Geopolitics

Highlight Growth perked up in the major economies in October, and the manufacturing recession appears to have passed without event. The October employment report testified to the underlying health of the U.S. economy and clears the way for a rate hike at the FOMC's December meeting. Markets are skeptical that December's hike will be the first in a series, opening the door for a dollar rally while the Fed moves to meet its projected timetable. Unconvinced that global growth is about to accelerate in a meaningful way, and concerned about the ripple effects of a stronger dollar, we maintain the defensive bias in our model portfolios. Feature October was a good month for growth, as highlighted by broadly encouraging data across the major developed economies. U.S. GDP had its best print in two years in the third quarter, and European PMIs, firmly ensconced above 50, point to Eurozone growth around 1.5%. The plunge in sterling appears to have sheltered the U.K. from the worst effects of Brexit, even if it has triggered some unease about inflation. Japan remains hobbled, but our Global Investment Strategy service argues that reduced fiscal drag and a weaker yen will boost growth. The October employment data painted a portrait of a vibrant U.S. labor market. Job gains remained steady while the broad U-6 measure of unemployment, including discouraged job seekers and those working part time who would prefer to be working full time, fell by two ticks to a new post-crisis low (Chart 1). Consistent with the shrinking pool of idled workers, average hourly earnings surged, notching their biggest year-over-year gains of the expansion. The pickup in wages rekindled hopes of a virtuous circle linking hiring, wages, consumption, capex and more hiring. Chart 1The Supply Of Idled Workers Is Shrinking The Supply Of Idled Workers Is Shrinking The Supply Of Idled Workers Is Shrinking One GDP print does not make a trend, of course, and the hoped-for inflection point has remained out of reach throughout the post-crisis period (Chart 2 and Chart 3). Aggregate demand remains mushy even if it is improving. Forward-looking markets typically take their cues from direction rather than level, and punk post-crisis growth certainly hasn't hurt U.S. equities. The valuation backdrop has become much less hospitable, however, and the Fed appears less inclined to spike the punch bowl with its most potent fuel. The unsettled picture could make for a bumpy U.S. equity ride, especially if markets have become overly complacent about the pace of rate hikes. Chart 2The Post-Crisis Inflection: Ever In Sight... bca.bcasr_sr_2016_11_09_001_c2 bca.bcasr_sr_2016_11_09_001_c2 Chart 3...But Always Out Of Reach bca.bcasr_sr_2016_11_09_001_c3 bca.bcasr_sr_2016_11_09_001_c3 Economic Growth In The U.S. And Beyond What matters most to markets, a metric's current position (level), or its path (direction)? Favoring direction is generally a reliable stock market rule of thumb, though it's not always easy to recognize in real time. The key challenge for investors today is determining if the recent improvements are short-lived wiggles or a true inflection point. It would be helpful to know if extraordinary policy measures can boost organic growth or if they will simply redistribute it via exchange-rate adjustments. Measures of global trade are inconclusive. While things look much better in hubs like Korea and Taiwan (Chart 4), aggregate global trade volume is still mired in a one-step-forward, one-step-back pattern around the zero line (Chart 5). Isolated improvements in a handful of economies against a flat global backdrop highlight that a broad rebound has yet to take hold. Signs of life in individual countries should not be written off - it is promising that Korean and Taiwanese exports have staged their rebounds despite steady exchange-rate gains - but overall global export activity remains at a level more commonly associated with recessions than quickening expansions. Chart 4Some Exporters Are Stirring... Some Exporters Are Stirring... Some Exporters Are Stirring... Chart 5...But Aggregate Trade Is Stagnant ...But Aggregate Trade Is Stagnant ...But Aggregate Trade Is Stagnant Global PMI data are more broadly encouraging. Major-economy manufacturing PMIs are at levels consistent with decent growth and are sending a message, echoed by G7 industrial production (Chart 6), that the manufacturing recession is over. Although manufacturing typically accounts for less than a third of major-economy activity, its cyclicality helps it punch above its weight, and industrial slowdowns have the potential to trigger recessions. This time around, manufacturing failed to heat up enough to induce a broader slowdown and reliable recession signals are quiet (Chart 7). Chart 6The End Of The Manufacturing Recession The End Of The Manufacturing Recession The End Of The Manufacturing Recession Chart 7No Recession In Sight No Recession In Sight No Recession In Sight The October employment situation report was solidly encouraging. The U.S. labor market has found firm footing. Job gains have been remarkably steady, and our employment model projects they will persist, even if at a slightly slower pace (Chart 8). Both the average hourly earnings series and the Atlanta Fed's wage tracker show that rank-and-file workers are finally capturing some real income gains (Chart 9). Chart 8When The Economy Tests NAIRU... bca.bcasr_sr_2016_11_09_001_c8 bca.bcasr_sr_2016_11_09_001_c8 Chart 9...Wages Get A Boost bca.bcasr_sr_2016_11_09_001_c9 bca.bcasr_sr_2016_11_09_001_c9 Third Quarter Earnings Season S&P 500 operating earnings present another level/direction dichotomy. Per Standard & Poor's projections,1 trailing four-quarter operating earnings will finish the quarter 11% below their 3Q14 high-water mark (Chart 10, top). But the direction is as strong as the level is weak. Not only does this quarter mark the first year-over-year earnings gain since 3Q14, it is the second strongest since the pace of earnings growth normalized in 2012 (Chart 10, bottom). Chart 10Breaking Out Of The Earnings Recession Breaking Out Of The Earnings Recession Breaking Out Of The Earnings Recession Margins widened and earnings grew broadly across sectors without a clear cyclical or defensive theme. Rate sensitives achieved the strongest top-line growth, but endured margin contraction (Chart 11). Looking ahead, margins seem more likely to contract than expand in the coming quarters, given building wage pressures. On the other hand, an end to the sharp declines in Energy earnings will remove a drag that has weighed on S&P 500 results for several quarters. Chart 11Margins' Last Gasp? Spotlight On U.S. Equities Spotlight On U.S. Equities Margins' seeming inability to defy budding wage gains makes it unclear exactly how investors should position themselves, but the outlook for the dollar could provide some insight. Multinationals are prominent among the S&P 500's largest constituents, and since 2011, the broad trade-weighted dollar index has exhibited a robust negative correlation with S&P 500 earnings. Peak acceleration in the dollar has led earnings troughs by a quarter or two and earnings growth has quickened when the dollar has consolidated or retraced its gains (Chart 12). In a rising-dollar environment, U.S. firms competing globally face the unpalatable choice of protecting their margins and ceding share, or ceding share to defend their margins. Chart 12Strong Dollar, Weak Earnings Strong Dollar, Weak Earnings Strong Dollar, Weak Earnings Fed Policy: The Known Unknown Chart 13Markets Are Sleeping On The Fed Markets Are Sleeping On The Fed Markets Are Sleeping On The Fed The Fed has evinced a clear desire to hike rates, and investors know that it will be withdrawing accommodation at the edges. But the terminal fed funds rate for this cycle, and the pace at which the FOMC approaches it, are unknown. Market expectations, as implied by OIS2 contracts, reveal that investors have become complacent about the pace of hikes. While the consensus expects a quarter-point hike at the FOMC's December meeting, money markets are discounting just an 11% chance of a second 25-bps hike by the end of October 2017 (Chart 13, top panel), and a 75% chance of a second hike by the end of October 2018 (Chart 13, bottom panel). The Fed's dot-plot rate hike forecasts have been laughably off the mark, and to this point investors have tuned them out to their benefit. The preconditions for a progression of hikes seem to be coming together, however, as labor slack disappears, wage pressures emerge and the output gap steadily narrows. Every FOMC voter or regional Fed president who's stepped within range of an open microphone the last few weeks has gone out of his or her way to endorse the notion that two 2017 rate hikes are reasonable, and those with a more hawkish bent appear to be comfortable with three. Viewed beside the data and the guidance, markets seem to be in denial. Currency exchange rates are subject to multiple cross-currents, but policy rate differentials have taken a leading role since the dollar's surge began in the second half of 2014. Some Fed hikes are already baked into the EUR-USD and USD-JPY crosses, but the implied expectation that it could take two years for the FOMC to lift the fed funds rate by 50 bps suggests that the path of least resistance for the dollar is up. The implications for global equity positioning point to favoring Europe- and Japan-based multinationals (on a currency-hedged basis) over their U.S. counterparts. They also argue for caution around emerging market assets, as a stronger dollar is a drag on commodity prices, makes it more difficult for domestic borrowers to service dollar-denominated debt, and imperils the supply of external capital that helps fund fiscal deficits. Investment Implications Putting it all together, we continue to favor a defensive stance. Real rates haven't budged during the post-Brexit sovereign yield backup (Chart 14, top panel), which has entirely been a function of less depressed term premiums (Chart 14, middle panel) and varying increases in inflation expectations (Chart 14, bottom panel). We are not yet convinced that the quickening in growth measures is anything other than one more of the false dawns that have been a regular feature of the last several years. We also see the uncertainty accompanying the Fed's turn away from accommodation at the margin as carrying considerable potential for disruption. It seems overly optimistic to think that policy makers will be able to shift course without causing at least a hiccup or two. With the S&P 500 trading at an elevated forward multiple (Chart 15), U.S. equities have little if any cushion against disappointment. Chart 14Bonds Aren't Pricing In Better Growth Bonds Aren't Pricing In Better Growth Bonds Aren't Pricing In Better Growth Chart 15Little Cushion Against Disappointment Little Cushion Against Disappointment Little Cushion Against Disappointment Maintaining a defensive portfolio bias is consistent with our qualms about growth and the potential for policy hiccups. We attribute cyclical sectors' outperformance relative to defensive sectors to technical rather than fundamental factors. Cyclicals had become oversold relative to defensives, as had emerging markets, at a time when the dollar needed to take a break from its upward sprint. We view the whole commodity/cyclical/EM complex as participating in a countertrend rally. We are vigilant, however, and we are asking ourselves where we could be getting it wrong even more frequently than usual. Many of the defensive spaces we currently favor have been bid up to levels where they would not seem to have any cushion at all. It is not comforting to invest on the basis of overshoots that are expected to become even more extended, but that is life with TINA in the ZIRP/NIRP era. Our model portfolios have underperformed over their first four weeks thanks to our income hybrids' underperformance versus plain-vanilla fixed income and defensives' underperformance versus cyclicals, but we think they will enhance the overall portfolios' risk-adjusted return profiles over time. The lack of a credible recession threat argues for maintaining our underweight in plain-vanilla fixed income products, but uncomfortably tight high-yield spreads have us concentrating our spread product exposure in the investment-grade space. We maintain our (currency-hedged) equity tilts toward Europe and Japan, and away from the U.S., largely on our expectations for ongoing dollar strength. That view also informs our allocations to mid- and small-cap U.S. equities, which are more domestically focused than their large- and mega-cap counterparts. Our Fed view underpins our dollar expectations, and any change in our policy take would result in portfolio changes. We will undertake a comprehensive view of our model portfolios in December, once they have two months of performance under their belts. Postscript: Dewey Defeats Truman Global ETF Strategy has a cyclical, not a tactical, orientation. Our process is directed toward catching cyclical moves and we avoid the chasing-our-own-tail spiral of trying to handicap short-term wiggles. As a result, when this report went to press Tuesday afternoon, we looked through the election and rejected tweaking our portfolios to position for any particular outcome. While we were surprised by the results of the election, our U.S. portfolios' domestic orientation, and the generally defensive cast to all of our portfolios, should help insulate them from any incremental volatility that may ensue over the rest of the year. The immediate market reaction soundly rejected our stance on the course of Fed rate hikes, but we think investors may change their tune given more time to reflect. We think it is far from certain that the Fed will tear up its playbook. Upheaval in the financial markets could well stay the FOMC's hand in December, but the first half hour of New York trading suggests that the potential for upheaval was rather overhyped. We do not see why the election results would have any impact on the labor market and the creeping upward pressure on wages. Markets are said to hate uncertainty and the actions of a Trump administration are surely harder to predict than the actions of a Clinton administration. We are not going to become traders, but we will be more vigilant over the two-plus months before the Inauguration and the first weeks of the new administration. We will adopt a more tactical orientation if conditions warrant, but we are not acting hastily now. We expect that there will be a lot of head fakes before markets find their true course. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 With 84% of S&P 500 constituents having reported through November 3rd, Standard & Poor's projected year-over-year growth in operating earnings of nearly 14%. 2 Overnight index swaps (OIS) are our preferred vehicle for deriving rate hike expectations because they represent contracts between real-life market participants and are thus more reliable than survey measures.

Highlights De-globalization is accelerating. Europe is holding together, with populism in check. China power consolidation reflects extreme risks. Brexit is more likely, not less, after court ruling. Feature Chart I-1America Has Soured On Globalization De-Globalization De-Globalization The world woke up on Wednesday to President-elect Donald J. Trump. It will take time for the markets to digest the new regime in Washington D.C., but something tells us that it will not be business-as-usual over the next four years. We give our post-mortem assessment in the enclosed In Focus Special Report, starting on page 28. The divisive campaign reached epic lows in decorum and polarization, but both candidates did have one major thing in common: They shared a negative view of globalization, representing a paradigm shift in geopolitics and macroeconomics. Investors often take policymakers to be agents of political supply. Political rhetoric is taken seriously, analyzed, and its implications for various assets are discussed with confidence. But this approach gets the causality all wrong. Politicians are merely supplying what the political marketplace is demanding. In those terms, Donald Trump was not an agent of change. He was merely a product of his environment. So what is the American median voter demanding? Judging by the success of Donald Trump - and Senator Bernie Sanders in the Democratic primary race - the answer is less free trade, more government spending, and a promise to keep entitlement spending at current, largely unsustainable levels. Americans empirically support globalization at a lower level than the average of advanced, emerging, or developing economies (Chart I-1). What is the problem with globalization? In our 2014 report titled "The Apex Of Globalization - All Downhill From Here," we argued that globalization was under assault due to three dynamics:1 Deflation is politically pernicious: Globalization was one of the greatest supply-side shocks in recent history and thus exerted a strong deflationary force (Chart I-2). A persistently low growth environment that flirts with deflation is unacceptable for the majority of the population in advanced economies. Citizens have already experienced a combination of wage suppression and debt escalation. And while globalization produced disinflationary forces on the price of labor and tradeable goods, it has done little to check the rising costs of education, health care, child care, and housing (Chart I-3), which cannot be outsourced to China or Mexico. Chart I-2Globalization Was A Major Supply-Side Shock Globalization Was A Major Supply-Side Shock Globalization Was A Major Supply-Side Shock Chart I-3You Can't Ship Daycare To China bca.gps_mp_2016_11_09_s1_c3 bca.gps_mp_2016_11_09_s1_c3 The death of the Debt Supercycle: The 2008 Great Recession shifted the demand curve inward. BCA coined the "debt supercycle" framework in the 1970s to characterize the overarching trend of rising debt in a world where political leaders, with the Great Depression and Second World War in the back of their mind, continually resorted to reflationary policies to overcome each new recession. However, the 2008 economic shock permanently shifted household preferences in the West, reducing demand by turning consumers into savers (Chart I-4A and Chart I-4B). This contributes to the global savings glut and reinforces the deflationary environment. Chart I-4AGlobal Demand Engine ... bca.gps_mp_2016_11_09_s1_c4a bca.gps_mp_2016_11_09_s1_c4a Chart I-4B...Is Not Coming Back bca.gps_mp_2016_11_09_s1_c4b bca.gps_mp_2016_11_09_s1_c4b Multipolarity: Global leadership by a dominant superpower can overcome ideological challenges and demand deficiencies by providing a consumer of last resort. In game-theory terms, such a global hegemon acts as an exogenous coordinator, turning a non-cooperative game into a cooperative one. But in today's world, geopolitical and economic power is becoming more diffuse. We know from history that intense competition between a number of leading nations imperils globalization (Chart I-5). This is particularly the case in a low-growth environment. Geopolitical and economic multipolarity increase market risk premiums. Chart I-5Multipolarity Imperils Globalization Multipolarity Imperils Globalization Multipolarity Imperils Globalization These factors imperiled globalization well before Donald Trump, Bernie Sanders, Jeremy Corbyn, and Nigel Farage came to dominate the news flow in 2016. The macroeconomic and geopolitical context guaranteed that anti-globalization rhetoric would prove successful at the ballot box. Chart I-6Sino-American Macroeconomic Symbiosis Ended##br## In 2008 Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over In addition to these structural challenges to globalization, the next U.S. administration will also have to handle the increasingly complex Sino-American relationship. The future of the post-Bretton Woods macroeconomic and geopolitical system will be decided by these two great powers. And we fear that both economic and geopolitical tensions will worsen.2 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart I-6). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth - moving the economy up the value chain. Or, they can use protectionism - particularly non-tariff barriers to trade - to defend their domestic market from competition.3 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West. The problem with this choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into global trade (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open up its economy as it became wealthy. Today, 45% of China's population is middle class, which makes China potentially the world's second largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism.4 What should investors expect in a world that has less globalization, more populism, and rising Sino-American tensions? We think there are five structural investment themes afoot: Chart I-7Globalization And MNCs: A Tight Embrace bca.gps_mp_2016_11_09_s1_c7 bca.gps_mp_2016_11_09_s1_c7 Inflation is back: Globalization has been one of the most important pillars of a multi-decade deflationary era. If it is imperiled, political capital will swing from capitalists to the owners of labor. Sovereign bonds are not pricing in this paradigm shift, which is why investors should position themselves for the "End Of The 35-Year Bond Bull Market."5 We are long German 10-year CPI swaps as a strategic play on this theme. USD strength: The market got the USD wrong. Trump is not bad for the greenback. More government spending and higher inflation will allow U.S. monetary policy to be tighter than that of its global peers. Furthermore, U.S. policymakers will not look to arrest the dollar bull market. "Main street" loves a strong dollar, particularly U.S. households and consumers. King Dollar will be the righteous agent of plebeian retribution against the patrician corporations used to getting their way on Capitol Hill. And finally, more geopolitical risk will mean more safe haven demand. RMB weakness: China needs to depreciate its currency in order to ease domestic monetary policy and is therefore constrained by its slowing and over-leveraged economy. But in doing so, it will export deflation and ensure that a trade war with the U.S. ensues. In addition, China's EM peers will suffer as their competitiveness vis-à-vis their main export market - China - declines. We expect that China will hasten its ongoing turn towards protectionism itself. This means that if investors want to take advantage of China's rise, they should buy Chinese companies, not the foreign firms looking to grab a share of China's middle-class market. Long defense stocks: Global multipolarity is correlated with armed conflict. We have played this theme by being long U.S. defense / short aerospace equities. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, recommends investors initiate a structural overweight in the global defense index.6 Long SMEs / Short MNCs: A world with marginally less free trade, and marginally more populism, will favor domestically oriented sectors. Small- and medium-sized enterprises (SMEs) in the U.S., for example. Multinational corporations (MNCs) have particularly benefited from free trade and laissez faire economics. The relationship between globalization and S&P 500 operating earnings has been tight for the past 50 years (Chart I-7). Not anymore. In the new environment, investors will want to be long domestically-oriented sectors and economies against externally-oriented ones. These are structural themes supported by structural trends. We would have recommended these five investment themes irrespective of who won the U.S. election. In this Monthly Report, we focus on leadership races around the world. Our In Focus section gives a post-mortem on the U.S. presidential election. The rest of this Global Overview focuses on upcoming elections in Europe (as well as the December 4 Italian constitutional referendum) and the impending Chinese leadership rotation in 2017. We also give our two cents on recent developments related to Brexit in the U.K. Europe: Election Fever Continues Chart I-8Italian Referendum: Likely A 'No' Italian Referendum: Likely A "No" Italian Referendum: Likely A "No" The Netherlands, France, Germany, and potentially, Italy could all hold elections over the next 12 months, a recipe for market volatility. These four countries are part of the EMU-5 and account for 71% of the currency union's GDP and 66% of its population. Should investors expect a paradigm shift? We think the answer is yes, but surprisingly, not towards more Euroskepticism. Our view is that continental Europe - unlike its Anglo-Saxon peers, the U.K. and the U.S. - is actually moving marginally towards the center.7 The median voter in Europe is not becoming more Euroskeptic and even appears to support modest, pro-business, structural reforms! Wait... what? Indeed. Read on. Italy The constitutional referendum being held on December 4 remains too close to call, although we suspect that it will fail (Chart I-8). However, we doubt very much that the defeat of the government's position will initiate a sequence of events that takes Italy out of the euro area. As we argued in a recent Special Report titled "Europe's Divine Comedy: Italian Inferno," Italian policymakers are using Euroskepticism to extract concessions from Europe. But Italy is structurally constrained from exiting European institutions because of its bifurcated economy.8 Moreover, a failed referendum outcome is not a strategic risk to Europe: Euro support: Italians continue to support euro area membership, albeit at a lower level than in the past (Chart I-9). As such, the Euroskeptic Five Star Movement (M5S) has political reasons to become less opposed to euro area membership, as its anti-establishment peers have done in Greece, Portugal, and Spain. Bicameralism: If the constitutional referendum fails, then the Senate will remain a fully empowered chamber in the Italian Parliament. Given Italy's complicated electoral laws, M5S will be unable to capture both houses in Italy's notoriously bicameral legislative body, unless it does very well in the next election. But M5S has consistently trailed the incumbent, pro-establishment Democratic Party (PD) in the polls (Chart I-10). Sequence: As Diagram I-1 shows, the contingent probability of the December constitutional referendum leading to an Italian exit from the euro area is 1.2%. Chart I-9Italy & Euro: OK (For Now) bca.gps_mp_2016_11_09_s1_c9 bca.gps_mp_2016_11_09_s1_c9 Chart I-10Italy: Euroskeptics Peaking? bca.gps_mp_2016_11_09_s1_c10 bca.gps_mp_2016_11_09_s1_c10 Diagram I-1From Referendum To Referendum: Contingent Probability Of Italy ##br##Leaving The Euro Area Following The Constitutional Referendum Vote De-Globalization De-Globalization Investors should not translate our sanguine view into a positive view of Italy. As we outlined in the above-cited Special Report, we remain skeptical that Italy can improve its potential growth rate by boosting productivity. But there is a big leap between more-of-the-same in Italy and a euro area collapse. The Netherlands The anti-establishment and Euroskeptic Party for Freedom (PVV) is set to perform poorly in the upcoming March 15 Dutch election. Polls suggest that it will roughly repeat its 10% performance from the 2012 election (Chart I-11). This is extremely disappointing given its polling earlier in the year. PVV's support has collapsed recently, most likely the result of the immigration crisis abating (Chart I-12) and the Brexit referendum in June. Many Dutch may be interested in casting a protest vote against the establishment, but a large majority still support euro area membership (Chart I-13). As such, they are put off by the vociferous Euroskepticism represented by the PVV. Chart I-11The Netherlands: Euroskeptics Collapsing bca.gps_mp_2016_11_09_s1_c11 bca.gps_mp_2016_11_09_s1_c11 Chart I-12Read Our Chart: Migration Crisis Is Over bca.gps_mp_2016_11_09_s1_c12 bca.gps_mp_2016_11_09_s1_c12 Chart I-13The Netherlands & Euro: Love Affair bca.gps_mp_2016_11_09_s1_c13 bca.gps_mp_2016_11_09_s1_c13 The Netherlands is a very important euro area member state. Its economy is large enough that its views matter, despite its small population. Euroskepticism in the Netherlands is notable, but it does not mean that the country's leadership will contemplate a referendum on membership. More likely, the establishment will seek to counter the populist PVV by becoming stricter on immigration and looser on budget discipline. Investors can live with both. France The French election is a two-round affair that will be held on April 23 and May 7. The key question is who will win the November 20 primary of the center-right party, Les Républicains, formerly known as the Union for a Popular Movement. According to the latest polls, former Prime Minister (1995-1997) Alain Juppé is set to win the primary over former President Nicolas Sarkozy (Chart I-14). Who is Alain Juppé? The 70-year old has been the mayor of Bordeaux since 2006, but he is better remembered for the failed social welfare reforms (the Juppé Plan) that caused epic strikes in France back in 1995. He is pro-euro, pro-EU, and pro-economic reforms. In other words, he is everything that Brexit and Trump/Sanders/Corbyn are not. According to the latest polls, Juppé is a heavy favorite against the anti-establishment candidate Marine Le Pen (Chart I-15). This is unsurprising as Le Pen's popularity peaked in 2013, as we have been stressing to clients for years (Chart I-16). Chart I-14Please Google Alain Juppe... bca.gps_mp_2016_11_09_s1_c14 bca.gps_mp_2016_11_09_s1_c14 Chart I-15...The Next President Of France De-Globalization De-Globalization Chart I-16Le Pen's Popularity In A Secular Decline bca.gps_mp_2016_11_09_s1_c16 bca.gps_mp_2016_11_09_s1_c16 Why has Le Pen struggled to gain traction in an era of terrorism, migration crises, and the success of anti-establishment peers such as Brexiters and Donald Trump? There are two major reasons. First, she continues to oppose France's membership in the euro area, despite very large support levels for the common currency in the country (Chart I-17). Second, she is holding together a coalition of northern and southern National Front (FN) members. This coalition pins together a diverse group. Northern right-wing FN members are more akin to their Dutch peers, or the "alt-right" movement in the U.S. They are anti-globalization, anti-political correctness (PC), and anti-immigration - specifically, further immigration of Muslims to France. However, this northern FN faction is ambivalent on social issues such as homosexuality (in fact, many of Le Pen's closest advisors from the north of France are openly gay), and they oppose Islam from a position that Muslim immigrants are incompatible with French liberal values. The southern FN faction is far more traditionally conservative, drawing their roots from the old anti-Gaullist, staunchly Catholic right wing. When Le Pen loses the 2017 presidential election, it will spell doom for the National Front. The only thing holding the two factions together is her leadership. Therefore, not only is France likely to elect a pro-reform president from the political establishment, but also its anti-establishment, Euroskeptic movement may be facing an internal struggle. Germany The German federal election is expected to be held sometime after August 2017. Chancellor Angela Merkel faces a decline in popularity (Chart I-18) and a challenge from the populist Alternative für Deutschland (AfD), which performed well in two Lander (state) elections this year. Nonetheless, the migration crisis that rocked Merkel's hold on power has abated. As Chart I-12 shows, migrant flows into Europe peaked at 220,000 last October and began to plummet well before the EU-Turkey deal that the press continues to erroneously cite as the reason for the reduction in migrant flows. As we controversially explained at the height of the crisis, every migration crisis ultimately abates as border enforcement strengthens, liberal attitudes towards refugees wane, and the civil wars prompting the flow exhaust themselves.9 Germany's centrist parties maintain a massive lead over the upstart AfD and Die Linke, the left-wing successor of East Germany's Communist establishment (Chart I-19). However, AfD's successes in Mecklenburg West Pomerania and Berlin have prompted investors to ask whether it will garner greater national support in the general election. Chart I-17France & Euro: Loveless Marriage,##br## But Together For The Kids bca.gps_mp_2016_11_09_s1_c17 bca.gps_mp_2016_11_09_s1_c17 Chart I-18Merkel's Popularity Has Suffered,##br## But Stabilized Merkel's Popularity Has Suffered, But Stabilized Merkel's Popularity Has Suffered, But Stabilized Chart I-19There Is A##br## Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... We doubt it. Both states are sort of oddballs in German politics. For example, Mecklenburg West Pomerania is known for a strong anti-establishment sentiment. AfD largely took votes away from the National Democratic Party (ultra-far-right, neo-Nazis) and Die Linke. These two parties won a combined 25% of the vote in 2011. In 2016, the combined anti-establishment vote, including AfD, was 33%. Clearly this is a notable gain for the non-centrist parties, but it is hardly a paradigm shift. In Berlin, the AfD gained a solid 14% of the vote, but the sensationalist media conveniently avoided mentioning that it came in fifth in the final count. By our "back-of-the-envelope" calculation, AfD managed to take only about 8% of the vote from establishment parties. The bulk of its success once again came from taking votes from other populist parties. For example, Berlin's Pirate Party - yes, "pirates" - took 8% of the vote in the last election and none in 2016. Nonetheless, we suspect that time may be running out for Angela Merkel. She has been in power since 2005 and many voters have lost confidence in her. Merkel may choose not to contest the election at the CDU party conference in early December, or she may step aside as the leader following the election. Why? Because polls suggest that Merkel's CDU will have to once again rely on a Grand Coalition with its center-left opponent, the SPD, to govern. Politically, this is a failure for Merkel as the Grand Coalition was always intended to be a one-term arrangement. If Merkel decides to retire, how will the ruling CDU choose its successor? The process is relatively closed off and dominated by the party elites. The Federal Executive Board of the CDU selects the candidates for chairperson and the party delegates must choose the leader with a majority. The outcome is largely preordained, and Merkel has typically won above 90% of the party congress delegate vote. The possibility of a chancellor from the CDU's Bavarian sister-party, the Christian Social Union (CSU), is also decided by the elites. Therefore, the likelihood of an anti-establishment candidate hijacking the CDU/CSU leadership is minimal. How will the markets react to Merkel's resignation? Investors are overstating Merkel's role as the "anchor" of euro area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent euro area fiscal backstop mechanism due to upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. In addition, her likely successor will not mark a paradigm shift in terms of Germany's pro-euro outlook (Box I-1). Bottom Line: Investors may wake up in mid-2017 to find that the U.K. is firmly on its way out of the EU and that the U.S. is embroiled in deepening political polarization. Meanwhile, France and Spain will be led by reformist governments, Italy will remain in the euro area, and Germany will be mid-way through a rather boring electoral campaign featuring pro-euro establishment parties. What is keeping the European establishment in power? In early 2016, we argued that it was its large social welfare state. Unlike the laissez-faire economies of the U.S. and the U.K., European "socialism" has managed to redistribute the gains of globalization sufficiently to keep the populists at bay. As such, European voters are not flocking to populist alternatives, despite considerable challenges such as the migration crisis and terrorism. Populists are gaining votes in Europe nonetheless. To counter that trend, we should expect to see Europe's establishment parties turn more negative towards immigration, positive on fiscal activism, and more assertive towards security and defense policy. But on the key investment-relevant issue of euro area membership and European integration, we see the consensus remaining with the status quo. China: Xi Is A "Core" Leader... So What? Chinese President Xi Jinping's recent designation as the "core" of the Chinese leadership should be seen as a marginally market-positive event in an otherwise bleak outlook. Not because the president has a new title, but because of the underlying reality that he is consolidating power ahead of the 19th National Party Congress. Set for the fall of 2017, the Congress will feature a major rotation of top Communist Party leaders and mark the halfway point of his 10-year administration. The new title was not a