Geopolitics
Highlights The bill is bullish for growth and therefore for the equity markets and the U.S. dollar; The bill consists mostly of tax cuts, not reforms, that favor corporations and the wealthiest taxpayers; The bill is bullish for growth in the short term, but also inflationary and hence a risk to growth in the medium term; A non-populist White House is a relief to the markets, particularly on trade policy, but may mean a more hawkish foreign policy. Feature Chart 1Trump: A Boon For##BR##Main Street And Wall Street Since the November 2016 election, and particularly since President Donald Trump's inauguration, financial markets have celebrated. This is ironic given that on the campaign trail, Trump often adopted populist rhetoric indistinguishable from that of Bernie Sanders, the bête noire of the business community. Trump's cabinet, however, quickly took on a pro-business outlook following the inauguration. Despite appointing several notable trade hawks, the administration sported half a dozen former Goldman Sachs employees. Business confidence soared, especially among small businesses, while regulatory worries hanging over CEO's melted away (Chart 1). Both Wall Street and Main Street took one look at President Trump's cabinet at the end of January and decided that there was not an iota of genuine populism in the White House. This view was reinforced by three early decisions by the Trump administration: China: President Trump reneged on his promise to designate China a currency manipulator formally on day one of his administration.1 Instead, he hosted President Xi Jinping at the Mar-A-Lago Summit in April and agreed to engage in trade talks over the rest of the year. (He again declined to accuse China of currency manipulation in October.) Budget: President Trump's "skinny budget" proposal in May oozed with Republican Party orthodoxy, bolstering spending on defense and border security, while calling for drastic cuts to domestic programs. The implication was that future tax cuts would ultimately be "paid for" via draconian fiscal austerity in the distant future. "Breitbart clique" ousted: Steve Bannon, the White House Chief Strategist and self-described economic nationalist, was fired in mid-August, with several prominent allies ousted in the wake of his departure. Bannon's departure left Treasury Secretary Steven Mnuchin, chief economic advisor Gary Cohn, and Commerce Secretary Wilbur Ross firmly in charge of economic policy. Enter Tax Cuts The coup-de-grâce of Republican orthodoxy is the just-proposed tax cut plan. The proposal by the House Ways and Means Committee is heavily stacked in favor of corporations and the top-income brackets. As Table 1 clearly illustrates, the household component of the plan is nearly balanced - and therefore deserving of the moniker "reform" - whereas the corporate side of the ledger is closer to a pure and simple cut. Table 12017-2018 Republican Tax Cut Proposal - House Ways And Means Committee (Oct. 2017) Some of the more prominent measures proposed by the House and Ways Committee are: Household Income The highest tax rate remains 39.6%, but would now only kick in at $1 million in taxable income;2 The Alternative Minimum Tax (AMT) will be repealed, which hurts the upper middle class and wealthy by limiting tax benefits from a variety of deductions; The estate tax will be fully eliminated by 2024; The standard deduction will be doubled from $12,700 to $24,000, one of the few direct benefits to lower-income families; The plan would repeal the state and local income and sales tax deductions, while capping the state and local property tax deduction to $10,000; Almost all itemized deductions will be eliminated - such as medical expenses, property losses, casualty losses, etc.; The mortgage interest rate deduction for future home purchases will be capped, with only homes up to $500,000 covered. Corporate Income The corporate tax rate will be cut from 35% to 20%; Companies will be able to deduct the full amount of business investments in the year that they are made, although the provision would expire at the end of 2022; The tax rate on income from pass-through businesses would fall to 25%, considerably below the top household income tax rate; Several deductions would be eliminated, including the deduction of interest on debt; The "worldwide" tax system would be overhauled and foreign earnings repatriated: U.S. multinational corporations would pay a 12% tax rate on past profits that they repatriate, while future overseas earnings would be taxed at the new 20% corporate rate. We would caution clients from parsing too carefully through the proposal, lest they waste their time. The Senate is likely to pass a completely different set of proposals. The GOP plan is to get to a "conference committee" as fast as possible, where a new draft legislation can be hammered out from the two disparate proposals. We suspect that this entire process will miss the self-imposed target of "before Christmas," and probably last until the end of the first quarter.3 Nonetheless, we can discern the priorities of the House Republicans by gauging the winners and losers of their proposal. Our immediate take is that the tax cuts greatly benefit upper-income filers (households making over $423,000), moderately hurt upper-middle-class / lower-upper-class filers (those making between $260,000 and $423,000), and are largely neutral for the rest of households. First, the highest income groups are the clear beneficiaries: households making between roughly $450,000 and $1,000,000 will see their income tax rates fall by nearly 5%, by far the largest decrease planned. And, obviously, it is upper-income households that benefit from repealing the estate tax. Meanwhile, the upper middle class takes on the brunt of the burden of "reform": households making between $260,000 and $423,000 will see far fewer benefits under the proposed legislation. First, they are the only income bracket that will see a tax increase, from 33% to 35%. Second, they will not necessarily have the wherewithal to reclassify their income as pass-through business income. Third, many of the itemized deductions that will be eliminated will make a real difference in their filings. Fourth, they were the most likely to purchase homes between $500,000 and $1,000,000, which will no longer be eligible for interest-rate deduction. Fifth, the repeal of the estate tax will make less of a difference for this income group. Sixth, if they are domiciled in high-tax rate states and municipalities, these households will now be limited to how much they can deduct from federal taxes.4 Overall, the proposed tax cut plan fits general Republican orthodoxy.5 It tries to stimulate growth by favoring corporations and the wealthy. For economic growth, the plan is bullish in the short term. Particularly bullish is the ability of corporations to fully deduct the amount of business investment for the next five years. This provision could significantly increase investment in the short term, especially given the implicit threat that the opportunity will expire in 2022.6 Will the plan fail? It could, if enough Republican voters turn against it. The latest polling from Pew research - albeit from April of this year - shows that Americans no longer think that they pay too much in taxes (Chart 2). On the other hand, Republican and Republican-leaning voters do have a problem with the complexity of the tax code (Chart 3), and the proposed plan simplifies taxes for some middle-income households by doubling the standard deduction and repealing