Greece

President Erdogan and the Justice and Development Party emerged as the winner of the Turkish general election which was concluded yesterday. This victory means that their expansive policies of the past decade will continue, and Turkish assets will suffer. Across the Aegean, the Greeks voted to reelect the New Democrats under the leadership of Prime Minister Mitsotakis. Their fiscal prudence and structural reforms will be continued as voters had rewarded them with another term in office. Go long Greek versus Turkish equities.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The golden rule for investing in the stock market simply states: “Stay bullish on stocks unless you have good reason to think that a recession is imminent.” The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Still, we can learn a lot from past recessions. As we document in this week’s report, every major downturn was caused by the buildup of imbalances within the economy, which were then laid bare by some sort of catalyst, usually monetary tightening. Today, the US is neither suffering from an overhang of capital spending, as it did in the lead-up to the 2001 recession, nor an overhang of housing, as it did in the lead-up to the Great Recession. US inflation has risen, but unlike in the early 1980s, long-term inflation expectations remain well anchored. This gives the Fed scope to tighten monetary policy in a gradual manner. Outside the US, vulnerabilities are more pronounced, especially in China where the property market is weakening, and debt levels stand at exceptionally high levels. Fortunately, the Chinese government has enough tools to keep the economy afloat, at least for the time being. Equity Bear Markets And Recessions Go Hand In Hand Bottom Line: Equity bear markets rarely occur outside of recessions. With global growth set to remain above trend at least for the next 12 months, investors should continue to overweight equities. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services. Macro Matters Investors tend to underestimate the importance of macroeconomics for stock market outcomes. That is a pity. Charts 1, 2, and 3 show that the business cycle drives the evolution of corporate earnings; corporate earnings, in turn, drive the stock market; and as a result, the business cycle determines the path for stock prices. Chart 1The Business Cycle Drives Earnings… Chart 2…Earnings In Turn Drive Stock Prices… An appreciation of macro forces leads to our golden rule for investing in the stock market. It simply states: Stay bullish on stocks unless you have good reason to think that a recession is imminent. Chart 3…Hence, The Business Cycle Is The Main Driver Of Equity Returns Historically, stocks have peaked about six months before the onset of a recession. Thus, it usually does not pay to turn bearish on stocks if you expect the economy to grow for at least another 12 months. In fact, aside from the brief but violent 1987 stock market crash, during the past 50 years, the S&P 500 has never fallen by more than 20% outside of a recessionary environment (Chart 4). Peering Around The Corner The catch, of course, is that it is difficult to know whether a recession is lurking around the corner. Leo Tolstoy began his novel Anna Karenina with the words “Happy families are all alike; every unhappy family is unhappy in its own way.” By the same token, every economic boom seems the same, whereas every recession has its own unique features. This makes forecasting recessions difficult. Difficult, but not impossible. Even though recessions differ substantially in their magnitude and causes, they all share the following three characteristics: 1) The buildup of imbalances that make the economy vulnerable to a downturn; 2) A catalyst that exposes these imbalances; and 3) Amplifiers or dampeners that either exacerbate or mitigate the slump. Let us review six past recessions to better understand what these three characteristics reveal about the current state of the global economy. Chart 4Equity Bear Markets And Recessions Go Hand In Hand The 1980 And 1982 Recessions The double-dip recessions of 1980 and 1982 were the last in which inflation played a starring role. Throughout the 1970s, the Fed consistently overstated the degree of slack in the economy (Chart 5). This led to a prolonged period in which interest rates stayed below their equilibrium level. The resulting upward pressure on inflation from an overheated economy was compounded by a series of oil shocks, the last of which occurred in 1979 following the Iranian revolution. Chart 6The Volcker Era: It Took Massive Monetary Tightening To Bring Down Inflation Chart 5The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s In an effort to break the back of inflation, newly appointed Fed chair Paul Volcker raised rates, first to 17% in April 1980, and then following a brief interlude in which the effective fed funds rate dropped back to 9%, to a peak of 19% in July 1981 (Chart 6).   The 1990-91 Recession Overheating also contributed to the early 1990s recession. After reaching a high of 10.8% in 1982, the unemployment rate fell to 5% in 1989, about one percentage point below its equilibrium level at that time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 7).   The 2001 Recession An overhang of IT equipment sowed the seeds of the 2001 recession. Spending on telecommunications equipment rose almost three-fold over the course of the 1990s, which helped lift overall nonresidential capital spending from 11.2% of GDP in 1992 to 14.7% in 2000 (Chart 8). Chart 7Overheating In The Leadup To The 1990-91 Recession The recession itself was fairly mild. After subsequent revisions to the data, growth turned negative for just one quarter, in Q3 of 2001. However, due to the lopsided influence of the tech sector in aggregate profits – and even more so, in market capitalization – the dotcom bust had a major impact on equity prices (Chart 9). Chart 9The Dotcom Bust Dragged Down Tech Earnings Chart 8A Glut Of I.T. Equipment Sowed The Seeds Of The 2001 Recession Having raised rates to 6.5% in May 2000, the Fed responded to the downturn by easing monetary policy. Falling rates were effective in reviving the economy – indeed, perhaps too effective. The resulting housing boom paved the way for the Great Recession.   The Great Recession (2007-2009) The housing sector was the source of imbalances in the lead-up to the Great Recession. In the US, and in other countries such as Spain and Ireland, house prices soared as lenders doled out credit on increasingly lenient terms. Chart 10A Long House Party Rising house prices stoked a consumption boom and incentivized developers to build more homes. In the US, the personal savings rate fell to historic lows. Residential investment reached a high of 6.7% of GDP, up from an average of 4.3% of GDP in the 1990s (Chart 10). While the housing bubble would have burst at some point anyway, tighter monetary policy helped expedite the downturn. Starting in June 2004, the Fed raised rates 17 times, pushing the fed funds rate to 5.25% by June 2006. The ECB also hiked rates; it raised the refi rate from 2% in December 2005 to 4.25% in July 2008, continuing to tighten policy even after the Fed had begun to cut rates. Once global growth started to weaken, a number of accelerants kicked in. As is the case in every recession, rising unemployment led to less spending, which in turn led to even higher unemployment. To make matters worse, a vicious circle engulfed the housing market. Falling home prices eroded the collateral underlying mortgage loans, producing more defaults, tighter lending standards, and even lower home prices. The Fed responded to the crisis by cutting rates and introducing an alphabet soup of programs to support the financial system. However, the zero lower-bound constraint limited the degree to which the Fed could cut rates, forcing it to resort to unorthodox measures such as quantitative easing. While these measures arguably helped, they fell short of what was needed to resuscitate the economy. Fiscal policy could have picked up the slack, but political considerations limited the scale and scope of the 2009 Recovery Act. The result was a needlessly long and drawn-out recovery.   The Euro Crisis (2012) Chart 11The State Is Here To Mop Up The Mess A reoccurring theme in economic history is that financial crises often force governments to assume private-sector liabilities in order to avoid a full-scale economic collapse. Unlike Greece, where government debt stood at very high levels even before the GFC, debt levels in Spain and Ireland were quite modest before the crisis. However, all that changed when Spain and Ireland were forced to bail out their banks (Chart 11). Unlike the US, UK, and Japan, euro area member governments did not have access to central banks that could serve as buyers of last resort for their debts. This limitation created a feedback loop where rising bond yields made it more onerous for governments to service their debts, which led to a higher perceived likelihood of default and even higher yields (Chart 12). Chart 12Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort The ECB could have short-circuited this vicious cycle. Unfortunately, under the hapless leadership of Jean-Claude Trichet, instead of providing assistance, the central bank raised rates twice in 2011. This helped spread the crisis to Italy and other parts of core Europe. It ultimately took Mario Draghi’s “whatever it takes pledge” to restore some semblance of normality to European sovereign debt markets. Lessons For Today The current environment bears some resemblance to the one preceding the recessions of the early 1980s. As was the case back then, inflation today has surged well above the Federal Reserve’s target, forcing the Fed to turn more hawkish. Oil prices have also risen, despite slowing global growth. Even Russia has returned to its status as the world’s leading geopolitical boogeyman. Yet, digging below the surface, there is a big difference between today and the early ‘80s. For one thing, long-term inflation expectations remain well anchored. While expected inflation 5-to-10 years out has risen to 3.1% in the latest University of Michigan survey, this just takes the reading back to where it was not long after the Great Recession. It is still nowhere near the double-digit levels reached in the early ‘80s (Chart 13). Market-based inflation expectations are even more subdued. In fact, the widely watched 5-year/5-year forward TIPS breakeven inflation rate is currently well below the Fed’s comfort zone (Chart 14). Chart 13Long-Term Inflation Expectations Are Inching Up But Are Still Low Chart 14Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Higher oil prices are unlikely to have the sting that they once did. The energy intensity of the global economy has fallen steadily over time, especially in advanced economies (Chart 15). Today, the US generates three-times as much output for every joule of energy consumed than it did in 1970. Household spending on energy has declined from a peak of 8.3% of disposable income in 1980 to 3.8% in December 2021. The US also produces over 11 million barrels of oil per day, more than Saudi Arabia (Chart 16). Chart 15The Global Economy Has Become Less Energy Intensive Over Time Chart 16When It Comes To Energy Production, The USA Is Now #1 Unlike in the late 1990s, advanced economies do not face a significant capex overhang. Quite the contrary. Capital spending has been fairly weak across much of the OECD. In the US, the average age of the nonresidential capital stock has risen to the highest level since the 1960s (Chart 17). Looking out, far from cratering, capital spending is set to rise, as foreshadowed by the jump in core capital goods orders (Chart 18). Chart 17The Aging Capital Stock Chart 18The Outlook For US Capex Is Bright Chart 19Need More Houses In contrast to the glut of housing that helped precipitate the Global Financial Crisis, housing remains in short supply in many developed economies. In the US, the homeowner vacancy rate has fallen to a record low. There are currently half as many new homes available for sale as there were in early 2020 (Chart 19). Even in Canada, where homebuilding has held up well, government officials have been hitting the panic button over a brewing home shortage.   The Biggest Risk Is Debt The biggest macroeconomic risk the global economy faces stems from high debt levels. While household debt has fallen by 20% of GDP in the US, it has risen in a number of other economies. Corporate debt has generally increased everywhere, in many cases to finance share buybacks and M&A activity (Chart 20). Public debt has also soared to the highest levels since during World War II. Chart 20Mo' Debt Among emerging markets, China’s debt burden is especially pronounced. Total private and public debt reached 285% of GDP in 2021, nearly double what it was in early 2008. The property market is also slowing, which will weigh on growth. Like many countries, China finds itself in a paradoxical situation: Any effort to pare back debt is likely to crush nominal GDP by so much that the debt-to-GDP ratio rises rather than falls. Ironically, the only solution is to adopt reflationary policies that allow the economy to run hot. In the near term, this could prove to be a favorable outcome for investors since it will mean that monetary policy stays highly accommodative. Over the long haul, however, it may lead to a stagflationary environment, which would be detrimental to equities and other risk assets. In summary, investors should remain overweight stocks for now. However, they should underweight the tech sector since tech stocks remain disproportionately vulnerable to rising rates, increased regulation, and a retrenchment in pandemic-induced spending on electronics and online services.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Special Report

Highlights Contagion risk from Italy to its European peers presents a buying opportunity; Italian policymakers are constrained by the bond market and avoiding brinkmanship; In a game of chicken between Berlin and Rome, Chancellor Angela Merkel is behind the wheel of a 2.5-ton SUV; Italy's ultimate constraint is its bifurcated economic system - staying in the EU helps manage this problem; Underweight Italian bonds in a global portfolio and short Italian bonds versus their Spanish equivalents. Feature Chart 1Is Contagion Warranted? On May 31, Italy formed the second overtly populist government in the Euro Area. The first was the short-lived SYRIZA government in Greece, which lasted from January to September 2015. Under the leadership of Prime Minister Alexis Tsipras and his colorful finance minister Yanis Varoufakis, Athens took Greece to the brink of Euro Area exit in the summer of 2015. Ultimately, Greek politicians blinked, folded, and re-ran the January election in September, transforming SYRIZA from an overtly euroskeptic party to a europhile party in just eight months. Investors are concerned that "this time will be different." We disagree. To use a poker analogy, Italian policymakers are better positioned to "bluff" their European counterparts as their chip stack is larger. But they are still holding a bad hand, and other players at the table still hold big stacks. The recent turbulence in Italian bond markets has spilled over into other Mediterranean countries (Chart 1). This contagion is unwarranted, as there has been much improvement across the region over the past few years, both politically and economically. As for Italy itself, it is positive that populists have come to power today, for several reasons. First, it will force them to actually run the country, a sobering process that often tempers anti-establishment zeal, as it did in Greece. Second, they will run the country at a time when popular support for the Euro Area and EU remains strong enough to deter an overt attempt to exit those institutions. Third, Italy remains massively constrained by material forces outside of their control, which will force compromises in negotiations with Brussels and fellow EU member states. There Will Be No Contagion From Italy Markets overreacted to the political risks emanating from Italy in recent weeks. Fundamentally, Italy's peripheral peers have emerged stronger from the Euro Area crisis. Since the onset of the Euro Area crisis, Greece, Portugal, Ireland, and Spain - the hardest-hit economies in 2010 - have seen their unit labor costs contract by an average of 8.7%. Over the same period, the rest of the Euro Area inflated its labor cost structure by around 10.9% (Chart 2). Italy remains saddled with a rigid, under-educated, and rather unproductive workforce that has seen no adjustment in labor costs.1 Meanwhile, its Mediterranean peers have practically closed their once-enormous unit labor-cost gap with Germany. Furthermore, all southern European countries now run primary surpluses, reducing the need for external funding (Chart 3). It is fair that the market should apply a fiscal premium to Italy, given the new government's plans to blow out the budget deficit. But no such fiscal plan is in the works in the rest of the Mediterranean. The cyclically-adjusted primary balance - for Italy, Spain, Portugal, and Greece - has gone from a deficit of 4.4% during the height of the debt crisis, to a surplus of 1.4% today. One can argue about whether such fiscal austerity was really necessary. The advantage, however, is that the improvement in structural budget balances has diminished the need for additional austerity measures and could also provide greater fiscal space during the next recession. Finally, household balance sheets have been on the mend for some time. Consumer debt levels as a percentage of disposable income in Spain, Portugal, and Ireland - the epicenter of the original Euro Area debt crisis - have now dipped below U.S. levels. In the case of Italy, importantly, the household sector was never over-indebted to begin with (Chart 4). Chart 2Italy Has Had No Labor-Cost Adjustment Chart 3Mediterranean Austerity Is Over Chart 4No Household Credit Bubble In Italy On the political front, Italians are clearly more euroskeptic than their Euro Area peers (Chart 5). Although only 30% of Italians oppose the common currency, in line with Greece, this is still considerably higher than in Spain and Portugal (Chart 6). Italians also feel less "European" than the Spanish or the Portuguese - i.e., they identify more exclusively with their unique nationality. Again this is in line with Greek sentiment (Chart 7). Italians were not always this way: in the early 1990s, they felt the most European. Chart 5Italy Lags In Support For The Euro... Chart 6...But Only 30% Of Italians Want Out Chart 7Italians Are Feeling More Italian In Portugal and Spain, parties across the political spectrum have responded to improving political and economic fundamentals. In Spain, the mildly euroskeptic Podemos is polling below its June 2016 election result. Its leadership has also abandoned any ambiguity on its support of the common currency, although it still campaigned in 2016 on restructuring Spain's foreign debt. The leading party in the Spanish polls is the centrist Ciudadanos (Chart 8), led by 38-year old Albert Rivera. Much like French President Emmanuel Macron, Rivera has a background in finance - he worked as a legal counsel at La Caixa - and presents a centrist vision for Europe, favoring more integration. The rise of Ciudadanos is important as Spain could have new elections soon. Conservative Prime Minister Mariano Rajoy resigned following a vote of no-confidence engineered by the Spanish Socialist Party (PSOE) leader Pedro Sánchez. However, PSOE only holds 84 seats of the 350-seat parliament. As such, it is unclear how the Socialist minority government will govern, particularly with the budget vote coming in early fall. But investors should welcome, not fear, early elections in Spain. With Ciudadanos set to join a governing coalition, it is clear that Spain's commitments to the Rajoy structural reforms will remain in place while no discussions of Spanish exit from European institutions is on any investment-relevant horizon. In Portugal, the minority government of Prime Minister António Costa has overseen a brisk economic recovery. Costa's center-left Socialist Party has received support in parliament from the far-left, euroskeptic Left Bloc, plus the Communists and Greens. Despite the involvement of the Left Bloc, the minority government has not initiated any euroskeptic policy. The latest polling suggests that Costa could win a majority in 2019. An election has to be held by October of that year, thus potentially strengthening the pro-European credentials of the Portuguese government (Chart 9). Finally, in Greece, the once overtly euroskeptic SYRIZA is polling well below their 2015 levels of support. Ardently europhile and centrist New Democracy (ND) is set to win the next election - which must be held by October 2019 - if polling remains stable (Chart 10). The fascist and euroskeptic Golden Dawn remains a feature of Greek politics, but has a support rate under 10%, as it has over the past decade. In fact, the rising player in Greek politics is the centrist and europhile Movement for Change, an alliance that includes the vestiges of the center-left PASOK, which polls around 10%. Chart 8There Is No Populism In Spain... Chart 9...Or Portugal... Chart 10...And Surprisingly None In Greece Bottom Line: Italy stands alone in the Mediterranean as a laggard on both economic and political fundamentals. Contagion risk from Italy to the rest of its European peers should be faded by investors. It represents a buying opportunity every time it manifests itself. What Car Is Italy Driving In This Game Of Chicken? The new ruling coalition in Rome has a democratic mandate for a confrontation with Brussels over fiscal spending. The coalition consists of the Five Star Movement (M5S) and the League (Lega), formerly known as the "Northern League." In his inaugural speech to the Italian Parliament, Prime Minister Guiseppe Conte emphasized that the mandate of the new coalition includes "reducing the public debt ... by increasing our wealth, not with austerity."2 So, the gloves are off! Not really. Almost immediately, Conte pointed out that "we are optimistic about the outcome of these discussions and confident of our negotiating power, because we are facing a situation in which Italy's interests... coincide with the general interests of Europe, with the aim of preventing its possible decline. Europe is our home." PM Conte subsequently focused in his speech on increasing social welfare payments to the poor, conditional on vocational training and job reintegration. Talk of a "flat tax" was replaced with an eponymous concept that is anything but a "flat tax."3 And there was no mention of overturning unpopular pension reforms, but merely "intervening in favor of retirees who do not have sufficient income to live in dignity."4 We may be reading too much into one speech. However, the time for brinkmanship is at the beginning of a government's mandate. And Conte's opening salvo suggests that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit by 5% of GDP, putting the total at 7%. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. Conte's relatively tame speech represents one of three concessions that Rome has made before it even engaged Brussels in brinkmanship. The two others were to replace the original economy minister designate - euroskeptic Paulo Savona - and to form a government in the first place. The latter is particularly telling. Polls have shown that the two populist parties would have an even stronger hand if they waited until the fall to re-run the election (Chart 11). In particular, Lega has seen its support rise by 9% since the election. It is politically illogical to form a governing coalition with less political capital when a new election would strengthen the hand of both populist parties. So why the concessions? Because Italian policymakers are not interested in brinkmanship. The populist campaign rhetoric and hints of euroskepticism were an act. And perhaps the act would have continued, but the bond market reaction was so quick and jarring (Chart 12) - including the largest day-to-day selloff since 1993 (Chart 13) - that it has disciplined Italy's policymakers almost immediately. Chart 11Lega Gave Up A Lot By Forming A Coalition Chart 12Bond Vigilantes Are... Chart 13...A Massive Constraint On Rome This is instructive for investors. In 2015, Greece decided to play the game of brinkmanship with Europe and ultimately lost. Our high-conviction view at the time was that Athens would back off from brinkmanship because it was massively constrained.5 Not only would an exit from the Euro Area mean a government default and the redenomination of all household saving into "monopoly money," but the level of euroskepticism in Greece was not high enough to support such a high-risk strategy. At the time, we pointed out that most investors - and practically all pundits - were wrong when they argued that brinkmanship between Greece and Brussels was "unpredictable." This conventional view was supported by an incorrect reading of game theory, particularly the "game of chicken." Game theory teaches us that a game of chicken is the most dangerous game because it can create an equilibrium in which all rational actors have an incentive to stick to their guns - to "keep driving" in the parlance of the game - despite the risks.6 In Diagram 1, we can see that continuing to drive carries the most risks, but it also carries the most reward, provided that your opponent swerves. Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. When this does not happen, the bottom-right quadrant emerges, one of chaos and deeply negative payouts for everyone involved in the crash. The problem with this analysis is that - as with most game theory - its parsimony belies deep complexity that often varies due to a number of factors. The first such factor is replayability. The decisions of Italian policymakers will be informed by the outcomes of the 2015 Greek episode, which did not go well for Athens. Another factor that obviously varies the payout matrix is the relative strength of each player; or, to stick with the analogy, the type of vehicle driven by each actor. Greece and its Euro Area peers were not driving the same car. The classic game of chicken only produces the payouts from Diagram 1 if all participants are driving the same vehicle. However, if Angela Merkel is behind the wheel of a Mercedes-Benz G-Class SUV, while Greek PM Alexis Tsipras is riding a tricycle, then the payouts are going to be much different in the case of a crash. In that case, the payouts should approximate something closer to Diagram 2. Diagram 1Regular Game Of Chicken Diagram 2Greece Versus Euro Area In 2015 So the crucial question for investors is what vehicle are Italian policymakers driving? We do not doubt that it is an actual car, unlike Tsipras's tricycle. But it is more likely to be a finely-crafted Italian sportscar, adept at hugging the twists and turns of Rome's policy, rather than an SUV capable of colliding with Merkel's ominous truck. Why doesn't Rome have more capability than Greece? Because of time horizons. An Italian exit from the Euro Area would undoubtedly shake the foundations of the common currency and the European integrationist project. But Rome actually has to exit in order to shake those foundations. As we have learned with Brexit, such an "exit" scenario could take months, if not years. In the process of trying to exit, the Italian banking system would become insolvent, turning household savings and retirements into linguini. This would occur immediately and would exert economic, financial, and - most importantly - political pressure on Italian policymakers instantaneously. Our colleague Dhaval Joshi, BCA's Chief European Strategist, has argued that a 4% Italian bond yield is the "line in the sand" regarding the survival of Italy's banks.7 As Dhaval points out, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). Based on this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart 14). Although the net NPL figure has improved much from the peak in 2015, it remains large. It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. Dhaval estimates that this equates to the 10-year BTP yield breaching and remaining above 4% (Chart 15). Chart 14Italian Banks' Equity Capital ##br##Exceeds Net NPLs By Euro 35 Bn Chart 15Italian Banks' Solvency Would Be In ##br##Question If The 10-Year BTP Yield Breached 4% Additionally, while Italian support for the common currency is relatively low, there is still a majority of around 60% that support the euro. This is similar to the level of support for the euro in Greece in 2015. We would suspect that the support for the currency would rise - and that populist parties would decline in popularity - if Italian policymakers set off a bond market riot that caused the insolvency of Italian banks. Does this mean that the bond market is a permanent constraint on Italian exit from the Euro Area? No. At some point in the future, after a deep recession that raises unemployment levels substantively, popular support for the common currency could tank precipitously. But we are far from that point. In fact, Italy has enjoyed a relatively robust recovery over the past 18 months. As such, any economic crisis today will be blamed on the populist policymakers themselves, yet another reason for them to moderate and seek the path of calm negotiations with the EU. Bottom Line: With regards to any potential "game of chicken" negotiations with the rest of Europe, Italian policymakers are not riding a tricycle like their Greek counterparts were in 2015. Italians are behind the wheel of a finely-crafted, titanium-chassis, Italian roadster. Unfortunately, Chancellor Angela Merkel is still in a Mercedes SUV that weighs 2.5 tons. This is a high-conviction view based on the actions of Italian policymakers over the past month. Despite an improvement in polling, populists have backed off from calling for a new election (which would have been perfectly logical) and that would have been advantageous to them and have abandoned some of the most controversial - and expensive - platforms of their coalition agreement. Unlike their peers in Greece, Italian populists have proven to have little stomach for actual confrontation. The Ultimate Constraint: Risorgimento In a report published back in 2016, we argued that Italy's original sin was its unification in 1861.8 Risorgimento brought together the North and South in a political and economic union that made little sense. The North had developed a market economy during the Middle Ages (and gave the West its Renaissance!), while the South had remained under feudalism well into the early twentieth century. Given the limited resources, governance, and technology of the mid-nineteenth century, the scope, ambition, and yes, folly of uniting Italy were probably several orders of magnitude greater than the effort to forge a common currency union in Europe in the twenty-first century. To this day, Italy remains an economically bifurcated country. Map 1 shows that the four wealthiest and most-productive regions of Europe, outside of capital cities, are the German Rhineland, Bavaria, the Netherlands, and Northern Italy. Meanwhile, the Italian South - or Mezzogiorno - is as undeveloped as Greece and Eastern Europe. Map 1Core Europe Extends Well Into Northern Italy The units of analysis in Map 1 are the so-called EU "nomenclature of territorial units for statistics" (NUTS).9 These regions matter because Brussels uses them to determine how