surprise when it trickled out of the Chinese Communist Party's Sixth Plenary meeting on October 24-27. But the media took the opportunity once again to decry President Xi's "ever-expanding power."10 As our readers know, we do not think there has been a palace coup in China. That is, we do not think Xi has overthrown the "collective leadership" model, i.e. rule by the Politburo Standing Committee, established after the death of Chairman Mao.11 Instead, we think he is presiding over a major centralization phase in Chinese politics. Xi's status as the "core" feeds into the broader idea of re-centralization that we identified as a key theme for this administration when it began its term back in 2012.12 The Sixth Plenum reinforced this view in various ways:13 Xi is clearly in charge: A smattering of local party officials started calling him the core leader earlier this year, but now it has been endorsed in official documents at the highest level. Again, it is not the title itself that matters, but the fact that Xi compelled the whole party to give him the title. This distinguishes him from his two predecessors, Presidents Hu Jintao and Jiang Zemin, and in this way he resembles his mighty predecessor Deng Xiaoping. Xi already developed a strong track record for re-centralizing the political system prior to receiving the new title.14 Collective leadership persists: Deng invented the idea of the "core" leader specifically as a way to assert the need for a top leader or chief executive without reverting to Maoist absolutism. The core leader is the supreme leader within a collective leadership system. This interpretation was expressly reaffirmed by the communique issued at the Sixth Plenum, which denounced ruling by a single person and praised the current system.15 Corruption purge has not split the party: The focus of the plenum was the Communist Party's rules for disciplining its own members. This specifically highlighted Xi's harsh anti-corruption campaign, which has netted numerous party officials, and has not yet concluded (Chart I-20). The fact that this campaign has continued longer than expected without prompting significant resistance shows that centralization is acceptable to the party (and anti-corruption is positive for the party's public image). Policy coherence could improve: A rash of rumors suggest that Xi will not only promote his allies but also tweak party rules and norms in order to ensure he retains a factional majority on the Politburo Standing Committee after 2017. This should be positive for policymaking since the cohort of leaders ready to rise up the ranks is weighted against his faction as a result of the previous administration's appointments. These developments would be negative if Xi avoids appointing successors next year and thus appears ready to cling to power beyond 2022.16 Unified government is a plus amid crisis: Deng initiated the "core leader" concept in the dark days after the Tiananmen massacre, when the party faced internal rifts and potential regime collapse. In other words, it is in times of crisis that the party needs to reaffirm that rule-by-committee still requires a final arbiter at the top. This latter point is the most relevant for investors. It suggests that China's party leadership perceives itself to be in the midst, or on the brink, of a crisis. Why should this be the case? There has been an improvement in China's economic situation in 2016 - stimulus efforts have stabilized the economy and growth momentum is picking up (Chart I-21). Economic relations with Asian nations are also improving. All of this information has supported the China bulls, who argue that China is not particularly overleveraged, still has a long way to go in terms of economic development, and needs to stimulate demand in order to outgrow any problems it faces from debt and overcapacity (Chart I-22). Chart I-20Anti-Corruption ##br##Campaign Reaccelerating Anti-Corruption Campaign Reaccelerating Anti-Corruption Campaign Reaccelerating Chart I-21Chinese Economy##br## Improved This Year Chinese Economy Improved This Year Chinese Economy Improved This Year Chart I-22Chinese Capacity Utilization: ##br##A Historical Perspective Chinese Capacity Utilization: A Historical Perspective Chinese Capacity Utilization: A Historical Perspective Nevertheless, the latest reflation efforts have peaked (Chart I-23), and there are clear warning signs for what lies ahead. The RMB continues to weaken, capital outflows may reaccelerate as a result, the yield curve is flattening, and economic policy uncertainty remains markedly elevated (Chart I-24). As such, the China bears argue that exorbitant credit growth cannot continue indefinitely (Chart I-25). When credit growth slows, the credit-reliant economy will slow too, and China will face a cascade of bad loans and insolvent companies and banks. Chart I-23Latest Mini-Stimulus##br## Is Over Latest Mini-Stimulus Is Over Latest Mini-Stimulus Is Over Chart I-24China:##br## Who Is Driving This Bus? China: Who Is Driving This Bus? China: Who Is Driving This Bus? Chart I-25China's Corporate And Household Credit: ##br##The Sky's The Limit? China's Corporate And Household Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? While economists can argue over the nature of things, politicians do not have that luxury: China's government must be prepared for the worst-case scenario. The China bears may be right even if their economic analysis proves overly pessimistic or poorly timed, because policymakers may eventually decide they must do more to tackle excessive leverage and overcapacity. Chart I-26Rebalancing Is Slowing Down Rebalancing Is Slowing Down Rebalancing Is Slowing Down An optimistic long-term assumption about Xi's consolidation of power has been that he eventually intends to use that power to pursue painful structural reforms, as outlined at the Third Plenum in 2013.17 However, the intervening three years have shown that he is pragmatic and does not want to impose aggressive reforms that would undercut an already weak and slowing economy (Chart I-26). Thus, deep reforms are only going to occur if they are forced upon the leaders as a result of an intense bout of instability, uncertainty, and market riots. The implication of this is that Xi is concentrating power in preparation for further crisis points that may be thrust upon his administration. For instance, if recent efforts to tamp down on property prices end up bursting the bubble, then eventually China could be plunged into socio-political (as well as financial) turmoil. By that time, the party would not be able to re-centralize and consolidate power carefully and gradually. It would either have loyal tools at its disposal already, or would lose precious time (and likely make mistakes) trying to assemble them. Thus Xi's moves to consolidate power are marginally market-positive in an overall negative climate. He is making himself and the Politburo Standing Committee better prepared to handle a crisis, which suggests that he believes that a crisis is either occurring or close at hand. In short, the Communist Party is girding for war; a war for regime stability if and when the massive credit risks materialize. What about the 19th National Party Congress, set to take place next fall? We will revisit this topic in the future, but for now the key point is this: It would require a surprise and/or a new political dynamic to prevent Xi from getting his way in forming the Politburo Standing Committee next year. While there is a mixed record of policy stimulus for the years preceding the Chinese midterm leadership reshuffle, we certainly do not expect aggressive structural reforms to occur before then (Chart I-27). Policy tightening in the real estate sector and SOE restructuring efforts will be gradual. Chart I-27Unimpressive Record Of Stimulus Before Five-Year Party Congresses Unimpressive Record Of Stimulus Before Five-Year Party Congresses Unimpressive Record Of Stimulus Before Five-Year Party Congresses Only around the time of the party congress will it be possible to find out whether Xi wants his administration to be remembered for anything other than power consolidation - such as ambitious reforms. One reform effort we are confident will continue amid rising centralization, however, is tougher government policy against pollution. Pollution threatens social stability, especially among the restless new middle class, and stimulus efforts perpetuate the heavily polluting industries. Environmental spending has been the biggest growth category in government spending under Premier Li Keqiang.18 To capitalize on the darkening short-term outlook for stocks and Xi's policy momentum, we suggest shorting Chinese utilities, whose profit margins and share prices trade inversely with rising environmental spending (Chart I-28). Bottom Line: We remain overweight China relative to EM: The government has resources and is unified. However, the long-term outlook is mixed. Investors should steer clear of Chinese risk assets in absolute terms. Short utilities as a play on rising environmental spending and regulation, and stay short the RMB. Brexit Update: The "Legion Memorial" Is Alive And Well Chart I-28Anti-Pollution Push Hurts Utilities Anti-Pollution Push Hurts Utilities Anti-Pollution Push Hurts Utilities The Brexit movement encountered its first apparent setback last week when the country's High Court ruled that parliament must vote on invoking Article 50 of the Lisbon Treaty to initiate the withdrawal from the European Union. We have always held a high-conviction view that parliament approval would ultimately be necessary, as we wrote in July.19 But, politically, it matters a great deal whether parliament votes before or after the exit negotiations. The High Court ruling is an obstacle to the government's Brexit plan because it could result in (1) the parliament's outright blocking Brexit, though this outcome is highly unlikely; (2) the parliament's insisting on a "soft Brexit" that leaves U.K.-EU relations substantially the same as before the referendum on matters like immigration and market access. However, the saga is nowhere near finished. The government is appealing the ruling, the Welsh assembly is contesting the appeal, and the Supreme Court will decide the matter in December. Until then, we expect U.K. markets to benefit marginally, ceteris paribus, from the belief that the odds of a soft Brexit are rising. Investors could be encouraged by the continuation of monetary stimulus and a new blast of fiscal stimulus, which we think will surprise to the upside on November 23 when the annual Autumn Statement is released by the Chancellor of the Exchequer. The High Court-prompted rebound in U.K. assets will remain vulnerable for the following reasons: The Supreme Court has not yet ruled: It is not certain that the Supreme Court will uphold the High Court's insistence on a parliamentary role. Both views have legitimate arguments and the issue is not settled until the Supreme Court rules. Parliament's role is political, not merely legal: Assuming parliament gets to vote on whether to trigger the process of leaving the EU, the decision will depend on politics. For instance, it is highly unlikely that the Commons will flatly reject the popular referendum, and the House of Lords can at best delay it. Yes, parliament is sovereign, but that is because it represents the people. While the 1689 Glorious Revolution established the Bill of Rights and parliamentary supremacy, in as early as 1701 there was a crisis over whether parliament should flatly overrule popular will. At that time, the writer Daniel Defoe, representing "the people," delivered the so-called Legion Memorial directly to the Speaker of the Commons. It read: "Our name is Legion, for we are Many."20 Parliament backed down. The politics of the moment favor the government: Polling shows a stark divergence in popular opinion since the referendum in favor of the Tories (Chart I-29). This is a clear signal - on top of the referendum outcome and the sweeping Tory election win in 2015 - that the popular will favors leaving the European Union. It is also a clear signal that Prime Minister Theresa May has the mandate to do it her way. Her approval rating has waned a bit (Chart I-30), but she is still supported by nearly half the population. If the government fails to win parliamentary support on Brexit, it would likely lead to a vote of no confidence and early elections. Yet the current dynamics suggest an early election would return a Conservative majority with a clear mandate to vote for Brexit. Until those dynamics undergo a change, "Brexit means Brexit." Economics favor the government: One danger for the anti-Brexit coalition is that the Supreme Court may compel a parliamentary vote in the near future. The economy has not yet suffered much from Brexit, whatever it may do in future, so there is little motivation for widespread "Bregret," i.e. the desire to reverse course and stay in the EU. By contrast, in two years' time, the negative economic consequences and uncertainties of the actual exit plan, combined with ebbing popular enthusiasm, would likely give parliament a stronger position from which to soften or reverse Brexit. Although Article 50 is arguably irrevocable, it seems hard to believe that the EU would not find a way to allow the U.K. to stay in the union if its domestic politics shifted in favor of staying, since that is clearly in the EU's interest. The President of the European Council Donald Tusk has implied as much.21 Chart I-29Brexit Helped Tories, Hurt Labour Brexit Helped Tories, Hurt Labour Brexit Helped Tories, Hurt Labour Chart I-30Prime Minister May's Popularity Still Strong De-Globalization De-Globalization From the arguments above we can draw three conclusions. First, parliament will not simply repudiate the popular referendum. Second, if parliament must vote, the political context suggests it will vote on a bill that substantially favors the government's approach toward Brexit. If that happens, the High Court ruling this week will be only a pyrrhic victory for the Bremain camp. However, parliamentary involvement does imply a softer Brexit than otherwise, and it is possible that parliament could extract major concessions. Third, the High Court ruling makes Brexit more, not less, likely. This is because it is forcing parliamentarians to vote on Brexit so early in the process, when Brexit's negative consequences are yet not evident. What do the latest Brexit twists and turns portend for European and global growth? We do not see them as particularly damaging. The British turn toward greater fiscal spending adds yet another to the list of those countries supporting one of our key investment themes: "The Return of G," or government spending.22 As we predicted, Canada is overshooting its budget deficits, Japan is engaging in coordinated monetary and fiscal stimulus, and Italy is expanding spending and daring Germany and the European Council to stop it, especially in the face of badly needed earthquake reconstruction and the ongoing immigration crisis (Chart I-31). Chart I-31G7 Fiscal Thrust Is Going Up De-Globalization De-Globalization This leaves the United States and Germany as two outstanding questions. The U.S. election means that Trump will launch potentially large spending increases with a GOP-held Congress. As for Germany, the CDU/CSU appears to be shifting toward more government spending, but the direction will not be clear until the election in the fall of 2017. Bottom Line: The High Court ruling has made Brexit more rather than less likely. By forcing the parliament to make a ruling on Brexit before the economic damage is clear, the High Court has put parliamentarians in the difficult position of going against the public. We are closing our long FTSE 100 / short FTSE 250 Brexit hedge in the meantime. The market may, incorrectly, price a lower probability of Brexit, while domestic stimulus will aid the home-biased FTSE 250. Nonetheless, we remain short U.K. REITs to capitalize on the long-term uncertainty, as well as negative cyclical and structural factors that are affecting commercial real estate. We also expect the GBP/USD to remain relatively weak and vulnerable relative to the pre-Brexit period. We would expect the GBP/USD to retest its mid-October-low of 1.184 over the next two years. BOX I-1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Wolfgang Schäuble, Finance Minister (CDU): The bane of the financial community, Schäuble is seen as the least market-friendly option due to his hardline position on bailouts and the euro area. In our view, this is an incorrect interpretation of Schäuble's heavy-handedness. He is by all accounts a genuine Europhile who believes in the integrationist project. At 74 years old, he comes from a generation of policymakers who consider European integration a national security issue for Germany. He has pursued a tough negotiating position in order to ensure that the German population does not sour on European integration. Nonetheless, we doubt that he will chose to take on the chancellorship if Merkel retires. He suffered an assassination attempt in 1990 that left him paralyzed and he has occasionally had to be hospitalized due to health complications left from this injury. As such, it is unlikely that he would replace Merkel, but he may stay on as Finance Minister and thus be as close to a "Vice President" role as Germany has. Ursula von der Leyen, Defense Minister (CDU): Most often cited as the likely replacement for Merkel, Leyen nonetheless is not seen favorably by most of the population. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has gone so far as to say that the refugee crisis and the debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. While the markets and pro-EU elites in Europe would love Leyen, the problem is that her Europhile profile may disqualify her from chancellorship at a time when most CDU politicians are focusing on the Euroskeptic challenge from the right. Thomas De Maizière, Interior Minster (CDU): Maizière is a former Defense Minister and a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could be a compromise candidate between the Europhiles and Eurohawks within the CDU ranks. However, he has also been implicated in scandals as Defense Minister and may be tainted by the immigration crisis due to his position as the Interior Minister. Julia Klöckner, Executive Committee Member, Deputy Chair (CDU): A CDU politician from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel. While she has taken a more right-wing stance on the immigration crisis, she has remained loyal to Merkel otherwise. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist." We think that she would be a very pro-market choice as she combines the market-irrelevant populism of anti-immigration rhetoric with market-relevant centrism of favoring further European integration. Hermann Gröhe, Minister of Health (CDU): Gröhe is a former CDU secretary general and very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Grohe, although they may take some time to get to know who he is! Volker Bouffier, Minister President of Hesse (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier may be disqualified from leadership due to his apparent close links with Deutsche Bank. Nonetheless, he is a heavyweight within the CDU's leadership and a staunch Europhile. Fritz Von Zusammenbruch, Hardline Euroskeptic (CDU): This person does not exist! Section II: U.S. Election: Outcomes & Investment Implications Highlights Trump won by stealing votes from Democrats in the Midwest. His victory implies a national shift to the left on economic policy. Checks and balances on Trump are not substantial in the short term. U.S. political polarization will continue. Trump is good for the USD, bad for bonds, neutral for equities. Favor SMEs over MNCs. Close long alternative energy / short coal. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." — Newt Gingrich, January 2, 2001 Former Speaker of the House Newt Gingrich (and a potential Secretary of State pick), was asked on NBC's Meet the Press two days before the U.S. election whether he still thought that "competition for power in the U.S. remains largely a debate between people who can work together once the election is over." Gingrich made the original statement in January 2001, merely weeks after one of the most contentious presidential elections in U.S. history was resolved by the Supreme Court. Gingrich's answer in 2016? "I think, tragically, we have drifted into an environment where ... it will be a continuing fight for who controls the country." Despite an extraordinary victory - a revolution really - by Donald J. Trump, the fact of the matter remains that the U.S. is a polarized country between Republican and Democratic voters. As of publication time of this report, Trump lost the popular vote to Secretary Hillary Clinton. His is a narrower victory than either the epic Richard Nixon win in 1968 or George W. Bush squeaker in 2000. Over the next two years, the only thing that matters for the markets is that the U.S. has a unified government behind a Republican president-elect and a GOP-controlled Congress. We discuss the investment implications of this scenario below and caution clients to not over-despair. On the other hand, we also see this election as more evidence that America remains a deeply polarized country where identity politics continue to play a key role. What concerns us is that these identity politics appear to transcend the country's many cultural, ethical, political, and economic commonalities. Republicans and Democrats in the U.S. are fusing into almost ethnic-like groupings. To bring it back to Gingrich's quote at the top, that would suggest that the U.S. is no longer that much different from Bosnia or Northern Ireland.23 Election Post-Mortem Chart II-1Election Polls Usually##br## Miss By A Few Points De-Globalization De-Globalization Donald Trump has won an upset over Hillary Clinton, but his campaign was not as much of a long-shot as the consensus believed. U.S. presidential polls have frequently missed the final tally by +/- 3% of the vote, which was precisely the end result of the 2016 election (Chart II-1). Therefore, as we pointed out in our last missive on the election, Trump's victory was not a "wild mathematical oddity."24 Why Did Trump Win The White House? Where Trump really did beat expectations was in the Midwest, and Wisconsin in particular. He ended up outperforming the poll-of-polls by a near-incredible 10%!25 His victories in Florida, Ohio, and Pennsylvania were well within the range of expectations. For example, the last poll-of-polls had Trump leading in both Florida (by a narrow 0.2%) and Ohio (by a solid 3.5%), whereas Clinton was up in Pennsylvania by the slightest of margins (just 1.9% lead). He ended up exceeding poll expectations in all three (by 2% in Florida, 6% in Ohio, and 3% in Pennsylvania), but not by the same wild margin as in Wisconsin. When all is said and done, Trump won the 2016 election by stealing votes away from the Democrats in the traditionally "blue" Midwest states of Michigan, Pennsylvania, and Wisconsin. This was a far more significant result than his resounding victories in Ohio (which Obama won in 2012) or Florida (where Obama won only narrowly in 2012). Our colleague Peter Berezin, Chief Strategist of the Global Investment Strategy, correctly forecast that Trump would be competitive in all three Midwest states back in September 2015! We highly encourage our clients to read his "Trumponomics: What Investors Need To Know," as it is one of the best geopolitical calls made by BCA in recent history.26 As Peter had originally thought, Trump cleaned up the white, less-educated, male vote in all of the three crucial Midwest states. He won 68% of this vote in Michigan, 71% in Pennsylvania, and 69% in Wisconsin. To do so, Trump campaigned as an unorthodox Republican, appealing to the blue-collar white voter by blaming globalization for their job losses and low wages, and by refusing to accept Republican orthodoxy on fiscal austerity or entitlement spending. Instead, Trump promised to outspend Clinton and protect entitlements at their current levels. This mix of an outsider, anti-establishment, image combined with a left-of-center economic message allowed Trump to win an extraordinary number of former Obama voters. Exit polls showed that Obama had a positive image in all three Midwest states, including with Trump voters! For example, 30% of Trump voters in Michigan approved of the job Obama was doing as president, 25% in Pennsylvania, and 27% in Wisconsin. That's between a quarter and a third of eventual people who cast their vote for Trump. These are the voters that Republicans lost in 2012 because they nominated a former private equity "corporate raider" Mitt Romney as their candidate. Romney had famously argued in a 2008 New York Times op-ed that he would have "Let Detroit go bankrupt." Obama repeatedly attacked Romney during the 2011-2012 campaign on this point. Back in late 2011, we suspected that this message, and this message alone, would win President Obama his re-election.27 Why is the issue of the Midwest Obama voters so important? Because investors have to know precisely why Donald Trump won the election. It wasn't his messages on immigration, law and order, race relations, and especially not the tax cuts he added to his message late in the game. It was his left-of-center policy position on trade and fiscal spending. Trump is beholden to his voters on these policies, particularly in the Midwest states that won him the election. Final word on race. Donald Trump actually improved on Mitt Romney's performance with African-American and Hispanic voters (Table II-1). This was a surprise, given his often racially-charged rhetoric. Meanwhile, Trump failed to improve on the white voter turnout (as percent of overall electorate) or on Romney's performance with white voters in terms of the share of the vote. To be clear, Republicans are still in the proverbial hole with minority voters and are yet to match George Bush's performance in 2004. But with 70% of the U.S. electorate still white in 2016, this did not matter. Table II-1Exit Polls: Trump's Win Was Not Merely About Race De-Globalization De-Globalization Congress: No Gridlock Ahead Republicans exceeded their expectations in the Senate, losing only one seat (Illinois) to Democrats. This means that the GOP control of the Senate will remain quite comfortable and is likely to grow in the 2018 mid-term elections when the Democrats have to defend 25 of 33 seats. Of the 25 Senate seats they will defend, five are in hostile territory: North Dakota, West Virginia, Ohio, Montana, and Missouri. In addition, Florida is always a tough contest. Republicans, on the other hand, have only one Senate seat that will require defense in a Democrat-leaning state: Nevada (and in that case, it will be a Republican incumbent contesting the race). Their other seven seats are all in Republican voting states. As such, expect Republicans to hold on to the Senate well into the 2020 general election. In the House of Representatives, the GOP will retain its comfortable majority. The Tea Party affiliated caucuses (Tea Party Caucus and the House Freedom Caucus) performed well in the election. The Tea Party Caucus members won 35 seats out of 38 they contested and the House Freedom Caucus won 34 seats out of 37 it contested. The race to watch now is for the Speaker of the House position. Paul Ryan, the Speaker of the incumbent House, is likely to contest the election again and win. Even though his support for Donald Trump was lukewarm, we expect Republicans to unify the party behind Trump and Ryan. A challenge from the right could emerge, but we doubt it will materialize given Trump's victory. The campaign for the election will begin immediately, with Republicans selecting their candidate by December (the official election will be in the first week of January, but it is a formality as Republicans hold the majority). Bottom Line: Trump's victory was largely the product of former Obama voters in the Midwest switching to the GOP candidate. This happened because of Trump's unorthodox, left-of-center, message. Trump will have a friendly Congress to work with for the next four years. How friendly? That question will determine the investment significance of the Trump presidency. Investment Relevance Of A United Government Most clients we have spoken to over the past several months believe that Donald Trump will be constrained on economic policies by a right-leaning Congress. His more ambitious fiscal spending plans - such as the $550 billion infrastructure plan and $150 billion net defense spending plan - will therefore be either "dead on arrival" in Congress, or will be significantly watered down by the legislature. Focus will instead shift to tax cuts and traditional Republican policies. We could not disagree more. GOP is not fiscally conservative: There is no empirical evidence that the GOP is actually fiscally conservative. First, the track record of the Bush and Reagan administrations do not support the adage that Republicans keep fiscal spending in check when they are in power (Chart II-2). Second, Republican voters themselves only want "small government" when the Democrats are in charge of the White House (Chart II-3). When a Republican President is in charge, Republicans forget their "small government" leanings. Chart II-2Republicans Are##br## Not Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Chart II-3Big Government Is Only ##br##A Problem For Opposition bca.gps_mp_2016_11_09_s2_c3 bca.gps_mp_2016_11_09_s2_c3 Presidents get their way: Over the past 28 years, each new president has generally succeeded in passing their signature items. Congress can block some but probably not all of president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed in their second term. Clinton lost on healthcare, but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). Median voter has moved to the left: Donald Trump won both the GOP primary and the general election by preaching an unorthodox, left-of-center sermon. He understood correctly that the American voter preferences on economic policies have moved away from Republican laissez-faire orthodoxies.28 Yes, he is also calling for significant lowering of both income and corporate tax rates. However, tax cuts were never a focal point of his campaign, and he only introduced the policy later in the race when he was trying to get traditional Republicans on board with his campaign. Newsflash: traditional Republicans did not get Trump over the hump, Obama voters in the Midwest did! Investors should make no mistake, the key pillars of Trump's campaign are de-globalization, higher fiscal spending, and protecting entitlements at current levels. And he will pursue all three with GOP allies in Congress. What are the investment implications of this policy mix? USD: More government spending, marginally less global trade, and pressure on multi-national corporations (MNCs) to scale back their global operations should be positive for inflation. If growth surprises to the upside due to fiscal spending, it will allow the Fed to hike more than the current 57 bps expected by the market by the end of 2018. Given easy monetary stance of central banks around the world, and lack of significant fiscal stimulus elsewhere, economic growth surprise in the U.S. should be positive for the dollar in the long term. At the moment, the market is reacting to the Trump victory with ambivalence on the USD. In fact, the dollar suffered as Trump's probability of victory rose in late October. We believe that this is a temporary reaction. We see both Trump's fiscal and trade policies as bullish. BCA's currency strategist Mathieu Savary believes that the dollar could therefore move in a bifurcated fashion in the near term. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer - or remain flat - against DM currencies such as the EUR, CHF, and JPY.29 Bonds: More inflation and growth should also mean that the bond selloff continues. In addition, if our view on globalization is correct, then the deflationary effects of the last three decades should begin to reverse over the next several years. BCA thesis that we are at the "End Of The 35-Year Bond Bull Market" should therefore remain cogent.30 As one of our "Trump hedges," our colleague Rob Robis, Chief Strategist of the BCA Global Fixed Income Strategy, suggested a 2-year / 30-year Treasury curve steepener. This hedge is now up 18.7 bps and we suggest clients continue to hold it. Fed policy: Trump's statements about monetary policy have been inconsistent. Early on in his campaign he described himself as "a low interest rate guy", but he has more recently become critical of current Federal Reserve policy - and Fed Chair Janet Yellen in particular - claiming that while higher interest rates are justified, the Fed is keeping them low for "political reasons." What seems certain is that Janet Yellen will be replaced as Fed Chair when her term expires in February 2018. Yellen is unlikely to resign of her own volition before then and it would be legally difficult for the President to remove a sitting Fed Chair prior to the end of her term. But Trump will get the opportunity to re-shape the composition of the Fed's Board of Governors as soon as he is sworn in. There are currently two empty seats on the Board need to be filled and given that many of Trump's economic advisers have "hard money" leanings, it is very likely that both appointments will go to inflation hawks. Equities: In terms of equities, Trump will be a source of uncertainty for U.S. stocks as the market deals with the unknown of his presidency. In addition, markets tend to not like united government in the U.S. as it raises the specter of big policy moves (Table II-2). However, Trump should be positive for sectors that sold off in anticipation of a Clinton victory, such as healthcare and financials. We also suspect that he will continue the outperformance of defense stocks, although that would have been the case with Clinton as well. Table II-2Election: Industry Implications De-Globalization De-Globalization In the long term, Trump's proposal for major corporate tax cuts should be good for U.S. equities. However, we are not entirely sure that this is the case. First, the effective corporate tax rate in the U.S. is already at its multi-decade lows (Chart II-4). As such, any corporate tax reform that lowers the marginal rate will not really affect the effective rate. Why does this matter? Because major corporations already have low effective tax rates. Any lowering of the marginal rate will therefore benefit the small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then Trump's policy will not necessarily benefit all firms in the U.S. equally. Chart II-4How Low Can It Go? bca.gps_mp_2016_11_09_s2_c4 bca.gps_mp_2016_11_09_s2_c4 Investors have to keep in mind that Trump has not run a pro-corporate campaign. He has accused American manufacturing firms of taking jobs outside the U.S. and tech companies of skirting taxes. It is not clear to us that his corporate tax reform will therefore necessarily be a boon for the stock market. In the long term, we like to play Trump's populist message by favoring America's SMEs over MNCs. If we are ultimately correct on the USD and growth, then export-oriented S&P 500 companies should suffer in the face of a USD bull market and marginally less globalization. Meanwhile, lowering of the marginal corporate tax rate will benefit the SMEs that do not get the benefit of K-street lobbyist negotiated tax loopholes. Global Assets: The global asset to watch over the next several weeks is the USD/RMB cross. China is forced by domestic economic conditions to continue to slowly depreciate its currency. We have expected this since 2015, which is why we have shorted the RMB via 12-month non-deliverable forwards (NDF). Risk to global assets, particularly EM currencies and equities, would be that Beijing decides to depreciate the RMB before Trump is inaugurated on January 20. This could re-visit the late 2015 panic over China, particularly the narrative that it is exporting deflation. Our view is that even if China does not undertake such actions over the next two months, Sino-American tensions are set to escalate. It is much easier for Trump to fulfill his de-globalization policies with China - a geopolitical rival with which the U.S. has no free trade agreement - than with NAFTA trade partners Canada and Mexico. This will only deepen geopolitical tensions between the two major global powers, which has been our secular view since 2011. Finally, a quick note on the Mexican peso. The Mexican peso has already collapsed half of its value in the past 18 months and we believe the trade is overdone. Investors have used the currency cross as a way to articulate Trump's victory probability. It is no longer cogent. We believe that the U.S. will focus on trade relations with China under a Trump presidency, rather than NAFTA trade partners. Our Emerging Markets Strategy believes that it is time to consider going long MXN versus other EM currencies, such as ZAR and BRL. Investors should also watch carefully the Cabinet appointments that Trump makes over the next two months. Since Carter's administration, cabinet announcements have occurred in early to mid-December. Almost all of these appointments were confirmed on Inauguration Day (usually January 20 of the year after election, including in 2017) or shortly thereafter. Only one major nomination since Carter was disapproved. These appointments will tell us how willing Trump is to reach to traditional Republicans who have served on previous administrations. We suspect that he will go with picks that will execute his fiscal, trade, and tax policies. Bottom Line: After the dust settles over the next several weeks, we suspect that Trump will signal that he intends to pursue his fiscal, trade, immigration, and tax policies. These will be, in the long term, positive for the USD, negative for bonds (including Munis, which will lose their tax-break appeal if income taxes are reduced), and likely neutral for equities. Within the equity space, Trump will be positive for U.S. SMEs and negative for MNCs. This means being long S&P 600 over S&P 100. Lastly, close our long alternative energy / short coal trade for a loss of -26.8%. Constraints: Don't Bet On Them Domestically, the American president can take significant action without congressional support through executive directives. Lincoln raised an army and navy by proclamation and freed the slaves; Franklin Roosevelt interned the Japanese; Truman tried to seize steel factories to keep production up during the Korean War. Truman's case is almost the only one of a major executive order being rebuffed by the Supreme Court. The Reagan and Clinton administrations have shown that a president thwarted by a divided or adverse congress will often use executive directives to achieve policy aims and satisfy particular interest groups and sectors. Though the number of executive orders has gone down in recent administrations (Chart II-5), the economic significance has increased along with the size and penetration of the bureaucracy (Chart II-6). The economic impact of executive orders is always debatable, but the key point is that the president's word tends to carry the day.31 Chart II-5Rule By Decree De-Globalization De-Globalization Chart II-6Executive Branch Is Growing De-Globalization De-Globalization Trade is a major area where Trump would have considerable sway. He has repeatedly signaled his intention to restrict American openness to international trade. The U.S. president can revoke international treaties solely on their own authority. Congressionally approved agreements like the North American Free Trade Agreement (NAFTA) cannot be revoked by the president, but Trump could obstruct its ongoing implementation.32 He would also have considerable powers to levy tariffs, as Nixon showed with his 10% "surcharge" on most imports in 1971.33 Bottom Line: Presidential authority is formidable in the areas Trump has made the focus of his campaign: immigration and trade. Without a two-thirds majority in Congress to override him, or an activist federal court, Trump would be able to enact significant policies simply by issuing orders to his subordinates in the executive branch. Long-Term Implications: Polarization In The U.S. Does the Republican control of Congress and the White House signal that polarization in America will subside? We began this analysis by focusing on the investment implications when Republicans control the three houses of the American government. But long-term implications of polarization will not dissipate. Investors may overstate the importance of a Republican-controlled government and thus understate the relevance of continued polarization. We doubt that Donald Trump is a uniting figure who can transcend America's polarized politics, especially given his weak popular mandate (he lost the popular vote as Bush did in 2000) and the sub-50% vote share. And, our favorite chart of the year remains the same: both Donald Trump and Hillary Clinton have entered the history books as the most disliked presidential candidates ever on the day of the election (Chart II-7). Chart II-7Clinton And Trump Are Making (The Wrong Kind Of) History De-Globalization De-Globalization According to empirical work by political scientists Keith Poole and Howard Rosenthal, polarization in Congress is at its highest level since World War II (Chart II-8). Their research shows that the liberal-conservative dimension explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension.34 Chart II-8The Widening Ideological Gulf In The U.S. Congress De-Globalization De-Globalization Meanwhile, a 2014 Pew Research study has shown that Republicans and Democrats are moving further to the right and left, respectively. Chart II-9 shows the distribution of Republicans and Democrats on a 10-item scale of political values across the last three decades. In addition, "very unfavorable" views of the opposing party have skyrocketed since 2004 (Chart II-10), with 45% of Republicans and 41% of Democrats now seeing the other party as a "threat to the nation's well-being"! Chart II-9U.S. Political Polarization: Growing Apart De-Globalization De-Globalization Chart II-10Live And Let Die De-Globalization De-Globalization Much ink has been spilled trying to explain the mounting polarization in America.35 Our view remains that politics in a democracy operates on its own supply-demand dynamic. If there was no demand for polarized politics, especially at the congressional level, American politicians would not be so eager to supply it. We believe that five main factors - in our subjective order of importance - explain polarization in the U.S. today: Income Inequality and Immobility The increase in political polarization parallels rising income inequality in the U.S. (Chart II-11). The U.S. is a clear and distant outlier on both factors compared to its OECD peers (Chart II-12). However, Americans are not being divided neatly along income levels. This is because Republicans and Democrats disagree on how to fix income inequality. For Donald Trump voters, the solutions are to put up barriers to free trade and immigration while reducing income taxes for all income levels. For Hillary Clinton voters, it means more taxes on the wealthy and large corporations, while putting up some trade barriers and expanding entitlements. This means that the correlation between polarization and income inequality is misleading as there is no causality. Rather, rising income inequality, especially when combined with a low-growth environment, shifts the political narrative from the "politics of plenty" towards "politics of scarcity." It hardens interest and identity groups and makes them less generous towards the "other." Chart II-11Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization Chart II-12Opportunity And Income: Americans Are Outliers De-Globalization De-Globalization Generational Warfare The political age gap is increasing (Chart II-13). This remains the case following the 2016 election, with 55% Millennials (18-29 year olds) having voted for Hillary Clinton. The problem for older voters, who tend to identify far more with the Republican Party, is that the Millennials are already the largest voting bloc in America (Chart II-14). And as Millennial voters start increasing their turnout, and as Baby Boomers naturally decline, the urgency to vote for Republican policymakers' increases. Chart II-13The Age Gap In American Politics The Age Gap In American Politics The Age Gap In American Politics Chart II-14Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Geographical Segregation Noted political scientist Robert Putnam first cautioned that increasing geographic segregation into clusters of like-minded communities was leading to rising polarization.36 This explains, in large part, how liberal elites have completely missed the rise of Donald Trump. Left-leaning Americans tend to live in a left-leaning community. They share their morning cup-of-Joe with Liberals and rarely mix with the plebs supporting Trump. And of course vice-versa. University of Toronto professors Richard Florida and Charlotta Mellander have more recently shown in their "Segregated City" research that "America's cities and metropolitan areas have cleaved into clusters of wealth, college education, and highly-paid knowledge-based occupations."37 Their research shows that American neighborhoods are increasingly made up of people of the same income level, across all metropolitan areas. Florida and Mellander also show that educational and occupational segregation follows economic segregation. Meanwhile, the same research shows that Canada's most segregated metropolitan area, Montreal, would be the 227th most segregated city if it were in the U.S.! This form of geographic social distance fosters increasing polarization by allowing voters to remain aloof of their fellow Americans, their plight, needs, and concerns. The extreme urban-rural divide of the 2016 election confirms this thesis. Immigration Much as with income inequality, there is a close correlation between political polarization and immigration. The U.S. is on its way to becoming a minority-majority country, with the percent of the white population expected to dip below 50% in 2045 (Chart II-15). Hispanic and Asian populations are expected to continue rising for the rest of the century. For many Americans facing the pernicious effects of low-growth, high debt, and elevated income inequality, the rising impact of immigration is anathema. Not only is the country changing its ethnic and cultural make-up, but the incoming immigrants tend to be less educated and thus lower-income than the median American. They therefore favor - or will favor, when they can vote - redistributive policies. Many Americans feel - fairly or unfairly - that the costs of these policies will have to be shouldered by white middle-class taxpayers, who are not wealthy enough to be indifferent to tax increases, and may be unskillful enough to face competition from immigrants. There is also a security component to the rising concern about immigration. Although Muslims are only 1% of the U.S. population, many voters perceive radical Islam to be a vital security threat to the nation. As such, immigration and radical Islamic terrorism are seen as close bedfellows. Media Polarization The 2016 election has been particularly devastating for mainstream media. According to the latest Gallup poll, only 32% of Americans trust the mass media "to report the news fully, accurately and fairly." This is the lowest level in Gallup polling history. The decline is particularly concentrated among Independent and Republican respondents (Chart II-16). With mainstream media falling out of favor for many Americans, voters are turning towards social media and the Internet. Facebook is now as important for political news coverage as local TV for Americans who get their news from the Internet (Chart II-17). Chart II-15Racial Composition Is Changing De-Globalization De-Globalization Chart II-16A War Of Words bca.gps_mp_2016_11_09_s2_c16 bca.gps_mp_2016_11_09_s2_c16 Chart II-17New Sources Of News Not Always Credible De-Globalization De-Globalization The problem with getting your news coverage from Facebook is that it often means getting news coverage from "fake" sources. A recent experiment by BuzzFeed showed that three big right-wing Facebook pages published false or misleading information 38% of the time while three large left-wing pages did so in nearly 20% of posts.38 The Internet allows voters to self-select what ideological lens colors their daily intake of information and it transcends geography. Two American families, living next to each other in the same neighborhood, can literally perceive reality from completely different perspectives by customizing their sources of information. Chart II-18Gerrymandering Reduces Competitive Seats bca.gps_mp_2016_11_09_s2_c18 bca.gps_mp_2016_11_09_s2_c18 In addition to these five factors, one should also reaffirm the role of redistricting, or "gerrymandering." Over the last two decades, both the Democrats and Republicans (but mainly the latter) have redrawn geographical boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart II-18). This improves job security for incumbent politicians and legislative-seat security for the party; but it also discourages legislators from reaching across the ideological aisle in order to ensure re-election. Instead, the main electoral challenge now comes from the member's own party during the primary election. For Republicans, this means that the challenge is most often coming from a candidate that is further to the right. Incumbent GOP politicians in Congress therefore have an incentive to maintain highly conservative records lest a challenge from the far-right emerges in a primary election. Given that the frequency of elections is high in the House of Representatives (every two years), legislators cannot take even a short break from partisanship. Redistricting deepens polarization, therefore, by changing the political calculus for legislators facing ideologically pure electorates in their home districts. Bottom Line: Polarization in the U.S. is a product of structural factors that are here to stay. Trump's narrow victory will in no way change that. But How Much Worse? Chart II-19Party Is The Chief Source Of Identity De-Globalization De-Globalization Political polarization is not new. Older readers will remember 1968, when social unrest over the Vietnam War was at its height. Richard Nixon barely got over the finish line that year, beating Vice-President Hubert Humphrey by around 500,000 votes.39 Another contested election in a contested era. Our concern is that the Republican and Democrat "labels" - or perhaps conservative and liberal labels - appear to be ossifying. For example, Pew Research showed in 2012 that the difference between Americans on 48 values is the greatest between Republicans and Democrats. This has not always been the case, as Chart II-19 shows. We suspect that the data would be even starker today, especially after the divisive 2016 campaign that has bordered on hysterical. This means that "Republican" and "Democrat" labels have become real and almost "sectarian" in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Why is this happening? We suspect that the shift in urgency and tone is motivated at least in part by the changing demographics of America. Two demographic groups that identify the most with the Republican Party - Baby Boomers and rural or suburban white voters - are in a structural decline (the first in absolute terms and the second in relative terms). Both see the writing on the political wall. Given America's democratic system of government, their declining numbers (or, in the case of suburban whites, declining majorities) will mean significant future policy decisions that go against their preferences. America is set to become more left-leaning, favor more redistribution, and become less culturally homogenous. Not only are Millennials more socially liberal and economically left-leaning, but they are also "browner" than the rest of the U.S. As we pointed out early this year, 2016 was an election that the GOP could reasonably attempt to win by appealing exclusively to white and older voters. The "White Hype" strategy was mathematically cogent ... at least in 2016.40 It will get a lot more difficult to pursue this strategy in 2020 and beyond. Not impossible, but difficult. We suspect that conservative voters know this. As such, there was an urgency this year to lock-in structural changes to key policies before it is too late. Donald Trump may have been a flawed messenger for many voters, but it did not matter. The clock is ticking for a large segment of America and therefore Trump was an acceptable vehicle of their fears and anger. Bottom Line: Polarization in the U.S. is likely to increase. Two key Republican/conservative constituencies - Baby Boomers and rural or suburban white voters - are backed into the corner by demographic trends. But it also means that a left counter-revolution is just around the corner. And we doubt that the Democratic Party will chose as centrist of a candidate the next time around. Final Thoughts: What Have We Learned 1. Economics trump PC: Civil rights remain a major category of the American public's policy concerns. However, the Democratic Party's prioritization of social issues on the margins of the civil rights debate has not galvanized voters in the face of persistent negative attitudes about the economy. More specifically, the surge in cheap credit since 2000 that covered up the steady decline of wages as a share of GDP has ended, leaving households exposed to deleveraging and reduced purchasing power (Chart II-20). American households have lost patience with the slow, grinding pace of economic recovery, they reject the debt consequences of low inflation with deflationary tail risks, and they resent disappointed expectations in terms of job security and quality. Concerns about certain social preferences - as opposed to basic rights - pale in comparison to these economic grievances. Chart II-20Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income 2. Polls are OK, but beware the quant models that use them: On two grave political decisions this year, in two advanced markets with the "best" quality of polling, political modeling turned out to be grossly erroneous. To be fair, the polls themselves prior to both Brexit and the U.S. election were within a margin of error. However, quantitative models relying on these polls were overconfident, leading investors to ignore the risks of a non-consensus outcome. As we warned in mid-October - with Clinton ahead with a robust lead - the problem with quantitative political models is that they rely on polling data for their input.41 To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." But combining polls is mathematically the same as combining bad mortgages into securities. The philosophy behind the methodology is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening. Well, something bad did happen. The quantitative models were massively wrong! We tried to avoid this problem by heavily modifying our polls-based-model with structural factors. Many of these structural variables - economic context, political momentum, Obama's approval rating - actually did not favor Clinton. Our model therefore consistently gave Donald Trump between 35-45% probability of winning the election, on average three and four times higher than other popular quant models. This caused us to warn clients that our view on the election was extremely cautious and recommend hedges. In fact, Donald Trump had 41% chance of winning the race on election night, according to the last iteration of our model, a very high probability.42 3. Professor Lichtman was right: Political science professor Allan Lichtman has once again accurately called the election - for the ninth time. The result on Nov. 8 strongly supports his life's work that presidential elections in the United States are popular referendums on the incumbent party of the last four years. Structural factors undid the Democrats (Table II-3), and none of the campaign rhetoric, cross-country barnstorming, or "horse race" polling mattered a whit. The Republicans had momentum from previous midterm elections, Clinton had suffered a strong challenge in her primary, the Obama administration's achievements over the past four years were negligible (the Affordable Care Act passed in his first term). These factors, along with the political cycle itself, favored the Republicans. Trump's lack of charisma did not negate the structural support for a change of ruling party. Investors should take note: no amount of mathematical horsepower, big data, or Silicon Valley acumen was able to beat the qualitative, informed, contemplative work of a single historian. Table II-3Lichtman's Thirteen Keys To The White House* De-Globalization De-Globalization 4. Non-linearity of politics: Lichtman's method calls attention to the danger of linear assumptions and quantitative modeling in attempting the art of political prediction. Big data and quantitative econometric and polling models have notched up key failures this year. They cannot make subjective judgments regarding whether a president has had a major foreign policy success or failure or a major policy innovation - on all three of those counts, the Democrats failed from 2012-16. There really is no way to quantify political risk because human and social organizations often experience paradigm shifts that are characterized by non-linearity. Newtonian Laws will always work on planet earth and as such we are not concerned about what will happen to us if we board an airplane. Laws of physics will not simply stop working while we are mid-air. However, social interactions and political narratives do experience paradigm shifts. We have identified several since 2011: geopolitical multipolarity, de-globalization, end of laissez-faire consensus, end of Chimerica, and global loss of confidence in elites and institutions.43 5. No country is immune to decaying institutions: The United States has, with few exceptions, the oldest written constitution among major states, and it ensures checks and balances. But recent decades have shown that the executive branch has expanded its power at the expense of the legislative and judicial branches. Moreover, executives have responded to major crisis - like the September 11 attacks and the 2008 financial crisis - with policy responses that were formulated haphazardly, ideologically divisive, and difficult to implement: the Iraq War and the Affordable Care Act. The result is that the jarring events that have blindsided America over the past sixteen years have resulted in wasted political capital and deeper polarization. The failure of institutions has opened the way for political parties to pursue short-term gains at the expense of their "partners" across the aisle, and to bend and manipulate procedural rules to achieve ends that cannot be achieved through consensus and compromise. 6. U.S. is shifting leftward when it comes to markets: Inequality and social immobility have, with Trump's election, entered the conservative agenda, after having long sat on the liberals' list of concerns. The shift in white blue-collar Midwestern voters toward Trump reflects the fact that voters are non-partisan in demanding what they want: they want to retain their existing rights, privileges, and entitlements, and to expand their wages and social protections. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 5 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 6 Please see BCA Global Alpha Sector Strategy Special Report, "Brothers In Arms," dated October 28, 2016, available at gss.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refuges, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 10 The BBC is exemplary of the mainstream Western press on this point. Please see Stephen McDonell, "The Ever-Growing Power Of China's Xi Jinping," BBC News, China Blog, dated October 29, 2016, available at www.bbc.com. 11 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Special Report, "China: Two Factions, One Party - Part II," dated September 12, 2012, available at gps.bcaresearch.com. 13 Please see the "Eighteenth Communist Party Of China Central Committee Sixth Plenary Session Communique," dated October 27, 2016, available at cpc.people.com.cn. 14 Jiang Zemin, China's ruler from roughly 1993 to 2002, was also referred to as the "core" leader, but he received this moniker from Deng Xiaoping. Xi is following in Deng's footsteps by declaring himself to be the core and winning support from the party. As for his centralizing efforts, prior to being named the "core leader," Xi had already waged a sweeping crackdown on political opponents and dissidents. He had used his position as head of the party, the state bureaucracy, and the armed forces to reshuffle personnel in these bodies extensively. He had already created new organizational bodies, including the National Security Commission, and initiated plans to restructure the military to emphasize joint-operations under regional battle commands. A weak leader would not have advanced so quickly. 15 Deng named Mao the "core" of the first generation of leaders, but it was evident that he sought a different leadership model. 16 Specifically, Xi could prevent the preferment of successors for 2022, he could reduce the size of the Politburo Standing Committee further to five members, or he could modify or make exceptions to the informal rule that top officials must not be promoted if they are 68 or older. Please see Minxin Pei, "A Looming Power Struggle For China?" dated October 28, 2016, available at www.cfr.org. 17 Please see "Communique of the Third Plenary Session of the 18th Central Committee of the Communist Party of China," dated January 15, 2014 [adopted November 12, 2013], available at www.china.org.cn. 18 Please see "China: The Socialist Put And Rising Government Leverage," in BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Brexit Update: Does Brexit Really Mean Brexit?" dated July 15, 2016, available at gps.bcaresearch.com. For the High Court ruling, please see the U.K. Courts and Tribunals Judiciary, "R (Miller) -V- Secretary of State for Exiting the European Union," dated November 3, 2016, available at www.judiciary.gov.uk. 20 At that time a Tory majority in the House of Commons had enraged the populace by imprisoning a group of petitioners from Kent. Both the Kentish Petition and the Legion Memorial demanded that parliament heed the will of the populace. 21 Presumably, the European Council could vote unanimously under Article 50 to extend the negotiation period for a very long time. 22 Please see BCA Geopolitical Strategy Monthly Report, "Nuthin' But A G Thang," dated August 12, 2015, available at gps.bcaresearch.com. 23 Except that it is better armed. 24 Please see BCA Geopolitical Strategy Client Note, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com. 25 However, Wisconsin polling was rather poor as most pollsters assumed that it was a shoe-in for Democrats. One problem with polling in Midwest states is that they were, other than Pennsylvania and Ohio, assumed to be safe Democratic states. Note for example the extremely tight result in Minnesota and the absolute dearth of polling out of that state throughout the last several months. 26 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Special Report, "U.S. General Elections And Scenarios: Implications," dated July 11, 2012, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 29 Please see BCA Foreign Exchange Strategy Weekly Report, "When You Come To A Fork In The Road, Take It," dated November 4, 2016, available at fes.bcaresearch.com. 30 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gps.bcaresearch.com. 31 Only a two-thirds majority of Congress, or a ruling by a federal court, can undo an executive action, and that is exceedingly rare. The real check on executive orders is the rotation of office: a president can undo with the stroke of a pen whatever his predecessor enacted. Congress has the power of the purse, but it is sporadic in its oversight and has challenged less than 5% of executive orders, even though those orders often re-direct the way the executive branch uses funds Congress has allocated. More often, Congress votes to codify executive orders rather than nullify them. 32 Trump is not alone in calling for renegotiating or even abandoning NAFTA. Clinton called for renegotiation in 2008, and Senator Bernie Sanders has done so in 2016. 33 In Proclamation 4074, dated August 15, 1971, Nixon suspended all previous presidential proclamations implementing trade agreements insofar as was required to impose a new 10% surcharge on all dutiable goods entering the United States. He justified it in domestic law by invoking the president's authority and previous congressional acts authorizing the president to act on behalf of Congress with regard to trade agreement negotiation and implementation (including tariff levels). He justified the proclamation in international law by referring to international allowances during balance-of-payments emergencies. 34 The "primary dimension" of Chart II-8 is represented by the x-axis and is the liberal-conservative spectrum on the basic role of the government in the economy. The "second dimension" (y-axis) depends on the era and is picking up regional differences on a number of social issues such as the civil rights movement (which famously split Democrats between northern Liberals and southern Dixiecrats). 35 We have penned two such efforts ourselves. Please see BCA Geopolitical Strategy Special Report, "Polarization In America: Transient Or Structural Risk?," dated October 9, 2013, and "A House Divided Cannot Stand: America's Polarization," dated July 11, 2012," available at gps.bcaresearch.com. 36 Putnam, Robert. 2000. Bowling Alone. New York: Simon and Schuster. 37 Please see Martin Prosperity Institute, "Segregated City," dated February 23, 2015, available at martinprosperity.org. 38 Please see BuzzFeedNews, "Hyperpartisan Facebook Pages Are Publishing False And Misleading Information At An Alarming Rate," dated October 20, 2016, available at buzzfeed.com. 39 Nonetheless, due to the third-party candidate George Wallace carrying the then traditionally-Democratic South, Nixon managed to win the Electoral College in a landslide. 40 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 41 Please see BCA Geopolitical Strategy Special Report, "You've Been Trumped!," dated October 21, 2016, available at gps.bcaresearch.com. 42 For comparison, Steph Curry, the greatest three-point shooter in basketball history, and a two-time NBA MVP, has a career three-point shooting average of 44%. With that average, he is encouraged to take every three-pointer he can by his team. In other words, despite being less than 50%, this is a very high percentage. 43 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, and "Strategy Outlook 2016 - Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. Section III: Geopolitical Calendar

Highlights Trump won by stealing votes from Democrats in the Midwest. His victory implies a national shift to the left on economic policy. Checks and balances on Trump are not substantial in the short term. U.S. political polarization will continue. Trump is good for the USD, bad for bonds, neutral for equities. Favor SMEs over MNCs. Close long alternative energy / short coal. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." -- Newt Gingrich, January 2, 2001 Former Speaker of the House Newt Gingrich (and a potential Secretary of State pick), was asked on NBC's Meet the Press two days before the U.S. election whether he still thought that "competition for power in the U.S. remains largely a debate between people who can work together once the election is over." Gingrich made the original statement in January 2001, merely weeks after one of the most contentious presidential elections in U.S. history was resolved by the Supreme Court. Gingrich's answer in 2016? "I think, tragically, we have drifted into an environment where ... it will be a continuing fight for who controls the country." Despite an extraordinary victory - a revolution really - by Donald J. Trump, the fact of the matter remains that the U.S. is a polarized country between Republican and Democratic voters. As of publication time of this report, Trump lost the popular vote to Secretary Hillary Clinton. His is a narrower victory than either the epic Richard Nixon win in 1968 or George W. Bush squeaker in 2000. Over the next two years, the only thing that matters for the markets is that the U.S. has a unified government behind a Republican president-elect and a GOP-controlled Congress. We discuss the investment implications of this scenario below and caution clients to not over-despair. On the other hand, we also see this election as more evidence that America remains a deeply polarized country where identity politics continue to play a key role. What concerns us is that these identity politics appear to transcend the country's many cultural, ethical, political, and economic commonalities. Republicans and Democrats in the U.S. are fusing into almost ethnic-like groupings. To bring it back to Gingrich's quote at the top, that would suggest that the U.S. is no longer that much different from Bosnia or Northern Ireland.1 Election Post-Mortem Chart II-1Election Polls Usually ##br##Miss By A Few Points De-Globalization De-Globalization Donald Trump has won an upset over Hillary Clinton, but his campaign was not as much of a long-shot as the consensus believed. U.S. presidential polls have frequently missed the final tally by +/- 3% of the vote, which was precisely the end result of the 2016 election (Chart II-1). Therefore, as we pointed out in our last missive on the election, Trump's victory was not a "wild mathematical oddity."2 Why Did Trump Win The White House? Where Trump really did beat expectations was in the Midwest, and Wisconsin in particular. He ended up outperforming the poll-of-polls by a near-incredible 10%!3 His victories in Florida, Ohio, and Pennsylvania were well within the range of expectations. For example, the last poll-of-polls had Trump leading in both Florida (by a narrow 0.2%) and Ohio (by a solid 3.5%), whereas Clinton was up in Pennsylvania by the slightest of margins (just 1.9% lead). He ended up exceeding poll expectations in all three (by 2% in Florida, 6% in Ohio, and 3% in Pennsylvania), but not by the same wild margin as in Wisconsin. When all is said and done, Trump won the 2016 election by stealing votes away from the Democrats in the traditionally "blue" Midwest states of Michigan, Pennsylvania, and Wisconsin. This was a far more significant result than his resounding victories in Ohio (which Obama won in 2012) or Florida (where Obama won only narrowly in 2012). Our colleague Peter Berezin, Chief Strategist of the Global Investment Strategy, correctly forecast that Trump would be competitive in all three Midwest states back in September 2015! We highly encourage our clients to read his "Trumponomics: What Investors Need To Know," as it is one of the best geopolitical calls made by BCA in recent history.4 As Peter had originally thought, Trump cleaned up the white, less-educated, male vote in all of the three crucial Midwest states. He won 68% of this vote in Michigan, 71% in Pennsylvania, and 69% in Wisconsin. To do so, Trump campaigned as an unorthodox Republican, appealing to the blue-collar white voter by blaming globalization for their job losses and low wages, and by refusing to accept Republican orthodoxy on fiscal austerity or entitlement spending. Instead, Trump promised to outspend Clinton and protect entitlements at their current levels. This mix of an outsider, anti-establishment, image combined with a left-of-center economic message allowed Trump to win an extraordinary number of former Obama voters. Exit polls showed that Obama had a positive image in all three Midwest states, including with Trump voters! For example, 30% of Trump voters in Michigan approved of the job Obama was doing as president, 25% in Pennsylvania, and 27% in Wisconsin. That's between a quarter and a third of eventual people who cast their vote for Trump. These are the voters that Republicans lost in 2012 because they nominated a former private equity "corporate raider" Mitt Romney as their candidate. Romney had famously argued in a 2008 New York Times op-ed that he would have "Let Detroit go bankrupt." Obama repeatedly attacked Romney during the 2011-2012 campaign on this point. Back in late 2011, we suspected that this message, and this message alone, would win President Obama his re-election.5 Why is the issue of the Midwest Obama voters so important? Because investors have to know precisely why Donald Trump won the election. It wasn't his messages on immigration, law and order, race relations, and especially not the tax cuts he added to his message late in the game. It was his left-of-center policy position on trade and fiscal spending. Trump is beholden to his voters on these policies, particularly in the Midwest states that won him the election. Final word on race. Donald Trump actually improved on Mitt Romney's performance with African-American and Hispanic voters (Table II-1). This was a surprise, given his often racially-charged rhetoric. Meanwhile, Trump failed to improve on the white voter turnout (as percent of overall electorate) or on Romney's performance with white voters in terms of the share of the vote. To be clear, Republicans are still in the proverbial hole with minority voters and are yet to match George Bush's performance in 2004. But with 70% of the U.S. electorate still white in 2016, this did not matter. Table II-1Exit Polls: Trump's Win Was Not Merely About Race De-Globalization De-Globalization Congress: No Gridlock Ahead Republicans exceeded their expectations in the Senate, losing only one seat (Illinois) to Democrats. This means that the GOP control of the Senate will remain quite comfortable and is likely to grow in the 2018 mid-term elections when the Democrats have to defend 25 of 33 seats. Of the 25 Senate seats they will defend, five are in hostile territory: North Dakota, West Virginia, Ohio, Montana, and Missouri. In addition, Florida is always a tough contest. Republicans, on the other hand, have only one Senate seat that will require defense in a Democrat-leaning state: Nevada (and in that case, it will be a Republican incumbent contesting the race). Their other seven seats are all in Republican voting states. As such, expect Republicans to hold on to the Senate well into the 2020 general election. In the House of Representatives, the GOP will retain its comfortable majority. The Tea Party affiliated caucuses (Tea Party Caucus and the House Freedom Caucus) performed well in the election. The Tea Party Caucus members won 35 seats out of 38 they contested and the House Freedom Caucus won 34 seats out of 37 it contested. The race to watch now is for the Speaker of the House position. Paul Ryan, the Speaker of the incumbent House, is likely to contest the election again and win. Even though his support for Donald Trump was lukewarm, we expect Republicans to unify the party behind Trump and Ryan. A challenge from the right could emerge, but we doubt it will materialize given Trump's victory. The campaign for the election will begin immediately, with Republicans selecting their candidate by December (the official election will be in the first week of January, but it is a formality as Republicans hold the majority). Bottom Line: Trump's victory was largely the product of former Obama voters in the Midwest switching to the GOP candidate. This happened because of Trump's unorthodox, left-of-center, message. Trump will have a friendly Congress to work with for the next four years. How friendly? That question will determine the investment significance of the Trump presidency. Investment Relevance Of A United Government Most clients we have spoken to over the past several months believe that Donald Trump will be constrained on economic policies by a right-leaning Congress. His more ambitious fiscal spending plans - such as the $550 billion infrastructure plan and $150 billion net defense spending plan - will therefore be either "dead on arrival" in Congress, or will be significantly watered down by the legislature. Focus will instead shift to tax cuts and traditional Republican policies. We could not disagree more. GOP is not fiscally conservative: There is no empirical evidence that the GOP is actually fiscally conservative. First, the track record of the Bush and Reagan administrations do not support the adage that Republicans keep fiscal spending in check when they are in power (Chart II-2). Second, Republican voters themselves only want "small government" when the Democrats are in charge of the White House (Chart II-3). When a Republican President is in charge, Republicans forget their "small government" leanings. Chart II-2Republicans Are Not ##br##Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Chart II-3Big Government Is Only ##br##A Problem For Opposition bca.gps_mp_2016_11_09_s2_c3 bca.gps_mp_2016_11_09_s2_c3 Presidents get their way: Over the past 28 years, each new president has generally succeeded in passing their signature items. Congress can block some but probably not all of president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed in their second term. Clinton lost on healthcare, but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). Median voter has moved to the left: Donald Trump won both the GOP primary and the general election by preaching an unorthodox, left-of-center sermon. He understood correctly that the American voter preferences on economic policies have moved away from Republican laissez-faire orthodoxies.6 Yes, he is also calling for significant lowering of both income and corporate tax rates. However, tax cuts were never a focal point of his campaign, and he only introduced the policy later in the race when he was trying to get traditional Republicans on board with his campaign. Newsflash: traditional Republicans did not get Trump over the hump, Obama voters in the Midwest did! Investors should make no mistake, the key pillars of Trump's campaign are de-globalization, higher fiscal spending, and protecting entitlements at current levels. And he will pursue all three with GOP allies in Congress. What are the investment implications of this policy mix? USD: More government spending, marginally less global trade, and pressure on multi-national corporations (MNCs) to scale back their global operations should be positive for inflation. If growth surprises to the upside due to fiscal spending, it will allow the Fed to hike more than the current 57 bps expected by the market by the end of 2018. Given easy monetary stance of central banks around the world, and lack of significant fiscal stimulus elsewhere, economic growth surprise in the U.S. should be positive for the dollar in the long term. At the moment, the market is reacting to the Trump victory with ambivalence on the USD. In fact, the dollar suffered as Trump's probability of victory rose in late October. We believe that this is a temporary reaction. We see both Trump's fiscal and trade policies as bullish. BCA's currency strategist Mathieu Savary believes that the dollar could therefore move in a bifurcated fashion in the near term. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer - or remain flat - against DM currencies such as the EUR, CHF, and JPY.7 Bonds: More inflation and growth should also mean that the bond selloff continues. In addition, if our view on globalization is correct, then the deflationary effects of the last three decades should begin to reverse over the next several years. BCA thesis that we are at the "End Of The 35-Year Bond Bull Market" should therefore remain cogent.8 As one of our "Trump hedges," our colleague Rob Robis, Chief Strategist of the BCA Global Fixed Income Strategy, suggested a 2-year / 30-year Treasury curve steepener. This hedge is now up 18.7 bps and we suggest clients continue to hold it. Fed policy: Trump's statements about monetary policy have been inconsistent. Early on in his campaign he described himself as "a low interest rate guy", but he has more recently become critical of current Federal Reserve policy - and Fed Chair Janet Yellen in particular - claiming that while higher interest rates are justified, the Fed is keeping them low for "political reasons." What seems certain is that Janet Yellen will be replaced as Fed Chair when her term expires in February 2018. Yellen is unlikely to resign of her own volition before then and it would be legally difficult for the President to remove a sitting Fed Chair prior to the end of her term. But Trump will get the opportunity to re-shape the composition of the Fed's Board of Governors as soon as he is sworn in. There are currently two empty seats on the Board need to be filled and given that many of Trump's economic advisers have "hard money" leanings, it is very likely that both appointments will go to inflation hawks. Equities: In terms of equities, Trump will be a source of uncertainty for U.S. stocks as the market deals with the unknown of his presidency. In addition, markets tend to not like united government in the U.S. as it raises the specter of big policy moves (Table II-2). However, Trump should be positive for sectors that sold off in anticipation of a Clinton victory, such as healthcare and financials. We also suspect that he will continue the outperformance of defense stocks, although that would have been the case with Clinton as well. Table II-2Election: Industry Implications De-Globalization De-Globalization In the long term, Trump's proposal for major corporate tax cuts should be good for U.S. equities. However, we are not entirely sure that this is the case. First, the effective corporate tax rate in the U.S. is already at its multi-decade lows (Chart II-4). As such, any corporate tax reform that lowers the marginal rate will not really affect the effective rate. Why does this matter? Because major corporations already have low effective tax rates. Any lowering of the marginal rate will therefore benefit the small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then Trump's policy will not necessarily benefit all firms in the U.S. equally. Chart II-4How Low Can It Go? bca.gps_mp_2016_11_09_s2_c4 bca.gps_mp_2016_11_09_s2_c4 Investors have to keep in mind that Trump has not run a pro-corporate campaign. He has accused American manufacturing firms of taking jobs outside the U.S. and tech companies of skirting taxes. It is not clear to us that his corporate tax reform will therefore necessarily be a boon for the stock market. In the long term, we like to play Trump's populist message by favoring America's SMEs over MNCs. If we are ultimately correct on the USD and growth, then export-oriented S&P 500 companies should suffer in the face of a USD bull market and marginally less globalization. Meanwhile, lowering of the marginal corporate tax rate will benefit the SMEs that do not get the benefit of K-street lobbyist negotiated tax loopholes. Global Assets: The global asset to watch over the next several weeks is the USD/RMB cross. China is forced by domestic economic conditions to continue to slowly depreciate its currency. We have expected this since 2015, which is why we have shorted the RMB via 12-month non-deliverable forwards (NDF). Risk to global assets, particularly EM currencies and equities, would be that Beijing decides to depreciate the RMB before Trump is inaugurated on January 20. This could re-visit the late 2015 panic over China, particularly the narrative that it is exporting deflation. Our view is that even if China does not undertake such actions over the next two months, Sino-American tensions are set to escalate. It is much easier for Trump to fulfill his de-globalization policies with China - a geopolitical rival with which the U.S. has no free trade agreement - than with NAFTA trade partners Canada and Mexico. This will only deepen geopolitical tensions between the two major global powers, which has been our secular view since 2011. Finally, a quick note on the Mexican peso. The Mexican peso has already collapsed half of its value in the past 18 months and we believe the trade is overdone. Investors have used the currency cross as a way to articulate Trump's victory probability. It is no longer cogent. We believe that the U.S. will focus on trade relations with China under a Trump presidency, rather than NAFTA trade partners. Our Emerging Markets Strategy believes that it is time to consider going long MXN versus other EM currencies, such as ZAR and BRL. Investors should also watch carefully the Cabinet appointments that Trump makes over the next two months. Since Carter's administration, cabinet announcements have occurred in early to mid-December. Almost all of these appointments were confirmed on Inauguration Day (usually January 20 of the year after election, including in 2017) or shortly thereafter. Only one major nomination since Carter was disapproved. These appointments will tell us how willing Trump is to reach to traditional Republicans who have served on previous administrations. We suspect that he will go with picks that will execute his fiscal, trade, and tax policies. Bottom Line: After the dust settles over the next several weeks, we suspect that Trump will signal that he intends to pursue his fiscal, trade, immigration, and tax policies. These will be, in the long term, positive for the USD, negative for bonds (including Munis, which will lose their tax-break appeal if income taxes are reduced), and likely neutral for equities. Within the equity space, Trump will be positive for U.S. SMEs and negative for MNCs. This means being long S&P 600 over S&P 100. Lastly, close our long alternative energy / short coal trade for a loss of -26.8%. Constraints: Don't Bet On Them Domestically, the American president can take significant action without congressional support through executive directives. Lincoln raised an army and navy by proclamation and freed the slaves; Franklin Roosevelt interned the Japanese; Truman tried to seize steel factories to keep production up during the Korean War. Truman's case is almost the only one of a major executive order being rebuffed by the Supreme Court. The Reagan and Clinton administrations have shown that a president thwarted by a divided or adverse congress will often use executive directives to achieve policy aims and satisfy particular interest groups and sectors. Though the number of executive orders has gone down in recent administrations (Chart II-5), the economic significance has increased along with the size and penetration of the bureaucracy (Chart II-6). The economic impact of executive orders is always debatable, but the key point is that the president's word tends to carry the day.9 Chart II-5Rule By Decree De-Globalization De-Globalization Chart II-6Executive Branch Is Growing De-Globalization De-Globalization Trade is a major area where Trump would have considerable sway. He has repeatedly signaled his intention to restrict American openness to international trade. The U.S. president can revoke international treaties solely on their own authority. Congressionally approved agreements like the North American Free Trade Agreement (NAFTA) cannot be revoked by the president, but Trump could obstruct its ongoing implementation.10 He would also have considerable powers to levy tariffs, as Nixon showed with his 10% "surcharge" on most imports in 1971.11 Bottom Line: Presidential authority is formidable in the areas Trump has made the focus of his campaign: immigration and trade. Without a two-thirds majority in Congress to override him, or an activist federal court, Trump would be able to enact significant policies simply by issuing orders to his subordinates in the executive branch. Long-Term Implications: Polarization In The U.S. Does the Republican control of Congress and the White House signal that polarization in America will subside? We began this analysis by focusing on the investment implications when Republicans control the three houses of the American government. But long-term implications of polarization will not dissipate. Investors may overstate the importance of a Republican-controlled government and thus understate the relevance of continued polarization. We doubt that Donald Trump is a uniting figure who can transcend America's polarized politics, especially given his weak popular mandate (he lost the popular vote as Bush did in 2000) and the sub-50% vote share. And, our favorite chart of the year remains the same: both Donald Trump and Hillary Clinton have entered the history books as the most disliked presidential candidates ever on the day of the election (Chart II-7). Chart II-7Clinton And Trump Are Making (The Wrong Kind Of) History De-Globalization De-Globalization According to empirical work by political scientists Keith Poole and Howard Rosenthal, polarization in Congress is at its highest level since World War II (Chart II-8). Their research shows that the liberal-conservative dimension explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension.12 Chart II-8The Widening Ideological Gulf In The U.S. Congress De-Globalization De-Globalization Meanwhile, a 2014 Pew Research study has shown that Republicans and Democrats are moving further to the right and left, respectively. Chart II-9 shows the distribution of Republicans and Democrats on a 10-item scale of political values across the last three decades. In addition, "very unfavorable" views of the opposing party have skyrocketed since 2004 (Chart II-10), with 45% of Republicans and 41% of Democrats now seeing the other party as a "threat to the nation's well-being"! Chart II-9U.S. Political Polarization: Growing Apart De-Globalization De-Globalization Chart II-10Live And Let Die De-Globalization De-Globalization Much ink has been spilled trying to explain the mounting polarization in America.13 Our view remains that politics in a democracy operates on its own supply-demand dynamic. If there was no demand for polarized politics, especially at the congressional level, American politicians would not be so eager to supply it. We believe that five main factors - in our subjective order of importance - explain polarization in the U.S. today: Income Inequality And Immobility The increase in political polarization parallels rising income inequality in the U.S. (Chart II-11). The U.S. is a clear and distant outlier on both factors compared to its OECD peers (Chart II-12). However, Americans are not being divided neatly along income levels. This is because Republicans and Democrats disagree on how to fix income inequality. For Donald Trump voters, the solutions are to put up barriers to free trade and immigration while reducing income taxes for all income levels. For Hillary Clinton voters, it means more taxes on the wealthy and large corporations, while putting up some trade barriers and expanding entitlements. This means that the correlation between polarization and income inequality is misleading as there is no causality. Rather, rising income inequality, especially when combined with a low-growth environment, shifts the political narrative from the "politics of plenty" towards "politics of scarcity." It hardens interest and identity groups and makes them less generous towards the "other." Chart II-11Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization Chart II-12Opportunity And Income: Americans Are Outliers De-Globalization De-Globalization Generational Warfare The political age gap is increasing (Chart II-13). This remains the case following the 2016 election, with 55% Millennials (18-29 year olds) having voted for Hillary Clinton. The problem for older voters, who tend to identify far more with the Republican Party, is that the Millennials are already the largest voting bloc in America (Chart II-14). And as Millennial voters start increasing their turnout, and as Baby Boomers naturally decline, the urgency to vote for Republican policymakers' increases. Chart II-13The Age Gap In American Politics The Age Gap In American Politics The Age Gap In American Politics Chart II-14Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Geographical Segregation Noted political scientist Robert Putnam first cautioned that increasing geographic segregation into clusters of like-minded communities was leading to rising polarization.14 This explains, in large part, how liberal elites have completely missed the rise of Donald Trump. Left-leaning Americans tend to live in a left-leaning community. They share their morning cup-of-Joe with Liberals and rarely mix with the plebs supporting Trump. And of course vice-versa. University of Toronto professors Richard Florida and Charlotta Mellander have more recently shown in their "Segregated City" research that "America's cities and metropolitan areas have cleaved into clusters of wealth, college education, and highly-paid knowledge-based occupations."15 Their research shows that American neighborhoods are increasingly made up of people of the same income level, across all metropolitan areas. Florida and Mellander also show that educational and occupational segregation follows economic segregation. Meanwhile, the same research shows that Canada's most segregated metropolitan area, Montreal, would be the 227th most segregated city if it were in the U.S.! This form of geographic social distance fosters increasing polarization by allowing voters to remain aloof of their fellow Americans, their plight, needs, and concerns. The extreme urban-rural divide of the 2016 election confirms this thesis. Immigration Chart II-15Racial Composition Is Changing De-Globalization De-Globalization Much as with income inequality, there is a close correlation between political polarization and immigration. The U.S. is on its way to becoming a minority-majority country, with the percent of the white population expected to dip below 50% in 2045 (Chart II-15). Hispanic and Asian populations are expected to continue rising for the rest of the century. For many Americans facing the pernicious effects of low-growth, high debt, and elevated income inequality, the rising impact of immigration is anathema. Not only is the country changing its ethnic and cultural make-up, but the incoming immigrants tend to be less educated and thus lower-income than the median American. They therefore favor - or will favor, when they can vote - redistributive policies. Many Americans feel - fairly or unfairly - that the costs of these policies will have to be shouldered by white middle-class taxpayers, who are not wealthy enough to be indifferent to tax increases, and may be unskillful enough to face competition from immigrants. There is also a security component to the rising concern about immigration. Although Muslims are only 1% of the U.S. population, many voters perceive radical Islam to be a vital security threat to the nation. As such, immigration and radical Islamic terrorism are seen as close bedfellows. Media Polarization The 2016 election has been particularly devastating for mainstream media. According to the latest Gallup poll, only 32% of Americans trust the mass media "to report the news fully, accurately and fairly." This is the lowest level in Gallup polling history. The decline is particularly concentrated among Independent and Republican respondents (Chart II-16). With mainstream media falling out of favor for many Americans, voters are turning towards social media and the Internet. Facebook is now as important for political news coverage as local TV for Americans who get their news from the Internet (Chart II-17). Chart II-16A War Of Words bca.gps_mp_2016_11_09_s2_c16 bca.gps_mp_2016_11_09_s2_c16 Chart II-17New Sources Of News Not Always Credible De-Globalization De-Globalization The problem with getting your news coverage from Facebook is that it often means getting news coverage from "fake" sources. A recent experiment by BuzzFeed showed that three big right-wing Facebook pages published false or misleading information 38% of the time while three large left-wing pages did so in nearly 20% of posts.16 The Internet allows voters to self-select what ideological lens colors their daily intake of information and it transcends geography. Two American families, living next to each other in the same neighborhood, can literally perceive reality from completely different perspectives by customizing their sources of information. Chart II-18Gerrymandering ##br##Reduces Competitive Seats bca.gps_mp_2016_11_09_s2_c18 bca.gps_mp_2016_11_09_s2_c18 In addition to these five factors, one should also reaffirm the role of redistricting, or "gerrymandering." Over the last two decades, both the Democrats and Republicans (but mainly the latter) have redrawn geographical boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart II-18). This improves job security for incumbent politicians and legislative-seat security for the party; but it also discourages legislators from reaching across the ideological aisle in order to ensure re-election. Instead, the main electoral challenge now comes from the member's own party during the primary election. For Republicans, this means that the challenge is most often coming from a candidate that is further to the right. Incumbent GOP politicians in Congress therefore have an incentive to maintain highly conservative records lest a challenge from the far-right emerges in a primary election. Given that the frequency of elections is high in the House of Representatives (every two years), legislators cannot take even a short break from partisanship. Redistricting deepens polarization, therefore, by changing the political calculus for legislators facing ideologically pure electorates in their home districts. Bottom Line: Polarization in the U.S. is a product of structural factors that are here to stay. Trump's narrow victory will in no way change that. But How Much Worse? Political polarization is not new. Older readers will remember 1968, when social unrest over the Vietnam War was at its height. Richard Nixon barely got over the finish line that year, beating Vice-President Hubert Humphrey by around 500,000 votes.17 Another contested election in a contested era. Chart II-19Party Is The Chief Source Of Identity De-Globalization De-Globalization Our concern is that the Republican and Democrat "labels" - or perhaps conservative and liberal labels - appear to be ossifying. For example, Pew Research showed in 2012 that the difference between Americans on 48 values is the greatest between Republicans and Democrats. This has not always been the case, as Chart II-19 shows. We suspect that the data would be even starker today, especially after the divisive 2016 campaign that has bordered on hysterical. This means that "Republican" and "Democrat" labels have become real and almost "sectarian" in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Why is this happening? We suspect that the shift in urgency and tone is motivated at least in part by the changing demographics of America. Two demographic groups that identify the most with the Republican Party - Baby Boomers and rural or suburban white voters - are in a structural decline (the first in absolute terms and the second in relative terms). Both see the writing on the political wall. Given America's democratic system of government, their declining numbers (or, in the case of suburban whites, declining majorities) will mean significant future policy decisions that go against their preferences. America is set to become more left-leaning, favor more redistribution, and become less culturally homogenous. Not only are Millennials more socially liberal and economically left-leaning, but they are also "browner" than the rest of the U.S. As we pointed out early this year, 2016 was an election that the GOP could reasonably attempt to win by appealing exclusively to white and older voters. The "White Hype" strategy was mathematically cogent ... at least in 2016.18 It will get a lot more difficult to pursue this strategy in 2020 and beyond. Not impossible, but difficult. We suspect that conservative voters know this. As such, there was an urgency this year to lock-in structural changes to key policies before it is too late. Donald Trump may have been a flawed messenger for many voters, but it did not matter. The clock is ticking for a large segment of America and therefore Trump was an acceptable vehicle of their fears and anger. Bottom Line: Polarization in the U.S. is likely to increase. Two key Republican/conservative constituencies - Baby Boomers and rural or suburban white voters - are backed into the corner by demographic trends. But it also means that a left counter-revolution is just around the corner. And we doubt that the Democratic Party will chose as centrist of a candidate the next time around. Final Thoughts: What Have We Learned Chart II-20Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income 1. Economics trump PC: Civil rights remain a major category of the American public's policy concerns. However, the Democratic Party's prioritization of social issues on the margins of the civil rights debate has not galvanized voters in the face of persistent negative attitudes about the economy. More specifically, the surge in cheap credit since 2000 that covered up the steady decline of wages as a share of GDP has ended, leaving households exposed to deleveraging and reduced purchasing power (Chart II-20). American households have lost patience with the slow, grinding pace of economic recovery, they reject the debt consequences of low inflation with deflationary tail risks, and they resent disappointed expectations in terms of job security and quality. Concerns about certain social preferences - as opposed to basic rights - pale in comparison to these economic grievances. 2. Polls are OK, but beware the quant models that use them: On two grave political decisions this year, in two advanced markets with the "best" quality of polling, political modeling turned out to be grossly erroneous. To be fair, the polls themselves prior to both Brexit and the U.S. election were within a margin of error. However, quantitative models relying on these polls were overconfident, leading investors to ignore the risks of a non-consensus outcome. As we warned in mid-October - with Clinton ahead with a robust lead - the problem with quantitative political models is that they rely on polling data for their input.19 To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." But combining polls is mathematically the same as combining bad mortgages into securities. The philosophy behind the methodology is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening. Well, something bad did happen. The quantitative models were massively wrong! We tried to avoid this problem by heavily modifying our polls-based-model with structural factors. Many of these structural variables - economic context, political momentum, Obama's approval rating - actually did not favor Clinton. Our model therefore consistently gave Donald Trump between 35-45% probability of winning the election, on average three and four times higher than other popular quant models. This caused us to warn clients that our view on the election was extremely cautious and recommend hedges. In fact, Donald Trump had 41% chance of winning the race on election night, according to the last iteration of our model, a very high probability.20 3. Professor Lichtman was right: Political science professor Allan Lichtman has once again accurately called the election - for the ninth time. The result on Nov. 8 strongly supports his life's work that presidential elections in the United States are popular referendums on the incumbent party of the last four years. Structural factors undid the Democrats (Table II-3), and none of the campaign rhetoric, cross-country barnstorming, or "horse race" polling mattered a whit. The Republicans had momentum from previous midterm elections, Clinton had suffered a strong challenge in her primary, the Obama administration's achievements over the past four years were negligible (the Affordable Care Act passed in his first term). These factors, along with the political cycle itself, favored the Republicans. Trump's lack of charisma did not negate the structural support for a change of ruling party. Investors should take note: no amount of mathematical horsepower, big data, or Silicon Valley acumen was able to beat the qualitative, informed, contemplative work of a single historian. Table II-3Lichtman's Thirteen Keys To The White House* De-Globalization De-Globalization 4. Non-linearity of politics: Lichtman's method calls attention to the danger of linear assumptions and quantitative modeling in attempting the art of political prediction. Big data and quantitative econometric and polling models have notched up key failures this year. They cannot make subjective judgments regarding whether a president has had a major foreign policy success or failure or a major policy innovation - on all three of those counts, the Democrats failed from 2012-16. There really is no way to quantify political risk because human and social organizations often experience paradigm shifts that are characterized by non-linearity. Newtonian Laws will always work on planet earth and as such we are not concerned about what will happen to us if we board an airplane. Laws of physics will not simply stop working while we are mid-air. However, social interactions and political narratives do experience paradigm shifts. We have identified several since 2011: geopolitical multipolarity, de-globalization, end of laissez-faire consensus, end of Chimerica, and global loss of confidence in elites and institutions.21 5. No country is immune to decaying institutions: The United States has, with few exceptions, the oldest written constitution among major states, and it ensures checks and balances. But recent decades have shown that the executive branch has expanded its power at the expense of the legislative and judicial branches. Moreover, executives have responded to major crisis - like the September 11 attacks and the 2008 financial crisis - with policy responses that were formulated haphazardly, ideologically divisive, and difficult to implement: the Iraq War and the Affordable Care Act. The result is that the jarring events that have blindsided America over the past sixteen years have resulted in wasted political capital and deeper polarization. The failure of institutions has opened the way for political parties to pursue short-term gains at the expense of their "partners" across the aisle, and to bend and manipulate procedural rules to achieve ends that cannot be achieved through consensus and compromise. 6. U.S. is shifting leftward when it comes to markets: Inequality and social immobility have, with Trump's election, entered the conservative agenda, after having long sat on the liberals' list of concerns. The shift in white blue-collar Midwestern voters toward Trump reflects the fact that voters are non-partisan in demanding what they want: they want to retain their existing rights, privileges, and entitlements, and to expand their wages and social protections. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Except that it is better armed. 2 Please see BCA Geopolitical Strategy Client Note, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com. 3 However, Wisconsin polling was rather poor as most pollsters assumed that it was a shoe-in for Democrats. One problem with polling in Midwest states is that they were, other than Pennsylvania and Ohio, assumed to be safe Democratic states. Note for example the extremely tight result in Minnesota and the absolute dearth of polling out of that state throughout the last several months. 4 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "U.S. General Elections And Scenarios: Implications," dated July 11, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "When You Come To A Fork In The Road, Take It," dated November 4, 2016, available at fes.bcaresearch.com. 8 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gps.bcaresearch.com. 9 Only a two-thirds majority of Congress, or a ruling by a federal court, can undo an executive action, and that is exceedingly rare. The real check on executive orders is the rotation of office: a president can undo with the stroke of a pen whatever his predecessor enacted. Congress has the power of the purse, but it is sporadic in its oversight and has challenged less than 5% of executive orders, even though those orders often re-direct the way the executive branch uses funds Congress has allocated. More often, Congress votes to codify executive orders rather than nullify them. 10 Trump is not alone in calling for renegotiating or even abandoning NAFTA. Clinton called for renegotiation in 2008, and Senator Bernie Sanders has done so in 2016. 11 In Proclamation 4074, dated August 15, 1971, Nixon suspended all previous presidential proclamations implementing trade agreements insofar as was required to impose a new 10% surcharge on all dutiable goods entering the United States. He justified it in domestic law by invoking the president's authority and previous congressional acts authorizing the president to act on behalf of Congress with regard to trade agreement negotiation and implementation (including tariff levels). He justified the proclamation in international law by referring to international allowances during balance-of-payments emergencies. 12 The "primary dimension" of Chart II-8 is represented by the x-axis and is the liberal-conservative spectrum on the basic role of the government in the economy. The "second dimension" (y-axis) depends on the era and is picking up regional differences on a number of social issues such as the civil rights movement (which famously split Democrats between northern Liberals and southern Dixiecrats). 13 We have penned two such efforts ourselves. Please see BCA Geopolitical Strategy Special Report, "Polarization In America: Transient Or Structural Risk?," dated October 9, 2013, and "A House Divided Cannot Stand: America's Polarization," dated July 11, 2012," available at gps.bcaresearch.com. 14 Putnam, Robert. 2000. Bowling Alone. New York: Simon and Schuster. 15 Please see Martin Prosperity Institute, "Segregated City," dated February 23, 2015, available at martinprosperity.org. 16 Please see BuzzFeedNews, "Hyperpartisan Facebook Pages Are Publishing False And Misleading Information At An Alarming Rate," dated October 20, 2016, available at buzzfeed.com. 17 Nonetheless, due to the third-party candidate George Wallace carrying the then traditionally-Democratic South, Nixon managed to win the Electoral College in a landslide. 18 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "You've Been Trumped!," dated October 21, 2016, available at gps.bcaresearch.com. 20 For comparison, Steph Curry, the greatest three-point shooter in basketball history, and a two-time NBA MVP, has a career three-point shooting average of 44%. With that average, he is encouraged to take every three-pointer he can by his team. In other words, despite being less than 50%, this is a very high percentage. 21 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, and "Strategy Outlook 2016 - Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com.

