Global

Highlights Last year's broad-based global growth recovery has given way to slower growth and increasing differentiation in growth rates across economies. The U.S. has gone from laggard to leader in the global growth horse race, helping to drive the dollar to a five-month high. The biggest risk to our cautious view on emerging markets is that China stimulates the economy proactively as an insurance policy against a possible trade war. So far, there is little evidence that this is happening, but we are watching the data closely. The turmoil in Italy's bond markets is a timely reminder that if the European periphery wants more stimulus, this has to happen through a weaker euro rather than through larger budget deficits. Stay short EUR/USD. We expect to take profits at around the 1.15 level. Feature From Convergence To Divergence 2017 was the year of synchronized global growth. For the first time since 2007, all 46 countries tracked by the OECD experienced positive GDP growth. The euro area economy surprised on the upside, recording real GDP growth of 2.3%. This was slightly above U.S. levels, despite the fact that trend growth is about half a percentage point lower in the euro area. Growth in Japan nearly doubled to 1.7% from the prior year. Emerging markets, which succumbed to a broad-based slowdown starting in 2015, came roaring back. The U.S. dollar tends to perform poorly when global growth is accelerating and the composition of that growth is shifting away from the United States. This was precisely the setting that the global economy found itself in last year, which is why the greenback came under pressure. Things are looking sharply different this year. Global growth has cooled, as evidenced by both the PMIs and economic surprise indices (Chart 1). Euro area growth was sliced in half in the first quarter; U.K. growth decelerated further; and Japanese growth fell into negative territory for the first time since 2015. In contrast, the U.S. has held up relatively well. While growth did dip to 2.3% in Q1, the latest tracking estimates suggest a rebound in the second quarter. Retail sales accelerated in April. The Philly Fed PMI also surprised on the upside, with the new orders component reaching the highest level since 1973. The New York's Fed model is pointing to growth of 3.2% in Q2, while the Atlanta Fed's Nowcast is signaling growth of 4.1%. The divergence in growth rates between the U.S. and most major economies has been mirrored in recent inflation prints. U.S. core inflation has moved higher, but has stumbled elsewhere (Chart 2). Chart 1Global Growth Has Cooled With The U.S.##br## Faring Best Global Growth Has Cooled With The U.S. Faring Best Global Growth Has Cooled With The U.S. Faring Best Chart 2Inflation Is Accelerating In The U.S., ##br##Decelerating Elsewhere Inflation Is Accelerating In The U.S., Decelerating Elsewhere Inflation Is Accelerating In The U.S., Decelerating Elsewhere The relatively strong pace of U.S. growth has led to a widening in interest-rate differentials between the United States and its peers. The 10-year U.S. Treasury yield has risen by 95 basis points since its September lows, compared to 20 points for German bunds, 47 points for U.K. gilts, and 4 points for JGBs. With the exception of the U.K., the increase in spreads has been dominated by the real rate component (Chart 3). Chart 3Widening Interest Rate Differentials Between The U.S. And Its Peers ##br##Have Been Driven By The Real Component Desynchronization Is Back Desynchronization Is Back King Dollar Reigns Supreme Conceptually, it is real, rather than nominal, interest rate differentials that ought to move currencies. We noted earlier this year that the dollar's failure to strengthen on the back of rising Treasury yields was an anomaly that was unlikely to persist. Sure enough, the dollar has now begun to recouple with real interest rate differentials (Chart 4). Our sense is that this year's trends can last a while longer. Leading Economic Indicators have continued to move in favor of the U.S., suggesting that U.S. outperformance is not likely to end anytime soon (Chart 5). Fiscal policy should also help prop up U.S. aggregate demand. The U.S. structural budget deficit is set to widen much more than elsewhere over the next few years (Chart 6). Chart 4Dollar Is Recoupling With Rate Differentials Dollar Is Recoupling With Rate Differentials Dollar Is Recoupling With Rate Differentials Chart 5U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers Chart 6U.S. Fiscal Policy Is More Stimulative U.S. Fiscal Policy Is More Stimulative U.S. Fiscal Policy Is More Stimulative The U.S. economy is now back to full employment. For the first time in the 17-year history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), the number of job openings exceeds the number of unemployed workers (Chart 7). Our composite labor survey indicator has continued to move higher (Chart 8). Core PCE inflation has already accelerated to 2.3% on an annualized 6-month basis and 2.6% on a 3-month basis. The New York Fed's Inflation Gauge, which leads inflation by about 18 months, is pointing to higher inflation over the coming quarters (Chart 9). This means that the bar for further gradual rate hikes is quite low. Chart 7There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 8U.S. Wage Growth Is Set To Grind Higher U.S. Wage Growth Is Set To Grind Higher U.S. Wage Growth Is Set To Grind Higher Chart 9U.S. Inflation: Upside Risks U.S. Inflation: Upside Risks U.S. Inflation: Upside Risks Recent revelations by Kevin Warsh - who was once the favorite to lead the Federal Reserve - that Trump was dismissive of the Fed's historic independence during their interview, is only likely to strengthen Jay Powell's resolve to avoid being seen as a Trump flunky.1 China: Shifting Into The Slow Lane? Of course, the outlook for the dollar and bond spreads will also hinge on what happens in the rest of the world. We are watching two economies especially closely: China and Italy. The latest data suggest that China has lost some growth momentum. Retail sales and fixed asset investment decelerated in April. Property sales also declined from an elevated level. Sales tend to lead prices. Home prices were flat in most tier 1 cities over the prior year, reflecting elevated inventory levels, tighter lending standards, and stricter administrative controls (Chart 10). Further price weakness is likely, which could dampen construction activity in the months ahead. Industrial production beat expectations in April, but the overall trend in industrial activity remains to the downside. Electricity production, freight traffic, and excavator sales have all been decelerating (Chart 11). Import growth has also come down, which is one reason why GDP growth in the rest of the world has moderated (Chart 12). Chart 10China: Housing Has Cooled China: Housing Has Cooled China: Housing Has Cooled Chart 11China: Industrial Activity Is Slowing China: Industrial Activity Is Slowing China: Industrial Activity Is Slowing Chart 12China: Import Growth Has Decelerated China: Import Growth Has Decelerated China: Import Growth Has Decelerated Trade War Fears: Will China Overcompensate? In addition to the regular cyclical growth risks, concerns about a trade war loom in the background. The Trump Administration's decision last weekend to defer imposing tariffs on China caused investors to breathe a sigh of relief, but much remains unresolved, including ongoing allegations that China is stealing intellectual property from the U.S. and other countries. Trump's decision to pull out of June's summit with North Korea will only strain America's relationship with China. Considering the damage to China that a full-out trade war would cause, it would be sensible for the government to take out some insurance against a possible downturn. Thus far, any evidence that the authorities are trying to stimulate the economy through either fiscal or monetary means is sketchy (Chart 13). Reserve requirements were cut by 100 basis points in April, but corporate borrowing costs remain elevated. Fiscal outlays are growing at broadly the same pace as last year. The trade-weighted RMB has continued to strengthen. Still, it is hard to believe that the government has not put together a contingency plan that it could roll out if circumstances warrant it. The biggest risk to our fairly cautious view on emerging markets is that China launches a stimulus package in response to a trade war that quickly ends in détente. Similar to what occurred in 2008/09, this would leave China with more stimulus than it actually needed. Italy: From Fiscal Austerity To Bunga Bunga Unlike in China, Italy's incoming coalition government - forged through an uneasy alliance between the populist Five Star Movement (M5S) and the right-leaning League - has made no secret about its desire to ease fiscal policy. The M5S wants more social spending while the League has lobbied for a flat tax. These measures, along with a host of others, would add €100 billion, or 6% of GDP, to the budget deficit. Given that the Italian unemployment rate stands at 11% - 5.3 percentage points above its 2007 low - one could make a compelling case that Italy would benefit from temporary fiscal stimulus. However, the proposed policies are being marketed as permanent in nature. Moreover, several policies, such as the proposal to roll back the planned increase in the retirement age, would actually reduce potential GDP by shrinking the size of the labor force. It is no wonder that bond markets are worried (Chart 14). Chart 13China: No Clear Evidence Of Stimulus ... Yet China: No Clear Evidence Of Stimulus ... Yet China: No Clear Evidence Of Stimulus ... Yet Chart 14Mamma Mia! Mamma Mia! Mamma Mia! Propping Up Demand In Italy Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from a shrinking working-age population and anemic productivity growth, both of which reduce the incentive for firms to expand capacity. Like many other European countries, Italy also suffers from a debt overhang. This is obviously true for government debt but it is also true, to some extent, for private debt. While the ratio of private debt-to-GDP is below the euro area average, it stills stands at 113%, up from 65% in the mid-1990s (Chart 15). The desire to save more in order to pay back debt, coupled with a reluctance to invest in new capacity, has left Italy with what economists call a private-sector financial surplus (Chart 16). Chart 15Italian Private Sector Has Been Taking ##br## On Less Debt Since The Crisis Italian Private Sector Has Been Taking On Less Debt Since The Crisis Italian Private Sector Has Been Taking On Less Debt Since The Crisis Chart 16Italy: The Private Sector Wants To Save Italy: The Private Sector Wants To Save Italy: The Private Sector Wants To Save If the private sector earns more than it spends, the excess savings have to be absorbed either by the government through its own dissaving or by the rest of the world through a current account surplus. Both options are problematic for Italy. Running large budget deficits for a prolonged period of time would take the level of government debt-to-GDP to stratospheric levels. Japan has been able to get away with this strategy because it issues debt in its own currency. This is a luxury that is not at Italy's disposal. Despite Mario Draghi's pledge to do "whatever it takes" to preserve the euro area, it is far from clear that the ECB would keep buying Italian debt if the country began to openly skirt the EU's deficit rules. Absent an effective lender of last resort, the Italian bond market could fall victim to a speculative attack - a process in which higher yields lead to even higher yields, and eventually a default (Chart 17). Chart 17When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Desynchronization Is Back Desynchronization Is Back This just leaves the option of trying to bolster aggregate demand by exporting excess production abroad via a current account surplus. To its credit, Italy has been able to shift its current account balance from a deficit of 1.4% of GDP in 2007 to a projected surplus of 2.6% of GDP this year. However, some of that surplus simply reflects the fact that a weak economy has suppressed imports. Progress in reducing unit labor costs relative to its euro area peers has been painfully slow (Chart 18). Chart 18Italy: More Work To Be Done To Improve Competitiveness Italy: More Work To Be Done To Improve Competitiveness Italy: More Work To Be Done To Improve Competitiveness If Italy had a flexible exchange rate, it could simply devalue its currency to gain competitiveness. Since it does not have one, it has to improve competitiveness by restraining wage growth and implementing productivity-enhancing structural reforms. The former requires the presence of labor market slack, while the latter, even in a best-case scenario, will take substantial time to achieve. And neither option is politically popular. Given the difficulty of raising Italy's competitiveness relative to the rest of the euro area, the only realistic short-term solution is to boost it relative to the rest of the world. That requires a weak euro which, in turn, requires a dovish ECB. Investment Conclusions In our Second Quarter Strategy Outlook, published on March 30th, we predicted that the dollar was poised to experience a violent rally as short sellers rushed to cover their positions. This view has played out in spades. As we go to press, the nominal broad-trade weighted dollar has gained 4% since early April. It is up 30% since bottoming in July 2011 and is only 6% below its December 2016 peak (Chart 19). The dollar rally has brought our views closer in line with the market. Notably, EUR/USD is now less than two percent above our target of $1.15. The dollar is an ultra-high momentum currency. Chart 20 shows that a simple strategy of buying the DXY when it was above its moving average and selling it when it was below its moving average would have delivered a sizable profit over the past two decades (the exact moving average does not matter much, but the 50-day seems to work best). As such, while we intend to turn neutral on the dollar if it gains another few percent or so, an overshoot is quite probable. Chart 19The Dollar Has Bounced Back The Dollar Has Bounced Back The Dollar Has Bounced Back Chart 20The Dollar Trades On Momentum Desynchronization Is Back Desynchronization Is Back About 80% of EM foreign-currency debt is denominated in dollars. In many cases, dollar borrowers have non-dollar revenue streams. Thus, a stronger dollar automatically hurts their businesses. In the past, this has often ignited a feedback loop where a stronger dollar triggers capital outflows from emerging markets, leading to an even stronger dollar. Our EM strategists strongly feel that such a vicious cycle is fast approaching, especially if China's economy continues to slow. In the late 1990s, brewing EM tensions triggered several brutal equity selloffs. For example, the S&P lost 22% between July 20 and October 8, 1998. However, EM stress also restrained the Fed from tightening too quickly. The resulting dose of liquidity set the stage for a massive blow-off rally between the fall of 1998 and the spring of 2000. A similar dynamic could unfold this time around. We remain overweight global equities for now, but are hedging the risk by being short AUD/JPY, a trade that has gained 5% since we initiated it on February 1st. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Ben White, "How Trump could break from the Fed's independence," Politico, May 9, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Stable global demand; steady declines in Venezuela's crude oil output; and the cumulative loss of 500k b/d of Iranian exports to U.S. sanctions by 2H19 will lift average Brent and WTI prices to $80 and $72/bbl in 2019, respectively (Chart of the Week). Brent prices will average $78/bbl in 2H18, while WTI goes to $72/bbl, as these supply-side effects are not material to prices this year. We lowered our estimate of Venezuela output to 1.2mm b/d by end-2018 (vs. 1.3mm b/d previously), and to 1.0mm b/d by end-2019 (vs. 1.2mm b/d). Offsetting these losses and continued deterioration in non-Gulf OPEC supply in 2019, we assume OPEC 2.0 slowly restores 1.2mm b/d in 1H19, and U.S. shale oil grows 1.4mm b/d. Even so, balances tighten significantly (Chart 2).1 Chart of the WeekBrent Will Average $80/bbl In 2019 Brent Will Average $80/bbl In 2019 Brent Will Average $80/bbl In 2019 Chart 2Balances Tighter As Supply Falls Balances Tighter As Supply Falls Balances Tighter As Supply Falls If Venezuela collapses, and its ~ 1mm b/d of crude exports are lost, Brent crude oil could go to $100/bbl by end 2019, in the simulation we ran assuming exports collapse in 2H18. Uncertainty over supply and demand responses to higher prices makes this difficult to model. Highlights Energy: Overweight. Our options recommendations - long Brent call spreads spanning Dec/18 to Aug/19 delivery - are up an average 50.5%. Our long S&P GSCI position, recommended Dec 7/17 to take advantage of increasing backwardation, is up 18.9%.2 Base Metals: Neutral. Copper rallied earlier this week on an apparent easing of trade tensions between the U.S. and China. However, a statement by U.S. President Trump suggesting uncertain progress in talks led to a reversal in most of these gains by mid-day Wednesday. Precious Metals: Neutral. Our long gold portfolio hedge and tactical long silver position were relatively flat over the past week, as the broad trade-weighted USD moved higher. Ags/Softs: Underweight. China's Sinograin, the state grain buyer, reportedly was in the market this week showing interest in purchasing U.S. soybeans, according to agriculture.com's Successful Farming website. Feature Barring the immediate collapse of Venezuela's oil industry and the loss of its ~ 1mm b/d of oil exports, which we discuss below beginning on page 7, the global crude market will continue to tighten from the supply side, on the back of ratcheting geopolitical pressures. Chief among these are the continuing loss of Venezuelan crude oil production, which, even without a total collapse that wipes out its ~ 1mm b/d of exports, will see production fall to 1.2mm b/d by the end of this year from ~ 1.44mm b/d at present. This represents a decline in our previous estimate of 100k b/d. By the end of 2019, we expect Venezuela production to fall to 1.0mm b/d, 200k b/d below our previous estimate. One year ago, Venezuela was producing just under 2.0mm b/d of crude. The other supply source affected by geopolitics is Iran, where we expect export volumes to fall later this year, due to the re-imposition of U.S. nuclear-related sanctions (Chart 3). We are modeling a loss of 200k b/d by year-end 2018, and a cumulative loss of 500k b/d by the end of 1H19.3 Lastly, we have raised the probability OPEC 2.0 keeps its production cuts in place in 2H18 to 100% from 80%. This added $2/bbl to our 2018 Brent forecast. We expect a wider Brent - WTI differential this year, and left our 2018 WTI forecast at $70/bbl. Chart 3Iran Exports Down 500k b/d By 2H19, In BCA Model Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019 Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019 The steady decline in Venezuelan production and the loss of Iranian exports, coupled with an extension of OPEC 2.0's production cuts to end-2018, will take total OPEC crude oil production to 32.0mm b/d this year (down 300k b/d y/y), and 31.7mm b/d next year. Non-Gulf OPEC production also falls: coming in at 7.5mm b/d this year, these producers account for a 300k b/d y/y loss, and, at 7.0mm b/d next year, a 500k b/d y/y loss in 2019. Once again this leaves non-OPEC production as the leading source of new supply: We have total non-OPEC liquids (crude, condensates and other liquids) up 2.12mm b/d to 60.7mm b/d this year, and up 2.11mm b/d next year. This is led - no surprise - by U.S. shales, which we expect to increase by 1.3mm b/d this year to 6.52mm b/d, and 1.5mm b/d next year to 7.98mm b/d, respectively (Chart 4). Net, we expect global crude and liquids supply to average 99.73mm b/d this year, and 101.76mm b/d in 2019. On the demand side, our growth estimates are unchanged in our latest balances model. We continue to expect global demand growth of 1.7mm b/d this year and next - the prospects of which strengthened with an apparent dialing back of U.S. - China trade animosities over the past week (Chart 5). This will move the level of global consumption up to 100.3mm b/d this year and 102mm b/d next year, as can be seen in Table 1. Chart 4Steady Decline In Venezuela Exports,##BR##Iran Sanctions Tighten Markets Steady Decline In Venezuela Exports, Iran Sanctions Tighten Markets Steady Decline In Venezuela Exports, Iran Sanctions Tighten Markets Chart 5Global Demand Remains Strong In##BR##Our Updated Balances Models Global Demand Remains Strong In Our Updated Balances Models Global Demand Remains Strong In Our Updated Balances Models The effect of the supply-side adjustments to our model - holding our demand assumptions pretty much constant - can be seen in the new path of OECD inventories vis-à-vis the 2010 - 2014 five-year average level of stocks (Chart 6). OPEC 2.0's strong compliance with its production-management agreement, along with losses of Venezuelan and Iranian exports and above-average demand growth caused estimated OECD commercial inventories to fall ~ 303mm bbls versus Jan/17 levels. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019 Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019 Chart 6Tighter Markets, Lower Inventories,##BR##Keep Forward Curves Backwardated Tighter Markets, Lower Inventories, Keep Forward Curves Backwardated Tighter Markets, Lower Inventories, Keep Forward Curves Backwardated Keeping OECD inventories below their 2010 - 2014 average levels means Brent and WTI forward curves will remain backwardated at least to the end of 2019, which, we believe, is OPEC 2.0's ultimate goal. This will ensure the coalition's member states receive the highest price along these forward curves, while the coalition's U.S. shale-oil rivals are forced to hedge at a lower price a year or two forward. Backwardation also works to the advantage of commodity index investors, particularly when the investable index is heavily weighted to oil and refined products like the S&P GSCI.4 This recommendation is up 18.9% since it was recommended Dec 7/17. Net, we expect Brent prices to average $78/bbl in 2H18, while WTI goes to $72/bbl. For next year, we expect Brent to average $80/bbl and WTI to average $72/bbl. Simulation Of A Venezuela Supply Shock To Oil Markets The likelihood Venezuela manages to maintain exports of ~ 1mm b/d this year and next falls daily.5 Were markets to lose these export volumes, they initially would scramble to replace them, leading to a short-term price spike, in our view. We simulated the loss of Venezuela's ~ 1mm b/d of exports, assuming these volumes fall off in June, and starting, in Jul/18, OPEC 2.0 gradually restores the 1.2mm b/d it actually cut from production over 2H18. By Jan/19 OPEC 2.0's 1.2mm b/d cuts are fully restored, in our simulation. However, the loss of Venezuela exports is only fully realized in 2H19, assuming oil consumption stays strong. Brent prices end 2019 ~ $100/bbl (Chart 7). OECD inventories fall to ~ 2.65 billion bbls by end 2018, and to ~ 2.32 billion bbls by end-2019 (Chart 8). This is not unreasonable, given the inelasticity of demand to price over the short term, but we would expect that in 1H20, demand would fall in response to higher prices. Chart 7Oil Prices Move Higher In Our Simulation,##BR##If Venezuela's Exports Collapse... Oil Prices Move Higher In Our Simulation, If Venezuela"s Exports Collapse... Oil Prices Move Higher In Our Simulation, If Venezuela"s Exports Collapse... Chart 8... OECD Inventories Drop Sharply,##BR##As Well ... OECD Inventories Drop Sharply, As Well ... OECD Inventories Drop Sharply, As Well Of course, by that time, the supply side likely would have adjusted as well. We will be exploring this further and developing additional simulations to understand the evolution of prices beyond 2020. How this plays out is unknowable at present. But, as a starting point for understanding the implications of losing Venezuela's exports, this is a reasonable set of assumptions, given the challenges in not only returning OPEC 2.0 volumes removed from the market, but getting them to refining centers in 2H18. What is unclear at present is how governments will use their strategic petroleum reserves (SPRs), and whether OPEC will fire up spare capacity to handle the loss of Venezuela's exports, should this occur. Much will depend on how OPEC 2.0 and consumer governments' SPRs interact if exports collapse. Production Cuts, Inventories, SPRs And Spare Capacity In the simulation above, we reckon OPEC 2.0 flowing production can be brought back to market in fairly short order, and that still-ample inventories and spare capacity would be available to cover the sudden loss of Venezuela's exports, to say nothing of strategic petroleum reserves held in the U.S., China, Japan, and the EU. The key, though, is how long it would take to get this supply to market, and how governments holding SPRs react. We estimate it will take anywhere from one to three months to begin to restore the volumes OPEC 2.0 took off the market if Venezuela goes offline. It will take a few months for the restored crude production to start flowing into pipelines and on to ships, followed by 50- to 60-day journeys from the Gulf to be delivered to refining centers. Chart 9OPEC Spare Capacity ~ 2% Of Global Supply,##BR##Lower Than 2003 - 2008 Price Run-Up OPEC Spare Capacity ~ 2% Of Global Supply, Lower Than 2003 - 2008 Price Run-Up OPEC Spare Capacity ~ 2% Of Global Supply, Lower Than 2003 - 2008 Price Run-Up In the meantime, refiners would continue to draw crude inventory to supply product markets, along with product inventories, a critical consideration going into the northern hemisphere's summer driving season. In a short-term pinch, governments could draw their strategic petroleum reserves to fill the gaps while OPEC 2.0 production is being restored, and markets get back to the status-quo ante prevailing prior to the loss of Venezuela's exports.6 OPEC's ~ 1.9mm b/d of spare capacity - most of which is located in KSA - could be called upon in an emergency; however, this requires 30 days to be brought on line, per U.S. EIA, and can only be sustained for at least 90 days (Chart 9). The EIA is forecasting OPEC spare capacity will fall from current levels of 1.9mm bbls to ~ 1.3mm bbls by end-2019.7 Given these uncertainties, we continue to recommend investors remain long Brent crude oil option call spreads, which we recommended over the course of the past few months.8 We expect prices and volatility to move higher, both of which are positive for option positions. Bottom Line: Venezuela's crude oil production is in free-fall. We estimate it will drop to 1.2mm b/d by the end of this year, and to 1.0mm b/d by the end of next year. Iran's exports could fall 500k b/d by the end of 1H19, as a result of the re-imposition of nuclear sanctions by the U.S. These geopolitically induced supply losses tighten markets in 2019, raising our prices forecasts for Brent and WTI to $80 and $72/bbl, respectively. We are raising our Brent forecast for 2018 by $2/bbl, expecting prices to average $76 and $70/bbl, respectively, since these risks likely do not kick in until late in 2018. A collapse in Venezuelan production could spike prices to $100/bbl by the end of 2019, even as OPEC 2.0 restores the 1.2mm b/d of production it removed from markets beginning in 2H18. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its production cuts of ~ 1.2mm b/d and natural declines have removed ~ 1.8mm b/d from the market. 2 Backwardation is a term of art used in commodity markets to describe an inverted forward price curve - i.e., prompt-delivery commodities trade higher than the same commodity delivered in the future. The opposite of backwardation is contango. 3 There is an extremely high degree of uncertainty around this estimate, which is why we are treating it as our Bayesian prior, and will be revising it as additional information becomes available. We do not believe all of the production restored by Iran post-sanctions - 1mm b/d - will be lost to export markets, but starting with a prior of ~ half of it being lost due to less-than-full re-imposition of sanctions is reasonable. 4 Commodity-index total returns are the sum of price appreciation registered by being long the index; "roll yield," which comes from buying deferred futures in backwardated markets, letting them roll up the forward curve as they approach delivery, selling them, then replacing them with cheaper deferred contracts in the same commodity; and collateral yield, which accrues to margin deposits on the futures comprising the index. Roll yield can be illustrated by way of a simplistic example: Assume the oil exposure in an index is established in a backwardated market - say, spot is trading at $62/bbl and the 3rd nearby WTI future trades at $60/bbl. Assuming nothing changes, an investor can hold the 3rd nearby contract until it becomes spot, then roll it (i.e., sell it in the spot month and replace it with another 3rd nearby contract at $60/bbl) for a $2/bbl gain. This process can be repeated as long as the forward curve remains backwardated. 5 Matters have only gotten worse since the Council on Foreign Relations published its so-called Contingency Planning Memorandum No. 33 February 13, 2018, titled "A Venezuelan Refugee Crisis," which opened with the following: Venezuela is in an economic free fall. As a result of government-led mismanagement and corruption, the currency value is plummeting, prices are hyperinflated, and gross domestic product (GDP) has fallen by over a third in the last five years. In an economy that produces little except oil, the government has cut imports by over 75 percent, choosing to use its hard currency to service the roughly $140 billion in debt and other obligations. These economic choices have led to a humanitarian crisis. Basic food and medicines for Venezuela's approximately thirty million citizens are increasingly scarce, and the devastation of the health-care system has spurred outbreaks of treatable diseases and rising death rates. The CFR's memo is available at https://www.cfr.org/report/venezuelan-refugee-crisis 6 There is no way to model exactly how this will play out, absent a detailed plan put forward by the IEA and China, where the largest SPRs reside. IEA members have bound themselves to hold reserves equal to 90 days of net petroleum imports. Among the largest SPRs, U.S. holds just over 660mm barrels of oil in its SPR; China held ~ 290mm barrels at the end of last year, based on IEA estimates. Germany and Japan together hold close to 550mm bbls, according to the Joint Organizations Data Initiatives (JODI). KSA's crude oil inventories - not exactly SPRs - stood at ~ 235mm barrels in March, according to JODI. We are highly confident disposition of these reserves in the event of a shock to Venezuela's exports is being discussed in Washington, Paris, Riyadh and Beijing. Please see p. 2 of the U.S. Government Accountability Office's Testimony Before the subcommittee on Energy, Committee on Energy and Commerce, House of Representatives, "Strategic Petroleum Reserve, Preliminary Observations on the Emergency Oil Stockpile," released for publication Nov. 2, 2017. 7 This actually is a fairly low level of spare capacity, amounting to ~ 2% of global supply. During, the price run-up of 2003 - 2008, OPEC's total spare capacity was near or below 3% of supply and that was considered tight at the time. 8 Please see p. 11 for a summary of these trades' performance. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019 Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019 Trades Closed in 2018 Summary of Trades Closed in 2017 Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019 Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019

"Amongst all unimportant subjects, football is by far the most important." - Pope John Paul II From June 14 to July 15, billions of people will tune into the 2018 FIFA World Cup, with untold loss of productivity, working hours, and quality family time as a consequence. At BCA Research, we decided to stop pretending that we are indifferent to the quadrennial sporting pilgrimage - or to our staff hogging bandwidth by live-streaming games during business hours - and instead harness the best young minds of the company to deliver this most eminently unimportant forecast. To our clients who may worry that their hard-earned dollars are subsidizing fleeting research pursuits, we want to assure you that the research herein was produced "off the clock." In our firm's 70-year history, the principal question driving all analysis has been "so what?" Each and every piece of analysis produced at BCA Research is intended to conclude with an investment angle that makes sense of the noise produced by the cacophony of data. We do not intend to evolve out of that genetic material. At the same time, we are passionate about research. Even though this report does not have obvious investment implications, it is an excellent example of our research fundamentals.1 We develop a macro framework through qualitative analysis, enrich it with data manipulated in novel ways, and articulate it through empirical testing. Just as we produced this report "off the clock," we hope that our clients consume it in their down time. The following pages are a respite from President Trump's tweets, elevated equity valuations, prospects of tepid returns, renewed confrontation in the Middle East, and trade wars. It is also the first in a series of in-depth, multi-disciplinary reports that we intend to produce. Stay tuned. This BCA Special Report presents a unique two-step empirical approach to predict the outcome of each World Cup match. Our approach includes micro (player level) and macro (team level) factors to forecast game matches. We present this model in Section I. Section II then introduces several interesting qualitative narratives, focusing on specific teams attending this year's competition. Section III builds on the existing academic literature and our own unique framework to establish whether the World Cup has any market and economic implications. I. Two-Step Model: Forecasting The 2018 FIFA World Cup In this section we introduce a two-step simulation of the upcoming World Cup. Building on academic literature that has shown that teams respond differently to the various stages of the tournament, we develop two separate models for the group and knockout stages of the competition (Box 1).2 Box 1: The World Cup: A Quick Overview The quadrennial World Cup finals will take place in Russia over a period of one month. The tournament is referred to as the "finals" because the actual competition to select the 32 teams began in 2015. The qualification tournament whittled down the 209 FIFA member states (minus the already qualified host, Russia) over the course of three years via continental qualification tournaments. The 32 teams competing in the finals are separated into eight groups. Each team will play one game against each of their group opponents. The top two performers advance to the knockout stage of the competition. In this stage, the World Cup resembles the NCAA March Madness tournament in that teams face immediate elimination. The 2018 FIFA World Cup is the 21st edition of the competition that goes back to 1930. In the history of the competition, only eight nations have won the cup. Brazil has won five times, Germany and Italy four, Argentina and Uruguay twice, and France, England, and Spain once each. We are not the first to attempt to predict the World Cup. In a recent innovative approach, Clemente et al. (2015) use parameters from network analysis to analyze the tournament's matches. More traditional models rely on the FIFA World Ranking, which ranks teams based on past performance.3 Other conventional models draw on economic fundamentals to explain the success and failure of national teams. A literature overview from 2004 of both quantitative and qualitative models found that a simulator running a commercially produced computer game offered the most successful prediction of the World Cup.4 This should not come as a surprise. The computer gaming industry has overtaken Hollywood in terms of total revenue, while production costs of some computer games are running higher than those of blockbuster movies.5 Given that realism is an important feature of sport simulation, it should follow that computer games have a better forecasting track record than humans. In this report, we combine macro and micro variables to develop a unique two-step model. Our micro factors are based on an extensive database consisting of individual player statistics. Inspired by the 2004 study above, we rely on the computer gaming industry for player ranking, modifying it with our own collective soccertise. The list of potential explanatory variables that we considered including in our model is available in Table 1. Table 1Variables Considered And Used For The Models The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup By relying on individual player attributes we believe that we have avoided the pitfalls of more "macro"-oriented models, such as those relying on overall team rankings. Overall team rankings are established on the basis of team performance over a multi-year period of time. We find that this approach overstates team performance over team quality in present time. These models also fail to incorporate tactical analysis into the model. We introduce these macro and qualitative factors - such as reputation and long-term historical performance - in the qualitative part of our evaluation, while letting objective, player- and team-specific data, dominate our model. Data To determine which variables from Table 1 had the highest predictive power we relied on the 192 matches that occurred during the 2006, 2010 and 2014 FIFA World Cups. There are two reasons we focused only on the last three tournaments. The first is data availability. The second is that football has undergone dramatic evolution in strategy in the twenty-first century. Among the 192 matches, 48 took place in the knockout stage of the competition, while the remaining 144 games occurred during the group stages. We rely on the database of player statistics used in Electronic Arts (EA) Sports FIFA computer simulation. The database includes player statistics from August 2004 to present. At the time of the publication of this report, not all 32 teams had made official their final list of 23 players (the lists will be published on June 4th by the FIFA). Therefore, we relied on the most recent World Cup qualifiers, as well as all the friendly matches played year-to-date to come up with the most likely line-ups for these teams. Step One: The Group Stage Model To simulate the 2018 group stage matches, we developed an Ordered Probit (OP) model estimated on past World Cups group stage games. Ordered Probit models are powerful when modeling an ordinal outcome (i.e. the response value has a strictly increasing ordering known prior to the estimation). Football matches can end in either a loss, a draw, or a win, with a well-defined order from loss to win. The Ordered Probit model therefore allows us to use this information, increasing the predictive ability of the model.6 The Ordered Probit model selected is represented using a continuous latent variable yi* that is linearly determined by a set of explanatory variables χι: The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Where φ is the cumulative normal distribution function and ϒ are arbitrary thresholds selected via log-likelihood maximization.7 Based on our sample of group-stage matches from the past three World Cups, we found that the best explanatory variables are: Team Average Player Rating Average Age - Forwards Average Number of Caps - Defenders Speed Positions Average Rating Group Stage Explanatory Variables Team Average Rating "Talent wins games, but teamwork and intelligence wins championships." Thus said six-time NBA champion Michael Jordan. Our model confirms that the insight from the basketball legend applies to football as well, as average team talent - based on the mean of individual player overall attributes taken from the EA Sports database - is the most significant predictor of game success in both stages of the competition. However, this variable becomes less important in the knockout stages, as the ability to play as a team ("teamwork"), as well as particular tactical matchups ("intelligence"), become paramount in winning the tournament. This is because, in the late stages of the competition, the talent differential between teams narrows substantively. Average Age - Forwards Teams with younger forwards tend to perform better than teams with older forwards due to the highly physical demands of the position. Forwards perform the highest amount of high-intensity efforts (sprinting and sudden changes of direction) and experience the most amount of physical contact among all positions in football.8 Considering that these abilities tend to peak in the early to mid-20's for most professional athletes, it is no surprise that our model gives a premium to youth in this position.9 Moreover, the annals of World Cup history are chock-full of tales of youthful forwards making a name for themselves when it matters.10 Figure 1Position Definitions The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Average Number Of Caps - Defenders Teams with more experienced defenders will tend to do better than teams with less experienced defenders. The physical demands on defenders tend to be less strenuous relative to other positions, given that they dish out the pain. This means that defenders tend to peak later than any other field position in football and are able to maintain peak performance sometimes well into their 30's. What defenders lack in athleticism they must make up in game IQ, as anticipation, composure, and tactical awareness are all acquired skills that improve with experience. Speed Positions Average Rating Teams with superior talent in their speed positions (full backs and wingers) will perform better in group stages (Figure 1). Academic research has shown that counterattacking football is the most effective tactic against unbalanced defenses.11 Wingers and full backs are crucial for both developing and defending against a counterattack as they cover the least congested part of the pitch, where there is generally the most space to run. Interestingly, this variable becomes less important in the knockout stages. This is most likely due to the fact that teams with skilled and fast wingers can easily exploit the space conceded by the tactically disorganized defenses of easier opponents that populate the early stages of the competition. In the later stages, teams are generally more tactically disciplined. Modeling Group Stage Games For each game, our model uses the spread between Team 1 and Team 2 of each explanatory variable to determine the probability of Team 1 winning the game. Table 2 lists all 32 teams and their descriptive statistics on the four explanatory variables. Table 3 presents how the 32 teams are ranked based on their probability of passing to the next stage inferred by these explanatory variables. Table 2Descriptive Statistics: Group Stage The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Table 3Group Stage Ranking The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Our predictive variables were selected based on the results of the 2006, 2010 and 2014 World Cups. The estimated coefficients are then used to produce 1,000 simulations of each game in order to obtain a distribution of the outcome. Table 4Marginal Effect Of Selected##BR##Variables: Group Stage The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The team average ratings are the core variables in our group stage model. However, due to the high level of multicollinearity in the disaggregated player rating variables, we could not capture the entire set of information from these individual variables. As a result, our final probabilities are derived from the weighted average of two separate estimations, Model 1 and Model 2. This allows our model to capture the importance of the speed positions average rating in predicting the outcome of the group stage matches, which displays the highest marginal impact on the winning probability (Table 4). Therefore, our final model for the probability of winning a game is: The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Where: Model 1 (M1)=ƒ (Team Average Player Rating, Forward Average Age, Defenders Average Caps) and, Model 2 (M2)= ƒ(Speed Positions Average Rating, Forward Average Age, Defenders Average Caps), and α and (1- α) are the weights given to each models.12 The ultimate product of our modeling is a coefficient we have termed E(points). As a reminder, teams are awarded three points for a win, one point for a draw, and zero points for a loss. The maximum amount of points a team can gain is nine, given that there are three matches (Box 2). BOX 2: E(points) Calculation The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup E(points) allows us to determine which teams have the highest probability of passing to the knockout stages. We caution readers from reading too much into E(points) in terms of which teams move on to the knockout rounds as the competition in each group greatly determines the value. For example, Denmark has a higher E(points) coefficient than Serbia, but that is a function of its relatively easy group (it faces weaker competition). Group Stage: Results Group A Group A was one of the most challenging to forecast (Table 5). First, Uruguay is probably one of the weakest of the group favorites in the competition.13 Second, host Russia and Egypt are separated by few points in terms of overall quality. Table 5Group A Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup To make our lives easier, we decided to attribute a significant home advantage bonus to Russia.14 History tells us that hosting the World Cup provides a clear advantage to almost any team (Table 6). One out of every three hosts has won the competition, going back to the first tournament in 1930. A whopping 65% of all hosts have made it all the way to the semi-finals. It pains us to see the "Egyptian King," Liverpool F.C. superstar Mohamed Salah, exit at the group stage. However, history is arrayed against his squad. Russia would have to be only the second host team ever - aside from South Africa in 2010 - to fail to capitalize on its home court in the group stage. And, as history teaches us, you just don't beat Russians on Russian soil. Group B Group B was, by far, the easiest to forecast (Table 7). The two Iberian giants will make it through, a high-conviction view. Portugal will try to become the fourth team to win the European Championship and the World Cup consecutively, joining such great teams as West Germany (Euro 1972, World Cup 1974), France (World Cup 1998, Euro 2000), and Spain (Euro 2008, World Cup 2010, Euro 2012). Our knockout stage model likes Portugal, giving it the fifth-best probability of winning the entire competition. Its performance in the group stage will go far in validating our confidence in the team. Table 6Home Advantage Is Real The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Table 7Group B Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Group C A pre-tournament favorite, France will look to avenge its stunning loss to Portugal sans Cristiano Ronaldo in the finals of the 2016 Euro. France starts its competition off in one of the weakest groups (Table 8). Group C lacks real competition, with Denmark having only a 25% probability of beating France. This is the lowest probability of success for any second-ranked team in the group stage of the competition. Anything less than 9 points for France would be a concern for the fans of Les Bleus. Table 8Group C Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Group D Argentina and Croatia are the favorites to go through in Group D, but our model likes Nigeria's and Iceland's chances (Table 9). Iceland keeps turning forecasters into fools. As we discuss in Section II, its success in international football is empirical evidence of the divine. Its run in the 2016 Euro Cup, and win against England, may be the greatest upset in any major sporting competition. However, the element of surprise is gone. Table 9Group D Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Nigeria, on the other hand, could be a dark horse. Our model likes their chances, with 31% probability that they advance to the next stage. They have also won only one of their last 12 World Cup matches, which suggests that they may be overlooked coming into the tournament. Group E Brazil is likely to dominate Group E, but the fight for second place, and thus qualification into the knockout round, will be vicious. Switzerland and Serbia represent a real challenge to our model. Their values in the four explanatory factors are tantalizingly close (Chart 1). Serbia gets the narrowest of pushes on three out of the four, but our model assigns identical probabilities of winning (39%) to each team when they face each other head-to-head (Table 10). The model gives the slightest of chances to Switzerland, mainly due to its higher probability of stealing points in its game against Brazil (48% compared to 46% for Serbia). It is a stunning revelation backed by history. Serbia has no luck against non-European competition in the tournament. Other than its impressive win against the eventual finalist Germany in 2010, it has lost to Argentina (by 6-0!), Ivory Coast, Ghana, and Australia. Furthermore, momentum is not on the side of the Orlovi, given that they backed their way into the World Cup with a 3-2 loss to Austria and a nail-biter against Georgia. These results prompted the Serbian federation to replace the head coach months ahead of the World Cup, not a reassuring sign. Chart 1Serbia Vs. Switzerland The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Table 10Group E Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Group F Germany, the 2014 World Cup winner, will find very little opposition in Group F and should easily avoid the fate of the past two reigning champions who were eliminated early (Table 11). Die Mannschaft was the only team in Europe that won all its qualification games, ending the qualifying tournament with an otherworldly +39 goal difference. Our model likes Mexico over Sweden. This makes sense given that El Tri have progressed past the group stage in the previous six World Cups (only to be promptly eliminated in the first game of the knockout stage every time). Table 11Group F Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Group G Our model finds Group G exceedingly easy to predict. Belgium and England will go through (Table 12). Both teams have a lot in common, starting with quality squads that have failed to make a mark in recent international competitions. Belgium comes to the 2018 World Cup with top quality players in many positions on the field (Table 13). The two squads will find no real competition in this group, but the pressure will be immense on both young squads. How they handle lowly Tunisia and Panama will determine their mental readiness for the knockout stage of the competition. Table 12Group G Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Table 13Top Players In Every Position On The Pitch The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Group H Group H is by far the most difficult to forecast (Table 14), with all four teams clustered around a similar E(points) value (Chart 2). Poland has the best player - Bayern Münich superstar Robert Lewandowski - and Colombia the best team. However, both Senegal and Japan could surprise. The forecasting error in Group H should have little bearing on further results given the relatively low ranking of all four teams (for example, both Switzerland and Serbia from Group E are ranked as superior teams). However, the top two teams from this group will "cross" against Belgium and England, the two chronic underachievers. As such, winning the group carries considerable upside as the winner would face the young, untested, and skittish England. This means that Colombia, Poland, or perhaps even Senegal and Japan, could end up stunning the world and finishing at least in the top eight. Table 14Group H Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Chart 2Probability Of Proceeding To The Knockout Stage The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Group Stage Results Table 15 illustrates group stage results. We assign points based on the highest probability outcomes (win, draw, loss) of each game. Table 15Group Stage Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup How confident are we of the results? Other than groups E and H, we are highly confident. Box 3 goes over our three most likely "Dark Horses" to go through to the second round. BOX 3: BCA's "Dark Horses" Serbia The Serbian national football team has faced many challenges over the past two decades. Despite these hurdles, Serbia has produced top-class footballers that are integral parts of several European super teams. An experienced defense and aggressive midfield - headlined by one of the world's premier defensive midfielder Nemanja Matic of Manchester United - makes Serbia a hard team to play against. There is little of the Balkan flair on this team that defined Yugoslav football in the 1980s. But perhaps that is a good thing, given that World Cup games are tight, nervous, and often devolve into a defensive slog. Senegal It has been 16 years since Les Lions de la Teranga last appeared in a World Cup - and what a memorable appearance that was. In 2002, Senegal reached the quarter finals, the second African team in history to make it that far in the competition. The 2018 squad shows similar potential. The Lions' forwards pose the kind of threat to opponents' defenses that many of their World Cup rivals would envy. Keep in mind some of these names: Sadio Mané (Liverpool F.C.), Ismaila Sarr (Rennes), and Keita Balde (A.S. Monaco). Peru Peru is our choice for a long shot at this year's tournament. The Peruvian national football team is unbeaten since November 2016, winning eight matches and drawing four, with many coming against elite opposition. Although we do not take overall team rankings into consideration when making forecasts, it is notable that Peru is ranked 11th in the world, according to the ELO index. Peru's path to Russia took it through the South American qualifying tournament, known for being the most competitive in the world. Teams have to play 18 games, many at high altitude or in unforgiving climates, against some of the world's most talented squads. While it is true that they were the last team to qualify, having to beat New Zealand in the intercontinental playoffs, Peru came ahead of Copa America champions Chile and just one and two points behind Colombia and Argentina, respectively. While our model does not believe in the relatively young and unproven Peruvian team, placing it last in the group, the team's excellent coaching and fearless play make it a potential candidate to come out of Group C along with France, especially given that our model may be overstating Denmark's potential. Step Two: The Knockout Stage Model The knockout stage is somewhat easier to model given that the set of possible outcomes is reduced to only {loss; win}. This difference with the group stage is not only relevant for the math behind our model. It is also relevant for the strategy teams employ during the games. Therefore, we simulated this part of our analysis using a probit model estimated on a sample of only knockout stage games from the 2006, 2010 and 2014 World Cups. The binary choice probability of observing a specific outcome becomes: The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup In this stage of the competition, we found the following factors to be the most important: Team Average Player Rating Club Level Synergy Player GINI Coefficient Average Rating - Midfielders Knockout Stage Explanatory Variables Team Average Rating As with the group stage, the overall rating of the team - based on the average of individual rankings from the EA Sports database - is the most powerful explanatory variable. Despite the higher marginal effect of the rating variables in the knockout stage sample, the standard deviation and average of these variables are significantly smaller than in the group stage.15 In other words, the gap in player quality between teams in the group stage is often vast. However, the knockout stage culls the minnows, narrowing the gap in overall player quality between teams. At this stage of the competition, our model has to be supplemented with variables that test for teamwork and synergy. Club Level Synergy Teams with more players playing in the same club tend to perform better in the knockout stages. This is evident from all the World Cup winners in our sample.16 Given the limited practice time that national teams have ahead of the tournament, the year-round experience of playing with teammates in club competition can provide a huge advantage. Especially for football teams from countries with major leagues - such as Germany, Spain and Italy. Their players are more likely to cluster on the major clubs in those leagues, whereas players from smaller footballing nations have to ply their trade in dispersed leagues and teams across the globe. Great Man Theory (Player GINI coefficient) Teams win games, but heroes win World Cups. To test whether superstars are relevant to winning games, we designed a player quality GINI measure. We find that teams with a higher GINI coefficient outperform those with a lower measure. It seems that having a superstar, or two or three, surrounded with role players is a superior strategy to having balanced talent across all positions. This variable only becomes significant in the knockout stages, where the overall talent level between teams narrows. While more skilled teams tend to be more balanced (Chart 3), once we normalize for skill, a higher GINI becomes a predictor of success. Chart 3The Great Man Theory The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Intuitively we agree with this finding. When the stress and tension of knockout stages peak and the weight of one's entire nation begins to crush a lesser player's shoulders, the Great Man shines through. Exceptional players have the skill, stamina, and otherworldly confidence to unlock the highly disciplined and tactically sound defensive schemes found in the latter stages of the competition. This should be good news for Belgium, Portugal, and Argentina, but really bad news for England. Average Rating - Midfielders Once we decompose the different positions in the field, we find that the midfield is more important to success than other positions in the knockout matches. Research has shown that midfielders, particularly those forming the "spine" of the team, are the most involved in a team's passing play, regardless of the tactics or strategy used.17 Precise and creative passing is key in knockout matches where tactically disciplined defenses are difficult to unlock. Defensive prowess in the midfield is also paramount to prevent the opposition from developing their attack.18 As with the group stage model, the final probabilities for the knockout stage games were derived from the average of two models in order to maximize the information contained in the average midfield player rating variable (Table 16). Table 16Marginal Effect Of Selected Variables: Knockout Stage The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Therefore, our final probability is: The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Where: Model 1 (M1) = ƒ(Team Average Player Rating, Club Level Synergy, Player GINI Coefficient) and, Model 2 (M2) = ƒ(Midfielders Average Rating, Club Level Synergy, Player GINI Coefficient), and a and (1 - α) are the weights given to each models.19 Table 17 summarizes the descriptive statistics of each team according to the four variables used to model their performance. Table 17Descriptive Statistics: Knockout Stage The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Knockout Stage: Results The Round of 16 There were no surprises in the round of 16 (Table 18). The two matches worth paying attention to are England vs. Colombia and Portugal vs. Uruguay. Our model gives the two European teams a 60% chance of winning their respective games. We see the "Great Man Theory" carrying Portugal forward to the quarter-finals. We are essentially willing to bet that Ronaldo is at least worth a quarter-finals berth at the World Cup. Table 18Round Of 16 Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The England-Colombia matchup is essentially a coin toss. The young and untested Three Lions will face a tough challenge in Colombia. However, it is safer to carry England over to the next round as their "conditional probability" of progressing to the quarter-finals is significantly higher than that of Colombia (53% to 17%) (Chart 4). Why the difference? Conditional probability takes into account the original probability of passing the group stage. Given England's easy group, and Colombia's challenging competition, it is mathematically safer to bet on England. Chart 4Probability Of Advancing To The Quarter-Finals The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Quarter-Finals Making it into the quarter-finals of the World Cup is an extraordinary success reserved for only eight footballing nations. At this point, teams have played four intense and decisive games over three weeks. Fatigue sets in, especially given that the superstars are playing at the end of a grueling club season in what is normally their off-season. Our model bets strongly on the previous two World Cup winners (Table 19), while Brazil and France struggle against their opponents. Belgium and Portugal are left to wonder what might have been, although for Belgium the pain will be greater. Not only will they yet again fail to meet expectations, but also they will waste the highest conditional probability of advancing to the next stage of the four teams that do not advance (Chart 5). Table 19Quarter-Finals Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Chart 5Probability Of Advancing To The Semis The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup France Vs. Portugal: Setting The Record Straight The loss to Portugal in the final of the 2016 Euro, on home soil no less, still stings for France. The loss was particularly painful given that Portugal's superstar, Real Madrid's Cristiano Ronaldo, had to leave the game due to an injury and spent the majority of the game hopping on one leg, yelling instructions to his teammates from the sidelines. Our model gives France a 66% probability of winning the game. The French team is superior in every facet of the game, other than in the speed positions (Diagram 1). France also sports two of the game's best defensive midfielders, Chelsea's N'Golo Kanté and Juventus's Blaise Matuidi, to whom it will fall on to neutralize Portugal's Great Man. French coach Didier Deschamps has also benefited from the overall improvement in the French Ligue 1, calling upon players that play together in the local league. Diagram 1Les Bleus Vs. A Selecao das Quinas The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Diagram 2A Selecao Vs. The Red Devils The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup We expect a tight match, with intense man-on-man coverage of Ronaldo. France will dominate the ball, slowly building chances against Portugal's defense. In 2016, a young and inexperienced French team wasted a plethora of chances against Portugal's version of the Maginot Line. We do not see history repeating itself. Brazil Vs. Belgium: Red Devils Don't Dance Samba The second tight matchup predicted by our model pits Brazil against Belgium. As with the France-Portugal matchup, the underdog has a solid one-in-three chance of winning the game. What makes Belgium so dangerous is their overall midfielder rating, which we identified as one of the four most relevant factors for winning the game. The problem for Belgium is that it trails Brazil by a lot in other facets of the game (Diagram 2). Its defense is particularly suspect. Belgium has no players ranked in the top five of their defensive position, whereas Brazil sports a fifth of all the best defensive players in the entire tournament. Spain Vs. Argentina: Don't Cry For Me Lionel Our model has no time for La Albiceleste, giving Argentina a paltry 10% chance of defeating Spain. As a reminder, our model is completely ignorant of head-to-head matchups between teams, but it has essentially predicted the 6-1 drubbing that La Roja gave Argentina in a friendly in late March. Granted, Argentina's superstar, and F.C. Barcelona icon, Lionel Messi watched the spanking from the bench. But unless Messi can play defense at the same high level at which he finishes attacks, Argentina is in trouble. Argentina's 2018 squad is essentially the stereotype of every team we have watched from the nation in the last half-century. Its forwards are world class, perhaps the best in the tournament (Diagram 3). Four Argentines are amongst the 15 best forwards in our sample, an extraordinary number (see Table 13). Nevertheless, the rest of the team is subpar relative to other favorites, and particularly against Spain. Germany Vs. England: Hard Brexit Defending champions rarely meet expectations at the World Cup. The tournament is simply too grueling, the pressure too great, and the chasm of time between tournaments too wide to bridge within a single generation. However, Germany faces a young, untested English team in our bracket. Getting to the quarter finals would be seen as a success for England, one upon which to build a winning generation for the 2022 tournament in Qatar. Germany tops England in all facets of the game and across the pitch (Diagram 4). Our model gives England little chance against Die Mannschaft. England has greater chances of extracting a soft Brexit from Berlin than of penetrating Germany's clinical press. Diagram 3La Furia Roja Vs. A Albiceleste The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Diagram 4Die Mannschaft Vs. The Three Lions The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Semi-Finals Our model gives Belgium and Portugal decent odds for advancing to the semis, leaving a door open for surprises in the quarter-final round. In the semi-finals, however, the model tightens the odds, snuffing out the chances for an aging Germany and an inexperienced Brazil (Table 20). Brazil's and Germany's chances fall to just 15% and 11%, respectively (Chart 6). Table 20Semi-Finals Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Chart 6Conditional Probability Of##BR##Advancing To The Finals The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Spain's conditional probability of reaching the finals hovers at an extraordinarily high 54%. France remains at a respectable, and yet uncertain, 41%. France Vs. Brazil: Painful Memories We are not surprised that our model assigns Brazil just a 27% probability against France. France practically coasted to the finals of the Euro 2016, defeating Germany. In terms of quality, the two teams are even on forwards. Brazil takes a big advantage in speed positions and defenders, but France wins where it matters: midfield (Diagram 5). For many years now, Brazil has been known to produce some of the best forwards and defenders, but apart from Ballon d'Or winner Kaka, who retired a couple of years ago, it is difficult to name an outstanding Brazilian midfielder in recent years. Diagram 5Les Bleus Vs. A Selecao The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The French squad also displays better results on the club synergy variable, the second-best reading for the teams in the knockout stage behind Spain. This is the result of improvements to its domestic league. Meanwhile, Brazil's top players continue to be dispersed across a number of different top clubs. Brazil will avenge its disastrous result from 2014 with a solid showing in Russia. Its pride will be reestablished and memories of the 7-1 drubbing softened. However, it will fail yet again against a European power. Spain Vs. Germany: The Battle Of Champions The other semi-final game will feature the 2010 champion (La Furia Roja) against the 2014 champion (Die Mannschaft). You have to go back all the way to the 1990 World Cup to see the two previous World Cup winners face each other in the semi-finals. Our model is indifferent to Germany's more recent success, giving Spain an overwhelming 85% probability of winning. In 2018, Spain has superior quality across the pitch (Diagram 6). Diagram 6 La Furia Roja Vs. Die Mannschaft The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup In 2010, the year of Spain's last title, the team relied heavily on what made F.C. Barcelona unbeatable in Europe: heavy possession of the ball and gameplay built on crisp passes. This still holds true today, as tiki-taka has become part of Spain's footballing DNA. However, after underperforming in the 2014 World Cup and at the 2016 Euro, new coach Julen Lopetegui has slowly improved overall play. This has particularly involved raising the quality of the Spanish attack. As Spain discovered in the last two major competitions, it is not enough to have possession for 80% of the game if one cannot do anything with the ball. The Finals: Spain Vs. France BCA's Two-Step World Cup model predicts that, on July 15, 2018, the world will see Spain dispatch France in the finals of the world's sporting pilgrimage (Diagram 7). The two teams have the highest conditional probability of traveling down the grueling camino a la gloria eterna, from the group stages to the final (Chart 7). Intriguingly, of the teams knocked out in the quarter-finals, Portugal shows up with a slight conditional probability of winning the tournament. The England-Colombia matchup is essentially a coin toss. Diagram 7Road Map Of The World's Sporting Pilgrimage The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Chart 7Conditional Probability Of Entering Elysium The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Our model gives Spain a 59% probability of beating France (Chart 8), large enough to give us confidence, but not an overwhelming figure. It is undeniable that Spain has superior quality across the pitch (Diagram 8). Chart 8Final Matchup Probabilities The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Diagram 8La Furia Roja Vs. Les Bleus The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Moreover, Spain clearly excels over France in its defense - it conceded just three goals in its ten qualifier matches - and in its club synergy value, where it scores the highest mark. Five players sampled in our data play for F.C. Barcelona and five play for Real Madrid. What of the game for third place? Surprisingly, it may be the game of the tournament.20 Sure, third place means little. However, this game will mean a lot. If our model is correct, Brazil will face nemesis Germany in a revenge game. The young Brazilian team, completely revamped after the 7-1 Blitzkrieg on home soil, will be playing for the future, for revenge, and for national pride. Our model gives Brazil only a slight edge over Germany (Table 21). This is unsurprising, given that Brazil is, by far, superior in defense, forward, and speed positions, even though it is considerably inferior where it matters: the midfield (Diagram 9). Table 21Third Place Match Summary Results The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup How does our forecast compare with current betting odds? Chart 9 shows that our model gives Spain an extraordinarily high probability of winning the tournament. Spain's 32% odds are double what the bookies' favorites, Brazil and Germany, command. Overall, we think that the betting market is underestimating the odds of a Mediterranean champion, while overstating the odds of both Germany and Brazil. Diagram 9A Selecao Vs. Die Mannschaft The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Chart 9We Do Not Condone Betting!##BR##(But If You Were Wondering...) The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup II. Teams And Narratives To Watch In Russia: A Qualitative Assessment The World Cup is not just about winning. It is the most watched event - sporting or non-sporting - in the world because it weaves so many narratives and themes together. In this section, we explore some of these narratives and themes. Some are investment relevant, some are geopolitically relevant. Our qualitative assessments are ordered from the lowest-ranked teams to the highest-ranked. South Korea - A New Era Dawns, With The Same Football Results Coming from a country that has imprisoned every former president, including the one it just impeached, it should come as no surprise that South Korea's national team lacks stable leadership. The Koreans had a remarkable coach - the German sweeper Uli Stielike - who had dedicated three years to preparing them for this tournament. They fired him last year, however, due to a handful of losses. He has been replaced with a native son - a known advantage in World Cup football - Shin Tae-yong. Shin Tae-yong threw a special winter training camp for the team in order to establish himself as coach and get to know the squad given such a short time remaining before the tournament. Activities consisted of drinking tiger's blood and hiking up to the Unicorn Lair of Kiringul where, rumor has it, former North Korean dictator Kim Jong Il was conceived. South Korea made it to fourth place when it co-hosted the World Cup in 2002. While it had a lot to do with the Flying Dutchman coach, Guus Hiddink, he was not playing on the field. Rather, it was the insatiable Korean thirst to perform better than their co-host and erstwhile colonial overlord, Japan.21 In 2018, South Korea has a good defense: they seldom have let the ball in the net in recent tournaments. The only problem is that they do not know how to score goals. Young star player Son Heung-min, of Tottenham Hotspurs fame, has shown that he can score multiple goals late in the game - but only when playing against Uzbekistan. Of course, South Korea does have a tremendously compelling national story this year: the war with North Korea is finally over! President Moon Jae-in and his North Korean counterpart, dictator Kim Jong Un, held the third Inter-Korean summit on April 27, and declared for the first time since 1952 that they would stop trying to kill each other, at least formally. Peace is the word of the day. Can the optimism of an era free of war, with potential Korean reunification on the horizon, translate to a morale booster that helps Korean athletes? Probably not. Our model assigns Korea only a 3% chance of making it out of the group stage. The 2018 Winter Olympics were held in South Korea - they even entered the opening ceremony jointly with their communist neighbors. But while the South Koreans did well, winning several golden medals, they did not set a new record. Unlike the South Korean women's hockey team, the South Korean men's football team won't receive an infusion of North Koreans. Nor will they host a North Korean art troupe. Although we doubt that either would help their odds in Russia. Egypt, Morocco, Tunisia, And Saudi Arabia - Renaissance Or Regression? It is now eight long and turbulent years since the Arab Spring ignited with protests in Tunisia. Since then, stagnant regimes have been toppled, hundreds of thousands of people killed in civil wars, and an Islamic State has been created and crushed. Tunisia and Morocco stand out as clear outliers in terms of geopolitics. Since the 2014 parliamentary elections, Tunisia has begun paving the way towards becoming the first country in the Arab world with a functional democracy. Morocco is far from a democracy, but has remained stable over the past decade in stark contrast to the region. King Mohammed VI has enacted a number of reforms that have forestalled, for now, expression of grievances from the public. Saudi leadership has decided to follow the Moroccan example and preempt social unrest by enacting wide ranging reforms from the top. The 33-year old Crown Prince Mohammad Bin Salman has not only pledged to reform the economy, but also to fundamentally change conservative Saudi society. Women have been given the right to drive, the religious police has been regulated into irrelevance, and there is even talk of eliminating public gender segregation. BCA believes that these reforms are genuine and that they will be executed with vigor.22 Saudi leadership is reacting to the reality that the majority of the population is under 30 years of age (Chart 10). Mohammad Bin Salman therefore did not "come out of nowhere," as many commentators claim. He is the regime's response to the socio-economic realities of Saudi Arabia. Chart 10Saudis Are Catering To The Youth The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup In contrast with these three countries, Egypt has stagnated in terms of governance and political reforms. In many ways, the country has regressed back to the military-backed rule that preceded the Arab Spring protests. However, President Abdel Fattah el-Sisi has launched and followed through on some private-sector and macro reforms which should result in marginal improvements for the economy.23 If football is a reflection of socio-economic conditions, then the participation of these four states at the World Cup is a harbinger of a brighter future. In Russia, Arab countries will have the highest number of representatives ever in the World Cup. Given that three of the four countries qualified in the highly competitive African continental qualification tournament, the