the AMT. The White House has already begun stressing this feature given that it polls well with voters. Chart 2American Voters Think Taxes Are Fair... Chart 3...But Republican Voters Think They Are Too Complex Polling suggests that President Trump remains relatively popular with Republican voters despite his dismal polling with the general public (Chart 4). He is polling only slightly below the average of previous Republican presidents at this point in his term in office. As long as Trump remains more popular with Republican voters than his Republican peers in Congress, we think that he will be able to force the tax plan through both the Senate and the House. In fact, we could even see some Democrats in the Senate supporting these tax cuts. Table 2 lists the 2018 Senate races to watch, particularly the vulnerable Democrats campaigning in red states that President Trump carried in 2016. Senators Nelson (D - Florida), Donnelly (D - Indiana), McCaskill (D - Missouri), Tester (D - Montana), Heitkamp (D - North Dakota), Brown (D - Ohio), and Baldwin (D - Wisconsin) are especially vulnerable. That makes seven potential votes for the Trump tax cut, potentially enough "slack" for the Republicans in the Senate to lose one or two votes on the tax bill. Chart 4Trump Remains Popular With GOP Voters Table 22018 Senate Races To Watch Is it even worthwhile to contemplate a scenario in which Republicans pass the tax cuts with Democrat support in the Senate? The short answer is yes. The 2001 Economic Growth and Tax Relief Reconciliation Act, the first of two Bush-era tax cuts, passed with 58 votes in favor, including 12 Democrats. Of the 12 that voted with Republicans, only three were from blue states, while the other nine were from red states that President Bush had carried in 2000. The 2003 tax-cut bill, Jobs and Growth Tax Relief Reconciliation Act of 2003, also passed with Democratic support with only 51 votes in favor. Senators Bayh (D - Indiana), Miller (D - Georgia), and Nelson (D - Nebraska) all crossed the aisle. Bayh was facing reelection in 2004, as was Nelson in 2006, in their respective red states. Bottom Line: The proposed tax cuts will benefit corporations and the upper-income Americans. The Senate may make some symbolic changes to the proposal to make it more palatable to the median American - given that senators have to capture the median voter in their state to win reelection. For example, the estate tax repeal may be scrapped and rules on deducting state and local taxes may be modified. Regardless of how the horse-trading goes, we believe that the U.S. economy will receive a modest stimulus in the form of a roughly $1.5 trillion tax cut (over ten years). Given that the U.S. economy is at full employment and firing on all cylinders, the proposed tax cuts should be marginally bullish for growth and inflation (Chart 5). Chart 5Regardless Of Tax Cuts, U.S. Economy Is Ripped What Do The Tax Cuts Tell Us About President Trump? We are big believers in the theory of "revealed preferences." While this concept was formally applied by economist Paul Samuelson to consumer behavior, we like to apply it to policymakers. The idea is to ignore the rhetoric and focus on what patterns of behavior reveal about genuine preferences. Politicians talk a lot, particularly during an election campaign. As a presidential candidate, Donald Trump was a clear populist candidate. He only revealed his tax reform plan in late September 2015 and then rarely mentioned it on the campaign trail. While his tax cut proposal languished on the campaign website, Trump focused on rallying voters around a combination of populist promises. These were, in no particular order, to build the border wall (and make Mexico pay for it), to rebuild American infrastructure, to repeal Obamacare, to destroy the Islamic State terrorist movement while disengaging the U.S. from global affairs, and to punish the unfair practices of trade partners like China and Mexico. Fast forward 12 months and we are now half-way to the 2018 mid-term election, with the Republicans controlling all three branches of government, and yet the only electoral promise that President Trump is even close to achieving is the just-announced tax cut.7 The revealed preference of the Trump administration, at least at this point, is Republican orthodoxy. Trump is a pro-growth, pro-business, anti-tax, anti-spending, red-blooded Republican. He has eschewed trade conflict with China, ignored infrastructure proposals, largely toed-the-line of foreign policy orthodoxy, and left hedge fund managers - a punching bag on the campaign trail - alone.8 To put it bluntly, Trump's behavior thus far suggests that he is a pluto-populist. A pluto-populist is someone who rules on the behalf of a plutocracy - an oligarchy controlled by the wealthiest citizens - but whose main tactic is to rally the plebeians (the common people) through populist policies. The House's draft tax plan provides sweeping gains for the wealthiest. It also preserves or expands some benefits for the poorest groups, so as to make it politically achievable. The upper middle class - the professional class - stands to suffer the most under the new tax scheme. If this analysis is correct, what does it reveal about President Trump's strategy going forward? Anti-globalization rhetoric is just talk: The fourth round of NAFTA renegotiations ended with a bang: the U.S. delivered four new demands, two of which both Ottawa and Mexico City have identified as non-starters.9 However, in the pluto-populist scenario, even if NAFTA is ultimately abrogated, the Trump administration will ensure that the critical components are preserved in bilateral agreements with Canada and Mexico. While those agreements are negotiated, the Trump Administration will not raise tariffs to the maximum, "bounded," level as allowed by the WTO. Meanwhile, trade relations with China may still sour in 2018, but they will not produce a trade war. Social unrest could increase: As we argued in a recent Special Report, the American structural context is ripe for more social unrest due to "elite overproduction."10 Trump's policies are likely to feed this condition. Meanwhile, his rhetoric and symbolic gestures will fuel the flames of division in order to play to his base, and force Democrats to argue about how to respond. This would be the populist part of pluto-populism. Hawkish foreign policy: With most of his domestic policies stymied, President Trump will pivot to the foreign theatre. We would particularly watch the growing tensions in the Middle East between Saudi Arabia and Iran, which could soon involve Lebanon.11 President Trump has also decertified the Iran nuclear deal, setting the stage for Congress to decide whether it will impose new sanctions and thus abrogate the deal. Plus, there is always North Korea. Bottom Line: Essentially, President Trump's strategy will be to pass pro-business, pro-market economic policies while distracting his largely anti-business, anti-market voters through ancillary issues. Investment Implications On the one hand, this analysis implies a very bullish policy mix as the Trump administration will not do anything domestically that hurts the ongoing bull market. On the other hand, some of those "ancillary" issues could flare up and impact the market, particularly if they involve a ratcheting up of tensions with Iran and North Korea. Chart 6No Debate: There Is No##BR##Trickle-Down From Tax Cuts The one risk that we remain concerned about is protectionism. We expected Trump to be more disruptive this year, and