Highlights Donald Trump's momentum in the national polls has been arrested; Colorado, Pennsylvania, New Hampshire and Florida are key states and Clinton is up in all of them; We are forecasting a narrow Clinton victory; Trump needs Electoral College to be tied, or polls to be wrong, to win; Re-initiate our "Clinton hedge": long S&P 500 / short gold. Feature The momentum behind Donald Trump's polls has hit a wall over the weekend (Chart 1). In four-way polling, Clinton's lead is now 3.3%. This is still massively down from 7.1% in mid-October. However, her lead has stabilized and has been at 2% for a week. Chart 1Trump Deals With A Wall Of His Own Trump Deals With A Wall Of His Own Trump Deals With A Wall Of His Own When it comes to state polls (four-way poll-of-polls from RealClearPolitics.com), Clinton sports a near, or above, 4% lead in Maine, Michigan, Virginia, and Wisconsin. Trump's momentum in all of these swing-states has been arrested or fully reversed. Trump's momentum continues in Arizona, Georgia, Iowa, North Carolina, and Ohio, where he is leading. Truly undecided swing states are: Colorado (Clinton lead of 2.9%), Pennsylvania (Clinton lead of 2.4%), Florida (Clinton lead below 1%), and New Hampshire (Clinton lead below 1%). However, Trump's momentum has clearly stopped in Colorado and Pennsylvania, whereas the momentum of both Clinton and Trump appears to have stalled in Florida. The state-of-play Electoral College Map 1 therefore remains very close. According to the latest polling, and our "rules-of-the-map" below, Trump has 237 Electoral College votes.1 Hillary Clinton narrowly leads with 239 votes. She has a lead in all four swing states. She has led Colorado for most of the election and Pennsylvania for the entirety of the election. Map 1Electoral College Map: The State Of Play On November 8 U.S. Election: Trump's Arrested Development U.S. Election: Trump's Arrested Development To construct the above Electoral College Map 1, we were highly favorable to Trump. Our rules were: A) Democratic Leaning States: Clinton has to have a +3.5% lead in order to have swing states awarded to her as "Democratic Leaning." B) Republican Leaning States: We awarded Trump any swing state where he has any lead in the polls, even the most minimal (such as Maine's Second Congressional District). C) Potential Swing States: If Clinton's lead is less than 3.5%, that state is considered a "Potential Swing State." This is because we are hedging for any mistakes in the polls due to "shy Trump" voters (voters who are uncomfortable confirming their true preference). Chart 2Hispanic Voters Could Be Difference Makers U.S. Election: Trump's Arrested Development U.S. Election: Trump's Arrested Development Early voting data favors the Democrats. Women appear to be voting in large numbers across the country. Furthermore, Hispanic turnout could reach a record high this year. In Arizona, 13% of early voters were Hispanic, compared to 11% in 2011.2 In Florida, a November 1 figure of early voting showed that Hispanics made up 14.1% of the early vote, up from 9.6% in 2012.3 And in Texas, 18.8% of early voters had "Spanish surnames," up 20% on the 2012 figure.4 Hispanic turnouts were also up in Georgia and North Carolina. Hispanic voters are unlikely to make a difference in Texas and Georgia, but the overall trend ought to concern Trump's campaign as Hispanic voters could make a difference in Colorado, Florida, and Nevada. Hispanic voters have the lowest turnout among the different demographic groups and thus also the largest potential to increase their participation (Chart 2). Our quantitative model continues to call the election for Clinton, albeit by less of a margin than in mid-October.5 The latest iteration - on November 8 - of the model gives Clinton 60.9% probability of winning the election. The model gives her better than 75% probability to win 247 Electoral College votes (Chart 3). Trump only has 180 Electoral College votes in the same category. We are quite confident in our model, given that it always gave Trump a solid probability of winning the election. Unlike other models available to clients at FiveThirtyEight.com or NYTimes.com, our model has not had any wild gyrations. It always gave Trump at least a 34.5% chance and thus did not have to adjust violently to "catch up to reality" following the FBI's announcement that it was looking into more emails related to the Clinton email probe. Chart 32016 U.S. Presidential Election: GPS Polls-Plus Model Full Results U.S. Election: Trump's Arrested Development U.S. Election: Trump's Arrested Development Bottom Line: Clinton is a low-conviction favorite to win the election. She leads all four swing states. Furthermore, we are generously awarding Trump states where he has the most minimal of leads in the polls. If he underperforms in any of the states that we noted are "Republican Leaning," he will lose the election. But Can Trump Still Win? Chart 4Election Polls Usually Miss By A Few Points U.S. Election: Trump's Arrested Development U.S. Election: Trump's Arrested Development Yes. Trump can win and it would not be a wild mathematical oddity if he did. As we pointed out before, national polls have underperformed by 3% in the past, Clinton's four-way lead in the poll-of-polls is just above 3% (Chart 4). In addition, there may be "shy Trump" voters who refuse to speak the truth when it comes to giving their election preferences to pollsters.6 On the other hand, the recent rally in Trump's polling reveals that many of these "shy Trump" voters have been emboldened by the recently re-opened FBI investigation into Clinton's emails to reveal their true preference. The extremely sharp rally would suggest that these voters were leaning towards Trump all along and that the FBI revelation was a cathartic event that allowed them to "speak their mind," so to say. What should worry Trump is that the momentum has now ended. This could mean that the "shy Trump" voter phenomenon is no longer as cogent. Or, at least, that the probability that the polls are still underestimating Trump may now be much lower. As mentioned, early voting data - the turnout among Hispanics and women in particular - suggests that the polls could be underestimating Clinton's support, especially in a state like Nevada where Trump is now in the lead according to the polls, but where early voting suggests that the Democratic Party "ground game" is going to give the state to Clinton. Bottom Line: Trump can still win. We are comfortable with our quantitative model's probability of a Trump victory at 39.1%, fairly high. As such, our view that Clinton is the favorite is a low conviction view. Can There Be A Tie? The Electoral College Map suggests that a tie is possible. If Clinton wins the Maine Second Congressional District and Trump wins New Hampshire, then both will be tied at 240 Electoral College (EC) votes. If Trump then wins Florida's 29 EC votes, a state where Clinton's lead is extremely narrow, he will have 269 EC votes. Meanwhile, if Clinton wins the other two states where her lead is more robust - Colorado and Pennsylvania - then she would have 269 EC votes as well. A tie will favor Trump for two reasons: The House of Representatives would break the Electoral College tie by casting one vote per state delegation. This means that representatives of each state would have to decide among themselves how they would choose the next president. Given the Republican majority in the House and among the states, Trump would likely prevail as president with 66% of the House vote. Faithless Electors will hurt both candidates. It is possible that an Electoral College member or "elector" could refuse to cast his or her ballot for the candidate chosen by popular vote in that elector's state. Already an elector in Washington State, likely to be pledged to Clinton given the state's liberal leaning, has pledged himself to be a "faithless elector" and thus not give her the vote. In addition, we would not be surprised if a win is contested by either candidate due to very narrow margin of victory in one or more states. As such, investors should prepare for potential continued market volatility beyond November 8. Investment Implications We are closing our sector-based Trump hedge of being long biotech / short S&P 500 exporters for a 0.71% loss. In addition, investors should close the long 10-year Treasury hedge as well. However, we will keep our currency hedge (long USD / short SEK, currently up 0.68%) and fixed-income hedge (2-year / 30-year Treasury curve steepener, currently up 3.8 bps). In addition, our volatility hedge was stopped out yesterday. Given our view that Clinton will eke out a narrow win, we are also re-opening our Clinton hedge of being long S&P 500 / short gold, but with a tight stop-loss of 2.5%. To our American friends, colleagues, and clients, happy Election Day! Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 We give Donald Trump the one Electoral College vote from the Maine Second Congressional District, a generous gift given that he is only up by 0.5% there and that Barack Obama won the district by 11.2% in 2008 and 8.5% in 2012. Nonetheless, Maine awards two Electoral College votes by Congressional Districts and Trump is leading by a narrow margin in one of them. 2 Please see The Arizona Republic, "Arizona leads nation in early-voting surge by Latinos," dated November 3, 2016, available at azcentral.com. 3 Please see CNN, "Early voting data in 3 key states show spike in Latino turnout," dated November 5, 2016, available at cnn.com. 4 Please see Austin-American Statesman, "Texas Latino turnout up sharply in early voting surge, analysis shows," dated November 4, 2016, available at mystatesman.com. 5 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "You've Been Trumped!" dated October 21, 2016, available at gps.bcaresearch.com.

Highlights Today, we are sending out a previously scheduled Special Report, highlighting our thoughts on the how to assess the impact of China on global bond markets. This is an important topic that we hope you will find of great interest. We will not be offended, however, if that report sits in your inboxes for a day or two while the world awaits the results of today's U.S. Presidential election. Feature Global financial markets have been subject to extraordinary volatility over the past couple of weeks as the election campaign has drawn to a close. Investors have had to deal with the steady inflow of shifting poll results, overbearing media punditry, surprising FBI letters and wild conspiracy theories, all while trying to price the risks associated with two of the most polarizing presidential candidates in U.S. history. The recent narrowing of Hillary Clinton's lead in the polls has forced investors to seriously consider the possibility of a President Donald J. Trump, with all the change from the status quo that he represents. Given how markets have reacted to Trump closing the gap with Clinton - falling equity prices, higher volatility, lower bond yields and a weaker U.S. dollar - a Trump win could trigger a true risk-off market rout, with global investors wanting to avoid been burned by another political surprise after Brexit. Our colleagues at BCA Geopolitical Strategy still view a narrow Clinton victory as the most likely outcome, with admittedly lower conviction levels than usual for such an important election. Such is the problem of making predictions when polls are within margins of error. However, given the well-understood realities of the U.S. Electoral College map and the still-uphill climb needed for Trump to win, the result that would catch investors most off-guard would be The Donald pulling off the upset. From our perspective at BCA Global Fixed Income Strategy, a Clinton victory would keep the global economy on its current positive growth track in the near-term. This would shift bond investors' focus back over to the Fed and a likely December rate hike. However, a risk-off market move after a Trump win would represent the biggest risk to our current portfolio recommendations: We are positioned for rising global bond yields via an overall below-benchmark duration stance, given our view that we are in a cyclical growth upturn that is also pushing global inflation higher (more details on China's contribution to that can be found in the Special Report sent out today). In terms of regional bond allocation, we are favoring the areas with the lowest inflation rates and most credible dovish central banks, via an above-benchmark tilt in core Europe and a neutral stance on Japan and Canada. We are underweight the countries where central bankers are either in the process of raising rates (the U.S.) or will soon face a decision to tighten policy in the face of strong growth and rising inflation pressures (the U.K., Australia). We are also underweight Peripheral European debt (Italy, Spain, Portugal) versus Germany due to our concerns over decelerating growth in the Periphery combined with the ongoing stresses on Euro Area banks. We are overweight inflation protection (via linkers and CPI swaps) in the U.S. and U.K. where we see the greatest potential for rising inflation expectations. Within global credit markets, we are maintaining a defensive stance via underweights in U.S., Euro Area and Emerging Markets High-Yield (which are all overvalued and overlevered). Within Investment Grade corporates, we are only maintaining a neutral stance in the U.S. and above-benchmark tilts in the Euro Area and U.K. We are also neutral on Emerging Market hard currency debt, both sovereigns and corporates. In the event that Trump pulls out the win tonight, we would expect our overall below-benchmark duration call to suffer if bond yields declines in a risk-off move. However, our "break-even" level on that call allows some cushion to stick with the underweight, as we initiated the recommendation back in July when the 10-year U.S. Treasury yield was just below 1.60%. A return to those levels would be a 25bp decline from yesterday's closing level of 1.83%, which would be a massive move if it happened in a short period of time immediately after Trump was declared the winner. Yet if such large move in yields were to occur, it would almost certainly be in the context of a rout in global equity markets. Our underweight stance on high-yield corporates and Peripheral Europe would perform very well there. Our generally cautious stance on higher-quality corporates and Emerging Markets would likely cause minor hits only via our overweights in Europe, but with those markets supported by the ongoing central bank buying by the ECB and Bank of England, the losses should be relatively well-contained. There is also a risk that our overweights in inflation protection in the U.S. and U.K. would underperform, especially if the market rout turns into a lasting shock to global growth and inflation expectations. That will be difficult to determine in the immediate aftermath of a Trump win. Summing it all up, there are enough offsetting positions within our recommended portfolio to not suggest any changes into tonight's election. Let us hope that the election result is decisive enough that a winner can be declared tonight and this period of U.S. political uncertainty can end, whoever wins. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product

Highlights Bond yields have room to move higher in the near run, but a move above 2% would represent a buying opportunity. U.S. elections are too close to call. Even if Trump wins, we caution that federal fiscal spending programs will have to work hard to offset the ongoing drag from sluggish state and local spending. Economic and inflation data will not stand in the way of a Fed rate hike in December. But heightened market volatility associated with the elections could still derail their plans. Feature October was a tough month for Treasuries, as the 10-year climbed 25 basis points since October 1. The sell-off puts Treasury yields closely in line with our bond strategists' estimate of fair value. This week, we review the factors that argue for or against a further rise in bond yields. Our conclusion is that the Treasury sell-off is likely to continue in the near run. Yields above 2% would represent a buying opportunity. The primary bearish driver for Treasuries in the next two months is the Fed. As we discuss below, recent economic data has been decent enough to meet the Fed's threshold for a rate hike and inflation indicators are moving towards the Fed's 2% target. Indeed, the FOMC statement released last Wednesday sent a mildly hawkish signal by highlighting that growth has improved, while both inflation expectations and realized inflation are tracking higher. The statement very much keeps a December rate hike in play, but it does not elevate the odds. In the FOMC meeting just prior to last year's rate hike, the Fed specifically mentioned the "next meeting" as a possibility for a rate increase. The Fed did not go as far this time around1 as policymakers are no doubt wary of spooking the markets when uncertainty is running high ahead of the U.S. election. Whether the Fed actually pulls the trigger in December will continue to hinge on the incoming economic data and the behavior of the markets following the election, but our base case remains that the Fed will follow through with a rate hike. The market is currently priced for a 65% chance of a rate move before the end of the year. This is roughly the same as the probability of a 2015 rate hike at this time last year (Chart 1). As long as the economic data remain reasonably firm, as we expect, then rate hike probabilities should follow last year's path and move to 100% by the December 13-14 FOMC meeting. Last year, the revision in the rate hike probability from November-December corresponded with a 35 bps rise in the 10-year Treasury. Chart 1Room For Expectations To Move Higher Room For Expectations To Move Higher Room For Expectations To Move Higher Since last year, the Fed has drastically downgraded its long-term rate projections. Recall that ahead of the December 2015 FOMC meeting, the Fed projected that the Fed funds rate would reach 1.4% in 2016. Since then, the Fed has revised downward its interest rate forecast to two rate hikes in 2017. Assuming the Fed does not revise these forecasts, it is unlikely that Treasuries respond as negatively as they did in 2015. Moreover, as we noted above, at 1.8% today, Treasuries are already roughly at fair value. During last year's sell-off, bond yields were starting from a substantially overbought level. This argues for a somewhat more muted reaction to a Fed rate hike, although we still expect yields could move higher. Beyond December, i.e. once the rate hike is priced in, our base case is that yields trend sideways for a time. The Fed's forecast for growth in 2017 is 2.0%, which would represent an increase of 0.5% from the first three quarters of 2016. If economic growth meets the Fed's expectation of 2%, then it is reasonable to expect that policymakers would increase twice next year, i.e. in line with their current forecasts. As shown in Chart 1, the Treasury market is not yet priced for this outcome: market participants currently assign only 80% odds to one rate hike by the end of 2017. The message is that the Fed, even with a reasonable (for the first time in years!) forecast for growth, will end up being a source of upward pressure on bond yields beyond 2017. There is nonetheless an important mitigating factor for bond yields: the U.S. dollar. A stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. Indeed, a central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. In the current environment, the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because its actions will be exaggerated by movements in the currency. The bottom line is that we expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. Given that the bond market is not yet priced for this, the recent sell-off in bond yields will continue, perhaps to as high as 2%. Thereafter, we would expect Treasuries to trade in a fairly narrow range, with 2% representing the higher end of the band. A Coin Toss Election In the very near term, the U.S. elections pose an important risk to the view expressed above. For the past several months, market odds of a Trump Presidency have been positively correlated with the uncertainty index and negatively correlated with Treasury yields (Chart 2 and Chart 3). On the eve of the election, the race is once again too close to call. Our expectation has been that any flight-to-quality related to a Trump victory will be short-lived. However, with equity market multiples stretched and the earnings outlook still leaving much to be desired, equity markets are ripe for a correction. Chart 2Bond Market Tracks Uncertainty Bond Market Tracks Uncertainty Bond Market Tracks Uncertainty Chart 3Trump And Uncertainty bca.usis_wr_2016_11_07_c3 bca.usis_wr_2016_11_07_c3 In our September 26 Weekly Report, we warned that investors may be assigning too low odds of a Trump Presidential win. We posited that if the polls remained tight, the potential for further volatility was high. We followed up in mid-October, advising clients how to implement portfolio insurance against downside market risks, and specifically against a Trump election win. One recommended vehicle for insurance that we highlighted was the U.S. dollar, which is part of our Protector Portfolio (Chart 4 and Chart 5). We believe the currency will rally due to the combination of coming fiscal expansion and risk aversion flows on the back of a Trump win. True, this strategy has not held up in recent days, as the U.S. dollar has softened while Trump improves in the polls and risk assets have corrected. Still, the dollar's reputation as a safe-haven currency is well-deserved. It has consistently outperformed during times of crisis - even when the U.S. itself was the source, as most recently demonstrated during the summer 2011 budget impasse. Chart 4Protector Portfolio Components bca.usis_wr_2016_11_07_c4 bca.usis_wr_2016_11_07_c4 Chart 5Protector Portfolio Returns bca.usis_wr_2016_11_07_c5 bca.usis_wr_2016_11_07_c5 In a recent report,2 our geopolitical strategists outline several things to watch for on November 8, the day of the election, and in its immediate aftermath. The immediate developments most relevant for investors are anything that prolongs the period of uncertainty regarding voting. For example, the 2000 election is a reminder that the results may not be clear immediately. Although the 2000 election was held on November 7, the official result was not declared until November 26; Al Gore did not concede until December 12. This time, any number of things could delay declaring a winner, including a tie in the electoral college, or a "faithless elector," i.e. an electoral college member that does not cast his/her ballot for the candidate chosen by popular vote, and therefore causes the Supreme Court to intervene. A delay in declaring the election result would increase uncertainty and therefore be negative for risk assets. Longer term, the margin of victory has become important for policy. It is now clear that a Clinton win, if it were to happen, will be a narrow one. According to our Geopolitical Strategy team, it is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives are zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. The probability of a compromise between the White House and GOP in Congress is therefore declining and puts in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The likelihood of more fiscal spending in 2017 has become common lore among investors. Thus, a disappointment on that front would be negative for risk assets. Post-Election Government Spending Throughout the twists and turns of the U.S. election campaign, one higher conviction view that has endured at BCA is that popular sentiment is shifting away from fiscal austerity and that 2017 would feature more ambitious spending programs. That would be quite welcome, given that real government consumption and investment - at all levels of government - has been a drag on growth during most of the recovery since the Great Recession. Ongoing weakness at the Federal level is due to restraint in defense expenditure, while state and local spending has been weak due to a significant downtrend in tax revenues. It is notable that the decline in state tax revenues is not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year.3 Remember that states can only spend what they take in outside of infrastructure spending. If state and local governments can manage to cut the drag on real GDP to 0%, that would still leave a major onus for government spending on the federal government. Assuming the contribution to real GDP from state and local spending is zero, it would require a 6% annual growth in federal spending to return total government spending as a contribution to GDP back to its historic average of 0.4% (Chart 6). As Chart 7 shows, fiscal spending of that magnitude rarely occurs outside of recession. Chart 6(Part 1) How Much Fiscal Spending? (Part 1) How Much Fiscal Spending? (Part 1) How Much Fiscal Spending? Chart 7(Part 2) How Much Fiscal Spending? bca.usis_wr_2016_11_07_c7 bca.usis_wr_2016_11_07_c7 Importantly, how much long-term effect a fiscal boost will deliver depends on how well fiscal multipliers - which measure how much a dollar of increased government spending or reduced taxes raises output - are working. Indeed, the magnitude of fiscal multipliers continues to be a massive source of disagreement in policy circles. Recent work by the IMF suggests that the multiplier, in some economies and under certain interest rate settings, could be as high as four: for each dollar the U.S. government spends, it will generate another $4 dollars of GDP!4 Other academics put the fiscal multiplier at less than 0.5. The wide range of forecasts is due to several factors, but there are nonetheless some generally held principles: Fiscal stimulus tends to be more effective when the output gap is large: when output is well below its potential, the monetary policy response to an increase in spending is likely to be limited. In other words, fiscal multipliers are larger in recessions than in expansions.5 The type of fiscal stimulus matters, a lot. Table 1 shows a range of CBO estimates for different types of government activity. For example, income tax cuts on high income earners tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Multiplier effects tend to last no more than eight quarters when output is close to potential. Fiscal stimulus tends to have a more impressive impact, although short-lived (four quarters) when the output gap is large. Table 2 shows the CBO-estimated effect of an increase in demand over eight quarters under two different economic scenarios. The first is when monetary policy is constrained, and the second is when monetary policy responds to the increase in demand from government stimulus. Our guess is that we are currently somewhere in between the two economic scenarios presented: there is still an output gap and monetary policy is already off the zero bound. Thus, the fiscal multiplier is likely a little above than one, meaning that government spending does not "crowd out" private spending. Table 1Ranges For U.S. Fiscal Multipliers Policy, Polls, Probability Policy, Polls, Probability Table 2The Effect Of A $1 Increase In Aggregate Demand Over Eight Quarters Policy, Polls, Probability Policy, Polls, Probability Overall, government expenditures will contribute positively to GDP next year, though the amount of fiscal expansion is dependent on the political configuration in Washington after the elections. Similarly, the impact of any spending will depend on what form new fiscal measures takes. CBO research suggests that the fiscal multiplier will be slightly above 1. Business Sentiment: Neither Euphoria Nor Misery Without further participation from the government sector, the economy is likely to achieve above 2% real GDP growth. A more optimistic scenario could unfold if capex improves substantially and/or a Trump win significantly opens the fiscal taps. Recent private sector data shows that businesses are continuing on a mild expansion path. The ISM surveys of business confidence were little changed in October - sentiment among manufacturers is broadly unchanged, while respondents from the service sector were slightly less optimistic than the previous month (Chart 8). Still, the major indices remain above their boom/bust lines and respondents' comments suggest neither euphoria nor misery. Meanwhile, payrolls increased by 161,000 in October. Although this was slightly below the consensus forecast of 175,000, there was a cumulative 44,000 in upward revisions to the prior two months. Elsewhere, wages accelerated more than expected and average hourly earnings rose 0.4% m/m, pushing the annual growth rate to a new cyclical high of 2.8% (Chart 9). Chart 8ISM Surveys Are Steady bca.usis_wr_2016_11_07_c8 bca.usis_wr_2016_11_07_c8 Chart 9Wage Growth Is Perking Up bca.usis_wr_2016_11_07_c9 bca.usis_wr_2016_11_07_c9 To paraphrase from this week's FOMC statement, the employment report provides some further evidence that the U.S. economy is progressing towards the Fed's dual mandate. In itself, it reinforces the case for the Fed raise interest rates in December. It seems now that the only thing that could derail the Fed is an election surprise and related heightened market volatility. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/press/monetary/20151028a.htm 2 Please see Geopolitical Strategy Special Report "It Ain't Over 'Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com 3 http://www.rockinst.org/pdf/government_finance/state_revenue_report/2016-09-21-SRR_104_final.pdf 4 https://www.imf.org/external/pubs/ft/wp/2014/wp1493.pdf 5 "How Powerful Are Fiscal Multipliers In Recessions? Alan Auerbach and Yuriy Gorodnichenko, NBER Reporter 2015, http://www.nber.org/reporter/2015number2/auerbach.html

