Chart I-11Mexico: Economic Downturn Is Well Advanced Chart I-12Mexican Bourse Is A Play On Consumer Staples Unlike many EM countries, the Mexican economy is much more leveraged to the U.S. than to China. One of our major themes remains favoring U.S. growth plays versus Chinese ones. Finally, Mexican equity valuations have improved quite a bit both in absolute terms and relative to EM. Chart I-13 shows our in-house CAPE ratios for Mexican stocks in absolute terms and relative to the EM overall benchmark: Mexican equity valuations are not cheap but they are no longer expensive. Consistent with upgrading our economic outlook on Mexico, fixed-income investors should bet on yield curve steepening in local rates. We initiated this strategy on January 31 but hedged the NAFTA risk by complementing it with a yield curve flattening leg in Canada. Now, we are closing that trade and initiating a new one: fixed-income traders should consider paying 10-year swap rates and receiving 2-year swap rates. The yield curve is as flat as it typically gets (Chart I-14, top panel). Moreover, 2-year swap rates are not yet pricing enough rate cuts (Chart I-14, bottom panel) but will soon begin gapping down pricing in a large (potentially close to 200 basis points) rate cut cycle. Chart I-13Mexican Equities Are No Longer Expensive Chart I-14Bet On Yield Curve Steepening In Mexico Bottom Line: In line with our recent upgrade of Mexican local and U.S. dollar bonds as well as the currency outlook versus their EM peers, this week we recommend EM dedicated equity portfolios shift to an overweight position in Mexican stocks. Fixed-income trades should bet on yield curve steepening by paying 10-year swap rates and receiving 2-year rates. Investors who are positive on global risk assets should consider buying Mexican local bonds outright. Russia: Geopolitics Trumps Economics Chart I-15Russian Assets Relative To EM Benchmarks:##br## Various Asset Classes The sudden crash in Russian financial markets this week following the imposition of new U.S. sanctions has reminded us that geopolitics can often eclipse economics. Our overweight recommendation on Russian assets versus their EM peers was based on two pillars: (1) healthy and improving macro fundamentals and an unfolding cyclical economic recovery; and (2) easing tensions between Russia and the West. Clearly, the second part of our assessment is wrong, or at least premature. While BCA's Geopolitical Service team maintains that on a 12-month horizon tensions between Russia and the West will subside, the near-term risks are impossible to assess. For this reason we are closing our overweight allocation in Russian financial markets and recommend downgrading it to neutral. In particular, we are shifting Russia to a neutral allocation within the EM equity, sovereign and corporate credit and local currency bonds portfolios (Chart I-15). Consistently, we are closing the following trades: Long Russian / short Malaysian stocks (27.6% gain); Long Russian energy / short global energy stocks (2.8% gain); Long RUB / short MYR (3.1% loss); Short COP / long basket of USD & RUB (16.2% loss); Long RUBUSD / short crude oil (29.1% loss). Sell Russian 5-year CDS / buy South African 5-year CDS (317 basis points gain); Long Russian and Chilean / short Chinese Corporate Credit (12% gain); Long Russian 5-year bonds / short Brazilian 5-year bonds (flat). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We have removed the Russian ruble from the version of this chart shown in March 29, 2018 EMS report to assure that the recent idiosyncratic developments - the selloff triggered by the U.S. sanctions - in Russia's financial markets do not impact the reading of this indicator. 2 Pease see Emerging Markets Strategy Weekly Report "EM Local Bonds And U.S. Twin Deficits", dated February 21, 2018, Page 14. 3 Pease see Emerging Markets Strategy Weekly Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, Page 14. 4 Pease see Emerging Markets Strategy Weekly Report "EM: Perched On An Icy Cliff", dated March 29, 2018, available at ems.bcaresearch.com. 5 Pease see Geopolitcial Strategy Weekly Report "Expect Volatility... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations