Geopolitics

Highlights An investment's long-term attractiveness depends on the trade-off between its expected long-term return and its risk of suffering an intermediate loss. On this risk-adjusted basis: Bonds are now less ugly than equities. U.S. T-bonds are more attractive than the average euro area government bond. European equities and U.S. equities are fairly valued against each other... ...but European equities can outperform when euro breakup risk eventually fades. Feature The English poet Samuel Taylor Coleridge coined the term "willing suspension of disbelief" in his Biographia Literaria published in 1817. It describes the sacrifice of reason and logic to believe the unbelievable. Coleridge suggested that if he could instil a "semblance of truth" into a fantastic tale, the reader would suspend judgement about the implausibility of the narrative in order to enjoy it. Today, it feels like financial market prices are relying on the willing suspension of disbelief. At our client meetings, almost everybody disbelieves that current valuations allow developed market equities to generate attractive long-term returns. Yet many investors are willing to suspend this disbelief, at least for the time being. Our own return forecasts justify the disbelief (Chart I-2). In Outlook 2017, Shifting Regimes,1 my colleague and BCA Chief Economist, Martin Barnes, published our long-term nominal return forecasts for the major asset classes. Allowing for market moves since publication, four of those 10-year annualised total returns2 now stand at: Chart I-2Valuation Drives Long-Term Returns Valuation Drives Long-Term Returns Valuation Drives Long-Term Returns European equities3 5.0% U.S. equities4 3.2% U.S. 10-year T-bond 2.3% Euro area 10-year sovereign bond5 1.2% With annual inflation expected at 2%, these numbers imply paltry real returns from mainstream investments over the coming decade. Still, in terms of ranking relative attractiveness, it might appear reasonable to follow the sequence of returns:6 European equities; U.S. equities; the U.S. 10-year T-bond; and then the euro area 10-year sovereign bond. But that sequence would be wrong - at least in the medium term. The key point is that the four investments are not equally risky. For a riskier asset, investors should expect today's price to generate a higher long-term return as compensation for the extra risk of intermediate loss. Put another way, a risky asset must offer a higher long-term return than a less risky asset for an investor to be indifferent between them. If it doesn't, the danger is that the price will adjust (down) at some point until it does. European Equity Valuations Must Allow For Euro Breakup Risk Consider European equities versus U.S. equities. The sovereign bond market is discounting a 5% annual risk of euro break-up (Chart I-3). This shows up as a discount on German bund yields, because in that tail-event a new deutschmark would rise; and a symmetrical premium on Italian BTP yields, because a new lira would fall. But for the aggregate euro area bond, the risk largely cancels out because intra-euro currency redenomination would be zero sum (Chart I-4). Unfortunately, for the aggregate European stock market, the risk does not cancel out. If the euro broke up, European equities would suffer a much greater drawdown than other markets. Recall that at the peak of the euro debt crisis in 2011, the Eurostoxx600 underperformed the S&P500 by 25% in one year (Chart I-5). In an outright break-up, the underperformance would almost certainly be worse, let's conservatively say 30%. So assuming a 5% annual risk, European equities must compensate with a valuation discount which allows a 1.5% excess annual return over U.S. equities. Chart I-3The Bond Market Is Discounting##br## A 5% Risk Of Euro Breakup... The Bond Market Is Discounting A 5% Risk Of Euro Breakup... The Bond Market Is Discounting A 5% Risk Of Euro Breakup... Chart I-4...Based On The Sovereign Yield Spread##br## Between Italy And Germany ...Based On The Sovereign Yield Spread Between Italy And Germany ...Based On The Sovereign Yield Spread Between Italy And Germany Chart I-5In The Euro Crisis, The Eurostoxx ##br##Underperformed By 25% In The Euro Crisis, The Eurostoxx Underperformed By 25% In The Euro Crisis, The Eurostoxx Underperformed By 25% There is also the issue of the post-2016 bailout rules for European banks. At a stroke, the Bank Recovery and Resolution Directive (BRRD) has made European bank equity investment more risky. In the event of a bank failure, investors must now suffer the first losses - including full wipe-out - before governments can step in. Combining this with the risk of euro breakup, the 1.8% excess annual return that we expect from the Eurostoxx600 versus the S&P500 makes European equity valuations look fair, rather than attractive, on a relative risk-adjusted basis. That said, the good news is that if the risk of euro area breakup gradually fades, it would permit a healthy re-rating of the Eurostoxx600 versus the S&P500. For example, if the annual risk of breakup declined from 5% to 1%, it would equate to a 12% outperformance. But as the greatest political risk to the euro now emanates from Italy - and not the upcoming French Presidential Election - we recommend playing this re-rating opportunity closer to, or after, Italy's next general election.7 Equity Valuations Reliant On "Willing Suspension Of Disbelief" Now consider equities versus bonds. An expected 3.2% annual return from the S&P500 versus a 2.3% 10-year T-bond yield implies an ex-ante 10-year equity risk premium (ERP) of just 0.9% (Chart I-6). This is significantly lower than the 135-year average of 5% and even the post war average of 2.5%8 (Chart of the Week). Chart of the WeekThe Ex-Ante Equity Risk Premium Is Close To Zero The Ex-Ante Equity Risk Premium Is Close To Zero The Ex-Ante Equity Risk Premium Is Close To Zero Chart I-6In The U.S., The Expected 10-Year Return From Equities And Bonds Is Now Almost The Same In The U.S., The Expected 10-Year Return From Equities And Bonds Is Now Almost The Same In The U.S., The Expected 10-Year Return From Equities And Bonds Is Now Almost The Same What can justify the "willing suspension of disbelief" that permits today's abnormally low ERP? There are three arguments. All have Coleridge's "semblance of truth" but are ultimately flawed. Chart I-7In The 1970s Inflation Scare, Equities##br## Suffered Much More Than Bonds In The 1970s Inflation Scare, Equities Suffered Much More Than Bonds In The 1970s Inflation Scare, Equities Suffered Much More Than Bonds First, it is argued that the ERP should be low because bonds have become more risky. With 10-year bond yields so low, bond prices have limited upside but substantial downside. The problem with this argument is that equities are a much longer duration asset than a 10-year bond, so if inflation did take hold, equities would suffer the much greater drawdown - as they did in the 1970s (Chart I-7). Another counterargument is that bond yields have been this low on previous occasions in the past 135 years, but on those previous occasions the ex-ante ERP was not as depressed as it is today. Second, it is argued that the ERP should be low because central banks now have a tried and tested weapon - QE - which they can pull out at the slightest sign of trouble. Empirically, it might be true that QE did compress the ERP. But theoretically, it shouldn't. Even Ben Bernanke told us at our 2015 New York Conference that QE is nothing more than a signalling mechanism for interest rate policy. So it works by compressing bond yields rather than the ERP. In this sense, justifying a low ERP with QE is a worry rather than a hope. Third, and most recently, it is argued that the surprise arrival of the Trump administration is a game changer for investments - structurally positive for equities, structurally negative for bonds. The jury is out on this. But given the speed of market moves, our sense is that is the hope of fast-moving momentum traders. Slow-moving value investors are still on the side lines, waiting to see what - if anything - will really change. Mr. Market Is Little Short Of Silly In his 1949 seminal work, The Intelligent Investor Benjamin Graham, the grandfather of value investing, introduced us to a whimsical character called Mr. Market. Every day, Mr. Market quotes a price for your investments, at which you can buy or sell. Sometimes, Mr. Market's idea of value seems plausible. At other times: "Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you little short of silly." The point of Graham's allegory is that investors should not cheerlead the market come what may. Mr. Market will not always quote you an attractive price; sometimes he will quote you a very unattractive price (Chart I-8). Chart I-8Mr. Market Will Not Always Quote You An Attractive Price Markets Suspended In Disbelief Markets Suspended In Disbelief "At which the long-term investor certainly should refrain from buying and probably would be wise to sell." Today, when we see the ugly long-term returns offered by Mr. Market and we risk-adjust for potential drawdowns, we conclude: Bonds are now less ugly than equities. U.S. T-bonds are more attractive than the average euro area government bond. European equities and U.S. equities are fairly valued against each other, but European equities can outperform when euro breakup risk eventually fades. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on December 20, 2016 and available at www.bcaresearch.com 2 Nominal local currency returns including income. 3 Outlook 2017 showed "Other (non-U.S.) developed equities" but this aligns with our forecast for European equities. 4 Since Outlook 2017 was published, equity markets are up around 5%. So 10-year return forecasts have been reduced by around (5/10) = 0.5%. 5 Euro area weighted average 10-year yield weighted by sovereign issue size. 6 This assumes investors can cheaply hedge currency exposure, as is the case now. 7 Please see the Geopolitical Strategy Service Weekly Report titled "Political Risks Are Understated In 2018", dated April 12, 2017 and available at gps.bcaresearch.com 8 In this report we define the ex-ante ERP at any point in time as the Shiller P/E's implied prospective 10-year equity return (see Chart 8) less the 10-year bond yield. Fractal Trading Model* This week's trade is to go long the sugar number 11 futures contract on the NYB-ICE exchange, with a profit target of 7%. Alternatively, a more hedged position is long sugar / short aluminium with a profit target of 10%. 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-9 Long Sugar Long Sugar Chart I-10 Long Sugar Vs. Aluminium Long Sugar Vs. Aluminium * 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 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The Trump-Xi summit offers hopeful signs that the two sides are mending once-severely tested bilateral relations. The risk of escalation in trade tensions has declined. President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to show to his working-class electorates, while Xi's primary objective is to avoid the "Thucydides trap". This offers space for compromises. Unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Feature The summit between President Donald Trump and President Xi Jinping in Mar-a-Lago last week was hailed by both sides as an "ice breaking" success. Even though no substantive details have been offered, the two countries have formulated a new mechanism for senior-level dialogue, and established a 100-day process for addressing bilateral trade frictions. The risk still exists that Trump could unilaterally impose punitive measures against Chinese goods with his administrative powers, and it is overly simplistic to draw too much information from one particular event. However, the Trump-Xi summit confirms a developing trend: that some of President Trump's highly controversial remarks on his campaign trail are being quickly rolled back. The risk of escalating trade tensions between the world's two largest economies has on margin abated. Trump Goes Mainstream? America's China policy under recent administrations can best be described as "congagement" - an ambiguous mixture of containment and engagement by varying degrees. Trump's remarks on the campaign trail and in his early days in office suggested he was mainly interested in confrontation. But the Trump-Xi summit, along with some recent developments, implies that Trump's China policy is coming back to the middle ground, at least for now. After setting off a fierce firestorm on the Taiwan issue late last year, Trump reaffirmed the "One China" policy in a February phone call with President Xi, re-stating long-standing U.S. policy and easing a key source of diplomatic tensions. Taiwan is still re-emerging as a source of risk.1 But it is unquestionably positive in the short-term that Trump backed away from his initial, highly provocative approach. Treasury Secretary Steven Mnuchin stated in February that the Trump administration will stick to the existing statutory process in judging whether China manipulates its currency, a marked departure from Trump's repeated campaign pledges. It is almost certain that China will not be named a currency manipulator in the U.S. Treasury's upcoming semi-annual assessment due later this week.2 In his visit to Beijing last month, Secretary of State Rex Tillerson used Chinese verbiage to characterize the U.S.-China relationship. This verbiage was not repeated by other officials during Xi's visit to Florida, so it is unclear whether it signals the Trump administration's adoption of China's idea of a "new model of great power relations." Nonetheless, it is a drastic change from Tillerson's aggressive remarks at his congressional confirmation hearings, when he suggested blockading Chinese-built islands in the South China Sea. Separately, Secretary of Defense James Mattis, on his first trip abroad to Japan and South Korea, said he did not anticipate any "dramatic military moves" in the South China Sea. More recently, Steve Bannon, White House Chief Strategist, was removed from the National Security Council. It is futile to try to understand all the internal power struggles within the new administration. Nevertheless, Bannon's departure from the NSC is probably a positive development, viewed through the Chinese lens. Bannon not long ago openly identified China as a major threat to the U.S. and predicted a war in the South China Sea as inevitable. In short, President Trump's summit with President Xi marked continued "mainstreaming" of his China policy. Some strong anti-China rhetoric from him and his inner circle has apparently been sanded off, setting the stage for constructive negotiations with Beijing. Can China Accommodate? The restructuring of the Sino-U.S. comprehensive dialogue and the declaration of a 100-day process for addressing economic frictions are probably the most tangible outcomes from the discussions between the two leaders during the summit. Further detail deserve close attention in order to map out how relations between the world's two largest economies will evolve in the near future. In our view, China is likely to make concessions and avoid confrontations. First, trade appears to be front and center in President Trump's grand dealings with China, an important change compared with previous U.S. administrations that also focused heavily on values and ideological issues, such as democracy, freedom of speech and human rights. From China's perspective, the government has a lot more flexibility in making concessions on trade and economic fronts than in dealing with ideological differences. In the past, China has almost always yielded to U.S. pressure on trade-related issues. For instance, China depegged the RMB from the dollar in 2005 and allowed the RMB to continue to appreciate after the global economic recovery began, all under American political pressure. Chinese senior officials routinely led massive commercial delegations touring the U.S. with big procurement orders for everything from aircraft to agricultural goods in order to address American complaints. Both the U.S. and China understand that bilateral trade imbalances favor the U.S. in the event of an all-out trade war, which China will try its best to avoid. Strategically, President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to deliver on promises to his working-class electorate, while Xi is more interested in establishing a cooperative and productive strategic standing with the world's sole superpower. Xi's primary objective is to avoid the "Thucydides trap" - the likelihood of conflict between a rising power and a currently dominant one - by convincing the U.S. to grant China greater global sway. In this vein, Trump's withdrawal from the Trans Pacific Partnership (TPP) has been viewed as an important positive development from Xi's perspective, and it is likely that Beijing will offer incentives to further discourage President Trump to "pivot to Asia". It is already rumored that Beijing has drafted investment plans in the U.S. that could create 700,000 jobs, as well as further opening up agricultural goods imports and financial market access. We suspect these deals will be announced during the 100-day negotiation period, which should give Trump a much-needed boost in his approval ratings. Economically, Trump's resentment of China's trade practices is based on the old growth model that the country no longer adheres to. Trump's version of Chinese manufacturers - "sweat shops" operating in "pollution heaven" heavily dependent on state subsidies and a cheap currency - is increasingly out of touch with today's reality, as discussed in detail in a previous report.3 In a nutshell, Chinese manufacturers have quickly climbed up the value-add ladder due to rapidly rising labor costs, and pollution control has become an urgent social issue. Meanwhile, the RMB has been under constant downward pressure in recent years, and the Chinese authorities may welcome coordinated efforts to weaken the dollar and support the yuan. In short, China will not find it too painful to accept Trump's terms and conditions, as the "sick parts" of the Chinese economy will inevitably be cleansed regardless of pressure from the U.S. The risk to this view is that Trump finds China's progress too slow and grows impatient. Previous American presidents have come to accept China's gradualism and have demurred from punitive measures. Trump, with his populist base and promises, may at some point find it politically expedient to exact a price on China for failing to deliver the desired results on his electoral timeline. Across the board tariffs on Chinese imports are unlikely, but highly symbolic sanctions and anti-dumping measures remain distinct possibility. The End Game Of Sino-U.S. Trade Imbalances However, any immediate concessions from China on trade will do little to fundamentally change the U.S.'s external imbalances. It is well known that a country's current account balance is the residual of its national savings and domestic capital spending. Therefore, it is unrealistic to expect a meaningful reduction in the country's current account deficit without lifting America's domestic savings rate. Chart 1 shows the chronic nature of America's external deficit. It is worth noting that the "Nixon shock" in 1971 - the policy package of closing the gold window and imposing across-the-board tariffs on imports - was triggered when the U.S. was on track to have its first annual trade deficit since the 19th century. Fast forward 46 years later, various attempts by American administrations have failed to rescue the deteriorating trend. Many countries over the years such as Germany, Japan and newly-industrialized economies in Asia were all singled out as conducting unfair trade practices with the U.S., but none of the bilateral and multi-lateral efforts were effective with lasting impact. A fundamental change in global trade over the past four decades has been the rapid industrialization of China. In essence, China has become the final point of an increasingly integrated global assembly line, and therefore America's chronic deficit has been transferred from other countries to China. Chart 2 shows China's surplus with the U.S. has ballooned, while other countries' surpluses have dwindled. This has put China squarely under the spotlight, replacing previous scapegoats. Chart 1America's Secular Deficit... America's Secular Deficit... America's Secular Deficit... Chart 2... From Changing Sources ... From Changing Sources ... From Changing Sources From China's perspective, the country will continue to run a surplus with the U.S. so long as it remains in the most manufacturing-intensive phase of its development curve, though the product mix will continue to shift from lower-value-added goods to higher-value-added ones. Meanwhile, the Chinese corporate sector will shift production capacity to even lower cost countries, similar to what Japan, Hong Kong and Taiwan have done in relation to China since the early 1980s when China began to open up. Already, China's direct investment to Vietnam has surged in recent years, which partially explains the sharp increase in Vietnam's trade surpluses with the U.S. (Chart 3). In fact, Vietnamese trade surplus with the U.S. account for 15% of the country's GDP, even though its overall trade balance is barely positive. This means that America's demand for cheap consumer goods is the main driving forces for its deficit, rather than any particular country's unfair trade practices. The fact is that the U.S. has moved beyond industrialization and become a post-industrial society, where the service sector generates more wealth than the manufacturing sector. China's shrinking share of imports from the U.S. is the mirror image of America's shrinking share of the manufacturing sector in the overall economy (Chart 4). Furthermore, the self-imposed restrictions on some high-tech goods exports to China further limits American firms growth potential, as this is the most competitive segment of America's manufacturing sector in the global market. Without removing these restrictions, it is unrealistic to expect a material increase in sales to China. Chart 3The "China Factor" In Vietnam's##br## Growing Trade Surpluses The "China Factor" In Vietnam's Growing Trade Surpluses The "China Factor" In Vietnam's Growing Trade Surpluses Chart 4America's Deindustrialization And ##br##Shrinking Market Share In China America's Deindustrialization And Shrinking Market Share In China America's Deindustrialization And Shrinking Market Share In China For now, the Trump-Xi summit offers hopeful signs that the two sides are mending severely tested bilateral relations and that the risk of escalation in trade tensions has declined. Trump may adopt a "good cop / bad cop" strategy that creates greater volatility. Longer term, unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Imposing tariffs on Chinese imports only pushes Chinese surpluses to other less-competitive countries; it does not bring jobs back to the U.S. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The RMB: Back In The Spotlight," dated March 16, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global political risks are understated in 2018; U.S. policy will favor the USD, as will global macro trends; Trump's trade protectionism will re-emerge; China will slow, and may intensify structural reforms; Italian elections will reignite Euro Area breakup risk. Feature In our last report, we detailed why political risks are overstated in 2017.1 First, markets are underestimating President Trump's political capital when it comes to passing his growth agenda. Second, risks of populist revolt remain overstated in Europe. Third, political risks associated with Brexit probably peaked earlier this year. Next year, however, the geopolitical calendar is beset with potential systemic risks. First, we fear that President Trump will elevate trade to the top of his list of priorities, putting fears of protectionism and trade wars back onto the front burner. In turn, this could precipitate a serious crisis in the U.S.-China relationship and potentially inspire Chinese policymakers to redouble their economic reforms - so as not to "let a good crisis go to waste." That, in turn, would create short-term deflationary effects. Meanwhile, we fear that investors will have been lulled to sleep by the pro-market outcomes in Europe this year. The series of elections that go against populists may number seven by January 2018 (two Spanish elections, the Austrian presidential election, the Dutch general election, the French presidential and legislative elections, and the German general election in September). However, the Italian election looms as a risk in early 2018 and investors should not ignore it. Investors should remain overweight risk assets for the next 12 months. Our conviction level, however, declines in 2018 due to mounting geopolitical risks. Mercantilism Makes A Comeback Fears of a trade war appear distant and alarmist following the conclusion of the Mar-a-Lago summit between U.S. President Donald Trump and his Chinese counterpart Xi Jinping. We do not expect the reset in relations to last beyond this year. Trump has issued a "shot across the bow" and now the two sides are settling down to business - but investors should avoid a false sense of complacency.2 Investors should remember that candidate Trump's rhetoric on China and globalization was why he stood out from the crowd of bland, establishment Republican candidates. Despite the establishment's tenacious support for globalization, Americans no longer believe in the benefits of free trade, at least not as defined by the neoliberal "Washington Consensus" of the past two decades (Chart 1). We take Trump's views on trade seriously. They certainly helped him outperform expectations in the manufacturing-heavy Midwest states of Michigan, Pennsylvania, and Wisconsin (Chart 2). And yet, Trump's combined margin of victory in the three states was just 77,744 votes -- less than 0.5% of the electorate of the three states! That should be enough to keep him focused on fulfilling his campaign promises to Midwest voters, at least if he wants to win in 2020.3 Chart 1America Belongs To The Anti-Globalization Bloc Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chart 2Protectionism Boosted Trump In The Rust Belt Protectionism Boosted Trump In The Rust Belt Protectionism Boosted Trump In The Rust Belt In 2017, Trump's domestic agenda has taken precedent over international trade. The president is dealing with several key pieces of legislation, including the repeal and replacement of the Affordable Care Act, comprehensive tax reform, the repeal of Obama-era regulations, and infrastructure spending. However, there is considerable evidence that trade will eventually come back up: President Trump's appointments have favored proponents of protectionism (Table 1) whose statements have included some true mercantilist gems (Table 2). Table 1Government Appointments Certifying That Trump Is A Protectionist Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Table 2Protectionist Statements From The Trump Administration Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Secretary of Treasury Steven Mnuchin, who is not known as a vociferous proponent of protectionism, prevented the G20 communique from reaffirming a commitment to free trade at the March meeting of finance officials in Baden-Baden, Germany.4 Such statements were staples of the summits over the past decade. The Commerce Department - under notable trade hawk Wilbur Ross - looks to be playing a much more active role in setting the trade agenda under President Trump. Ross has already imposed a penalty on Chinese chemical companies in a toughly worded ruling that declares, "this is not the last that bad actors in global trade will hear from us - the games are over." He is overseeing a three-month review of the causes of U.S. deficits, planning to add "national security" considerations to trade and investment assessments, proposing a new means of collecting duties in disputes, and encouraging U.S. firms to bring cases against unfair competition. Ross is likely to be joined by a tougher U.S. Trade Representative (who has historically been the most important driver of trade policy in the executive branch). In addition, we believe that Trump's success on the domestic policy front, in combination with the global macro environment, will lead to higher risk of protectionism in 2018. There are three overarching reasons: Domestic Policy Is Bullish USD: We do not know what path the White House and Congress will take on tax reform. We think tax reform is on the way, but the path of least resistance may be to leave reform for later and focus entirely on tax cuts in 2017. Whatever the outcome, we are almost certain that it will involve greater budget deficits than the current budget law augurs (Chart 3). Even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows (Chart 4). This will perpetuate the dollar bull market. Chart 3Come What May, Trump Will Increase The Budget Deficit Come What May, Trump Will Increase The Budget Deficit Come What May, Trump Will Increase The Budget Deficit Chart 4A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation Chinese Growth Scare Is Bullish USD: At some point later this year, Chinese data is likely to decelerate and induce a growth scare. Our colleague Yan Wang of BCA's China Investment Strategy believes that the Chinese economy is on much better footing than in early 2016, but that the year-on-year macro indicators will begin to moderate.5 This could rekindle investors' fears of another China-led global slowdown. Meanwhile, Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally on the interbank system. The seven-day repo rate, a key benchmark for Chinese lending terms, has surged to its highest level in two years, according to BCA's Foreign Exchange Strategy. It could surge again, dissuading small and medium-sized banks from bond issuance (Chart 5). Falling commodity demand and fear of another slowdown in China will weigh on EM assets and boost the USD. European Political Risks Are Bullish USD: Finally, any rerun of political risks in Europe in 2018 will force the ECB to be a lot more dovish than the market expects. With Italian elections to be held some time in Q1 or Q2 2018 - more on that risk below - we think the market is getting way ahead of itself with expectations of tighter monetary policy in Europe. The expected number of months till an ECB rate hike has collapsed from nearly 60 months in July 2016 to just 20 months in March, before recovering to 28 months as various ECB policymakers sought to dampen expectations of rate hikes (Chart 6).6 In addition, our colleague Mathieu Savary of BCA's Foreign Exchange Strategy has noted that a relationship exists between EM growth and European monetary policy (Chart 7), which suggests that any Chinese growth scares would similarly be euro-bearish and USD-bullish.7 Chart 5Interbank Volatility Will ##br##Dampen Chinese Credit Growth Interbank Volatility Will Dampen Chinese Credit Growth Interbank Volatility Will Dampen Chinese Credit Growth Chart 6Market Is Way Ahead Of ##br## Itself On ECB Hawkishness Market Is Way Ahead Of Itself On ECB Hawkishness Market Is Way Ahead Of Itself On ECB Hawkishness Chart 7EM Spreads, ECB Months-To-Hike: ##br##Same Battle EM Spreads, ECB Months-To-Hike: Same Battle EM Spreads, ECB Months-To-Hike: Same Battle The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. There are two parallels that investors should be aware of: 1971 Smithsonian Agreement - President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."8 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening a reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table.9 Economists in the cabinet opposed the surcharge, fearing retaliation from trade partners, but policymakers favored brinkmanship.10 The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. 1985 Plaza Accord - The U.S. reached for the mercantilist playbook again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 8). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that Americans were serious about tariffs. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 9). Chart 8Dollar Bull Market And ##br## Current Account Balance Dollar Bull Market And Current Account Balance Dollar Bull Market And Current Account Balance Chart 9The U.S. Got What It ##br##Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism as a negotiating tool in recent history. In fact, Trump's Trade Representative, the yet-to-be-confirmed Robert Lighthizer, is a veteran of the latter agreement, having negotiated it for President Ronald Reagan.11 Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. The problem is that 2018 is neither 1971 nor 1985. The Trump administration will face three constraints to using currency devaluation to reduce the U.S. trade imbalance: Chart 10Globalization Has Reached Its Apex Globalization Has Reached Its Apex Globalization Has Reached Its Apex Chart 11Global Protectionism Has Bottomed Global Protectionism Has Bottomed Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that engineers structural bull markets in the euro and RMB respectively. For Europe, the risk is that peripheral economies may not survive a back-up in yields. For China, monetary policy tightness would imperil the debt-servicing of its enormous corporate debt horde. Apex of Globalization: U.S. policymakers could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 10), average tariffs appear to have bottomed (Chart 11), and the number of preferential trade agreements signed each year has collapsed (Chart 12). Temporary trade barriers have ticked up since 2008 (Chart 13). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Geopolitics: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. is still involved in European defense, its geopolitical relationship with China is hostile. What happens when the Smithsonian/Plaza playbook fails? We would expect the Trump administration to switch tactics. Two alternatives come to mind: Protectionism: As the Nixon surcharge demonstrates, the U.S. president has few legal, constitutional constraints to using tariffs against trade partners.12 As the Trump White House grows frustrated in 2018 with the widening trade imbalance, it may reach for the tariff playbook. The risk here is that retaliation from Europe and China would be swift, hurting U.S. exporters in the process. Dovishness: There is a much simpler alternative to a global trade war: inflation. Our theory that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation and growth pick up. But what if the Fed decides to respond to higher nominal GDP growth by hiking rates more slowly? This could be the strategy pursued by the next Fed chair, to be in place by February 3, 2018. We do not buy the conventional wisdom that "President Trump will pick hawks because his economic advisors are hawks" for two reasons. First, we do not know that Trump's economic advisors will carry the day. Second, we suspect that President Trump will be far more focused on winning the 2020 election than putting a hawk in charge of the Fed. Chart 12Low-Hanging Fruit Of Globalization Already Picked Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chart 13Temporary Trade Barriers Ticking Up Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Bottom Line: Putting it all together, we expect that U.S. trade imbalances will come to the forefront of the political agenda in 2018. This will especially be the case if the USD continues to rally into next year, contributing to the widening of the trade deficit. We expect any attempt to reenact the Smithsonian/Plaza agreements to flame out quickly. America's trade partners are constrained and unable to appreciate their currencies against the USD. This could rattle the markets in 2018 as investors become aware that Trump's mercantilism is real and that chances of a trade war are high. On the other hand, Trump may take a different tack altogether and instead focus on talking down the USD. This will necessitate a compliant Fed, which will mean higher inflation and a weaker USD. Such a strategy could prolong the reflation trade through 2018 and into 2019, but only if the subsequent bloodbath in the bond market is contained. China Decides To Reform Presidents Trump and Xi launched a new negotiation framework on April 6 that they will personally oversee, as well as a "100 Day Plan" on trade that we expect will result in a flurry of activity over the next three months. One potential outcome of the meeting is a rumored plan for massive Chinese investment into the U.S. that could add a headline 700,000 jobs, complemented with further opening of China's agricultural, automotive, and financial sectors to U.S. investment and exports. Investors may be fêted with more good news, especially with President Trump slated to visit China before long. President Trump, a prominent China-basher, may decide that the deals he brings home from China will be enough to convince the Midwest electorate that he has gotten the U.S. a "better deal" as promised. This would enable him to stabilize China relations in order to focus on other issues, as all presidents since Reagan have done. However, we doubt that the Sino-American relationship can be resolved through short-term trade initiatives alone. There is too much distrust, as we have elucidated before.13 The 100-day plan is a good start but it carries an implicit threat of tariffs from the Trump administration if China fails to follow through; and China is not likely to give Trump everything he wants. Moreover, strategic and security issues are far from settled, despite some positive gestures. As such, we expect both economic and geopolitical tensions to resurface in 2018. Meanwhile Chinese policymakers may decide to use tensions with the U.S. as an opportunity to redouble efforts towards structural reforms at home. Since the Xi Jinping administration pledged sweeping pro-market reforms in 2013, the country has shied away from dealing with its massive corporate debt hoard (Chart 14) and has only trimmed the overcapacity in sectors like steel and coal (Chart 15). It fears incurring short-term pain, albeit for long-term gain. However, if Beijing can blame any reform-induced slowdown on the U.S. and its nationalist administration, it will make it easier to manage the political blowback at home, providing a means of rallying the public around the flag. Chart 14China's Corporate Debt Pile Still A Problem... China's Corporate Debt Pile Still A Problem... China's Corporate Debt Pile Still A Problem... Chart 15...And So Is Industrial Overcapacity ...And So Is Industrial Overcapacity ...And So Is Industrial Overcapacity China has, of course, undertaken significant domestic reforms under the current administration. It has re-centralized power in the hands of the Communist Party and made steps to improve quality of life by fighting pollution, expanding health-care access, and loosening the One Child policy. These measures have long-term significance for investors because they imply that the Chinese state is responsive to the secular rise in social unrest over the past decade. The political system is still vulnerable in the event of a major economic crisis, but the party's legitimacy has been reinforced. Nevertheless, what long-term investors fear is China’s simultaneous backsliding on key components of economic liberalization. Since the global financial crisis, the government has adopted a series of laws that impose burdens on firms, especially foreign and private firms, relating to security, intellectual property, technology, legal (and political) compliance, and market access. Moreover, since the market turmoil in 2015-16, the government has moved to micromanage the country’s stock market, capital account, banking and corporate sectors, and Internet and media. The general darkening of the business environment is a major reason why investors have not celebrated notable reform moves like liberalizing deposit interest rates or standardizing the business-service tax. These steps require further reforms to build on them (i.e. to remove lending preferences for SOEs, or to provide local governments with revenues to replace the business tax). But all reforms are now in limbo as the Communist Party approaches its “midterm” party congress this fall. Most importantly for investors, the government has still not shown it can "get off the train" of rapid credit growth that has underpinned China's transition away from foreign demand (Chart 16). The country's relatively robust consumer-oriented and service-sector growth remains to be tested by tighter financial conditions. And the property sector poses an additional, perpetual financial risk, which policymakers have avoided tackling with reforms like the proposed property tax (a key reform item to watch for next year).14 The PBoC's recent tightening efforts come after a period of dramatic liquidity assistance to the banks (Chart 17), and even though interbank rates remain well below their brief double-digit levels during the "Shibor Crisis" in 2013 (see Chart 5 above, page 6), any tightening serves to revive fears that financial instability could re-emerge and translate to the broader economy. Chart 16China's Savings Fueling Debt Buildup China's Savings Fueling Debt Buildup China's Savings Fueling Debt Buildup Chart 17PBoC Lends A Helping Hand PBoC Lends A Helping Hand PBoC Lends A Helping Hand What signposts should investors watch to see whether China re-initiates structural reforms? Already, personnel changes at the finance and commerce ministries, as well as the National Development and Reform Commission and China Banking Regulatory Commission, suggest that the Xi administration may be headed in this direction. Table 3 focuses on the steps that we think would be most important, beginning with the party congress this fall. Given current levels of overcapacity and corporate leverage, we suspect that genuine structural reform will begin with a move toward deleveraging, and involve a mix of bank recapitalization and capacity destruction, as it did in the 1990s and early 2000s. These reforms included the formation of new central financial authorities, like policy banks, regulatory bodies, and asset management companies, to oversee the cleaning up of bank balance sheets and the removal of numerous inefficient players from the financial sector.15 They eventually entailed transfers of funds from the PBoC, from foreign exchange reserves, and from public offerings as major banks were partially privatized. On the corporate side, the reforms witnessed the elimination of a range of SOEs and layoffs numbering around 40% of SOE employees, or 4% of the economically active workforce at the time. Table 3Will China Launch Painful Economic Restructuring Next Year? Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chinese President Jiang Zemin launched these reforms after the party congress of 1997, just as his successor, Hu Jintao, attempted to launch similar reforms following the party congress of 2007. The latter got cut short by the Great Recession. The question now for Xi Jinping's administration is whether he will use his own midterm party congress to launch the reforms that he has emphasized: namely, deep overcapacity cuts and financial and property market stabilization through measures to mitigate systemic risks.16 Bottom Line: China may decide to use American antagonism as an "excuse" to launch a serious structural reform push following this fall's National Party Congress. Short-term pain, which is normal under a reform scenario in any country, could then be blamed on an antagonistic U.S. trade and geopolitical policy. While reforms in China are a positive in the long term, we fear that a slowdown in China would export deflation to still fragile EM economies. And given Europe's high-beta economy, it could also be negative for European assets and the euro. Europe's Divine Comedy Investors remain focused on European elections this year. The first round of the French election is just 11 days away and polls are tightening (Chart 18). Although Marine Le Pen is set to lose the second round in a dramatic fashion against the pro-market, centrist Emmanuel Macron (Chart 19), she could be a lot more competitive if either center-right François Fillon or left-wing Jean-Luc Mélenchon squeaks by Macron to get into the second round.17 Chart 18Melenchon's Rise: Comrades Unite! Melenchon's Rise: Comrades Unite! Melenchon's Rise: Comrades Unite! Chart 19Le Pen Cruisin' For A Bruisin' Le Pen Cruisin' For A Bruisin' Le Pen Cruisin' For A Bruisin' The risk of someone-other-than-Macron getting into the second round is indeed rising. However, Mélenchon's rise thus far appears to be the mirror image of Socialist Party candidate Benoît Hamon's demise. At some point, this move will reach its natural limits: not all Hamon voters are willing to switch to Mélenchon. At that point, the Communist Party-backed Mélenchon will have to start taking voters away from Le Pen. This is definitely possible, but would also create a scenario in which it is Mélenchon, not Le Pen, that faces off against a centrist candidate in the second round. As such, we see Mélenchon's rise primarily as a threat to Le Pen, not Macron.18 While we remain focused on the French election, we think that any market relief from that election - and the subsequent German one - will be temporary. By early next year, investors will have to deal with Italian elections. Unfortunately, there is absolutely no clarity in terms of who will win the Italian election. If elections were held today, the Euroskeptic Five Star Movement (M5S) would gain a narrow victory (Chart 20). However, it is not clear what electoral law will apply in the next election. The current law on the books, which the Democratic Party-led (PD) government is attempting to reform by next February, would give a party reaching 40% of the vote a majority-bonus. As Chart 20 illustrates, however, no party is near that threshold. As such, the next election may produce a hung parliament with no clarity, but with a Euroskeptic plurality. Meanwhile, the ruling center-left Democratic Party is crumbling. Primaries are set for April 30 and will pit former PM Matteo Renzi against left-wing factions that have coalesced into a single alliance called the Progressive and Democratic Movement (DP). For now, DP supports the government of caretaker PM Paolo Gentiloni, but its members have recently embarrassed the government by voting with the opposition in a key April 6 vote in the Senate. If Renzi wins the leadership of the Democratic Party again, DP members could formally split and contest the 2018 election as a separate party. The real problem for investors with Italy is not the next election, whose results are almost certain to be uncertain, but rather the Euroskeptic turn in Italian politics. First, aggregating all Euroskeptic and Europhile parties produces a worrying trend (Chart 21). And we are being generous to the pro-European camp by including the increasingly Euroskeptic Forza Italia of former PM Silvio Berlusconi in its camp. Chart 20Five Star Movement Set For Plurality Win Five Star Movement Set For Plurality Win Five Star Movement Set For Plurality Win Chart 21Euroskeptics Take The Lead Euroskeptics Take The Lead Euroskeptics Take The Lead Unlike its Mediterranean peers Spain and Portugal, Italian support for the euro is still plumbing decade lows -- no doubt a reflection of the country's non-existent economic recovery (Chart 22). It is difficult to see how Italians can regain confidence in European integration given that they are unwilling to pursue painful structural reforms. Chart 22Italian Economic Woes Hurt Euro Support Italian Economic Woes Hurt Euro Support Italian Economic Woes Hurt Euro Support The question is not whether Italy will face a Euroskeptic crisis, but rather when. It may avoid one in 2018 as the pro-euro centrists cobble together a weak government or somehow entice the center-right into forming a grand coalition. But even in that rosy scenario, such a government is not going to have a mandate for painful structural reforms that would be required to pull Italy out of its low-growth doldrums. As such, it is unlikely that the next Italian government will last its full five-year term. Bottom Line: Investors should prepare for a re-run of Europe's sovereign debt crisis, with Italy as the main event. We expect this risk to be delayed until after the Italian election in 2018, maybe later. However, it is likely to have global repercussions, given Italy's status as the third-largest sovereign debt market. Will Italy exit the euro? Our view is that Italy needs a crisis in order to stay in the Euro Area, as only the market can bring forward the costs of euro exit for Italian voters by punishing the economy through the bond market. The market, economy, and politics have a dynamic relationship and Italian voters will be able to assess the costs of an exit first hand, as yields approach their highs in 2011 and Italian banks face a potential liquidity crisis. Given that support for the euro remains above 50% today, we would expect that Italians would back off from the abyss after such a shock, but our conviction level is low.19 Housekeeping This week, we are taking profits on our long MXN/RMB trade. We initiated the trade on January 25, 2017 and it has returned 14.2% since then. The trade was a play on our view that Trump's protectionism would hit China harder than Mexico. Given the favorable conclusion to the Mar-a-Lago summit - and the likely easing of risks of a China-U.S. trade war in the near term - it is time to book profits on this trade. We still see short-term upside to MXN and investors may want to pair it by shorting the Turkish lira. We expect more downside to TRY given domestic political instability, which we expect to continue beyond the April 15 constitutional referendum. We see both the yes and no outcomes of the referendum as market negative. In addition, we are closing our short Chinese RMB (via 12-month non-deliverable forwards) trade for a profit of 5.89% and our long USD/SEK trade for a gain of 1.27%. Our short U.K. REITs trade has been stopped out for a loss of 5%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 For this negotiating sequence, please see BCA Geopolitical Strategy and The Bank Credit Analyst Special Report, "A Q&A On Political Dynamics In Washington," dated November 24, 2016, available at bca.bcaresearch.com, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 3 Trump loves to win. 4 Please see Federal Ministry of Finance, Germany, "Communique - G20 Finance Ministers and Central Bank Governors Meeting," dated March 18, 2017, available at www.bundesfinanzministerium.de. 5 Please see BCA China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. 6 The head of the Lithuanian central bank, Vitas Vasiliauskas, was quoted by the Wall Street Journal in early April stating that "it is too early to discuss an exit because still we have a lot of significant uncertainties." This was followed by the executive board member Peter Praet dampening expectations of even a reduction in the bank's bond-buying program and President Mario Draghi stating that the current monetary policy stance remained appropriate. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 8 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 9 Treasury Secretary John Connally was particularly protectionist, with two infamous mercantilist quips to his name: "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 10 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." 11 We highly recommend that our clients peruse Lighthizer's testimony to the U.S.-China Economic and Security Review Commission. Beginning at p. 29, he recommends three key measures: using the 1971 surcharge as a model (p. 31); going beyond "WTO-consistent" policies (p. 33); and imposing tariffs against China explicitly (p. 35). Please see Robert E. Lighthizer, "Testimony Before the U.S.-China Economic and Security Review Commission: Evaluating China's Role in the World Trade Organization Over the Past Decade," dated June 9, 2010, available at www.uscc.gov. 12 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. See also the recent Geopolitical Strategy and Emerging Market Equity Sector Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 14 Please see BCA's Commodity & Energy Strategy Special Report, "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015, available at ces.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "China: Is Beijing About To Blink?" in Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 16 At a meeting of the Central Leading Group on Financial and Economic Affairs, which Xi chairs, the decision was made to make some progress on these structural issues this year, but only within the overriding framework of ensuring "stability." The question is whether Xi will grow bolder in 2018. Please see "Xi stresses stability, progress in China's economic work," Xinhua, February 28, 2017, available at news.xinhuanet.com. 17 That said, the most recent poll - conducted between April 9-10 - shows that Mélenchon may be even more likely to defeat Le Pen than Macron. He had a 61% to 39% lead in the second round versus Le Pen. 18 In the second round, Macron is expected to defeat Mélenchon by 55% to 45%, according to the latest poll, conducted April 9-10. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com.