much "structural funding" - essentially development aid - each country receives from the EU. The EU "regional and cohesion" funding - totaling €351.8 billion for the 2014-2020 budget period - is not distributed based on the aggregate wealth of each country, since that would favor the new entrants into the union. The EU's discerning eye when it comes to distributing development funds is not accidental. It is a product of decades of lobbying by Italy (and Spain) to prevent a shift of structural funding to Eastern European member states. From Rome's perspective, the real European development project is not in Poland or Greece, but in the Mezzogiorno. Chart 16Italy Shares The Burden Of The Mezzogiorno With The EU To this day, Italy and Spain receive the second and third largest amount of EU development aid (Chart 16). Despite contributing, in gross terms, 13% to the EU's total revenues, Italy's net contribution per person is smaller than those of the Netherlands, Sweden, Denmark, Finland, and Austria (Chart 17). Given that Italy is a wealthy EU state, its net budget contribution of approximately €3 billion, 0.2% of GDP, essentially means that it gets the benefits of EU membership for free. Chart 17Italy Gets To Join The Club For Free And EU membership comes with many benefits. Membership in the Euro Area - combined with sharing the same "lender of last resort" with Germany, the European Central Bank - allows Italy to finance its budget deficits at low interest rates and to issue government debt in the world's second largest reserve currency (Chart 18). These financial benefits are even greater than the rebate it gets from Europe. Access to cheap financing allows Italy to carry the costs of Mezzogiorno on its own. Chart 18The Big Difference Between 2011 & Today It is somewhat ironic that Lega is today preaching populism and euroskepticism. In the early 1990s, its main target of angst was not the EU and Brussels, but Italy's South and profligate Rome, which funneled the North's taxes to the South. This early iteration of the party was quite pro-EU, as it saw Italy's North as genuinely European and worthy of membership in EU institutions. Some of its politicians and voters hoped that Northern Italy could meld into the EU, leaving the Mezzogiorno to fend for itself. Hence there is no deep, ideological euroskepticism in Lega's DNA. The party's evolution also illustrates how opportunistic and pragmatic Italian policymakers can be. The reality is that if Italy were to act on its threat of "exit," it would undoubtedly become far worse off economically. Not only would Northern Italy have to support the Mezzogiorno alone, but any structural reforms that could lift productivity and education in the South would become far less likely as anti-establishment forces took hold. Bottom Line: Our high-conviction view is now the same as it was in 2016. Italy is "bluffing." Leaving the EU or the Euro Area makes no sense given its economic bifurcation, which is the result of Risorgimento. Both policymakers and voters understand this. The real intention in the game of chicken between Brussels and Rome is to see an easing of austerity. We expect that Italian policymakers will ultimately succeed in getting leniency from Brussels on allowing deficit-widening fiscal stimulus, but the stimulus will be much smaller than their original plans that spooked the bond market laid out. To European and Italian politicians, Italy's economic bifurcation is well understood. Jean-Claude Juncker, the President of the European Commission, specifically referred to it when he said, "Italians have to take care of the poor regions of Italy." He was later forced to apologize for his comments, with leaders of M5S and Lega faking outrage. But given that the ideological roots of Lega are precisely in the same intellectual vein as Juncker's comments, investors should understand that politicians in Rome are well aware of their fundamental constraints. Juncker's comments were a dog whistle to Rome. The actual message was: we know you are bluffing. Investment Implications Our analysis suggests that the path of least resistance for the M5S-Lega coalition is to negotiate some austerity relief from the EU Commission, but to definitively pivot away from talk of "exit" from European institutions. PM Conte has reaffirmed that exiting the euro is off the table and that it was never on the table to begin with. The new economy minister, Giovanni Tria, followed this up with a comment that "the position of this government is clear and unanimous... there are no discussions taking place about any proposal to leave the euro." Meanwhile, Lega leader and new Italian interior minister Matteo Salvini has focused his early efforts and commentary on the party's promise to check illegal immigration to Italy. This will be a policy upon which Lega will test its populist credentials, not a fight with Brussels. Is the worst of the crisis therefore "over"? Is it time to buy Italian assets? Not yet. Both Italian bonds and equities rallied throughout 2017. Italian equities, for example, have a higher Shiller P/E ratio than both Spanish and Portuguese stocks (Chart 19). As such, a sell-off was long overdue. Chart 19Why Did Italian Equities Rally So Much? Chart 20Italy's Binary Future Furthermore, we do not expect Rome's negotiations with Brussels to proceed smoothly. It is very likely that the bond market will have to continue to play the role of disciplinarian. The government debt-to-GDP ratio could quickly become unsustainable if the current primary budget balance is thrown into a deficit (Chart 20). According to the IMF and BCA Research calculations, Italian long-term debt dynamics are stable even with real interest rates rising to 2% - from just 0.5% today - and real GDP growth remaining at a muted 1%. But this stability requires the country to continue to run a primary budget surplus of around 2% of GDP (Chart 21). Conversely, running a persistent primary deficit of 2% would result in an explosive increase in Italy's debt dynamics. Even if that stimulus produces real GDP growth of 3%, the "bond vigilantes" could protest the surge in debt and drive real interest rates to 3.5% or higher. As such, the country's fiscal space will ultimately be determined by the bond market. Rome can afford to lower its primary budget surplus, but only so far as the bond market does not riot. Our colleague Dhaval Joshi believes that the math behind an Italian fiscal stimulus would make sense if it provides enough of a sustainable boost to economic growth without blowing out the budget deficit.10 We suspect that the bond market will eventually agree, but only if Brussels and Berlin bless the ultimate fiscal package as well. While investors wait to see the outcome of Rome-Brussels budget talks, which will likely last well into Q4, we prefer to play Mediterranean politics by shorting Italian government bonds versus their Spanish equivalents. BCA's Global Fixed Income Strategy initiated such a trade on December 16, 2016, which has produced a total return of 5.8%. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign-debt fundamentals, and political stability were all much worse than those of Spain (Chart 22). These differences were not reflected in relative bond prices. Chart 21Three Factors Will Influence Italy's Debt Trajectory Chart 22Spain Trumps Italy On All Fronts Ongoing political turmoil in Italy has justified sticking with the trade. Looking ahead, there is potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth; the deficit outlook will invariably worsen for Italy with the new coalition government; and Spanish support for the euro and establishment policymakers remains far higher and more buoyant than in Italy. All these factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 23). Chart 23Stay Short 5-Year Italy Vs. 5-Year Spain Chart 24Stay Underweight Italian Debt One final critical point - the timing of any budget related uncertainty could not be worse for Italy. Economic growth is slowing and leading indicators say that this trend will continue, which suggests that Italian government bonds should continue to underperform global peers (Chart 24). Our Global Fixed Income Strategy team has argued that government debt in the European "periphery" should be treated more like corporate credit rather than sovereign debt.11 Faster economic growth leads to fewer worries about debt sustainability and increased risk-taking behavior by investors, both of which lead to reduced credit risk premiums and eventually, stronger growth. In other words, think of Italian BTPs as a BBB-rated corporate bond rather than a "risk-free" Euro Area government bond. So as long as the Italian economy continues to lose momentum, an underweight stance on Italian government bonds is justified. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 2 Please see Repubblica, "Il discorso di Conte in Senato, la versione integrale," dated June 6, 2018, available at repubblica.it. 3 Conte's exact quote was "the objective is the 'flat tax,' that is a tax reform characterized by the introduction of rates that are fixed, with a system of deductions that can guarantee that the tax code remains progressive." This is our own translation from Italian and therefore we may be missing something. However, a "flat tax" that has a number of different rates and that remains progressive is, by definition, not a flat tax. 4 In fact, the speech could be read with an eye towards some genuine supply-side reforms, particularly in bringing the country's youth into the labor force, improving governance, reforming the judiciary, cracking down on corruption and privileges of the political class, and generally de-bureaucratizing Italy. If successful, these would all be welcome reforms. 5 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," July 8, 2015, available at gps.bcaresearch.com. 6 The game derives its name from a test of manhood by which two drivers drive towards each other on a collision course, preferably behind the wheel of a 1950s American muscle car. Whoever swerves loses. Whoever keeps driving, wins and gets the girl. 7 Please see BCA European Investment Strategy Weekly Report, "Italy's 'Line In The Sand,'" dated May 31, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 The acronym stands for Nomenclature des Unités Statistiques. 10 Please see BCA European Investment Strategy Special Report, "Italy Vs. Brussel: Who's Right?" dated May 24, 2018, available at eis.bcaresearch.com. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?" dated May 22, 2018, available at gfis.bcaresearch.com.

Dear Client, I am travelling this week meeting clients in Asia, so this report has been written by my colleagues, Billy Zicheng Huang and Sophie McGrath. Greece, the epicentre of the euro debt crisis, is finally recovering. Declining net NPLs, an upturn in investor confidence and improving employment are encouraging. But there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Hence, we are recommending a neutral weighting in the Greek equity market as a whole comprising four overweight ideas counterbalanced by four underweight ideas. We expect companies with essential product focus, low debt levels and strong asset health to outperform non-essential product providers, highly leveraged players and weak asset-quality counterparts. Dhaval Joshi Best Overweight And Underweight Ideas Table I-1Single-Stock Statistics On Select Greek Companies* Greece: The Long Road To Recovery Macro indicators in Greece have improved and investors have become more confident. This is highlighted by the recent upgrade of Greece's long-term sovereign credit rating to B and an oversubscribed seven-year bond sale, confirming high investor demand. Nevertheless, there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Listing the improvements, economic sentiment is approaching previous peaks (Chart I-1), the unemployment rate has dropped to its lowest level since 2011 (Chart I-2) and the youth unemployment rate has fallen around 20 percentage points from its high (Chart I-3). Chart I-1Economic Sentiment Has Improved Chart I-2Unemployment Is Down... Chart I-3...Youth Unemployment Even More So Furthermore, the most intense headwinds from fiscal drag are over. In the depths of the debt crisis, fiscal drag reached 7% of annual GDP. While Greece is not set to receive a sustained fiscal 'thrust' in the medium term, it appears the worst is over on the austerity front (Chart I-4). The most promising indicator is competitiveness. Greece appears to have made the necessary adjustments to unit labor costs and is no longer a euro area outlier (Chart I-5). Chart I-4Peak Fiscal Drag##br## Is Over Chart I-5Unit Labour Costs Are Now In Line ##br##With Euro Area Counterparts Recent developments in the banking system are also encouraging. Bank liquidity has improved, and the use of ECB Emergency Liquidity Assistance (ELA) has significantly diminished (Chart I-6). Net NPLs have declined sharply and are now covered by bank equity capital (Chart I-7). An unprecedented legal foundation is now in place to address the NPL stockpile. These measures include the introduction of electronic auctions to recover claims, the simplification of the out-of-court settlement process and reducing the liability of individuals involved. If net NPLs continue to fall, we can expect a healthier banking sector to support the economy, as witnessed in Spain, Ireland, and more recently in Italy. Chart I-6Banks Are No Longer Reliant ##br##On Emergency Funding Chart I-7Bank Equity Capital Finally ##br##Exceeds Net NPLs Despite these encouraging signs, the consumption recovery is fragile as households continue to delever (Chart I-8). Additionally, retail sales have dipped again recently (Chart I-9). Chart I-8Households Continue To Delever Chart I-9Retail Sales Have Dipped Regarding the bailout exit and debt sustainability, markets have seemingly priced in the wrapping up of the third review later this year, with the Eurogroup meeting on January 22 having recorded progress. However, what is more uncertain is whether this will take the form of a 'clean' or 'dirty' exit. The level of post-bailout monitoring that is agreed upon will ultimately dictate the pace of Greece's return to capital market normalcy. Considering the uncertainties in the overall picture, we recommend a market neutral portfolio in Greece with an overall beta of 0.15, consisting of four overweight companies versus four underweight counterparts from the consumer discretionary, telecoms, real estate, banking, consumer staples and energy sectors (Table I-2). Through our selection process we focused on companies with better growth profiles in essential sectors of the Greek economy. Table I-2Select Companies And 12-Month Beta Vs. MSCI EM Sector Specifics/Dynamics Our overweight (OW) basket performance over the past three years has been exceptionally strong relative to the underweight (UW) names. The OW basket has outperformed by 59% (Chart I-10A). However, this was primarily due to a selloff in Piraeus Bank (UW) in the second half of 2015. On a short-term horizon we see a different picture. Looking at one-year performance, the OW basket has actually just closed the underperformance gap over the past two months (Chart I-10B). Chart I-10AThree-Year Performance: ##br##Overweight Vs. Underweight Basket Chart I-10BOne-Year Performance: ##br##Overweight Vs. Underweight Basket Valuations favor the OW basket, especially from the second half of 2017 on, when OW and UW share prices began to diverge. Compared to historical valuations, OW names are currently trading close to their three-year average P/E, while their UW counterparts are trading at one standard deviation above historical P/E (Chart I-11A, Chart I-11B, and Chart I-11C). Chart I-11AOW Basket Displays Appealing Valuations##br## Relative To UW Basket... Chart I-11B...And Its Own ##br##Historical Average... Chart I-11C...While UW Basket Is Trading One Standard##br## Deviation Above Mean Non-bank OW companies display stronger operating margin dynamics, despite a recent dip, while the OW bank demonstrates superior net interest margins. Both margin trends are translating into solid profitability (Chart I-12A and Chart I-12B). Chart I-12ARobust Operational Level Performance... Chart I-12B...Feeds Into Solid Profitability Additionally, the OW basket displays more favorable debt dynamics, with debt remaining at low levels and trending down, whereas the debt ratio in the UW basket is already at an elevated level and continues to climb (Chart I-13). Meanwhile, free cash flow yield has favored UW players since mid-2016 when banks are excluded (Chart I-14). Chart I-13Debt Levels Remain ##br##Low In OW Companies Chart I-14Free Cash Flow Yield Favors ##br##UW Non-bank Names Specifically for banks, Alpha Bank (OW) enjoys a much healthier asset quality profile compared to Piraeus Bank (UW), with a combination of a lower NPL ratio and a higher tier-1 ratio (Chart I-15). Please also note that EPS growth is not shown as we normally do in our reports due to abrupt volatility in both baskets, which prevents us from drawing comparative conclusions. Dividend yield is also omitted due to the fact that most companies we have selected do not pay dividends. Chart I-15Alpha Bank Illustrates Healthier Asset Quality The Overweight Basket Jumbo (BELA GA) Jumbo (BELA GA) (Chart I-16) Chart I-16Performance Since February 2017: ##br##Jumbo Vs. MSCI EM Jumbo reported financial results for the fiscal 2017 year on October 12. Revenue increased by 7% year over year. Despite a difficult year in Greece, sales were compensated largely by organic growth in Romania and Bulgaria, with one new store open in each country respectively. EBITDA grew by 6% year over year, on the back of an effective cost management effort, while EBITDA margin remained virtually flat at 25.2%. As a result, the bottom line expanded by 8% year over year, with profit margin up 20 basis points to 19.2% Jumbo is currently trading at a forward P/E of 15.5x, while the market is forecasting an EPS CAGR of 6.3% over the next three years. The company is expected to continue its strong expansion drive in Eastern Europe, with one more store open in Romania in November 2017 (the 9th store) and one more store to be open next year in Bulgaria. At the same time, a drop in unemployment and a pick-up in household consumption will help Jumbo's recovery in the Greek market, signaling upside potential for the share price. Hellenic Telecom (HTO GA) Hellenic Telecom (HTO GA) (Chart I-17) Chart I-17Performance Since February 2017: ##br##Hellenic Telecom Vs. MSCI EM Hellenic Telecom (OTE) reported full-year 2017 results on February 22. Revenues declined slightly year over year by 1.3% to €3857 million, dragged down mainly by mobile operations in Albania, where revenues declined by 11.8%. Mobile operations in Romania remained positive, aided by a strong fourth-quarter performance which saw revenues increase by 14.4% year over year. Revenue growth in Greece remained solid in both mobile and fixed line, increasing by 0.7% and 1% year over year respectively. EBITDA shrank by 1.3% year over year, while EBITDA margin remained flat at 33.8%. As a result of muted top line growth on an annual basis as well as elevated operating costs, the bottom line contracted by 20% year over year, in line with market expectations. Hellenic Telecom is currently trading at a forward P/E of 86x, while the market is forecasting an EPS CAGR of 6.9% over the next three years. Management guidance indicates that free cash flow (FCF) and adjusted capex will start to return to normal levels in 2018 after heavy investments in both its fixed and mobile network capabilities in 2017. Additionally, growing confidence in the company's outlook is signalled by its announcement of a new shareholder return policy, where 100% of the FCF will be distributed through a combination of a dividend payout and share buybacks. We expect that its recent investment in mobile and fixed capabilities and an improving Greek economy should drive a positive performance in 2018. Grivalia Properties (GRIV GA) Grivalia Properties (GRIV GA) (Chart I-18) Chart I-18Performance Since February 2017: ##br##Grivalia Properties Vs. MSCI EM Grivalia Properties reported stellar full-year 2017 financial results on January 31. The top line displayed solid results, with rental income advancing 7% year over year. Furthermore, the company realized a strong net gain of EUR18.8 million from fair value adjustments on investment property, compared to a EUR13.6 million loss in 2016. This was mainly driven by new property investments. As a result, operating profit surged by 102% year over year. All this translated into 139% year-over-year net income growth. Due to loan growth, the loan-to-value ratio grew by 8 percentage points to 14%, while NAV per share expanded by 5% year over year. Grivalia Properties is trading at a forward P/E of 15x, while the market is forecasting an EPS contraction of 1% over the next three years. The company announced in February the acquisition of office space in Maroussi, which has already been leased out to multinational companies. Two more properties were acquired in Greece in the same month. We believe a stabilizing property market leaves ample room for