Euro Area

Highlights French labor reforms stack up well against German and Spanish predecessors; We remain bullish on French industrials versus German industrials; Populism is overrated in Germany - European integration may not accelerate, but it will continue; The U.K.'s position remains weak in Brexit talks ... don't expect much from sterling. Feature On recent travels across Asia Pacific, the U.K., and the U.S., Europe has rarely featured in our conversations with clients. We proclaimed European politics a "trophy red herring" in our annual Strategic Outlook.1 Following the defeat of populists in Austria, the Netherlands, Spain, and particularly France, the market now agrees with us (Chart 1). Chart 1European Political Risk Was Overstated In this report, we ask whether there is anything left to say about Europe. First, we provide an update on French structural reforms, which we predicted with enthusiasm in February.2 Second, we give a post-mortem of the German election. Third, we dissect U.K. Prime Minister Theresa May's speech in Florence. We remain positive on near-term and mid-term prospects for European assets. We have recently closed our unhedged long Euro Area equities trade for a 7.88% gain (open from January 25 to September 6). We have reopened the position on September 6 with a currency hedge given our view that there is some downside risk for the euro in the near term. We also remain long French industrials / short German industrials, with gains of 9.30% since February 3. The French Revolution Continues President Emmanuel Macron has ignored tepid union protests and signed five decrees overhauling French labor rules on September 22. While there is more to be done, Macron's swift action just five months after assuming office justifies our optimism about France earlier this year. As we posited in February, investors are surprised every decade by a developed market that defies all stereotypes and catches the markets off guard with ambitious, pro-market and pro-business structural reforms. Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s. Sweden surprised the world in the 1990s. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own "socialist" label and moved the country to the right of the economic spectrum. Finally, the past decade's reform surprise came from Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. How do French labor reforms stack up against the German and Spanish efforts? Table 1 surveys the measures and classifies them into three categories. On unemployment benefits, Macron's effort falls short of the considerable cuts implemented as part of the Hartz reforms in Germany. However, while benefits will still be generous, France's unemployed will now be cut off if they refuse job offers that pay within 25% of the salary they previously held. On increasing labor market flexibility, we give France high marks. Reforms will simplify the termination process for economic reasons and cap damages that can be awarded to employees, in line with the Spanish experience. Macron has also managed to neuter the power of national unions by allowing firm-level collective bargaining to take precedence. France's labor bargaining reform is also a carbon copy of the Spanish effort and both are attempts to create a more German-like management-employee context. Table 1Measuring French Reforms Against German And Spanish Reforms What should investors expect as a result? Spain is instructive. While its unemployment rate remains 5.8% above the Italian rate and 7.3% above the French rate, it still fell from a high of 26.3% in 2013 to 17.1% today. Meanwhile, Italian and French unemployment rates remain stubbornly high (Chart 2). In addition, Spain's export competitiveness has had one of the sharpest recoveries in Europe since 2008, whereas Italy and France continue to languish (Chart 3). Spain accomplished this feat via a considerable reduction in labor costs relative to peers (Chart 4). Chart 2Italy, France: Unemployment Still High Chart 3Spain Regained Competitiveness Chart 4Spain Cut Labor Costs The key pillar of Prime Minister Mariano Rajoy's reforms was to create a more flexible labor market so as to restore competitiveness to the economy by aligning labor costs with productivity. Reforms, passed in February 2012, removed stringent collective bargaining agreements and replaced them with firm-level agreements. This has made it easier for firms to negotiate their own labor conditions, including reducing wages as an alternative to termination of employment. France is now on the path to do the same. True, it is difficult to establish a clear causal connection between Rajoy's structural reforms and Spain's economic performance since 2008. Nevertheless, reforms also work as a signaling mechanism, encouraging investment and unleashing animal spirits by affirming the government's commitment to a pro-business agenda. Under Rajoy's leadership, Spain has moved from 62nd in the World Bank "Ease of Doing Business" survey in 2009 to 32nd in 2017, 18 spots above Italy. Given the speed and commitment of the Macron administration, we would expect an even stronger signaling effect in France. German Hartz reforms are easier to assess because more time has passed since 2005 (when the final stage, Hartz IV, was implemented). Prior to the reforms, Germany's GDP growth rate was falling and unemployment was rising (Chart 5). At least on these two broad measures, it appears that reforms were positive. Chart 5Hartz Reforms Marked Turning Point In Germany Chart 6German Long-Term Unemployment Benefits Were Cut Down To OECD Average Germany's problem prior to the Hartz reforms was that generous unemployment benefits discouraged unemployed workers from finding employment. Long-term benefits could be as high as 53% of the terminated salary and eligible for indefinite renewal! The Hartz IV reforms specifically targeted these benefits, with the intention of forcing the unemployed to get back to work. Germany brought these benefits into line with the OECD average (Chart 6). The long-term impact of the Hartz reforms was a dramatic decline in the unemployment rate from a bottom of 9.2% in 2001 to the still falling 3.7% of today! Reforms have also seen a steady increase in wage growth, despite the conventional view saying the opposite. Wages have been steadily rising since implementation in 2005, only slowing down during the global financial crisis and the subsequent European debt crisis (Chart 7). This does not mean that labor reforms failed. The intention of the Hartz reforms was to push people back into the labor force, not necessarily suppress their wages. Chart 8 shows the effect on the hours worked in the economy, with a clear uptrend after the reform was enacted. Chart 7German Wages Recovered... Chart 8...While Working Hours Increased In line with the previous labor reform efforts in Europe, we think that investors should expect three broad developments from French labor reforms: Competitiveness: As Chart 3 suggests, Spain and Germany have had the best export performance in Europe. By allowing companies some flexibility in setting costs, these economies were able to regain export competitiveness. As a play on this theme, we are long French industrials relative to German peers. Unemployment: Forcing the unemployed back to the labor market by ending their unemployment benefits if they refuse a job offer within 25% of the previous income level should encourage workers to get back to the labor force. Confidence: Macron's labor reforms are only the beginning of a packed agenda that also includes reducing the size of the public sector, reducing the wealth tax on productive assets, and cutting corporate taxes significantly. What of the opposition to the reform effort? What if the French leadership backs down in the face of protest? First, we must ask, what protest? The labor union response has been underwhelming. In part, this is because Macron's reforms are packed with pro-union clauses. The intention is to empower union activity at the firm level in order to neuter its activity at the national level. Second, Macron's electoral victory was overwhelming, both the presidential and legislative. Yes, turnout was low. And yes, many voted for Macron just so that Marine Le Pen would not become president. But the fact remains that 85% of the seats in the National Assembly are held by pro-reform parties, including the pro-business, right-wing Les Républicains, who want even stricter reforms. Bottom Line: Our clients, colleagues, friends, and family all tell us that France will not reform. But we have seen this film before, with Germany in the 2000s and Spain in the 2010s. One day, investors will wake up and France will be more competitive. Fin. A German Election Post-Mortem The media narrative before and after the German election tells of the rise of Alternative für Deutschland (AfD), a far-right party that campaigned on an anti-EU and anti-immigration platform. Indeed, the performance of the center-right Christian Democratic Union (CDU) and center-left Social-Democratic Party (SPD), which have dominated German politics since the Second World War, was historically poor (Chart 9). Chart 9Germany's Dominant Parties Underperformed... Despite the media hysterics, there were no surprises this year. The AfD performed in line with its polls, only outperforming their long-term polling average by around 2%. Meanwhile, the historic underperformance of the CDU and SPD was also due to the solid performance of the other two establishment parties, the liberal Free Democratic Party (FDP) and the center-left Greens (Chart 10). The FDP stormed back into the Bundestag by more than doubling their performance from 2013, while the Greens maintained their roughly 9% performance. Die Linke, a left-wing party whose Euroskeptic tendencies have dissipated, also gained around 9% of the vote. From a historical perspective, the combined CDU and SPD performance was bad, but roughly in line with their 2009 election result. Chart 10... While Minor Parties Outperformed That said, there was no once-in-a-lifetime global recession this time around to excuse the poor performance of the two establishment parties. German GDP growth is set to be 2.1% in 2017 and the unemployment rate is at a historic 3.7%. Meanwhile, support for the euro is at 81% (Chart 11), which begs the question of why 12.6% voters decided to entrust AfD with their votes. Chart 11Germans Love The Euro The simple answer is immigration and the 2015 asylum crisis. The more complex answer is that AfD's performance was particularly strong in East Germany, where the party is now the second largest after the CDU. The same forces that fueled the Brexit referendum and the election of President Donald Trump are at work in Germany. Voters who feel left behind by the transition to a globalized, service-oriented economy have rebelled against a system that favors the educated and mobile voters. In Germany, the angst is particularly notable in the East, where economic progress has lagged that of the rest of the country. On the other hand, it is ludicrous to compare AfD to Brexit and Trump. After all, AfD received only 12% of the vote. This is in line with, or slightly trails, the performance of other right-wing parties in Europe (Chart 12). Yes, it is disturbing to see a far-right party back in the Bundestag, but it was also naïve to believe that Germany could remain a European outlier forever. In fact, like other right-wing parties in Europe, the party is beset with internal rivalries. Party chairwoman Frauke Petry, who represents the moderate wing of the party, decided to quit one day after the election.3 We would suspect that the party will struggle going forward, particularly now that the influx of asylum seekers has trickled down to insignificance (Chart 13). Chart 12German Far Right Performed In Line With Other European Anti-Establishment Parties Chart 13Refugee Crisis Is Over In Germany And Europe Going forward, Chancellor Angela Merkel will retain her hold on power. However, she will likely have to do so via a "Jamaica coalition" with the FDP and the Greens.4 Forming such a challenging coalition could take until the New Year. Particularly problematic are the positions of the FDP and the Greens on Europe. The former are mildly Euroskeptic, the latter are rabidly Europhile. Merkel's 2009-13 coalition with the FDP was similarly challenging. The FDP moved towards soft Euroskepticism after the Great Financial Crisis. It combined with CDU's Bavarian sister party - the Christian Social Union (CSU)5 - to vote against a number of European rescue efforts and institutional changes (Chart 14). Merkel had to rely on the opposition SPD, which is staunchly Europhile, to push several European reforms through the Bundestag. More broadly, both the FDP and the CSU were a brake on Merkel during this period, leading to Berlin's halting response to the Euro Area crisis. Chart 14The FDP Hampered German Rescue Efforts Amid Euro Crisis Going forward, a Jamaica coalition is investment-relevant for three reasons: First, it would likely pour cold water on recent enthusiasm about accelerated European integration spurred by the election of President Emmanuel Macron in France. But investors should not read too much into it. As Chart 11 clearly illustrates, Germans are not Euroskeptic. The Euro Area works for Germany. If there is a future crisis, Germany will react to it in an integrationist fashion, shoving aside any coalition agreements to the contrary. And if Merkel has to rely on opposition SPD votes to push through the evolving European agenda, she will do so, regardless of what is said between now and December. Second, Merkel will have to respond to the poor performance of her party. She has to give in to the right wing on illegal immigration. Investors should expect to see tighter border enforcement on Europe's external borders. More relevant to the markets, we expect mildly Euroskeptics critics in her own party, as well as in the FDP and CSU, to be satisfied by officially pushing for Jens Weidmann's presidency at the ECB. Weidmann has recently toned down his criticism of ECB policies - publically defending low interest rates - which is likely a strategy to make himself palatable as the next president. Third, it is widely being discussed that the FDP will demand the finance ministry from Merkel, replacing Wolfgang Schäuble. This would definitely complicate any future efforts to deal with Euro Area sovereign debt crises, were they to emerge. However, the FDP is making a mistake. If they take the finance portfolio, they will be signing off on bailouts in the future. That is a guarantee. Europe is full of moderately Euroskepic finance ministers who have done the same (see: Austria, Finland, and the Netherlands in particular). Finally, the election was a clear failure by Merkel to defend her brand. While she has not signaled a willingness to resign, it is highly likely that she will try to groom her successor over the next four years. The 63 year-old has been in power since 2005. At the moment, the list of potential names for CDU leadership is long, but devoid of star power (Box 1). The one quality of all the potential candidates, however, is that they are pro-Europe. Bottom Line: In the short term, markets have read German elections overly negatively. The euro reacted on the news as if the currency bloc breakup risk premium had risen. It hasn't. In fact, the election could prove to be a long-term bullish euro outcome, given that Merkel will likely have to acquiesce to Jens Weidmann's candidacy for the ECB presidency. The German Bundestag remains overwhelmingly pro-Europe. The now-in-opposition SPD is pro-integration, as are the likely new coalition members, the Greens. Die Linke has evolved from anti-capitalist, soft Euroskeptics to left-of-SPD Europhiles. While FDP remains committed to a mildly Euroskeptic line (pro-Europe, but opposed to further integration), its members will likely have to sacrifice this position in order to be in government in the long term. They won't say that they are doing that, but trust us, they are. The performance of Germany's populist right wing is largely in line with that of other European countries. As such, it signals that Germany is a "normal country," not that there is something particularly disturbing going on. Box 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Ursula von der Leyen (CDU): Leyen, who has served most recently as defense minister, is often cited as a likely replacement for Merkel. However, she is not seen favorably by most of the population: she has not won first place in her district in any of the past three general elections. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has argued that the European refugee crisis and debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière (CDU): Maizière, who has served as minister of interior and minister of defense, is a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could become a compromise candidate between the Europhiles and Eurohawks within CDU ranks. Though he has been implicated in scandals as defense minister, he has remained popular by drawing a relatively hard line on immigration policy and internal security. Julia Klöckner (CDU): A CDU deputy chairwoman from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel and a hence a likely candidate to replace her. While remaining loyal to Merkel, she has taken a more right-wing stance on the immigration crisis. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist," though she has insisted that AfD voters are not all "Nazis" but are mostly in the middle of the political spectrum and need to be won back by the CDU. We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe (CDU): Gröhe last served as minister of health and is a former CDU secretary general. He is very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier is in a position to capitalize on Brexit. He is a heavyweight within the CDU's leadership and a staunch Europhile. He has already declared he will run for the top state office again in 2018, though he will be 67 years old by then. The U.K.: Fall In Florence Prime Minister Theresa May tried to reset Brexit negotiations with the EU recently by giving a speech in Florence. We were told by clients and colleagues that it would be an important event, so we tuned in and listened. The speech was largely a dud. It confirmed to us the constraints on London's negotiating position as well as the challenges that Brexit poses to the British economy. May's team is struggling to navigate both. There are three things that investors should take from the speech - most which we have been emphasizing for over a year: The EU exit bill: The U.K. will pay. The one concrete point that Prime Minister May agreed with, for the first time ever, is that London will continue to pay into the current EU seven-year budget period (2014-2020). This should never have been in doubt. Britain's refusing to pay would be the equivalent of a tenant giving notice that he is ending his lease in 24 months, then refusing to pay in the interim. What May did not say is whether the U.K. would pay anything beyond its share of contribution to the EU budget. At the moment, the answer appears to be no, but we don't expect that to be the final word. Services really (really) matter: The U.K. has a competitive advantage in services. This is why May has tried to signal that she wants the broadest trade deal possible, since regular free trade agreements (FTAs) do not provide for deep integration in services. What will the U.K. give in return? May appears to want a Norway-type EU trade agreement with Canada-type liabilities. This won't fly in Brussels. The transition deal will last two years at minimum: This was never in doubt. But due to domestic political pressures, May was afraid of voicing it in public until today. Below we provide excerpts of the most relevant (or irrelevant, but comical) parts of May's speech.6 Our running commentary is in brackets. Theresa May's Florence Speech On Brexit, September 2017: A Reinterpretation By GPS It's good to be here in this great city of Florence today at a critical time in the evolution of the relationship between the United Kingdom and the European Union. It was here, more than anywhere else, that the Renaissance began - a period of history that inspired centuries of creativity and critical thought across our continent and which in many ways defined what it meant to be European. [GPS: Strong opening by May. Odd location for the speech, however. Unless she was looking to ingratiate herself with Matteo Renzi, former mayor of Florence, former prime minister of Italy, and current leader of the ruling Democratic Party]. * * * The British people have decided to leave the EU; and to be a global, free-trading nation, able to chart our own way in the world. For many, this is an exciting time, full of promise; for others it is a worrying one. I look ahead with optimism, believing that if we use this moment to change not just our relationship with Europe, but also the way we do things at home, this will be a defining moment in the history of our nation. [GPS: This is a crucial argument by proponents of Brexit, that leaving the EU is not just about leaving the bloc's oversight, but also about domestic renewal. At the heart of this view is the belief that the EU has shackled the U.K.'s potential economic output with its regulatory oversight and protectionist trade policies. For this to be true, the U.K. has to replace significance labor force growth - from the EU Labor Market - with even greater productivity growth. If the U.K. fails to do this, its potential GDP growth rate will be substantively lower in the future. We do not buy the optimism. For one, the EU has not been a drag on the U.K.'s World Bank Ease Of Doing Businness rankings, where the country ranks seventh. Second, several other EU member states are in the top 20, including Sweden, Estonia, Finland, Latvia, Germany, Ireland and Austria. Third, developed economies have been dealing with sub-standard productivity growth for over a decade, both EU members and non-members. As such, we are pretty certain that the U.K.'s potential GDP growth rate will be lower over the next decade, not higher.] And it is an exciting time for many in Europe too. The European Union is beginning a new chapter in the story of its development. Just last week, President Juncker set out his ambitions for the future of the European Union. [GPS: A nod to the reality that without the U.K. stalling its integration, Europe is now better able to build its "ever closer union." May is essentially conceding here to Charles de Gaulle's argument, articulated in the 1960s, that letting Britain into the club would ultimately be a mistake.]7 There is a vibrant debate going on about the shape of the EU's institutions and the direction of the Union in the years ahead. We don't want to stand in the way of that. [GPS: Reality check: it has literally been the foreign policy of the U.K. to "stand in the way of" of a united Europe for at least six hundred years ...] * * * Our decision to leave the European Union is in no way a repudiation of this longstanding commitment. We may be leaving the European Union, but we are not leaving Europe. Our resolve to draw on the full weight of our military, intelligence, diplomatic and development resources to lead international action, with our partners, on the issues that affect the security and prosperity of our peoples is unchanged. Our commitment to the defence - and indeed the advance - of our shared values is undimmed. Our determination to defend the