Feature Game theory teaches us that "credible threats" are an important part of creating stable equilibria. To enforce a credible threat, a geopolitical actor must have the capability and willingness to act on a standing threat. For example, if a country A states that action X will produce a response a, it must follow through decisively with a if X occurs. Otherwise, the lack of action will incite other actors to shirk compliance and conduct action X with little threat of retaliation. The lack of enforcement raises the probability of action X occurring in the future. President Donald Trump has re-established American credibility when it comes to the long-standing opposition to the use of chemical weapons. According to various news reports, approximately 50 BGM-109 Tomahawk cruise missiles were launched from two U.S. Navy destroyers - USS Porter and USS Ross - in the Eastern Mediterranean. The air strike targeted Syrian government-controlled Shayrat Air Base 30km southeast of Homs. The air base was allegedly used by Syrian forces earlier in the week to launch the chemical attack that left at least 86 people, including 28 children, dead. The following are facts that we know surrounding the attack: Russian angle: Russian military has had a presence at the Shayrat air base since December 2015, which has included a contingent of attack helicopters since April 2016.1 This information is public knowledge and therefore was known to American officials ahead of the strike. According to news reports, U.S. officials informed their Russian counterparts of the strike earlier in the day, but President Trump did not speak to President Vladimir Putin ahead of the attack. Limited target: Cruise missiles focused on the parts of the airbase critical to launching further air strikes: runway, aircraft hangars, and fuel depots. However, given the American warning to Russia of the incoming attack, it is highly likely Syrian forces had advance warning as well. Therefore, the attack is likely to have had no discernable military effect. Justification: President Trump justified the attack in broad terms in his statement following the attacks, citing "vital national security interest... to prevent and deter the spread and use of deadly chemical weapons." He also cited Syria's obligations under the Chemical Weapons Convention and U.N. Security Council rulings. There is no evidence that the U.S. is preparing a more comprehensive intervention in Syria. While such an action cannot be ruled out, given that Trump has been overseeing a comprehensive policy review, the nature of the strike suggests that it was designed to re-establish America's credible threat against the use of chemical and biological weapons. What does America's commitment to use of military force mean in broader geopolitical sense? We think that the timing and the optics of the attack are relevant in five ways: Re-establishing "red lines": The alleged chemical attack - if indeed perpetrated by the armed forces of the Syrian government and not by rebel forces or the Islamic State to draw the U.S. into conflict - has little or no military utility. As such, it appears to have been conducted precisely to test President Trump's credibility and commitment to enforcing American "red lines," which were put into question in Syria in particular by the previous administration. We speculate, but the attack may have been encouraged by Assad's allies Iran and Russia to create a low-cost crisis - where both could claim plausible deniability - that tests Trump's resolve to retaliate militarily. Objectively speaking, President Trump has passed the test. Signaling: The quick reaction from Washington signals to potential foes like Iran and North Korea that President Trump has a lower threshold for using military force than his predecessor. Most notably, President Trump did not seek authorization of U.S. Congress for the attack, instead justifying the use of force via international law and longstanding U.S. commitment to defending allies.2 Timing: The attack occurred while President Trump and China's President Xi Jinping were dining at the Mar-a-Lago Florida resort. President Trump notably stated ahead of Xi's visit that "if China is not going to solve North Korea, we will." His administration has also said that time was running out on North Korea and all options were on the table. Words like these carry greater weight in light of Trump's actions today. On the other hand, the attack against Syria does allow Trump to scale-down rhetoric on North Korea and South China Sea - having now proven his military mettle - where conducting a military show-of-force would have been much more difficult for the U.S. Capabilities: The attack reminds the world that U.S. military capabilities and its global reach are unrivaled. Much has been made of Russian power-projection capabilities since their successful intervention in Syria. However, the U.S. was able to deliver a payload of 50-60 cruise missiles without tipping its hand and with little fanfare.3 Russian and Chinese capabilities to project power within their spheres of influence have increased dramatically over the past ten years. However, the U.S. remains the only actor capable of acting globally. Doctrine: President Trump's quick decision to use force suggests that he will not follow an extreme isolationist foreign policy. As we wrote in a February note, a truly isolationist America would produce paradigm shifting outcomes, including the eventual loss of U.S. dollar reserve currency status.4 However, Trump's decision to cite international law and American responsibility to allies as justifications for the Syrian air strikes suggest that the Trump White House has abandoned the isolationist rhetoric of the campaign. It also reveals the preferences of the U.S. defense and intelligence establishment, which has re-established its influence in the Trump White House. Incidentally, the air strike coincides with the removal of ultra-isolationist Steve Bannon - campaign chief and White House Chief Strategist - from the National Security Council. Investment Implications We believe that the air strikes are a limited attack whose main purpose is messaging. If the U.S. planned to accomplish broader goals, we would have expected to see multiple strikes against Syrian air force, air defense installations, and command and control capabilities. A risk to this view would be any follow-up rhetoric from the White House on establishing "no-fly zones" above Syrian air space. We suspect that the attack against Shayrat air base will instead be eventually followed by closer coordination with Russia and other regional players to find a diplomatic solution to the Syrian civil war. As such, any negative market reaction, bid-up in oil prices, or safe-haven flows should be temporary (Chart 1). In fact, the attack is bullish for risk assets for three reasons: Political recapitalization: We suspect that President Trump will see a bump in approval rating due to the limited, but resolute, air strikes. Currently, Trump is plumbing unseen lows in overall popularity and even his support among Republican voters appears to be slipping (Chart 2).The strikes will be a shot-in-the-arm, at least among GOP voters. This will further aid President Trump in his ongoing squabbles with the fiscally conservative Freedom Caucus and thus increase the probability of tax legislation being passed by Congress later this year.5 Chart I-1Market Reaction ##br##Should Be Temporary Trump Re-Establishes America's "Credible Threat" Trump Re-Establishes America's "Credible Threat" Chart 2Can A Resolute Strike ##br##Rescue Trump's Popularity? Trump Re-Establishes America's "Credible Threat" Trump Re-Establishes America's "Credible Threat" Establishment strikes back: The air strikes are a highly orthodox reaction to a foreign policy crisis, suggesting that the extreme isolationist rhetoric of the Trump's presidential campaign has been abandoned. It also suggests that the U.S. establishment has wrestled control of foreign policy from unpredictable novices like Steve Bannon. Escalation is limited: We don't see the probability of air strikes against North Korea as having risen. As we will show in a forthcoming military assessment of the risks on the Korean peninsula, North Korea retains considerable retaliatory capacity. It can still inflict massive civilian casualties on Seoul via a conventional artillery barrage. We suspect that the market will quickly realize the objective superiority of a foreign policy that enforces credible threats. As such, the probability of future use of force declines, now that the U.S. has reestablished its commitment to military retaliation when its "red lines" are crossed. The two risks to our view are that: Russia decides it must respond to the U.S. attack for either strategic or domestic political reasons; President Trump is emboldened by the political recapitalization that follows the attack to expand operations in Syria or to attempt a similar strike in North Korea. We doubt that either will happen, but it may take time for the market to be convinced. First, Russia will likely oppose U.S. involvement rhetorically, given the close proximity of its forces to the attack. This is despite the fact that the U.S. informed Russia, showing the courtesy of a geopolitical peer. Indeed, Russian officials are already threatening to scuttle the agreement with the U.S. that keeps the two militaries informed of each other movement in Syria. Second, we doubt that the U.S. defense establishment will advise President Trump to attack North Korea, as it has understood Pyongyang's retaliatory capability for decades. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 The airport was used by the Russian forces as an "advance airfield," which means that it was mainly used for quick refueling and rearming of frontline aviation. There was no permanent presence of Russian troops. 2 In his statement following the attacks, President Trump stated that destabilization of the region and ongoing refugee crisis threatened the U.S. and its allies. 3 As a side note, the number of cruise missiles involved in the strike appears to be complete overkill given the limited nature of the attack. The number appears to have been selected for maximum PR effect, showing again that the attack was meant to serve a signaling purpose. 4 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com.

Highlights The rally in risk assets appears to have stalled, raising fears that the misnamed "Trump Trade" has ended. Investors are attaching too much importance to the reality show in Washington and not enough to the fundamentals underpinning the acceleration in global growth and corporate earnings. For now, these fundamentals are strong, and should remain so for the next 12 months. Beyond then, the impulse from easier financial conditions will dissipate and policy will turn less friendly, setting the stage for a major slowdown - and possibly a recession - in 2019. Stay overweight global equities and high-yield credit, but be prepared to reduce exposure next spring. Feature Risk Assets Hit The Pause Button After rallying nearly non-stop following the U.S. presidential election, risk assets have stalled since early March (Chart 1). The S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. Globally, the picture has been much the same (Chart 2). The yen - a traditionally "risk off" currency - has strengthened, while "risk on" currencies such as the AUD and NZD have faltered. EM currencies have dipped, as have most commodity prices. Only gold has found a bid. Chart 1A Pause In Risk Assets In The U.S.... A Pause In Risk Assets In The U.S.... A Pause In Risk Assets In The U.S.... Chart 2...And Globally ...And Globally ...And Globally The key question for investors is whether all this merely represents a correction in a cyclical bull market for global risk assets, or the start of a more sinister trend. We think it is the former. Global Growth Still Solid For one thing, it would be a mistake to attach too much significance to the unfolding reality show in Washington. As we discussed in last week's Q2 Strategy Outlook,1 the recovery in global growth and corporate earnings began a few months before last year's election and would have likely continued regardless of who won the White House (Chart 3). For now, the global growth picture still looks reasonably bright. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 4). Consumer confidence is also soaring. If history is any guide, this will translate into stronger consumption growth in the months ahead (Chart 5). Chart 3Recovery Predates President Trump Recovery Predates President Trump Recovery Predates President Trump Chart 4Global Growth Backdrop Remains Solid Global Growth Backdrop Remains Solid Global Growth Backdrop Remains Solid Chart 5Rising Consumer Confidence Will Provide A Boost To Consumption Rising Consumer Confidence Will Provide A Boost To Consumption Rising Consumer Confidence Will Provide A Boost To Consumption The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 6 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will stay sturdy for the remainder of 2017. Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year. Global EPS is expected to expand by 12.5% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 7 shows that the global earnings revisions ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Chart 6Easing Financial Conditions Will Support Activity In 2017 Easing Financial Conditions Will Support Activity In 2017 Easing Financial Conditions Will Support Activity In 2017 Chart 7Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Gridlock In Washington? As far as developments in Washington are concerned, it is certainly true that the failure to repeal and replace the Affordable Care Act has cast doubt on the ability of Congress to implement other parts of President Trump's agenda. Despite reassurances from Trump that a new health care bill will pass, we doubt that the GOP can cobble together any legislation that jointly satisfies the hardline views of the Freedom Caucus and the more moderate views of the Republicans in the Senate. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for Trump and the Republican Party. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). According to the Congressional Budget Office, the proposed legislation would have caused 24 million fewer Americans to have health insurance in 2026 compared with the status quo. The bill would have also reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. Now, that would have warranted lower bond yields and a weaker dollar. Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Granted, the political fireworks over the past month serve as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy This is not to say that the "Trump Trade" won't fizzle out. It will. But that will be a story for 2018 rather than this year. This is because the disappointment for investors will stem not from the failure to cut taxes, but from the underwhelming effect that tax cuts end up having on the economy. The highly profitable companies that will benefit the most from lower corporate taxes are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the tax cuts will simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 8From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 8). In his Special Report on U.S. fiscal policy, my colleague Martin Barnes argues that "it is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control."2 As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and major fiscal stimulus but end up getting neither. Investment Conclusions Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors should stay overweight global equities and high-yield credit at the expense of government bonds and cash. We prefer European and Japanese equities over the U.S., currency-hedged (See Appendix). As we discussed in detail last week, global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months. By historic standards, it will probably be a mild one. However, with memories of the Great Recession still fresh in most people's minds and President Trump up for re-election in 2020, the response could be dramatic. This will set the stage for a period of stagflation in the 2020s. Chart 9 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 9Market Outlook For Major Asset Classes The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com 2 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies And Fantasies," dated April 5, 2017, available at bca.bcaresearch.com. Appendix Tactical Global Asset Allocation Monthly Update We announced last week that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 2Global Asset Allocation Recommendations (Percent) The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet In a Special Report published last year, we laid out the quantitative factors that have historically predicted stock market returns. Appendix Chart 1 updates the output of that model for the U.S. It currently shows a slightly above-average return profile for the S&P 500 over the next three months. Appendix Chart 1S&P 500: Above Average Returns Over The Next 3 Months The Trump Trade Will Fizzle Out, But Not Yet The Trump Trade Will Fizzle Out, But Not Yet Applying this model to the rest of the world yields a somewhat more positive picture for Europe and Japan, given more favorable valuations and easier monetary conditions in those regions. The technical picture has also improved in Europe and Japan. This is especially true with respect to price momentum: After a long period of underperformance, euro area equities have outpaced the U.S. by 11.5% in local-currency terms since last summer’s lows. Japanese stocks have suffered over the past few months, but are still up 12.5% against the U.S. over the same period (Appendix Chart 2). Turning to government bonds, the extreme bearish sentiment and positioning that prevailed in February and early March has been largely reversed, suggesting that the most recent rally in bonds could run out of steam (Appendix Chart 3). Looking ahead, yields are likely to rise anew on the back of strong economic growth and rising inflation. Thus, an underweight allocation to government bonds is warranted, particularly in the U.S. Appendix Chart 2Relative Performance Of Euro Area ##br##And Japanese Equities Troughed Last Summer Relative Performance Of Euro Area And Japanese Equities Troughed Last Summer Relative Performance Of Euro Area And Japanese Equities Troughed Last Summer Appendix Chart 3Rally In Bonds Could Soon Peter Out Rally In Bonds Could Soon Peter Out Rally In Bonds Could Soon Peter Out Clients should consult our Q2 Strategy Outlook for a more detailed discussion of the global investment outlook. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Global political risks are overstated, at least in 2017; Global rally in risk assets hinges on hard data, not politics; But Trump and the GOP can still pass tax reforms or cuts this year; The EU's guidelines on Brexit are benign, risks have peaked; The French presidential election remains harmless to markets. Feature Investors have a love/hate relationship with populism. On one hand, we fear what anti-establishment movements will mean for the twentieth-century institutions that have underpinned post-Cold War stability.1 On the other, markets have cheered populism and its ability to jolt policymakers out of their torpor, particularly on fiscal policy.2 This dichotomy of outcomes informs our investment theme for 2017, which holds that markets are navigating a "Fat-Tails World."3 The failure to repeal and replace the Affordable Care Act (ACA, "Obamacare") - which took us by surprise - reminded investors that President Trump will not have smooth sailing through the murky waters of congressional politics. Opposition to him has put into doubt the consensus view that populism is a political defibrillator that will shock policymakers into action. Instead of right-tail outcomes, markets are again fretting about left-tail risks: namely gridlock and obstructionism, but also protectionism, trade war, and competing nationalisms. In the long term, we are pessimists. We do not see how China and the U.S. will escape the dreaded "Thucydides Trap." We remain concerned that President Trump will grow frustrated with America's trade imbalances and strike out at friends and foes alike. But these are concerns for 2018 and beyond. In 2017, we believe that political risks remain overstated. In this weekly, we explain why. It's The Economy, Stupid! The global macro backdrop remains positive for the time being. Despite a very high global policy uncertainty index print, the market is responding to strong economic data (Chart 1), with the sum of the Citibank global economic- and inflation-surprise indexes rising to the highest level in the 14-year history of the survey.4 Chart 1Is Political Risk Overstated? Is Political Risk Overstated? Is Political Risk Overstated? Chart 2The Apex Of Globalization... Delayed? The Apex Of Globalization... Delayed? The Apex Of Globalization... Delayed? The global economic improvements are real. Chart 2 shows that PMI indexes in the developed world have reached their highest level since 2011, with global export volumes recovering from their multi-year doldrums. The Baltic dry index has gone vertical. Several other positive developments have caught our eye: Global Earnings: The global growth story has started to funnel down to company earnings, with a recovery in the net earnings-revisions ratio (Chart 3), which had been negative since 2011. Chart 3Strong Global Earnings Global Earnings Recovering Global Earnings Recovering Chart 4Godot Is Here! Return Of Capex Godot Is Here! Return Of Capex Godot Is Here! Return Of Capex U.S. Capex: The long-awaited capex recovery may finally be coming to the U.S., with real non-residential investment bottoming in 2016 (Chart 4). Manufacturing Renaissance: Global industrial production should have a solid year, at least judging by the strong leading economic-indicator print (Chart 5). Chart 5Industrial Renaissance Industrial Renaissance Industrial Renaissance Chart 6Consumers Are Elated Consumers Are Elated Consumers Are Elated Consumer Confidence: U.S. consumer confidence is at its highest level in 16 years (Chart 6), and should firm up from here, according to the BCA disposable-income indicator (Chart 7), and our expectation that Trump and the Republicans pass tax cuts.5 Chart 7Income Growth To Follow Income Growth To Follow Income Growth To Follow Chart 8Euro Area Is Doing Great Euro Area Is Doing Great Euro Area Is Doing Great European Renaissance: Data from the Euro Area remains bullish, despite the focus on political risk (Chart 8). BCA's real GDP growth models, introduced by The Bank Credit Analyst in their March report, corroborate the bullish view (Chart 9).6 Chart 9BCA's GDP Models Are Bullish BCA's GDP Models Are Bullish BCA's GDP Models Are Bullish The broad-based recovery in the data strongly suggest that the market's performance since the U.S. election is based on more than just a bet on Trump and his policies. Markets are responding to genuine improvements in the global economic outlook. Certainly there is something of a bet on the populists "getting it right," but hard data should continue to back up the optimism. How long can the party last? Our colleagues Martin Barnes and Peter Berezin have both recently warned of heightened recession risks in 2019.7 We are perhaps even less sanguine, observing dark clouds gathering for 2018. However, we will save that story for next week's missive. This week, we will provide our reasons for optimism about the remainder of this year. U.S.: Fade The Trumpocalypse S&P 500 fell 1.2% on March 21, the day that apparently sealed the fate of the Republicans' seven-year pledge to repeal and replace Obamacare. In our view, investors are overstating the conditional relationship between "repeal and replace" and the GOP's forthcoming tax bill. The most important political question for investors this year is simple: will the GOP blow out the budget deficit or focus on austerity? Getting the answer to this question right will go a long way in determining whether the impact on nominal GDP growth, inflation expectations, and thus the Fed's reaction-function is bullish for the S&P 500 and the U.S. dollar. This is the Trump trade: the idea that overarching reflation policy is swinging from monetary to fiscal. We still believe in Trump! That said, we acknowledge that comprehensive tax reform is tough - otherwise it would have occurred more recently than 1986.8 It is also true that the failure to repeal Obamacare will leave a few hundred billion dollars in the federal deficit that would have otherwise been available for tax cuts. Table 1 shows that the average time it takes to pass tax reform - from introduction of the bill to its signing by the president - is around five months. It is therefore not impossible, though assuredly difficult, for Congress to return from August recess this year and squeeze through a bill by Christmas Eve. TableMajor Tax Legislation And The Congressional Balance Of Power Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Chart 10Intra-Party GOP Polarization Falls##br## In Line With Last 80 Years Intra-Party GOP Polarization Falls In Line With Last 80 Years Intra-Party GOP Polarization Falls In Line With Last 80 Years Plus, Trump could always pivot away from tax reform and go after tax cuts, which are what Presidents Reagan and Bush did in 1981 and 2001. Both of these efforts took only one month to pass.9 From an economic perspective, the less ambitious option of tax cuts would be more flammable than tax reform, as it would merely increase the deficit and thus act as a more significant short-term stimulus. We see five reasons why the GOP will pass some form of tax legislation this year that will (1) add to the budget deficit, (2) lower household and probably corporate tax rates, and (3) likely include some provisions for infrastructure spending: Polarization is overstated: Intraparty ideological polarization is rising within the Republican Party, whereas it appears to be significantly declining in the Democratic Party (Chart 10).10 However, the move is not as significant as the media suggests. The average level of polarization within the GOP is well within the range of the past century. In fact, the GOP remains considerably less polarized than the Democrats were for most of the post-Second World War era. The data therefore suggests that while the GOP is indeed becoming more conservative (Chart 11), it is doing so uniformly. The measurable differences between the "Tea Party," represented in the House of Representatives by the Freedom Caucus, and the rest of the party are overstated. Chart 11Polarization Increasing Between, Not Within, The Two Parties Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Trump still has political capital: Despite a slump in national opinion polls, the president retains support among Republican voters (Chart 12). This means that he can threaten to campaign against Freedom Caucus representatives in the 2018 mid-term elections, as he did recently in an ominous tweet.11 Data suggest that voters would indeed follow Trump and dump the Freedom Caucus. Trump is very popular among Tea Party voters, even in Texas when put up against the state's Tea Party champion Senator Ted Cruz (Chart 13). Given that voter turnout in primary races in a mid-term election is below 10% for Republicans, a series of Trump rallies in Freedom Caucus districts could be sufficient to change the course of the election. Chart 12Republican Voters Support Trump Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Chart 13Trump Is A Threat To The Tea Party Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Chart 14Budget Deficits: Not As Hot Of A Priority Budget Deficits: Not As Hot Of A Priority Budget Deficits: Not As Hot Of A Priority Budget deficits are less relevant: Given the first two points, why did the Freedom Caucus oppose President Trump on health care? Because Obamacare and its replacement were both "big government programs," whereas these are "small government" Republicans. It was not because Freedom Caucus constituencies are laser-focused on lowering budget deficits! In fact, 22% fewer Republicans see reducing the budget deficit as the top policy priority as did in 2012, when the Tea Party was in full stride (Chart 14). Tax cuts are popular among Republican voters. Expanded budget deficits can be sold to them as a way to "starve the beast" of government.12 Institutional constraints to reform are overstated: "God put the Republican Party on earth to cut taxes." The famous quip from Washington Post columnist Robert Novak is a good guide for investors on tax reform. Many of our colleagues and clients tend to over-complicate their political analysis. Opposing tax reform and/or cuts will be political suicide for Republican legislators. And if budget deficits grow too much, the GOP can rely on two time-tested strategies to find "offsets" for tax cuts: Revenue Offsets: Republicans still have a handful of possibilities to raise revenues to offset the loss from cuts in tax rates even if they abandon the border adjustment tax (which they have not yet done). First, they can require companies to repatriate their offshore earnings, whose taxes are deferred. Second, they could engage in limited reform by closing some loopholes in the tax code. Third, they could let certain "tax extenders" expire at the end of the year as they are technically scheduled to do. Fourth, they could reduce the size of the tax cuts from the very ambitious plans outlined in their now outdated 2016 proposals. These decisions would be politically difficult, but that does not mean that all of them will fail. Crucially, the leader of the Freedom Caucus, Representative Mark Meadows (R-N.C.), now claims he would support tax cuts that are not fully offset by revenues. The Freedom Caucus appears to have expended most of its political capital on opposing the Obamacare replacement and is now tucking its tail between its legs! Dynamic Scoring: Republicans have emphasized macroeconomic feedback, i.e. the fact that tax cuts generate growth, which in turn generates tax revenues, defraying the initial revenue losses of the cuts. The Republicans will argue that static accounting methods make tax cuts seem more costly than they will be in reality. For instance, while it is true that President Bush's White House vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 15). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 16). Chart 15Bush Was Right, ##br##CBO Was Wrong! Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Chart 16Dynamic Scoring Will Offset About##br## 10% Of Revenues Lost To Tax Cuts Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 Timing is flexible: The GOP have the option of making tax cuts retroactive and thus avoiding a huge market disappointment if tax cuts come later in the year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.13 Chart 17Republicans Are Not Deficit-Neutral Republicans Are Not Deficit-Neutral Republicans Are Not Deficit-Neutral Our high-conviction view remains that tax reform - or less ambitious tax cuts - is still coming this year. It is empirically false that Republicans care more about balancing the budget than about reducing the tax burden on individuals and corporates (Chart 17). Arguments to the contrary rely on the time-tested (and failed) analytical strategy of "this time is different." Of course, the timing and legislative process lack clarity (Diagram 1). Republicans still plan to use "budget reconciliation" to sneak through tax reform or cuts. This allows them to approve tax policy with a simple majority, i.e. to bypass any "points of order" or filibusters in the Senate that would raise the bar to a 60-vote supermajority. The rules of reconciliation require a bill to be deficit-neutral beyond the five- or ten-year window mapped out in Congress's preceding budget resolution (the latter, for FY2018, has not yet passed). But this means that a bill that blows out the budget deficit can still be passed as long as it has a "sunset clause" at the end of the 10-year period, as was the case with President Bush's tax cuts.14 We are also sanguine on the more immediate question of government funding. Congress has to agree to fund the government by April 28 - the expiration date of December's continuing resolution - in order to avoid a government shutdown. Democrats are threatening to sink the appropriations bills (or omnibus bill) if Republicans attach noxious "riders" to it, such as defunding Planned Parenthood or building Trump's border wall. We think the Democrats are bluffing. Furthermore, leading Republicans are already signaling that they will postpone their moves on the most toxic issues to avoid a shutdown that would make them look incompetent. Diagram 1U.S. Congressional Budget Timeline 2017 Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 What about the upcoming vote to confirm President Trump's pick for the Supreme Court, Judge Neil M. Gorsuch? Is there any investment relevance of the pick? We do not think so. Judge Gorsuch will replace Judge Antonin Scalia and thereby protect the slightly conservative tilt of the court. Investors should watch to see if enough Democrats in fact filibuster the nomination and if Republicans change Senate rules to override filibusters for Supreme Court nominations (the so-called "nuclear option"). If Democrats insist on goading Republicans into this rule change, then the odds of bipartisan compromise on legislative initiatives (such as an infrastructure package) will fall, relative to a situation where some Democrats endorse Gorsuch and Republicans uphold Senate norms. Bottom Line: The market no longer believes that corporate tax reform will happen. High tax-rate companies have given back all of their post-election equity gains (Chart 18). We think this selloff is a mistake. As our report this week attests, we base our view on a study of political, legislative, and constitutional constraints to tax reforms and cuts. We are highly skeptical of "this time is different" narratives that overstate the power of the Freedom Caucus. As a direct bet on our high conviction view, we recommend that investors go long the high tax-rate basket relative to the S&P 500. Chart 18How To Profit From Tax Reform How To Profit From Tax Reform How To Profit From Tax Reform Chart 19Brexit Political Risk Bottomed In January Brexit Political Risk Bottomed In January Brexit Political Risk Bottomed In January Brexit: Much Ado About Nothing? The market has ignored both the invocation of Article 50 by London on March 29 and the publication of the EU's negotiation "guidelines" on March 31.15 As we discussed in January, political tensions between the EU and the U.K. likely peaked before January 16. This was the day when the market fully priced in the rumors that the U.K. would seek to withdraw from the EU Common Market. Prime Minister Theresa May confirmed the rumors on January 17 with a key speech. We have been long the GBP since.16 Investors continue to fret that there are more risks to come, but the market agrees with our assessment. The GBP bottomed against the EUR on October 11 (just after the Conservative Party conference where PM May affirmed the government's commitment to the referendum result) and bottomed against the USD on January 16. It has rallied against both currencies since the latter date (Chart 19). Why? First, the EU guidelines on the Brexit negotiations do not appear to be aggressive. The EU has offered the U.K. a "transition period," for an indefinite time between the U.K.'s technical withdrawal (March 29, 