recovery, which is expected to support Grivalia's overweight Greek real estate portfolio and its risk diversification. Alpha Bank (APLHA GA) Alpha Bank (APLHA GA) (Chart I-19) Chart I-19Performance Since February 2017: ##br##Alpha Bank Vs. MSCI EM Alpha Bank reported solid third-quarter 2017 financial results on November 30. Net interest income improved by 2% year over year, with net interest margin growing 20 basis points to 2.9%. However, on a quarter-over-quarter basis, growth was negative. Fee income depicted a similar picture, up 2% year over year but down 7% quarter over quarter. On the positive side, operating expenses were under control, declining by 3% year over year, effectively pushing down the cost/income ratio. With the help of a decline in impairment losses, net income surged by 386% year over year. Asset quality showed a pattern of recovery: The NPL ratio went down by 7.4 percentage points to 33.2% year over year, while the tier-1 ratio improved by 1 percentage point to 17.8%. Moreover, ELA has trended down year to date. The market is forecasting an EPS CAGR of 53.6% over the next three years. Despite uncertainty regarding stress testing and the overall trajectory of Greek economic growth, Alpha Bank has demonstrated a solid pace of recovery in terms of a better asset-liability mix, improved liquidity and steady disengagement with the ELA. As guided by management, ELA funding is expected to be further replaced by strong deposit inflows, deleveraging initiatives and an increase in interbank lending. The Underweight Basket Intralot (INLOT GA) Intralot (INLOT GA) (Chart I-20) Chart I-20Performance Since February 2017:##br## Intralot Vs. MSCI EM Intralot reported mixed third-quarter financial results on November 27. Top-line growth was solid, up 10% year over year, mainly boosted by licensed operations in Jamaica, Azerbaijan and Poland. This also drove up gross margin by 2.8 percentage points to 18.1% year over year. However, a cost hike took a bite out of profits, with operating expenses expanding by 8%. Along with a 49% surge in R&D costs, the bottom line was still in negative territory. On a year-to-date basis, cash flow grew by 23%. However, this was mainly boosted by financing activities, with operating cash flow almost unchanged. Meanwhile, long-term debt has grown by over 50% year over year, which has prompted questions on solvency and the ability to further carry the interest payment burden. The market is forecasting negative EPS over the next three years. We believe the 80% share sale of the company's Peruvian operations reflects its need for cash inflow and raises concerns on balance sheet health. Coca-Cola HBC (EEE GA) Coca-Cola HBC (EEE GA) (Chart I-21) Chart I-21Performance Since February 2017:##br## Coca-Cola HBC Vs. MSCI EM Coca-Cola HBC reported solid full-year 2017 financial results on February 14. Revenues came in strong, growing by 5% year over year. Sales volume in developed markets, developing markets and emerging markets went up 1%, 7%, and 7% respectively. Looking at product lines, Sparkling was the best seller, driven by new flavor launches (such as lime, lemon, and cucumber). Stripping out foreign exchange effects, FX-neutral revenue grew by 6% year over year. Cost of sales ticked up by 4% year over year. EBITDA expanded by 10% year over year, while EBITDA margin added 60 basis points to 14.3%. As a result, the bottom line expanded by 24% year over year, beating market expectations. Coca-Cola HBC is currently trading at a forward P/E of 20x, while the market is forecasting an EPS CAGR of 11% over the next three years. The stock price rallied in the second half of 2017 following the company's announcement that it was acquiring 54.5% of Coca-Cola Beverages Africa (CCBA), indicating market complacency toward a strong synergy effect the deal could bring. However, given its weak profitability, CCBA is not expected to be as accretive as many investors believe. With the acquisition news priced in, CCHBC's year-to-date stock price has begun reverting to its true fundamentals. Hellenic Petroleum (ELPE GA) Hellenic Petroleum (ELPE GA) (Chart I-22) Chart I-22Performance Since February 2017:##br## Hellenic Petroleum Vs. MSCI EM Hellenic Petroleum reported full-year 2017 financial results on February 22. Revenue increased by 21% year over year, driven by higher volumes (exports +12% and +14% in domestic net sales, mainly helped by aviation and bunkering) in the refining division and improved average selling prices. However, this result was offset by higher cost of sales, up 23% year over year, driven by increased input prices, sending gross margin 160 basis points lower to 13.6%. Operating income was 4.7% higher year over year, helped by lower operating expenses. EBITDA was up 14% year over year, while EBITDA margin was 200 basis points lower, finishing at 10.6%. The company secured bottom line growth of 15.7%, but came in below the market expectation by 4.5%. Hellenic Petroleum is currently trading at a forward P/E of 6.5x, while the market is forecasting an EPS CAGR of 4.6% over the next three years. The reopening of the Elefsina refinery will enable Hellenic Petroleum to return to normal capacity in 2018. However, continued maintenance work expected to end in March 2018 and higher crude prices will continue to place pressure on margins. We expect weak domestic demand to continue to impact carbon revenue, despite strong sales growth from increased tourism. Piraeus Bank (TPEIR GA) Piraeus Bank (TPEIR GA) (Chart I-23) Chart I-23Performance Since February 2017: ##br##Piraeus Bank Vs. MSCI EM Piraeus Bank delivered disappointing third-quarter 2017 financial results on November 9. Net interest income came in weak, sliding 3% year over year, with net interest margin remaining virtually flat at 2.7%. On the positive side, net fee income displayed strong growth, up 24% year over year. Operating expenses contracted by 5% year over year, pushing down the cost/income ratio by 5 percentage points to 51%. Despite robust pre-provisional income, the impairment on loans dragged down net income into negative territory, compared to a positive bottom line during the same period last year. Asset quality was a mixed bag: The NPL ratio went down by 2.6 percentage points to 48.3%, but is still the highest among its peers. The loan-to-deposit ratio declined, with ELA loan exposure trending slightly down year-to-date. The market is forecasting an EPS contraction of 8.8% over the next three years. Piraeus Bank has shown little signs of operational recovery, with most cost-savings efforts achieved through branch reductions (-8% year to date) and employee layoffs (-7% year to date). We believe the bank is still a long way away from a real turning point and prefer to monitor on the sidelines. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed stocks below, which would consist of overweight positions in four select Greek companies and underweight positions in the other four. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Jumbo (BELA GA) vs. Intralot (INLOT GA) Hellenic Telecom (HTO GA) vs. Coca-Cola HBC (EEE GA) Grivalia Properties (GRIV GA) vs. Hellenic Petroleum (ELPE GA) Alpha Bank (ALPHA GA) vs. Piraeus Bank (TPEIR GA) ETFs: There are no ETFs that would allow for an overweight/underweight position in the same sector. Funds: There are no funds that would allow for an overweight/underweight position in the same sector. Please note this trade recommendation is strategic and based on an overweight/underweight pair trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the overall market neutral exposure, the portfolio performance will be largely immune to the direction of Greek economic growth and political developments. Some macro risk factors stem from a slower-than-expected property market recovery, which would affect the rental income of Grivalia Properties. Other major macro risks include an oil price drop, which would benefit Hellenic Petroleum's profit margins within its refining operations. Also, a slow recovery of consumer sentiment and retail sales would put downward pressure on Jumbo's domestic top-line performance. Company specific risks worth mentioning include remarkable management efforts in CCBA's financial performance in the coming quarters. This would send the market a bullish signal on Coca-Cola HBC's stock price due to potentially strong synergies, posing upside risk to the underweight basket. Furthermore, Jumbo would be negatively affected by excessive focus on overseas markets, and thus it could miss further business development and market share expansion opportunities in the domestic market. Last but not least, asset quality remains problematic among banks, reflected by elevated NPLs, which would weigh on performance indefinitely if not properly tackled. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Sophie McGrath, Research Assistant sophiemc@bcaresearch.co.uk

Special Report

Highlights European populism is a red herring in 2017; France is a buy, Le Pen is overrated; Merkel's demise would be an opportunity, not a risk; Yet Italy poses a real risk - elections will be crucial; Moreover, Euro breakup risk is rising over the long run. Feature Clients are nervous. Nationalist and Euroskeptic French presidential candidate Marine Le Pen continues to lead first-round polling in the elections. Meanwhile, one of her establishment opponents - François Fillon - is facing corruption charges while anti-police riots have flared up in the banlieue of Aulnay-sous-Bois, northeast of Paris. Everything seems to be falling in place for another "black swan" political outcome (Chart 1). With Brexit and President Trump's victory fresh in everyone's consciousness, it is unsurprising that Le Pen's election probability is more than double our own assessment of 15% (Chart 2). Chart 1Another Black Swan In The Making? Chart 2Brexit/Trump Drive Up Bets On Le Pen In this analysis, we take our clients around Europe in under 3,000 words. There is a lot happening on the continent this year. Yet, as we argued in our Strategic Outlook, Europe is setting up to be a massive red herring for investors.1 For example, France is more likely to have a free-market revolution than a populist one! It could be the chief investment opportunity in developed markets over the next several years.2 We are also optimistic about the Netherlands and Germany, despite alarms about populism. As such, we are going to play devil's advocate in this analysis and push our sanguine view to its limit. Where does our bullish logic break down? The Netherlands We begin with the Netherlands, which is the first to hit a busy electoral calendar in 2017. General elections are set for