the above analysis suggests that protectionism, too, is merely hot air. However, Trump has only been in office for ten months. The absence of trade tensions with China may be a function of ongoing negotiations with North Korea: the U.S. needs China's cooperation in order to force North Korean leader Kim Jong-Un to the table. Ironically, then, a resolution of North Korean tensions could increase America's maneuvering vis-à-vis China, allowing Trump to become a lot more protectionist in 2018.12 Moreover, investors may be overemphasizing headline trade negotiations such as NAFTA or the China talks. The Trump administration may pursue protectionist aims through selective tariffs, such as countervailing and anti-dumping duties, in selective fashion. In other words, investors should pay attention to individual tariff decisions rather than overall negotiations.13 As for his electoral base, as long as President Trump can continue to ensure that they are focused on social disputes at home and hawkish rhetoric abroad, they may not notice the lack of movement on domestic promises. In particular, we have a high-conviction view that the just-proposed tax cuts will do nothing to curb income inequality in the U.S., and will likely deepen it, as previous such GOP-efforts did (Chart 6). Will this hurt President Trump in his 2020 reelection bid? We doubt it. But it does portend still greater socio-economic tensions and political populism in the long run. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The promise was made in a Wall Street Journal opinion piece that then-candidate Trump penned on November 9, 2015. Please see Donald J. Trump, "Ending China's Currency Manipulation," dated November 9, 2015, available at wsj.com. 2 The top marginal tax rate of 39.6% is currently applied to single individuals making more than $418,401, a head of household making more than $444,501, and married couples, filing jointly, making more than $470,701. Technically, according to the current draft bill, the top tax rate in the House plan is supposedly about 45.6% between $1-$1.2 million, after which it falls back to 39.6%. A quirk in the proposal holds that once a filer hits $1 million of income, the IRS starts clawing back the $12,000 that the filer saved from having a 12% tax rate on his first $90,000 of income instead of a 25% tax rate. That clawback comes in the form of 6% surtax on income above $1 million. The $12,000 is completely reclaimed once the filer hits $1.2 million. By extension, everyone who makes over $1.2 million has had to pay that extra $12,000 in taxes. 3 For more on how the reconciliation process works, and how it will affect the timeline, please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 4 From a political perspective, the GOP may have simply made a bet that high-tax-rate, blue-state households making $260,000-to-$430,000 do not vote Republican. 5 The congressional budget resolution that sets out the reconciliation instructions for these tax cuts also includes draconian spending cuts, which would presumably help balance the books. Although none of those cuts will pass Congress, they reveal the traditional preference of the Republican party: cut taxes, pay for the cuts by means of a smaller government delivering fewer services. 6 And perhaps this investment boost will come just in time to help re-elect Trump in 2020! 7 Although he deserves some credit for bringing to conclusion the pre-existing fight against the Islamic State. 8 In fact, the House tax bill leaves the "carried interest" tax break in the code. 9 For more on NAFTA, please see our upcoming Special Report with BCA's Global Investment Strategy, to be published on November 10. 10 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 11 Lebanese Sunni Prime Minister Saad Harriri recently resigned while visiting Saudi Arabia, claiming that he feared for his life due to Iranian influence in Lebanon; Saudi Arabia itself is engaged in deep political struggle. 12 Indeed, in our original forecast of Trump's trade policy, we surmised that 2017 would largely be a year of negotiations, while 2018 would see the real fireworks. Please see BCA Geopolitical Strategy, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 13 An important such decision looms by January 12, 2018, which is the deadline by which President Trump must decide whether to impose "safeguard" tariffs on imports of solar panels and washing machines.
Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-14 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Our out-of-consensus call on oil prices - Brent and WTI are expected to trade to $65 and $63/bbl, respectively, next year - has the most upside risk from unplanned production outages in Iraq and Venezuela. The potential for export losses from Libya, while not as acute, remains high. Downside price risks - e.g., a meaningful softening of demand, or sharply higher U.S. shale-oil production - are not as elevated as upside price risks, in our view. Favorable global macro conditions will continue to support the synchronized global upturn in GDP, keeping oil demand growth on track. The strained balance sheets of many U.S. shale-oil producers and deepwater-producing Majors likely will limit their ability to fund drilling, as recent earnings calls from oil-services companies attest.1 We continue to monitor global monetary conditions, particularly in the U.S. With global oil markets tightening as supply contracts and demand expands, the broad trade-weighted USD will become more of a factor in oil-price determination next year. Energy: Overweight. Our long $55/bbl WTI calls vs. short $60/bbl WTI call spreads in Jul/18 and Dec/18 recommended last week are up 9.3% and 5.8%, respectively. Base Metals: Neutral. Copper has been well bid, and is up 8.5% since the beginning of the month. The proximate cause of the price strength is investor optimism regarding global growth, particularly in China. However, following their biannual meeting earlier this week, the International Copper Study Group kept its projected 2017 deficit unchanged, and downgraded their 2018 projection to 105k MT, from 170k MT. Precious Metals: Neutral. Gold is under pressure as markets weigh the possibility President Trump will appoint a more hawkish Fed Chair to succeed Janet Yellen. Ags/Softs: Neutral. Following a backlash from Midwestern politicians, the Environmental Protection Agency (EPA) abandoned proposed changes to the U.S. Renewable Fuel Standard. The EPA also will keep 2018 renewable fuel volume mandates at or above current proposed levels. Corn gained 2.4% since this announcement last week. Our corn-vs.-wheat spread is up 1.6% since inception. Feature Our out-of-consensus call on Brent and WTI prices for next year has a significant amount of daylight between the prices we expect - $65 and $63/bbl for Brent and WTI, respectively - and price estimates we derive using the U.S. EIA's supply, demand and inventory expectations, which are $15.1 and $13.8/bbl lower (Chart of the week). Chart of the WeekPrices Derived Using BCA And EIA##BR##Global Balance Estimates Our bullish oil price call is predicated on stronger global demand growth than EIA and other forecasters' estimates (Chart 2 & Table 1), and an extension of the OPEC 2.0 production cuts to end-June 2018 (Chart 3).2 These fundamentals combine to sustain a supply deficit for the better part of 2018 (Chart 4), which results in stronger inventory draws in the OECD (Chart 5). Net, we expect OECD stocks to fall below their five-year average level by year-end 2018. Chart 2Stronger Global Demand Growth ... Chart 3...And Continued OPEC 2.0 Discipline... Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Chart 4...Produce A Supply Deficit For Most Of 2018... Chart 5...Leading To OECD Inventory Normalization Upside Price Risks Dominate In 2018 In assessing the "known unknown" risks to our call, those on the upside clearly dominate in 2018. Chief among these risks are unplanned production outages, which have been somewhat under control versus the past two years (Chart 6). Nonetheless, we believe the risk of unplanned outages within OPEC - in Iraq and Venezuela, in particular - are elevated. The potential for export losses from Libya, while not as acute, remains high (Chart 7). Chart 6Unplanned Outages Are Down ... Chart 7...But Key States Are At Risk The risk of unplanned outages is highest in Iraq, where production is running at ~ 4.5mm b/d in 3Q17 (Chart 7, panel 1). Exports on the Ceyhan pipeline from Iraq's northern Kurdish region through Turkey to the Mediterranean fell by more than half to as low as 225k b/d, following a non-binding independence referendum in Iraq's restive Kurdistan region at the end of September. This led to armed conflict between Iraqi and Kurdish forces.3 Independence for the semi-autonomous region was supported by more than 90% of Iraqi Kurds. However, the Iraqi government in Baghdad, along with its neighbors in Turkey and Iran, opposed the referendum, as did the U.S. This lack of support likely prompted the Kurdistan Regional Government's (KRG) offer to "freeze" the referendum this week, and to seek immediate cease-fire talks with Baghdad. Export flows from Kirkuk and the Kurdish region have been restored this week to ~ 300k b/d, or half of the volumes exported prior to the referendum, according to Bloomberg.4 Even with the offer to freeze the referendum - presumably, this means the semi-autonomous Kurdish government will abstain from pressing for independence if its offer is accepted and Baghdad agrees to negotiate an immediate cease-fire - this issue is far from settled. BCA's Geopolitical Strategy noted last month, the critical issue for the oil market remains sustained conflict between the Iraqi central government and the KRG. The question that cannot be answered yet is what "would (a conflict) do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production."5 A huge "known unknown" resides in Venezuela, where we have production running at ~ 1.96mm b/d in 3Q17, sharply down from 2.4mm b/d during 2011-2015. The state oil company, Petroleos de Venezuela, SA, or PDVSA, is struggling to amass enough cash to meet critical near-term international interest and debt payment obligations, and can no longer afford to buy the chemicals and equipment required to make the country's heavy oil suitable for refining. This lack of cash is causing oil quality from Venezuela to deteriorate, as more exports are showing up with high levels of water, salt or metals. This is raising the odds refiners from the U.S. to China could turn barrels away in the near future unless the situation is reversed.6 Indeed, Reuters reported Phillips 66, a U.S. refiner, cancelled "at least eight crude cargoes because of poor oil quality in the first half of the year and demanded discounts on other deliveries, according to ... PDVSA documents and employees from both firms. The cancelled shipments - amounting at 4.4 million barrels of oil - had a market value of nearly $200 million." Venezuela's financial condition has steadily worsened following the collapse of oil prices at the end of 2014. Production is at its lowest level in 30 years, and banks have stopped extending letters of credit, which are critical to trading in the international oil market, in the wake of U.S. sanctions ordered by President Trump, as Reuters notes. In addition, PDVSA has been denied access to storage facilities in St. Eustatius terminal, because it owes the owner of the facility, Texas-based NuStar Energy, some $26 million in fees.7 Markets will be watching closely to see if Venezuela performs on $2 billion in USD-denominated bond payments, one of which is due tomorrow, and the other due next week (November 2). Venezuela missed debt coupon payments of some $350mm earlier this month, and has a total outstanding obligation for this year of $3.4 billion.8 In all likelihood, Venezuela will once again turn to Russia for additional financial support, which has stepped in as a "lender of last resort" replacing China.9 Venezuela owes Russia some $17 billion. Of this, Rosneft Oil Co., a Russian oil company, has loaned PDVSA $6 billion.10 In Libya, where we have production at 910k b/d in 3Q17 (Chart 7, panel 3), the risk of unplanned production outages is not as acute as the risks in Iraq and Venezuela, but important nonetheless. As a failed and fractured state, Libya faces particular challenges in maintaining production. Wood Mackenzie believes Libyan production likely has plateaued. The oil consultancy believes Libya's max production is limited to 1.25 million b/d.11 However, "Reaching this would be quite an achievement, given ongoing challenges, including international oil companies' reluctance to recommit capital and expertise, a national oil company starved of funding - and, not least, the propensity for violence to flare up and armed groups to hinder oil output." Downside Price Risks Less Daunting In 2018 Chart 8The USD Will Become More Important##BR##As Oil Markets Tighten Next Year Downside price risks - e.g., a meaningful softening of demand, or sharply higher U.S. shale-oil production - are not as elevated as risks to the upside, in our view. The favorable global macro conditions we discussed in last week's forecast will continue to support the synchronized global upturn in GDP. This will keep global oil demand growing at ~ 1.67mm b/d on average in 2017 and 2018, based on our estimates. We expect U.S. shale production to increase to 5.17 mm b/d in 2017 and to 6.09 mm b/d next year, as higher prices incentivize renewed drilling activity. However, the strained balance sheets of many shale-oil producers and a renewed - although perhaps only temporary - push from equity investors for shale producers to focus on improving economic returns rather than merely pursuing maximal production growth, likely will limit their ability to fund drilling, as recent earnings calls from oil-services companies attest. Away from fundamentals, we are monitoring U.S. monetary policy closely, given the potential for the USD to become a headwind once again for commodity prices generally, and oil prices in particular. As we noted last week, we expect the tightening of oil markets globally to restore the linkage between the USD and oil prices - i.e., the inverse correlation between them (a stronger USD is bearish for crude oil prices, and vice versa). The transitory noise surrounding the next Fed Chair will dissipate within the next few weeks, allowing the U.S. central bank and markets to focus on the evolution of monetary policy next year, following a widely expected rate hike in December. During the transitional phase the oil market is currently passing through - falling supply and stout demand are tightening the market globally - the USD's importance will increase as a determinant of oil prices (Chart 8). Bottom Line: Our oil-price call for next year - $65/bbl for Brent and $63/bbl for WTI - is predicated on stronger global demand growth, and an extension of the OPEC 2.0 production cuts to end-June 2018. These fundamentals will produce stronger inventory draws in the OECD, and bring stocks below their five-year average by year-end 2018. In our view, upside price risks clearly dominate in 2018. Chief among these risks are unplanned production outages in key OPEC states - Iraq, Venezuela and Libya - which account for ~ 7.4mm b/d of production at present. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Oilfield Service Quarterly Update: U.S. Stagnation," published October 25, 2017. It is available at nrg.bcaresearch.com. 2 OPEC 2.0 is the producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Please see last week's feature article in Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," for a discussion of our assumptions, models and estimates. It is available at ces.bcaresearch.com. 3 Please see "Update 2 - Iraqi Kurdistan faces first major oil outage since referendum," published by uk.reuters.com October 18, 2017. See also "Iraq's NOC vows to maintain Kirkuk oil flows after ousting Kurds," published by S&P Global Platts October 17, 2017, for additional background. 4 Please see "Iraqi Kurds Offer To Freeze Independence Referendum Results," published October 25, 2017, by Bloomberg.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report "Iraq: An Emergent Risk," p. 23 in the September 20, 2017 issue. It is available at gps.bcaresearch.com. 6 Please see "Venezuela's deteriorating oil quality riles major refiners," published by reuters.com October 18, 2017. 7 Please see "Exclusive: PDVSA blocked from using NuStar terminal over unpaid bills," published by uk.reuters.com October 20, 2017. 8 Please see "Venezuela is blowing debt payments ahead of a huge, make-or-break bill," published by cnbc.com on October 20, 2017. 9 Please see "Special Report: Vladimir's Venezuela - Leveraging loans to Caracas, Moscow snaps up oil assets," published by reuters.com on August 11, 2017. 10 Rosneft's majority owner is the Russian government. See "Glencore sells down stake in Russia's Rosneft," published by telegraph.co.uk on September 8, 2017. Glencore's 14.6% stake in Rosneft was sold to CEFC China Energy, according to the Telegraph. 11 Please see "WoodMac: Libya's oil production might have reached near-term potential," in the October 20, 2017, issue of Oil & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights China's ascendancy will increase U.S.-China tensions in the medium and long term; "Xi Jinping Thought" is China's rejection of Soviet-style collapse; Xi's new policies face very few domestic political constraints; Xi is playing down GDP targets and playing up centralization; Tax cuts are still coming to the U.S. Feature Global risk assets continue to rally despite an apparent loss of faith in world leaders. In Spain, the showdown between Catalonia and Madrid is escalating as Spanish lawmakers vote to withdraw aspects of self-rule from the wealthy northeastern province. In the U.K., the Brexit negotiations are floundering, causing the Labour Party to raise the alarm against a "no deal" exit from the European Union. In Brazil, the interim president is under legislative scrutiny for corruption; in South Africa, the ruling party is grasping at government employees' pension funds to keep a struggling state airliner afloat. However, policymakers are not always as incompetent as investors (and the financial media) like to think. In China, President Xi Jinping has turned himself into the highest authority since Mao Zedong and Deng Xiaoping. And the country has sprung back from the 2015-16 deflationary spiral so well that financial authorities are tightening financial controls and contemplating interest rate hikes (Chart 1). In Japan, Prime Minister Shinzo Abe has won a two-thirds supermajority in the House of Representatives for the second time, giving him a mandate to continue his "Abenomics" agenda (Chart 2). With unemployment already exceedingly low at 2.8%, Abe could make history. He could rouse the country out of both its deflationary and pacifist slumber in the face of the historic challenges posed by a rising China and multipolar world. Less grandiose, but still highly market-relevant, the U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to hit President Donald Trump's desk by the end of the first quarter of next year. This development is in marked contrast to informal surveys of investors around the world, including at BCA's annual New York Conference last month. The market has hardly reacted to the positive news (Chart 3). Chart 1Real Deposit Rate Is Negative Chart 2Shinzo Abe Does It Again Chart 3Market Still Doubts Trump In this report, we focus on China and the United States. Our recent assessments of Spain and Japan are on track - the former is an overstated risk, the latter an opportunity now largely priced in.1 It is the "G2" that poses the biggest risk of negative surprises over the next 12 months. First Take On The Party Congress China's nineteenth National Party Congress will conclude just as we go to press. Our assessment of the line-up of the new Politburo and specific changes to the Communist Party's constitution will have to wait for a Special Report next week. We can still draw some preliminary conclusions, however.2 First, Xi Jinping's induction into the Communist Party's constitution, under the slogan "Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era," makes him second only to Chairman Mao as a philosophical guide in the party. This says as much about the spirit of the age as about Xi's (formidable) power. It is an era of "charismatic authority," in which populations are restless and political elites either adopt populist tactics (like Xi), or are populists themselves.3 The Communist Party wanted a new Mao and Xi obliged them. Why is this the case in China? The Communist Party has based its legitimacy on economic growth since Deng Xiaoping came to power in 1978. But economic growth is slowing as a result of irreversible, secular trends. The party needs a new source of legitimacy, and Xi has offered a "synthesis" of Mao and Deng: he promises to preserve the Communist regime above all, yet also to continue Deng's pragmatic use of the market to strengthen the fundamentally socialist economy. Thesis, antithesis, synthesis. Xi's focus remains on power, namely reinforcing China's ruling institutions and asserting its international influence.4 We will take the latter first, as it is the biggest source of change in the world and a key driver of market-relevant geopolitical risk. Multipolarity Chart 4U.S. Decline Vis-à-Vis China The most important takeaway from the party congress is that it perfectly captures our long-term investment theme of global multipolarity. This describes a world run by multiple independent powers as American power declines in relative terms.5 The erosion of U.S. global dominance is most striking in relativity to China (Chart 4).6 Xi has declared that it is time for China to take "center stage" in world affairs. He also modified an earlier goal to say that China will become a "leading global power" by 2050. China is unified under a single leader and a single party, its economy has been robust, and it is therefore feeling confident in its ability to take action in the global arena. The implications are disruptive over the long run: Assertive foreign policy will continue: China will continue with the bolder foreign policy it has demonstrated over the past ten years. China's military expenditures, which are widely believed to be larger than official statistics reveal, will continue to drive regional security dynamics (Chart 5).7 Maritime tensions still matter: China's "core interests" in separatist-prone regions like Tibet and Xinjiang have become more secure, whereas its interests in Taiwan and the South China Sea are less secure because of increasing pushback from the U.S. and its allies. The South China Sea is still a potential flashpoint as it governs the vital supply lines of China's major regional rivals and $4 trillion in trade (Diagram 1).8 Diagram 1The South China Sea: Still A Risk Economic statecraft is the new norm: China is using its economic heft to fill spaces left void by the United States. The U.S. is perceived across the region as relying increasingly on "hard power," ceding ground to China to create "soft power" relationships through trade and investment. Beijing is launching its own system of multilateral trade and finance that could someday operate as a sphere of influence in Asia outside of U.S.-led international norms - such as Xi's "Belt and Road Initiative," which was also enshrined in the Communist Party constitution (Chart 6). Moreover, Beijing is using its growing economic leverage to achieve political goals, having imposed informal sanctions on Japan, both Koreas, Vietnam, Taiwan and others in recent years.9 Chart 5China Raises Asian Security Fears Chart 6China's Belt And Road Club These trends were all reaffirmed at the party congress, confirming our view that U.S.-China frictions are a serious geopolitical risk. Fortunately, neither Xi nor China is a loose cannon. Most of these trends are developing over the long run. With Xi Jinping overseeing an extensive overhaul of the People's Liberation Army, there is less reason to suppose that the PLA will act aggressively independent of civilian leadership (as was a concern under the previous administration). One would also think that a transition across the armed forces is an inopportune time to instigate conflicts. Notably, the Xi administration has also tactically adopted a milder diplomatic approach since President Trump's coming to power with an arsenal of threats aimed at China. This approach is evident with Japan, India, and Southeast Asian neighbors. Trump's perceived belligerence gives China the ability to play a mediating role and promote trade and investment with other powers looking to hedge against the U.S. Finally, Beijing appears to have domestic unrest in check, at least for now. Public security disturbances have been elevated in the wake of the global financial crisis, but have declined since 2011 (Chart 7). This is a positive sign for markets because China will have greater ability to push domestic reforms - and less reason to be aggressive abroad - if unrest is subdued. Official statistics suggest that China spends about as much on public security as national defense, revealing a key vulnerability to the state (Chart 8). Chart 7Domestic Unrest Down, Though Not Out Chart 8Domestic Unrest A Risk To The State Bottom Line: The party congress has highlighted China's rising global influence. This ultimately creates higher geopolitical risk, especially in U.S.-China relations. China also has greater control over domestic factors that could instigate conflicts, at least for the time being. Thus the U.S.'s next moves will be critical. Reform And Opening Up The second major takeaway is that the Xi administration is still officially committed to the reform agenda laid out in the 2012 party congress, the 2013 Third Plenum, and the supply-side structural reforms announced in 2015. Xi's work report calling for "sustained and sound" growth is a nod to the need to reduce capital intensity and systemic risks. He also said that supply-side structural reform would be the "main task" for economic policy for the foreseeable future. His economic reform slogans also made it into the party's constitution. Significantly, there are no more GDP targets beyond 2020. Broadly, we have defined Xi's reform agenda as a combination of centralizing control, improving governance, and streamlining the economy.10 Centralization is not necessarily market-positive, but under the Xi administration it has coincided with efforts to improve governance (fighting corruption, reining in provincial freewheeling, and reducing pollution). This is a sign of growing policy responsiveness to public demands and as such is marginally positive. The clear takeaway from the congress is that the anti-corruption campaign will be institutionalized across the country through new "supervisory commissions." This campaign should improve the legitimacy of the party-state and the implementation of central government policies. We have always been skeptical of progress on structural economic reforms, but the party congress marks a new phase in the political cycle: Xi is in a better position than any Chinese leader since Deng Xiaoping to launch significant reforms. He has increased his political capital massively over the past few years, as illustrated by the dotted line in our "J-Curve of Structural Reform" (Diagram 2). Cyclically, the next opportunity for China to undertake bold reforms may not occur until 2027. Hence it is either now or never for reform. The policy focus is supposed to push along China's economic transition from investment- to consumption-led growth (Chart 9). Importantly, Xi declared that the "principle contradiction" in Chinese society has changed since the 1980s. The principle contradiction used to be that of a poor, economically and technologically "backward" country trying to meet the basic material needs of the population. Now the contradiction is that of an "imbalanced" and under-developed economy trying to provide people with "better lives." These goals can be put into perspective by comparison with South Korea, which reveals both how far China has come and how far it has to go (Chart 10). Xi's statement points to an overall shift in policy toward addressing imbalances and improving quality of life. Diagram 2The J-curve Of Structural Reform Chart 9Changing The Economic Model Chart 10From Basic Needs To 'Better Lives' To put a time frame on many of these reforms, Xi created a new long-term deadline of 2035 to become a fully "modernized" economy, which is smack in the middle of the country's previously declared two "centenary goals" of 2020 (middle income status) and 2050 (global prominence). The interim deadline includes a target for narrowing regional and income disparities. Wealth inequality in China has become extreme and ultimately poses a threat to the regime (Chart 11). Such a goal will require serious redistributionist policies as well as ongoing efforts to build a better social safety net. As expected, Xi reaffirmed China's embrace of globalization, claiming that the door of trade "will only open wider." The financial sector is likely to be at the forefront of any new opening measures - top financial officials claim that a package of reforms is forthcoming. The developed world has begun to doubt China's commitment to financial reform given the closing of the capital account last year and other negative trends, like the persistently low (and falling) share of foreign banks in domestic lending. Only recently have foreign banks begun lending again after withdrawing funds in preceding years (Chart 12). Foreign ownership of domestic equities, which is tightly controlled, has also fallen in importance (Chart 13). Chart 11Inequality: A Liability For The Party Chart 12Banks Shying Away From China Chart 13Foreign Investors Limited In China The centralization of power should speed up policy implementation, but it also raises risks. The important thing is whether we see hard evidence that Xi's "absolute power" is corrupting absolutely. This would