Highlights Despite a tough week, the dollar bull market is intact. The U.S. economy's resilience to a strong dollar is growing. But, if Trump wins, the dollar could temporarily sell off against EUR, CHF, and JPY. Favor these currencies against EM and commodity currencies. Thanks to the High Court's Brexit ruling, the outlook for the pound is brightening. Wait for the appeal procedure to be over before implementing directional bets. Feature Despite this week's violent correction in the dollar, we remain dollar bulls. However, the recent reaction of the greenback to the rising probability of a Trump victory raises the need to hedge such an outcome. Still Bullish On The Dollar... The U.S. is unlikely to fall from its perch at the top of the distribution of G10 interest rates, a historically dollar-bullish environment (Chart I-1). Chart I-1Dollar Tailwinds Dollar Tailwinds Dollar Tailwinds The hidden slack in the U.S. labor market has dissipated. The amount of workers outside of the labor force who do want a job is at 6.2%, a level in line with the readings recorded between 2000 and 2007, when hidden slack was low (Chart I-2). Moreover, wages and salary continue to grow in the national income. Skewing the income distribution away from profits and rents is akin to a redistribution of income away from the top 1% of households, who derive nearly 50% of their income from profits. Importantly, middle-class households have a much higher marginal propensity to consume than rich ones. So great is the difference that since 1981, the 10% increase in the share of national income accruing to the top 1% of households has helped depress consumption by 3%. As a result, income redistribution will depress the U.S. savings rates going forward (Chart I-3). Since 70% of household consumption is geared toward the service sector, a component of the economy where productivity growth is hard to come by, increasing consumption is likely to directly result in job creation. Chart I-2U.S. Wages Can Rise U.S. Wages Can Rise U.S. Wages Can Rise Chart I-3The U.S. Savings Rate Has Downside bca.fes_wr_2016_11_04_s1_c3 bca.fes_wr_2016_11_04_s1_c3 With the unemployment gap being closed, consumption growth will cause wage growth to accelerate, further supporting consumption. Hence, the Fed can increase rates more aggressively than the 70 basis points priced into the OIS curve until the end of 2019. These kinds of dynamics have historically been very dollar bullish (Chart I-4). Moreover, the feedback loop linking the dollar and financial conditions to the economy is weakening. Not only is the economy increasingly driven by household expenditures, but the weight of commodity and manufacturing capex in the economy has collapsed in response to the dollar's strength (Chart I-5). Even if the sensitivity of these sectors to the dollar and financial conditions is unchanged, their impact on the broad economy has diminished. Chart I-4A Virtuous Circle##br## For The Dollar bca.fes_wr_2016_11_04_s1_c4 bca.fes_wr_2016_11_04_s1_c4 Chart I-5Lower Impact Of Manufacturing ##br##And Commodities bca.fes_wr_2016_11_04_s1_c5 bca.fes_wr_2016_11_04_s1_c5 Outside of the U.S. some key factors will prevent a normalization of policy rates in the major economies. Euro area rates will stay depressed for much longer. Conditions to generate inflation are absent. The output gap remains wide and negative, unemployment is significantly above NAIRU, and fiscal austerity, while diminished, is still de rigueur (Chart I-6). While the IMF pegs the output gap at 1.2% of GDP, the ECB estimates it to stand at 6% of GDP. Additionally, the European credit impulse is likely to roll-over. European bank stock prices have led European credit growth. They now point to slowing loan growth (Chart I-7). Even if loan growth were only to stabilize, this would imply a fall in the impulse. Chart I-6Inflationary Pressures##br## In Europe Inflationary Pressures In Europe Inflationary Pressures In Europe Chart I-7Downside Risk To The##br## Euro Area Credit Impulse bca.fes_wr_2016_11_04_s1_c7 bca.fes_wr_2016_11_04_s1_c7 These forces will weigh on the euro. The SNB floor under EUR/CHF remains credible and exercised. Therefore, USD/CHF will mostly stay a function of EUR/USD. For Japan, as we highlighted in the September 23 and October 28 reports, conditions are falling into place to see rising wages and inflation expectations. Rates being pegged at 0% until inflation greatly overshoots 2% will lower Japanese real rates along with the yen. Bottom Line: The 12-18 months outlook for the dollar remains bright. The resilience of U.S households will lead to stronger wage growth and an economy powered by consumption. The Fed will surprise markets with more rate hikes than anticipated. Meanwhile, European and Japanese real rates are unlikely to rise much if at all. ...But The Short-Term Outlook Is Bifurcated Yet, the short-term outlook is murky. BCA believes that a Trump presidency is likely to supercharge any dollar rally. Not only would his presidency imply huge infrastructure projects, his trade tactics should put upward pressure on wages and inflation, prompting an even more hawkish Fed than we anticipate. However, if recent dynamics are any clue, a Trump victory next week could also cause an immediate but temporary knee-jerk sell-off in the dollar. Since the FBI announced a re-examination of the Clinton emails affair, Trump's probability of winning has skyrocketed. While USD/MXN has rallied, so has EUR/USD, driven by a favorable move in interest rate differentials (Chart I-8). This raises the specter of a bifurcated move in the dollar over the next month or so. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer against EUR, CHF, and JPY. Why would the dollar rise against EM and commodity currencies? Cyclically and tactically, the stars are lining up against this set of currencies. The economic situation in EM and China is as good as it gets right now. The Keqiang index is near cyclical highs, suggesting that the upswing in Chinese industrial activity is unlikely to strengthen further, especially as loan demand remains tepid (Chart I-9). Chart I-8A Trump Indigestion bca.fes_wr_2016_11_04_s1_c8 bca.fes_wr_2016_11_04_s1_c8 Chart I-9China: As Good As It Gets China: As Good As It Gets China: As Good As It Gets Worryingly, Chinese fiscal stimulus is dissipating, which will act as a drag on the nation's investment and industrial activity. Chinese authorities panicked in 2015 as the Chinese economy was moving toward a hard landing. The government direct fiscal spending impulse surged (Chart I-10). Also, private-public partnerships originally expected to invest $1.2 trillion in infrastructure over three years were deployed in six months. As these tactics caused the economy to deviate from Beijing's stated goal to rebalance China away from investment, they are now being rolled back. Additionally, Chinese deflationary pressures are likely to resurface. Our bullish stance on the dollar implies a negative view on commodity prices. PPI will suffer if the dollar rallies given that Chinese producer prices are highly correlated with commodity prices (Chart I-11). This increases the likelihood that industrial activity in China will slow again. Chart I-10Vanishing Fiscal##br## Support Vanishing Fiscal Support Vanishing Fiscal Support Chart I-11Chinese PPI And Commodity Prices:##br## Brothers In Arms Chinese PPI And Commodity Prices: Brothers In Arms Chinese PPI And Commodity Prices: Brothers In Arms These risks are not priced in by EM assets and related plays. Risk reversals on EM currencies are priced in for perfection. Slowing Chinese growth would represent a negative surprise for EM debt, EM currencies, and commodity currencies (Chart I-12). An additional worry for EM currencies is momentum. A paper by the BIS shows that momentum continuation strategies are very profitable in EM FX.1 Hence, if EM currencies begin to fall, this fall will prompt further weaknesses. Finally, a Trump presidency is another headwind for EM and commodity currencies. In an earlier Special Report, we argued that a key factor that boosted the profitability of FX carry strategies was the rise of globalization (Chart I-13).2 This growing global trade mostly benefited small open economies, EM economies, and commodity producers, the so-called "carry-currencies". Trump's rhetoric promises a roll-back of this trend, a move that will disproportionally hurt such currencies. Compounding this risk, this cycle, the performance of FX carry trades has been inversely correlated to global bond yields (Chart I-14). BCA's underweight duration represents another problem for EM and commodity currencies. Chart I-12EM Plays Are Priced For Perfection EM Plays Are Priced For Perfection EM Plays Are Priced For Perfection Chart I-13Carry Trades Love Globalization Carry Trades Love Globalization Carry Trades Love Globalization Chart I-14Rising Yields Hurt Carry Currencies Rising Yields Hurt Carry Currencies Rising Yields Hurt Carry Currencies However, what could temporarily lift the euro, the Swiss franc, and the yen despite a negative cyclical outlook? Risk aversion and a global equity market correction prompted by a Trump victory. In short, a flight to safety amid uncertain times. These currencies are underpinned by current account surpluses ranging from 3% of GDP for the euro area to 10% for Switzerland. They therefore export investments abroad. This capital usually displays a strong home bias when global risks spike, and EUR, CHF, and JPY strengthen when global equities weaken. Finally, our current negative predisposition toward carry trades would also support funding currencies, currencies with deeply negative rates like EUR, CHF, or JPY. Bottom Line: In the direct aftermath of a Trump victory, the dollar could suffer from some temporary downward pressure against the EUR, CHF, and JPY. However, it will strengthen against EM and commodity currencies. On a cyclical basis, the USD will be stronger against these latter currencies than against European currencies. Key Investment Recommendations We are opening long EUR/AUD and short CAD/JPY positions. The EUR is less sensitive to EM downside than the AUD. Deteriorating EM currencies' risk reversals often coincide with a stronger EUR/AUD (Chart I-15). Also, the euro is cheaper than the Aussie, trading at a 5% discount to PPP. Additionally, EUR/USD could appreciate in the event of a Trump presidency, but its negative impact on EM economies and global trade will drag down AUD. The CAD/JPY position is primarily a Trump hedge. CAD will sell off if Trump wins as investors ponder the future of NAFTA. Meanwhile, the yen will benefit from safe-haven flows and from the eradication of any probability of MoF interventions (Chart I-16). Japan already meets two of the three criteria to be labeled a currency manipulator by the U.S. Treasury. Under a Trump presidency, such a label will have very real consequences. Chart I-15A Fall In EM Assets Would##br## Support EUR/AUD A Fall In EM Assets Would Support EUR/AUD A Fall In EM Assets Would Support EUR/AUD Chart I-16If Trump Wins, The MoF ##br##Will Not Intervene If Trump Wins, The MOF Will Not Intervene If Trump Wins, The MOF Will Not Intervene Moreover, CAD/JPY is also negatively affected by a deterioration of EM risk reversals. However, we are more worried for the JPY's long-term outlook than the EUR's. This is because of the more aggressive policy stance taken by the BoJ. Thus, this trade is more tactical than the EUR/AUD bet. Finally, investors wanting to play a Trump victory using European currencies should consider going long CHF/SEK. Sweden, a small open economy with deep trade links with EM, has been a key beneficiary of globalization. It will be a big loser if global trade shrinks. Meanwhile, CHF is likely to rally. Critically, this trade is for very nimble traders. At EUR/CHF 1.06, the SNB will intervene with all its might. The U.K.'s Über Thursday Yesterday, not only did the Bank of England announce its monetary policy decision and economic forecasts, but also, the High Court ruled that the Article 50 process preceding Brexit requires a vote from Parliament. While we expect Parliament to follow the popular vote and engage in Brexit, a parliamentary vote is much more likely to result in negotiating a "soft Brexit" rather than a "hard Brexit". In a "soft Brexit", the U.K. would retain access to the common market, and passporting of financial services would be allowed. However, freedom of movement would have to be maintained and the U.K. would have to contribute to the EU's purse. Unsurprisingly, the government is appealing the decision. Practically, this means it is still too early to aggressively bid up the pound. If the government wins its appeal, GBP/USD will move toward 1.10. If the government loses its appeal, FDI flows in the U.K. could regain some composure and help finance the large British current account deficit. This would lift GBP/USD toward 1.30 - 1.40. Probabilities are skewed toward the government losing its appeal. Economics, too, warrants caution. While the household sector's resilience has been a surprise to the Bank of England, it is unlikely to continue for long. First, the U.K. household credit impulse has rolled over and is now contracting at a GBP 1 billion pace, pointing to slowing growth. Second, in line with falling capex intentions, employers are paring their hiring intentions (Chart I-17). A slowdown in household nominal income growth should ensue. British households' real income will soon be squeezed, especially as the BoE increased it inflation forecast to 2.7% for 2018 due to the pass-through from the 15% fall in the trade-weighted GBP (Chart I-18). Additionally, the RICS survey points to further weakness in house prices. Chart I-17Deteriorating U.K. Labor Market Outlook Deteriorating U.K. Labor Market Outlook Deteriorating U.K. Labor Market Outlook Chart I-18Mechanics Of A Real Income Squeeze Mechanics Of A Real Income Squeeze Mechanics Of A Real Income Squeeze Hence, the BoE is on hold for a longer time than was anticipated in August. Moreover, Chancellor Hammond has made it clear that while the fall budget will loosen the fiscal austerity penciled in under the Osborne budgets, it is too early for investors to expect a large fiscal easing from the government. This suggests that risks remain tilted toward further easing by the "Old Lady." Bottom Line: Until we get clarity on the results of the government's appeal of yesterday's High Court Brexit ruling, we are inclined to fade strength in the pound. Any move above GBP/USD 1.25 would create a tactical shorting opportunity. A strangle with strikes at 1.27 and 1.15 and a January maturity makes sense for investors wanting to play the volatility around the ultimate ruling on the government's appeal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies", BIS Working Papers (2011). 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Policy Commentary: "The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives" - FOMC Statement (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Policy Commentary: "[On ECB Stimulus]...the initial date set to end the buying program is March, but the most advisable action is that it be a process that's as slow as possible" - ECB Governing Council Member Luis Maria Linde (October 28, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_04_s2_c5 bca.fes_wr_2016_11_04_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_04_s2_c6 bca.fes_wr_2016_11_04_s2_c6 Policy Commentary: "[On wether the BOJ would buy regional domestic bonds]..Regional domestic bonds are issued by the various local governments, and are traded separately. There are various factors that would make it difficult to consider them for monetary policy, but we will give the suggestion due consideration" - BoJ Governor Haruhiko Kuroda (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Policy Commentary: "...indicators of activity and business sentiment have recovered from their lows immediately following the referendum and the preliminary estimate of GDP growth in Q3 was above expectations. These data suggest that the near-term outlook for activity is stronger than expected three months ago" - BOE Monetary Policy Report (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_04_s2_c9 bca.fes_wr_2016_11_04_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "In Australia, the economy is growing at a moderate rate. The large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Household consumption has been growing at a reasonable pace, but appears to have slowed a little recently" - RBA Statement (November 1, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "There are unconventional monetary policies that give us more room to maneuver than previously believed...These include pushing interest rates below zero or buying longer-term bonds to compress long-term yields" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "In Switzerland the negative interest rate is currently indispensable, owing to the overvaluation of the Swiss franc and the globally low level of interest rates" - SNB President Thomas Jordan (October 24, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. presidential election is now too close to call. Hillary Clinton has a 61.6% chance of winning, according to our quant model. But Trump's real chances are approaching 50%, given momentum. Trump still trails in Virginia and Colorado, the two key swing states. A narrow Clinton win revives the fear of gridlock with a GOP-controlled House. Hedge against Trump by going long USD/SEK, long biotech stocks / short S&P 500 exporters, and long U.S. Treasurys. Feature After penning our latest missive on the U.S. election, "You've Been Trumped!" for our sister publication the Global Investment Strategy, a client complained that giving Trump 34.5% probability of winning the election was "laughable."1 To be fair to the client, our odds of a Trump victory were on average three times higher than that of other quantitative models.2 BCA's Geopolitical Strategy is not a stranger to receiving hate mail. Nor are we strangers to giving higher odds than the consensus to unexpected political events (see: Brexit).3 Since our October 21 report, Trump has narrowed Clinton's lead in the polls from 6.2% to 2.2%. Chart 1 shows that polls are retreating into their now-familiar oscillating pattern. In addition, FBI Director James Comey disclosed to Congress on October 28 that the law enforcement agency was reopening its investigation into Clinton's email practices while secretary of state. Chart 1Trump As The 'Comeback Kid' It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Needless to say, we are quite comfortable with the 38.4% Trump odds that our "polls-plus" model is forecasting.4 The reason it gives Trump such strong odds is because we do not only rely on the polls to make our forecast. Polls are a (poor) snapshot of reality, but predicting the future is about more than just "traveling with events." Forecasting requires a strong net assessment of structural factors through which one filters the incoming data, whether they be new polls or "October surprises." In this note, we revisit our quantitative model, review our qualitative "White Hype" model, and update our forecast. We suggest that clients hedge for a Trump victory. Quant Model: Trump Remains A Strong Candidate Our net assessment remains that this election is a much closer affair than the media narrative would have it. The FBI revelation is only important because it highlights that Hillary Clinton is a structurally weak candidate who is susceptible to "October surprises." This is best exemplified by Chart 2, which we have repeatedly published and shown to clients in meetings. It is simply difficult to take polls seriously when they are asking voters to choose between a "fire" and a "frying pan." Chart 2Clinton And Trump: The Least Charismatic Candidates Ever It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings To be clear, Secretary Clinton has several structural advantages: The Democratic party has a strong Electoral College lead over the GOP, a lead that Donald Trump has to overcome by winning a slew of large states that Mitt Romney lost in 2012; Hillary Clinton is polling well with minorities and women, both constituencies that preferred her to Bernie Sanders in the Democratic primary; Clinton is not a five-year-old trapped in the body of a 70-year-old. On the other hand, the "plus" in our polls-plus model reveals some structural weakness in the Clinton campaign: Two-Term Curse: It is notoriously very difficult for the incumbent party to retain the presidency after a successful multiple-turn run. Since the start of the twentieth century, this has happened only four times: William Taft (1908), Herbert Hoover (1928), Harry S. Truman (1948), and George H. W. Bush (1988). Only the last two examples are relevant in the modern context, and they happened in the wake of the monumentally popular presidencies of FDR and Ronald Reagan.5 We code for this factor in our model. Third Party: Our model also accounts for the presence of prominent third party candidates. At face value, this ought to hurt both Hillary Clinton and Donald Trump equally. However, Libertarian Gary Johnson has seen a dramatic drop in support, from nearly 10% in September to roughly just 5% today. The expanding correlation between Trump and Johnson's polling breaks negative in mid-October, suggesting that some Johnson fans are jumping the Mary Jane bus and getting on the Trump bandwagon (Chart 3). Meanwhile, Stein continues to take approximately 2% of the vote away from Clinton, which could make a difference in a close election in key swing states. Obama: Finally, we also code for the incumbent president's approval rating. While Obama's 52.5% is a solid number, it is not an "out of the ballpark" figure. Bill Clinton held a 58% approval rating in October 2000 as did Dwight Eisenhower in October 1960. Both saw their anointed successors lose in extremely tight races. Our model also relies on voting patterns and economic variables to "correct" the polling numbers for political cycles. First, we use each state's previous election results, going back to 1980, to gauge voter predisposition. We also include a momentum variable which measures the change in the differential between the two previous elections. In addition to the actual election data, we constructed two dichotomous variables to account for voter polarization and the presence of a strong third party. These structural forces favor the Republican challenger. Second, we use changes in state and national economic conditions prior to the elections to capture the macroeconomic context. These include national GDP, oil prices, and state-level disposable income. Since the economy has definitely seen improvement in the last four years of Obama's presidency, the data give the edge to the Democrats. Chart 3Third-Party Voters##br## Shifting To Trump bca.gps_sr_2016_11_01_c3 bca.gps_sr_2016_11_01_c3 Table 1Probabilities Of Victory:##br## GPS Polls-Plus Model It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Our model gives 60% weight to the probabilities derived from state polling and 40% to our structural econometric model. At the moment, the model is giving Clinton a 61.6% chance of winning the election (Table 1). Chart 4 shows that Clinton has 260 electoral votes in states where she has more than a 70% chance of winning. These are strong figures for Clinton, but they still give Trump around 38.4% chance of winning the election. We think it is closer to 50% and we discuss below why. Chart 42016 U.S. Presidential Election: GPS Polls-Plus Model Full Results It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: Given our quantitative model, we give Clinton a very slight edge to win the election. But the actual election is likely too close to call at this point. As we pointed out in our latest missive, a 3% lead in the polls for Clinton would not be enough to give us any confidence in our forecast due to the potential for polls to underappreciate Trump's support. Are Polls Wrong? The risk that polls are "wrong" remains considerable. Voters could be lying about supporting Trump because of various social stigmas related to it. For that reason, we suspect that any Clinton lead of less than 3% turns this election into "too close to call" and any lead of less than 5% leaves us with only a "low conviction" view that Clinton will win. We did not pick these numbers randomly; recent U.S. elections reveal that polls can miss results by as much as 3% (Chart 5). Our concern about the quality of polling is not random. It is informed by three factors: Undecideds: At this point in the election cycle, one would expect only 6% of voters to remain undecideds. However, this year, that figure stands at 9% (Chart 6). Now, this is likely because both candidates are deeply unfavorable, as Chart 2 illustrates. However, it could be because many voters are responding to pollsters with the "undecided" answer instead of saying that they support the controversial and politically incorrect candidate Donald Trump. In other words, the large number of undecideds could be where the "shy Trump voters" are hiding and ought to worry Clinton supporters a lot. Chart 5Election Polls Usually Miss By A Few Points It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Chart 6More Undecided Voters This Time Around bca.gps_sr_2016_11_01_c6 bca.gps_sr_2016_11_01_c6 Libertarian Collapse: Our theory about the undecideds could already be playing out with the Johnson voters. As we pointed out above, Johnson's support has halved in just one month. Most of his support appears to have gone to Donald Trump, but some could be bolstering Clinton's support levels in the "Mountain West" states of Colorado and New Mexico. Johnson's support may be inflated by voters who are embarrassed to say that they support Trump yet may end up voting for him. Poll Oscillation: We modified Chart 1 into Chart 7 by adding some "chart chat" to indicate when Trump made controversial - read: stupid - comments about Hispanics, Muslims, or women, which prompted a huge outcry from the media and society in general. Each event caused Trump's support to fall by an average of 4.9% from peak to trough. What would have happened to his polls had he not made such comments? Or, in other words, what is the true Trump support trajectory ex-controversial comments? Thus Chart 7 shows our back-of-the-envelope "technical" analysis of Trump's support. The reason polls are constantly oscillating may be that, with each egregious comment, Trump's real fans become "shy fans" and decline to select him during polling. But his true level of support may be very much on par with Hillary Clinton. Chart 7Trump's Surprising Resilience It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: There is some anecdotal evidence that Trump's support is underestimated by the polls. Hillary Clinton has to carry a +3% lead in the polls on November 8 for us to have any confidence in our quantitative model's predictions that she is indeed the favorite to win. This is no longer the case. Qualitative Model: "White Hype" Is Still Not Enough Our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one.6 Our colleague Peter Berezin, Chief Strategist of the BCA Global Investment Strategy, did so as early as September of last year.7 Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states. We also pointed out that getting a 5.7% swing in Iowa could be feasible. Chart 8 shows the result of our qualitative work on the White Hype model. It illustrates that while Florida and Ohio are well within Trump's grasp, Michigan, Pennsylvania and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1% respectively. Chart 8Trump Needs X Percent Of White Voters To Switch To The GOP It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings We used the figures from Chart 8 to create Trump's "ideal Electoral College map." Map 1 shows how our White Hype model grafts onto the Electoral College. Even if we give Trump Ohio, Florida, Iowa, and North Carolina (the latter because Mitt Romney won it in 2012), Trump still needs 11 Electoral College votes to win the election. Map 1Trump's Ideal Electoral College Map It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Where could he get those 11 votes? The answer is Virginia (13) or a combination of Colorado (9) and either Nevada (6) or New Hampshire (4). In other words, Virginia and Colorado are critical to Trump's chances of winning the election and he remains behind Clinton by 5.2% and 4% in the two respectively. In addition, while Trump has narrowed his lead on Clinton nationally, we have only noticed significant narrowing of the state polls in Florida, Ohio, Nevada, New Hampshire, and Michigan. In Michigan and New Hampshire, however, Clinton's lead remains 6.3% and 5.6%. Meanwhile, the narrowing has been either minor or non-existent in Colorado, Maine, Minnesota, Pennsylvania, Virginia, and Wisconsin (Chart 9). In each of these states, Clinton's lead is either around or above 5%. Unless the FBI investigation or some other surprise changes the dynamic, Trump's recent rally appears to be concentrated in states that are either GOP strongholds, are predicted to go to Trump by our "White Hype" model in Map 1, or are out of his reach anyway (like Michigan). Chart 9Trump's Comeback In The Swing States It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: State-by-state analysis of the polls shows that our White Hype model remains a cogent guide for this election. Trump can win both Ohio and Florida and he may still lose the election. This is because his White Hype electoral strategy works in those two critical states, but appears insufficient to overcome the Democrat advantage in white voters in the Midwest (Michigan, Pennsylvania, and Wisconsin). Ultimately, we stick to our call from March: this election will come down to Virginia and Colorado, two states where Clinton's lead remains 5.2% and 4% respectively. That said, Trump has momentum nationally and in swing states. Investment Implications: Hedging A Trump Victory Our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy pointed out in September 30 missive that volatility typically spikes in October of each U.S. presidential election.8 Charts 10 and 11, as well as Table 2, summarize the findings of his research that looked at the last seven presidential cycles going back to 1988. We agree and suspect that this year's election could see even more volatility in November given the narrowing in the polls and the ongoing FBI investigation into Clinton's email scandal. Chart 10October Surprises The Markets, 1988-96 bca.gps_sr_2016_11_01_c10 bca.gps_sr_2016_11_01_c10 Chart 11October Surprises The Markets, 2000-12 bca.gps_sr_2016_11_01_c11 bca.gps_sr_2016_11_01_c11 Table 2VIX Spikes The Month Before The U.S. Election It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings We recommend that our clients read Anastasios research first, and then put on his volatility hedge by buying a VIX 20-25 bullish call spread for November 16th expiry (capturing the election result), and to sell a 13 strike November 16th VIX put in order to bring down the cash outflow. The total cost for this hedge is $0.80/contract with a maximum gain capped at $5/contract, as of intra-day trading at the time of writing November 1. There is downside risk with selling the put option, but Anastasios points out that the VIX is unlikely to fall below 10, thus the risk to the downside is losing the $0.80/contract plus $2.68/contract assuming the VIX collapses to the 2014 closing low. In addition, we would hedge for a Trump victory by initiating the following trades: Currencies: Mathieu Savary, Chief Strategist of BCA's Foreign Exchange Strategy, recommends that we hedge a Trump win via a long USD/SEK trade. As our colleague Peter Berezin has posited before, the USD will rally if Trump wins due to the combination of coming fiscal expansion and risk aversion flows.9 Meanwhile, SEK would be hurt due to the realization by investors that globalization is at an end, given that Sweden is a small, highly open, economy. Trump's trade policies will be a nail in the coffin of globalization, proving our "Apex of Globalization" theme.10 Additionally, investors may want to do the obvious and short "NAFTA currencies" versus the USD. Sectors: Our favorite way to hedge a Trump victory via U.S. sectors would be to go long biotech / short S&P 500 exporters.11 Biotech would rally on the news that the risk of Clinton's regulatory action against