result is impressive. Our quantitative model gives Morocco, Saudi Arabia, and Tunisia little chance to reach the knockout rounds. Egypt, on the other hand, is only eliminated because we have decided to give Russia a host premium. Since 1930, as a host, only South Africa failed to qualify for the round of 16 in 2010. Egypt has a real chance to be one of the dark horses in this year's tournament. It has the requisite footballing tradition to be able to withstand the pressure of a major tournament. Egypt has won seven African Cup of Nations, the most among its continental peers, and nearly half of its likely squad play in major international leagues. The most important among these is Mohamed Salah, "The Egyptian King," of Liverpool F.C. Salah may be the best forward in the world at the moment and will certainly wreak havoc in the group stage against Russia and Saudi Arabia. These four Arab states have already accomplished a lot by qualifying. But if one of them progresses to the knockout stage, it would be notable. BCA Emerging Markets Strategy research has shown that genuine structural reforms that improve the quality of governance are required for long-term productivity growth, and thus, asset performance.24 But a change in attitude comes first. Confidence is an important part of that change, and seeing Mo Salah and Egypt take on the world's best could light the spark for a Middle East Renaissance. Iceland - A Footballing Black Swan Iceland's football team success is a great reminder to investors that the probability of unexpected events is often greater than the consensus expectation. Iceland has a population of 330,000, just slightly larger than Swansea, Wales' second-largest city and home of "the Swans," the perennial bottom-feeders of the English Premiership League. If one eliminates Iceland's female population, the infirm, and the too old and too young, the pool of available humans for the country's football team is about 40,000. Iceland's qualification for the World Cup is extraordinary. Its success at the Euro 2016, where the country advanced to the last eight teams after defeating England, is nothing short of evidence of the divine. It may be the greatest upset in sports. Ever. Consider that in order to even participate at the Euro 2016, Iceland had to survive a qualification group that included the Netherlands (which failed to qualify!), Czech Republic, Turkey, Kazakhstan, and Latvia.25 Iceland finished second in the group and thus qualified directly for the event. Then, to get to the final eight at the Euro, Iceland had to survive a group made up of Hungary, Portugal, and Austria (where it finished ahead of the eventual Euro champion Portugal!).26 It defeated England in the round of 16 by a score of 2 to 1, only to finally be vanquished by the host nation France.27 What makes Iceland's success so astonishing is statistics, specifically the concept of conditional probability. Because qualification for a major event, such as the Euro, requires successive results, the conditional probability of Iceland getting through to the quarter-finals eventually is close to zero.28 Especially when one considers that there is no element of surprise for a country like Iceland once it shocks the world by qualifying. This is not college basketball, where the knockout nature of the March Madness tournament - and lack of scouting of small universities - creates the potential for upsets. This is international football, played by grown men getting paid millions of dollars to do their job (i.e., not lose to Iceland). What is the secret behind the success of Strákarnir okkar (Our Boys)? Several theories have been advanced: investment in coaching, heated football pitches, "Nordic mentality," "The Breath of Odin," etc.29 To us, all of this smells of the hindsight rationalization that Nassim Taleb identified as the hallmark of Black Swan events.30 Icelandic footballing success is a shock, a rift in the space-time continuum, and unlikely to be replicated. Our model gives Iceland little chance against Argentina, Croatia, and Nigeria. Of course, the whole point of a Black Swan event is that it is impossible to model. So, sit back, relax, and enjoy the Viking War chant!31 Japan - Bad Timing For New Leadership Japan is a nation in ascendancy, having emerged from its "Lost Decades" in recent years to reclaim a leading position among the nations of the world. What stirred the giant from its slumber? A global financial crisis, earthquakes, tsunamis, nuclear meltdowns, debt-deflation, and the revival of its ancient Chinese foe. A new era is dawning. That is fortunate, as it means that Japan's failures in the World Cup will fall under the final year of the outgoing emperor's reign. The problem, once again, is the lack of stable leadership. Just as factions in the ruling Liberal Democratic Party are busy trying to remove the hugely successful Prime Minister Shinzo Abe before a critical party leadership vote, so factions within the Japan Football Association have removed the head coach, Vahid Halilhodzic, just two months ahead of the tournament. Unlike his Korean counterpart, Akira Nishino has not held a winter camp to familiarize himself with the team. Instead, he will rely on the rock-solid supposition that the Japanese would think it ignoble to be led into battle by a foreigner. There is a basis for believing that teams do better under the leadership of a coach who is a national. But there is only so far that ethnic solidarity can go. After all, this is a team that wrestled Haiti and Mali to a draw. To throw its coach under the bus at the last minute is to ensure that Japan's squad remains, in the words of William Durant, "inclined to picturesque suicide". Croatia & Serbia - Strength In Numbers Extrapolating into the future from their vantage point in 1990, leaders of Yugoslav federal republics Slovenia and Croatia made an understandable forecast. First, communism was dead, and it was time for economic and political reforms. Second, "economies of scale" no longer mattered. The future was in global trade and open borders. Therefore, membership in a still-communist federal Yugoslavia dominated by semi-authoritarian Serbia was suboptimal. Looking back at the decision today, it is hard to argue with the results. Slovenia is in the Euro Area with a GDP per capita of $21,304 (2016), while Croatia is close behind, in the EU with a GDP per capita of $12,090 (2016). Meanwhile, their neighbor and aggressive "big brother" Serbia, which fought a war against both to keep them in Yugoslavia, is on the outside looking in. Its GDP per capita ($5,348 in 2016) has only recently recovered to the 1989 Yugoslav levels! There is no argument that Croatia and Slovenia made the right choice, at the time, by choosing secession. But the question is whether they would have still done it knowing everything we know about the present. For one thing, we cannot extrapolate globalization into the future. We are, in fact, at its apex.32 Strength in numbers will matter in a de-globalized, multipolar world of the twenty-first century. And while Croatia and Slovenia are part of a bigger whole - the EU - their size relative to the EU population and economy is laughable relative to their importance in Yugoslavia (Chart 11). Chart 11Small Parts Of A Bigger Whole The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup And then, of course, there is sport. Both Serbia and Croatia are present in Russia. Our model ranks them 14th and 15th respectively. If we combine their rosters into 23 top-ranked players, their ranking jumps to eight, high enough that a semi-final berth becomes a possibility given good luck. This is not the best team that former Yugoslavia could have featured. In 1998, Croatia came third in France with an over-the-hill squad. But in 1994, Serbia and Montenegro (still called Yugoslavia at the time) were banned from competing while that same Croatia was unprepared to compete in the qualifications, which began just after the country's independence. That 1994 team would have featured in-prime Croatian stars33 - who came within two Lilian Thuram goals of the 1998 finals - and a team of Serbian,34 Montenegrin,35 and Macedonian36 players who took Red Star Belgrade to its Champions League title in 1991. Given the relatively weak competition in 1994 (Bulgaria and Sweden made the semi-finals), Yugoslavia could have been crowned World Cup champion in 1994. Of course, if pigs had wings, they would fly. On the other hand, the fact is that Slovenia and Croatia are among the two most Euroskeptic countries in the EU. Clearly, there is some buyers' remorse in both. Perhaps as part of a reformed, democratic, and federal Yugoslavia, both would have enjoyed greater clout in Brussels and thus, greater say in what kind of policies the EU imposed on them. And if that did not work, at least looking at the shiny 1994 FIFA World Cup Trophy would have helped put everything else into perspective. Russia - The World Cup As The Ultimate Lagging Indicator Expectations are low for the Russian national team at the 2018 World Cup. Despite its size, population, relative wealth, and strong tradition of government support for sports, Russia is just not a footballing nation. Its best result at the World Cup was way back in 1966 (fourth place), although it did win a European title in 1960. That was more than half a century ago! As a host, we would expect Russia to get a bump out of its woefully easy group. But from there, the focus will shift away from the Sbornaya to the organization of the tournament. This is the second time Russia is hosting a major international competition, following the 2014 Sochi Winter Olympics, and all eyes will be on the updated infrastructure and tight security measures. The World Cup presents a much greater challenge than the Sochi Olympics because there are 11 venues spread out over a geography the size of Western Europe. Three of the venues - Volgograd, Rostov-on-Don, and Sochi - are also close to the Caucasus region. Russian security forces essentially encircled Sochi in 2014, severely limiting movement into and out of the Black Sea resort town.37 This is unfeasible to do for the country's 11 largest cities. Chart 12Russia - The World Cup As##BR##The Ultimate Lagging Indicator The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup There is an additional problem of limiting hooligan violence. We assume that Russian law enforcement will be much better at limiting the influx of troublemakers than its European neighbors. However, Russia has plenty of domestic hooligans to create violence, which was on clear display at the Euro 2016 clash between English and Russian "fans." All of this brings up the question: Why is Russia organizing the World Cup in the first place? Especially given its semi-pariah status following a spate of controversial geopolitical events thus far in 2018? The answer is that major sporting events are the ultimate lagging indicator of a country's economy, its geopolitics, and market performance. The Sochi selection was made in 2007, amidst an epic commodity bull market and at the peak of the "BRICS are taking over" narrative. The World Cup selection was made in 2010, well before Crimea was annexed, Ukraine was destabilized, and Russia decided to play "peacemaker" in Syria (Chart 12). Just like Brazil in 2014, the World Cup therefore arrives to Russia at an odd time, with the market, economy, and the country's relations with the West hitting rock bottom. Of course, the 2014 World Cup was the bottom for Brazil, with a spate of seismic economic and political changes following. Brazilian equities are up nearly 50% from the closing ceremony of the World Cup to today. Can the same happen in Russia? Mexico - Will Anything Change? Mexican voters will go to the polls on July 1 as its national football team competes in Russia. The election has been dubbed the "biggest election in Mexican history" by the country's National Electoral Institute. We agree. For the first time in Mexico's history, a left-wing, anti-establishment movement has a chance to win (Chart 13). Chart 13The "Biggest Election In Mexican History"? The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Will Mexico's football team also break with tradition? For the past six World Cups, Mexico has emerged from the group stage only to be promptly eliminated in the knockout stage every time. In 2018, El Tri again have a great chance to emerge from the group. While Germany is a formidable foe, the other European nation in the group, Sweden, barely qualified and is playing without its only top-class footballer, Zlatan Ibrahimovic. As such, Mexico should accomplish the usual feat relatively easily. The question is whether it can do more. Unfortunately, second-place finish in its group will pair it, baring a major surprise, with Brazil. This is where its road will most certainly end. Will politics mirror football? Is Andres Manuel Lopez Obrador (AMLO) just more of the same? We are hopeful that Mexico's left-wing answer to President Donald Trump could actually make some changes for the better. First, the Mexican Congress is unlikely to give AMLO free rein in governing the country. Second, AMLO has moderated his campaign, purposefully hiring centrists and technocrats to signal moderation. Third, AMLO has the charisma and the gravitas to sit down with President Trump and negotiate face-to-face, unlike his predecessor, Enrique Peña Nieto, who never quite got used to Trump's rhetoric and aggressive style. In the end, if AMLO fails to make serious inroads with economic reforms, ongoing drug-related crime, and negotiations with President Trump, at least Mexicans will have one major success to take from 2018. Mexico qualified for the 2018 World Cup, whereas its eternal football rival the U.S. did not! Belgium & Switzerland - The Upside Of Immigration Let us state the facts. Without footballers of immigrant descent, we would not be writing an analysis on the Belgian and Swiss football teams today. Of the 23 call-ups for the international friendlies ahead of the World Cup, 13 were of immigrant background for the Swiss team and 12 for the Belgian. This includes the majority of the stars of both teams, such as Granit Xhaka (Albanian) and Ricardo Rodriguez (Spanish-Chilean) for Switzerland, and Vincent Kompany (Congolese-Belgian), Marouane Fellaini (Moroccan), and Romelu Lukaku (Congolese) for Belgium. In large part, this is a tired topic already well covered by the Belgian and Swiss media. It also draws on the main narrative following the 1998 French World Cup win. Half of the legendary Les Bleus team was made up of players with immigrant backgrounds, including essentially all of its stars. Of the 14 goals scored by the French team, nine came from its multicultural stars Zinedine Zidane, Youri Djorkaeff, Thierry Henry, Lilian Thuram, and David Trezeguet. What separates the 1998 French team from the Belgian and Swiss teams today, however, is the geopolitical context. The 2015 migration crisis in Europe - when the influx of illegal immigrants reached a peak of 220,000 per month in October of that year - still dominates politics on the continent (Chart 14). Although the crisis is now definitively over - the monthly influx figure is below 3,000 - both anti-establishment and establishment parties have swung hard against immigration. Chart 14What Migration Crisis? The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup But wait, are these players really immigrants to begin with? The answer is an obvious and definitive no. Only six Swiss and none of the Belgian players were born outside the country. Even the 1998 French team had only two players who were actually born outside of France (and an additional two were from overseas French territories). This reflects one of the greatest misunderstandings in the political narratives regarding European immigration. There essentially is no longer any non-European immigration to Europe. At least not via legal channels. Players who are visible minorities on these teams are almost universally the children and grandchildren of the post-World War II immigrants from the former colonies (and three of the six foreign-born Swiss players are not visible minorities at all, given that they are from the former Yugoslavia). Several European countries undoubtedly have a problem integrating non-European immigrants. Our colleague Peter Berezin has made a connection between a generous social welfare state and lack of successful integration, with Belgium and Sweden as prominent examples of the connection.38 However, few commentators understand that there is no ongoing large-scale influx of immigrants to Europe, aside from occasional migration crises prompted by wars. The migrations of the 1950s and 1960s, from former colonies, was followed in the 1960s and 1970s by "guest worker" migration. Since then, Europe has progressively tightened its migration policies to all but internal migration from EU member states. What does this mean for Europe's national football teams? Nothing. Football is a sport played by the middle and lower classes almost universally.39 The high proportion of visible minorities on Europe's football rosters is simply a reflection of the fact that many immigrants and their kids grow up in precisely such communities. Eventually, they become French, Belgian, or Swiss. After all, nobody would today doubt Michel Platini's Frenchness. But he is as much a product of immigration as Zinedine Zidane or Zlatan Ibrahimovic. England - A Football Brexit It is well known that the English national team is cursed in World Cup football. If not for the home team advantage, they never would have won their single trophy in 1966. Many commentators in England lament the strength of the English Premier League. Best teams are collections of superstars from other countries who receive the highest wages in football, yet naturally return every four years to play for their mother country. In other words, the English fight wars with mercenaries hired from abroad whose loyalties lie elsewhere. Imagine that! The English national team has chronically underperformed despite having one of the most expensive, and productive, leagues in the world. Like many other U.K. industries, English football leverages the high productivity of extraordinary immigrants. Indeed, the percentage of foreign players in the English Premier League is the highest in the world (Chart 15).40 Chart 15The Most Globalized Labor Market? The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The immigrant free-for-all, however, almost ended. Just as concerns over immigration prompted Brexit, concerns that English football was being dominated by the non-English almost led to changes to the domestic league Homegrown Player Rule. A proposal to put more stringent rules on foreign players in order to fix the talent pipeline in English football almost took hold under the previous FA chairman, Greg Dyke. Fortunately, the worst effects of the Brexit vote have already passed: The team suffered their worst upset in 66 years at the hands of Iceland in the 2016 Euro Cup, just days after the referendum was held. Remember, there are fewer people in Iceland than there are Sikhs in the United Kingdom. This devastating upset was the first material instance of "Bremorse" in the wake of the referendum. The team is unlikely to suffer such an upset again. Instead, it will perform just like it did in 1066: defeating the likes of the King of Norway and Iceland only to be invaded and enslaved by the King of France. But unfortunately for England, it does not get a rematch with Iceland in group play. Rather, its group of four affords an occasion for an even greater humiliation, perhaps even the crowning humiliation of the entire Brexit saga: a loss to Brussels. Such a loss is likely if only because the signal lesson of British history teaches that Europeans can never successfully invade the island unless it happens to be suffering from deep internal divisions. And with Jeremy Corbyn and a second Brexit referendum on the horizon, such "intestine" divisions are utterly assured. Given all of the above, does it seem likely that this is the year in which England will break a half-century-long curse? No. But our model gives the young team great odds of reaching the knockout stage. Argentina - Promise Vs. Performance Every investor knows the old adage that at the turn of the twentieth century, Argentina was "one of the ten richest countries in the world," ahead of European heavyweights France, Germany, and Italy. And that in 1950, Argentina's GDP-per-capita was six times greater than the likes of South Korea. After half a century of Argentine economic mismanagement and unfulfilled promises, South Korea has today doubled Argentina's national wealth (Chart 16). Chart 16Argentina - Promise Vs. Performance The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup At probably the height of the country's economic and political mismanagement - during the nearly decade-long military rule between 1976 and 1983 - Argentina's football team won two World Cups: 1978 and 1986. Since then, however, it has left behind a legacy of unfulfilled promises and lost opportunities that largely mirror its last thirty years of economic performance. Since the 1990 World Cup in Italy, Argentina has entered every World Cup as one of the favorites. Its fans consider the team one of the world's five greatest footballing nations. To its credit, it has made the finals twice, in 1990 and 2014, and the quarter-finals three other times in that span. But its status as a perennial superpower is under threat. We would argue that Argentina is, in fact, the greatest underperformer in the last three decades of international football. Despite being the fourth highest-ranked team over the past two decades - according to Elo scores, which we interpret to represent the consensus view - the country has failed to lift the World Cup. The greatest threat to Argentina's legacy as a footballing superpower is that, in another twenty years of unfulfilled promises, fans will look back at its past success the way we think of Uruguay's two World Cups, won in 1930 and 1950. One could argue, for example, that its two titles are a product of a single, golden generation, not of eternal status as a superpower. Since Diego Maradona stopped playing, Argentina has only advanced past the quarterfinals once. Coming into the 2018 World Cup, the expectations are once again high. Argentina still has one of the world's top-two players in Lionel Messi. And Elo again ranks it as the fourth-best team, with expectations of at least a semi-final appearance. Our model is more skeptical, dropping it to a sixth-best ranking and predicting yet another quarter-final exit. If Argentina wastes its "Messi generation," the chances that its unfulfilled football promises mirror that of its economy will grow. Portugal - The "Great Man" Theory The "Great Man Theory" posits that a large portion of human history can be explained by the impact of "Great Men" (and women) on global events. Popular from the Greek and Roman classics through the nineteenth century, the theory has been contradicted by post-modern philosophers, sociologists, and historians. BCA's Geopolitical Strategy largely rejects the idea in its methodology. We focus on the constraints to "Great People," rather than their preferences. After all, preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. Enter Cristiano Ronaldo dos Santos Aveiro. Perhaps the greatest footballer ever, Ronaldo is indeed a Great Man. He has willed his teams (whether at club level or internationally) to extraordinary feats. Even in injury, his defeat on the battlefield inspired his teammates to play incredible football in the Euro 2016 final against a superior France. Ronaldo lacks mortal constraints on the football pitch. He has scored 308 goals in 289 appearances for Real Madrid (since 2009), an incredible per-game ratio (Chart 17). In the 2017-2018 season, at the age of 33, he has scored 41 goals in 38 appearances, maintaining a per-goal average of his entire career at the Spanish club. His game appearance total this season is lower than at any other time since 2009-2010, suggesting that he will come into the World Cup fresh and rested. Chart 17The Ronaldo Effect The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Football, however, is a game played on a wide pitch by 11 players. How can one man, even one as great as Ronaldo, make a difference? Gravity. Ronaldo is such a dangerous player with the ball that defensive midfielders and defenders have to constantly gravitate towards his presence on the pitch. This opens up lanes for his Portuguese teammates to counterattack. And Ronaldo's teammates are not as bad as the consensus thinks. Our quantitative model ranks Portugal seventh, just a few points below Brazil. They are also fortunate to be in a relatively easy group. While the matchup with Spain will be a tense affair, Portugal will easily dispatch Iran and Morocco. And if they come second in the group, they will face the easiest group winner of the next round, Group A's Uruguay. While we do not subscribe to the Great Man theory as a methodology, we respect it. Over the long term, and over a great number of iterations, focusing on great individuals is folly. But when faced with specific events, there is definitely value in thinking about how extraordinary human effort matters. Portugal's path to the quarter finals is easy. Once there, games will become tighter, the pressure unbearable, the stage infinitely larger. It is in these moments that legends play like Great Men, while lesser footballers play like mere mortals. Brazil - Redemption? As host of the last World Cup in 2014, Brazil didn't so much hit rock bottom as descend to the ninth circle of hell. Its merciless 7-1 obliteration by Germany in the semifinals - the sharpest rebuke to home-team self-confidence in history - would have scarred the national psyche even if the country had not proceeded into the worst economic recession in a hundred years. At that point the country's politics became a Shakespearean tragedy in which a handful of corrupt aristocrats slaughtered each other on stage, for all the world to see. Chart 18No Neymar Home The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup "Brazil is back," say the fans - just as the bulls in the financial markets. The argument goes like this: The crisis has proven that the country has resilient institutions. Inflation (read: hubris) has collapsed to the lowest point in years, while the country has tightened its belt (both financially and figuratively), in a long-overdue act of self-discipline. The only difference is that the football comeback, unlike the economic one, is built on firm foundations. The Brazilian squad has made an impeccable run since Dunga stepped down as coach in 2016. It was the first team to qualify for this year's World Cup, going undefeated for quite a stretch of time. Today, the team is coached by Tite, a former player. The least we can say is that he reinvented the way Brazil plays. Brazil's lamentable disappointment under coach Luiz Felipe Scolari ultimately comes down to the need for a new football identity and a new crop of players. That's what they have today. They are a very good team, and freshly humbled. We expect them to go far, though not all the way. It is not certain that all of Brazil's demons have been purged. By way of illustration, the leading presidential candidate is an advocate of military dictatorship, with no pro-market candidate in sight (Chart 18). France - Marchons, Marchons! In 2016, France lost to Portugal in the final of the Euro Cup on home court. This was not the first gut-wrenching loss in the final of a major tournament. In 2006, its aging 1998 generation lost a bitterly fought final against Italy. In Russia, France comes as one of the favorites. Its team is celebrating the 20-year anniversary of its epic 1998 run. Meanwhile, at home, France is marching in lockstep to President Emmanuel Macron's reforms. The economy is booming, cantankerous unions are either defeated or capitulating, and even equity market performance is leaving traditional competitors in the dust (Chart 19). Chart 19France - Marchons, Marchons! The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Our model sees France reaching the final of the World Cup. However, it also predicts that France will lose this final, a repeat of the 2016 and 2006 performances. Les Bleus will come close, but not light the victory cigar. Football in France is embedded in the cultural fabric; its team is portrayed by the media as a reflection of the contemporary socio-economic narratives. When France won in 1998, for example, the team's multicultural heritage was touted as a model of integration and as a symbol of open-minded, post-colonial France. The 2010 debacle in South Africa, on the other hand, where French players literally went on strike following an altercation with their coach, was presented as a symbol of declining French relevance and growing national impotence. Since 2014, however, positive momentum has been building both on the football pitch and in real life. A young team managed to qualify for the 2014 World Cup, losing to the eventual champion Germany in a closely contested quarter-final game. Two years later, that same team defeated World Champion Germany in a semi-final of the Euro tournament. On the political front, 39-year old Emmanuel Macron swept aside populists and left-wing firebrands, stunning the world by campaigning from a staunchly centrist perspective. The question for France in 2018 is whether it will fall short of victory, yet again. We ask the question both in terms of the performance on the football pitch and in politics. The youthful, energetic, president mirrors the youthful, energetic, squad. But a lot is at stake and second place may not be good enough for either. We remain optimistic that genuine reforms are coming to France.41 And despite our model's preference for Spain in the finals of the World Cup, France has a great chance of repeating the glory from twenty years ago. Spain - Divided It Stands, And Wins On October 1, 2017, 92% of Catalan voters decided that Catalonia should secede from Spain in a referendum deemed illegal by Madrid.42 Soon after, images of old ladies and students being beat up by riot police flooded the internet, as Mariano Rajoy's government signaled its refusal to compromise on the question of independence. Chart 20Catalan Separatism: Overstated Risk The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Intriguingly, Spain's most independent-minded regions have often produced some of its best footballers. Cesc Fàbregas, Gerard Piqué, Carles Puyol, Xavi Hernandez, and Sergio Busquets are all of Catalan descent and have dutifully defended the Spanish colors in several successful Euro and World Cup campaigns. Meanwhile, the bitter Barcelona-Real Madrid rivalry has been at the heart of Spanish football and deeply embedded in the country's political and socioeconomic history for generations. In other countries, such divisions and rivalries would let politics get in the way. In Yugoslavia, the civil war is famously said to have begun with fan rioting at a 1991 Dinamo Zagreb vs. Crvena Zvezda match. But Spain, somehow, channels the chaos into beautiful, and effective, football. Pro-independence sentiment has begun to waver in Catalonia, as BCA's Geopolitical Strategy predicted (Chart 20).43 This is bullish for the Spanish economy and assets, but also for its football team. Spain conquered the world of football at the height of its economic crisis, in 2010. Will it do so again, on the heels of its political crisis? Our model predicts yes. And we agree. It would seem that Spain's greatest attribute as a nation is to produce diamonds under pressure. III. Investment Implications: Does The World Cup Matter? The FIFA World Cup is the most widely watched sporting event in the world by far (Chart 21). Does all that passion and emotion translate into any economic or market implications? Chart 21World Cup Is The Most Important Unimportant Event In The World The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Academic literature on the topic is, at best, inconclusive. International football, as an industry, is largely inconsequential. For instance, the wealthiest football club in the world - Manchester United - generates less than 8% of the revenue of the 500th company in the Fortune 500 index. To assess whether the World Cup matters, we take two approaches. First, we explore the implications of hosting the event on the economy of the host nation. Second, we examine the implications of the World Cup on equity markets. Hosting The World Cup Despite the size and the reach of the World Cup, we find little evidence that hosting the event is beneficial to the host's economy. There appears to be little to no effect on either a short or long-term horizon. We found no "World Cup effect" on any of the economic variables one would assume may be impacted. Nonetheless, some patterns are worth highlighting (Table 22). Table 22Is It Worth It? The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup We chose to look at the behavior of each economic variable one year before and after the World Cup, with the exception of core consumer price inflation and the unemployment rate, which we observed on a three-year horizon around the event. The rationale behind this is that the labor market tends to react slowly to changes in underlying economic activity, due to factors such as the rigidity of employment contracts and stickiness of wages. The study starts with the 1990 World Cup hosted by Italy. Interestingly, some patterns are apparent. Out of all the variables we analyzed, inward FDI tends to consistently increase in the host country following the World Cup. Our suspicion is that hosting the event demonstrates, on the margin, that the country meets suitable conditions (governance, return on capital, etc.) to attract foreign capital. On the other hand, we may be capturing a trend already underway, which itself was revealed by the fact that the country was selected to host the World Cup in the first place. As Table 23 illustrates, the selection process lags the actual event, as with any major sporting event (such as the Olympics). Intriguingly, the time-lag is, on average, six years, almost precisely the length of an economic cycle. As such, the decision to award the hosting of the event to a particular country may already take into account the bullish macroeconomic cycle. By the time the event is hosted, the cycle is in full swing and may actually be peaking. Table 23Soccernomic Cycles? The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Consistently, capital expenditures also tend to increase following the Word Cup. As more foreign capital flows in the country, more investment takes place. Currencies, however, on a one-year horizon, do not react to these FDI flows since the short-term gyrations are dictated by more volatile short-term portfolio flows. As FDI flows in, the unemployment rate falls and tends to continue falling after a World Cup. However, some caution is advised in interpreting these conclusions. Macroeconomic business cycles, commodity prices, and other structural factors are still dominating factors in determining the trend and health of economies. As we indicated in our analysis of Russia in the qualitative section above, the World Cup itself can be considered a lagging indicator of the economy. This certainly appears to be the case with the three members of the BRICS who have hosted the event: South Africa, Brazil, and Russia. As such, hosting the World Cup may signal the top of the bullish cycle, as it certainly did for Brazil. This warrants a few key observations: Brazil did not see a rise in capital expenditure after hosting the World Cup in 2014. In fact, it suffered one of the deepest recessions in the last century. Consistently, unemployment did not fall as it did for other countries as commodities entered a bear market in 2015 and weighed heavily on the economy. Although South Africa did see its unemployment rate fall before the World Cup, the trend did not continue following the event. In the few years leading up to the global financial crisis, the world economy was in the midst of a period of stellar growth. Therefore, it makes sense that Germany was experiencing rising FDI, capital expenditure, and inflationary pressures prior to hosting the event in 2006. In addition, the implementation of the Hartz IV reforms in the early part of the decade put an end to the long-term structural uptrend in the unemployment rate, which has since declined by more than 7%. The year 2002 was an important one for Japan, as the turn of the millennium marked the end of the "lost decade". Subsequently, Japan experienced a falling unemployment rate and rising GDP growth. However, the end of the "lost decade" also saw the beginning of the self-feeding deflationary expectations which have anchored expected inflation levels near zero. As such, consumer prices fell before and after the event. France went through a period of intense reforms in the late 1990s. Prior and subsequent to 1998, growth rates were falling simply because 1998 recorded a higher growth rate of 3.3%, compared to 1.6% in 1997 and 3.1% in 1999. The lowering of the VAT rate, income, and corporate tax by the Chirac government led to real capital expenditure and real household consumption increases during the late 1990s. Furthermore, substantial labor market reforms helped to decrease the unemployment rate. The 1990s were the longest period of economic expansion in U.S. history. In fact, 1994 was the year where the number of jobs created was one of the largest on record, at 3.85 million. As such, real GDP growth and business investment expenditures were high, and the unemployment rate was falling. The prospects of high growth also brought in increased foreign direct investment in the same period in which the World Cup coincided. However, emerging markets were seeing an equally stellar period of growth, which was supported by high capital inflows and appreciating EM currencies, thus leading to a lower U.S. dollar. Although the Federal Reserve began hiking interest rates in 1994, the effect on the dollar was not registered until the beginning of 1995, which also marked the beginning of a dollar bull market. In the 1990s, the Italian government was heavily liberalizing the economy, leading to its eventual inclusion in the Euro Area at the end of the decade. Italian growth during the late '80s and early '90s was high enough for it to surpass Britain and France in terms of GDP growth, consumption and investment growth in 1990 were high. However, the 1990s oil price shock depressed consumer and business activity. Bottom Line: In line with the academic literature, the results of our assessment are at best inconclusive. However, the data does suggest that hosting of the World Cup coincides with some positive macroeconomic developments, particularly in terms of FDI inflows. This, however, may reflect the fact that the decision to host the event is usually made at the beginning of a bullish upcycle, which means that the actual event marks the peak, or top, of the cycle. Equity Market Implications The World Cup may be most relevant, not as a catalyst for market action, but rather as a distraction. The European Central Bank, for example, concluded in a 2012 study that trading volumes dropped considerably during match times.44 The World Cup in Russia could be particularly distracting. Because of Russia's time zone, most matches will be played between 8:00 am and 2:00 pm in New York, and 1:00 pm and 7:00 pm in London. As opposed to the economic impact, there seems to be a general consensus in the academic literature regarding the equity market implications of World Cup matches. For instance, a cross-sectional analysis of 39 countries looking at World Cup and relevant qualifying matches between 1973 and 2004 (that represents 1,162 matches!) concludes that losses have an economically and statistically significant negative effect on the losing country's stock market.45 Furthermore, the study finds that this effect is stronger in small caps, which are disproportionately held by local investors and therefore are more strongly affected by sentiment following a football match. Another study found that being short NYSE and long Treasuries during World Cups would produce a higher return from 1950 to 2007.46 This is due to the decisions taken by foreign investors in U.S. bond and equity markets. During the World Cup, these investors would withdraw capital to invest in their local markets, which would put downward pressures on NYSE prices. Table 24 presents the daily stock return deviation from what one would expect outside of World Cups for all the matches in the past seven World Cups, starting with the quarter-finals (for the period from 1990 to 2014). We report the local equity market movement of the teams playing up to three days after a match took place. Table 24Do World Cup Matches Impact The Local Stock Returns Of The Teams Playing? The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup Several observations can be made: We observe positive "abnormal" returns, i.e., deviations from trend, in the day following the matches, for any of the teams playing, and larger "abnormal" returns when it comes to the winning team. While we observe positive abnormal returns for the winners at t+1, it appears that more than 70% of the daily returns used to compute this average turn out to be negative - implying that, on average, the winners' local equity markets experience small negative returns and, in a few instances, large abnormal positive returns. In line with the literature, we observe negative abnormal returns on t+1 for the losers, regardless of how we define our benchmark. A high number of abnormal daily returns, up to three days after the match, appear to be negative (this is also the case regardless of whether we compare it to the past average, median, or non-World Cup daily returns). Bottom Line: We do not recommend that investors "play" the World Cup. Generally speaking, equity markets react, on average, positively to wins and negatively to losses. However, this is not always the case. The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup 1 There are, however, some less obvious investment implications ... but we do not encourage gambling on sporting events! 2 C. Cotta, A. M. Mora, and J. J. Merelo, "A Network Analysis of the 2010 FIFA World Cup Champion Team Play," Journal of Systems Science 26:1 (2013), 21-42. 3 For instance, please see Gregory T. Papanikos, "Economic, population and political determinants of the 2014 World Cup match results," Soccer & Society 18:4 (2017), 516-532; and Fabian Wunderlich and Daniel Memmert, "Analysis of the predictive qualities of betting odds and FIFA World Ranking: evidence from the 2006, 2010 and 2014 Football World Cups," Journal of Sports Sciences 34:24 (2016), 20176-20184. 4 Please see O'Donoghue et al, "An evaluation of quantitative and qualitative methods of predicting the 2002 FIFA World Cup. Part II: Game activity and analysis," Journal of Sports Sciences 22:6 (2004), 513-514 5 Please see, The Economist, "Why video games are so expensive to develop," September 25, 2014, available at www.economist.com. 6 The OP model makes two critical assumptions: (1) it assumes that the (χ'ι, β, γ) function has the form of a continuous probability distribution function which is the standard normal distribution function of a linear combination of our explanatory variables; (2) it assumes proportional odds between each category in the dependent variable. Assumption (2) was confirmed using the proportional odds Brant test, confirming that the ordered probit is the best suited model for our purpose. Please see Alexander, Carol, Market Risk Analysis: Practical Financial Econometrics (John Wiley & Sons) 2008, 426 pages. 7 Please see EViews 8.1 User's Guide II, pp.259-284. 8 Please see J. Bloomfield, R. Polman, and P. O'Donoghue, "Physical Demands of Different Positions in FA Premier League Soccer," Journal of Sports Science & Medicine 6:1 (2007), 63-70. 9 Please see Seife Dendir, "When do soccer players peak? A note," Journal of Sports Analytics 2 (2016), 89-105. 10 Think 22-year old Mario Götze's stunning game-winner four years ago. 11 Please see H. Sarmento et al, "Match analysis in football: a systematic review," Journal of Sports Sciences 32:20 (2014), 1831-1843. 12 In order to favor our core model (M1), which uses the team average player rating variable, we assigned a weight α = 0.66. 13 We are sure that this is a pure coincidence. Being paired with the host Russia had nothing to do with this. Nothing. 14 A "Novichok bonus" perhaps? 15 Remember that the marginal effect represents the impact of a 1-unit change in the rating variable on the probability of winning. This is why we need to be careful when comparing both stages' marginal effect. A 1-unit change in the rating variable is less frequent, but extremely important in the knockout stage, hence the higher coefficient. 16 In 2006, Italy had 10 players from either Juventus or AC Milan; in 2010, Spain had 12 players from either F.C. Barcelona or Real Madrid; and in 2014, Germany had 11 players from either Bayern Munich or Borussia Dortmund. 17 Please see M. Clemente et al, "Midfielder as the prominent participant in the building attack: A network analysis of national teams in FIFA World Cup 2014," International Journal of Performance Analysis in Sport 15:2 (2015), 704-722. 18 For instance, please see F. M. Clemente et al, "Using Network Metrics in Soccer: A Macro-Analysis," Journal of Human Kinetics 45 (2015), 123-134. 19 In order to favor our core model (M1), which uses the team average player rating variable, we assigned a weight α = 0.66. 20 This would not be the first time that the third place game steals the spotlight. Going back to 1978, the third place game has outscored the final by a considerable margin. Teams usually enter the game with no pressure and therefore commit to a flowing, attacking style of play. Some of the most exciting games in World Cup history were played for third place: think Germany's 3-2 win over Uruguay in 2010, or Turkey's thrilling 3-2 win against South Korea. 21 As well as ... yes, atrocious refereeing. 22 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available from gps.bcaresearch.com. 23 Please see BCA Frontier Market Strategy Special Report, "Egypt: Giving Benefit Of Doubt," dated February 6, 2018, available at fms.bcaresearch.com. 24 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Ranking EM Countries Based On Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 25 The Netherlands has a population 50 times greater than Iceland and a GDP 35 times greater. 26 Portugal has a population 30 times greater than Iceland and a GDP 10 times greater. 27 England has a population 200 times greater than Iceland and a GDP 110 times greater. 28 Just in case any of our Icelandic clients take offense to our premise, we want to point out that the country has competed in a number of Games of the Small States of Europe. Participants at this biannual event includes such sporting powerhouses as Andorra, Cyprus, Liechtenstein, Luxembourg, Malta, Monaco, Montenegro, and San Marino. Iceland actually trails Cyprus in the total tally of medals collected since 1985. 29 Please see Frode Telseth and Vidar Halldorsson, "The success of Nordic football: the cases of the national men's teams of Norway in the 1990s and Iceland in the 2010s," Sport In Society, November 1, 2017. 30 Please see Taleb, Nassim, Fooled By Randomness (New York: Random House), 316 pages. 31 Unless you are a U.S. soccer fan. The U.S. has a population 1,000 times greater than Iceland and a GDP 800 times greater. Please light yourself on fire responsibly. 32 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 33 Robert Prosinecki would have been 25-years old, and at the time one of the highest paid players in the world. In 1998, due to a number of injuries, he was playing for Croatia and largely an afterthought in the team. Davor Šuker and Zvonimir Boban would have also been 25 in 1994 and both at the peak of their careers. 34 Vladimir Jugovic and Sinisa Mihajlovic, were both in their prime in 1994, and both were stars in Italy. 35 The eventual Real Madrid legend Predrag Mijatovic would have been in-prime 25 years of age in 1994 (and unlikely to make the starting 11 of the combined Yugoslav team!), while, by then, the three-time Champions League winner Dejan Savicevic would have already been A.C. Milan's best player. 36 Shout out to Darko Pancev, the 1991 European Golden Boot award winner! 37 For example, for the duration of the 2014 Winter Olympics, only vehicles registered in Sochi, or those with special permission, were allowed through security checkpoints set a 100 kilometers outside the city. 38 Please see BCA Global Investment Strategy Weekly Report, "The End Of Europe's Welfare State," dated June 26, 2015, available at gis.bcaresearch.com. 39 Except in the U.S., which is maybe why it continues to underperform in global competitions. 40 Contrary to most leagues, the Premier League does not have a cap on the number of foreign players a team can have. It just requires eight players to be home grown (three years with an English team before the age of 21). 41 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 42 The turnout of the referendum was a woeful 43%, however. 43 Please see BCA Geopolitical Strategy Weekly Report, "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 44 Ehrmann, M. and Jansen D., "The Pitch Rather Than The Pit: Investor Inattention During FIFA World Cup Matches," European Central Bank, Working Paper 1424, February 2012. 45 Please see Edmans, A., Garcia, D., & Norli, O. "Sports Sentiment and Stock Returns," The Journal of Finance 62:4 (2007), 1967-1998. 46 G. Kaplanski, and H. Levy, "Exploitable Predictable Irrationality: the FIFA World Cup effect on the U.S. Stock Market," Journal of Financial and Quantitative Analysis 45:2 (2010), 535-553. 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M. Mora, and J. J. Merelo (2013) "A Network Analysis of the 2010 FIFA World Cup Champion Team Play," Journal of Systems Science 26(1): 21-42. Seife Dendir (2016), "When do soccer players peak? A note," Journal of Sports Analytics, 2: 89-105. A. Edmans, D. Garcia, and O. Norli (2007), "Sports Sentiment and Stock Returns," The Journal of Finance, 62 (4), 1967-1998. J. Geyer-Klingeberg, M. Hang, M. Walter, and A. Rathgeber (2018), "Do stock markets react to soccer games? A meta-regression analysis," Applied Economics, 50:19, 2171-2189. G. Kaplanski, and H. Levy (2010), "Exploitable Predictable Irrationality: the FIFA World Cup effect on the U.S. Stock Market," Journal of Financial and Quantitative Analysis, 45(2): 535-553. Jorge Knijnik (2014), "Playing for freedom: Sócrates, futebol-arte and democratic struggle in Brazil," Soccer & Society, 15:5, 635-654. 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Halldorsson (2017), "The success culture of Nordic football: the cases of the national men's teams of Norway in the 1990s and Iceland in the 2010s," Sport in Society. Dag Tuastad (2014), "From football riot to revolution. The political role of football in the Arab world," Soccer & Society, 15:3, 376-388. Scott Waalkes (2017), "Does soccer explain the world or does the world explain soccer?" Soccer and globalization, Soccer & Society, 18:2-3, 166-180. D. Wong, and S. Chadwick (2017), "Risk and (in)security of FIFA football World Cups - outlook for Russia 2018," Sport in Society, 20:5-6, 583-598. F. Wunderlich, and D. Memmert (2016), "Analysis of the predictive qualities of betting odds and FIFA World Ranking: evidence from the 2006, 2010 and 2014 Football World Cups," Journal of Sports Sciences, 34:24, 20176-20184. D. Zec, and M. Paunovic (2015), "Football's positive influence on integration in diverse societies: the case study of Yugoslavia," Soccer & Society, 16:2-3, 232-244.

Highlights Global Yields: Relative growth and inflation trends continue to favor the U.S., with divergences widening as non-U.S. is downshifting. This means that the cyclical peak in spreads between U.S. Treasuries and other developed market government bonds has not been reached yet, and the latest bout of U.S. dollar strength can continue. Stay underweight U.S. Treasuries in global government bond portfolios. Italy: Concerns over the future policies of the new Five-Star/League populist coalition government in Italy have triggered a selloff in Italian financial markets. While investors are right to be worried about the potential for greater fiscal stimulus and move vocal euroskepticism from those in charge in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns. Downgrade Italy to underweight (2 of 5) in global government bond portfolios. Feature After knocking on the door of the 3% threshold several times this year, the 10-year U.S. Treasury yield finally blew through that level last week. The ease with which this move occurred was a bit surprising, given that bond investor sentiment has stayed consistently bearish and Treasury market positioning remains extremely short. This raises the odds of a potential pullback in yields if the U.S. economy or inflation were to lose upside momentum. The only problem for the Treasury market is that neither of those trends is occurring at the moment. Chart of the WeekTreasuries Are Losing##BR##For The Right Reasons Treasuries Are Losing For The Right Reasons Treasuries Are Losing For The Right Reasons U.S. real GDP expanded at a 2.3% annualized rate in the first quarter of 2018, and the latest real-time GDP estimates for the second quarter from the Atlanta Fed (+4.1%) and New York Fed (+3.0%) are calling for an acceleration. The leading economic indicators produced by both the OECD and the Conference Board continue to climb higher, in stark contrast to the lost momentum in hard data and lead indicators in other major regions like Europe and Japan (Chart of the Week). Similar divergences are occurring in the inflation data, where core CPI inflation is accelerating in the U.S. and languishing elsewhere. The ability of U.S. Treasury yields to ignore the negative international headlines coming from typical trouble spots like Turkey, Argentina, Italy, Iran and North Korea is impressive. Clearly, none of these developments are big enough (yet!) to have any negative impact on U.S. growth expectations and, in turn, Fed rate hike expectations. At the same time, Fed officials continue to signal that another two or three rate increases are still likely over the remainder of the year. Add in the steady climb in inflation expectations, supported by oil prices reaching multi-year highs, and it is no surprise that those aggressive Treasury short positions have been on the right side of the market. If we were to apply a weather analogy to the global economy, conditions appear "partly sunny" if looking at the U.S, but "mostly cloudy" when looking elsewhere. This has major implications for the future path of U.S. Treasury yields versus other government bond markets, and for the U.S. dollar as well. Expect U.S. Bond Relative Underperformance To Continue From a more global perspective, the ability of non-U.S. bond yields to rise has become more limited. The overall OECD leading economic indicator - which is correlated to real global bond yields - looks to be rolling over, and our diffusion index of individual country indicators shows that this trend is broad-based (Chart 2). Within the major developed economies, only the U.S. stands out as having a rising leading economic indicator (although the Canadian index is holding up at a high level). The most depressed readings come from the three markets we are overweight in our model bond portfolio - the U.K., Japan and Australia (Chart 3). These growth divergences are not only visible in "soft" economic data like leading indicators and purchasing manager indices. U.S. retail sales showed a surprising burst of strength in April, and the release of that data last week was the trigger for pushing the 10-year Treasury yield above 3%. Meanwhile, readings on real GDP growth in the first quarter for the euro area and Japan were quite weak compared to the acceleration seen throughout 2017. In the case of Japan, GDP actually contracted at a 0.6% annualized rate in Q1, ending a run of eight consecutive quarters of positive growth which was the longest such streak in 28 years (Chart 4). Chart 2A Stagflationary Tug-Of-War##BR##On Global Yields A Stagflationary Tug-Of-War On Global Yields A Stagflationary Tug-Of-War On Global Yields Chart 3U.S. Growth##BR##Stands Out U.S. Growth Stands Out U.S. Growth Stands Out Chart 4Is China To Blame For##BR##Slowing Non-U.S. Growth? Is China To Blame For Slowing Non-U.S. Growth? Is China To Blame For Slowing Non-U.S. Growth? At the same time, China's domestic economy has seen some slowing of growth, as well, as evidenced by the rapid deceleration of import growth (bottom panel). For the economies in Europe and Japan where growth is still heavily geared towards exports, and where domestic demand still struggles to gain sustainable upward momentum in the absence of an export/production cycle, a slowing China poses a big problem - one that is less of an issue for the more domestically-focused U.S. economy. The divergence of growth and inflation accelerating in the U.S. but potentially peaking out elsewhere, can be seen in the widening of government bond yield spreads between the U.S. and its developed market peers. In Table 1, we show the change in the bond yield spread between 10-year U.S. Treasuries and similar maturity government debt from the U.K., Germany, Japan, Canada and Australia since the last major trough in global yields in September 2017. The spread changes are broken down into movements in inflation expectations and real yields to see which was more influential. For example, of the 75bps widening in the 10-year U.S. Treasury-German Bund spread, 55bps has been due to widening real yield differentials and only 20bps has come from higher inflation expectations in the U.S. Table 1Cross-Country Yield Spread Changes (in bps) Since The September 2017 Low In U.S. Treasury Yields Is It Partly Sunny Or Mostly Cloudy? Is It Partly Sunny Or Mostly Cloudy? These changes show that the underperformance of U.S. Treasuries (i.e. spread widening) has come mostly though higher real yields in the U.S. Inflation expectations are widening in the U.S., but are also moving higher in all other countries except the U.K. So the relative change in inflation expectations between the U.S. and the other countries has been more modest than the absolute change in U.S. TIPS breakevens (Chart 5). The fact that the real yield differentials are moving increasingly in favor of the U.S. has implications for the U.S. dollar. The greenback has finally begun to appreciate after the weakness seen in 2017, with potentially a lot more room to run judging by the levels implied by those wide real yield gaps. This is most evident for the euro, yen and British pound (Chart 6). Chart 5Higher Inflation Expectations##BR##& Yields In The U.S. Higher Inflation Expectations & Yields In The U.S. Higher Inflation Expectations & Yields In The U.S. Chart 6USD Finally Responding To Wide##BR##Real Yield Differentials USD Finally Responding To Wide Real Yield Differentials USD Finally Responding To Wide Real Yield Differentials The path of the U.S. dollar is the key to how this U.S./non-U.S. growth divergence story will end. If the dollar continues to strengthen as the Fed lifts rates in the coming months, then monetary conditions in the U.S. run the risk of moving into restrictive territory. This could spur a bout of renewed U.S. market turbulence not unlike that seen in 2015 and 2016 when the Fed was trapped in what we described at the time as a "policy loop", where a higher dollar and rising market volatility (especially in the emerging markets) prompted the Fed to delay planned rate hikes. The circumstances are different now compared to three years ago. The dollar is only mildly appreciating from the depressed levels of 2017, U.S. core inflation is approaching the Fed's 2% target, and the U.S. economy is at full employment with fiscal stimulus on the way. In other words, the hurdle for the Fed to alter its current rate hike plans is much higher than it was in 2015/16 when the U.S. economy and inflation were in more fragile states. For now, we continue to see relative growth and inflation trends pushing in a direction for continued U.S. government bond underperformance over the balance of 2018. One-sided bearish positioning may create a backdrop where Treasury yields could fall for a brief period, but the true cyclical peak in yields - somewhere in the 3.25-3.5% range - and in U.S./non-U.S. yield spreads has not been reached yet. Bottom Line: Relative growth and inflation trends continue to favor the U.S., with divergences widening as non-U.S. is downshifting. This means that the cyclical peak in spreads between U.S. Treasuries and other developed market government bonds has not been reached yet, and the latest bout of U.S. dollar strength can continue. Stay underweight U.S. Treasuries in global government bond portfolios. Italy: Worry More About Slowing Growth Than Politics Italian political risk returned to European financial markets last week after details of the policy program for the new Five-Star Movement/League coalition government were leaked to the press. Some of the more alarming proposals included: Having the European Central Bank (ECB) "freeze" or "cancel" the €250bn in Italian government debt it holds via its asset purchase program. Revising the rules of the European Union (EU) Growth and Stability Pact, specifically its fiscal rules on debt and deficits, while also asking for Europe to, more generally, return to a "pre-Maastricht" (pre-euro?) position. These headlines were interpreted as a sign that the populists taking over Italy were looking for a way to loosen fiscal policy in excess of EU rules, if not abandon the euro currency entirely. This would be a realization of the outcome from the March election that investors feared the most. Markets responded as expected, with Italian government bond yields soaring across the entire yield curve and Italian equities and the euro selling off (Chart 7). We last discussed Italy back in February in a Special Report co-written with our colleagues at BCA Geopolitical Strategy.1 We concluded that, even though euroskepticism would continue to have appeal in Italy because support for the common currency is much weaker than in the rest of the euro area (Chart 8), none of the likely coalition partners in a new government would make noise about potentially bringing back the lira with the economy in a cyclical expansion. All of the likely winning coalitions would seek to ease Italian fiscal policy, however, which would bring back investor worries about Italian debt sustainability. Chart 7The Return Of##BR##The Italy Risk Premium The Return Of The Italy Risk Premium The Return Of The Italy Risk Premium Chart 8The Euro Is Still Less Popular##BR##In Italy Than Elsewhere The Euro Is Still Less Popular In Italy Than Elsewhere The Euro Is Still Less Popular In Italy Than Elsewhere The first part of our conclusion went in a fashion that we did not expect, with the anti-establishment Five-Star party joining forces with the far-right League in a populist coalition that could embrace euroskepticism more emphatically. The second part of that conclusion does appear to be panning out, with the new government already looking to cut taxes and ramp up fiscal spending. These outcomes would be enough for investors to begin pricing in a higher fiscal risk premium in Italian assets, thus justifying the market moves seen last week. Yet there was one other conclusion from our report that is more relevant now for fixed income investors. Italian government bonds would not begin to underperform until there were signs that Italy's economy was slowing - which is what appears to be happening now. Like the rest of the euro area, Italy saw a deceleration of economic growth in the first quarter of the year. The most cyclical components of the Italian economy, manufacturing and exports, have both shown a considerable deceleration. Exports to non-EU countries, in particular, have noticeably slowed (Chart 9), which is likely yet another sign of how slowing Chinese growth is spilling over into much of the global economy through trade channels. Domestic demand has seen some cyclical strength on the back of the surge in exports, production and employment seen in 2016/17. However, the risk now is that slowing exports feed back into slowing production and weaker hiring activity. Any sign of a slowdown would only embolden the new coalition government to aim for easier fiscal policy. That would be a logical response by any government, particularly with current budget forecasts calling for tightening fiscal policy over the next few years. The latest set of debt and deficit projections from the IMF show that Italy is expected to have a balanced budget by 2021 (Chart 10). This would imply that the primary budget balance (i.e. net of interest payments) would rise to as high as 3.6% of GDP - an enormously restrictive policy stance that no advanced economy currently runs. Chart 9Italian Cyclical Momentum##BR##Has Peaked Italian Cyclical Momentum Has Peaked Italian Cyclical Momentum Has Peaked Chart 10This Rosy Trajectory For##BR##Italian Debt Will Not Happen This Rosy Trajectory For Italian Debt Will Not Happen This Rosy Trajectory For Italian Debt Will Not Happen That degree of fiscal tightening also makes the debt dynamics of Italy look much more sustainable, with debt/GDP projected to fall by ten percentage points by 2021 according to the IMF (bottom panel). Given the leanings of the new government, and with the economy starting to lose some momentum, there is zero chance that the IMF deficit and debt projections will come to fruition. In fact, the opposite is likely to happen under the new government, with the fiscal deficit likely to widen and debt/GDP likely to increase. While a return to the "bad old" economic policies of Italy might harken back to the days of the 2011 European debt crisis, there are two major differences between then and now: Italy's borrowing costs are far lower, thanks to the hyper-easy monetary policies of the ECB (both zero/negative interest rates and outright bond purchases). The average debt on newly-issued Italian government debt has plunged from the 6-7% levels around the time of the debt crisis to less than 1% over the past three years, according to the Bank of Italy (Chart 11). This has helped substantially reduce the amount of net interest payments made by the Italian government - by one full percentage point of GDP, according to the IMF. Less Italian debt is owned by non-Italian residents than during the crisis. According to data from the Bruegel think tank in Brussels, the percentage of Italian sovereign debt held by non-Italian residents is now 36%, compared to 50% during the years before the crisis (Chart 12). As that crisis unfolded, those investors rapidly dumped their Italian bonds, cutting their ownership share by ten percentage points in less than one year. Domestic Italian banks were forced to pick up the slack, which increased the already significant fiscal exposure of the Italian banking system. Now, the ownership mix is much more balanced, including the 20% of Italian bonds owned by the ECB. This means that, today, 64% of Italy's debt is owned by those with a vested interest in Italian stability, rather than fickle foreign investors who would be much more willing to dump their bonds when the Italian news turns less favorable. Chart 11The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today Chart 12A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 This is not to say that another Italian debt crisis could not happen, especially if the Five-Star/League coalition were to more seriously discuss a potential exit from the euro. The only difference now is that Italy's debt sustainability issues are not as acute as in 2011 because of the low borrowing costs and more diverse ownership of Italian debt. Chart 13Downgrade Italian Debt To Underweight Downgrade Italian Debt To Underweight Downgrade Italian Debt To Underweight From a bond strategy perspective, however, we are more focused on the growth dynamics in Italy than the current political noise. As we also concluded in our February Special Report, the time to downgrade Italian debt was when the economy was clearly about to slow, as heralded by a decline in the OECD's leading economic indicator for Italy. That series has been highly correlated to the relative performance of Italian government debt (Chart 13) and, therefore, is a useful indicator to follow to determine Italian bond strategy. With the leading indicator now falling for four consecutive months, and with hard Italian data also starting to slow, a period of Italian bond underperformance has likely just begun - an outcome that can only be made worse by the new euroskeptic and free spending Italian government. Thus, we are downgrading Italy in our country rankings this week to underweight (2 out of 5), and cutting our recommended allocations to Italian debt in our model bond portfolio to ½ index weight. We place the proceeds of that reduction into German bonds across the yield curve. Bottom Line: Concerns over the future policies of the new Five-Star/League populist coalition government in Italy have triggered a selloff in Italian financial markets. While investors are right to be worried about the potential for greater fiscal stimulus and move vocal euroskepticism from those in charge in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns. Downgrade Italy to underweight (2 of 5) in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Geopolitical Strategy Special Report, "Italy: Growth Cures All Ills ... For Now", dated February 21st 2018, available at gfis.bcaresearch.com and gps.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Is It Partly Sunny Or Mostly Cloudy? Is It Partly Sunny Or Mostly Cloudy? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation is either too high or too low, and the current account position is either too large or too small. The global economy has made significant progress in moving towards both internal and external balance over the past few years, but shortfalls remain. A number of large economies, including Japan, China, and Italy, continue to need stimulative fiscal policy to prop up domestic demand. In Italy's case, investor unease about the country's fiscal outlook is likely to raise borrowing costs for the government, curb capital inflows into the euro area, and push the ECB in a more dovish direction. All this will weigh on the euro. The U.S. should be tightening fiscal policy at this stage in the cycle. Instead, President Trump has pushed through significant fiscal easing. This is the main reason the 10-year Treasury yield hit a seven-year high this week. An overheated U.S. economy will pave the way for further Fed hikes, which will likely result in a stronger dollar. Rising U.S. rates and a strengthening dollar will hurt emerging markets. Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Feature The Dismal Science, Illustrated Last week's report discussed the market consequences of the tug-of-war that policymakers often face in trying to achieve a variety of economic objectives with a limited set of policy instruments.1 In passing, we mentioned that some of these trade-offs can be depicted using the so-called Swan Diagram, named after Australian economist Trevor Swan. This week's report delves further into this topic by estimating where various economies find themselves inside the Swan Diagram, and what this may mean for their currency, equity, and bond markets. True to the reputation of economics as the dismal science, the Swan Diagram depicts four "zones of economic unhappiness" (Chart 1). Each zone represents a different way in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). This amounts to saying that an economy can suffer from one of the following: 1) high unemployment and an excessively large current account deficit; 2) high inflation and an excessively large current account surplus; 3) high unemployment and an excessively large current account surplus; and 4) high inflation and an excessively large current account deficit. Box 1 describes the logic behind the diagram. Chart 1Four Zones Of Unhappiness Swan Songs Swan Songs BOX 1 The Logic Behind The Swan Diagram As noted in the main text, the Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation are either too high or too low, and the current account balance is either too large or too small. A rightward movement along the horizontal axis can be construed as an easing of fiscal policy, whereas an upward movement along the vertical axis can be thought of as an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule, which corresponds to the ideal state where the economy is at full employment and inflation is stable, is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order to keep the economy from overheating. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. A depreciation of the currency via an easing in monetary policy is necessary to bring imports back down. Any point to the right of the internal balance schedule represents too much inflation; any point to the left represents too much unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Note that according to the Swan Diagram, an economy that suffers from high unemployment may still need a weaker currency even if it already has a current account surplus. Intuitively, this is because a depressed economy suppresses imports, leading to a "stronger" current account balance than would otherwise be the case. We use two variables to estimate the degree to which an economy has diverged from internal balance: core inflation and the output gap (Chart 2). If the output gap is negative, the economy is producing less output than it is capable of. If the output gap is positive, the economy is operating beyond full capacity. All things equal, high core inflation and a large and positive output gap is symptomatic of an economy that is showing signs of overheating. Chart 2The Two Dimensions Of Internal Balance Swan Songs Swan Songs When it comes to estimating the extent to which an economy is deviating from external balance, we include both the current account position and the net international investment position (NIIP) in our calculations (Chart 3). The NIIP is the difference between an economy's external assets and its liabilities. If one were to sum all current account balances into the distant past and adjust for valuation effects, one would end up with the net international investment position. If a country has a positive NIIP, it can run a current account deficit over time by running down its accumulated foreign wealth.2 Chart 3The Two Dimensions Of External Balance Swan Songs Swan Songs Policy And Market Outcomes Within The Swan Diagram Chart 4 shows our estimates of where the main developed and emerging markets fall into the Swan Diagram. The top right quadrant depicts economies that need to tighten both monetary and fiscal policy. The bottom left quadrant depicts economies that need to ease both monetary and fiscal policy. The other two quadrants denote cases where either tighter fiscal/looser monetary policy or looser fiscal/tighter monetary policy are appropriate. In order to gauge progress over time, we attach an arrow to each data point. The base of the arrow shows where the economy was five years ago and the tip shows where it is today. Chart 4Policy Prescription Arising From The Swan Diagram Swan Songs Swan Songs From a market perspective, an economy's currency is likely to weaken if it finds itself in one of the two quadrants requiring easier monetary policy. Among developed economies, the best combination for equities in local-currency terms is usually an easier monetary policy and a looser fiscal policy. That is also the configuration that results in the sharpest steepening of the yield curve. Conversely, the worst outcome for developed market stocks in local-currency terms is tighter monetary policy coupled with fiscal austerity. That is also the policy package that is most likely to result in a flatter yield curve. In dollar terms, a stronger local currency will typically boost returns. This is particularly the case in emerging markets, where stock markets are likely to suffer in situations where the home currency is under pressure. A few observations come to mind: The global economy has made significant progress in restoring internal balance over the past five years. That said, negative output gaps remain in nearly half of the countries in our sample. And even in several cases where output gaps have disappeared, a shortfall in inflation suggests the presence of latent slack that official estimates of excess capacity may be missing. External imbalances have also declined over time. Since earth does not trade with Mars, the global current account balance and net international investment position must always be equal to zero. Nevertheless, the absolute value of current account balances, expressed as a share of global GDP, has fallen by half since 2006 (Chart 5). Chart 5Shrinking Global Imbalances Swan Songs Swan Songs The decline in China's current account balance has played a key role in facilitating the rebalancing of demand across the global economy. The current account showed a deficit in Q1 for the first time in 17 years. While several technical factors exacerbated the decline, the current account will probably register a surplus of only 1% of GDP this year, down from a peak of nearly 10% of GDP in 2007. The Chinese economy also appears to be close to internal balance. However, maintaining full employment has come at the cost of rapid credit growth and a massive quasi-public sector deficit, which the IMF estimates currently stands at over 12% of GDP (Chart 6). Thus, one could argue that a somewhat weaker currency and less credit expansion would be in China's best interest. Similar to China, Japan has been able to reach internal balance only through lax fiscal policy (Chart 7). The lesson here is that economies such as China and Japan which have a surfeit of savings - partly reflecting a very low neutral real rate of interest - would probably be better off with cheaper currencies rather than having to rely on artificial means of propping up demand. Chart 6China's 'Secret' Budget Deficit Swan Songs Swan Songs Chart 7The Cost Of Propping Up Demand Swan Songs Swan Songs Germany has overtaken China as the biggest contributor to current account surpluses in the world. Germany's current account surplus now stands at over 8% of GDP, up from a small deficit in 1999, when the euro came into inception. In contrast to China and Japan, Germany is running a fiscal surplus. Solely from its perspective, Germany would benefit from more fiscal stimulus and a stronger euro. The problem, of course, is that a stronger euro would not be in the best interest of most other euro area economies. While external imbalances within the euro area have decreased markedly over the past decade, they have not gone away (Chart 8). Investors also remain wary of fiscal easing in Southern Europe. This week's spike in Italian bond yields - fueled by speculation that a Five-Star/League government will abandon plans for fiscal consolidation - is a timely reminder that the bond vigilantes are far from dead (Chart 9). The Italian government's borrowing costs are likely to rise over the coming months, which will curb capital inflows into the euro area and push the ECB in a more dovish direction. All this will weigh on the common currency. Chart 8The Euro Club: Imbalances Have Been Decreasing The Euro Club: Imbalances Have Been Decreasing The Euro Club: Imbalances Have Been Decreasing Chart 9Uh Oh Spaghettio! Uh Oh Spaghettio! Uh Oh Spaghettio! The U.S. is the opposite of Germany. Unlike Germany, it has a large fiscal deficit and a current account deficit. The Swan Diagram says that the U.S. would benefit from tighter fiscal policy and a weaker dollar. President Trump and the Republicans in Congress have other plans, however. They have pushed through large tax cuts and significant spending increases (Chart 10). This will likely prompt the Fed to raise rates more aggressively than the market is currently discounting, leading to a stronger dollar. Chart 10The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Rising U.S. rates and a strengthening dollar will hurt emerging markets, particularly those with current account deficits and negative net international investment positions. High levels of external debt could exacerbate any problems (Chart 11). On that basis, Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Chart 11External Debt And Debt Servicing Across EM Swan Songs Swan Songs Investment Conclusions Chart 12The U.S. Economy Is Doing ##br##Better Than Its Peers The U.S. Economy Is Doing Better Than Its Peers The U.S. Economy Is Doing Better Than Its Peers The global economy is approaching internal balance, but this may produce some unpleasant side effects. Productivity growth is anaemic and the retirement of baby boomers from the workforce will reduce the pace of labor force growth. In such a setting, potential GDP growth in many countries is likely to remain subpar. If demand growth continues to outstrip supply growth, inflation will rise. Heightened stock market volatility this year has partly been driven by the realization among investors that the Goldilocks environment of above-trend growth and low inflation may not last as long as they had hoped. The U.S. economy has now moved beyond full employment, and bountiful fiscal stimulus could lead to further overheating. This is the main reason the 10-year Treasury yield reached a seven-year high this week. Continued above-trend growth is likely to prompt the Fed to raise rates more than the market expects, which should result in a stronger dollar. The fact that the U.S. economy is outperforming the rest of the world based on economic surprise indices and our leading economic indicators could give the dollar a further lift (Chart 12). A resurgent dollar will help boost competitiveness in developed economies such as Japan and Europe. Emerging markets will also benefit in the long run from cheaper currencies, but if the adjustment happens rapidly, as is often the case, this could exact a short-term toll. For the time being, investors should overweight developed over emerging markets in equity portfolios. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 2 To keep things simple, we assume that a country's Net International Investment Position (NIIP) shrinks to zero over 50 years. Thus, if a country has a positive NIIP of 50% of GDP, we assume that it should target a current account deficit of 1% of GDP; whereas if it has a negative NIIP of 50% of GDP, it should target a current account surplus of 1% of GDP. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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