stability, security and prosperity of our European neighbours and friends remains steadfast. [GPS: As we have argued repeatedly, the U.K. and EU share crucial geopolitical and economic links. As such, it is difficult to see negotiations devolving into the sort of acrimony that many have expected. May understands this and is reminding Europe of how important the U.K. role is, and will continue to be, geopolitically for Europe.] * * * The strength of feeling that the British people have about this need for control and the direct accountability of their politicians is one reason why, throughout its membership, the United Kingdom has never totally felt at home being in the European Union. [GPS: A not-so-slight dig at Europe. Basically, May is saying that U.K. voters live in a democracy. EU voters live in something else.] And perhaps because of our history and geography, the European Union never felt to us like an integral part of our national story in the way it does to so many elsewhere in Europe. [GPS: This is true and can be empirically measured (Chart 15).] Chart 15Brits Have A Strong Sense Of National Identity * * * For while the UK's departure from the EU is inevitably a difficult process, it is in all of our interests for our negotiations to succeed. If we were to fail, or be divided, the only beneficiaries would be those who reject our values and oppose our interests. [GPS: This is all true and very well put. But it also appears to be a line of argument designed to tug at Europe's emotional strings. Like a husband asking his wife to take it easy on him in a divorce "for the sake of the children."] So I believe we share a profound sense of responsibility to make this change work smoothly and sensibly, not just for people today but for the next generation who will inherit the world we leave them. [GPS: Literally the line about the kids followed immediately!] * * * But I know there are concerns that over time the rights of EU citizens in the UK and UK citizens overseas will diverge. I want to incorporate our agreement fully into UK law and make sure the UK courts can refer directly to it. Where there is uncertainty around underlying EU law, I want the UK courts to be able to take into account the judgments of the European Court of Justice with a view to ensuring consistent interpretation. On this basis, I hope our teams can reach firm agreement quickly. [GPS: An important concession - the first in the speech so far, and we are more than halfway through: London will apparently take into account ECJ rulings when dealing with EU citizens living in the U.K. That is a huge concession to Europe and an arrangement unlike anywhere else in the world.] * * * The United Kingdom is leaving the European Union. We will no longer be members of its single market or its customs union. For we understand that the single market's four freedoms are indivisible for our European friends. We recognise that the single market is built on a balance of rights and obligations. And we do not pretend that you can have all the benefits of membership of the single market without its obligations. [GPS: As we have said in the past, May's decision to concede this point in January was a major concession to the EU and is the reason that the negotiations are not and will not be acrimonious. If the U.K. demanded access to the Common Market without accepting the "four freedoms," it would have received an acrimonious response, given that its request would have been construed as "special treatment."] So our task is to find a new framework that allows for a close economic partnership but holds those rights and obligations in a new and different balance. But as we work out together how to do so, we do not start with a blank sheet of paper, like other external partners negotiating a free trade deal from scratch have done. In fact, we start from an unprecedented position. For we have the same rules and regulations as the EU - and our EU Withdrawal Bill will ensure they are carried over into our domestic law at the moment we leave the EU. [GPS: May is correct. The EU-U.K. trade negotiations should be relatively smooth given that the U.K. is not starting from scratch in negotiating the relationship. The Canada-EU FTA took seven years because they were starting from scratch.] So the question for us now in building a new economic partnership is not how we bring our rules and regulations closer together, but what we do when one of us wants to make changes. One way of approaching this question is to put forward a stark and unimaginative choice between two models: either something based on European Economic Area membership; or a traditional Free Trade Agreement, such as that the EU has recently negotiated with Canada. I don't believe either of these options would be best for the UK or best for the European Union. European Economic Area membership would mean the UK having to adopt at home - automatically and in their entirety - new EU rules. Rules over which, in future, we will have little influence and no vote. [GPS: We pointed out why such an arrangement would be illogical in March 2016. Essentially, the U.K. would leave the EU due to its onerous regulation and infringement on sovereignty only to accept the onerous regulation as a fait accompli with no room for British sovereignty (Diagram 1)!] Diagram 1The Central Paradox Of Brexit Such a loss of democratic control could not work for the British people. I fear it would inevitably lead to friction and then a damaging re-opening of the nature of our relationship in the near future: the very last thing that anyone on either side of the Channel wants. As for a Canadian style free trade agreement, we should recognise that this is the most advanced free trade agreement the EU has yet concluded and a breakthrough in trade between Canada and the EU. But compared with what exists between Britain and the EU today, it would nevertheless represent such a restriction on our mutual market access that it would benefit neither of our economies. [GPS: This is, by far, the most critical part of May's speech. She is essentially saying that a Canadian FTA deal would benefit the EU more than it benefits the U.K., a point we have made for nearly two years now. This is true. The U.K. needs access to the EU services market, where British exporters have a comparative advantage. Were they to secure an FTA deal with the EU instead, they would be giving Europe a massive advantage, given the bloc's comparative advantage in tradable goods (Chart 16). However, this takes us back to Diagram 1. What kind of a relationship does May expect to get from the EU when she is unwilling to accept any of the liabilities inherent in such a deep trade deal? That is precisely what the Common Market is for.] Chart 16Brexit Hinders U.K.'s Comparative Advantage Bottom Line: Prime Minister May's Florence speech has shown the limits of the U.K.'s negotiating position. May set a friendly tone with Europe, but she has nothing to bargain with. Much of the speech reiterated British commitment to Europe's security and its capacity to defend the continent from external threats. In exchange, May argues, the U.K. ought to receive the deepest and most expansive access to the EU Common Market without any of the liabilities that go with it. In particular, she wants access to the EU's services market, where U.K. exporters have a comparative advantage. The problem with the tradeoff between U.K. geopolitical benefits and EU economic benefits is that it suggests that London has an alternative to being a geopolitical ally to Europe! As if it could suddenly shift its geopolitical, military, and diplomatic focus elsewhere. Berlin, Brussels, and Paris will call London's bluff. The U.K. is not in North America, it is in Europe. As such, Europe's problems are the U.K.'s problems, and the U.K. must defend against them even if it receives little in return. We expect the U.K. to succumb to the reality that the EU holds most of the cards in the negotiations. The U.K. will have a lower potential GDP growth rate after Brexit. But before Brexit is solidified, we expect considerable domestic political upheaval. In the short term, there is some upside for the pound. In the long term, it is a sell. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Although she has herself played a role in kicking out the original, even more moderate, founders of the party. 4 The CDU, FDP, and Greens coalition is dubbed the "Jamaica coalition" because of their traditional colors - black, yellow, and green - which combine to make the colors of the Jamaican flag. 5 The CSU does not directly compete against the CDU on the federal level. It only fields candidates in Bavaria, where the CDU does not compete. 6 For the full transcript, please see "Theresa May's Florence speech on Brexit, full text," The Spectator, September 22, 2017, available at blogs.spectator.co.uk. 7 In turn, this will allow the EU to build up its power, develop a navy, and finally conquer the British Isles with a new armada somewhere around 2066! Geopolitical Calendar

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite and long-standing indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter monetary policy is required, validating the recent hawkish shift by policymakers. Feature September has been an active month for central bankers. The Bank of Canada hiked rates again, the European Central Bank gave strong hints that a tapering of its asset purchase program will soon be announced, and the Bank of England warned that tighter policy might soon be required. Just last week, the Federal Reserve began the process of reducing its massive balance sheet while also making no changes to its plans to hike interest rates several times over the next year. This is setting up a potential nasty surprise for bond markets. Investors have became deeply skeptical about the possibility of policymakers shifting in a more hawkish direction without an obvious trigger from faster inflation. Yet the global economy is in a synchronized expansion with the largest share of countries operating at (or beyond) full employment since the pre-crisis years. Inflation is in the process of stabilizing, or grinding higher, in most of the major economies. In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors - one of our favorite indicators to assess the potential for monetary policy changes. The broad conclusion - the Monitors are all at or above the threshold signaling that tighter policy is required, validating the recent hawkish shift by policymakers (Chart of the Week). Chart of the WeekGrowing Pressures To Tighten, According To Our Central Bank Monitors An Overview Of The BCA Central Bank Monitors Chart 2Upward Pressure On Global Bond Yields The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are all near or above the zero line, providing context for why central bankers have shifted towards a more hawkish bias of late. Actual rate hikes are still not likely over the next few months outside of the Fed and BoC (we remain skeptical on the potential for the BoE to realistically tighten policy). More importantly, the underlying growth and inflation pressures indicated by the Monitors suggest that policymakers will maintain a hawkish bias (or, at best, a neutral tone) in their communications with the markets. One new addition to the individual country sections in this Chartbook are charts showing the Monitors, broken into growth and inflation components. The conclusion from these new charts is that the current level of the overall Monitors is a reflection of strong economic growth in all countries, with the inflation components giving more mixed signals. The Fed Monitor: Neutral For Now, Likely To Head Higher Again Our Fed Monitor has drifted lower over the past several months, and now sits just slightly above the zero line, calling for no imminent need to change U.S. monetary policy (Chart 3A). FOMC members have been sending more balanced messages in their recent speeches, specifically noting the confusing mix of what appears to be a U.S. economy operating at full employment but with slowing core inflation (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. When looking at the breakdown of our Monitor into its main inputs (Chart 3C), the growth component remains in a steady grinding uptrend. The inflation component had softened since the peak earlier this year, but the latest reading shows a slight uptick. Chart 3CPressure On The Fed From U.S. Growth. Is Inflation Next? Looking ahead, we expect realized U.S. inflation, which looks to be stabilizing after the downturn since the spring, to grind higher alongside a steadily expanding U.S. economy. With corporate profits and household incomes expanding, and with leading indicators steadily climbing, there is little reason to expect much sustained slowing of U.S. growth in the next few quarters. The next move in our Fed Monitor will likely be upward. The historical correlations between changes in our Fed Monitor and changes in U.S. Treasury yields suggest that any renewed increase in the Monitor should put more upward pressure on the front end of the yield curve than the back end (Chart 3D). This suggests that Treasury curve would bear-flatten as the market priced in more Fed rate hikes. However, we see a greater near-term risk of a bear-steepening of the curve given the low level of market-based inflation expectations. The Fed will want to see those rise - which will require signs of realized inflation rebounding - before delivering another rate hike, perhaps as soon as December. Chart 3DThe Fed Monitor Is Most Correlated To Shorter-Maturity USTs BoE Monitor: The Window Is Closing For A Rate Hike Our Bank of England (BoE) Monitor has been in the "tight money required" zone since the end of 2015 and has not signaled a need for easier monetary policy since 2012 (Chart 4A). This is unsurprising with the U.K. economy running beyond full employment for over three years alongside a steady rise in inflation (Chart 4B). Chart 4AU.K.: BoE Monitor Chart 4BTight Capacity In The U.K. The after-effects of the Brexit vote last year are still an issue for the U.K. economy and the BoE. The central bank eased monetary policy (rate cuts and QE) after the Brexit shock as insurance against the massive economic uncertainty. Yet that not only provided stimulus to an economy that was already operating beyond full employment, but also resulted in a 16% peak-to-trough decline in the British Pound. The result: a surge in headline U.K. inflation to 2.9%, well above the BoE's 2% target. The BoE sent a hawkish message at the policy meeting earlier this month, signaling that interest rates would have to rise if growth evolves in line with their forecasts. We are skeptical on that front: U.K. leading economic indicators have rolled over, real income growth has stagnated due the high inflation, and business confidence continues to be dragged down by Brexit uncertainties. Also, the greater stability in the trade-weighted Pound - now essentially flat versus year-ago levels - should result in some cooling off of the currency-driven surge in inflation, which the inflation component of our BoE Monitor is already signaling (Chart 4C). Chart 4CThe Inflation Component Of The BoE Monitor Has Collapsed We remain neutral on Gilts, as we expect the BoE to remain on hold and not follow through on their recent hawkish commentary (Chart 4D). Chart 4DThe Gilt/BoE Monitor Correlations Are Higher At The Long-End ECB Monitor: On Course For A 2018 Taper Our European Central Bank (ECB) Monitor has steadily climbed over the course of 2017 and now sits right on the zero line (Chart 5A). The solid and broad-based economic expansion in the Euro Area has soaked up spare capacity. The unemployment rate has fallen to an 8-year low of 9.1%, suggesting that the Euro Area economy is very close to full employment for the first time since the Great Recession (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BExcess Capacity In Europe Dwindling Fast Against that strong growth backdrop, core inflation has been grinding higher off the lows, but at 1.4% remains below the ECB 2% target for headline inflation. When looking at the components of our ECB Monitor, however, rising inflation pressures have been as important a reason behind the pickup in the Monitor as stronger growth (Chart 5C). Chart 5CGrowth Has Pushed The ECB Monitor Higher This Year The deflation threat that prompted the ECB to begin its own asset purchase program in 2015 has passed, and we expect the ECB to announce a tapering of the bond buying starting in January 2018. If growth and inflation evolve according to the ECB's forecasts - which is likely barring an additional major surge in the euro from current elevated levels - then there is a good chance that the asset purchase program will be wound down by the end of 2018. Interest rate hikes are still some time away, though. The market is currently discounting a first 25bp ECB rate hike around October 2019. We agree with that pricing, as the ECB will "follow the Fed playbook" and not begin rate hikes until well after the end of the asset purchase program. We remain underweight Euro Area government debt, with a bias towards bear-steepening of yield curves as inflation expectations should steadily climb higher and the ECB keeps policy rates unchanged (Chart 5D). Chart 5DStronger Bond/ECB Monitor Correlations At The Short-End BoJ Monitor: Creeping Higher, Surprisingly The Bank of Japan (BoJ) Monitor has steadily climbed throughout 2017 and now sits right on the zero line (Chart 6A). While overall inflation rates remain well below the 2% BoJ target, the steady economic expansion has absorbed spare economic capacity, with the unemployment rate now down to a mere 2.8% (Chart 6B). Both the growth and inflation components of our BoJ Monitor have been rising (Chart 6C). Chart 6AJapan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation While the pickup in inflation off the lows is a welcome sight for the BoJ, there is no immediate pressure to shift to a less accommodative policy stance (Chart 6D). In fact, the central bank has already done its own version of a "taper" by moving to a 0% yield target on JGBs one year ago. Maintaining that yield level has required a slower pace of asset purchases by the central bank, which are running at an annualized pace of 70 trillion yen so far in 2017, below the 80 trillion yen target for the current QE program. Chart 6CTight Labor Market, But Still No Inflation We do not see the BoJ abandoning the 0% yield target anytime soon. By depressing JGB yields, the BoJ hopes to engineer additional weakness in the yen which will feed through into faster inflation and rising inflation expectations. This appears to be the only way to generate any inflation in Japan, even with such a low unemployment rate. Chart 6DLow Correlations Between the BoJ Monitor & JGB Yields It will require a rise in Japanese core inflation back towards 2% before the BoJ will even begin to discuss any real tapering of its QE program. Thus, JGBs will remain a low-beta "safe-haven" among Developed Market government bonds, where there is greater risk of central bank tightening actions that will push yields higher. Remain overweight. BoC Monitor: More Tightening To Come The Bank of Canada (BoC) Monitor has been comfortably above the zero line throughout 2017 (Chart 7A). The Canadian economy has shown robust growth, which has soaked up spare capacity (Chart 7B). The BoC is projecting that the output gap in Canada will likely be fully closed before the end of this year. The surprising surge in growth is likely to continue given the strength in the leading economic indicators and the robust readings from the BoC's own Business Outlook Survey. Chart 7ACanada: BoC Monitor Chart 7BStill Not Much Inflation In Canada The central bank has already responded to the faster-than-expected pace of growth with two 25bps rate hikes since July. This took place even without much of a pick-up in realized inflation or in the inflation component of our BoC Monitor (Chart 7C). Clearly, the BoC is focusing more on the rapidly accelerating economy, with real GDP growth surging to a 3.7% year-over-year pace in Q2. With the BoC Overnight Rate still at a very low level of 1%, well below the central bank's own estimate of the neutral "terminal" rate of 3%, there is room for additional rate hikes as long as growth remains robust. Chart 7CRising Growth Pressures On The BoC, Still No Inflation The surging Canadian dollar is not yet a concern for the BoC, as this reflects both the improving Canadian economy and the Fed taking a pause on its own rate hiking cycle. With the latter poised to resume in December and continue into 2018, the appreciation of the "Loonie" is likely to cool off, even if the BoC keeps raising rates. We have maintained an underweight stance on Canadian bonds, with a curve flattening bias, since mid-year (Chart 7D). We are sticking with that stance, even with the market now priced for nearly 70bps of additional rate hikes over the next year. If the Canadian economy continues to grow rapidly, and the Fed returns to hiking rates, the BoC can tighten to levels beyond current market pricing. Chart 7DA Rising BoC Monitor Typically Leads To A Flatter Canadian Yield Curve RBA Monitor: Conflicting Forces Our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory (Chart 8A). Core inflation has picked up slightly, dragging market expectations along with it, but headline price growth has declined below 2% (Chart 8B). However, commodity prices continue to ease, survey-based measures of inflation expectations have pulled back and the inflation component of the RBA Monitor has retreated from the highs (Chart 8C). Chart 8AAustralia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA The RBA is facing conflicting forces of an improving labor market and booming house prices, combined with high consumer indebtedness and nonexistent real wage growth. Though employment growth has recently spiked, part time employment as a percentage of total is just starting to roll over and underemployment remains elevated. Labor market conditions will need to tighten considerably for wages to rise and consumer confidence to recover. A wide output gap, mixed employment backdrop and a lack of inflation pressure will likely keep the policymakers on hold for longer than the market expects. Chart 8CRBA Facing Surging Growth Pressures & Cooling Inflation Pressures We are currently at a neutral stance on Australian government bonds, given the mixed economic backdrop. Instead, we prefer to maintain our 2yr/10yr yield curve flattener trade. The short end will remain anchored by an inactive RBA, with the long end facing downward pressure from soft inflation expectations and macro-prudential measures in the housing market dampening credit growth. Even if the RBA were to tighten policy as markets expect, the yield curve would flatten. Additionally, negative correlations between Australian yield curves and the RBA monitor have been more robust in the post-crisis era (Chart 8D). As labor markets continue to improve, the other components of the Monitor, such as wages, retail sales and consumer confidence, will follow. Chart 8DThe Entire Australian Curve Is Highly Correlated To Our RBA Monitor RBNZ Monitor: Rate Hikes Are Needed Our Reserve Bank of New Zealand (RBNZ) Monitor has been the strongest of all our Monitors, and is currently well into "tight money required" territory" (Chart 9A). The solid New Zealand economic expansion has fully absorbed spare capacity, and both headline core inflation are accelerating towards the RBNZ target (Chart 9B). Both the inflation and growth components are surging, contributing to the overall sharp rise in the RBNZ Monitor (Chart 9C). Chart 9ANew Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ So with growth and inflation looking perkier, why has the RBNZ not delivered on rate hikes this year? They central bank has highlighted "international uncertainties" related to geopolitical risks as well as trade tensions between China and the U.S. that could spill over into New Zealand exports to Asia. The central bank has also shown caution in its own growth and inflation forecasts, despite the signs of strength. Chart 9CHow Much Longer Can The RBNZ Ignore This? More likely, the RBNZ has been actively trying to avoid an unwanted surge in the currency that could derail the economy. Given the elevated geopolitical tensions with North Korea, it is likely that the RBNZ will stick with a dovish message - especially given the recent pickup in the currency. We have been running long positions in New Zealand government debt versus U.S. Treasuries and German Bunds in our Tactical Overlay portfolio since May. We've been heeding the commentary of the central bank rather than our own RBNZ Monitor, although the divergence between the two is becoming unsustainable (Chart 9D). The Q3 CPI inflation report due in October will be critical to assess the RBNZ's next move. We are sticking with our recommended trades, for now. Chart 9DNZ Bonds Are Vulnerable To Current Cyclical Growth & Inflation Pressures Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The Fed still wants to hike in December and thrice next year, but euro area inflation could roll-over versus the U.S. This could cause some weakness in EUR/USD. Long USD/JPY remains a cleaner way to capitalize on the Fed and on higher U.S. bond yields. U.K. trend growth is falling, this will limit how high the BoE will push interest rates up. While the pound can rebound further until year-end, it is not as cheap as it may currently look. AUD/NZD could move back toward parity, but be patient before shorting this cross. Feature The Fed Is On, The Dollar Will Strengthen The dollar bear market is likely over for now, but in our view, U.S. inflation still needs to bottom meaningfully for the DXY to be able to move above 95, and for EUR/USD to trade below 1.15. We expect inflation to bottom late in the fourth quarter, and noticeably re-accelerate in 2018. For now, markets will have to fully price a December rate hike from the Federal Reserve and handle the fallout of a potential slowdown in euro area inflation in the coming months. Moreover, the European Central Bank's tapering announcement next month has been well telegraphed, and is likely to be fully priced in a euro already trading well above levels implied by interest rate differentials. Fed Chair Janet Yellen and the Fed's economic projections have been unequivocal: Governor Lael Brainard has not convinced the rest of the FOMC that U.S. inflation expectations are becoming unmoored to the downside. As a result, the Fed still plans to hike in December and still expects to lift U.S. interest rates thrice next year. The committee also continues to foresee inflation returning to 2% in 2019. The market got the message: on Wednesday, the dollar experienced its strongest rally in eight months, and bond yields moved higher. New evidence is also accumulating that U.S. core CPI will soon trough. This week, U.S. non-oil import prices, a key input to non-oil goods prices continued to increase and the Philly Fed survey's prices-paid and price-received components both showed improvement - corroborating the message from the ISM price paid, which has shot up to 62. This should give Wednesday's message from the Fed more credence among investors. Meanwhile, euro area growth remains very strong, but there are early signs that core inflation may be peaking. BCA's euro area core CPI diffusion index has rolled over and fallen below 50%, normally a precursor sign to a top in core CPI (Chart I-1). Moreover, the strength in EUR/USD is redistributing previous U.S. deflationary pressures into the euro area. As Chart I-2 illustrates, the tightening in euro area financial conditions relative to the U.S. points to a rollover in relative inflation trends. Chart I-1Euro Area CPI Peaking? Chart I-2Euro Area Core CPI Peaking Against The U.S. The market is still pricing far too little in the way of rate hikes in the U.S. over the next two years, while it is pricing the ECB appropriately, anticipating a 2019 lift-off of euro area policy rates (Chart I-3). This leaves the EUR/USD quite vulnerable if the market reassesses the Fed's capacity to lift rates, as this pair continues to trade at a level of premium to interest rate parity models last recorded in 2009 (Chart I-4) - premia that have historically been followed by declines over the following six months, averaging 6%. Chart I-3The Potential For A Repricing Of The ##br##Fed Relative To The ECB... Chart I-4..Will Hurt ##br##EUR/USD The yen too remains at risk. The yen might be cheaper than the euro, trading in line with its interest rate-implied fair value, but it is also burdened by a central bank inclined to leave policy as easy as possible for as long as possible. In fact, new Bank of Japan board member Goshi Kataoka dissented this week because, in his view, Japan needs more easing, both fiscal and monetary. Thus, in an environment where the Fed is trying to lift interest rates and where U.S. Treasury yields trade well below fair value (Chart I-5), the yen could suffer greatly as interest rate differentials move in favor of the USD, since the BoJ will still cap JGB yields for an extended period. Moreover, on the political front, an October election is becoming increasingly possible. Japanese Prime Minister Shinzo Abe's popularity has rebounded, and the opposition is in disarray, pointing to a very likely win for the LDP. Abe is seeking a new mandate as he wants to set a referendum to amend the Japanese constitution, removing its pacifist bias in order to increase military spending, which has greatly lagged that of rival China (Chart I-6). The North Korean crisis is obviously beneficial to this goal, and Abe wants to capitalize on it. Chart I-5Biggest Problem For The Yen Chart I-6Abe Wants To Rectify This Gap In order to increase the likelihood of a successful referendum, we anticipate Abe to push for more stimulus to goose the economy. Additionally, when Japanese wages are adjusted for the change in the breakdown between full-time and part-time positions, wage growth has already picked up significantly - well above 3% compared to a paltry 0.4% annual rate for the headline measure. This combination of potential fiscal stimulus, improving underlying wage growth and a staunchly dovish central bank could ultimately put upward pressure on inflation expectations, and thus downward pressure on Japanese real yields. This could further augment the negative impact of rising U.S. bond yields on the yen. Bottom Line: The dollar is set to appreciate against the euro and the yen in the coming weeks. The Fed has not deviated from its message and it still intends to follow the path set in the "dot plot." Meanwhile, euro area inflation could roll over, limiting how close to today markets can bring forward the first hike from the ECB. The euro is too expensive to withstand this eventuality. The BoJ in unwilling to abandon its current extremely dovish policy, setting the stage for additional yen weakness in the face of higher U.S. bond yields. GBP: As Cheap As It Seems? GBP/USD is currently trading at a large 20% discount to its purchasing parity equilibrium rate, and the trade-weighted pound is 10% below our long-term fair value estimate (Chart I-7). Since valuations have been strong predictors of currency returns on a two- to five-year horizon, this begs the following question: Is the pound a buy? Tactically, yes, the GBP still offers upside for the next three months or so, especially vis-à-vis the euro. The Brexit negations are likely to lead to long transition periods for FTAs after the U.K. leaves the EU. Moreover, interest rate markets currently assign a 65% probability of a hike by the Bank of England in November. However, recent communications from BoE Governor Mark Carney and his colleagues suggest the British central bank will hike that month. House prices have regained some composure and wage growth has rebounded to 2.2% after hitting a low of 1.7% six months ago, explaining some of the recent strength in retail sales. Inflation remains sticky at 2.9% per annum, and even the non-tradeable sector, where the pound's movements should bear little influence, continues to experience elevated inflation readings. This would support Carney's recent assertion that the U.K.'s output gap is closing faster than the BoE originally anticipated. It also raises question marks as to whether long-term inflation expectations in the private sector are beginning to become unanchored - something that would justify removing monetary accommodation from the system. Beyond this time horizon, the picture becomes more complex. The problem for the pound arises from the fact that the earlier-than-expected closure of the output gap is first and foremost a reflection of falling trend growth, a phenomenon that will continue well into the future. It is one of the inevitable consequences of last year's Brexit vote. Brexit principally impacts trend growth by depressing the U.K.'s labor force growth. As Chart I-8 illustrates, pre-Brexit, the U.K. experienced much more robust labor force growth than its EU peers thanks to a steady inflow of immigrants. However, at its core, the Brexit vote was a referendum on immigration. The U.K. government's hard stance on rejecting free movement of people going forward demonstrates that the Conservatives understand this, and it will remain a key pillar of their strategy going forward. Chart I-7Is The Pound Really That Cheap? Chart I-8U.K. Trend Growth Will Fall Problematically, leaving the EU will not improve the British trade balance, despite the fall in the pound. It may even hurt it. The fall in the pound can marginally help the U.K.'s goods balance with the EU, which currently stands at a deficit of 5% of GDP. However, this deficit is structural and reflects the U.K.'s lack of competitive advantage in manufacturing vis-à-vis the rest of the EU. Thus, a fall in the pound will do little to fully redress this gap. Meanwhile, the U.K. runs a surplus of 1.3% of GDP in the services balance (Chart I-9). However, by leaving the EU, the U.K.'s service sector is likely to lose much access to the continent as trade in services is heavily regulated, and creating new trade deals on services between the U.K. and the EU will prove a difficult process. Moreover, this services balance seems insensitive to the gyrations in EUR/GBP. Thus, while leaving the EU might marginally help the goods balance thanks to a lower pound, this exchange rate benefit will be nullified by a loss of access to EU markets by U.K. service sector firms. Why does a lower trend growth matter for the pound in the long run? The U.K. has been running a large current account deficit for 20 years. Even at 3.9% of GDP, this deficit does not have to be a problem if it can be financed. Thankfully, the U.K. has benefited from a higher level of neutral interest rates, itself a function of Britain's higher trend GDP growth. This higher neutral rate means the U.K. has been able to enjoy higher interest rates in general than the EU or the U.S. (Chart I-10). These higher returns have attracted the necessary capital to finance the current account. Chart I-9A Lower Pound Will Not Undo##br## The Pain Of Leaving The EU Chart I-10Lower Trend Growth Equals##br## Lower Terminal Rate Going forward, lower trend growth will lower the neutral interest rate, which will limit both the terminal rate hit by the BoE this cycle as well as the average level of rates in the U.K. In this context, the U.K. will need a permanently cheaper pound to finance its current account deficit. As a result, the apparent cheapness of the pound on long-term valuation metrics may prove to be nothing more than an illusion. Chart I-11Will Higher GBP Volatility Hurt London? The other problem that could negatively affect the pound is that the U.K. remains a global financial center. Historically, having low exchange rate volatility has helped financial centers achieve the pre-requisite level of stability needed to attract foreign capital (Chart I-11). However, the pound's volatility has increased in the aftermath of Brexit. If realized volatility was computed from 2000 to 2015, the standard deviation of the pound's returns rank below that of the Swiss franc and the Norwegian krone; if the sample is expanded to today, its volatility ranks above that of the CHF and the NOK. Not only does this point to a large increase in the relative volatility of the pound in the interim two years, but this trend could continue in the future, especially if as our Geopolitical Strategy sister service argues, the leftward-shift in the U.K.'s median voter could lead to a Corbyn Premiership down the road.1 Bottom Line: The pound still has upside in the short-term as markets re-assess the path of the BoE toward a rate hike this year, removing the emergency easing implemented in the wake of the last year's referendum. However, the long-term outlook for the pound is trickier. The GBP's apparent cheapness is warranted. The U.K.'s potential growth rate is falling, which will drag down the country's neutral interest rates. As a result, the BoE will not be able to increase interest rates much over the course of the cycle. This means that financing the U.K.'s current account deficit will require the pound to remain cheap for an extended period of time. AUD/NZD: The RBNZ Can Tighten More Than The RBA The AUD/NZD is likely to experience a move toward parity over the next six months. Currently, AUD/NZD trades approximately 10% above its long-term fair value (Chart I-12, left panels), a level that has historically resulted in sharp reversals. This cross is also trading at a significant premium to our Intermediate-Term timing model (Chart I-12, right panels), further highlighting the medium-term downside risk for the aussie/kiwi. Chart I-12AAUD/NZD Is Expensive Chart I-12BAUD/NZD Is Expensive Valuations are not the only consideration raising a red flag for AUD/NZD. Relative monetary policy dynamics could also weigh on this cross going forward. As the Reserve Bank of New Zealand has been trying to talk down the kiwi, interest rate markets are pricing in 34 basis points of hikes over the next 12 months, while they expect the Reserve Bank of Australia's Cash Rate to increase by 41 basis points over the same timeframe. We think the RBNZ has more room to tighten policy than the RBA, especially as our central bank monitor is much more hawkish on New Zealand than Australia (Chart I-13). Corroborating the message of this indicator, the New Zealand output gap is now at 0.9% of potential GDP while it stands at -1.6% in Australia, suggesting more pronounced underlying inflationary pressures in the smaller economy. Moreover, New Zealand's growth is outpacing Australia's by nearly 1%, and relative LEIs suggest no end in sight for this trend. Thus, the relative output gap between the two countries will continue to move in favor of a tighter RBNZ than RBA. Additionally, Australia house prices have been in a cyclical downtrend versus New Zealand, depreciating nearly 15% in relative terms since 2011. This is resulting in a large underperformance of Australia's credit growth against New Zealand, which points to downside risk in AUD/NZD (Chart I-14). Mirroring these two factors, Aussie retail sales are lagging their neighbors by a near-record 3% annual pace. Beyond domestic conditions, terms-of-trade dynamics are also a negative for AUD/NZD. This cross tends to mimic movements in the prices of metals relative to dairy prices, reflecting the composition of the two nations' exports. Since May this year, metals have been outperforming milk, but AUD/NZD has massively overshot this driver (Chart I-15), exposing the cross to a reversal in relative commodities prices. Going forward, with Chinese monetary conditions tightening, with Chinese fiscal stimulus waning, and with EM money growth sharply decelerating, metals prices, which are much more sensitive to global industrial activity, are likely to underperform the less growth-sensitive dairy prices. Chart I-13The RBNZ Needs To be More##br## Hawkish Than The RBA Chart I-14Disconnect Between AUD/NZD##br## And Relative Credit Growth Chart I-15AUD/NZD Out Of Line ##br##With Terms Of Trade Technically, it is too early to enter this bet with any degree of certainty. Short-term momentum metrics are deeply oversold, and AUD/NZD, currently trading at 1.085, could rebound once it moves to 1.08 - the next key support level and slightly above the 50% retracement of the rally begun in June. This rebound could lift AUD/NZD close to the 1.11 neighborhood. Thus, we will wait for a better entry point to begin shorting this cross, especially as this weekend's election remains too close to call despite a recent rebound in the National Party. A Labour/NZ First coalition could cause a temporary sell-off in the NZD. Bottom Line: AUD/NZD is very expensive, and the market is underestimating the risk that the RBNZ will tighten policy more than the RBA over the next 12 months. The New Zealand economy has much less slack and is growing more strongly than Australia's, pointing to greater inflation risk. Additionally, metals prices are likely to underperform dairy prices, which will hurt Australian terms of trade relative to New Zealand. Technically, a better opportunity to short AUD/NZD is likely to emerge in the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The highlight of this week was the Fed's Monetary Policy meeting, where the FOMC announced the unwinding of the Fed's US$4.5 trillion balance sheet in October. It also intend to boost in interest rates in December, with the probability of a hike that month now at 63%. This is likely to move to 100%. While data continued to be mixed this week - existing home sales slowed but the Philly Fed survey was very strong, the Fed decided to ignore this as well as the potential impact of hurricanes, instead concentrating on the strong fundamentals underpinning the U.S. economy. Interest rates will therefore increase alongside inflation, providing a fillip for the greenback. On the fiscal side, tax cuts seem increasingly likely to be implemented. As investors begin to price out fiscal policy disappointments, the dollar will rally. Nevertheless, inflation is likely to pick up some time in 2018, and the dollar will fully bloom then. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data continues to outperform expectations: Core CPI, unchanged at 1.3%, beat expectations of 1.2%; Headline CPI also remained unchanged at 1.5%; German ZEW Economic Sentiment outperformed greatly coming out at 17.0, while the Current Situation also outperformed at 87.9; German producer prices grew at 2.6% annually, outperforming expectations of 2.5%. While the euro traded positively on the news, it lost most of this week's gains due to the Fed policy decision. We believe that sustained growth in the euro area will sustain the euro between 1.15 and 1.20. However, a pickup in U.S. inflation in 2018 could push EUR/USD toward 1.10. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth underperformed to the downside, contracting by 7.5%. The contraction also accentuated from July to August. Domestic corporate goods price yearly growth also underperformed, coming in at 2.9%. However both export and import growth outperformed expectations, coming in at 18.1% and 15.2% respectively. Additionally the merchandise trade balance in August also outperformed, coming in at 113.6 Billion yen. The Bank of Japan decided to leave their policy rate unchanged at -0.1% on Wednesday on an 8 to 1 vote, with dissenter Goshi Kataoka presenting an even more dovish slant. The BoJ highlighted that the economy continues to expand moderately, and that inflation should continue to slowly grind higher. Overall we are more bearish on the ability of the BoJ to spur inflation without a meaningful depreciation in the yen. Continue to long USD/JPY. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has surprised to the upside: Retail sales growth and retail sales ex-fuel growth outperformed expectations coming in at 2.4% and 2.8% respectively. Manufacturing production yearly growth came in at 2.9%, also outperforming expectations. Furthermore the ILO unemployment rate came in at 4.3%, outperforming expectations. The BoE left rates unchanged in their latest interest rate decision by a majority of 7 to 2. The BoE was more hawkish than expected, commenting that monetary policy could need to be "tightened by a somewhat greater extent over the forecast period than current market expectations". Overall we continue to be positive on the pound relatively to the euro. However on a longer term basis, the outlook for the pound remains tricky, as Brexit could result in a lower neutral rate in the U.K., and thus a lower pound. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD fell sharply following RBA Governor Philip Lowe's speech. Lowe stated that "a rise in global interest rates has no automatic implications for us here in Australia", prompting a repricing of Aussie rates. The high level of household debt was also brought to light, with Governor Lowe highlighting that "household spending could be quite sensitive to increases in interest rates, something the Reserve Bank will be paying close attention to." He also surmised that "there are risks on the horizon, with the Chinese economy going through some difficult adjustments". This speech largely confirms are bearish view on the Australian dollar. While the AUD did rally this summer, this was mostly due to disappointing U.S. inflation. When inflation re-emerges, which we believe will be in early 2018, the AUD could give up most of its gains. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Electronic card retail sales yearly growth increased to 4.4% from 2% the month before. Gross Domestic product yearly growth came at 2.5%, in line with expectations. Meanwhile the current account outperformed to the upside, coming in at a deficit of 2.8% of GDP, compared to expectations of 3%. Finally the Business NZ PMI came in at 57.9, increasing significantly from last month's reading of 55.4. The kiwi has appreciated in the past 2 weeks, as a weak dollar coupled with positive data in New Zealand and falling political risk in that country have helped the currency. At the present, we are bearish on AUD/NZD, as the inflationary backdrop continues to be more positive in New Zealand than in Australia. Meanwhile iron ore prices seem to have peaked. These factors should weigh on this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian consumer sector remains strong, with wholesale sales increasing at a 1.5% monthly pace in July, beating the expected 0.9% contraction. Higher rates are also increasing portfolio inflows, as foreign portfolio investment in Canadian securities jumped to CAD 23.95 bn in July, from the previous outflow of CAD 0.86 bn, also larger than the expected CAD 4.46 bn. While the CAD depreciated against the USD following the Fed's monetary policy meeting, it remained largely flat against other G10 currencies. The CAD will continue to fight headwinds against the USD but to rally on its crosses. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Producer price inflation came in at 0.6%, beating expectations. The trade balance came in at 2.713 billion CHF for the month of August, underperforming expectations. A week ago the SNB left rates unchanged as expected. Most importantly, there was a slight upward revision in the inflation forecast, with the SNB anticipating an inflation rate of 0.4% in 2018 and 1.1% in 2019 compared to the previous forecast of 0.3% and 1%. These forecast assume a 3-month LIBOR of -0.75% through the forecast period. Moreover, the central bank also expects the modest recovery in Switzerland to continue. However, it seems that the floor under EUR/CHF will stay for the time being, as the SNB said that the Swiss Franc continues to be "highly valued" and that that continued intervention in the FX market will continue to be necessary. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Despite a rebound in Norway's economic surprise index, Norway continues to experience a marked lack of inflation: Headline inflation came in at 1.3%, decreasing from last month's reading of 1.5% and underperforming expectations. Core inflation also underperformed expectations, falling from 1.2% last month to 0.9% in the latest data point. Yesterday the Norges Bank decided to keep rates unchanged at 0.5%. The bank released a statement highlighting that capacity utilization is "on the rise, and higher than previously assumed", however they also highlighted that "wage growth will remain moderate". More importantly they signaled that they would likely increase rates somewhat earlier than previously expected. Overall we continue to be bullish on USD/NOK, as interest rate expectations should help the dollar against the krone. That being said, higher oil prices should help the krone outperform its commodity peers and the euro. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has remained flat for a month, as markets are assessing the situation between the two hawkish central banks. Data in Sweden has disappointed recently: Manufacturing PMI went down to 54.7 from 60.4; The current account decreased by SEK 39.5 bn; Industrial production also grew by 5.3% annually, lower than the previous 8.9% figure; New orders are also growing by less than before at 2.1%; Inflation also underperformed the expected 2.2%, coming in at 2.1%; However, the unemployment rate dropped significantly from 6.6% to 6%. While inflation disappointed, it still remains in the target range and the upward trend is still intact. The Swedish economy is performing very well, and the Riksbank is likely to join the Fed and the BoC in hiking rates next year. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. Expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. This yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD. Underweight U.K. consumer services versus the FTSE100. Overweight German consumer services versus the DAX. The September 24 German election and October 1 proposed referendum on Catalan independence are not major catalysts for the financial markets. Feature A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. As monetary policy resynchronizes, it will become clear that the extreme desynchronization of monetary policies over the past few years was the great anomaly (Chart of the Week and Chart I-2). This anomaly reached its peak in 2014 when policies at the ECB and the Federal Reserve moved in diametrically opposite directions. The ECB signalled the start of its quantitative easing just as the Fed began to end its own. Chart of the WeekThe Desynchronization Of Monetary##br## Policy Was An Anomaly Chart I-2The Desynchronization Of Monetary##br## Policy Was An Anomaly Why Did Monetary Policy Desynchronize? The extreme desynchronization of monetary policy would not have happened if it was just about economics. On the basis of the hard economic data, the ECB could have emulated the unconventional policies of the Fed, BoJ and BoE years before it eventually did in 2015. If it had, ECB policy would have been much more synchronized with the other major central banks. However, unconventional monetary policy wasn't, and isn't, just about economics. The ECB faced, and still faces, much tougher political and technical hurdles than other central banks. The euro area does not have one government, it has 19. The ECB had to convince sceptical core euro area governments that zero and negative interest rate policy and bond buying were not just a bailout for the periphery, especially with the euro debt crisis so fresh in the mind. Likewise, the euro area does not have one sovereign bond, it has 19. To design and implement an asset purchase program in the euro area is much more complicated than in the U.S., Japan or the U.K. But by mid-2014 it had become clear that each wave of unconventional monetary easing - through its impact on exchange rates - had allowed other major economies to 'steal' some inflation from the euro area (Chart I-3). With the ECB still undershooting its inflation mandate, it was becoming a dereliction of duty for the ECB not to do what the Fed, BoJ and BoE had already done several years earlier. As the saying goes, it is better for a reputation to fail conventionally, than to succeed unconventionally. Chart I-3Currency Depreciations "Steal" Inflation From Other Economies Why Will Monetary Policy Resynchronize? Three years and several trillion euros later, the ECB can feel it has had a fair crack at unconventional easing (Chart I-4). At the same time, the central bank must contend with fresh political and technical hurdles. How many more German bunds can it realistically buy without irking Germany's policymakers? Chart I-4The ECB Has Had A Fair Crack At QE The ECB is also aware that ultra-loose monetary policy - by compressing banks' net interest margins - endangers banks' fragile profitability. This impairs the bank credit channel which is the mainstay of private sector credit intermediation in the euro area.1 Meanwhile, the euro area's configuration of solid economic growth, solid job growth and subdued inflation is common to most large developed economies (the exception is the U.K. which we explain below). Putting all of this together, the theme for the coming years has to be monetary policy resynchronization, one way or the other. One way is that the more hawkish central banks will become less hawkish, as subdued inflation limits the scope for monetary policy tightening. The other way is that the more dovish central banks will become less dovish as the benefits of ultra-accommodation diminish and the costs rise. Or, both ways will happen together. Nowhere are negative bond yields more absurd and more inappropriate than in Sweden (Chart I-5). In just three years the economy has grown 12% and house prices have surged 50%. Furthermore, unlike in other parts of Europe, the housing market in Sweden did not suffer a meaningful setback in either 2008 or 2011. Yet Sweden's negative interest rate policy means that it stills pays people to borrow and further bid up house prices. If anywhere is at risk of a bubble from ultra-accommodative monetary policy, Sweden must be it. For bond yield spreads and currencies - which are relative trades - it doesn't really matter how the resynchronization of monetary policies occurs. We expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. And this yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD (Chart I-6). Chart 5A Negative Bond Yield ##br##In Sweden Is Absurd Chart I-6If The Swedish Bond Yield Shortfall ##br##Compresses, The Krona Will Rally The Myth Of The Beneficial Currency Devaluation Sharp depreciations in a currency result in an economy 'stealing' inflation from its major trading partners. Chart I-7 and Chart I-8 suggest that absent the post Brexit vote slump in the pound, the gap between U.K. and euro area inflation would be almost 1% less than it is. Chart I-7The Weaker Pound Lifted ##br##U.K. Headline Inflation... Chart I-8...And U.K. ##br##Core Inflation So the Brexit vote explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. Which means that the pound's weakness has choked households' real incomes. Against this, textbook economic theory says that a currency devaluation should make a country's exports more competitive and thereby boost the net export contribution to economic growth. But in the textbook the only thing that is supposed to change is the exchange rate. The textbook assumes that the country's trading framework with its partners remains unchanged. In the case of the U.K. leaving the EU, this assumption clearly does not apply, mitigating the concept of the 'beneficial currency devaluation'. A lot of the benefits of the textbook devaluation come because firms can trade in markets that were previously unprofitable to them. This process requires investment - for example, in marketing and distribution. If Brexit means that many of those markets are no longer available, or come with tariffs, then firms will hold off making the necessary investments - unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. We also hear the myth of the beneficial currency devaluation applied to the weaker members of the euro area. As in, why don't these countries just break free from the euro, and devalue their way to prosperity? The simple answer is that if they left the euro, they would also risk losing access to the largest single market in the world - defeating the whole purpose of the beneficial currency devaluation! A Tale Of Two Consumers Chart I-9A Good Pair Trade: Long German Consumer ##br##Services, Short U.K. Consumer Services For the time being, hawkish comments from the BoE have given the pound a boost. But U.K. consumer spending now faces one of two headwinds. If the BoE follows through with a rate hike, household borrowing is likely to fade as a driver of spending. Alternatively, if the BoE backs off from its threat, the pound will once again weaken, push up inflation and weigh on real incomes. So for the time being, stay underweight U.K. consumer services versus the FTSE100. In Germany, the opposite logic applies. Stay overweight German consumer services versus the DAX. Euro strength helps German consumers in as much as it reduces the prices of imported food and energy. But for German exporters, the strong euro hurts the translation of their multi-currency international profits back into local currency terms. A good pair trade is to be long German consumer services, short U.K. consumer services (Chart I-9). Finally, regarding two upcoming political events - the September 24 German election and the October 1 proposed referendum on Catalan independence, we do not see either as a major catalyst for the financial markets. In the case of the German election, it is because no likely outcome is especially malign (or benign). In the case of the Catalan referendum, it is because it will be hard to draw any meaningful conclusion from the result, given that Madrid has ruled the referendum illegal - and many 'unionists' are unlikely to participate. Please note that there is no Weekly Report scheduled for next week as I will be at our New York Conference. I hope to see some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the euro area, small and medium sized companies tend to access credit through banks rather than through the bond market. Fractal Trading Model This week, we note an excessive underperformance of U.K. personal and household goods (dominated by BAT, Unilever, Reckitt Benckiser) versus U.K. food and beverages (dominated by Diageo and Associated British Foods). Go long U.K. personal and household goods versus U.K. food and beverages with a profit target / stop loss of 4.5%. In other trades, short nickel / long silver hit its 8% profit target, while short MSCI China / long MSCI EM hit its 2.5% stop loss. This leaves three open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights U.S. Treasury yields should continue to rise as investors price-out doomsday risk; Tensions surrounding North Korea will continue, but there are signs that negotiations have started and that China is playing ball on sanctions; Meanwhile, our view that tax cuts are coming is finally coming to fruition; Fade renewed European risks regarding Brexit and Catalan independence; But the independence push by Kurds in Iraq could have market impact. Feature Early in the second quarter, BCA's Geopolitical Strategy made two predictions. First, we said that summer would be a time to stay invested in U.S. equities and largely ignore domestic politics.1 Second, that North Korea would become an investment-relevant risk and buoy safe-haven plays but would not lead to a full-scale war (and hence not cause a global correction).2 The summer proved lucrative for both risk-on and risk-off trades, best emblemized by solid returns for both the S&P 500 and 10-year U.S. Treasury (Chart 1 A & B). Chart 1ARisk Assets Have Rallied... Chart 1B...At The Same Time As Safe Havens Can this continue? We do not think so. Geopolitics can influence the 10-year Treasury yield via two mechanisms: safe-haven flows and fiscal policy. On both fronts, we see movements that should support a pickup in yields over the rest of the year, a view corroborated by our colleagues on the fixed-income team. First, investors finally have progress on tax legislation that we have been forecasting since President Trump's election. Given the markets' collective pessimism on corporate tax reform (Chart 2), we expect any good news to change the current narrative. While it is still difficult to envision tax legislation that massively stimulates the economy, it is also difficult to imagine tax legislation that is revenue-neutral. As such, fiscal policy in the U.S. should be at least mildly stimulative in 2018, supporting higher yields. Second, we remain concerned that North Korea could escalate the ongoing tensions in East Asia.3 However, Pyongyang is constrained by its military capacity, which limits what it can realistically do to threaten its neighbors. As we discuss below, there are emerging signs of both diplomatic negotiations and Chinese pressure, key signposts that we have passed the peak on our "Arc of Diplomacy." As such, investors should prepare for the bond rally to reverse and the broader risk-on phase to extend through the end of the year. We expect the "Trump reflation trade" - USD appreciation, yield-curve steepening, and small-cap outperformance (Chart 3) - to restart if our views on the U.S. legislative agenda and North Korean tensions hold. Chart 2Investors Remain Pessimistic On Tax Reform... Chart 3...And On Trump's Policy In General U.S. Treasuries: Fade The Doomsday Trade Our colleagues at BCA's fixed-income desk have shown that flows into safe havens over the summer have widened the disconnect between global yields and economic fundamentals (Chart 4).4 Chief Fixed-Income Strategist Rob Robis points out that BCA's own valuation model for the 10-year U.S. Treasury yield indicates that "fair value" sits at 2.67%, nearly 55bps higher than current market levels (Chart 5).5 This is a level of overvaluation that even exceeds the extreme levels seen after the U.K. Brexit vote in July of 2016. Rob believes that the summer bond rally is about safe-haven demand, depressed investor sentiment, and underwhelming inflation, in that order. It is certainly not about growth expectations, which remain buoyant (Chart 6). Chart 4Falling Yields Reflect Save Haven Demand,##br## Not Slower Growth Chart 5U.S. Treasuries ##br##Are Overvalued Chart 6Global Growth##br## Remains Buoyant To prove that underwhelming inflation has not spurred the latest rally in Treasuries, Rob decomposes developed market bond yield changes since the July 7 peak in U.S. yields. The benchmark 10-year U.S. Treasury yield has risen 20bps off those September lows as investors have priced out doomsday risk. Table 1 shows that yields declined everywhere but Canada (where the central bank has been hiking interest rates). Yet the vast majority of the yield decline has come from falling real yields and not lower inflation expectations, which have actually stabilized over the summer. This has also occurred via a bull-flattening move in government bond yield curves, which suggests it is risk-aversion that has driven yields lower. Table 1Changes In DM Bond Yields Over The Summer (From July 7th Peak In U.S. Treasury Yields) The conclusion of our fixed-income team is that there is now considerable upside risk in global yields. We agree. While North Korea could retaliate against the just-imposed UN sanctions in various ways, it is difficult to see the market reacting with the same vigor as it did in July and August. Investors are becoming desensitized to North Korean provocations, especially as the latter remain confined to "expected and accepted" forms of belligerence, even in the current context of heightened tensions. Future North Korean safe-haven rallies will be of shorter amplitude and duration. The September 15 missile launch over Japan (the fourth time this has happened) has shown this to be the case. Chart 7Position For A Tactically Wider UST-Bund Spread Bottom Line: BCA's bond team remains short duration, a position that our political analysis supports. We will keep our 2-year/30-year Treasury curve-steepener trade open, despite it being in the red by 34.3bps. In addition, we are closing our short Fed Funds January 2018 futures position (for a gain of 0.51bps) and opening a new short Fed Funds December 2018 position. Any sign of emerging bipartisanship should also favor higher fiscal spending, as policymakers almost always come together to spend money rather than cut spending. In addition, we are recommending that our clients put on a U.S. Treasury-German Bund spread widening trade.6 Rob has pointed out that this is a way to profit directly from higher fiscal spending in the U.S., particularly since there is no sign that Germany will change its government spending following its unremarkable election campaign. The data also supports a tactical widening of the Treasury-Bund spread, which is correlated with the relative data surprises (Chart 7). U.S. Politics: From Impeachable To Ingenious The crucial moment for the Trump presidency was the White House purge of the "Breitbart clique" following the social unrest in Charlottesville, Virginia on August 11-12.7 That move has made headway for upcoming tax legislation and resolution of the debt ceiling imbroglio. While some investors saw the racially motivated rioting in Virginia as a harbinger of a major risk-off episode, we saw it essentially as a "Peak Stupid" moment in U.S. politics. We may not know precisely what goes on in President Trump's mind, but we know that he likes polls. And his polling with Republican voters suffered appreciably following the Charlottesville fiasco (Chart 8). Strong Republican support for President Trump is the main source of his political capital. He can use it to cajole and influence Republicans in Congress via the upcoming Republican primary process ahead of the midterm elections. If he loses that support, his political capital will erode and he could become the earliest "lame duck" president in recent U.S. history. Worse, if support among Republicans were to fall below 70%, Trump could embark upon a Nixonian trajectory that could indeed lead to impeachment (Chart 9). Chart 8Trump's Support With GOP Voters Suffered... Chart 9... But Remains Well Above Nixonian Levels Many clients have asked us about the debt ceiling deal that President Trump made with Democrats and whether it signals a radical shift towards bipartisanship. We do not think so. In fact, we think the deal is mostly irrelevant. As we argued throughout the summer, the idea that there would be another debt ceiling crisis this year was always a figment of the media's imagination. There was never any evidence that a sufficient number of members of the House of Representatives wanted to play brinkmanship with the debt ceiling. First, Democrats in both houses of Congress have been clear throughout the year that they would not play politics with the debt ceiling. Second, investors and the media continuously overestimate the strength of the Freedom Caucus, the fiscally conservative grouping of Tea Party-linked representatives. There are 41 members of the Freedom Caucus, whereas 55 Republicans in the House sit in districts that are at least theoretically vulnerable to a Democratic challenge (Table 2).8 The danger for House Speaker Paul Ryan is not that the Freedom Caucus abandons the establishment line, but that the 55 Republicans listed in Table 2 abandon the Republican line. This, in fact, happened throughout the Obama presidency, with centrist Republicans voting with Democrats in the House on a number of key legislative bills (Chart 10). Table 2Plenty Of Vulnerable Republican Representatives Chart 10The Obama Years: A Governing 'Grand Coalition' This is why Speaker Paul Ryan largely ignored the Freedom Caucus and proposed an eighteen-month extension of the debt ceiling. He was never going to allow the Freedom Caucus to play brinkmanship. That President Trump picked the shorter Democrat version is significant only in so far as it signaled that he was willing to work with Democrats. In other words, the move was a "shot across the bow" of Republicans, a message that they had better get started on tax legislation, or else ... What should investors watch now? There are three main issues to follow: Tax legislation outline: House Speaker Paul Ryan has set the week of September 25 as the deadline for Republicans to outline their tax policy plan. The good news for investors is that the outline will supposedly include an already agreed-upon framework by both the House Ways and Means Committee - Chaired by Representative Kevin Brady (R, TX) - and the Senate Finance Committee - Chaired by Senator Orin Hatch (R-UT). Brady and Hatch are serious players and their comments on tax policy should be followed closely. Both favor legislation that would be retroactively applied to FY 2017, even if the bill is actually passed in 2018. They are also part of the Republican "Big Six" group on tax policy, along with Speaker Ryan, Senate Majority Leader Mitch McConnell, Treasury Secretary Steven Mnuchin, and National Economic Council Director Gary Cohn. Reconciliation instructions: The House Budget Committee passed a FY 2018 budget resolution in late July that included "reconciliation instructions" for tax legislation. These instructions allow Republicans to use the reconciliation procedure - a process that allows the Senate to pass legislation without needing 60 votes.9 However, the House version of the budget resolution also included over $200 billion of spending cuts, which is unlikely to pass in the Senate. As such, investors have to carefully watch for the House and Senate Republicans to pass a final budget resolution in order to kick off the reconciliation process. This process will likely happen in October, after the tax legislation package is presented by the Big Six. At that point, the Freedom Caucus will have the ability to extract concessions from establishment Republicans as their votes are needed to pass the budget resolution. We suspect that no Democrats will support the budget resolution given that they have not been involved in the tax policy process thus far. Trump's involvement: President Ronald Reagan's personal support and lobbying for the 1986 tax reform proved critical in getting the bill through Congress.10 President Trump's focus and energy will have to be on par with that of Reagan's if he plans to accomplish the same. A headwind for Trump is the lack of legislative