pharmaceutical industry has dissipated. Meanwhile, major U.S. multinational exporters would be hurt by the twin effects of USD's likely appreciation and our "Apex of Globalization" theme, which would be supercharged following a Trump victory. Clients could alter this hedge by replacing biotech with financials, given that a Trump victory would allay investors' fears of further regulation against the financial industry. Fixed Income: BCA's U.S. Bond Strategy strategist, Ryan Swift, believes that a simple "buy-Treasurys" hedge is the best way to deal with the risk-off of a Trump presidency. A more long-term idea would be to underweight municipal bonds in a bond portfolio. A Trump tax-cutting administration would de-value the tax advantage in municipal bonds.12 Another hedge - this one courtesy of Rob Robis, Chief Strategist of BCA's Global Fixed Income Strategy - may be to consider a 2-year/30-year Treasury curve steepener. If the USD were to appreciate following a Trump victory, the Fed may think twice about a December rate hike, especially if the stock market sells off at the same time. The front end of the Treasury curve would rally in that environment. Meanwhile, the long end may react to the prospect of big deficit-financed fiscal expansion that Trump has promised, thus steepening the curve. The initial risk-off move after a Trump win may push the entire yield curve lower, but the bond market may quickly begin to price in the potential medium-term fiscal ramifications of a Trump presidency. What To Watch For On November 8? There are three things investors should watch on November 8, the day of the election, and in its immediate aftermath: Final results: In 2012, the statistical result was projected by the news networks around 11:30pm EST Nov. 6, according to the New York Times. Romney's concession speech occurred just after midnight on November 7. In the 2008 election, the result was projected by CNN as early as 7pm EST on election day (November 4), but that was due to the fact that the Obama win over Senator John McCain was a landslide. Obviously the 2000 election is a reminder that the results may not be clear immediately. The result in Florida was announced by 8pm EST on election day in favor of Gore, but the counting in the wee hours of the morning favored Bush. Gore conceded privately to Bush, then the tally went back to Gore, who withdrew his concession, and finally Bush was given the final tally several days later. The official result was not declared until November 26; Gore did not concede until December 12. The electoral college will vote on December 19, so states will have to resolve any recounts or disputes by December 13. Congress counts and certifies the result on January 6. Margin of victory: It is now clear that a Clinton win, if it were to happen, will be a narrow one. It is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives is at zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow Clinton win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. On top of the numbers, she will clearly have to deal with an unprecedented amount of investigations while in office. The chances of a compromise between the White House and GOP in Congress is therefore declining. Our "best-case scenario" of a Clinton-Paul Ryan compromise is therefore also very low. This will put in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The gridlock that will emerge from Congress under a Clinton presidency may, therefore, not be so sanguine after all. A Tie? What happens if the Electoral College vote is tied, or if by a fluke neither candidate wins a majority? There is a non-negligible probability that both Trump and Clinton could end up with 269 votes - i.e. one vote short of the 270 absolute majority required to win the White House. After all, Al Gore lost the 2000 election by only five electoral votes. How is the U.S. president chosen in that case? The House of Representatives convenes, allots one vote to each state (whose representatives must decide among themselves), and chooses the next president by a majority of the states. The presidential candidates in this case would be chosen from the top three recipients of electoral college votes.13 Here is the kicker: the vice-president would be chosen by the Senate from the top two candidates, meaning that Trump or Clinton would serve as the other's vice-president! Given the Republican majority in the House and among the states, Trump would likely prevail as president with 66% of the House vote, leaving Clinton to become vice-president. The United States would finally do what should always be done with squabbling children - force them to play on the same team! Faithless Electors: Another possibility is that an Electoral College member or "elector" could refuse to cast his or her ballot for the candidate chosen by popular vote in that elector's state. Electors are chosen by the political parties and are presumed to be staunch loyalists, but sometimes they deviate or make mistakes. Hardly more than half the states have passed laws to prevent or punish these so-called "faithless electors." No such elector has ever changed the outcome of a presidential race, but in an extremely tight race, abstentions, mistakes, or conscientious objection in the Electoral College could occur. The Supreme Court would have to settle any ensuing challenges, and would normally be expected to reassert the elector's independence to vote for any eligible candidate. Of course, the Supreme Court is currently undermanned at eight justices. If they were to split along ideological lines, any constitutional issues emanating from this election would remain gridlocked for a time, which would be a period of extreme uncertainty. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com David Boucher, Editor/Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "You've Been Trumped!" dated October 21, 2016, available at gps.bcaresearch.com. 2 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 31, 2016, available at fivethirtyeight.com. 3 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. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Of the four examples, only Bush Sr. in 1988 and Truman in 1948 are really relevant today. First, the Theodore Roosevelt transition to William Taft happened more than 100 years ago. Second, Hoover took over from eight years of Republican rule when the economy was at a peak, which is hard to compare with the post-financial crisis environments after 1929 and 2008. Thus the only relevant victories for the incumbent party following a multi-term presidency occurred after the reigns of two iconic presidents: Ronald Reagan and Frank D. Roosevelt, two of the greatest American presidents. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 8 Please see BCA's Global Alpha Sector Strategy Weekly Report, "Quarterly Review And Outlook," dated September 30, 2016, available at gss.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 11 The S&P 500 globally-exposed industry groups index is derived by BCA's U.S. Equity Strategy. 12 Please see BCA U.S. Bond Strategy, "Trading The Municipal Credit Cycle," dated October 18, 2016, available at usbs.bcaresearch.com. 13 Technically, then, Libertarian candidate Gary Johnson, the likeliest third-place candidate, would be eligible to become president under the House of Representative vote. Politically, however, it would be nearly impossible to orchestrate. The deadline for the House to decide this "contingent election" would be January 20, at which point the vice-president, elected by the Senate, would serve as acting president until the House resolved the issue. If the House and Senate have not chosen a president and vice-president by January 20, a new law must be passed to decide the outcome. Oh the humanity! Please see BCA Geopolitical Strategy Special Report, "U.S. Election Primer: Let's Get Ready To Truuuumble," dated February 29, 2016, available at gps.bcaresearch.com.

Highlights The U.S. presidential election is now too close to call. Hillary Clinton has a 61.6% chance of winning, according to our quant model. But Trump's real chances are approaching 50%, given momentum. Trump still trails in Virginia and Colorado, the two key swing states. A narrow Clinton win revives the fear of gridlock with a GOP-controlled House. Hedge against Trump by going long USD/SEK, long biotech stocks / short S&P 500 exporters, and long U.S. Treasurys. Feature After penning our latest missive on the U.S. election, "You've Been Trumped!" for our sister publication the Global Investment Strategy, a client complained that giving Trump 34.5% probability of winning the election was "laughable."1 To be fair to the client, our odds of a Trump victory were on average three times higher than that of other quantitative models.2 BCA's Geopolitical Strategy is not a stranger to receiving hate mail. Nor are we strangers to giving higher odds than the consensus to unexpected political events (see: Brexit).3 Since our October 21 report, Trump has narrowed Clinton's lead in the polls from 6.2% to 2.2%. Chart 1 shows that polls are retreating into their now-familiar oscillating pattern. In addition, FBI Director James Comey disclosed to Congress on October 28 that the law enforcement agency was reopening its investigation into Clinton's email practices while secretary of state. Chart 1Trump As The 'Comeback Kid' It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Needless to say, we are quite comfortable with the 38.4% Trump odds that our "polls-plus" model is forecasting.4 The reason it gives Trump such strong odds is because we do not only rely on the polls to make our forecast. Polls are a (poor) snapshot of reality, but predicting the future is about more than just "traveling with events." Forecasting requires a strong net assessment of structural factors through which one filters the incoming data, whether they be new polls or "October surprises." In this note, we revisit our quantitative model, review our qualitative "White Hype" model, and update our forecast. We suggest that clients hedge for a Trump victory. Quant Model: Trump Remains A Strong Candidate Our net assessment remains that this election is a much closer affair than the media narrative would have it. The FBI revelation is only important because it highlights that Hillary Clinton is a structurally weak candidate who is susceptible to "October surprises." This is best exemplified by Chart 2, which we have repeatedly published and shown to clients in meetings. It is simply difficult to take polls seriously when they are asking voters to choose between a "fire" and a "frying pan." Chart 2Clinton And Trump: The Least Charismatic Candidates Ever It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings To be clear, Secretary Clinton has several structural advantages: The Democratic party has a strong Electoral College lead over the GOP, a lead that Donald Trump has to overcome by winning a slew of large states that Mitt Romney lost in 2012; Hillary Clinton is polling well with minorities and women, both constituencies that preferred her to Bernie Sanders in the Democratic primary; Clinton is not a five-year-old trapped in the body of a 70-year-old. On the other hand, the "plus" in our polls-plus model reveals some structural weakness in the Clinton campaign: Two-Term Curse: It is notoriously very difficult for the incumbent party to retain the presidency after a successful multiple-turn run. Since the start of the twentieth century, this has happened only four times: William Taft (1908), Herbert Hoover (1928), Harry S. Truman (1948), and George H. W. Bush (1988). Only the last two examples are relevant in the modern context, and they happened in the wake of the monumentally popular presidencies of FDR and Ronald Reagan.5 We code for this factor in our model. Third Party: Our model also accounts for the presence of prominent third party candidates. At face value, this ought to hurt both Hillary Clinton and Donald Trump equally. However, Libertarian Gary Johnson has seen a dramatic drop in support, from nearly 10% in September to roughly just 5% today. The expanding correlation between Trump and Johnson's polling breaks negative in mid-October, suggesting that some Johnson fans are jumping the Mary Jane bus and getting on the Trump bandwagon (Chart 3). Meanwhile, Stein continues to take approximately 2% of the vote away from Clinton, which could make a difference in a close election in key swing states. Obama: Finally, we also code for the incumbent president's approval rating. While Obama's 52.5% is a solid number, it is not an "out of the ballpark" figure. Bill Clinton held a 58% approval rating in October 2000 as did Dwight Eisenhower in October 1960. Both saw their anointed successors lose in extremely tight races. Our model also relies on voting patterns and economic variables to "correct" the polling numbers for political cycles. First, we use each state's previous election results, going back to 1980, to gauge voter predisposition. We also include a momentum variable which measures the change in the differential between the two previous elections. In addition to the actual election data, we constructed two dichotomous variables to account for voter polarization and the presence of a strong third party. These structural forces favor the Republican challenger. Second, we use changes in state and national economic conditions prior to the elections to capture the macroeconomic context. These include national GDP, oil prices, and state-level disposable income. Since the economy has definitely seen improvement in the last four years of Obama's presidency, the data give the edge to the Democrats. Chart 3Third-Party Voters##br## Shifting To Trump bca.gps_sr_2016_11_01_c3 bca.gps_sr_2016_11_01_c3 Table 1Probabilities Of Victory:##br## GPS Polls-Plus Model It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Our model gives 60% weight to the probabilities derived from state polling and 40% to our structural econometric model. At the moment, the model is giving Clinton a 61.6% chance of winning the election (Table 1). Chart 4 shows that Clinton has 260 electoral votes in states where she has more than a 70% chance of winning. These are strong figures for Clinton, but they still give Trump around 38.4% chance of winning the election. We think it is closer to 50% and we discuss below why. Chart 42016 U.S. Presidential Election: GPS Polls-Plus Model Full Results It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: Given our quantitative model, we give Clinton a very slight edge to win the election. But the actual election is likely too close to call at this point. As we pointed out in our latest missive, a 3% lead in the polls for Clinton would not be enough to give us any confidence in our forecast due to the potential for polls to underappreciate Trump's support. Are Polls Wrong? The risk that polls are "wrong" remains considerable. Voters could be lying about supporting Trump because of various social stigmas related to it. For that reason, we suspect that any Clinton lead of less than 3% turns this election into "too close to call" and any lead of less than 5% leaves us with only a "low conviction" view that Clinton will win. We did not pick these numbers randomly; recent U.S. elections reveal that polls can miss results by as much as 3% (Chart 5). Our concern about the quality of polling is not random. It is informed by three factors: Undecideds: At this point in the election cycle, one would expect only 6% of voters to remain undecideds. However, this year, that figure stands at 9% (Chart 6). Now, this is likely because both candidates are deeply unfavorable, as Chart 2 illustrates. However, it could be because many voters are responding to pollsters with the "undecided" answer instead of saying that they support the controversial and politically incorrect candidate Donald Trump. In other words, the large number of undecideds could be where the "shy Trump voters" are hiding and ought to worry Clinton supporters a lot. Chart 5Election Polls Usually Miss By A Few Points It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Chart 6More Undecided Voters This Time Around bca.gps_sr_2016_11_01_c6 bca.gps_sr_2016_11_01_c6 Libertarian Collapse: Our theory about the undecideds could already be playing out with the Johnson voters. As we pointed out above, Johnson's support has halved in just one month. Most of his support appears to have gone to Donald Trump, but some could be bolstering Clinton's support levels in the "Mountain West" states of Colorado and New Mexico. Johnson's support may be inflated by voters who are embarrassed to say that they support Trump yet may end up voting for him. Poll Oscillation: We modified Chart 1 into Chart 7 by adding some "chart chat" to indicate when Trump made controversial - read: stupid - comments about Hispanics, Muslims, or women, which prompted a huge outcry from the media and society in general. Each event caused Trump's support to fall by an average of 4.9% from peak to trough. What would have happened to his polls had he not made such comments? Or, in other words, what is the true Trump support trajectory ex-controversial comments? Thus Chart 7 shows our back-of-the-envelope "technical" analysis of Trump's support. The reason polls are constantly oscillating may be that, with each egregious comment, Trump's real fans become "shy fans" and decline to select him during polling. But his true level of support may be very much on par with Hillary Clinton. Chart 7Trump's Surprising Resilience It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: There is some anecdotal evidence that Trump's support is underestimated by the polls. Hillary Clinton has to carry a +3% lead in the polls on November 8 for us to have any confidence in our quantitative model's predictions that she is indeed the favorite to win. This is no longer the case. Qualitative Model: "White Hype" Is Still Not Enough Our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one.6 Our colleague Peter Berezin, Chief Strategist of the BCA Global Investment Strategy, did so as early as September of last year.7 Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states. We also pointed out that getting a 5.7% swing in Iowa could be feasible. Chart 8 shows the result of our qualitative work on the White Hype model. It illustrates that while Florida and Ohio are well within Trump's grasp, Michigan, Pennsylvania and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1% respectively. Chart 8Trump Needs X Percent Of White Voters To Switch To The GOP It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings We used the figures from Chart 8 to create Trump's "ideal Electoral College map." Map 1 shows how our White Hype model grafts onto the Electoral College. Even if we give Trump Ohio, Florida, Iowa, and North Carolina (the latter because Mitt Romney won it in 2012), Trump still needs 11 Electoral College votes to win the election. Map 1Trump's Ideal Electoral College Map It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Where could he get those 11 votes? The answer is Virginia (13) or a combination of Colorado (9) and either Nevada (6) or New Hampshire (4). In other words, Virginia and Colorado are critical to Trump's chances of winning the election and he remains behind Clinton by 5.2% and 4% in the two respectively. In addition, while Trump has narrowed his lead on Clinton nationally, we have only noticed significant narrowing of the state polls in Florida, Ohio, Nevada, New Hampshire, and Michigan. In Michigan and New Hampshire, however, Clinton's lead remains 6.3% and 5.6%. Meanwhile, the narrowing has been either minor or non-existent in Colorado, Maine, Minnesota, Pennsylvania, Virginia, and Wisconsin (Chart 9). In each of these states, Clinton's lead is either around or above 5%. Unless the FBI investigation or some other surprise changes the dynamic, Trump's recent rally appears to be concentrated in states that are either GOP strongholds, are predicted to go to Trump by our "White Hype" model in Map 1, or are out of his reach anyway (like Michigan). Chart 9Trump's Comeback In The Swing States It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: State-by-state analysis of the polls shows that our White Hype model remains a cogent guide for this election. Trump can win both Ohio and Florida and he may still lose the election. This is because his White Hype electoral strategy works in those two critical states, but appears insufficient to overcome the Democrat advantage in white voters in the Midwest (Michigan, Pennsylvania, and Wisconsin). Ultimately, we stick to our call from March: this election will come down to Virginia and Colorado, two states where Clinton's lead remains 5.2% and 4% respectively. That said, Trump has momentum nationally and in swing states. Investment Implications: Hedging A Trump Victory Our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy pointed out in September 30 missive that volatility typically spikes in October of each U.S. presidential election.8 Charts 10 and 11, as well as Table 2, summarize the findings of his research that looked at the last seven presidential cycles going back to 1988. We agree and suspect that this year's election could see even more volatility in November given the narrowing in the polls and the ongoing FBI investigation into Clinton's email scandal. Chart 10October Surprises The Markets, 1988-96 bca.gps_sr_2016_11_01_c10 bca.gps_sr_2016_11_01_c10 Chart 11October Surprises The Markets, 2000-12 bca.gps_sr_2016_11_01_c11 bca.gps_sr_2016_11_01_c11 Table 2VIX Spikes The Month Before The U.S. Election It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings We recommend that our clients read Anastasios research first, and then put on his volatility hedge by buying a VIX 20-25 bullish call spread for November 16th expiry (capturing the election result), and to sell a 13 strike November 16th VIX put in order to bring down the cash outflow. The total cost for this hedge is $0.80/contract with a maximum gain capped at $5/contract, as of intra-day trading at the time of writing November 1. There is downside risk with selling the put option, but Anastasios points out that the VIX is unlikely to fall below 10, thus the risk to the downside is losing the $0.80/contract plus $2.68/contract assuming the VIX collapses to the 2014 closing low. In addition, we would hedge for a Trump victory by initiating the following trades: Currencies: Mathieu Savary, Chief Strategist of BCA's Foreign Exchange Strategy, recommends that we hedge a Trump win via a long USD/SEK trade. As our colleague Peter Berezin has posited before, the USD will rally if Trump wins due to the combination of coming fiscal expansion and risk aversion flows.9 Meanwhile, SEK would be hurt due to the realization by investors that globalization is at an end, given that Sweden is a small, highly open, economy. Trump's trade policies will be a nail in the coffin of globalization, proving our "Apex of Globalization" theme.10 Additionally, investors may want to do the obvious and short "NAFTA currencies" versus the USD. Sectors: Our favorite way to hedge a Trump victory via U.S. sectors would be to go long biotech / short S&P 500 exporters.11 Biotech would rally on the news that the risk of Clinton's regulatory action against pharmaceutical industry has dissipated. Meanwhile, major U.S. multinational exporters would be hurt by the twin effects of USD's likely appreciation and our "Apex of Globalization" theme, which would be supercharged following a Trump victory. Clients could alter this hedge by replacing biotech with financials, given that a Trump victory would allay investors' fears of further regulation against the financial industry. Fixed Income: BCA's U.S. Bond Strategy strategist, Ryan Swift, believes that a simple "buy-Treasurys" hedge is the best way to deal with the risk-off of a Trump presidency. A more long-term idea would be to underweight municipal bonds in a bond portfolio. A Trump tax-cutting administration would de-value the tax advantage in municipal bonds.12 Another hedge - this one courtesy of Rob Robis, Chief Strategist of BCA's Global Fixed Income Strategy - may be to consider a 2-year/30-year Treasury curve steepener. If the USD were to appreciate following a Trump victory, the Fed may think twice about a December rate hike, especially if the stock market sells off at the same time. The front end of the Treasury curve would rally in that environment. Meanwhile, the long end may react to the prospect of big deficit-financed fiscal expansion that Trump has promised, thus steepening the curve. The initial risk-off move after a Trump win may push the entire yield curve lower, but the bond market may quickly begin to price in the potential medium-term fiscal ramifications of a Trump presidency. What To Watch For On November 8? There are three things investors should watch on November 8, the day of the election, and in its immediate aftermath: Final results: In 2012, the statistical result was projected by the news networks around 11:30pm EST Nov. 6, according to the New York Times. Romney's concession speech occurred just after midnight on November 7. In the 2008 election, the result was projected by CNN as early as 7pm EST on election day (November 4), but that was due to the fact that the Obama win over Senator John McCain was a landslide. Obviously the 2000 election is a reminder that the results may not be clear immediately. The result in Florida was announced by 8pm EST on election day in favor of Gore, but the counting in the wee hours of the morning favored Bush. Gore conceded privately to Bush, then the tally went back to Gore, who withdrew his concession, and finally Bush was given the final tally several days later. The official result was not declared until November 26; Gore did not concede until December 12. The electoral college will vote on December 19, so states will have to resolve any recounts or disputes by December 13. Congress counts and certifies the result on January 6. Margin of victory: It is now clear that a Clinton win, if it were to happen, will be a narrow one. It is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives is at zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow Clinton win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. On top of the numbers, she will clearly have to deal with an unprecedented amount of investigations while in office. The chances of a compromise between the White House and GOP in Congress is therefore declining. Our "best-case scenario" of a Clinton-Paul Ryan compromise is therefore also very low. This will put in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The gridlock that will emerge from Congress under a Clinton presidency may, therefore, not be so sanguine after all. A Tie? What happens if the Electoral College vote is tied, or if by a fluke neither candidate wins a majority? There is a non-negligible probability that both Trump and Clinton could end up with 269 votes - i.e. one vote short of the 270 absolute majority required to win the White House. After all, Al Gore lost the 2000 election by only five electoral votes. How is the U.S. president chosen in that case? The House of Representatives convenes, allots one vote to each state (whose representatives must decide among themselves), and chooses the next president by a majority of the states. The presidential candidates in this case would be chosen from the top three recipients of electoral college votes.13 Here is the kicker: the vice-president would be chosen by the Senate from the top two candidates, meaning that Trump or Clinton would serve as the other's vice-president! Given the Republican majority in the House and among the states, Trump would likely prevail as president with 66% of the House vote, leaving Clinton to become vice-president. The United States would finally do what should always be done with squabbling children - force them to play on the same team! Faithless Electors: Another possibility is that an Electoral College member or "elector" could refuse to cast his or her ballot for the candidate chosen by popular vote in that elector's state. Electors are chosen by the political parties and are presumed to be staunch loyalists, but sometimes they deviate or make mistakes. Hardly more than half the states have passed laws to prevent or punish these so-called "faithless electors." No such elector has ever changed the outcome of a presidential race, but in an extremely tight race, abstentions, mistakes, or conscientious objection in the Electoral College could occur. The Supreme Court would have to settle any ensuing challenges, and would normally be expected to reassert the elector's independence to vote for any eligible candidate. Of course, the Supreme Court is currently undermanned at eight justices. If they were to split along ideological lines, any constitutional issues emanating from this election would remain gridlocked for a time, which would be a period of extreme uncertainty. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com David Boucher, Editor/Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "You've Been Trumped!" dated October 21, 2016, available at gps.bcaresearch.com. 2 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 31, 2016, available at fivethirtyeight.com. 3 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. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Of the four examples, only Bush Sr. in 1988 and Truman in 1948 are really relevant today. First, the Theodore Roosevelt transition to William Taft happened more than 100 years ago. Second, Hoover took over from eight years of Republican rule when the economy was at a peak, which is hard to compare with the post-financial crisis environments after 1929 and 2008. Thus the only relevant victories for the incumbent party following a multi-term presidency occurred after the reigns of two iconic presidents: Ronald Reagan and Frank D. Roosevelt, two of the greatest American presidents. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 8 Please see BCA's Global Alpha Sector Strategy Weekly Report, "Quarterly Review And Outlook," dated September 30, 2016, available at gss.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 11 The S&P 500 globally-exposed industry groups index is derived by BCA's U.S. Equity Strategy. 12 Please see BCA U.S. Bond Strategy, "Trading The Municipal Credit Cycle," dated October 18, 2016, available at usbs.bcaresearch.com. 13 Technically, then, Libertarian candidate Gary Johnson, the likeliest third-place candidate, would be eligible to become president under the House of Representative vote. Politically, however, it would be nearly impossible to orchestrate. The deadline for the House to decide this "contingent election" would be January 20, at which point the vice-president, elected by the Senate, would serve as acting president until the House resolved the issue. If the House and Senate have not chosen a president and vice-president by January 20, a new law must be passed to decide the outcome. Oh the humanity! Please see BCA Geopolitical Strategy Special Report, "U.S. Election Primer: Let's Get Ready To Truuuumble," dated February 29, 2016, available at gps.bcaresearch.com.