present a new structural risk to the Chinese system, even if markets initially cheered. Why? Because an administrative (as opposed to propagandistic) turn in China in favor of a "cult of personality" as opposed to "collective leadership" would increase the odds of policy mistakes, set off factional struggle in the Communist Party, increase policy uncertainty for the foreseeable future, and jeopardize the smooth transition of power in 2022 ... or whenever "Chairman Xi" outwears his welcome. Therefore, the implementation of policy, the grooming of "heirs apparent," the position of the opposing faction in the party, and the upkeep of rules and norms will be important to monitor - not just after the party congress, but over the next five years. Bottom Line: Xi has reaffirmed formal structural economic goals like consumer-led growth and a commitment to globalization and has signaled that more reforms are in the works. Policy implementation will improve. Stay overweight H-shares within EM equities. However, excessive concentration of power in Xi himself is a serious political risk. It is only a positive in the long term if Xi uses his authority to build institutions rather than personalize them. Principal Contradictions China's declared goals are, of course, riddled with contradictions. As expected, Xi has tried to be everything to everyone. This leaves investors with a number of missing pieces to try to fit together. For example, the slogan indicating Xi's governing philosophy is a revision of Deng Xiaoping's market-oriented slogan, "Socialism with Chinese Characteristics" (Table 1). Xi is announcing that China has entered a "New Era" that will redefine Deng's formulation. Thus, by quoting Deng, he is reaffirming China's need to continue reforming and opening up. But by simultaneously qualifying Deng, he is reasserting the primacy of the state.11 Table 1Xi Jinping Thought What matters are the concrete policies China actually enacts. Nowhere are the contradictions clearer than in the party's constant assurances that it will both intensify reforms and keep the economy stable. Beijing continues to stress that it will deleverage the financial sector, restructure industry, eliminate overcapacity, and fight smog, all without any negative impact to growth. Given the sharp deceleration in the growth of China's monetary aggregates, we expect a significant slowdown in the coming year.12 "Reform" will in large part consist of demonstrating a higher-than-usual tolerance for slower growth so as to impose market discipline. Authorities will, as always, inject further stimulus if necessary to avoid a hard landing. A key risk to global markets, as discussed last week, is that fiscal spending may not offset a crunch in credit growth next year, should one occur. This is increasingly the case because the composition of fiscal spending in China is shifting as the country focuses more heavily on social stability and economic transition. Education, social security, worker training and relocation, and other public services are simply not as capital intensive as building railroads, urban infrastructure, and houses (Chart 14). Moreover, a critical test of the reform-stimulus trade-off will be Beijing's tolerance for failing companies. Bankruptcies have risen over the past year in China, which suggests that market forces are being given wider scope and that the central government is laying down the legal framework to make bankruptcy more acceptable (Chart 15), a notable reform. This is a clear sign of "short-term pain, long-term gain," but it remains to be seen how far it will go. Chart 14China's Fiscal Spending Is Becoming Less Capital Intensive Chart 15Creative Destruction At Long Last? It is also unclear whether failures will be allowed among state-owned enterprises (SOEs), which are the least profitable and most indebted Chinese companies. The future of SOE reform is no clearer than before the congress: Xi promised both to restructure the sector and to enlarge and strengthen it. The principle is in alignment with the Jiang Zemin administration's maxim, "grasp the large, let go of the small," and does not mean that reform is doomed. More than a fourth of SOEs are under water and the government is already committed to cutting the number of centrally administered SOEs in half. There are now several pilot projects for allowing partial privatization, or creating state holding companies, that can be rolled out nationally. And there are a range of perfectly un-strategic sectors (retail, chemicals, real estate, electronics, et al) that have substantial state ownership that could be liquidated. Judging by listed Chinese firms, those that are deemed to be strategic will not likely see their state share diluted much beneath 80% of ownership; yet those that are designated for partial privatization and mixed ownership could see the state share dwindle to less than 10% of ownership (Table 2). This implies that sweeping changes could occur if the government prioritized SOE reform. (This is true despite the fact that the state's hand would still be obtrusive overall.) Table 2Plenty Of Room For Privatization Bottom Line: Deleveraging and bankruptcies are a key aspect of reform but pose headwinds to growth. The profile of China's fiscal spending is changing to become less capital intensive, which will mean less stimulus for China's aging industries if reforms are pursued. This underscores a real risk to Chinese growth, capex, and imports, and hence to EM. There is no clarity on SOE reform, but it would have far-reaching consequences if prioritized in Xi's second term, given his soaring political capital. Tax Blues In The USA: Are Tax Cuts Really Coming? On the other side of the Pacific, investors remain highly skeptical that tax reform is on the legislative menu (Chart 16). This is after both houses of Congress passed their version of the budget resolution, containing reconciliation instructions for tax reform. Once the House of Representatives passes the Senate version of the budget resolution - which we assume will be swift - the reconciliation process will kick off.13 The Senate version of the budget resolution instructs the Senate Committee on Finance and the House Ways and Means Committee to limit the increase in the budget deficit to no more than $1.5 trillion through 2027.14 The resolution also instructed the Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT) to consider "to the greatest extent practicable... the budgetary effects of changes in economic output, employment, capital stock, and other macroeconomic variables resulting from such major legislation." In plain English, this refers to "dynamic scoring," macroeconomic modeling that takes into account the revenue-raising potential of major tax cuts. BCA's Geopolitical Strategy has harped on "dynamic scoring" since last November. The tool is a favorite of Republican legislators when passing tax legislation. It allows them to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. Democrats banned this practice when they took back the Senate in the Obama years, but the GOP promptly re-authorized it in January 2015. Fast forward a year later and two core conclusions of our November 2016 forecast on tax policy are now coming true.15 First, the tax bill will not be revenue neutral, except in the imagination of macroeconomic modeling pursued by Republican economists. The bill will be mildly stimulative, to the tune of $100-150 billion per year over the next decade. The numbers are modest, but given that the U.S. is close to full employment and wage