experience in his White House (Chart 11). However, since the appointment of Chief of Staff General John F. Kelly, there has been a clear shift of focus on the legislative process. Chart 11Trump Administration Is On The Low End Of Congressional Experience Bottom Line: We expect investors to start gleaning the outlines of tax policy by late September, with the budget resolution containing reconciliation instructions being passed by both houses of Congress by the end of November. It may be too much to ask Congress to have an actual bill ready to pass by the end of the year, as we originally expected,11 particularly as there is now a potential immigration deal to negotiate with Democrats and last-minute effort to repeal and replace Obamacare. As such, we still think that it will take until the end of Q1 2018 for tax legislation to pass Congress (Q2 in the worst-case scenario for Republicans). Investors, however, will begin to price in a higher probability of tax policy as soon as the outline of the bill emerges in October. As such, we are reiterating our recommendation that investors go long U.S. small caps relative to large caps. Tax policy should overwhelmingly benefit small caps, which actually pay the 35% corporate tax rate. In addition, we would expect the USD to arrest its decline and rally by the end of the year. North Korea: At The Apogee Of "The Arc Of Diplomacy" To illustrate the current North Korean predicament to readers, we have referred to an "arc of diplomacy" (Chart 12), which we illustrate by referencing the rise and fall of U.S. tensions with Iran from 2010-15. The pattern is for the U.S. to increase tensions deliberately in order to convince its enemy that the military option is "on the table." Only once a "credible threat" of war has been established can the negotiations begin in earnest. Chart 12A Lesson From Iran: Tensions Ramp Up As Nuclear Negotiations Begin We are at or near the peak of this process. First: what is the worst-case scenario for markets if the North causes a crisis short of a devastating war? Using our short list of geopolitical crises (Table 3),12 our colleague Anastasios Avgeriou, chief strategist of BCA's U.S. Equity Strategy, notes that while the average peak-to-trough drop of a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis. To illustrate the trend, Anastasios has constructed an S&P 500 profile of the average geopolitical crisis, and the picture is encouraging (Chart 13). It shows that the market is likely to grind higher even if North Korea does something truly out of the box. Table 3Geopolitical Crises And SPX Returns Nor is a geopolitical incident (again, short of total war) likely to cause a U.S. or global recession. Aside from direct shocks to oil, such as in 1973 and 1990, only the U.S. Civil War (that is, a war waged on U.S. turf) caused a recession at the outset. Other major wars (WWI, WWII, the Korean War) caused recessions when they concluded because of the sharp drop in federal spending as a result of reduced military spending. What makes us think we are at or near the peak of North Korea's belligerent threats? China appears to be enforcing sanctions: at least according to China's official statistics (Chart 14). There is no doubt there are discrepancies and black market activity, but it makes sense for China to dial up the pressure (while never imposing crippling sanctions) and that appears to be occurring. China and Russia agreed to reduce fuel supplies. Both sides agreed to new UN sanctions on September 11 that would partially cut off North Korean fuel. This is a significant step, given that Chart 14 indicates China is already moving in this direction. The U.S. and North Korea have begun diplomatic talks. According to Japan's NHK press on September 14, former U.S. diplomat Evans Revere met with Choe Kang-Il, the deputy director general of the North American bureau of North Korea's foreign ministry in Switzerland over the past week. The U.S. State Department spokeswoman Heather Nauert all but confirmed that some kind of communication is underway, and Secretary of State Rex Tillerson has described his diplomatic initiative as highly active. The last efforts at negotiations, via the longstanding New York channel, were discontinued in June after the death of a U.S. prisoner in North Korea. Those were focused on retrieving U.S. citizens, whereas the new talks allegedly centered on the latest UN sanctions, i.e. a crux of the relationship. The implication is that North Korea is responding to pressure now that its critical fuel supplies are at risk. South Korea is offering aid. South Korea's new government is looking to give the North humanitarian aid, as expected, and will decide on September 21 about a special package for pregnant women and infants. It is suggesting that such aid has no conditionality on the North's behavior. At the same time, the U.S. administration is talking down Trump's recent threat to discontinue the U.S.-South Korean free trade agreement - meaning that the U.S. may even condone the South Korean administration's more diplomatic approach to the North. Chart 13Who Is Afraid Of Geopolitical Crises? Chart 14Is China Finally Playing Ball? At the same time, North Korea is running out of options for provocations that it can commit without provoking a costly response from the U.S. and its allies. The September 15 missile test over Japan was essentially the fourth of its kind, and the market shrugged it off. Here are some options, drawn from our list of scenarios and probabilities (Table 4): Table 4North Korean Scenarios Over The Next Year More of the same: Nuclear and missile tests could continue, or be conducted at higher frequencies or simultaneously. While technical advances may become apparent, they will not change the game. U.S. Territory: The North could create a bigger risk-off move than we saw in July-August if it shot ICBMs toward Guam, or other U.S. territories, as it has suggested it might do. This is especially risky because the U.S. Secretary of Defense James Mattis has repeated Trump's warning to North Korea to not even threaten the United States. However, as long as no such missile actually strikes U.S. territory, the U.S. is unlikely to respond with an attack, and thus such a scare seems likely to fade like the others. Attacking South Koreans: The North has a history of state-backed terrorist actions and military actions. An attack limited to South Korea will cause a shock, in the current context, but the military consequences are still likely to be contained given the extensive history of such attacks. If it is an attack against South Korean civilians in a non-disputed territory, it will leave a bigger mark than it otherwise would, but the South is still likely either to retaliate in strict proportionality, or to refrain from action and use the event as a way of galvanizing international sanctions. Attacking Americans or U.S. allies: The true danger in the current climate is an attack that kills U.S. citizens, or U.S. allies who are not as, shall we say, understanding as the South Koreans (such as the Japanese). This could cause the U.S. or Japan or another ally to take a retaliatory action. Even if limited, this could cause a deep correction in the market. The U.S. response would likely still be limited and proportional. Then the question would be whether the North Koreans can afford to escalate. They can't. The military asymmetry is excessive. This is not the case of the Japanese in 1941, who believed they had the potential of defeating the U.S. if they acted quickly enough and the U.S. was distracted in Europe (Diagram 1). Diagram 1North Korea Crisis: A Decision Tree As the foregoing demonstrates, there could still be big ups and downs between now and the resumption of formal international negotiations, let alone a satisfactory diplomatic accord. The tensions could yet reach another peak. Nevertheless, our sense is that the pieces are falling into place for the North to moderate its behavior, sending the signal that it is ready to engage in real negotiations. Since the U.S. has consistently shown its readiness to talk directly with the North - coming from both Trump and Tillerson - we think we could see shuttle diplomacy taking place as early as this winter. Here are some dates and events to watch: Military exercises: Will the U.S., South Korea, and Japan stop or slow down the pace of military exercises? This could open space for North Korea to offer an olive branch in return. October 10 - anniversary of the Worker's Party of Korea: The North may take an extraordinary action, no action, or familiar actions like missile tests. October 11-25 - China's party congress: The North could fall silent ahead of the big event, or could attempt to disrupt it. China, in turn, could take action around this time (particularly afterwards) to send a signal to the North to tone down the belligerence. In previous periods of tension, China has reputedly drawn a harder line on North Korea in the month of December, when end-of-year quotas made certain trade measures more convenient. Late October - Japanese snap election? Rumor has it that Shinzo Abe is thinking of calling a snap election as early as this month. We normally dismiss such rumors but this time there is a certain logic: two North Korean missiles have flown over Hokkaido in as many months, while the Japanese opposition is in total disarray. If Abe calls early polls, it suggests that he thinks Korean fears are peaking. If he delays, and exploits these fears by pushing constitutional revisions through the Diet (our base case), then he may provoke a North Korean response, given that the revisions pave the way for Japan to "re-militarize." November 1 - APEC and Trump's visit to China: Trump is supposed to head to Vietnam for the APEC summit and to China to visit President Xi Jinping. Xi has recently shown his sensitivity to such summits by concluding the Doklam dispute with India just days ahead of the BRICS summit in Xiamen, China in order to ensure that Indian President Narendra Modi would attend. Xi may have also wanted to advertise his ability to negotiate solutions to international showdowns for the world (and U.S.) to see. Thus, progress on North Korea before or after Trump's arrival could improve Xi's authority both with Trump and the rest of the world. November 23 - U.S. Thanksgiving: North Korea likes to be "cute," so we cannot rule out attempts to unsettle the Americans on Thanksgiving or Christmas Day, as with the July 4 ICBM launch. Trump's visit is very consequential and it is more likely under the circumstances that China will receive him warmly, like Nixon, rather than coldly, like Obama last year. Trump is holding serious trade negotiations (via Commerce Secretary Wilbur Ross) and at the same time threatening to sanction Chinese companies and imports (via Treasury Secretary Steve Mnuchin). There are many reasons for Beijing to cooperate on North Korea in order to get advantageous treatment on the economic front. Bottom Line: The market is already discounting North Korea. We may be wrong temporarily if the North ups the ante yet again, but we are very near the peak of the latest round of tensions. The North is running out of options short of instigating a fight it would lose, while China is enforcing sanctions more seriously (including fuel), and Washington has apparently opened direct talks with Pyongyang. We will maintain our portfolio hedge of Swiss bonds and gold, for now. We are also re-opening our long CBOE China ETF volatility index to account for potential rising political uncertainty surrounding the coming October Party Congress and possibly for further North Korea related risks. However, we are closing our short KRW / THB trade for a gain of 5.33%. Europe: More Red Herrings Brexit is no longer market-relevant. Its economic effect was fully priced in when Prime Minister Theresa May announced on January 17 that the U.K. would not seek membership in the Common Market. Since then, the pound has effectively bottomed against both the dollar and the euro, as we argued it would (Chart 15).13 This does not mean that investors should necessarily go long the pound. Rather, we are pointing out that the moves in the U.K. currency have ceased to be Brexit-related since we called its bottom in January. Going forward, investors should make bets on the pound based on macroeconomic fundamentals, not on the U.K.-EU negotiations. The one political risk to the pound going forward is the potential for the Labour Party, headed by opposition leader Jeremy Corbyn, to come to power in the U.K. in the near term. Corbyn is the most left-of-center leader of a developed world economy since French president François Mitterrand in 1981. And he symbolizes a leftward shift on economic policy by the median voter. Nevertheless, the risks to PM May are overstated, for now. A key test for the Prime Minister, the EU (Withdrawal) Bill, passed its first parliamentary hurdle in Westminster on September 12. No Conservatives rebelled, with seven Labour politicians defying Corbyn's instructions to vote against the bill. The bill still faces several days of amendments, but it largely gives May a free hand to negotiate with Europe going forward. Bremain-leaning Tory backbenchers could have posed problems for May had they decided to obstruct the bill. That they did not tells us that nobody wants to challenge May and that she will likely remain the prime minister until the eventual deal with the EU is reached. Our clients often balk at our dismissal of Brexit as an investment-relevant geopolitical event. However, the crucial question post-Brexit was whether any other EU member states would follow the U.K. out of the bloc. We answered this question in the negative, with high conviction, the day of the U.K. referendum.14 Not only did no country follow U.K.'s lead, but the effect of Brexit was in fact the exact opposite of the conventional wisdom, with a slew of defeats for populists around Europe following the referendum. For the U.K. economy and assets, the key two Brexit-related questions were whether the economy's service sector would have unfettered access to the European market via membership in the Common Market (Chart 16); and whether the labor market would have access to the European labor pool (Chart 17). Both questions were answered by May during her January 17 speech in the negative, which is why we continue to cite that moment as the date when U.K. assets fully priced in Brexit. Chart 15Is Brexit##br## Still Relevant? Chart 16U.K. Needs A Free Services Agreement##br## With The EU, Not An FTA! Chart 17Intra-EU Migration Boosts ##br##Labor Force Growth What could change our forecast? We would need to see the negotiations with Europe become a lot more acrimonious. Disputes over the amount of the "exit bill" or the status of the Irish border simply do not count as acrimony. We need to see the threat of a "Brexit cliff" - where the EU-U.K. trade relationship reverts to "WTO rules" - emerge due to a conflict between the two powers. However, this is unlikely to happen as the EU greatly values its trade relationship with the U.K. And London's demand for an FTA actually plays to the EU's strengths, since FTAs normally privilege trade in goods (where Europe is competitive) relative to trade in services (where the U.K. has an advantage). Bear in mind, as well, that the U.K. and EU are negotiating an FTA from a starting point of a high degree of economic integration: this is not the equivalent of two separate economies pursuing an FTA for the first time. Similarly overstated as a risk is the upcoming Catalan independence referendum. As we argued this February, the referendum is a non-event.15 Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 18). And as we argued in our net assessment of the issue in 2014, a surge in internal migration since the Second World War has diluted the Catalan share of the total population.16 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.17 Another 10% identify non-Iberian languages as their first language, suggesting that migrants will further dilute support for sovereignty, as they have done in other places (most recently: Quebec). Chart 18Catalans Do Not Want Independence We expect the turnout of the upcoming referendum to be low. Given that Madrid will not recognize it, the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. What does that mean precisely? The globally recognized definition of sovereignty is the "monopoly of the legitimate use of physical force within a defined territory." To put it bluntly: the Catalan government has to be willing to take up arms in order for its referendum to be relevant to the markets. Without recognition from Spain, and with no support for independence from fellow EU and NATO peers, Catalonia cannot win independence at the ballot box. Bottom Line: Fade Brexit and Catalonia risks. Iraq: An Emergent Risk In 2014, we wrote the following about the future of Iraq:18 "Furthermore, the recent Kurdish occupation of Kirkuk - nominally to secure it from ISIS, in reality to (re)claim it for the Kurdish Regional Government (KRG) - will not be acceptable to Baghdad. In our conversations with clients, too much optimism exists over the stability of Kurdistan and its expected oil output. While we are broadly positive on the KRG, there are many challenges. First, three-quarters of Iraqi production is, in fact, located in the Southern part of the country, far from Iraqi Kurdistan. Second, Kirkuk and its associated geography has the potential to boost production, but the Kurds (and their ally Turkey) will eventually have to face-off against Baghdad (and its ally Iran) for control over this territory. Just because the KRG secured Kirkuk today does not mean that it will stay in their control in the future. We are fairly certain that once ISIS is defeated, Baghdad will ask for Kirkuk back." In 2016, we followed up again on the situation in Iraq by pointing out that a series of defeats for the Islamic State were raising the probability that a reckoning was coming between Baghdad and Iraqi Kurds.19 Now that the Islamic State threat is in the rear-view mirror, our forecast is coming to fruition. On September 25, Kurds in Iraq will hold an independence referendum. Opposition to the referendum is uniform across the region, with the U.S. - Kurds' strongest ally - requesting that it not take place. Why should investors care? First, there is the issue of oil production. There are no reliable figures regarding KRG production, but it is thought to be around 550,000 bpd, although KRG officials have themselves downplayed their production. This figure includes production from the Kurdish-controlled Bai Hassan and Avana fields in the Kirkuk province, which is not formally part of the KRG territory but which Kurds nominally control due to their 2014 anti-ISIS intervention. A conflict over Kurdish independence could impact this production, particularly if war breaks out over Kirkuk. However, the bigger risk to global oil supply is what it would do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production. Second, there are problematic regional dynamics. There are about six million Kurds in Iraq, about 20% of the total population. The Kurdish Regional Government controls the northeast corner of Iraq, but fighting against the Islamic State has allowed the Kurds to extend their control further south and almost double their territory (Map 1). Turkey has largely supported the KRG over the years, as the ruling party in the autonomous province is relatively hostile to the Kurdistan Workers' Party (PKK), which Turkey considers a terrorist organization. However, Turkey is opposed to the independence of the KRG due to fears that it would start the ball rolling on the independence of Kurds in Syria and potentially one day in Turkey as well. Also opposed to KRG secession are Iran (Baghdad's closest ally) and Syria (which is dealing with its own Kurdish question). Map 1Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey On the other hand, the KRG does have international support. Russia just recently concluded a major oil deal with KRG, promising to buy Kurdish oil and refine it in Germany. Moscow will also invest US $3 billion in KRG territory. Russia also supplied the KRG Peshmerga - armed forces - with weapons during their fight against the Islamic State. From Russia's perspective, any conflict in the Middle East is a boon. It stalls investment in the region, curbs its oil production, and potentially adds a risk premium to oil prices. In addition, a close alliance with the KRG would allow Russia to gain another ally in the region. Bottom Line: While it is difficult to see how the independence referendum will play out in the short term, we have had a high-conviction view that Iraq's stability will not improve with the fall of the Islamic State. For investors, rising tensions in Iraq are significant because they could curb investment in the long term and potentially even impact production in the short term. Unlike the Islamic State, which never threatened oil production in the Middle East in any significant way, Iraq and the KRG are both oil producers. In fact, their main conflict is over an oil-producing region centered on Kirkuk. Tensions in the region support BCA Commodity & Energy Strategy's bullish view on oil prices.20 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017; "North Korea: No Longer A Red Herring" in BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2017; and "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 5 BCA Global Fixed Income Strategy 10-year Treasury yield model only uses the global manufacturing PMI and sentiment towards the U.S. dollar as inputs. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Duration 'Hot Potato' Shifts Back To The U.S.," dated August 8, 2017, available at gfis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Is The 'Trump Put' Over?" dated August 23, 2017, available at gps.bcaresearch.com. 8 We use the Cook Political Report for their assessment of how U.S. electoral districts lean. Charlie Cook is Washington's foremost election handicapper with a long record of accomplishment. Anyone interested in closely following the U.S. midterm elections should consider his research, which is found on http://www.cookpolitical.com/ 9 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 10 Please see Joseph A. Pechman, "Tax Reform: Theory and Practice," The Journal of Economic Perspectives 1:1 (1987), pp. 11-28 (15). 11 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 12 Please see footnote 3 above. 13 The GBP/USD bottomed then and there. The GBP/EUR has recently hit a new low, for reasons other than Brexit. This bottom is only slightly below its previous lows in October 2016, when May confirmed that her government would seek to leave the EU in accordance with the referendum result, and in January 2017, when May admitted what the GBP/EUR had already reflected, that this meant leaving the Common Market. Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World," dated January 25, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, and Geopolitical Strategy Special Report, "The Coming EXITentialist Crisis," dated June 24, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 16 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 17 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat 18 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 20 Please see BCA Commodity & Energy Strategy Weekly Report, "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," dated September 14, 2017, available at ces.bcaresearch.com.