March 15 and the Euroskeptic Party for Freedom (PVV) of Geert Wilders will win a plurality of seats in the House of Representatives. According to the latest polls, Wilders' PVV will capture about 30 out of the 150 seats in the Tweede Kamer, the largest of any party. However, it is not enough to form a majority (Chart 3). Chart 3Dutch Populists A Minority In Parliament The problem for the centrist parties in the Netherlands is that there are too many of them. In Chart 3, we combine the center-left and center-right, pro-EU integration parties together. There are approximately ten such parties fighting over the pro-EU middle ground. None is expected to get to the 30-seat projected average of PVV. Given that the center-right and center-left parties split the establishment vote roughly in half (~60 seats each), it is likely that the Dutch pro-EU parties will need a cross-aisle "Grand Coalition" to produce a government. Coalitions take a long time to form in the Netherlands. In 2012, the process took 54 days, whereas in 2010 it took four months. The 2010 election is a good guide to this year's event, as it also produced a relatively complicated seat breakdown that ultimately forced the center-right to depend on PVV votes to govern. We suspect that the Netherlands will be deep into the coalition talks in the summer months, well after the French election is over. Investors take comfort in the fact that PVV cannot form an anti-EU/euro government on their own. This is true. We would also point out that the Dutch support the euro at a very high level (Chart 4) and that they surprisingly lack confidence in the country's future outside the EU (Chart 5). However, a "Grand Coalition" whose only purpose is to keep PVV out of government would cede the "opposition" ground to Wilders and his Euroskeptic government. And while this seems like a good idea today, while Europe's economic growth is rebounding and the migration crisis has abated (Chart 6), it could be a very bad idea once the next recession hits or the next geopolitical crisis reveals flaws in EU governance. Chart 4The Dutch Highly Approve Of The Euro... Chart 5...And See Little Future Outside The EU Chart 6Waning Migrant Crisis Undermines Populist France Constraints to a Le Pen victory in the upcoming presidential election - April 23 and May 7 - are considerable, and we expanded on them in our February 3rd Special Report "The French Revolution."3 Briefly, they are: Strong French support for the euro: Support appears to be inversely correlated with Le Pen's overall popularity, suggesting that her stance on the euro and EU creates a ceiling to her support level (Chart 7). Le Pen is weak in the polls: Le Pen continues to trail both centrist Emmanuel Macron and center-right François Fillon in the second-round polling, both by around 20% (Chart 8)! Comparing Le Pen's chances to those of Trump is a massive insult to the latter, given that Trump never trailed Clinton by more than 8% with three months to go. Bad omens for Le Pen's party: The December 2015 regional elections pose a troubling precedent for Le Pen and her National Front (FN). Her party was decimated in the two-round format, despite a slew of tailwinds at the time, including the largest terrorist attack in recent French history. Chart 7Le Pen Hobbled By Her Anti-Euro Stance Chart 8Le Pen Lags By ~20% In Key Second-Round Polls So, how does Le Pen win? We can imagine a scenario where a combination of another terrorist attack, banlieue rioting, and perhaps a restart of the migration crisis inspires enough voters to vote for Le Pen. Further, given that relatively liberal Macron is likely to make it to the second round, center-right voters may stay home or even shift to Le Pen in case of such a toxic brew. One problem with recent French electoral history is that it is replete with examples of center-left and left-wing voters strategically voting against Le Pen, yet little evidence exists that French conservative voters are willing to do the same and cast their vote for a left-leaning candidate. As such, despite better polling than Fillon in the second-round head-to-head against Le Pen, Macron remains vulnerable. What happens if Le Pen wins the election? This depends on whether FN wins the legislative elections set for June 11 and 18 - also a two-round election. Polls for the legislative election are sparse and unreliable, but it would be a shock if FN won a majority, especially given its performance in the December 2015 regional elections. As such, President Le Pen would have to co-habitate with an opposition-led parliament. The president of France has a lot of power, but it is checked by the National Assembly, the lower house of the parliament. For example, Le Pen's choice for prime minister would have to command a majority in the National Assembly in order to govern. And a number of constitutional powers - appointing members of the government, calling a referendum, dissolving the National Assembly, or ruling by decree - require the consent of the prime minister and cabinet. She would not even have a veto power over laws passed by parliament, as the French president can only delay legislation. Le Pen would only be unconstrained in matters of defense and foreign policy, where she could pursue several unorthodox policies. However, France's EU membership is written into the constitution (Article 88-1). Modifying the constitution would require an act of parliament (and potentially also a referendum, depending on a majority in parliament). In addition, France's membership in the euro is a legal obligation of its membership in the EU - given that France did not opt-out of the monetary union as Denmark and the U.K. did during the negotiations of the Maastricht Treaty. As such, it is unclear how Le Pen would be able to get the country out of the euro without pursuing the same procedure as the U.K. under Article 50 of the Lisbon Treaty, for which she would need to change the French constitution. All that said, these constraints may not be clear to the market if she is elected. We suspect that global markets would panic. A market riot, in fact, would be necessary to force Le Pen into orthodox policy, as it did with the surprise 1981 victory by socialist-leaning François Mitterrand. However, Mitterrand did not reverse policy until after two currency devaluations in the first year of his presidency, with the possibility of an IMF program openly discussed in Paris. The volte-face came after two years of sustained market pressure. It is not clear that France, or Europe for that matter, has that much time to dither today. Spain A referendum on the independence of Catalonia is expected by September. A referendum has been the main goal of the pro-independence government since Catalan elections in September 2015. The government combines far-left and center-right nationalists in an ungovernable coalition whose only common goal is independence. Chart 9Catalans Want Autonomy, Not Independence News flash to the markets: Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 9). 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.4 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.5 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). According to the Spanish constitution, Catalonia does not have the legal right to call for an independence referendum. We suspect that the center-right government in Madrid will continue to deny the legitimacy of any referendum. Ironically, this will suppress the anti-independence turnout and hand the nationalists a victory in September. What then? A low-turnout vote, combined with no recognition from Madrid, means that the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. 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 take up arms in order for its referendum to be relevant to markets (beyond the inevitable knee-jerk reactions surrounding the vote). Without recognition from Spain, and with no support from EU and NATO member states, Catalonia cannot win independence with a referendum alone. Germany General elections are set for September 24, with investors concerned that Chancellor Angela Merkel may face a tougher-than-expected challenge from the center-left Social Democratic Party (SPD). The new SPD Chancellor candidate, Martin Schulz, is polling very well and has even overtaken Merkel in the head-to-head polls (Chart 10). Schulz's overtly Europhile position - he has been the European Parliament Speaker since 2012 - appears to be winning over voters. The CDU held on to a double-digit lead over the SPD right up until Schulz took over as the primary challenger to Merkel (Chart 11). Chart 10Schulz Now Leads Merkel For Chancellor Chart 11Pro-Europe Sentiment Drives SPD Revival To some extent, CDU's drop in the polls was inevitable. It is correlated with a decline in Merkel's popularity (Chart 12). But we suspect there is more to it. Schulz's confidently pro-European attitude is a breath of fresh air for voters in Germany who have perhaps lost faith in Merkel's cautious approach to the euro crisis. Record-high support for the common currency in Germany suggests that we may be on to something (Chart 13). The German public is simply nowhere close to being as Euroskeptic as the financial media would have investors believe. And that is for good reason: euro area membership has clearly worked for Germany. Can Schulz and the Europhile SPD keep up the pressure on Merkel? Time will tell. But we take two messages from the polls. First, Euroskeptic parties are nowhere close to governing in Germany (Chart 14). Second, Merkel is a shrewd politician who has shamelessly pivoted on policy issues in the past. If Merkel senses that her lukewarm embrace of European integration can cost her the election, and that voters are buying Schulz's claim that she is to blame for the rise of populists in Europe, then she will pivot on Europe. This would be very bullish for markets as it would suggest that Berlin is ready and willing to apply fewer sticks and more carrots to its euro area peers. Chart 12Merkel's Popularity##br## In Decline Chart 13Germans See The Euro##br## As A Great Deal Chart 14There Is A Lot Of Daylight... ##br##Euroskeptic Parties Weak In Germany What if Schulz defeats Merkel and the SPD takes over the leadership of the grand coalition, or perhaps forms a coalition with left-leaning Greens and Die Linke? Is Merkel's demise not a risk to the markets? Most of our clients would see Merkel's retirement as a risk. We disagree. Investors are overstating Merkel's role as the "anchor" of euro area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent euro area fiscal backstop mechanism due to upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. Her