Highlights Clinton has a 65% chance of victory. She wins the election with 334 electoral votes. Trump has low odds of winning key swing states Virginia and Colorado. A Trump win requires a shock; it is not impossible by the historical record. A Clinton win is initially bullish and could bring some compromise. However, the median voter is moving to the left. The 1990s are gone. Feature BCA's Geopolitical Strategy made its initial U.S. general election forecast thirteen months ago in September 2015.1 We argued that the two most likely outcomes were: GOP Sweep Scenario: a Republican sweep (presidency and Congress) with a moderate candidate at the head of the party ticket; Democratic President / GOP Sweep of Congress: a Democrat win in the White House and a GOP that holds onto the House and Senate. Both outcomes would be positive for the markets given that (1) a GOP sweep would entail pro-market reforms (corporate taxes, de-regulation, entitlement reform, and modest fiscal spending) and (2) a divided government has historically produced a market-positive outcome. In December, we updated our forecast with a call that Hillary Clinton was a clear frontrunner given that a Trump nomination would greatly reduce the probability of a GOP sweep.2 Our reasoning then was that an anti-establishment Republican would fail to gather enough votes in the ideological middle of the American electorate. Although Trump has given Clinton a hardly believable run for her money, we continue to believe that misogynistic, racist, and narcissistic rhetoric are off-putting to the median American voter and distract from Trump's policy message (such as it is).3 In this final extended forecasting effort ahead of the election, our intention is to add value on three fronts: Get the final forecast right. Introduce the investment implications of our forecast. Ask what we have learned from this election so far. Quant Election Model: Trump Is A Red Herring Until very recently, the electoral polls showed a close race between Secretary Hillary Clinton and Mr. Donald Trump (Chart 1). However, our "Polls-plus" model, built using historical macroeconomic and election data since 1980, has been projecting a strong Clinton victory for some time. Based on our latest forecast, Hillary Clinton will win the 2016 presidential election in a landslide, with a projected electoral vote count of 334 (Chart 2). bca.gps_mp_2016_10_12_s2_c1 bca.gps_mp_2016_10_12_s2_c1 King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution In the following section, we introduce our model, its results, and explain why the predicted Clinton victory is so comfortable. To be clear, our model has favored Clinton well before the most recent series of gaffes by Mr. Trump. Part I: Structural Econometric Model Our econometric work combines state-level election and economic data as well as trends in national politics and opinion. The model's dependent variable is the difference in the share of the vote received by the Republicans and Democrats in each state. The explanatory variables break down into the following categories: Voting Patterns: Each state's previous election results, back to 1980, are computed as the differential between Republican and Democratic vote share, and used to gauge voter predisposition. We also include a momentum variable which measures the change in the differential between the two previous elections. Economic Variables: We use changes in state and national economic conditions prior to the elections to capture the macroeconomic context. These include national GDP, oil prices, and state-level disposable income. Political Intangibles: We include three different qualitative variables to capture political attitudes. "Polarization" is computed to factor in the likelihood that the incumbent party will be voted out after staying in power for multiple terms. The "alternative choice" measures the presence of a prominent third party. We also include current presidential approval ratings. Using these variables, and strictly avoiding any advantage of hindsight, our model correctly predicted the winner of every election since 1984 (Table 1 and Appendix 1): King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution 2012 - Obama v. Romney: The model slightly overestimated President Obama's support in West Virginia, Arizona, Arkansas, Louisiana, Missouri, and Tennessee. 2008 - Obama v. McCain: The model produced an accurate forecast on an aggregate level, but again underestimated Obama's support. It misallocated electoral votes in 7 states. 2004 - Bush v. Kerry: Our analysis was only off by giving two extra electoral votes to Bush, but once more misallocated votes in 7 states. The Third Party Vote In 1992, 1996, and 2000: The model accurately predicted the winner in each contest but produced more volatile results as our sample started to shrink. In addition, the strong third-party candidacy in 1992 and 1996 distorted the results. These two elections were a key bellwether for the success of our model in 2016, as this year also features prominent third-party choices. Gary Johnson of the Libertarian Party is currently polling around 6.3%. 1984 and 1988: Our earliest set of elections produced results that were quite close to reality despite a limited sample size. Although this is somewhat surprising, it is to be expected given the landslide victories that occurred in both instances. Part II: Econometric Modeling Meets Polls Most of the components from our econometric model are slow-moving structural factors. Opinion polls, on the other hand, change based on periodical surveys. They are more volatile, but provide a good indication of the day-to-day pulse of the electorate. For this reason, we created an augmented version of our econometric model using probabilities constructed from polls. First, we transformed our econometric forecasts into probabilities by using two scenarios and the historical volatility of our estimates. The two scenarios are based on the potential impact of the third parties: one in which they gather 5-10% of the popular vote, and the other in which they fail to reach that threshold. From there, we calculated the historical standard deviations for each scenario, getting the lower and upper limits of the election forecasts. Giving the two limits equal chances of occurring, we calculated the GOP's chances to win each state. We then added opinion polls to this model. We used the election probabilities from FiveThirtyEight, which are computed using simulations from a collection of weighted and adjusted polls, to add a shorter-term dimension to our forecast.4 We give a 60% weight to the probabilities from the polls and 40% to our structural econometric model to ensure that we capture the momentum effect. Part III: 2016 Election - All Hype, No Fight Our polls-plus model suggests that Clinton has a 65.4% chance of winning the election (Table 2). This is somewhat lower than the probability derived by other polls-plus models - such as FiveThirtyEight and the New York Times. Further, our model shows that Clinton already has 279 electoral votes in states where she has more than a 70% chance of winning (Chart 3). By the same standards, Trump has secured only 170 votes. These results mean that even under the unlikely scenario where the GOP wins all the remaining swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), if all else stays the same, the Democrats still win with 279 electoral votes. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Intriguingly, our "White Hype" model back in March produced the same result using an entirely different method (it asked simply what share of the white vote Trump needed to win the swing states). At that time we argued that Trump had a very good chance to win Florida, Ohio, and Iowa, but that it would still be insufficient to win the election.5 In other words, our White Hype model correctly forecast in March the ultimate probabilities that our polls-plus model is now gauging from the combination of econometric results and opinion polls in October. Put differently, after winning the swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), where the odds of winning are between 32% and 57%, the GOP would still need to steal the electoral votes in Virginia or Colorado (the latter in combination with Nevada or New Hampshire), away from the Democrats, where they are favored to win at 71.6% and 79.7%, respectively.6 This remains as unlikely now as it was in March.7 Bottom Line: Given the structural economic and political dynamics currently in place, our quantitative estimates show that Clinton is the clear favorite. Clinton has a 65.4% chance of winning the 2016 election, with an expected 334 electoral votes. Qualitative Election Model: Time To Dump Trump Thanks largely to the analysis of our colleague Peter Berezin, Chief Strategist of the BCA Global Investment Strategy, we took Donald Trump seriously long before most.8 We analyzed his electoral strategy - boosting the share of the white vote accruing to the GOP and away from the Democratic Party - and concluded that Trump did have a path to victory, albeit a very narrow one. Our research showed that Trump's strategy of increasing the Republican share of the white vote was mathematically the correct strategy for a GOP candidate to pursue, at least in 2016 when the white share of the total population remained large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states, which seems quite reasonable and feasible.9 We also pointed out that getting a 5.7% swing in Iowa could be feasible. On the other hand, we showed that "flipping" Midwest states like Michigan, Pennsylvania, and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1% respectively. At those numbers, Trump would have to win nearly 70% of Michigan's white voters, 65% of Pennsylvania's, and 58% of Wisconsin's. Of the three, Wisconsin looks the most feasible. On the other hand, the GOP only managed to pick up 52% of the state's white share in 2004, the last time a Republican candidate for president won an actual majority of the popular vote since 1988. So, getting to 58% is a high bar given Wisconsin's recent electoral history. How did our model hold up in terms of state-by-state polling? It did quite well! As we predicted, Trump has been doing relatively well in Iowa, Florida, and Ohio (Chart 4). In Michigan, Pennsylvania, and Wisconsin, Clinton's lead has remained higher than 5% through most of the election cycle and even through the periods where the media narrative shifted against her (Chart 5). bca.gps_mp_2016_10_12_s2_c4 bca.gps_mp_2016_10_12_s2_c4 bca.gps_mp_2016_10_12_s2_c5 bca.gps_mp_2016_10_12_s2_c5 Bottom Line: Despite a narrowing in the polls in mid-September - particularly following Clinton's September 11 health scare - we still concluded in our September Monthly Report that "the presidential race is Clinton's to lose."10 This is because both our quant (polls-plus) and qualitative (White Hype) models have correctly predicted that Trump's path to victory is extremely narrow. He would have to hold all of the swing-states where the White Hype model makes him competitive, and then also win either Virginia or Colorado plus Nevada, where he has struggled in the polls. Risks To Our View - A Trump Surprise! What scenario could occur between now and November 8 that throws off our forecast of a Hillary Clinton victory? As we have claimed from the beginning of the contest, Trump requires an exogenous factor to push him over the finish line. Given that Clinton's lead is now 6% in the polls, and that Trump is running out of time, he may need an act of God. That said, Trump has come a lot closer to winning the election than our polls-plus model suggests. Were it not for his idiosyncratic personality, the Democrats would have been a lot more vulnerable in 2016 than our predicted election outcome indicates. Why? Research by Professor Allan Lichtman, who has accurately predicted every U.S. presidential election since 1984, is instructive. Lichtman has called the election for Trump.11 His so-called "Keys" method - first outlined in a 1981 article and in his 1990 book, The Thirteen Keys To The Presidency - is a simple true or false quiz with thirteen propositions. If six or more of the answers are "false," the incumbent party loses the Oval Office (Table 3). King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution For instance, if it is true that the average GDP growth per capita is higher in the past four years than the preceding four years, then that fact favors the incumbent. Today, this "long-term economic key" favors Hillary (Chart 6). bca.gps_mp_2016_10_12_s2_c6 bca.gps_mp_2016_10_12_s2_c6 In 2016, at least five of Lichtman's keys clearly favor the GOP: In the House of Representatives, the incumbent Democrats lost seats in the 2014 midterm elections, relative to the 2010 midterms (Chart 7). The Democrats do not have an incumbent candidate advantage. Obama achieved no major policy initiative in the second term. There was nothing comparable in effect to the Affordable Care Act, his signature legislation (Chart 8). Obama achieved no major foreign policy success. The Iran nuclear deal is too controversial to satisfy this key, although we suspect that history will judge it as a major success. Instead, the public focus has been on the disastrous intervention in Libya and the dithering in Syria. Hillary Clinton is not charismatic, which is an understatement (Chart 9). In addition, Gary Johnson, of the Libertarian Party, is a third-party candidate who could garner more than 5% of the vote (Chart 10). Under Lichtman's methodology, this is a key that hurts the incumbent. Of course, Libertarians may suck more votes away from Trump than Clinton. But Lichtman has signaled this issue as a crux of the election, and thinks it favors Trump. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution bca.gps_mp_2016_10_12_s2_c10 bca.gps_mp_2016_10_12_s2_c10 Moreover, in our view, Lichtman's keys could predict an even worse outcome for Clinton than Lichtman himself admits. Lichtman is very forthright about the fact that the keys require subjective judgment of the sort that professional historians make all the time. We would note, first, that the contest in the Democratic primary was serious. Sanders performed nearly as well as Clinton herself did in 2008, and better than other second-rank Democratic contenders going back to 1984 (Chart 11). Second, social unrest has likely risen in Obama's second term, or at least is perceived to have done so (Chart 12). King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Thus the primary contest and social unrest could trigger two more strikes against the incumbent party, without even debating whether Obama administration scandals or Trump's charisma qualify as keys against the Democrats.12 We think that Lichtman's model speaks volumes about the built-in vulnerability that the Democratic Party has faced throughout 2016. It also supports our initial September 2015 forecast, which gave largely even odds to both a moderate GOP presidential candidate and Hillary Clinton. As such, Trump's defeat will be a disaster for the Republican Party and will initiate a period of introspection - if not civil war - within the organization. Bottom Line: Trump does have good odds of winning the election if Clinton's lead in the polls drops below 3% between now and Election Day. If Trump gets back within striking distance, it will suggest that Clinton cannot shake him even after the media narrative and GOP establishment turned against him. With a 3% gap in the polls, the "turnout thesis" would become a lot more cogent. This is the thesis that Clinton will struggle to get members of the "Obama coalition" (millennials and minorities) to come out and vote, while Trump will motivate the registered but non-voting white population to turn out for him. At this point in the cycle, however, we doubt that Trump will re-test this level of competitiveness. Investment Implications: More Bullish Than Priced-In A Trump surprise would trigger a correction in equity markets, which is already due based on valuations, earnings, and other factors. We would expect the USD, as a key safe haven, to rally sharply both on Trump policy uncertainty and heightened geopolitical risk. We would also expect bond yields to fall initially, as part of a broad risk-off move, but then sell off due to the implication of more inflationary fiscal policies. Trump's policy proposals suggest a budget deficit blowout at least comparable to that under George W. Bush, which went from 2% to almost -4% of GDP. A combination of more spending and less tax revenue would blow the top off the bond market. What about the expected Clinton victory? First, markets love divided government (Table 4). Why? Because spending remains in check and no new onerous policies are likely. This will likely be the case if the GOP keeps the House of Representatives. However, we also think a Republican House could be conducive to dealing with Clinton, particularly on a modest fiscal stimulus: King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Clinton is not Obama: She will enter the Oval Office unpopular and without a strong mandate. She may not win over 50% of the popular vote. The Senate is in play, with polls at RealClearPolitics suggesting that the Democrats would win at least the four seats they need (leaving Vice-President Tim Kaine to cast the tie-breaking vote on legislation). The House is unlikely to be in play. Thus, unlike Obama in 2009, she will have a slim Senate majority at best (not filibuster-proof) and a GOP-held House. She will have to cut deals to advance her agenda. The Grand Coalition Lives: In the past few years, Congress has passed a number of important bills because establishment Republicans voted alongside Democrats (Chart 13). This coalition would remain in place, cemented by the populist threat to both camps represented by Trump and Sanders. The Knives Will Be Out For The Tea Party: Trump's rise and fall would be seen as an infamous debacle that cost the Republicans a highly significant election well within their reach. The Republican establishment will be determined to regain the reins of the party apparatus and brand. The Tea Party and other populist or anti-establishment Republicans will be blamed not only for giving Clinton the keys to the White House but also for giving the Democrats the advantage on the Supreme Court for a generation. True, Republicans could take away a narrow reading of the election results. They could blame the entire loss on Trump, not the party, given that Trump and the party had a bad relationship and Trump endorsed various positions at odds with conservative platforms and principles. They could therefore draw the conclusion that the correct strategy for the future is not to change policies or compromise with Democrats, but simply avoid running inexperienced, flamboyant mavericks for president. This view would be supported by the fact that, with a Clinton victory, moderate Republicans in more competitive districts, not arch-conservatives in bright red ones, are more likely to lose seats in the House. Ironically, this means that House Republicans could be just as zealous in opposition as they were under Obama, or more, and thus poised to resume the game of obstruction. This is possible, but we think the anti-establishment will be on the defensive, at least initially. Clinton will receive some kind of honeymoon period after dealing a devastating blow to the GOP. There will be Republicans ready to compromise, under the leadership of Paul Ryan, who did not accept the House speakership in order not to compromise. And the far-right will have at least some waverers in their midst. As such, we can see the potential for modest corporate tax reform (broadening the tax base without lowering the effective corporate tax rate). Even though such reform is not extraordinary, it should boost economic growth by helping small and medium-sized businesses grow. We can also see the GOP under Paul Ryan agreeing to modest increases in fiscal spending in return. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, cogently argues that fiscal spending only comes amidst recessions. Chart 14 shows that mentions of "fiscal stimulus" in the news media are positively correlated with junk bonds and VIX, and negatively correlated with the yield curve. As such, fiscal stimulus only begins being contemplated when the pain of a recession hits. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution bca.gps_mp_2016_10_12_s2_c14 bca.gps_mp_2016_10_12_s2_c14 Could this time be different? Yes. 55% of Americans think the economy has not recovered from the Great Recession, and some polls suggest that over half think the U.S. is still in recession. As such, while a recession may not be occurring in reality, it may as well be as far as politicians are concerned. Moreover, the public apparently cares less about the deficit and debt than in the recent past: the number of Americans naming deficits as the "top priority" has fallen from 72% to 56% in the past few years. And again, the populist groundswell will reinforce the need to lift growth through policy. Beyond an immediate relief rally, we would fade any idea that Clinton's victory means a return to the Bill Clinton-environment for corporate profits and stock performance. A structural shift to the left is underway in American politics, both generational and economic, as we argued in June.13 Clinton will not be able to betray her pledges to Bernie Sanders supporters if she wants to be a two-term president. Thus, on a sectoral basis, we would expect Clinton to have quite a few negatives (Table 5). First, she would portend greater state involvement in healthcare, especially Big Pharma, despite the idea that repealing the Affordable Care Act would cause more uncertainty than keeping and changing it. We also would not expect her to be as favorable to the financial community as her list of donors suggests, given the challenges she faces on her left regarding financial regulation. On energy, she will benefit renewable energy companies more so than conventional ones, given her commitment to turning the U.S. into a "twenty-first century clean energy superpower." King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution We would expect her to be good for defense stocks, both because she has a lifetime of foreign policy hawkishness and because of the global trend of multipolarity, which increases both the number of global conflicts and the risks of additional conflicts.14 For Trump, there is little reason to speculate - he has no experience governing, has flip-flopped on many policy stances, and is generally unorthodox and impossible to predict (e.g. his healthcare "plan"). If we had to venture a guess, we would say that, like Clinton, he will be positive for defense stocks. His aggressively anti-regulatory positions on the financial and energy sectors should be a boon for both. A critical thing to remember is that recent American presidents do not have a bad track record of getting what they want (Box 1). Like all leaders, they are at the mercy of constraints and structural factors, whether political, military, economic, or social. Yet they also command a powerful (and increasingly so) executive branch of government in the world's most powerful country. If Clinton wants higher taxes on the wealthy and a stronger state hand in healthcare, she will most likely get them. If Trump wants tougher border security and deep corporate tax cuts, he will likely get those as well. Congress is a check, but only that. BOX 1 U.S. Presidents: Promises And Performance Over the past 28 years, each new president has generally succeeded in passing the signature items on his agenda. George Bush Sr. is the major exception. He took office in 1988 with a pledge of keeping growth rates constant, creating 30 million new jobs over eight years, keeping the peace abroad, and improving the budget deficit without raising taxes. Instead, after only one year in office, he faced a recession that caused a 1.2 percentage point drop in the growth rate from Reagan's average, resulting in only 2.6 million increase in the civilian labor force his first term, 12.4 million wide of the mark. He was famously forced to raise taxes, despite saying "read my lips: no new taxes," and the budget deficit expanded from 2.7% to 4.5%. Finally, Saddam Hussein's invasion of Kuwait drew him into the Gulf War. Bill Clinton got luckier. His chief pledge was to raise wages, shift government investment from defense to the domestic economy, make healthcare more affordable, and reform welfare. He failed in healthcare, but generally succeeded in other initiatives. Wages admit of some debate - average earnings grew faster than under Reagan-Bush, though median earnings did not. Still, Clinton presided over a longer more stable period of wage growth than his predecessors (Chart 1). Non-defense investment rose 19% (defense barely grew) and its share in federal spending rose from 10% to 12%. The participation rate in cash assistance and food stamp programs declined sharply, as did the length of time on the dole. George W. Bush came to power on the promise of reforming social policy - health, education, social security - and essentially transferring the Clinton budget surplus to voters through tax cuts. He succeeded in taxes, education (No Child Left Behind Act), and health (Medicare expansion), aided by Republican majorities and popular support after the September 11 attacks. He failed to partially privatize social security, however. Barack Obama promised to make the tax code more progressive, make healthcare accessible and affordable, reduce energy dependency on the Middle East, and phase out the wars in Iraq and Afghanistan. He has generally achieved these goals: the number of uninsured adults fell from 18% to 11%, healthcare price inflation has slowed from about 4% under Clinton and Bush to 3% per year, and U.S. energy imports have fallen from 33% to 25% of total consumption. However, while Obama succeeded broadly in withdrawing troops from the Middle East (Chart 2), he has failed to "finish" the war in Afghanistan. bca.gps_mp_2016_10_12_s2_c15 bca.gps_mp_2016_10_12_s2_c15 bca.gps_mp_2016_10_12_s2_c16 bca.gps_mp_2016_10_12_s2_c16 There are three chief takeaways: First, circumstances can overrule any president's plans, as occurred with George Bush Sr. Second, winning an election in reaction to a recession, as did Clinton and Obama, or suffering a crisis early in one's term, like Bush Jr., provides a tailwind for a president's initiatives. The flipside is that inheriting strong economic growth on the coattails of a popular two-term president may put an administration at risk of a cyclical downturn or general failure to meet expectations. (Warning for a Hillary Clinton administration!) Third, Congress can block some but probably not all of a president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed. Clinton lost on healthcare but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). For Bush Jr., the legislature switched after six years of his administration, yet social security had already proved to be the "third rail" of politics that he feared - he failed to reform it despite his own party's control of Congress. Final Thoughts: Lessons From 2016 The 2016 election has taught us some critical lessons. First, the world never would have believed, in the immediate aftermath of the global financial crisis, that populism would be more disruptive in the Anglo-Saxon countries than in continental Europe. But that is what has happened. The United States and the United Kingdom have both seen an explosion of pent-up forces as a result of decades - particularly the past 16 years in the U.S. - of declining middle classes, rising inequality, and weak median incomes.15 The consequences are only just beginning to be felt, and are of far greater global significance coming from the U.S. than the relatively small U.K. The chief of these is that, in the U.S., the median voter has clearly moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroot voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Rather, they want government to give them more goodies and protections. This fact, taken along with the demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters in a way that Bill Clinton and the "New Democrats" shifted to capture right-leaning centrist voters in the wake of Ronald Reagan and the collapse of the USSR. Part of this process will involve a political alignment in the U.S., now that the GOP's deep fractures have been exposed for all the world to see. Trump's candidacy could never have occurred if there had not first been a power vacuum at the center of the party. If Trump wins, it will be a veritable revolution for both parties. Fiscal conservatism (and social conservatism, for that matter) will have little to show by way of official party machinery. The global consequences will be highly disruptive as well since the executive branch has extensive power over all actions of the federal bureaucracy, trade, and foreign policy, and since the GOP will not obstruct Trump initially (whatever happens in the aftermath of any radical policy changes). If Trump loses, as mentioned above, the anti-establishment trend in the Republican Party will suffer the brunt of the blame - whether Tea Party or other. Though messy, this result could in fact be bullish for the U.S. in the long run, since it would discredit populism in the party and give a boost to reformers who seek to re-brand and redesign the party to respond to changes in the electorate. Thus, in 2020, either Clinton's policies will be working and Americans will not be demanding change, or they will not be working, and Americans will have a reformed GOP as an alternative. Alternatively, Trump's loss could fuel populism by showing the way for a similar candidate with similar policies yet who does not lack in charisma, oratory, and party backing. Trump's strategy of boosting white support for the GOP is demographically and mathematically possible at least until 2024. Or perhaps a different kind of Republican (or Democratic) candidate could attempt to capture aspects of Trumpism, given his left-tilt on economic policy, while appealing to the Democratic coalition of women, millennials, and minorities. The GOP shakeup should be watched closely. Lastly, the 2016 election has amplified a point that we have long emphasized: the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Similarly, it made the race competitive when Clinton's various scandals were "trending." As a result, investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. Trump's constraints, as we have contended, are too high. Appendix 1 shows the state-by state performance of the econometric model (without polls) for each of the past 8 elections. It compares the model's forecast (no hindsight bias) with actual results. APPENDIX 1 Back-testing GPS's Econometric Election Model Image Image Image Image 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election - Forecast & Investment Implications," dated September 9, 2015, available at gps.bcaresearch.com. 2 Please see Bank Credit Analyst Strategic Outlook, "Stuck In A Rut," dated December 17, 2015, available at gps.bcaresearch.com. 3 #shocker. 4 For a more detailed explanation of FiveThirtyEight's methodology, please see "A User's Guide To FiveThirtyEight's 2016 General Election Forecast," dated June 29, 2016, available at http://www.fivethirtyeight.com. 5 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcareseach.com. 6 The Democrats' probability of winning Nevada and New Hampshire are 74.4% and 80% respectively. 7 Please see BCA Geopolitical Strategy, "U.S. Election: Is The Election Over?" in Monthly Report, "Who's Afraid Of Big Bad Trump?" dated August 10, 2016, available at gps.bcaresearch.com. 8 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," September 4, 2015, available at gis.bcaresearch.com. 9 The assumption being that the turnout, non-white vote share, and white turnout do not change from 2012. In other words, our model only focuses on the white share of the vote for the Republican candidate. We assume that Clinton will not benefit from an anti-Trump tailwind among minorities, which is a big assumption given the pernicious effects of the "White Hype" strategy on the minority support of a Republican candidate. On the other hand, we also do not change the white voter turnout, which is unfair to Trump as he would likely be able to boost the white turnout as he increases the GOP share of the vote. 10 Please see BCA Geopolitical Strategy, "U.S. Election Update - The Home Stretch," in Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 11 Please see our book review below for a discussion of Lichtman's latest book. See also Peter W. Stevenson, "Trump Is Headed For A Win, Says Professor Who Has Predicted 30 Years Of Presidential Outcomes Correctly," Washington Post, September 23, 2016, available at www.washingtonpost.com. 12 Lichtman addresses the issues of Sanders, scandals, and Trump's charisma in Peter W. Stevenson, "This Professor Has Predicted Every Presidential Election Since 1984. He's Still Trying To Figure Out 2016," Washington Post, May 12, 2016, available at www.washingtonpost.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and "Annus Horribilis," dated January 20, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com.