Special Report

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced this year, it is always useful to pause and reflect on where currency valuations stand. In this context, this week we update our set of long-term valuation models for currencies that we introduced in February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 The models cover 22 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update on all of these long-term models in one stop. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, the models help us judge whether any given move is more likely be a countertrend development or not, offering insight on potential longevity. Finally, they assist us and our clients in cutting through the fog and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1The Dollar's Overvaluation Is Gone After its large 7.5% fall in trade-weighted terms since the end of 2016, the real effective dollar is now trading at a 2% discount vis-à-vis its fair value based on its principal long-term drivers - real yield differentials and relative productivity between the U.S. and its trading partners (Chart 1). The U.S. dollar's equilibrium - despite having been re-estimated higher earlier this year due to upward revisions by the Conference Board to its U.S. productivity series - has flattened as of late, as real rate differentials between the U.S. and the rest of the world have declined. While 2017 has been an execrable year for dollar bulls, glimmers of hope remain. First, the handicap created by expensive valuations has been purged. Second, the excessive bullishness toward the greenback that prevailed earlier this year has morphed into deep pessimism. Third, U.S. real interest rates have fallen as investor doubts that the Federal Reserve will be able to increase interest rates as much as it wants to in the face of paltry inflation have surged. However, the U.S. economy is strong and at full capacity, suggesting that inflation will hook back up at the end of 2017 and in the first half of 2018. This should once again lift the U.S. interest rate curve, the dollar's fair value, and the dollar itself. That being said, this story is unlikely to become fully relevant over the next three months. The Euro Chart 2The Euro's Fair Value Is Now Rising On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks and rate differentials. Thanks to its powerful rally this year, the euro's discount to its fair value has narrowed from 7% in February to 6% today (Chart 2). This narrowing is not as great as the rally in the trade-weighted euro itself as its fair value has also improved, mainly thanks to continued improvement in the euro area's net international position - a development driven by the euro zone's current account of 3% of GDP. Nonetheless, the EUR's current discount to fair value is still not in line with previous bottoms, such as those experienced in both early 1985 or in 2002. We do expect a new wave of weakness in the EUR to materialize toward the end of the year and in early 2018 as markets once again move to discount much more aggressive tightening by the Fed than what will be executed by the European Central Bank: U.S. inflation is set to move back towards the Fed's target, but European inflation will remain hampered by the large amount of labor market slack still prevalent in the European periphery. What's more, euro area inflation is about to suffer from the lagged effects of the tightening in financial conditions that have been created by a higher euro. However, the fact that the euro's fair value has increased implies it is now very unlikely for the EUR/USD to hit parity this cycle. The Yen Chart 3The Yen Is Very Cheap, But It May Not Count For Much The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The JPY discount to this fair value has deepened this year, despite the fall in USD/JPY from 118 to 108 (Chart 3). This is mainly because the euro and EM as well as commodity currencies have all appreciated against the Japanese currency. Low domestic inflation has been an additional factor that has depressed the Japanese real effective exchange rate. While valuations point to a higher yen in the coming year, this will be difficult to achieve. The Bank of Japan remains committed to boosting Japanese inflation expectations. To generate such a shock to expectations, the BoJ will have to keep policy at massively accommodative levels for an extended period. As global growth remains robust, global bond yields should experience some upside over the next 12 months. With JGB yields capped by the Japanese central bank, this will create downside for the yen. However, because the yen is so cheap, it is likely to occasionally rally furiously each time a risk-off event, such as any additional North Korean provocations, puts temporary downward pressure on global yields. The British Pound Chart 4The Pound Is Attractive On A Long-Term Basis The pound has fallen 6% against the euro this year, the currency of its largest trading partner. This has dragged down the GBP's real effective exchange rate to a large 11% discount to its fair value, the largest since the direct aftermath of the Brexit vote (Chart 4). Because Great Britain has entered a paradigm shift - the exit from the European Union will change the nature of the U.K. relationship on 43% of its trade - assessing where the pound's fair value lies is a more nebulous exercise than normal. However, signs are present that the pound is indeed cheap. British inflation remains perky, the current account has narrowed to 4% of GDP, and despite large regulatory uncertainty, net FDI into the U.K. has hit near record highs of 7% of GDP. Movements in cable are likely to remain a function of the gyrations in the U.S. dollar. However, at this level of valuation, the pound is attractive against the euro on a long-term basis. We had a target on EUR/GBP at 0.93, which was hit two weeks ago. This cross is likely to experience downside for the next 12 months. The biggest risk for the pound remains British politics - and not Brexit itself but its aftershock. The EU has made clear the transition process will be long, leaving time for the British economy to adjust. However, the conservative party has been greatly weakened, and Jeremy Corbyn's popularity is increasing. This raises the specter that, in the not-so-distant future, a Labour government could be formed. Under Corbyn's leadership, this would be the most left-of-center administration in any G10 country since François Mitterrand became French president in 1981. The early years of the Mitterrand presidency were marked by a sharp decline in the franc as he nationalized broad swaths of the French private sector, increased taxes and implemented inflationary policies. Keep this in mind. The Canadian Dollar Chart 5The CAD Has Lost Its Valuation Advantage The loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. In February, the CAD was trading in line with its fair value. However, after its blistering rally since May, when the Bank of Canada began to hint that policy could be tightened this year, the Canadian dollar is now expensive vis-à-vis its long-term fundamental drivers (Chart 5). In a Special Report two months ago, we argued that the BoC was one of the major global central banks best placed to increase interest rates.2 With the Canadian economy firing on all cylinders, and with the output gap closing faster than the BoC anticipated in its July Monetary Policy Statement, the two interest rate hikes recorded this year so far make sense, and another one is likely to materialize in December. However, while the CAD could continue to rise until then, traders have moved from being massively short the CAD to now holding very sizeable net long positions. Additionally, interest rate markets are now discounting more than two hikes in Canada over the next 12 months, while expecting less than one full hike in the U.S. over the same time frame. If this scenario were to pan out, the tightening in monetary conditions emanating from a massive CAD rally would likely choke the Canadian recovery. Instead, we expect U.S. rates to increase more than what is currently embedded in interest rate markets, thus limiting the downside in USD/CAD. We prefer to continue betting on a rising loonie over the next 12 months by buying it against the euro and the Australian dollar. The Australian Dollar Chart 6The AUD Is Very Expensive The fair value of the Aussie is driven by Australia's net international position and commodity prices. Even with the tailwind of stronger metal prices, the AUD's rallies have been beyond what fundamentals justify, leaving it at massively overvalued levels (Chart 6). This suggests the AUD is at great risk of poor performance over the next 24 months. Timing the beginning of this decline is trickier, and valuations offer limited insight. One of the key factors that has supported the AUD has been the large increase in fiscal and public infrastructure spending in China this year - a move by Beijing most likely designed to support the economy in preparation for the 19th National Congress of the Communist Party of China, where the new members of the Politburo are designated. As this event will soon move into the rearview mirror, China may abandon its aggressive support of the industrial and construction sectors - two key consumers of Australia's exports. The other tailwind behind the AUD has been the very supportive global liquidity backdrop. Global reserves growth has increased, dollar-based liquidity has expanded and generalized risk-taking in global financial markets has generated large inflows into EM and commodity plays.3 While U.S. inflation remains low and investors continue to price in a shy Fed, these conditions are likely to stay in place. However, a pick-up in U.S. inflation at the end of the year is likely to force a violent re-pricing of U.S. interest rates and drain much of the global excess liquidity, especially as the Fed will also be shrinking its balance sheet. This is likely to be when the AUD's stretched valuations become a binding constraint. The New Zealand Dollar Chart 7No More Premium In The NZD Natural resources prices, real rate differentials and the VIX are the key determinants of the kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities prices are currently causing gradual appreciation in the New Zealand's dollar equilibrium exchange rate. However, despite these improving fundamentals, the real trade-weighted NZD has fallen this year, and now trades in line with its fair value (Chart 7). Explaining this performance, the NZD began 2017 at very expensive levels, even when compared to the already-pricey AUD. Also, despite a very strong New Zealand economy, the Reserve Bank Of New Zealand has disappointed investors by refraining from increasing interest rates, as the expensive currency has tightened monetary conditions on its behalf. Going forward, the recent weakness in the real effective NZD represents a considerable easing of policy, which could warrant higher rates in New Zealand. As a result, while a tightening of global liquidity conditions could hurt the NZD in addition to the AUD, the kiwi is likely to fare better than the much more expensive Aussie, pointing to an attractive shorting opportunity in AUD/NZD over the next 12 months. The Swiss Franc Chart 8The CHF Is Cheap, The SNB Is Happy Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. The recent sharp rally in EUR/CHF has now pushed the Swissie into decisively cheap territory (Chart 8). The decline in political risk in the euro area along with the lagging economic and inflation performance of the Swiss economy fully justify the discount currently experienced by the Swiss franc: money has flown out of Switzerland, and the Swiss National Bank is doing its utmost to keep monetary policy as easy as it can. For a small open economy like Switzerland, this means keeping the exchange rate at very stimulative levels. The continued growth in the SNB's balance sheet is a testament to the strength of its will. For the time being, there is very little reason to bet against SNB policy; the CHF will remain cheap because the economy needs it. However, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to keep the CHF down. These low real rates are fueling bubble-like conditions in Switzerland real estate and are threatening the achievability of return targets for Swiss pension plans and insurance companies, forcing dangerous risk-taking. But until core inflation and wage growth can move and stabilize above 1%, these conditions will stay in place. The Swedish Krona Chart 9The Swedish Krona Has More Upside Even after its recent rebound, the Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet the undemanding valuations of the SEK hide a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. We expect the SEK to continue appreciating. While Swedish PMIs have recently softened, the Swedish economy is running well above capacity, and the Riksbank resources utilization indicator suggests the recent surge in inflation has further to run. Moreover, Sweden is in the thralls of a dangerous real-estate bubble that has pushed nonfinancial private-sector debt above 228% of GDP. With many amortization periods on new mortgages now running above 100 years, the Swedish central bank is concerned that further inflating this bubble could result in a milder replay of the debt crisis experienced in the early 1990s. The shift in leadership at the Riksbank's helm at the beginning of 2018 is likely to be the key factor that prompts the beginning of the removal of policy accommodation in that country. We like buying the krona against the euro. The USD/SEK tends to be a high-beta play on the greenback, and thus is very much a call on the USD. However, EUR/SEK displays a much lower correlation, and thus tends to be a more effective medium to isolate the upcoming tightening in monetary policy we expect from the Riksbank. The Norwegian Krone Chart 10The NOK is The Cheapest Commodity Currency The Norwegian krone remains the cheapest commodity currency in the world, along with the Colombian peso (Chart 10). The slowdown in Norwegian inflation and a very negative output gap of 2% of GDP implies that the Norges Bank will remain one of the most accommodative central banks in the G10. Thus, the NOK should remain cheap. However, we continue to like buying the krone against the euro. EUR/NOK has only traded above current levels when Brent prices have been below US$40/bbl. Not only is Brent currently trading above US$50/bbl, but the outlook for oil remains bright: production is in control as the agreement between Russian and OPEC is still in place. Additionally, the recent carnage and refinery shutdowns caused by hurricane Harvey should result in large drawdowns to finished-products inventories in the coming months. This will contribute to an anticipated normalization in global excess petroleum inventories, which have been the most important headwind to oil prices. Finally, the fact that the Brent curve is now backwardated also represents a support for oil prices, as this creates a "positive carry" for oil investors. The Yuan Chart 11The Yuan Can Rise On A Trade-Weighed Basis Despite the recent strength in both the trade-weighted RMB and the yuan versus the U.S. dollar, the renminbi still trades at a discount to its long-term fair value (Chart 11). Confirming this insight, China continues to sport a sizeable current account surplus, and its share of global exports is still on an expanding path. With the RMB being cheap, now that China is once again accumulating reserves instead of spending them to create a floor under its currency, the downside risk to the CNY has decreased significantly. Thus, since the People's Bank of China targets a basket of currencies when setting the yuan's value, to legitimize any bullish view on USD/CNY one needs to have a bullish view on the USD. While we do anticipate the dollar to rally toward the end of the year, our expectation that it will remain flat until then implies that we do not see much upside for now to USD/CNY. However, our bullish medium-term USD view, along with the cheapness of the CNY, suggests that the RMB could continue to appreciate on a trade-weighted basis going forward. While Chinese policymakers have highlighted their desire to make their currency a more countercyclical tool, the recent stability in Chinese inflation implies there is no need to let the CNY depreciate to reflate China. In fact, at this point, elevated PPI readings would argue that the Chinese authorities do have a built-in incentive to let the CNY appreciate on a trade-weighted basis for the coming six to 12 months. The Brazilian Real Chart 12The BRL is Vulnerable To A Pullback In Global Liquidity Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded since early 2016. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). This level of overvaluation points to poor returns for the BRL on a one-to-two-year basis, however, it gives no clue to timing. The strong sensitivity of the Brazilian real to EM asset prices implies that the BRL is unlikely to weaken significantly so long as EM bonds remain well-bid. Moreover, because the BRL still offers an elevated carry, until U.S. interest rate expectations turn the corner, U.S. market dynamics will continue to put a floor under the real. However, this combination suggests the BRL could become one of the prime casualties of any rebound in U.S. inflation. Such a development would cause global liquidity to fall, hurting EM bonds in the process and making the BRL's high-risk carry much less attractive. Confirming this danger, the fact that the USD/BRL has not been able to breakdown for more than a year despite the weakness in the USD suggests momentum under the BRL is rather weak. The Mexican Peso Chart 13Mexican Peso: From Bargain To Luxury In the direct aftermath of Trump's electoral victory, the Mexican peso quickly became one of the cheapest currencies in the world. However, the peso's 25% rally versus the U.S. dollar since January has eradicated this valuation advantage to the point where it is now one of the most expensive major currencies in the world (Chart 13). As the peso was collapsing through 2016, the Mexican central bank fought back, increasing interest rates. The massive surge in the prime lending rate points to a protracted period of weakness in the growth of nonfinancial private credit, which should weigh on consumption and investment. Actually, the growth in retail sales volumes has already begun to weaken. This could force the Banxico to cut rates, especially as inflation will slow in the face of peso's rebound this year. Lower Mexican rates, in the face of stretched long positioning in MXN by speculators, could be the key to generating a weakening in the peso over the next 12 months. To see real fireworks in the peso, one would need to see a resumption in the U.S. dollar bull market. Mexico has external debt equivalent to 66% of GDP, the highest among large EM nations. This makes the Mexican economy especially vulnerable to a strong dollar, as such a move would imply a massive increase in debt servicing costs. Thus, while the MXN may not be as vulnerable as the BRL, it could still suffer greatly if global liquidity becomes less generous next year. The Chilean Peso Chart 14CLP Needs HIgh Copper Prices The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies Chilean terms-of-trade. Thanks to the CLP's rally since the winter of 2015, the real peso is at a four-year high and is now in expensive territory (Chart 14). We expect copper to see downside from now until the end of the year, pulling down the CLP with it. Current dynamics in the Chinese real estate market and the Chinese credit cycle, which tend to be leading indicators of industrial metals prices, point to an upcoming selloff. Moreover, Chinese monetary conditions have begun to tighten, and are set to continue doing so. This will weigh on Chinese credit growth and capex, creating headwinds for copper and the peso. That being said, the CLP will likely outperform the BRL and the ZAR. M1 money growth is back in positive territory after contracting last year, while industrial activity seems to have hit a bottom and is now picking up. Moreover, since Chile's economy does not have the credit excesses of its other EM peers, we expect the CLP to show more resilience than other currencies linked to industrial metals. The Colombian Peso Chart 15COP: A Rare Bargain Among EM The real COP's fair value is driven by Colombia's relative productivity trends and the price of oil, the country's main export. The fall in oil prices since the beginning of the year have caused a small decline in the fair value of the COP. Nevertheless, the peso is still one standard deviation below fair value (Chart 15). This partly reflects the premium demanded by investors to compensate for Colombia's large current account deficit of 6.3% of GDP. Overall the COP looks attractive, particularly against other commodity currencies. Historically a discount of 20% or more, like what the peso has today, marks a bottom in the real effective exchange rate. Furthermore, our Commodity and Energy Strategy Service expects Brent prices to climb to US$60/bbl towards the end of year, as OPEC's and Russia's production controls translate into oil inventory drawdowns. This should further increase the value of the COP against the ZAR and the BRL. Domestic dynamics also point to outperformance of the peso against other EM currencies. As opposed to countries like Brazil, where private debt stands at nearly 85% of GDP, Colombia has a more modest 60% leverage ratio - the byproduct of an orthodox banking system. Thus, the peso should be able to withstand a liquidity drawdown in EM better than its peers. The South African Rand Chart 16Lack Of Productivity And Politics Are The Greatest Risk To The Rand South Africa's dismal productivity trend continues to be the greatest factor pulling the rand's long-term fair value lower. Due to this adverse trend, while the ZAR has been broadly stable this year, it is now slightly more expensive than it was in February (Chart 16). Not captured by the model, the political risks in South Africa remain elevated, creating a further handicap for the rand. The story behind the ZAR is very similar to the one underpinning the gyrations in the BRL. Both currencies, thanks to their elevated carries and deep liquidity - at least by EM currency standards - will continue to be buoyed by very generous global liquidity conditions. However, global real rates seem dangerously low and could move sharply higher, especially when U.S. inflation picks up at the end of the year and in early 2018. Such a move would cause the currently very supportive reflationary conditions to dissipate. This would put the expensive ZAR in a very precarious position. An additional danger for the ZAR is the price of gold. Gold and precious metals have also benefited from these generous global liquidity conditions. This has helped the South African terms of trade. However, gold is likely to be a key victim if U.S. interest rates rise because it is negatively correlated with both real interest rates and the U.S. dollar. Thus, while we do not see much upside for the expensive ZAR for the time being, it is likely to suffer greatly once U.S. inflation turns around, suggesting the ZAR possesses a very poor risk/reward ratio. The Russian Ruble Chart 17The Ruble Is Expensive But Russia Has The Best EM Fundamentals The RUB is currently trading at a very large premium to fair value (Chart 17). The risk created by such an overvaluation is only likely to materialize once U.S. inflation turns the corner and U.S. interest rates pick up - a scenario we've mentioned for late 2017 and early 2018. This risk is most pronounced against DM currencies, the U.S. dollar in particular. The RUB remains one of our favorite currencies within the EM space, especially when compared to other EM commodity producers. The Russian central bank is pursuing very orthodox policy, despite the fall in realized inflation, and is maintaining very elevated real interest rates in order to fully tame inflation expectations. Moreover, oil prices are likely to experience upside in the coming months as oil inventories are drawn down. This could result in an increase in the ruble's equilibrium exchange rate, which would help correct some of the RUB's overvaluation. The Korean Won Chart 18KRW Is Where You Can Really See The North Korean Tensions The fair value of the Korean won continues to be lifted by the combined effect of lower Asian bond spreads and Korea's current account surplus. Yet, the KRW is trading at an increasingly large discount to its equilibrium (Chart 18). At first glance, this seems highly surprising as global trade is growing at its fastest pace in six years - a situation that always benefits trading nations like South Korea. Instead, political developments are to blame. Not only is North Korea ramping up its tests of intercontinental ballistic missiles and nuclear devices, but also Seoul