2019) and the new cross-channel status quo (for example, a free trade agreement, FTA). This is significant given that financial media doubted whether any transitional deal would be on offer as recently as a week ago. Second, the EU has implied that it will at least begin talks on an FTA with the U.K. while the negotiations on withdrawal are still ongoing. This is not exactly what London asked for but it is close.17 This means that the EU will hold the U.K.'s liabilities to the bloc for ransom before it begins negotiating a post-membership deal, but it also means that the EU does not want to threaten a "status cliff" where the U.K. and EU fail to forge any deal and hence revert back to basic WTO tariffs. Third, a leaked copy of an EU parliamentary resolution on Brexit also suggests that a "transition period," in this case limited to three years, is in the offing.18 It also hints at what we have long argued, that the EU would treat the U.K.'s notice of withdrawal (triggering Article 50) as revocable, i.e. reversible. That said, some negatives are obvious from both documents: The EU parliamentary resolution insists that the City of London does not get special access to the EU's common market; Spain will get a veto on whether the final agreement applies to the territory of Gibraltar; The U.K. will have to settle its financial commitments to the EU; No "cherry picking" of common-market benefits will be allowed. These points do not surprise us. We have been pessimists on London's ability to retain access to the EU common market well before Brexit. And May's own speech on January 17 cited that London would not seek to "cherry pick" benefits from the common market. Our assessment remains that the EU is not out for blood. Or, as we put it in our January 25 note: Now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. May's January 17 speech was therefore a classic "sell the rumor, buy the news" moment. Of course, we expect further risks and crises, especially with the British press laser-focused on the issue. But much of the hysterics will be irrelevant. Take the issue of the dreaded "exit fee." The media has focused on the fee as if the EU is seeking to impose a blood tax on the U.K. Instead, the roughly €60 billion "fee" is merely the remaining portion of U.K.'s contribution to the 2014-2020 EU budget, plus other liabilities. The EU sets its budgets on a seven-year horizon and the U.K. is going to remain a member state until March 2019. Some British newspapers think that the U.K. can continue to live in an EU apartment for the remainder of its lease without paying rent! The fact of the matter is that the EU is a trading power focused on expanding its markets. It is not in the interest of core member states, especially the export-oriented powerhouses such as Germany, Sweden, and the Netherlands, to lose the U.K. as a trading partner. And it is certainly not in their interest to impose such painful retribution as to risk harming their own economies. What about the message that the EU would want to send to other member states? This is only important if the likelihood of exit by another EU member state is high. As we discussed immediately after the referendum, the risks of EU dissolution are grossly overstated.19 Recent elections in Austria and the Netherlands confirm our analysis, and we expect that French elections will as well. Yes, Italy is a risk to the EU, given that Euroskepticism is on the rise there. However, the EU has ample tools with which to dissuade the Italians from exiting - starting with a market riot that the ECB can induce at any time by reversing its offer to buy Italian debt. And it is doubtful that the EU can change Italian sentiment through punitive Brexit negotiations. What kind of a post-Brexit relationship should investors expect between the U.K. and the EU? There are three options: Customs union: The U.K. is not likely to accept a Turkish arrangement in which it belongs to the customs union but not the common market. That is because the customs union forces Turkey to apply the common EU tariff on all imports, while its exports do not benefit from other countries' trade deals with the EU. The U.K. wants more autonomy over trade, so this is unlikely to be the solution. The Turkish deal also excludes trade in services, which the U.K. will want to promote. Common market lite: The U.K. has a low-probability option of accepting the Norwegian or Swiss options of membership in the common market despite non-membership in the customs union. These options would allow only a few limits to the EU's demand of free movement of goods, services, people, and capital; they are currently non-starters because the U.K. is prioritizing curbs on immigration. It is possible that the U.K. could come around to something similar later, but it would require a shift in domestic politics, of which there is little evidence yet. Chart 20British Public Remains Divided On Brexit Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 FTA: The U.K. is more likely to have an FTA arrangement, comparable to the just-signed EU deal with Canada. This would give the U.K. more autonomy on trade deals with third parties, while keeping tariffs to a minimum and incurring no obligation of free movement of people. It would also likely be more robust than the Canadian deal because of the much higher level of existing integration. Still, the U.K.'s prized service sector would suffer, as FTAs rarely cover services adequately. In fact, one of London's long-standing problems with the EU itself was lack of implementation of the 2006 EU Services Directive, which was supposed to harmonize trade in services and reduce non-tariff barriers to trade. We place the probability of the U.K. reverting back to WTO rules on trade with the EU - the most adverse scenario - to zero. Why such a high-conviction view? The EU has a customs agreement with Turkey, a country that threatens Europe with a Biblical exodus of refugees once every fortnight. In comparison, the U.K. and the EU are geopolitical allies that cooperate on national security, foreign policy, climate change, and other issues. There is no way that investors will wake up in 2019 and find that the U.K. has a worse trade agreement with the EU than Turkey.20 It is not all smooth sailing for the U.K., however. Brexit is not an optimal outcome for the U.K. economy.21 Leaving the EU means a deep cut in its labor-force growth rate, service exports, and inward FDI flows, reducing the U.K.'s growth potential. That said, given that the transitional deal will likely extend the horizon of "final Brexit" to around 2022 - or even beyond - and that there is still a small chance of a total reversal of Brexit, it is very difficult to predict the final impact on the U.K. economy now. There is another option that investors should consider. With Scottish independence gaining steam,22 and political risks rising in Northern Ireland, perhaps the EU is trying to kill Brexit with kindness. Polls on the Brexit referendum remain tight (Chart 20), which suggests that the "Remain" camp could eventually regain the upper hand - particularly if the shock to household income from inflation persists (Chart 21). With the U.K.'s own union at risk, perhaps the Tory leadership will alter its exit strategy over the course of negotiations. Meanwhile, investors should remember that: Chart 21Bremain May Regain Popularity ##br##When Brexit Bites Bremain May Regain Popularity When Brexit Bites Bremain May Regain Popularity When Brexit Bites Chart 22British Public Not Divided On ##br##Current Leadership British Public Not Divided On Current Leadership British Public Not Divided On Current Leadership Article 50 is almost certainly revocable. This is a political issue, not a legal one, as we have long stressed, and as the EU parliament leak suggests. Theresa May has promised that the final deal with the EU will be put to a vote in parliament. The bearish view has assumed that a failure of the vote would cast the U.K. into the abyss of no trade relationship other than the WTO's general agreement on tariffs. But failure could also follow from a shift in politics in the U.K. that seeks to act on the revocability of Article 50 and rejoin the EU. We see no sign of such a shift at the moment (Chart 22), but two to five years is time enough for one to develop. The next U.K. election will take place by May 2020, unless the government engineers a special early election. That is only a year after Article 50's two-year withdrawal period ends. If political winds are changing direction, the EU's allowance of a transition period could widen the window for a relatively smooth reverse-Brexit. In other words, "Brexit still means Brexit," but there are various escape hatches if the public demurs. The Scottish referendum has put a new constraint on the Tories and the EU may have figured out that the best way to encourage the Brits to change their mind is to smother them with kindness. What indications would suggest that the U.K. is changing strategies or the EU turning aggressive? In the U.K., a move to hold early elections could suggest that Prime Minister May wants a mandate of her own. This could enable her to pursue her current strategy more resolutely, but it could also give her the flexibility to reverse it. A sudden loss of support for the Tories, or a surge in the polling in favor of "Bremain," could also trigger a change in the government's approach. A significant public concession by the government in the negotiations could also mark a pivot point. In the EU, the following actions would suggest that the Brexit strategy will become less benign (and that our sanguine view is wrong): stonewalling in the exit negotiations, a reversal of the "Barroso doctrine" in order to encourage Scottish independence, a decision to shorten or deny the transition period, a lack of seriousness in trade negotiations, a downgrading of security and defense relations, or a move to pry away Gibraltar, among others. Bottom Line: We maintain our view that the pound bottomed along with the political risk on January 16. Yes, Brexit is not an optimal outcome, but the EU appears to be willing to push off the final date of the break with the U.K. into the future. At some point, we expect the U.K.'s inward FDI to suffer as companies - especially banks - grapple with the reality of Brexit. However, given the negotiations and potential transitional deal of up to three years, that date could be anywhere from two to five years into the future. Update On France: Can We Worry Now? We have spent much ink this year explaining why populist Marine Le Pen is not going to win the two-round French election on April 23 and May 7.23 Polls continue to support our view, with Le Pen trailing Emmanuel Macron by 26% with 33 days to go to their likely second-round matchup (Chart 23). At this point in the U.S. election, candidate Trump trailed Secretary Hillary Clinton by only 5%. Even Francois Fillon appears to be rallying against Le Pen. Despite ongoing corruption allegations against him, Fillon is leading Le Pen in a hypothetical second-round matchup by 16%. Chart 23Le Pen Lags Both Her Rivals##br## In Key Second Round Le Pen Lags Both Her Rivals In Key Second Round Le Pen Lags Both Her Rivals In Key Second Round Chart 24Is American Midwest A Path To##br## Le Pen Presidency? Is American Midwest A Path To Le Pen Presidency? Is American Midwest A Path To Le Pen Presidency? Chart 25No Comparison Between ##br##Le Pen And Trump Political Risks Are Overstated In 2017 Political Risks Are Overstated In 2017 A sophisticated New York client challenged our comparison of Trump's national polling against Clinton to that of Le Pen and her rivals. Instead, the client asked us to focus on the massive underperformance of the polls in the Midwest, where Trump surprised to the upside and beat long odds to win in Pennsylvania, Michigan, and Wisconsin (Chart 24). We agree that it is all about voter turnout, but again the numbers bear out Le Pen's weakness. She would have to perform six times better than Trump did in the Midwest to win the election (Chart 25). Chart 26Italy's Euroskeptics Much ##br##Stronger Than France's Italy's Euroskeptics Much Stronger Than France's Italy's Euroskeptics Much Stronger Than France's Chart 27The Market Is Missing ##br##The Italian Risks The Market Is Missing The Italian Risks The Market Is Missing The Italian Risks Chart 28Long French Bonds, Short Italian Long French Bonds, Short Italian Long French Bonds, Short Italian We are not dogmatic on the subject, we just refuse to agree with the lazy conventional wisdom that "polls are wrong." They are not. National polls got the U.S. election almost perfectly (the polls predicted a 3.2% Clinton victory and she won the popular vote by 2.1%). It is not our problem that pundits overestimated Clinton's strength, especially in the rustbelt states. Our own quantitative model gave Trump a 40% chance of winning the election on the night of the vote, roughly double the consensus view.24 We will therefore upgrade Le Pen's chances of winning when she starts making serious improvement in her second-round, head-to-head polling. Meanwhile, in Italy, the establishment continues to lose support to Euroskeptic parties (Chart 26). The media have not caught on to this risk, perhaps because they are feasting on negative news from France (Chart 27). The bond market has begun to price higher risks in Italy, with spreads between French and Italian bonds having risen 76 bps since January 2016 (Chart 28). However, they remain 296 bps away from their highs in 2012. We suspect that Italian bonds will see further underperformance relative to French bonds. Bottom Line: We continue to monitor risks in France due to the presidential elections. However, Le Pen remains behind both of her likely opponents by double digits in the second round. We remain long French industrial equities relative to their German counterparts as a play on expected structural reforms post-election. In addition, we are initiating a long French bonds / short Italian bonds recommendation due to our fear that Italy is the one and only risk to European integration in the short and medium term. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 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. 2 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Investment Strategy Special Report, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. 6 Please see The Bank Credit Analyst, "March 2017," dated February 23, 2017, available at bca.bcaresearch.com. 7 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com. 10 Data for polarization analysis uses "nominate" (nominal three-step estimation), a multidimensional scaling method developed to analyze preference and choice. Researchers use the bulk of roll call voting in the U.S. Congress over its entire history. Our Chart 10 measures intra-party polarization along the "primary dimension," which is the liberal-conservative spectrum on the basic role of the government in the economy. 11 "The Freedom Caucus will hurt the entire Republican agenda if they don't get on the team, & fast. We must fight them, & Dems, in 2018!" @realDonaldTrump 12 The quote "starve the beast" is a proverbial phrase that has applied to taxes at least since the 1970s. Nowadays it refers to cutting taxes and revenue in an effort to force cuts in expenditures. While the quote is attributed to President Ronald Reagan, he never used it. Instead, he used the analogy of a child's allowance during his campaign in 1980: "If you've got a kid that's extravagant, you can lecture him all you want to about his extravagance. Or you can cut his allowance and achieve the same end much quicker." Subsequent Republican administrations have used similar rhetoric to justify tax cuts, including that of George W. Bush. 13 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and courts upheld the legislation. Hence there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 14 Please see Megan S. Lynch, "The Budget Reconciliation Process: Timing Of Legislative Action," Congressional Research Service, October 24, 2013, available at digital.library.unt.edu, and Tax Policy Center, "What Is Reconciliation," Briefing Book, available at www.taxpolicycenter.org. See also David Reich and Richard Kogan, "Introduction to Budget 'Reconciliation,'" Center on Budget and Policy Priorities, November 9, 2016, available at www.cbpp.org. 15 Please see Council of the European Union, "Draft guidelines following the United Kingdom's notification under Article 50 TEU," dated March 31, 2017, available at bbc.co.uk. 16 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 17 The exact wording from the EU guidelines: "While an agreement on a future relationship between the Union and the United Kingdom as such can only be concluded once the United Kingdom has become a third country, Article 50 TEU requires to take account of the framework for its future relationship with the Union in the arrangements for withdrawal. To this end, an overall understanding on the framework for the future relationship could be identified during a second phase of the negotiations under Article 50. The Union and its Member States stand ready to engage in preliminary and preparatory discussions to this end in the context of negotiations under Article 50 TEU, as soon as sufficient progress has been made in the first phase towards reaching a satisfactory agreement on the arrangements for an orderly withdrawal." 18 Please see Daniel Boffey, "First EU response to article 50 takes tough line on transitional deal," The Guardian, March 29, 2017, available at www.theguardian.com. 19 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 20 No way. 21 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, Special Report, "The French Revolution," dated February 3, 2017, Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com.