Highlights Global Volatility Vs. Inflation: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Feature Chart of the WeekThe Comeback Kids The Comeback Kids The Comeback Kids After a lengthy period of convalescence following the February VIX spike, some calm has been restored to financial markets. Global equities are staging a recovery from the correction seen earlier this year, with major indices like the U.S. S&P 500 and the MSCI All-Country World Index breaking out above key technical levels last week (Chart of the Week). Volatility in developed economy credit has also died down a bit, although corporate bond spreads still remain above the lows of the year in most countries. The resiliency of risk assets is even more impressive when viewed against the continuing climb of oil prices, fueled further by President Trump's announcement last week that the U.S. was pulling out of the Iran nuclear deal. With the benchmark Brent oil price now within hailing distance of $80/bbl, developed market government bond yields remain under upward pressure through higher inflation expectations (bottom panel). Yet as been the case for the past several months, the greatest upward pressure on global bond yields has been seen in the U.S., where the benchmark 10-year Treasury yield is once again knocking on the door of the 3% level. Global growth has lost some momentum in the first few months of the year, but not by enough to cause any loosening of capacity pressures through rising unemployment rates. Until the latter occurs, central banks will remain focused on the slow-but-steady rise in inflation pressures. This will limit any material decline in government bond yields as markets must price in both higher inflation expectations and some degree of interest rate increases. Not every central bank will deliver on what is currently discounted in terms of rate hikes, however, which continues to create more attractive relative fixed income country allocation opportunities now than have been seen in the past few years. We continue to recommend an overall below-benchmark portfolio duration stance, favoring corporate credit over sovereign debt. Within dedicated government bond portfolios, we favor underweight exposures in the U.S., Canada and core Europe while overweighting Australia, the U.K. and Japan. Lower U.S. Volatility Does Not Necessarily Mean Greater Global Stability The surge in market volatility earlier in the year began in the U.S. following the "wage inflation scare" in early February. The idea that dormant U.S. wage inflation could finally have awakened shook markets out of their slumber, driving the VIX index sharply higher (with some nudging from volatility-linked ETFs and other leveraged vehicles). Yet other markets saw a surge in vol, like currencies and the MOVE index of U.S. Treasury option prices (Chart 2). The latter development underscores one of our key investment themes for 2018, which is that the low market volatility environment will end through higher bond volatility.1 Faster U.S. inflation was expected to be trigger for that pickup in U.S. bond volatility, which would lead to a more aggressive path of Fed rate hikes and more uncertainty about the U.S. growth outlook beyond 2018. We did not expect that inflation-driven surge in bond volatility until the latter half of this year, but what happened in early February showed how the investing backdrop can turn ugly once inflation makes a comeback. Looking ahead, the subdued readings from the Chicago Board Options Exchange VVIX index, which measures the implied volatility of VIX options, indicate that the VIX can continue to head lower in the coming weeks (top panel). Combined with some easing of pressures seen in funding markets through the wider LIBOR-OIS spread (bottom panel), the backdrop is in place for continued recovery in U.S. equity and credit markets. It's a different story in non-U.S. markets, however. Softening global growth in the first quarter of the year, combined with steady increases in U.S. interest rate hike expectations, has resulted in the U.S. dollar staging a recovery after the pounding it took in 2017 (Chart 3). That combination of higher U.S. bond yields, a stronger dollar and weaker growth is a classic toxic brew for Emerging Market (EM) assets, which have been underperforming under the weight of investor outflows. None of those factors looks set to reverse in the near term, and we continue to recommend underweight allocations to EM fixed income (especially corporate debt). Chart 2The VIX Storm Has Blown Over The VIX Storm Has Blown Over The VIX Storm Has Blown Over Chart 3Not All Risk Assets Have Been Stabilizing Not All Risk Assets Have Been Stabilizing Not All Risk Assets Have Been Stabilizing Within the major developed markets, the most important factor at the moment is diverging inflation trends rather than growth. While U.S. inflation continues to drift higher, inflation in the euro area and U.K. has lost momentum (Chart 4). Surprisingly, Japanese inflation has finally started to show a bit of life - even after a period of yen appreciation - but perhaps that is because domestic inflation is finally awakening with annual wage growth hitting a 15-year high of 2.1% in March (3rd panel). Core inflation remains well below the Bank of Japan's 2% target, however. Meanwhile, last week's release of the April U.S. CPI data showed that inflation was still moving higher despite the outcome being slightly worse than expected (Chart 5). Importantly, some large and important elements of the CPI, like Shelter costs (33% of the total CPI index) and core goods prices (20%), saw a pickup in year-over-year inflation in line with our models and leading indicators. Given that U.S. real GDP growth leads core CPI inflation by about five quarters (top panel), this suggests that all of our inflation indicators are pointing to additional increases in U.S. inflation in the next 3-6 months. Chart 4Diverging Trends In Global Inflation Diverging Trends In Global Inflation Diverging Trends In Global Inflation Chart 5U.S. Inflation Momentum Still Trending Higher U.S. Inflation Momentum Still Trending Higher U.S. Inflation Momentum Still Trending Higher With U.S. inflation heading higher and non-U.S. developed market inflation languishing, there is still much more upside risk for U.S. Treasury yields than for the other government bond markets, mostly via higher U.S. inflation expectations. Stay underweight the U.S. within global hedged bond portfolios and remain long U.S. inflation protection by favoring TIPS over nominal Treasuries. Bottom Line: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: Outperformance To Continue Under New RBNZ Leadership Chart 6Good Timing On Our Bullish NZ Call Good Timing On Our Bullish NZ Call Good Timing On Our Bullish NZ Call One of the more successful trade recommendations we have made over the past year was to go long New Zealand government bonds versus U.S. Treasuries and German government debt in May 2017.2 Our call was predicated on a simple premise. The Reserve Bank of New Zealand (RBNZ) would maintain a dovish policy bias far longer than markets were expecting because of subdued inflation, at a time when the Fed would be hiking interest rates and the markets would begin to discount an end to the ECB's asset purchase program. Since we initiated that recommendation one year ago, headline New Zealand CPI inflation has slowed from 1.9% to 1%, while the RBNZ has kept policy rates unchanged. The spread between 5-year New Zealand government debt and 5-year U.S. Treasuries has collapsed from +74bps to -56bps, while the 5-year New Zealand-Germany spread has tightened from 292bps to 234bps. The overall New Zealand government bond index has outperformed the Barclays Global Treasury index by 120bps, currency hedged into U.S. dollars (Chart 6). Looking ahead, it may prove difficult to repeat those numbers from current levels. Yet it is even more challenging to construct a bearish case for New Zealand debt - the economy still looks sluggish, inflation is languishing well below the RBNZ target, and there have been changes at the central bank that will likely keep a dovish bias to New Zealand monetary policy. A Big Shakeup At The RBNZ There are several major moves that have just taken place at the RBNZ that should ensure that the central bank will not be raising rates anytime soon. First, Adrian Orr took over as RBNZ Governor back in March, replacing Graeme Wheeler. Orr was the Chief Executive of the New Zealand government pension (superannuation) fund, but was also a former RBNZ Chief Economist and Deputy Governor. He has stated an intention to make the RBNZ a more open, communicative central bank than Wheeler, who shunned media interviews and limited the number of on-the-record speeches by RBNZ officials. This will make the central bank a more transparent entity and limit the ability of the central bank from doing unexpected policy moves, as it has done in the past. The transparency will increase next year when the RBNZ moves to a full policy committee approach, where interest rates will be decided by a vote rather than a decision solely made by the Governor. Second, the New Zealand government has altered the RBNZ's monetary policy mandate following a review after the victory by the Labour party in last year's election. The central bank must now not only target price stability, but also seek to "maximize sustainable employment" in the New Zealand economy, not unlike the dual mandates of the U.S. Federal Reserve or Reserve Bank of Australia. This marks a major shift for the RBNZ, which was the first central bank to introduce an official inflation target in 1989. This change fulfils the new Labour-led government's campaign promise to promote job creation, which also includes restricting immigration. New Zealand Finance Minister Grant Robertson did state last November that the government would only consider candidates for RBNZ Governor that would be "willing and ready to adopt the new processes" of its review of the RBNZ's policy mandate.3 Robertson also noted that the new framework might result in monetary policy staying more accommodative from time to time. This smacks of increased government pressure on the RBNZ to keep policy as loose as possible to boost economic growth. Governor Orr has already had to go on the defensive, publicly stated that the central bank had "always" been considering short-term swings in employment when making its interest rate decisions. At a minimum, the case for future interest rate increases would have to be very strong under the new policy framework, focused on inflation seriously threatening the upside of the RBNZ's 1-3% target band. Economy Looking Sluggish After last week's monetary policy meeting, where the central bank kept the Overnight Cash Rate at 1.75% and downgraded its growth projections, Orr noted that the markets had "finally seemed to listen" to the RBNZ's message that policy rates would be on hold for a long time. He pointed to the decline in the New Zealand dollar (NZD) to a six-month low following the meeting as a "good thing for a trading nation" like New Zealand.4 His blunt, yet cautious, tone fits with developments in the New Zealand economy of late. Growth slowed over the course of 2017, with real GDP expanding at a 2.9% year-over-year rate in the fourth quarter after averaging 3.5% growth since 2014. The two major drags on growth were consumer spending and residential investment, both of which decelerated from unsustainably high growth rates in the prior few years that were fueled by high rates of net immigration (Chart 7). In the May 2018 Monetary Policy Report (MPR) released last week, the RBNZ noted that it expects net immigration to fall for three reasons: a strengthening Australian labor market, tighter visa requirements and the departure of those with temporary visas.5 The RBNZ is projecting immigration levels will steadily decline over the next four years, returning to levels last seen in 2011 in 2020, which will cause consumer spending growth to slow from over 4% to 2% by the end of the projection period (middle panel). That will also act as a major drag on housing activity, with no significant growth in real residential investment expected until 2020 (bottom panel). This will come on top of other regulatory changes introduced in 2016 to cool an overheated housing market (limiting loan-to-value ratios on mortgage lending). The RBNZ now expects real GDP growth to slow to 2.8% in 2018, a pace below its estimate of potential GDP growth of 3.2%. Not only is consumer spending and housing expected to slow, but the business sector is also projected to remain sluggish. Business confidence and capacity utilization are both well off the 2017 peak, thanks mainly to the slump in the dairy sector, which remains a critical part of the New Zealand economy (Chart 8). The fall in dairy prices and milk production was reportedly caused by poor weather conditions and falling demand from China, but the declines may be bottoming out (bottom panel). Besides the agricultural sectors, manufacturing and service sectors are still in decent shape, with the PMIs for both still above 50 even after last year's declines (top panel). The softer China demand story is not just about dairy, however. Growth in overall export demand from China has slowed dramatically over the past year, from 50% year-on-year down to -4.3% in March (Chart 9, 2nd panel). Australian export demand has also decelerated, which is critical given that those two countries represent 40% of total New Zealand exports. The RBNZ export survey, which has been a reliable leading indicator for New Zealand export growth, shows that exports are likely to continue falling over the next 6-8 months (top panel). With the overall commodity price index have clearly slowed (bottom panel), it is likely that the terms of trade will remain a drag on New Zealand economic growth, and the NZD, through a deteriorating current account deficit (now -3% of GDP) in the coming months. Chart 7Immigration-Fueled Growth Set To Reverse In NZ Immigration-Fueled Growth Set To Reverse In NZ Immigration-Fueled Growth Set To Reverse In NZ Chart 8Dairy Still Matters For NZ Dairy Still Matters For NZ Dairy Still Matters For NZ Chart 9NZ Exports Getting Hit NZ Exports Getting Hit NZ Exports Getting Hit Where's The Inflation? Despite the recent cooling of growth, the New Zealand unemployment rate is well below the OECD's estimate of the full employment NAIRU. Unlike other developed market countries with low unemployment rates, however, New Zealand's labor force participation rate is currently close to an historical high near 71% (Chart 10). While a high participation rate should mean that New Zealand is truly at full employment, wage growth remains anemic even with booming levels of job vacancies (3rd panel). The growth in average hourly pay for overall workers is still below the rate of headline CPI inflation, although this will get a bump with a 4.8% minimum wage increase being adapted last month. Overall, New Zealand's headline CPI inflation reached the RBNZ's target rate only once in Q1 2017, after several years of staying below that 2% benchmark, then started to slow down again over the rest of last year (Chart 11). Currently, headline and core CPI inflation are only 1.1% and 0.9%, respectively. This is now at the lower bound of the RBNZ's 1-3% target band, justifying the central bank's dovish bias. Chart 10Low Unemployment With No Wage Growth Low Unemployment With No Wage Growth Low Unemployment With No Wage Growth Chart 11No Inflation Problems For The New RBNZ Governor No Inflation Problems For The New RBNZ Governor No Inflation Problems For The New RBNZ Governor Within the main components of the index, non-tradables (i.e. domestically based) inflation has maintained stable growth near 2%, but tradables (i.e. globally based) prices are in outright deflation. This remains the biggest source for the undershoot of the RBNZ's inflation target over the past year - shockingly, a period when oil prices surged higher and the trade-weighted NZD softened. Yet the low levels of inflation are not filtering though into household expectations, with survey data showing that inflation is expected to stay above 2% next year, and even rise to 3% over the next five years. Policy To Stay On Hold For A Lot Longer The RBNZ is not as optimistic as households on inflation, however. The central bank is projecting that the headline CPI index will only rise by 1.1% in 2018 and will not return to the 2% target until 2021. On the back of this, the RBNZ is also projecting that the Overnight Cash Rate will remain at 1.75% until the end of 2020. Chart 12NZ Bonds Will Continue To Outperform NZ Bonds Will Continue To Outperform NZ Bonds Will Continue To Outperform The market is still pricing in one 25bp rate hike over the next 12 months, according to our calculations from the Overnight Index Swaps market (Chart 12). We see no reason for the RBNZ to not be taken at its word about holding rates steady, especially given the new dovish elements of the RBNZ's revised mandate. With price and wage inflation still so surprisingly low, the RBNZ can go for its maximum employment mandate and maintain highly accommodative monetary conditions. This includes both low policy rates and keeping the currency as weak as possible. We would recommend leaning against the mild increase in New Zealand bond yields, and the modest flattening of the yield curve, currently priced into the forwards (3rd and 4th panels). That suggests maintaining an above-benchmark duration stance for dedicated New Zealand fixed income investors. It also means adapting a bullish stance on New Zealand government bonds from a relative perspective to other developed markets. We are maintaining our current recommended spread trades for 5-year New Zealand bonds versus 5-year U.S. Treasuries and 5-year German debt. We have maintained the U.S. trade on a currency-hedged basis, as we typically do with all our recommendations. For the New Zealand-Germany spread trade, however, we made a rare exception and entered that trade on an unhedged basis. This was because we had a strong view that the euro would depreciate against most major currencies last year, including the NZD. That did not occur last year as the euro surged higher, which meant that our New Zealand-Germany trade took losses as NZD/EUR declined. For now, we are keeping that trade on an unhedged basis given the depressed level of NZD/EUR, but we will keep a tight stop going forward in the event of a broader breakdown in the NZD. Bottom Line: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 https://www.reuters.com/article/us-newzealand-economy-finmin/new-zealand-finance-minister-says-new-rbnz-governor-must-take-on-dual-mandate-idUSKBN1DG0EY?il=0 4 https://www.reuters.com/article/us-newzealand-economy-rbnz-orr/rbnz-governor-says-markets-finally-getting-the-hint-on-low-rates-idUSKBN1IC0LS 5 https://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement/mps-may-2018 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Serenity Now Serenity Now Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Tinbergen's rule says that the successful implementation of economic policy requires there to be at least as many "instruments" as "objectives." Policymakers today are increasingly discovering that they have too many of the latter but not enough of the former. By turning fiscal policy into a political tool rather than one for macroeconomic stabilization, the U.S. has found itself in a position where it can either meet President Trump's goal of having a smaller trade deficit or the Fed's goal of keeping the economy from overheating, but not both. In the near term, we expect the Fed's priorities to prevail. This will keep the dollar rally intact, which could spell bad news for some emerging markets. Longer term, the Fed, like most other central banks, must confront the vexing problem that the interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Getting inflation up a bit may be one way to mitigate this problem, as it would allow nominal interest rates to rise without pushing real rates into punitive territory. This suggests that the structural path for bond yields is up, consistent with our thesis that the 35-year bond bull market is over. Feature Constraints And Preferences The late Jan Tinbergen was one of the great economists of the twentieth century. Often referred to as the father of econometrics, Tinbergen and Ragnar Frisch were the first people to be awarded the Nobel Prize in Economics in 1969. One of Tinbergen's most enduring contributions was his demonstration that the successful implementation of economic policy requires there to be at least as many "instruments" (i.e., policy tools) as "objectives" (i.e., policy goals). Just like any system of equations can be "overdetermined" or "underdetermined," any set of "policy functions" may have a unique solution, many solutions, or no solution at all. The first outcome corresponds to a situation where there are as many instruments as objectives, the second where there are more instruments than objectives, and the third where there are fewer instruments than objectives. In essence, the Tinbergen rule is a mathematical formulation of the idea that it is hard to hit two birds with one stone. The Tinbergen rule often comes up in macroeconomics. Consider a country that wants to have a low and stable unemployment rate (what economists call "internal balance") and a current account position that is neither too big nor too small ("external balance"). This amounts to two objectives, which can be realized with the right mix of two instruments: Monetary and fiscal policy. As discussed in greater detail in Appendix A, the classic Swan Diagram, named after Australian economist Trevor Swan, shows how this is done. Chart 1Spain: The Cost Of The Crisis Spain: The Cost Of The Crisis Spain: The Cost Of The Crisis If the country wants to add a third objective to its list of policy goals, it has to either give up one of its existing objectives or find an additional policy instrument. Suppose, for example, that a country wants to move to a pegged exchange rate. It can either forego monetary independence, or introduce capital controls in order to allow domestic interest rates to deviate from the interest rates of the economy to which it is pegging its currency. This is the logic behind Robert Mundell's "Impossible Trinity," which states that an economy cannot simultaneously have all three of the following: A fixed exchange rate, free capital mobility, and an independent central bank. It can only choose two items from the list. Peripheral Europe learned this lesson the hard way in 2011. Not only did euro membership deny Greece, Italy, Spain, Portugal, and Ireland access to an independent monetary policy and a flexible currency, but the ECB's failure under the bumbling leadership of Jean-Claude Trichet to backstop sovereign debt markets necessitated fiscal austerity at a time when these economies needed stimulus. These countries were left with no effective macro policy instruments whatsoever, thus putting them at the complete mercy of the bond vigilantes, German politicians, and the multilateral lending agencies. The only thing they could do was incur a brutal internal devaluation to make themselves more competitive. Even for "success stories" such as Spain, the cost in terms of lost output was over one-third of GDP (Chart 1) - and probably much more if one includes the deleterious effect on potential GDP growth from the crisis. Trump Versus Tinbergen One might think that the U.S. is largely immune from Tinbergen's rule. It is not. President Trump and the Republicans in Congress have rammed through massive tax cuts and spending increases (Chart 2). By doing so, they have turned fiscal policy into a political tool rather than one for macroeconomic stabilization. In and of itself, that is not an insuperable constraint since monetary policy can still be used to achieve internal balance. The problem is that Trump has also declared that he wants external balance, meaning a much smaller trade deficit. Now we have two policy objectives (full employment and more net exports) and only one available instrument: Monetary policy. Chart 2The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline This puts the Fed in a bind. If the Fed hikes rates aggressively, this will keep the