is within range of Pyongyang's conventional artillery. BCA's Geopolitical Strategy service does not expect the current standoff to result in military conflict. Ultimately, North Korea is no match for the military might of the U.S. and its allies. Moreover, the capacity for Pyongyang's actions to shock financial markets is exhibiting diminishing returns. This suggests the risk premium imbedded in the won should dissipate. However, the won will remain very exposed to dynamics in the USD, global liquidity and global trade. Instead, a lower-risk way for investors to take advantage of the KRW's cheapness is to buy it against the Singapore dollar. While just as exposed to global liquidity as the won, the SGD is currently trading at a premium to fair value. The Philippine Peso Chart 19The PHP Has Over-Discounted The Fall In The Current Account The fair value of the Philippine peso is driven by the country's net international investment position and commodity prices. After falling 6% this year, the real effective PHP now trades at a 13% discount to its fair value (Chart 19). A deteriorating current account, which is now in deficit, has fueled a selloff in the peso, making the Philippine currency one of the worst performing in the EM space. Worryingly, this has occurred alongside faltering foreign exchange reserves. However, the deficit is mainly the mirror image of large capital inflows, fueled by the government's ambitious infrastructure spending. Remittances are growing again and, with a weaker peso, will support consumer spending going forward. Employment had a setback last year, but is growing again. Higher investment and consumer spending will likely push rates up. As inflation rebounded alongside commodity prices last year, it is now at its 3% target. Bangko Sentral ng Pilipinas will need to rein in inflationary pressures to avoid overheating the economy. While the Philippines economy should expand further, the 'Duterte Discount' remains in place. Negative net portfolio flows reflect negative investor sentiment, as policy uncertainty remains elevated. The Singapore Dollar Chart 20SGD Remains Expensive The fair value of the Singapore dollar is driven by commodity prices. This is because the exchange rate is the main policy tool used by the Monetary Authority of Singapore. As a result, when commodity prices rise, which leads to inflationary pressures, MAS tightens policy by spurring appreciation in the SGD. The opposite holds true when commodity prices weaken. Based on this metric, the SGD is currently 4.2% overvalued (Chart 20). Domestically, dynamics are quite mixed. Retail sales have picked up. However, both manufacturing and construction employment are contracting and labor market slack is increasing, pointing to continued subdued wage growth. Additionally, property prices are contracting and vacancy rates are on the rise, led by the commercial property sector. Thus, the recent pickup in inflation could soon vanish, especially as it has been driven by the rebound in oil prices in 2016. This combination suggests that Singapore still needs easy monetary conditions. USD/SGD closely follows the DXY. While the Fed will be able to increase interest rates by more than the 35 basis points priced over the next 24 months, Singapore still needs a lower exchange rate to maintain competitiveness and alleviate deflationary pressures. The Hong Kong Dollar Chart 21The Fall In The USD Has Helped The HKD The HKD remains quite expensive. However, being pegged to the USD, its valuation premium has decreased this year (Chart 21). The fall in the greenback has driven the HKD - which itself has fallen 0.75% versus the U.S. dollar - lower against the CNY and other EM currencies. If the U.S. dollar does resume its uptrend over the next six months, the valuation improvement in the HKD will once again dissipate. However, this does not spell the end of the HKD peg. With reserves of US$414 billion, or 125% of GDP, the Hong Kong Monetary Authority has the firepower to support the peg, which has been one of the cornerstones of Hong Kong economic stability since 1983. Instead, the HKMA will tolerate deep deflationary pressures that will cause a fall in the real effective exchange rate. This is the path that Hong Kong picked in the 1990s, and it will be the path followed again in the face of any broad-based USD appreciation. This suggests that Hong Kong real estate prices could experience significant downside in the coming years. The Saudi Riyal Chart 22The Riyal Is Still Expensive The Saudi riyal remains prohibitively expensive, even as its valuation premium has decreased this year (Chart 22). The SAR is afflicted by similar dynamics as the HKD: its peg with the USD means the greenback's gyrations are the main source of variation in the SAR's real effective exchange rate on a cyclical basis. However, on a structural horizon, the fair value of the riyal is dominated by Saudi Arabia's poor productivity. An economy dominated by crude extraction and processing and living on one of the most sizable economic rents in the world, Saudi Arabia has not endured the competitive pressures that are often the source of productivity enhancement in most nations. Additionally, Saudi capital expenditures are heavily skewed to the oil sector, a sector whose output growth has been limited for many decades by natural constraints. We do not believe the current valuation premium in the riyal will force the Saudi Arabian Monetary Authority to devalue the SAR versus the USD. Saudi Arabia, like Hong Kong, possesses copious foreign exchange reserves, and growth has improved now that oil prices have rebounded. Additionally, the KSA is also likely to tolerate deflationary pressures. Not only has it done so in the past, but Saudi Arabia imports most of its household products, especially its food needs. A fall in the SAR would cause a large amount of food inflation, representing a massively negative price shock for a very young population. This is a recipe for disaster for the royal family of a country with no democratic outlet. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 3 For a more detailed discussion on the global liquidity environment, please Foreign Exchange Strategy Weekly Report, "Dollar-Bloc Currencies: More Than Just China", dated August 18, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights The law of the vital few states that a small number of causes have a disproportionate impact on your overall investment performance. Get the bond yield direction right and your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. Expect the euro area versus U.S. bond yield spread to continue compressing. This means euro area banks will outperform U.S. banks and EUR/USD has cyclical upside. But within a European equity portfolio, banks should be at neutral weight. This implies upgrading Italy's MIB and Spain's IBEX to neutral and downgrading Germany's DAX to underweight. Feature "Less is more, and usually more effective" - Nassim Taleb The law of the vital few states that a small number of causes usually have a disproportionate impact on any overall result. Familiar examples of the law - also known as the Pareto principle or the 80/20 rule - are that a minority of bugs cause a majority of software problems; and that the top few salespeople in any company tend to be responsible for most of its sales. With investment research costs now coming under intense scrutiny, the law of the vital few has become highly significant for the investment management industry too. Every day, investors are bombarded with a seemingly endless stream of research, email alerts and newsfeeds. Yet most of the hundreds of choices that investors have to make reduce to getting just a handful of fundamental decisions right. We call this investment reductionism. The message from investment reductionism is to identify the few decisions that really matter, and to focus your time, effort and resources on these vital few rather than the trivial many. Because the vital few will have a disproportionate impact on hundreds of positions across different asset-classes in your investment portfolio. Bond Yields Are One Of The Vital Few Right now, one of the vital few decisions is the direction of high-quality government bond yields. Get bond yields right absolutely and relatively and you will get at least four investment decisions for the price of one. Not only will you get fixed income right, but your equity sector allocation, equity country allocation and currency allocation should end up outperforming too. In the most recent mini-cycle, the bond yield has driven the bank equity sector's relative performance almost tick for tick both in Europe (Chart I-2) and globally (Chart of the Week). There are two reasons. Higher bond yields fatten banks' net interest margins. They also signal an improving growth outlook and thereby a reduction in bad debts. Lower bond yields imply the exact opposite. Chart of the WeekGet Bond Yields Right And You"ll ##br##Get Banks Right Too Chart I-2Get Bond Yields Right And You"ll ##br##Get Banks Right Too In turn, the bank sector's relative performance has a major influence on equity country allocation. Investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-3 and Chart I-4) Which itself reduces to: will bond yields head higher? The bond yield - relative to those in other economies - is also a major driver of the exchange rate (Chart I-5). As we detailed in Who's Afraid Of A Stronger Euro?1 the transmission mechanism is the so-called fixed income portfolio channel. In a nutshell, a higher bond yield in one jurisdiction relative to others attracts international fixed income portfolio flows into that jurisdiction, pushing up its currency - until a new higher level of the currency repels any further bond inflows. Chart I-3Get Banks Right And You"ll ##br##Get Italy Right Too Chart I-4Get Banks Right And You"ll ##br##Get Spain Right Too Chart I-5Get Bond Relative Performance Right And##br## You"ll Get EUR/USD Right Too Follow Your High Convictions Still, it is impossible to have a high-conviction view on a macro call at all times. A golden rule of investing is to have a big position only where and when you have a high-conviction view. Chart I-6When Unemployment Is Plunging, Real Wage ##br##Inflation Should Be Rising, But It Isn"t At the moment, our high-conviction view on bond yields is a relative view. Specifically, the euro area versus U.S. yield shortfall will continue to compress one way or another. This is because the polarisation of monetary policy expectations in the euro area relative to the U.S. remains at odds with growth and inflation data that have been, are, and will continue to be near-identical. Using investment reductionism, a high-conviction view that the euro area versus U.S. yield spread will compress necessarily means overweighting European banks versus U.S. banks. And it means staying cyclically long EUR/USD. On the absolute direction of bond yields we have less conviction. On the one hand, major economies are growing well and unemployment rates are coming down. Yet as we explained in Why Robots Will Kill Middle Incomes,2 the current wave of technological progress is especially disinflationary for wages, and one of the reasons why the Phillips curve relationship between unemployment and wage inflation isn't working (Chart I-6). Even the Federal Reserve Bank of Philadelphia, in a recent research paper,3 "finds no evidence for relying on the Phillips curve". The upshot is that we are cyclically neutral on bonds, but structurally positive. Using investment reductionism again, a cyclically neutral stance on bonds necessarily means a cyclically neutral weighting to European banks versus other European sectors. In turn, this means a cyclically neutral weighting to Italy's MIB and Spain's IBEX versus the Eurostoxx600. Sector Skews Are One Of The Vital Few To reiterate, the key consideration for European equity country allocation is always: how to allocate to the vital few sectors that feature most often in the skews: in addition to Banks, this means Healthcare, Energy and Materials (Box I-1 and Appendix). Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Within a European equity portfolio, our cyclical stance to Banks is neutral. Healthcare's cyclical relative performance reduces to its defensiveness and low beta. This means that Healthcare tends to underperform in a strongly advancing market. But it tends to outperform when the market is doing no better than advancing weakly (Chart I-7). As this is our central expectation, our cyclical stance is to remain overweight Healthcare. Chart I-7Healthcare"s Cyclical Relative Performance Reduces To Its Defensiveness And Low Beta Regarding Energy, Materials (and Industrials), euro area equity markets with a large exposure to these export-heavy sectors will be under pressure, given our cyclical view on the euro. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. Hence, underweight these sectors. Finally, to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown above. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Italy, Spain, and Netherlands. Underweight: Germany, Sweden and Norway. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3, 2017 and available at eis.bcaresearch.com 2 Published on August 10 and available at eis.bcaresearch.com 3 https://www.philadelphiafed.org/-/media/research-and-data/publications/… Chart Appendix Chart I-8Germany (DAX) Is Overweight Chemicals, ##br##Underweight Banks Chart I-9France (CAC) Is Underweight Banks ##br##And Basic Materials Chart I-10Italy (MIB) Is Overweight Banks Chart I-11Spain (IBEX) Is Overweight Banks Chart I-12Netherlands (AEX) Is Overweight Technology, ##br##Underweight Banks Chart I-13Ireland (ISEQ) Is Overweight Airlines (Ryanair)##br## Which Is, In Effect, Underweight Energy Chart I-14The U.K. (FTSE100) Is Effectively##br## Underweight The Pound Chart I-15Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Chart I-16Sweden (OMX) Is Overweight ##br##Industrials Chart I-17Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Chart I-18Norway (OBX) Is##br## Overweight Energy Chart I-19The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks Fractal Trading Model* Our model successfully captured the early August technical bounce in USD/CAD, and is signalling another opportunity now. The profit target / stop loss is 2.5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-20 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##Br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights The ECB can talk down the euro, but not by much. The central bank has previously expressed comfort with EUR/USD at 1.15. The cyclical and structural direction of EUR/USD is higher... ...because the euro area versus U.S. long bond yield spread should ultimately compress to -40 bps from today's -130 bps. Remain neutral in Germany's DAX and underweight Sweden's OMX. Equity markets with a strong base currency and a large exposure to exporters will come under pressure. Overweight German consumer services equities versus German exporters and the DAX. Underweight U.K. consumer services equities versus the FTSE100. Feature When mariners know that a sea-change is coming, their concern is not whether it comes today, tomorrow or the day after tomorrow. The big issue is the sea-change itself - because it brings major implications for navigating the seas. In the same way, when currency markets know that a sea-change in monetary policy is coming, their concern is not whether the policy announcement comes on September 7, October 26 or December 141 - or indeed whether the sea-change will happen suddenly or gradually. At a sea-change, currency markets look much further ahead. Just as for mariners, the big issue is the sea-change itself. EUR/USD is now moving in lockstep with the expected differential between euro area and U.S. policy interest rates not next year, nor the year after next, but rather the differential five years out (Chart I-2). Chart I-1AA Strong Euro Is Good For ##br##German Consumer Services... Chart I-1B...A Weak Pound Is Bad For##br## U.K. Consumer Services Chart I-2EUR/USD Is Moving In Line With The Interest ##br##Rate Differential Expected In 2022 The ECB Can Talk Down The Euro, But Not By Much Chart I-3EUR/USD Might Find Support At 1.15 Therefore, if the ECB really wants to unwind the euro's sharp appreciation this year, the central bank must tell the market that the expectation for a sea-change is completely wrong. In other words, the ECB must indicate that it has no intention to dial back its emergency monetary accommodation. Such a volte-face is unlikely, for two reasons. First, the ECB likes to adjust market expectations incrementally rather than violently. The last policy meeting made the case "for proceeding gradually and prudently when approaching adjustments in the monetary policy stance and communication." Second, not to dial-back its emergency monetary accommodation flies in the face of a euro area economic expansion that is solid, broad, and among the strongest and best-established among major developed economies. "Postponing an adjustment for too long could give rise to a misalignment between the Governing Council's communication and its assessment of the state of the economy, which could (eventually) trigger more pronounced volatility in financial markets." Nevertheless, at the margin, dovish words from Draghi could pare back the euro. How much? Consider that at the last policy meeting EUR/USD stood at 1.15 and the ECB justified this level on the basis of the improved "relative fundamentals in the euro area vis-à-vis the rest of the world." (Chart I-3) Given that these relative fundamentals are still intact, 1.15 might provide a level of support in a technical retracement. Of course, EUR/USD also depends on the Federal Reserve and expectations for its policy rate five years out. EUR/USD would sink if the market became much more hawkish about where it sees the U.S. 'terminal' interest rate. However, for the terminal rate expectation to rise suddenly and sharply in the U.S. relative to the euro area would also fly in the face of the economic data on both sides of the Atlantic. Recently, there has been little difference in either economic growth or inflation rates. The 'Neutral' Real Interest Rates In The Euro Area And U.S. Are The Same More fundamentally, there is little difference in the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. Through the 19 years of the euro's life, the euro area versus U.S. long bond yield spread has averaged -40 bps2 (Chart I-4). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-5). Ergo, the real interest rate differential has averaged zero. Meaning, the neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-4Euro-U.S.: Average Interest ##br##Differential = -40bps Chart I-5Euro Area-U.S.: ##br##Inflation Differential = -40bps Bear in mind that the 19 year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Hence, 1999-2017 is a good representation of what the future holds, at least in relative terms if not in absolute terms. With little difference in the neutral real rates over the past two decades, is there any reason to expect a big difference in the future? Our starting assumption has to be no. Chart I-6If Composition Differences Were Removed, ##br##Euro Area And U.S. Inflation Would Be Near-Identical In fact, even the -40 bps annual inflation shortfall in the euro area is due to a compositional difference in the consumer price baskets. The euro area does not include owner occupied housing costs, whereas the U.S. does at a hefty weighting.3 If this compositional difference were removed, inflation would also be near-identical (Chart I-6). Still, each central bank must target inflation as it is defined in its respective jurisdiction, so let's assume the annual inflation differential continues to average -40 bps. In this case, the long bond yield spread should also ultimately compress to -40 bps from today's -130 bps. The biggest risk to this view is if the existential threat to the euro resurfaced. Looking at the political calendar, the German Federal Election on September 24 poses no such threat. Meanwhile, ahead of the Italian general election to be held no later than May 20 2018, even the non-establishment Five Star Movement and Northern League are toning down their anti-euro rhetoric. As my colleague Marko Papic, our Chief Geopolitical Strategist, puts it: "euro area politics are a red herring." On this basis, our central expectation is that the euro area versus U.S. yield spread has the scope to compress much further from its current -130 bps. This means that after a possible near-term retracement, we expect the cyclical and the structural rally in the euro to resume. German Consumers Are Winners, U.K. Consumers Are Losers When European currencies strengthen, the big winners are European consumers because they become richer in terms of the goods and services they can buy in international markets. This is significant because Europe imports its food and energy in large (and inelastic) volumes. Hence, their price decline in local currency terms significantly boosts the real spending power of consumers. And vice-versa (Chart I-7). As if to prove the point, German consumer services equities have rallied strongly this year (Chart I-8). And their outperformance has closely tracked euro strength (Chart of the Week, left panel). Across the English Channel, it is the mirror-image story. The pound has slumped. And the big losers are U.K. consumers, whose real spending power is evaporating as food and energy prices - in pound terms - rise. Again, to prove the point, U.K. consumer services equities have struggled to make any headway this year (Chart I-9). And their underperformance has closely tracked the trade-weighted pound's weakness (Chart of the Week, right panel). Chart I-7German Consumption Accelerating,##br## U.K. Consumption Decelerating Chart I-8German Consumer Services ##br##Have Rallied Chart I-9U.K. Consumer Services ##br##Have Struggled If the euro has more cyclical and structural upside - as we anticipate - then these equity performance trends have further to run. Chart I-10The Exporter Heavy DAX And##br## OMX Have Struggled Remain overweight German consumer services equities versus German exporters and the DAX. And remain underweight U.K. consumer services equities versus the FTSE100. At the same time, equity markets with a strong base currency and a large exposure to exporters will come under pressure. Mostly, this is because the translation of multi-currency international earnings into a strengthening base currency hurts index profits. For the time being, this influences our allocation to Germany's DAX - in which we have been neutral relative to the Eurostoxx600 - and Sweden's OMX - in which we have been underweight (Chart I-10). Next week, we will update our overall European country allocation. Given the large sector skews in European equity indexes, this country allocation is heavily dependent on the stance towards Healthcare and Banks. Hence, we await any incremental communication from the ECB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 These are the dates of the ECB's three remaining monetary policy meetings in 2017. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 The imputed cost of owner occupied housing (owners' equivalent rent of residences) comprises 25% of the U.S. consumer price basket but 0% of the euro area consumer price basket. Fractal Trading Model Basic materials equities are technically overbought. Initiate a short position relative to the broad market with a profit target / stop loss at 2.5%. In other trades, long Mediaset Espana / short IBEX35 hit its stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Highlights Even isolated North Korean attacks are unlikely to lead to a full-scale war; The USD sell-off will start to reverse once Trump makes Gary Cohn his official pick for Fed chairman; Europe is not a risk for investors ... even Italy is only a longer-term risk; France is reforming; stay long French industrials versus German. Feature Last week, in London, we were scheduled to give a talk on Sino-American tensions, East Asian geopolitical risks, and North Korea specifically. We submitted our topic of choice about a month ahead of the event, when tensions between Pyongyang and Washington were at their height. As tensions temporarily subsided following Supreme Leader Kim Jong-Un's decision to delay the planned missile launch towards Guam, several colleagues wondered if the topic was still a pertinent one. We stressed in our research that tensions would not dissipate and would continue to be market-relevant, if not critical for S&P 500.1 Unfortunately, we have been proven right. Forecasting geopolitics requires insight, multi-disciplinary methodology, and a treasure trove of empirical knowledge. But sometimes it also just comes down to using Google and looking at a calendar. For example, given the present context of heightened tensions, the annual U.S.