Highlights Dear Client, In light of the recent political crisis in South Africa, we are re-publishing the following brief from BCA’s Emerging Markets Strategy service. As we have argued since 2015, South African politics are devolving into populism. We believe that the market is finally catching up to that reality and we see little to cheer in the short term. For our clients who are interested in EM macro fundamentals, we suggest they give our Emerging Markets Strategy a try. Please contact your account manager for more details. Kindest Regards, Marko Papic, Senior Vice President Geopolitical Strategy Feature Political risks have not risen in South Africa with the dismissal of Finance Minister Pravin Gordhan. They had never declined in the first place. The markets have, however, ignored them in the past 12 months. Investors have failed to recognize the fundamental problem underpinning the disarray in the ruling African National Congress (ANC): growing public discontent with persistently high unemployment and income inequality. Despite a growing body of evidence that political stability has been declining for a decade, strong foreign portfolio flows have papered over the reality on the ground and allowed domestic markets to continue "whistling in the dark." Investors even cheered the poor performance of the ANC in municipal elections in August 2016, despite the fact that by far the biggest winners of the election were the left-wing Economic Freedom Fighters (EFF), not the centrist Democratic Alliance. This confirms BCA's Geopolitical Strategy's forecast that the main risk to President Jacob Zuma's rule is from his left flank, led by the upstart EFF of Julius Malema, and by the Youth and Women's Leagues of his own ANC.1 As such, it was absolutely nonsensical to expect Zuma to pivot towards pro-market reforms. Unsurprisingly, he has not. But could the Gordhan firing set the stage for an internal ANC dust-up that gives birth to a pro-reform, centrist party? This is the hopeful narrative in the press today. We doubt it. First, if the ANC splits along left-right lines, it is not clear that the reformers would end up in the majority. Therefore, the hope of the investment community that Deputy President Cyril Ramaphosa takes charge and enacts painful reforms is grossly misplaced. Second, Zuma may no longer be popular, but his populist policies are. While both the Communist Party (a partner of the Tripartite Alliance with the ANC) and the EFF now officially oppose his rule, they do not support pro-market reforms. Third, ethnic tensions are rising, particularly between the Zulu and other groups. These boiled over in social unrest last summer in Pretoria when the ruling ANC nominated a Zulu as the candidate for mayor of the Tshwane municipality (which includes the capital city). As such, we see the market's reaction as a belated acceptance of the reality in South Africa, which is that the country's consensus on market reforms is weakening, not strengthening. It is not clear to us that a change at the top of the ANC, or even a vote of non-confidence in Zuma, would significantly change the country's trajectory. In addition, the political tensions are growing at a time when budget revenue growth is dwindling and the fiscal deficit is widening (Chart 1). To placate investor anxiety over the long-term fiscal outlook, the government should ideally cut its spending. However, it is impossible to do so when there are escalating backlashes from populist parties and from within the ruling Tripartite Alliance. Odds are that the current and future governments will resort to more populist and unorthodox policies. That will jeopardize the public debt outlook and erode the currency's value. Needless to say, the nation's fundamentals are extremely poor - outright decline in productivity being one of the major causes (Chart 2). Chart 1South Africa: Fiscal Stress Is Building Up South Africa: Fiscal Stress Is Building Up South Africa: Fiscal Stress Is Building Up Chart 2Underlying Cause Of Economic Malaise Underlying Cause Of Economic Malaise Underlying Cause Of Economic Malaise We believe the rand has made a major top and local currency bond yields reached a major low (Chart 3). We continue to recommend shorting the ZAR versus both the U.S. dollar and Mexican peso. Traders, who are not short, should consider initiating these trades at current levels. Investors who hold local bonds should reduce their exposure. Dedicated EM equity investors should downgrade this bourse from neutral to underweight (Chart 4). Chart 3South Africa: ##br##Short The Rand And Sell Bonds South Africa: Short The Rand And Sell Bonds South Africa: Short The Rand And Sell Bonds Chart 4Downgrade South African##br## Equities To Underweight Downgrade South African Equities To Underweight Downgrade South African Equities To Underweight Finally, EM credit investors should continue underweighting the nation's sovereign credit within the EM universe and relative value trades should stay with buy South African CDS / sell Russian CDS protection. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, and Strategic Outlook, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com.

Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 5Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 11Less Investment Required Less Investment Required Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen The Neutral Rate Has Fallen The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift Return To Thrift Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The GOP's proposed legislation would have reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the corporate tax cuts may simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 17From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Euro Area Credit Impulse Will Fade In The Second Half Of 2018 Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 17). As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. Chart 19Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? An Upturn In Housing Construction? An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? What EM Deleveraging? What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 32The Contribution To Growth From Rising Human Capital Is Falling Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Chart 33Math Skills Around The World Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. Global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Second Quarter 2017: A Three-Act Play Second Quarter 2017: A Three-Act Play Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 36 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It ...No Matter How You Look At It ...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A Bit More Juice Left A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Pound: Cheap By All Accounts Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out Hot Money In, Hot Money Out Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

This month's Special Report, on Scotland's role in Brexit negotiations, was penned by our colleagues Matt Gertken, Marko Papic, and Jesse Kurri of BCA's Geopolitical Strategy service. Scottish secessionist sentiment has increased in response to First Minister Nicola Sturgeon's decision to push for a second popular referendum on Scottish independence, tentatively set for late 2018 or early 2019, though likely to be denied for some time by Westminster. The outcome of a referendum on leaving the U.K., which eventually will occur, is too close to call at this point. The possibility will influence the U.K.'s negotiations with the EU, and vice versa. The risk of a U.K. break-up adds an important constraint to Prime Minister Theresa May's government in the Brexit talks. Since the EU also has an interest in avoiding a devastating outcome for the U.K., our geopolitical team believes that the worst version of a "hard Brexit" will be avoided. That said, independence for Scotland cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s divorce proceedings. I trust that you will find the report as insightful as I did. Mark McClellan Senior Vice President A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland's First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.'s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the "Great Repeal Bill" that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the "Phoney War" has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart II-1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart II-2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart II-3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart II-1A Second Independence Referendum... A Second Independence Referendum ... A Second Independence Referendum ... Chart II-2...Is Looking More Likely ... Is Looking More Likely ... Is Looking More Likely Chart II-3Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, the outcome will be "too close to call," at least judging by the data available at present. In what follows we discuss why, and how Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "the End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland resented the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. If that had happened in 2014, it was estimated that the country's fiscal deficit would have been 5.9% of GDP and that its national debt would have been 109% of GDP. (Today those numbers are 8% and 84% of GDP respectively) (Table II-1). A newborn Scotland would have to adopt austerity quickly. Table II-1Scotland Would Be A High-Debt Economy April 2017 April 2017 Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart II-4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Chart II-4Highly Financialized Societies April 2017 April 2017 Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms Chart II-5Three Cheers For Brexit And The Tories Three Cheers For Brexit & The Tories Three Cheers For Brexit & The Tories In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart II-5). Brexit does indeed mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that a new independence vote would be justified in case of "a significant and material change in the circumstances that prevailed in 2014, such as Scotland being taken out of the EU against our will." Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart II-6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart II-7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart II-6Immigration Curbs Threaten Scots Growth April 2017 April 2017 Chart II-7Scottish Patriots Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart II-8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart II-9). Decommissioning costs are also expected to be high as the sector is wound down. Chart II-8No Golden Goose In The North Sea April 2017 April 2017 Chart II-9Limited Domestic Energy Supplies April 2017 April 2017 England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart II-10). Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart II-11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart II-12). Chart II-10The U.K. Pays For Scotland's Allegiance April 2017 April 2017 Chart II-11Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Chart II-12Scottish Financial Assets Need Currency Stability April 2017 April 2017 Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts II-13 and II-14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart II-15). Chart II-13Irish Independence: Poverty Not An Obstacle April 2017 April 2017 Chart II-14Scotland: If The Irish Can Do It So Can We April 2017 April 2017 Chart II-15EU Market No Substitute For British Market April 2017 April 2017 Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart II-16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart II-17). Youngsters are willing to take risks for the thrill of freedom, while their elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart II-16No Relationship Between IndyRef And Brexit April 2017 April 2017 Chart II-17Old Folks Loyal To The Union Jack April 2017 April 2017 The most striking indicator of Scottish secessionism is unemployment (Chart II-18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart II-19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart II-18Joblessness Boosts Independence Vote April 2017 April 2017 Chart II-19The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, though of course Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart II-5, page 24). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism and migration, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the common market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the common market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. Our Geopolitical Strategy service has been short EUR/GBP since mid-January and the trade is down 2%. This suggests that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer this currency trade as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken Associate Editor Geopolitical Strategy Marko Papic Senior Vice President Geopolitical Strategy Jesse Anak Kuri Research Analyst Geopolitical Strategy 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also may work against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com.

Highlights The financial market landscape has shifted over the past month with asset correlations changing and the so-called 'Trump trades' going into reverse. Equity valuation is stretched and plenty of risks remain. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. The economic data remain constructive for profits in the major countries. The risks posed by upcoming European elections have eased for 2017, now that the Italian election appears unlikely until 2018. The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. If a tax reform package proves too difficult to pass, then the GOP will settle for straight tax cuts and a modest amount of infrastructure spending. Market reaction to the FOMC's 'dovish hike' was overdone. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Not before September will the ECB be in a position to announce a further tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. In Japan, the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. Our views on U.S. fiscal policy and the major central banks paint a bullish picture for the dollar, and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Another key market development has been the continuing drop in risk asset correlations. This reflects falling perceptions of downside "tail risk", which is reflected in a declining equity risk premium (ERP). Absent further negative shocks, perceptions of downside risk should continue to wane, allowing risk premia and asset correlations to ease further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can focus more on long-term revenue generation rather than on guaranteeing their existence. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. The only adjustment to asset allocation we are making this month is an upgrade for U.S. high-yield based on improved valuation. Feature The financial market landscape has shifted over the past month with asset correlations changing and a number of popular trades going into reverse. First, the failure to replace Obamacare triggered a pull-back of the so-called 'Trump trades.' Stock indexes are holding up well, but the U.S. dollar has given back most of the gains made in March and the 10-year Treasury yield has dropped back to the bottom of the post-U.S. election trading range. Moreover, the negative correlation between the U.S. dollar and risk assets has flipped (Chart I-1). Even oil prices have diverged from their usual negative trading relationship with the dollar. Second, investors are questioning the FOMC's appetite for rate hikes in the coming months. They are also wondering how much longer the European Central Bank (ECB) and the Bank of Japan (BoJ) can maintain current hyper-stimulative policy settings. The whole narrative regarding equity strength, a dollar overshoot and bond price weakness may be over if there is not going to be any fiscal stimulus in the U.S., the Fed is not going to hike more aggressively than the market currently expects, and monetary policy is near a turning point in Japan and the Eurozone. Is it time for investors to become defensive, scale back on risk assets, upgrade bonds and short the dollar? We believe the answer is 'not yet', although 2017 was always destined to be a rough ride given the ups-and-downs in the U.S. legislative process and the lineup of European elections. President Trump's first 100 days are turning out to be even more tumultuous than many expected. Allegations of wiretaps and the FBI investigation into the alleged interference of Russia in the U.S. election are costing the President political capital, as well as raising question marks over the Republican Party's wish list. Simply removing the possibility of corporate tax cuts would justify a healthy haircut on the S&P 500. The political situation has admittedly become more complicated, but our geopolitical team makes the following observations: The GOP base supports Trump: Until the mid-term elections, Trump's popularity with Republican voters remains strong, which means that the President still has political capital (Chart I-2). Chart I-1Changing Correlations Changing Correlations Changing Correlations Chart I-2Trump Not Dead To Republicans Yet April 2017 April 2017 Republicans want tax reform: Even if reform gets bogged down, there is broad support for cutting taxes at a minimum. Many deficit hawks appear willing to use the magic of "dynamic scoring" to justify tax cuts as revenue-neutral. Even the chairman of the Freedom Caucus has signaled that he is open to tax reform that is not revenue neutral. Tax reform not conditional on Obamacare: The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. The Republicans will need to show success on at least one of their signature platforms before heading into the mid-term elections. The prospective savings from Obamacare's repeal are not needed to "fund" tax cuts. Infrastructure: We still expect that President Trump will get his way on additional spending on defense, veterans, infrastructure and the wall. The tax reform process will undoubtedly be full of drama and may be stretched out, adding volatility to the equity market. Our base case is that some sort of tax reform and infrastructure package will be passed by year end. However, if a reform package proves too difficult to pass, then we believe that the GOP will settle for straight-forward tax cuts and a modest amount of infrastructure spending (please see Table I-1 in the March 2017 monthly Bank Credit Analyst for the probabilities we have attached to the various GOP proposals). Tax cuts and increased spending will be positive for risk assets. The caveat is that we see little change in Trump's commitment to mercantilism. This means he will lean toward backing the border tax or tariff increases, which will offset some of the benefits for risk assets from reduced tax rates. Excess Reaction To FOMC Chart I-3FOMC & Market Disagree Beyond This Year FOMC & Market Disagree Beyond This Year FOMC & Market Disagree Beyond This Year Given the uncertainty on the fiscal side, one can't blame the FOMC for taking a "wait and see" approach. The range for the funds rate was raised to 0.75-1.00% at the March meeting, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50 bps of tightening is expected by the Committee this year, with 75 bps expected in both 2018 and 2019 (Chart I-3). The FOMC signaled in March that it was not yet prepared to adjust the 'dot plot,' sparking a rally in bond prices and a pullback in the dollar. This market reaction seemed excessive in our view. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target, as highlighted by the decision to strip the reference to the "current shortfall of inflation" from the statement. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Is The Dollar Bull Over? Still, recent market action suggests that the dollar may not get a lift from future Fed rate hikes because the outlook for global growth outside of the U.S. is brightening. Moreover, it could be that monetary policy in the Eurozone and Japan is at a turning point. There is increasing speculation that the ECB will have to taper the quantitative easing program sooner than planned. Some are even speculating the ECB will lift rates this year. The recent economic data for the euro area have indeed been stellar. The composite PMI surged to 56.7 in March, with the forward-looking new orders components hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart I-4). In addition, private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. Our real GDP model for the Eurozone, based on our consumer and business spending indicators, remains quite upbeat for the first half of the year. With unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to establish a consensus view on the ECB policy committee. The Bundesbank has been quite vocal on this issue, especially given that Eurozone headline HICP inflation reached 2% in February. The core rate of inflation remains close to 1%, but the rising diffusion index suggests that budding inflation pressure is becoming more broadly based (Chart I-5). Chart I-4Solid Eurozone Economic Data Solid Eurozone Economic Data Solid Eurozone Economic Data Chart I-5Eurozone Inflation Broadening Out Eurozone Inflation Broadening Out Eurozone Inflation Broadening Out BCA's Global Fixed Income Strategy service recently compared the current economic situation to that of the U.S. around the time of the Fed's 2013 "Taper Tantrum."1 In Chart I-6, we show "cycle-on-cycle" comparisons for the Euro Area and U.S. In the Euro Area, the number of months to the first rate hike discounted in money markets peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, this indicator has converged with the U.S. path. There is less spare capacity in European labor markets today than was the case in the U.S. when the Fed first hinted at tapering its asset purchases. Nonetheless, the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Not before September will the ECB be in a position to announce another tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. We do not believe that the ECB will raise short-term interest rates before it starts the tapering process. A rate hike would result in a stronger euro, downward pressure on inflation, and an unwanted tightening in financial conditions that would threaten the current economic impulse. This means that, between now and September, the window is still open for U.S./Eurozone interest rate spreads to move further in favor of the dollar. The European election calendar remains a risk to our view on currencies and risk assets. Widening OAT/Bund yield spreads highlight that investors remain concerned that the French election will follow last year's populist script in the U.K. and the U.S. However, our geopolitical team believes that Le Pen is unlikely to win since she trails in the polls by a 25-30% margin relative to Macron, her most likely opponent. Even if she were to pull off a win, she will not hold the balance of power in the National Assembly. Over in Germany, where the election is heating up, the fact that the Europhile SPD party is gaining in the polls means that the September vote is unlikely to be a speed bump for financial markets. The real political risk lies in Italy. While the election has been pushed off to February 2018, it appears that there will be genuine fireworks at that time because Euroskeptic parties have seized the lead in the polls (Chart I-7). In the meantime, European elections will be a source of volatility, but investors should ride it out until we get closer to the Italian election. Chart I-6Less Spare Capacity In Europe ##br##Now Vs. Pre-Taper Tantrum U.S. Less Spare Capacity in Europe Now vs Pre-Taper Tantrum U.S. Less Spare Capacity in Europe Now vs Pre-Taper Tantrum U.S. Chart I-7Italian Elections: The Big Risk Italian Elections: The Big Risk Italian Elections: The Big Risk Japanese Yield Cap To Hold Chart I-8Japanese Wages Still Disappointing Japanese Wages Still Disappointing Japanese Wages Still Disappointing Similar to our view on the ECB, we do not believe that the Bank of Japan (BoJ) will be in a position to begin removing monetary accommodation anytime soon. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. True, deflationary forces appear to have eased somewhat. Japan is also benefiting from the faster global growth on the industrial side. Nonetheless, the domestic demand story is less positive, with consumer confidence and real retail sales growth languishing. Wages continue to struggle as well (Chart I-8). This year's round of Japanese wage negotiations was particularly disappointing, with many manufacturing companies offering pay raises only half as large as those of last year. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. Our views on U.S. fiscal policy and the outlook for the major central banks paint a bullish picture for the dollar and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Admittedly, however, the next major move in global yields may not occur until the autumn when the ECB takes a less dovish tone. In the meantime, our fixed-income strategists remain underweight Treasurys within global currency-hedged portfolios. The team recently upgraded (low beta) JGBs to overweight at the expense of core European government bonds, which move to benchmark. Correlation, ERP And Hurdle Rates Chart I-9Market Correlations Are Shifting Market Correlations Are Shifting Market Correlations Are Shifting Another key market development has been the continuing drop in risk asset correlations, a trend that began before the U.S. election (Chart I-9). Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification. Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart I-10). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.2 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart I-11). But why was the ERP so elevated after 2007? Chart I-10Market Correlation And The ERP bca.bca_mp_2017_04_01_s1_c10 bca.bca_mp_2017_04_01_s1_c10 Chart I-11Modeling The Stock ##br##Correlation Within The S&P 500 Modeling The Stock Correlation Within The S&P 500 Modeling The Stock Correlation Within The S&P 500 The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.3 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending Chart I-12Capex Hurdle Rates Never Came Down Capex Hurdle Rates Never Came Down Capex Hurdle Rates Never Came Down An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.4 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart I-12). J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.5 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list, as highlighted in this month's Special Report on Brexit's implication for Scotland independence, beginning on page 19. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart I-13). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. We continue to favor higher beta developed markets where value is less stretched, such as the euro area and Japan, over the U.S. on a currency-hedged basis. Europe is about one standard deviation cheap relative to the U.S. index, although the extra value in the Japanese market has dissipated recently (Chart I-14). Moreover, both Eurozone and Japanese stocks in local currency terms will benefit from weaker currencies in the coming months, as rising inflation expectations and stable nominal interest rates result in declining in real rates, at least relative to the U.S. Chart I-13Forward Multiple Scenarios bca.bca_mp_2017_04_01_s1_c13 bca.bca_mp_2017_04_01_s1_c13 Chart I-14Eurozone Stocks Are Cheap Eurozone Stocks Are Cheap Eurozone Stocks Are Cheap Conclusion We have reassessed our asset allocation given that several market calls have gone against us over the past month. However, three key views argue to stay the course for now: Recent economic data support our view that a synchronized global acceleration is underway. This is highlighted by an update of the real GDP growth models we introduced last month (Chart I-15). The implication is that earnings growth will be constructive for stocks; Tax reform is still likely to be passed this year in the U.S. Moreover, were a broad tax reform package to elude the Administration, the fallback position will involve (stimulative) tax cuts, some infrastructure spending and de-regulation; and The FOMC will shift to a more hawkish tone in the coming months, while the ECB, Bank of England and Bank of Japan will maintain extremely accommodative monetary policy at least into the fall. The result is that stocks will outperform cash and bonds, while the dollar still has another 10% upside potential. The only adjustment we are making this month is in the U.S. high-yield corporate bond allocation. According to our fixed-income strategists, value has improved enough that it is worth upgrading the sector to overweight at the expense of Treasurys. Some of the indicators that comprise our default rate model have become more constructive for credit risk, including lending standards, the PMIs and profits. The combination of wider junk spreads and an improving default rate outlook have resulted in a widening in our estimate of the default-adjusted high-yield spread to 219 basis points (Chart I-16). Historically, high-yield earns a positive 12-month excess return 81% of the time when the default-adjusted spread is between 200 and 250 basis points. Chart I-15GDP Models Are Bullish GDP Models Are Bullish GDP Models Are Bullish Chart I-16Upgrade U.S. High Yield Upgrade U.S. High Yield Upgrade U.S. High Yield Turning to oil markets, we expect recent price weakness to reverse despite dollar strength. Building inventories have weighed on crude, but this is a head fake according to our commodity experts. We expect to see a sustained draw in OECD storage volumes this year, now that the year-end surge on crude product from OPEC's Gulf producers has been fully absorbed. With global supply/demand fundamentals now dominating price movements, the recent breakdown in the inverse correlation between oil prices and the dollar should persist. Oil prices will rise back toward the US$55 range that we believe will be the central tendency over 2016 and 2017. Risks are to the upside. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Shift to benchmark in Eurozone government bonds and upgrade JGBs to overweight within currency-hedged portfolios. The U.S. remains at underweight. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks over bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues in the U.S.; upgrade U.S. high-yield to overweight, but downgrade European investment-grade to underweight due to fading support from the ECB. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. Favor oil to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst March 30, 2017 Next Report: April 27, 2017 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?" dated March 7, 2017, available at gfis.bcaresearch.com. 2 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 3 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 4 Are Firms Underinvesting - and if so why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 5 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016. II. Will Scotland Scotch Brexit? This month's Special Report, on Scotland's role in Brexit negotiations, was penned by our colleagues Matt Gertken, Marko Papic, and Jesse Kurri of BCA's Geopolitical Strategy service. Scottish secessionist sentiment has increased in response to First Minister Nicola Sturgeon's decision to push for a second popular referendum on Scottish independence, tentatively set for late 2018 or early 2019, though likely to be denied for some time by Westminster. The outcome of a referendum on leaving the U.K., which eventually will occur, is too close to call at this point. The possibility will influence the U.K.'s negotiations with the EU, and vice versa. The risk of a U.K. break-up adds an important constraint to Prime Minister Theresa May's government in the Brexit talks. Since the EU also has an interest in avoiding a devastating outcome for the U.K., our geopolitical team believes that the worst version of a "hard Brexit" will be avoided. That said, independence for Scotland cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s divorce proceedings. I trust that you will find the report as insightful as I did. Mark McClellan Senior Vice President A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland's First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.'s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the "Great Repeal Bill" that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the "Phoney War" has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart II-1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart II-2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart II-3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart II-1A Second Independence Referendum... A Second Independence Referendum ... A Second Independence Referendum ... Chart II-2...Is Looking More Likely ... Is Looking More Likely ... Is Looking More Likely Chart II-3Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, the outcome will be "too close to call," at least judging by the data available at present. In what follows we discuss why, and how Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "the End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland resented the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. If that had happened in 2014, it was estimated that the country's fiscal deficit would have been 5.9% of GDP and that its national debt would have been 109% of GDP. (Today those numbers are 8% and 84% of GDP respectively) (Table II-1). A newborn Scotland would have to adopt austerity quickly. Table II-1Scotland Would Be A High-Debt Economy April 2017 April 2017 Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart II-4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Chart II-4Highly Financialized Societies April 2017 April 2017 Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart II-5). Brexit does indeed mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. Chart II-5Three Cheers For Brexit And The Tories Three Cheers For Brexit & The Tories Three Cheers For Brexit & The Tories It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that a new independence vote would be justified in case of "a significant and material change in the circumstances that prevailed in 2014, such as Scotland being taken out of the EU against our will." Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart II-6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart II-7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart II-6Immigration Curbs ##br##Threaten Scots Growth April 2017 April 2017 Chart II-7Scottish Patriots ##br##Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart II-8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart II-9). Decommissioning costs are also expected to be high as the sector is wound down. England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart II-10). Chart II-8No Golden Goose In The North Sea April 2017 April 2017 Chart II-9Limited Domestic Energy Supplies April 2017 April 2017 Chart II-10The U.K. Pays For Scotland's Allegiance April 2017 April 2017 Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart II-11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart II-12). Chart II-11Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Chart II-12Scottish Financial Assets Need Currency Stability April 2017 April 2017 Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts II-13 and II-14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart II-15). Chart II-13Irish Independence: ##br##Poverty Not An Obstacle April 2017 April 2017 Chart II-14Scotland: If The Irish ##br##Can Do It So Can We April 2017 April 2017 Chart II-15EU Market No ##br##Substitute For British Market April 2017 April 2017 Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart II-16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart II-17). Youngsters are willing to take risks for the thrill of freedom, while their elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart II-16No Relationship Between IndyRef And Brexit April 2017 April 2017 Chart II-17Old Folks Loyal To The Union Jack April 2017 April 2017 The most striking indicator of Scottish secessionism is unemployment (Chart II-18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart II-19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart II-18Joblessness Boosts Independence Vote April 2017 April 2017 Chart II-19The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, though of course Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart II-5, page 24). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism and migration, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the common market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the common market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. Our Geopolitical Strategy service has been short EUR/GBP since mid-January and the trade is down 2%. This suggests that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer this currency trade as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken Associate Editor Geopolitical Strategy Marko Papic Senior Vice President Geopolitical Strategy Jesse Anak Kuri Research Analyst Geopolitical Strategy 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also may work against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. III. Indicators And Reference Charts The S&P 500 index has pulled back from its recent highs, but it has not corrected enough to 'move the dial' in terms of the valuation or technical indicators. Stocks remain expensive based on our valuation index made up of 11 different measures. The technical indicator is still bullish. Our equity monetary indicator has dropped back to the zero line, meaning that it is not particularly bullish or bearish at the moment. The speculation index is elevated, however, pointing to froth in the market. The high level of our composite sentiment index and the low level of the VIX speaks to the level of investor complacency. Net earnings revisions remain close to the zero mark, although it is somewhat worrying that the earnings surprises index is slowly deteriorating. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. However, the widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking ahead, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. The composite technical indicator for the 10-year Treasury shows that oversold conditions are unwinding, although the indicator is not yet back to zero. This suggests that the consolidation period for bonds is not yet complete. Oversold conditions are almost completely gone in terms of the U.S. dollar. The dollar is very expensive on a PPP basis, although it is less so by other measures. We believe the dollar has more upside. Technical conditions are also benign in the commodity complex. However, we are only bullish on oil at the moment. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop ECONOMY: Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China