economy from overheating, thus achieving internal balance. But higher rates are likely to bid up the value of the dollar, leading to a larger trade deficit. On the flipside, if the Fed drags its feet in raising rates, the dollar could weaken, resulting in a smaller trade deficit and moving the economy closer to external balance. However, the combination of low real interest rates, a weaker dollar, and dollops of fiscal stimulus will cause the unemployment rate to fall further, leading to higher inflation. Investor uncertainty about which path the Fed will choose may be partly responsible for the gyrations in the dollar of late. At least for the next year or so, our guess is that the Fed's independence will keep it on course to raise rates more than the market is currently pricing in, which will result in a stronger dollar. Beyond then, the picture is less clear. This is partly because the increasing politicization of society may begin to affect the Fed's behavior. History suggests that inflation tends to be higher in countries with less independent central banks (Chart 3). But it is also because Tinbergen's ghost is likely to make another appearance, this time in a wholly different way. Chart 3Inflation Tends To Be Higher In Countries Lacking Independent Central Banks Tinbergen's Ghost Tinbergen's Ghost The Fed's "Other" Mandate Officially, the Fed has two mandates: ensuring maximum employment and stable prices. In practice, this "dual mandate" can be boiled down to a single policy objective: Keeping the unemployment rate near NAIRU, the so-called Non-Accelerating Inflation Rate of Unemployment. The Fed has sought to meet this objective through the use of countercyclical monetary policy: Easing monetary policy when output falls below potential and tightening it when the economy is at risk of overheating. So far, so good. The problem is that the Fed, like most other central banks, is being asked to take on another policy objective: ensuring financial stability. Here's the rub though: The interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Excessively low rates are a threat to financial stability. A decline in interest rates pushes up the present value of expected cash flows; the lower the discount rate, the more of an asset's value will depend on cash flows that may not be realized for many years. This tends to increase asset market volatility. In addition, borrowers need to devote a smaller share of their incomes towards servicing their debt obligations when interest rates are low. This tends to increase debt levels. From The Great Moderation To The Great Intemperance Starting in the 1990s, far from entering an era which policymakers once naively referred to as the "Great Moderation," it is possible that the world entered a precarious period where the only way to generate enough spending was to push down interest rates so much that asset bubbles became commonplace. In a world where central bankers have to choose between insufficient demand and recurrent asset bubbles, the idea of a "neutral rate" loses much of its meaning. By definition, the neutral rate is a steady-state concept. However, if the interest rate that produces full employment and stable inflation is so low that it also generates financial instability, how can one possibly describe this interest rate as "neutral"? Faced with the increasingly irreconcilable twin objectives of keeping the unemployment rate near NAIRU and putting the financial system on the straight and narrow, central bankers have reached out for a second policy instrument: macroprudential regulations. So far, however, the jury is still out on whether this tool is sufficiently powerful to prevent future financial crises. Politics has a bad habit of getting in the way of effective regulation. President Trump and the Republicans have been looking for ways to water down the Dodd-Frank Act. The Democrats are complaining that banks and other financial institutions are not doing enough to channel credit to various allegedly "underserved" groups. Faced with such political pressure, it is not clear that regulators can do their jobs. If You Can't Raise r-Star, Raise i-Star What is the Fed to do? One possibility may be to aim for somewhat more inflation. A higher inflation target would allow the Fed to raise nominal policy rates while still keeping real rates low enough to maintain full employment. Higher nominal rates would impose more discipline on borrowers and discourage excessive debt accumulation. Higher inflation would also reduce the likelihood of reaching the zero bound again, while also limiting the economic fallout of asset busts. The Case-Shiller 20-City Composite Index declined by 34% in nominal terms and 41% in real terms between April 2006 and March 2012. Had inflation averaged 4% over this period rather than 2.2%, a 41% decline in real home prices would have corresponded to a less severe 26% decrease in nominal prices, resulting in fewer underwater mortgages. Finally, higher inflation would allow countries to increase nominal income growth. In fact, higher inflation may be the only viable way to reduce debt-to-GDP ratios in a high-debt, low-productivity growth world. Investment Conclusions We advised clients on July 5, 2016 that we had reached "The End Of The 35-Year Bond Bull Market." As fate would have it, this was the exact same day that the 10-year yield reached an all-time closing low of 1.37%. Bond positioning is very short now (Chart 4), so a partial retracement in yields is probable. Cyclically and structurally, however, the path for yields is up. Much like what transpired between the mid-1960s and the early 1980s, investors should expect global bond yields to reach a series of "higher highs" and "higher lows" with each passing business cycle (Chart 5). Chart 4Traders Are Short Treasurys Traders Are Short Treasurys Traders Are Short Treasurys Chart 5A Template For The Next Decade? A Template For The Next Decade? A Template For The Next Decade? Just as was the case back then, the Fed is now behind the curve in raising rates. The three-month and six-month annualized change in core PCE has reached 2.6% and 2.3%, respectively. Yesterday's CPI report was softer than expected, but the miss was almost entirely due to a deceleration in used car prices and airfares, both of which are likely to be temporary. Meanwhile, the labor market remains strong. The unemployment rate is down to 3.9%, just slightly above the 2000 low of 3.8%. According to the latest JOLTS survey released earlier this week, there are now more job openings than unemployed workers, the first time this has happened in the 17-year history of the survey (Chart 6). Faced with this reality, the Fed will keep begrudgingly raising rates until the economy slows. Right now, the real economy is not showing much strain from higher rates. The cyclical component of our MacroQuant model, which draws on a variety of forward-looking economic indicators, moved back into positive territory this week. Both the housing market and capital spending are in reasonably good shape (Chart 7). Chart 6There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 7Higher Rates Have Not (Yet) Slowed The Economy Higher Rates Have Not (Yet) Slowed The Economy Higher Rates Have Not (Yet) Slowed The Economy The U.S. financial sector should also be able to weather further monetary tightening. Corporate debt has risen, but overall U.S. private-sector debt as a percent of GDP is still 18 percentage points lower than in 2008 (Chart 8). Lenders are also more circumspect than they were before the Great Recession. For example, banks have been tightening lending standards on credit and automobile loans, which should reverse the increase in delinquency rates seen in those categories (Chart 9). Chart 8U.S. Private Debt Still Below Pre-Recession Levels U.S. Private Debt Still Below Pre-Recession Levels U.S. Private Debt Still Below Pre-Recession Levels Chart 9Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Resilience to Fed tightening may not extend to the rest of the world, however. Following the script of the late 1990s, it is likely that the combination of higher U.S. rates and a stronger dollar will cause some emerging markets to fall out of bed before U.S. financial conditions have tightened by enough to slow U.S. growth (Chart 10). This week's turbulence in Turkey and Argentina may be a sign of things to come. For now, investors should underweight EM assets relative to their developed market peers. Chart 10Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com APPENDIX A The Swan Diagram The Swan Diagram depicts four "zones of economic unhappiness," each one representing the different ways in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). A rightward movement along the horizontal axis represents an easing of fiscal policy, whereas an upward movement along the vertical axis represents an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order keep the unemployment rate stable. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. To bring imports back down, the currency must weaken. Any point to right of the internal balance schedule represents overheating; any point to the left represents rising unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Appendix Chart 1Four Zones Of Unhappiness Tinbergen's Ghost Tinbergen's Ghost Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The U.S. dollar still has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. Fixed-income investors should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Argentine financial markets are rioting. We elaborate on our investment strategy below. Downgrade Indonesian stocks from neutral to underweight within an EM equity portfolio. Feature The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. Rüdiger Dornbusch Emerging markets (EM) currencies have come under substantial selling pressure. Various indexes of EM currencies versus the U.S. dollar have broken below their 200-day moving averages (Chart I-1). EM sovereign spreads are widening, and local bonds yields are moving higher from very low levels. Chart I-1EM Currencies: A Breakdown? EM Currencies: A Breakdown? EM Currencies: A Breakdown? Our view is that we are witnessing the beginning of a major down leg in EM currencies and a major up leg in the U.S. dollar. This constitutes a negative environment for all EM risk assets. As the above quote from professor Rüdiger Dornbusch eloquently states, a meltdown in financial markets could take much longer to develop, but once it commences it is likely to play out much faster than investors expect. This does not mean we are certain that a full-blown EM crisis is bound to happen. Neither can we predict the speed of financial market moves. Nevertheless, based on our macro themes, we maintain that this down leg in EM currencies and EM risk assets will likely be large enough to qualify as a bear market rather than a correction. Consistently, we continue to recommend that investors adopt defensive strategies or play EM risk assets on the short side. This bear market in EM could be comparable to the EM selloff episodes of 2013 (Taper Tantrum) or 2015 (China's slowdown). In this report, we first discuss the outlook for the broad U.S. dollar, then examine the factors that typically drive EM currencies, and those that do not. The Dollar: A Major Bottom In Place The U.S. dollar has recently rebounded sharply, and we believe this marks the beginning of a major rally. The following factors will support the greenback in the months ahead: The U.S. dollar does well in periods of a slowdown in global trade (Chart I-2). The average manufacturing PMI index of export-oriented Asia economies such as Korea, Taiwan and Singapore points to a peak in global export volumes (Chart I-3). Further, China's Container Freight index signifies an impending deceleration in Asian export shipments (Chart I-4, top panel). Chart I-2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Chart I-3A Peak In Global Export Growth A Peak In Global Export Growth A Peak In Global Export Growth Chart I-4A Leading Indicator For Asian Exports ##br##And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies Notably, this freight index - the price to ship containers - also correlates with emerging Asia currencies, and suggests that the latter stands to depreciate (Chart I-4, bottom panel). Chart I-5U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate The dollar should do particularly well if the epicenter of the global growth slowdown is centred in China - and if U.S. domestic demand remains robust due to fiscal stimulus, as we expect. Within advanced economies, the U.S. is the least vulnerable to a China and EM slowdown. Delta of relative growth will be shifting in favor of the U.S. versus the rest of the world. This will propel the dollar higher. Amid weakness in the world trade, growth will be priced at a premium. This will favor financial markets with stronger growth. The greenback will be the winner in the coming months. The U.S. twin deficits - the current account and budget deficits - would have acted as a drag on the dollar if global growth was robust/recovering. However, amid weakening global growth, the U.S. twin deficits are not a malignant phenomenon for the dollar; they will in fact support it as they instigate and reflect strong U.S. growth. As the Federal Reserve continues to reduce its balance sheet, the banking system's excess reserves will decline. Our U.S. dollar liquidity measure has petered out, which has historically been consistent with a bottom in the dollar; the latter is shown inverted on Chart I-5. As we have argued for some time, and to the contrary of widespread investor consensus, the U.S. dollar is not expensive. According to the real effective exchange rate based on unit labor costs, the greenback is fairly valued, as is the euro (Chart I-6). The yen is cheap but the Korean won is expensive (Chart I-6, bottom two panels). In our opinion, a real effective exchange rate based on unit labor costs is the most pertinent measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component in many companies and unit labor costs are critical to competitiveness. Chart I-7 demonstrates that commodities-related currencies including those of Australia, New Zealand and Norway are on the expensive side, while the Canadian dollar is fairly valued. Chart I-6The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive Chart I-7Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap There are no measures of real effective exchange rate based on unit labor costs for many EM currencies. If DM commodities currencies are not cheap, then it is fair to assume that EM commodities currencies are not cheap either. We are not suggesting that exchange rates of commodity producing EM nations are expensive, but we do believe their valuations are probably closer to neutral. When valuations are neutral, they are not a constraint for the underlying asset price. The latter can go either up or down. In short, the dollar is not expensive, and valuations will not deter its appreciation in the coming months. Finally, from the perspective of market technicals, the dollar's exchange rates versus many currencies appear to have encountered resistance at their long-term moving averages, as illustrated in Chart I-8A and Chart I-8B. Usually, when a market finds support (or resistance) at its long-term moving average, it often makes new highs (or lows). Chart I-8ATechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Chart I-8BTechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies We are not certain if the broad trade-weighted U.S. dollar will make a new high. However, some EM currencies will drop close to or retest their early 2016 lows. Such potential downside is substantial enough to short the most vulnerable EM currencies. Bottom Line: The U.S. dollar has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. What Really Drives EM Currencies A common narrative is that EM balance of payments and fiscal balances have already improved, making many EMs less vulnerable than they were during the 2013 Taper Tantrum. What's more, the interest rate differential between EM and the U.S. is still positive, heralding upward pressure on EM currencies. We do not subscribe to this analysis. First, current account balances do not always drive EM exchange rates. Chart I-9A and Chart I-9B illustrates that there is no meaningful positive correlation between EM currencies and both the level and changes in their current account balances. The same holds for the correlation between fiscal balances and exchange rates. Chart I-9ACurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Chart I-9BCurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Second, neither nominal nor real interest rate differentials over U.S. rates explain the trend in EM currencies, as shown in Chart I-10. Further, neither the level nor changes in interest rate differentials explain trends in EM exchange rates. On the contrary, it is the trend in EM currencies that drives local interest rates in EM. That is why getting the currencies right is of paramount importance to investors in various EM asset classes. So which factors do drive EM exchange rates? The key variables that define trends in EM currencies are U.S. bond yields, global trade cycles and commodities prices. The changes in U.S. bond yields and TIPS (inflation-adjusted) yields - not their difference with EM yields - have explained EM currency moves in recent years (Chart I-11). Chart I-10Interest Rate Differential Does Not ##br##Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Chart I-11EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields Chart I-4 on page 3 demonstrates that China's Container Freight index leads regional exports and strongly correlates with emerging Asian currencies. Non-Asian EM currencies are mostly leveraged to commodities prices, as these countries (all nations in Latin America, Russia and South Africa) produce commodities. Not surprisingly, the EM exchange rate composed primarily of EM non-Asian currencies correlates well with commodities prices (Chart I-12). Finally, EM currencies are substantially more exposed to China than to DM economies. Chart I-13 shows that when Chinese imports are underperforming DM imports, EM currencies tend to depreciate. Chart I-12EM Currencies And Commodities Prices EM Currencies And Commodities Prices EM Currencies And Commodities Prices Chart I-13EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM As such, what has caused EM currencies to riot in recent weeks? In short, it is the combination of the rise in U.S. bond yields and budding signs of slowdown in global trade. Chart I-14EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low Commodities prices have so far been firm with oil prices skyrocketing. We expect the combination of China's slowdown and a stronger U.S. dollar to eventually suppress commodities prices in the months ahead. That will produce another down leg in EM currencies. Finally, the volatility measure for EM currencies is still very low, albeit rising (Chart I-14). This suggests that investors remain somewhat complacent on EM exchange rates. Bottom Line: Our negative view on EM currencies has been anchored on two pillars: the U.S. dollar rally driven by higher U.S. interest rate expectations and weaker Chinese growth/lower commodities prices. We are now witnessing the first down leg in EM currency bear market propelled by the first pillar. It is not over yet. The second down leg will come when China's growth slows and commodities prices relapse in the coming months. All in all, there is still material downside in EM exchange rates. EM Local Bond And Credit Markets EM local bond yields typically rise when EM currencies drop meaningfully (Chart I-15). Foreign investors hold a large share of EM local currency bonds (Table I-1). Chart I-15EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies Table I-1Foreign Ownership Of EM Local Bonds EM: A Correction Or Bear Market? EM: A Correction Or Bear Market? As EM currency depreciation erodes foreign investors' returns on EM local currency bonds, there could be a rush to exit their positions. Chart I-16 portrays that the total return on J.P. Morgan GBI EM local currency bonds in U.S. dollar terms has broken below its 200-day moving average. Fluctuations in total return on local bonds is primary driven by currency moves. If our negative EM currency view is correct, there will be more downside in this EM domestic bonds total return index. EM sovereign and corporate credit spreads often widen when EM currencies depreciate (Chart I-17). As EM currencies lose value, U.S. dollar debt becomes more expensive to service, and credit spreads should widen to reflect higher credit risks. Chart I-16EM Local Bonds Total ##br##Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars Chart I-17EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies Finally, the ratios of U.S. dollar debt-to-exports and U.S. dollar debt-to-international reserves for EM ex-China are very elevated (Chart I-18). If these nations' exports stumble in the months ahead, the inflows of foreign currency will diminish, and credit spreads could widen to price this in. Chart I-18EM Ex-China: U.S. Dollar Debt ##br##Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective To be sure, this does not mean there will be widespread defaults. Simply, credit spreads are too low and investor sentiment is too upbeat. As EM growth deteriorates, asset prices will have to re-price. Bottom Line: Asset allocators should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Argentina Is Under Fire 10 May 2018 Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Chart II-1Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Chart II-2Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Chart II-3Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Chart II-4Argentina: Are Interest ##br##Rates High Enough? Argentina: Are Interest Rates High Enough? Argentina: Are Interest Rates High Enough? Chart II-5Argentina: Highest Real Interest ##br##Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Chart II-6Argentina: High Borrowing Costs ##br##Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Chart II-7Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Indonesia: Facing Major Headwinds 10 May 2018 Indonesian stocks appear to be in freefall in absolute terms and relative to the EM benchmark (Chart III-1). Meanwhile, the currency has been selling off and local currency as well as sovereign (U.S. dollar) bonds spreads are widening versus U.S. Treasurys from low levels (Chart III-2). Chart III-1Indonesian Equities: Absolute ##br##And Relative Performance Indonesian Equities: Absolute And Relative Performance Indonesian Equities: Absolute And Relative Performance Chart III-2Indonesian Local Bonds ##br##And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads These developments have been occurring due to vulnerabilities relating to Indonesia's balance of payments (BoP) dynamics. We believe Indonesia's BoP dynamics will deteriorate further and as such there is more downside for both the rupiah and its financial markets from here: Stronger U.S. growth and higher inflation prints will likely lead to higher interest rate expectations in the U.S. and lift the U.S. dollar further. This will likely lead to Indonesia's underperformance. Chart III-3 shows that Indonesia's relative equity performance versus the EM benchmark has been extremely sensitive to moves in U.S. Treasury yields. Hence, the cost of funding has been a critical variable for Indonesia. Indonesia is also a large commodities exporting nation and the latter account for around 30% of its exports. Specifically, coal, palm oil and copper make up about 9%, 8% and 2% of its exports, respectively. Coal exports are facing major headwinds. The Chinese government has moved to restrict coal imports in several Chinese ports in order to protect its domestic coal producers as we argued in our Special Report titled Revisiting China's De-Capacity Reforms.1 This development will be devastating for Indonesia's coal industry. Chart III-4 shows that the Adaro Energy's stock price - a large Indonesian coal mining company - is falling sharply. This stock price has already fallen by 40% in U.S. dollar terms since its peak on January 30. Chart III-3Indonesia Is Very Sensitive ##br##To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Chart III-4Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Further, palm oil prices have been weak while copper prices might be on edge of breaking down. Meanwhile, there are others negatives related to shipments of these commodities. Palm oil exports are at risk because India has imposed import duties on palm oil, while the European Parliament voted in favor of a ban on the use of palm oil in bio fuel by 2021. Offsetting these, however, China has just agreed to purchase more palm oil from Indonesia. In regard to copper, the ongoing dispute on environmental regulation between Freeport-McMoRan - a U.S. mining company that operates a large copper mine in Indonesia - and the Indonesian government, risks disrupting Freeport's copper production in Indonesia, hurting the country's export revenues. On the whole, export revenues are at risk of plummeting at a time when Indonesian imports are already too strong. This will worsen BoP dynamics further. Chart III-5 shows that a deteriorating trade balance in Indonesia is usually bearish for its equity market. It seems that the current account deficit will be widening when foreign funding is drying up. This requires either a major depreciation in the currency or much higher interest rates. As such, Bank Indonesia (BI) - Indonesia's central bank - might be forced to raise interest rates to cool down domestic demand and attract foreign funding to stabilize the rupiah. Even if the BI does not raise rates, it might opt to defend the rupiah by selling its international reserves. This would still bid up local interbank rates as defending the currency entails drawing down banking system liquidity, i.e., banks' reserves at the central bank. Chart III-6 shows that Indonesian interbank rates are starting to rise in response to falling international reserves. Chart III-5Indonesia: Swings In Trade ##br##Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Chart III-6Indonesia: Currency Defense By Selling ##br##FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Higher rates will weaken domestic demand and are bearish for share prices. Importantly, foreign ownership of local bonds is still high at 39% and a weaker rupiah could cause selling by foreign investors, pushing yields even higher. Chart III-7Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk Finally, a word on Indonesian banks is warranted. Financials account for 42% of Indonesia's MSCI market cap and 47% of its total earnings. Thus their performance is also very crucial for the outlook of the overall stock market. In our March 1st Weekly Report,2 we argued that Indonesian banks have been lowering their provisions to artificially boost earnings. This is not sustainable as these provisions are insufficient and will have to rise. As they ultimately rise, bank profits and share prices will hurt (Chart III-7). Bottom Line: We recommend investors to downgrade Indonesia's stocks from neutral to underweight within an EM equity portfolio. We also reiterate our short IDR / long USD trade and the short position in local bonds. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Revisiting China's De-Capacity Reforms," dated April 26, 2018, the link available on page 23. 2 Please see Emerging Markets Strategy Weekly Report "EM Equity Valuations (Part II)," dated March 1, 2018, the link available on page 23. Equity Recommendations Fixed-Income, Credit And Currency Recommendations