-South Korean military exercises - Key Resolve, which occurs normally in the spring, and Ulchi-Freedom Guardian, which occurs in August - are obvious dates to monitor. They are provocations that North Korea has to respond to for both foreign and domestic audiences. Pyongyang has chosen to do so by firing an ICBM across Japan and testing a sixth nuclear device, allegedly a miniaturized hydrogen bomb. While both these actions qualitatively expand on previous acts (missile and nuclear tests), neither cross a threshold. We are still in the realm of "territorial threat display." President Trump and Supreme Leader Kim are angling their "swords," but have not dared to cross them yet. Nonetheless, our clients have pointed out that our "arch of diplomacy" approach leaves a lot to imagination. Therefore, the first insight from the road of this week is that we need to put our thinking cap on and imagine a scenario where tensions do blow over into open conflict. How do we imagine such a scenario occurring and why would it not devolve into full out war that forces the U.S. to attack the North Korean mainland? Is North Korea About To Become A Praying Mantis? We can imagine a scenario where North Korea commits an act that takes us beyond the nuanced thresholds set by recent history (Chart 1). For example, we have cited to clients that an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.2 We could see the U.S. following the script from 1988 Operation Praying Mantis in the Persian Gulf - the largest surface engagement by the U.S. Navy since the Second World War - when the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines.3 Chart 1North Korean Provocations Rarely Affect Markets For Long Such an increase in tensions is not our baseline case, but we assign much higher probability to it than to an all-out war on the Korean Peninsula (which we still see as highly unlikely). How would the markets react to the sinking of North Korean submarines? How would Pyongyang react? The answer to the former (market's reaction) depends on the answer to the latter (what does Pyongyang do?). Our best guess is that Pyongyang would do nothing. In fact, we may never know that North Korean submarines were sunk. We would suspect that North Korean military strategists would chalk the subs as a loss and quietly move on to more missile tests. Leadership in Pyongyang is massively constrained by its quantifiable military inferiority. This part requires a bit of "order-of-battle" analysis, so bear with us for a few paragraphs. North Korea has around 6 million military personnel, about 25% of the total North Korean population, ready to fight. Which would be great if it were preparing to charge Verdun in WWI. Unfortunately for Pyongyang, it is arrayed against one of the most sophisticated defenses ever constructed by man. To burst through the Demilitarized Zone (DMZ), its mammoth ground forces would have at their disposal about 2000 T-55s (designed in the 1950s) and an unknown number of T-72s (designed in the 1970s). The former are obsolete, but the latter are solid main battle tanks that could do damage ... that is, in a world where war was not airborne. The problem is that North Korea would lose air superiority within hours of any serious engagement leaving its tanks and ground troops vulnerable to death-from-above. Since North Korean troops would have to enter about 20 miles into South Korea to threaten Seoul with occupation, they would have to exit the range of most of their air defenses. Choosing to turn on the most powerful of their systems - such as the KN-06 with a 150km range - would leave them vulnerable to the U.S. AGM-88 HARM missiles that sniff out active radar antenna or transmitters. To protect its invading forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15 and F-16s, plus American forces that would vary in size depending how many aircraft carriers were deployed in the vicinity and whether U.S. forces in Japan were deployed to counter the attack. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would likely quickly find themselves fighting a losing battle. Once the North Korean fighter jets were destroyed, the South Korean air force would turn the invasion into a massacre. The reality is that North Korea's ground forces are just for show. Its tanks and fighter jets will never see battle. North Korea really only has two gears: P & N. The first is for "Provocation" and the second is for "Nuclear Armageddon." This is why we highly doubt that we will see our Praying Mantis scenario play out, or lead to full-scale war if it does. North Korea is constrained by its technological inferiority. It does not have the ability to conduct war across a full spectrum of engagement. Neither did Iran in 1988, which is why it never retaliated for the loss of its navy, put all its revolutionary zeal and chest-thumping aside, and sued the U.S. at the International Court of Justice instead.4 The U.S. has a range of limited military engagements, particularly at sea, that could hurt Pyongyang's ability to project what little power it has. Given our constraint-based methodology, which requires one to have some understanding of military affairs, we have a fairly high conviction view that North Korea will continue to toe-the-line of the expected and thus accepted provocations along the lines of the history surveyed in Chart 1. Going beyond that list would threaten to expose the paucity of North Korea's military capabilities. Bottom Line: We are still in for a wild ride with North Korea. As we expected, regional safe haven assets continue to perform well. We will hold on to our safe haven basket of Swiss bonds and gold, up 2.6% since August 16. Nonetheless, we expect North Korea to steer clear of provoking a war. Gary Cohn Will Collapse The USD! (But What If He Already Did?) Several fast-money clients - both in the U.S. and Asia - have a theory for why the greenback continues to suffer: Gary Cohn. The theory goes that Cohn is an ultra-dove whose job as the next Fed Chair will be to stay "behind the curve" and drive down the USD. This would accomplish President Trump's lofty nominal GDP growth goals despite legislative hurdles to his fiscal policy. It would also keep risk assets well bid and help begin rebalancing the U.S. trade deficit. What do we know of Mr. Cohn's views on monetary policy? Not much: He defended the Trump administration goal of a 3% GDP growth target, suggesting that he has a far more optimistic view of U.S. growth than the current Fed projection;5 He believes that monetary policy is "globalized," intoning at a conference in Florida quickly after the election that the Fed policy of raising rates before the rest of the world is ready to do the same would be a mistake;6 In a January 2016 Bloomberg TV interview, he said that both the U.S. and Chinese currencies were overvalued and would both have to devalue.7 People who know and have worked with Gary Cohn (including one colleague at BCA!) speak highly of his pragmatism, work ethic, and focus. Most agree that he would likely be dove-ish, but there is not a single person we have spoken to who thinks that he will be Trump's puppet. As such, his disconnected statements largely say nothing about his potential style of leadership. His most ultra-dovish, USD-slaying comment comes from January 2016, with DXY 6.9% down since then (Chart 2). Mission Accomplished Mr. Cohn? The real reason for the USD slide, aside from a persistently disappointing inflation print, has been a realization by the market that President Trump's bark has no bite. On a slew of measures, President Trump's initial bravado has dissipated into flabby rhetoric. Chart 3 shows the initial surge in optimism regarding growth, tax reform, infrastructure spending, Mexico's comeuppance, and bi-partisanship (measured as support among independents). Each data point has not only fallen back to pre-election levels, but appears to have now been desensitized to any news that would have excited it in the past. For example, NAFTA negotiations are off to a poor start, President Trump continues to bash the trade deal, and yet the peso has rallied since Trump's inauguration! Chart 2Mission Accomplished, Mr. Cohn? Chart 3Trump's Bark Has No Bite? The Fed itself has lost faith in the president. The number of FOMC members who see upside risks to inflation and GDP growth, not unrelated to fiscal policy, has fallen after a brief surge after the election (Chart 4). Chart 4The Fed Also Doubts Trump What chances are there for the White House and Congress to re-write the fiscal narrative over the final quarter of 2017? As we wrote last week, Hurricane Harvey will ensure that a debt ceiling breach and government shutdown are avoided. However, Congress is likely to spend September making one last attempt at Obamacare repeal and replace, thus largely wasting the month before returning to tax reform in earnest in the new fiscal year. We expect some form of tax legislation to take shape by the end of December. Will it be comprehensive tax reform? Unlikely. It will now almost certainly be merely a tax-cutting exercise, with some revenue offsets attached to it. With the Republicans in Congress now leading the tax reform effort, it is unlikely that the budget deficit hole will be as wide as President Trump would have wanted. The problem is that both Trump's July tax reform proposal and the House GOP August plan come short of revenue-neutrality by around $3-3.5 trillion (over the decade-long period) (Table 1). Given that such a massive increase in the deficit would be unacceptable to fiscal hawks (or Democrats) in the House, we would expect tax rates to be cut by a much more modest degree. Table 1By How Much Will Republican Tax Cuts Widen The Deficit? Table 1 gives a detailed survey of the preferences (Tax Cuts) and constraints (Revenue Offsets). It is difficult to see how all the constraints are overcome through the legislative process. This will force Republicans to modify their preferences on the scale of tax cuts. We would expect that a corporate tax cut from 35% to around 27-28% could be possible, along with a minimal middle-class tax cut. Anything beyond that would be overly complicated. Therein lies the paradox for Chair Cohn. The only way that he can be "behind the curve" is if the curve gets "in front of him." But why would it if any coming tax legislation has very little stimulative effect on the economy? Currently, the expected change in the Fed Funds Rate over the next two years stands at a measly 40 bps (Chart 5). That is just barely two rate hikes until September 2019. How can Mr. Cohn get the expectations any lower at this point? Bottom Line: The appointment of Gary Cohn will be a classic "sell the (USD on the) rumor, buy (the USD) on the news." We expect his appointment in late November or early December, if President Trump goes by the lead time from the past two nominations (Chart 6). That may be the time to pare back USD shorts for those investors who have been bearish on the greenback. Chart 5Hard To Drive Expectations##BR##Lower For Rate Hikes Chart 6How Long Does It Take To##BR##Confirm The Fed Chair? Europe Is Not A Risk Chart 7Europe's Economy Zooming Along One clear insight from our five weeks on the road this summer is that Europe is no longer on anyone's radar. We had hardly any questions regarding the upcoming German or Italian elections. And while most investors were somewhat pessimistic regarding French structural reforms, none expressed any interest in betting against them either. The obvious reason is that Europe's economy has genuinely recovered (Chart 7). Consumer and business confidence are holding up while the manufacturing PMI and industrial production remain strong. That said, uniformity of view among clients across several geographies makes us nervous. On the future of the Euro Area, investors have swung wildly from morose to resigned that it is here to stay. Nonetheless, we generally agree with the consensus. Unlike at the beginning of this year, when we boldly claimed that European risks would turn out to be a "trophy red herring," we have no alpha to generate by disagreeing with the market.8 Here is why: German Election: We have a policy of not wasting our client's time by covering major geopolitical events that have no market-relevance. Germany is the world's fourth-largest economy and it will hold an election on September 24. However, we see no investment relevance in the election and therefore no reason to spend time covering it. Polls show that the center-left opposition Social Democratic Party (SPD) has arrested its decline and may force another Grand Coalition (Chart 8). The only moderately interesting question is whether Chancellor Angela Merkel's Christian Democratic Union (CDU) will be able to get its favored coalition ally, the Free Democratic Party (FDP), into government instead. The FDP has turned towards soft Euroskepticism since 2009. Its parliamentarians voted against several bills dealing with the Euro Area crisis during their 2009-2013 coalition with the CDU. That said, Chancellor Merkel has turned much more forcefully pro-Europe since the dark days of Greek bailouts and bond market rioting. The Chancellor can read the polls: Germans support the common currency at 81%, compared to 66% average between 2009-2013 (Chart 9). We expect the FDP to play along with the Europhile conversion by the CDU. Chart 8Another Grand Coalition? Chart 9Merkel Knows Germans Support The Euro If there is any significance to the calm ahead of the German election, it is that the country is at "peak normal." Its policymakers have dealt with a massive migration crisis, geopolitical crises to the East, terrorist attacks, and severe political and economic stresses in its sphere of influence, all with a near-complete absence of internal drama. This looks like either "as good as it gets," or the start of a new Golden Age in Europe, with Berlin in the lead. It is probably neither, but given European asset prices, and gearing to the growing global economy, we would remain overweight Euro Area equities going forward. Italian Election: Polls remain too-close-to-call in the upcoming Italian election, with Euroskeptic parties continuing to poll well (Chart 10). However, we are not sure one can truly call these parties Euroskeptic anymore. Despite a high level of Euroskeptic sentiment in the country (Chart 11), its Euroskeptic parties have been scared off by the failures of peers in Austria, the Netherlands, and France. Chart 10Italy: Euroskeptic Parties Poll Well... Chart 11...Reflecting Broader Euroskepticism Luigi Di Maio, leader of the anti-establishment Five Star Movement (M5S) in the Italian Chamber of Deputies, and Matteo Salvini, head of the right-wing, populist Lega Nord, both reversed positions on the euro this month. Di Maio will be 5SM candidate for prime minister in the upcoming elections - which must be held by May and will likely take place in February or March. He reiterated a position, which 5SM hinted at in the past, that leaving the Euro Area would only be the "last resort" if Brussels refused to relax strict budget rules. Meanwhile, the firebrand, populist, Salvini hid behind Italy's constitution, claiming that a referendum on the euro would be illegal. In the short term, this means that the election in 2018 is no longer a risk. In the long term, it does not change the fact that Italy is ripe for a bout of Euroskeptic crisis at some later stage. Migration Crisis: Bad news for right-wing populists everywhere: the migration crisis is over and in quite a dramatic fashion. This is an empirical fact (Chart 12). Europe's enforcement efforts and collaboration with Libyan authorities (such as they are) have now forced even the humanitarian agencies to abandon the Mediterranean route. One of the largest such agencies - the Migrant Offshore Aid Station (MOAS) - recently announced that it was packing its mothership, the Phoenix, for Myanmar. The group is the fourth to stop patrols for migrants. Medecins sans Frontieres, Save the Children, and Germany's Sea Eye all cited hostile actions taken by Libyan authorities towards their vessels as the main reason to stop rescuing migrants in Libyan waters. Chart 12The 'Migration Crisis' Is Definitively Over To be clear, what is happening in the Mediterranean is a result of European enforcement efforts, not any sudden awakening of Libyan capacity or sovereignty. The European Union and Italy are training and funding the Libyan Coast Guard, which has started to intercept humanitarian vessels, threaten them with force (often right in front of the Italian Navy!), and force them to return migrants to Libya, where they are subjected to extremely cruel internment. Prior to this development, human smugglers would launch barely seaworthy "crafts" towards humanitarian ships waiting literally yards away in Libyan waters to "rescue" the "migrants" to Europe. As such, humanitarian agencies were aiding and abetting human smuggling, by making it a lucrative enterprise with no downside risk for the smugglers. We expect the step-up in enforcement in Libyan waters to severely impair the cost-benefit calculus of attempting a Mediterranean crossing for a would-be migrant. Instead of a welcoming NGO vessel many will find themselves in Libyan Internment camps. Word will spread fast and the migration crisis will abate further. We have now come full circle on the migration crisis, which we predicted back in September 2015 would end precisely in such an illiberal fashion.9 Europe has a vicious streak ... who knew? Structural Reforms In France: In February, we penned a bullish report on France, arguing with high conviction that Marine Le Pen would lose and that structural reforms would follow.10 What is the status of the latter forecast? Despite a decline in President Emmanuel Macron's popularity (Chart 13), he is expending his political capital early in his term. He understands our "J-curve of Structural Reform" (Diagram 1). Policymakers who understand how the reform J-curve works know that they have to spend their political capital while they have it, at the beginning of their term, in order to reap the benefits, if there are any, while they are still in power. Chart 13Macron's Popularity Slips Diagram 1The J-Curve Of Structural Reform How do Macron's reforms compare with previous efforts? Generally speaking, Macron's reforms (Table 2) compare favorably with both the 2012 Mariano Rajoy reforms in Spain and the 2003 Hartz reforms in Germany. The Hartz reforms were instrumental in expanding temporary work contracts and restructured generous unemployment benefits. Similarly, the Rajoy reforms in Spain clarified economic grounds for dismissal and created more flexible "entrepreneur contracts." Macron's reforms fit these efforts, especially the proposals to put in place "project contracts" - an open-ended contract lasting for the duration of a project - and to establish a floor and a ceiling for allowances in cases of unfair terminations, and make termination for economic reasons easier. Table 2French Labor Reforms: The Key Bits The two criticisms of the reform efforts we most often hear are that France has not had a crisis to spur reforms and that unions will launch vicious protests. The first criticism is dubious, given that France is itself emerging from the low-growth doldrums of the post-Great Financial Crisis. It is simply false to say that France has had no crisis. The French public is acutely aware that its real per-capita GDP growth has been closer to Greek levels than German ones over the last two decades (Chart 14) and that it has lost competitiveness in the global marketplace (Chart 15). One cannot have a conversation with a French friend, colleague, or client without wanting to order a strong drink!11 Chart 14France's Lost Millennium Chart 15France's Lost Competitiveness Besides, what monumental crisis was it that propelled Germany into reforms in the early 2000s? A vicious recession? A massive bank crisis? It was neither. Germany was simply weighed down for a decade by fiscal transfers to East Germany and sensing that its export-oriented industry was facing a massive challenge from the Asian move up the value chain. It was this acute sense of competitive pressure, of falling behind, that spurred Germany to reform. With France, the acute sense of falling behind Germany (Chart 16) is at the heart of today's effort. Chart 16German Competition Puts A Fire Under France The second criticism, that the unions will hold protests, misjudges the political capital arrayed behind Macron. Despite his sagging popularity, 85.9% of the seats in the National Assembly are of pro-reform orientation (Diagram 2). The second-largest party in the parliament is Les Republicains, an even more zealously pro-reform group. This is a unique situation in French history and will allow the government to ignore protests on the street. Diagram 2The Balance Of Power In France's National Assembly In fact, two of the largest unions in France - Force Ouvrière and CFDT - have both said they would not protest the labor reforms. This leaves only the more militant CGT to protest, along with the left-wing presidential candidate Jean-Luc Mélenchon. The reason investors will still fret about protests this month is because CGT retains a strong representation in heavy industry and infrastructure sectors like energy and railways. As such, their industrial action could grind the country to a halt. We suspect that a repeat of the 1995 general strike or the 2010 French pension reform unrest - both of which CGT spearheaded - will be the final nail in the coffin of "Old France." Unlike those previous reform efforts, President Macron's effort has been clearly signaled ahead of the election and thus retains considerable democratic legitimacy. As such, any repeat of the 1995 or especially 2010 unrest would delegitimize the unions and give President Macron even more political capital. Bottom Line: We agree with the now conventional view that all is well in Europe. Stability ahead of the German election reminds investors of what a healthy country is supposed to look like. Italian election risks have dissipated. And our French structural reforms call remains on track. This gives us an opportunity to do some house-cleaning regarding our calls. First, we are closing our long French 10-year bond / short Italian 10-year bond trade for a gain of only 1 bps. Second, we are closing our overweight Euro Area equities relative to U.S. equities call for a gain of 7.88%. Given our euro-bullishness, we never recommended that this call be currency hedged. We are now reinstating it with a currency hedge. We are also closing our long German 10-Year CPI Swap for a gain of 45.5 bps. We will stick with our long French industrial equities / short German industrials, which is currently up 9.25%. This is a way we have chosen to articulate our bullish view on the reforms, although clients with greater sophistication in European sectors could come up with a more direct way to articulate the view. Separately, we are also booking profits on our long China volatility trade (CBOE China ETF Volatility Index) for a gain of 16.82%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 2 A North Korean submarine sank the South Korean corvette Cheonan in 2010, but that was still within the norm of behavior for the two countries that are still effectively at war and have contested maritime borders. 3 Romeo-class submarines are nearly 70 years old. As much as we harken back to Yugoslav engineering with pride at BCA's Geopolitical Strategy, Belgrade was never much of a naval power. Nonetheless, diesel-powered submarines are quite proficient in staying undetected and could present a problem for the U.S. Navy. At least until they had to resurface or get back to base, where nuclear-powered U.S. Virginia-class attack-subs would lie in wait for them. 4 Tehran won the court case in 2003! And the ICJ forced the U.S. to compensate Iran for its lost ships or else face invasion by the United Nations army. (We are just kidding obviously. Iran did win, but it got nothing.) Please see Pieter H.F. Bekker, "The World Court Finds that U.S. Attacks on Iranian Oil Platforms in 1987-1988 Were Not Justifiable as Self-Defense, but the United States Did Not Violate the Applicable Treaty with Iran," American Society of International Law Volume 8, Issue 25, dated November 11, 2003, available at: asil.org. 5 Please see CNBC, "Tax reform is coming in September, Trump economic advisor Gary Cohn says," dated June 29, 2017, available at cnbc.com. 6 Please see Wall Street Journal, "How Donald Trump's New Top Economic Adviser Views the World," dated December 14, 2016, available at wjs.com. 7 Please see Business Insider, "Trump and his top economic adviser have had completely different views on China," dated January 3, 2017, available at businessinsider.com. 8 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 11 Thankfully for France, the choice would still be French wine!

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of August 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com