pressures are certain to build up (Chart 17), any additional tax relief is bound to be stimulative for the economy. Chart 16High-Tax Firms Not Outperforming (Yet) Chart 17Inflation Coming Even Without Tax Cuts Second, Republican legislators are not fiscally conservative. The House budget resolution authorizing a $1.5 billion hole in the budget was passed with 18 Republicans dissenting, but 11 of them were from highly-taxed "blue states." Their contention with the bill was not that it would be profligate, but that it would do away with state and local tax deductions in order to pay for the likely $5-$6 trillion price tag. As such, they voted not to make tax cuts less, but rather more, profligate. Going forward, the real threat to the proposed tax bill is in the Senate, where Republicans hold only a slim 52-48 majority. This threat is a surprise, as 12 months ago the question was how a profligate bill would pass the supposedly conservative House. Three risks lurk in the Senate: Alabama: Judge Roy Moore, a highly conservative candidate for the December 12 special election, is holding onto a relatively slim lead against Democrat Doug Jones. A recent Fox News poll shows the two tied in public opinion. Even if the poll is unreliable, other polls suggest that Jones has narrowed the gap to single digits. This is remarkable because Alabama Republicans have defeated their Democrat opponents by an average of 36% in Senate races over the past decade.16 If Moore were to lose, the Republican majority in the Senate would fall to 51. This would leave room for only one defection in passing legislation. The Corker-Flake-McCain Axis: Senators Bob Corker (R - Tennessee), Jeff Flake (R - Arizona), and John McCain (R - Arizona) have all voted in favor of the Senate budget resolution authorizing reconciliation instructions for tax legislation. On that basis, there should be no problem. However, Corker and Flake have announced their retirement, in our view because they plan to challenge President Trump in the 2020 Republican primary. Furthermore, Corker has said in the past that he would not vote for a tax bill that is not revenue neutral. We think that Corker and Flake will ultimately vote for tax cuts, if only because their chances of successfully challenging Trump in 2020 will be higher if they stick to Republican orthodoxy. However, these three Senators are risks to our view as they have the freedom not to care about the 2018 midterms. God: The death of Massachusetts Senator Ted Kennedy on August 25, 2009 greatly changed the fortunes of President Barack Obama, who at the time was enjoying a 60-seat majority in the Senate.17 Democrats failed to move quickly on the Affordable Care Act, assuming that a Democrat would win the special election in staunchly liberal Massachusetts. (If the parallels with Alabama today seem eerie, it is because they are.) But the January 2010 election cost Democrats the 60th seat in a shocking upset. These things can happen again, especially given that the average age of a senator is 103.18 Any one of these factors could reduce the Republican majority in the Senate to 51, forcing President Trump to rely on vociferous critics McCain and Corker. The latter, by the way, is also a likely 2020 primary challenger against Trump. Could a Democrat come to the president's aid? The short answer is yes. The 2001 Economic Growth and Tax Relief Reconciliation Act, the first of two Bush-era tax cuts, passed with 58 votes in favor, including 12 Democrats. Of the 12 that voted with Republicans, only three were from blue states, while the other nine were from red states that President Bush had carried in 2000. The 2003 tax-cut bill, Jobs and Growth Tax Relief Reconciliation Act of 2003, also passed with Democratic support with only 51 votes in favor. Senators Bayh (D - Indiana), Miller (D - Georgia), and Nelson (D - Nebraska), all crossed the aisle. Bayh was facing reelection in 2004, as was Nelson in 2006, in their respective red states, while Zell Miller of Georgia effectively ceased to be a Democrat and endorsed President George W. Bush reelection at the 2004 Republican National Convention. Ominously for today's efforts, John McCain voted against both versions. Given that he is unlikely to campaign again due to terminal cancer, and given his vociferous opposition to President Trump, we have to assume that he will vote against the tax bill as well. Which Democrats could potentially cross the aisle with this year's reconciliation bill? Table 3 lists the 2018 Senate races to watch, particularly the vulnerable Democrats campaigning in red states that President Trump carried in 2016. Particularly vulnerable are Senators Nelson (D - Florida), Donnelly (D - Indiana), McCaskill (D - Missouri), Tester (D - Montana), Heitkamp (D - North Dakota), Brown (D - Ohio), and Baldwin (D - Wisconsin). That makes seven potential votes for the Trump tax cut, plenty of "slack" for the Republicans in Senate to lose one or two votes on the tax bill. Table 32018 Senate Races To Watch As far as the timing of the bill is concerned, we are sticking with our updated view that the end of Q1 2018 is far more likely for passage of tax legislation than the end of 2017. There are simply too many things on the legislative agenda between now and the end of the year, including a potential government shutdown and an immigration fight. Bottom Line: The market remains unconvinced that Republicans can pass tax legislation through Congress. However, the tax process has played out thus far almost exactly as we expected last year (aside from starting later). Republicans have proposed a profligate tax bill and are using dynamic scoring to get it through Congress. Going forward, we think that GOP can afford to lose one or two votes, as it did in 2003 with the highly controversial Bush tax cuts. This is because there are up to seven Democratic Senators who can pick up the slack. 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, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "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, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 7 Xi is also overhauling the armed forces to imitate modern American joint operations and combatant commands (as opposed to the army-centric Soviet system). 8 Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" March 28, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" July 5, 2017, available at gps.bcaresearch.com. 10 See note 4 above. 11 Whether Xi is mentioned specifically, and described as the founder of a school of "Thought," or a lesser "Theory," or something else, will be a notable watchword. 12 Please see note 2 above, "How To Read Xi Jinping's Party Congress Speech," and BCA Emerging Market Strategy Weekly Report, "China: Deflation Or Inflation?" October 4, 2017, available at ems.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 14 Please see S.Con.Res.25, available at congress.gov. 15 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcareserach.com. 16 Current U.S. Attorney General Jeff Sessions, whose retirement from the Senate has prompted the current special election, ran unopposed in 2014 and garnered 97.25% of the vote! 17 Democrats picked up eight seats in the Senate in the watershed 2008 election, boosting their majority to 57, with two Independents caucusing with the Democrats. Shortly after the election, Pennsylvania Republican Arlen Spector changed parties, giving Democrats the 60-seat, filibuster-proof, majority. 18 It is actually 62, but we wanted to make sure you were still reading. Geopolitical Calendar