handling of the migration crisis also left much to be desired, to put it kindly. The SPD has picked up on this line of criticism and Schulz has begun to blame Merkel's cautious approach and insistence on austerity for the populism sweeping Europe. Given that polls suggest that Germans are not really in favor of austerity, this is potentially a winning strategy (Chart 15). Chart 15Germans Are Not Obsessed With Austerity We therefore believe that Merkel's demise is not being correctly priced by the markets. First, investors seem to believe that she will easily win another term. Second, those that fret about her future incorrectly price the downside risk. We actually see Merkel's retirement as an opportunity, not a risk. Whether the SPD takes over, or a more Europhile member of the CDU replaces an embarrassed Merkel as the leader of a grand coalition (Box 1), investors should contemplate what the continent will look like with a new Europhile chancellor. BOX 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Wolfgang Schäuble, Finance Minister (CDU): The bane of the financial community, Schäuble is seen as the least market-friendly option due to his hardline position on bailouts and the euro area. In our view, this is an incorrect interpretation of Schäuble's heavy-handedness. He is by all accounts a genuine Europhile who believes in the integrationist project. At 74 years old, he comes from a generation of policymakers who consider European integration a national security issue for Germany. He has pursued a tough negotiating position in order to ensure that the German population does not sour on European integration. Nonetheless, we doubt that he will choose to take on the chancellorship if Merkel retires. He suffered an assassination attempt in 1990 that left him paralyzed and he has occasionally had to be hospitalized due to health complications from this injury. As such, it is unlikely that he would replace Merkel, but he may stay on as Finance Minister and thus be as close to a "Vice President" role as possible in Germany. Ursula von der Leyen, Defense Minister (CDU): Most often cited as the likely replacement for Merkel, Leyen nonetheless is not seen favorably by most of the population. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has gone so far as to say that the refugee crisis and the debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who has handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière, Interior Minister (CDU): Maizière is a former Defense Minister and a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could be a compromise candidate between the Europhiles and Eurohawks within the CDU ranks. Though he has been implicated in scandals as defense minister, his popularity as interior minister is surging at the moment as a result of his declared intention to overhaul immigration policy and internal security. Julia Klöckner, Executive Committee Member, Deputy Chair (CDU): A CDU politician from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel. While she has taken a more right-wing stance on the immigration crisis, she has remained loyal to Merkel otherwise. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist." We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe, Minister of Health (CDU): Gröhe is a former CDU secretary general and very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier, Minister President of Hesse (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier's handling of Brexit will attract much scrutiny. He is a heavyweight within the CDU's leadership and a staunch Europhile. Fritz Von Zusammenbruch, Hardline Euroskeptic (CDU): Significantly, no such candidate exists! Greece The financial media have begun to fret about the ongoing negotiations between Greece and its euro area creditors over further aid to the country. Greece faces a €7bn euro repayment in July, by which time the funding must be released or the government will run out of cash. The problem is that the IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. Europeans are willing to turn a blind eye to the reality in Greece and project high growth and primary surpluses. The IMF is not. And yet both Germany and Finland have made their participation in the Greek rescue conditional on the IMF's involvement. Even if a crisis emerges, the likely outcome would be early elections in Greece. Prime Minister Alexis Tsipras is holding on to a three-seat majority in the parliament. This majority is at risk, especially in a repeat of the 2015 crisis. Investors should cheer new elections in Greece, not fret about them. Polling shows that the pro-euro and pro-EU New Democracy Party is polling well above SYRIZA, and would produce a stable, pro-reform government (Chart 16). And there is no longer any Euroskeptic alternative in Greece. Chart 16No More Euroskeptic Option In Greece Given Tsipras's limited choices and the upcoming German elections, we suspect that investors will not see a return of the Greek saga this year, at least not at the same level of intensity as two years ago. And is Greek debt sustainable? Yes, it is sustainable as long as the Europeans decide to pretend that it is sustainable. Italy Last but not least is Italy. Investors have recently received some clarity on the timing of the next election as former Prime Minister Matteo Renzi has called a new leadership race in the ruling Democratic Party (PD). Given that the party must hold an internal election sometime in the spring, it is unlikely that elections will occur by mid-June, as Renzi had hoped. The most likely date is therefore in autumn 2017, given that Italy shuts down in the summer. However, interim Prime Minister Paolo Gentiloni, along with a large minority of MPs, opposes Renzi's leadership and could see him defeated in the leadership race. If that happens, investors may be spared an election until closer to the formal due date of May 23, 2018. The election, whenever held, will be the main political risk for European markets in 2017. First, support for the common currency continues to plumb multi-decade lows in Italy (Chart 17), while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart 18). Second, rising negative sentiment towards the euro and the EU are reflected in very strong polling for Euroskeptic parties. Chart 19 shows that establishment parties are barely fending off the Euroskeptic challenge - and that is only because we include the Forza Italia of former Prime Minister Silvio Berlusconi in the pro-Europe camp. Meanwhile, the ruling PD and Euroskeptic Five Star Movement (M5S) are neck-and-neck in the disaggregated polls (Chart 20). Chart 17Italians Turning Against The Euro Chart 18Italians Confident In Life Outside The EU Chart 19Euroskeptic Parties##br## Strong In Italy Chart 20Five Star Movement Rivals##br## Ruling Democratic Party What happens if M5S wins the election? Given the recent Supreme Court ruling on the electoral law, it is essentially impossible for any party to win the majority in the next election, at least with the current polling numbers. As such, M5S would have to break its electoral pledge not to form coalition governments and either form one or rule with an unstable minority. It is highly possible that M5S would use support from other Euroskeptic parties - such as the nationalist Lega Nord - to pass a law on a non-binding referendum on the euro. While the Italian constitution prohibits referenda on international treaties - and membership in the monetary union is such a treaty - a vote against the euro in a non-binding referendum would give M5S legitimacy in pursuing an Italian exit from the euro area. At such a point, we would expect that a severe market riot would be needed to push Italy away from the brink. Our assessment is that M5S would ultimately back off, as Greece did in 2015. However, Italians in 2017 are more Euroskeptic than Greeks were in 2015. Whereas Greeks saw euro membership as a key link to their membership in the Western club, Italians appear to be a lot more confident in their ability to survive euro exit. That said, M5S is not a single-issue party. Rather, it is a protest movement against government corruption and incompetence that is also moderately Euroskeptic. As such, it is not clear that it would risk an economic crisis and a potential popular revolt over an issue that has split the Italian electorate. Rather, we suspect that M5S would use the threat of euro exit to win concessions on fiscal spending from the rest of Europe. As we explained in our September 2016 net assessment of Italian politics, European integration is vital for Rome both politically and economically.6 While Italy would theoretically benefit from currency devaluation by exiting the euro, it would in practice lose access to the common market as its euro membership is legally tied to its EU membership. Politically, it would also be highly unlikely that the other euro member states would allow such a large economy to devalue against them. Investment Implications European markets remain in a sweet spot in 2017. Global growth is showing signs of improvement, the ECB will remain dovish relative to the Fed, the EU Commission is calling for more expansionary fiscal policy, and valuations continue to favor European plays over other developed market plays. Will politics spoil the party? Of the six risks we reviewed in this report, Italy is the one where the devil's advocate argument is most convincing. Polls in the country have shown no improvement in support for the euro despite the continent-wide resurgence in support (Chart 21). The other five risks will likely remain limited to fodder for the news media, allowing markets to climb the proverbial wall of worry in 2017, especially if Italian elections are pushed off into 2018. But even if the slew of elections returns pro-euro governments, long-term political risks are mounting in Europe. As we pointed out in 2013, there is a danger in relying on "Grand Coalitions" between the center-right and center-left to sustain European integration.7 Such a centrist consensus cedes the opposition ground to the Euroskeptics. If - or rather, when - a major recession or geopolitical crisis occurs, voters will no longer have a pro-establishment political alternative to turn to. As such, we agree with our market gauge of euro area breakup probability - which measures the probability of a common currency breakup over the next five years. It currently stands at 30.2% (Chart 22). Chart 21Italy Poses Chief Risk ##br##To European Integration Chart 22Euro Breakup##br## Risk Is Rising Thankfully for investors, neither a recession nor a geopolitical crisis is on the horizon in 2017. The migration crisis has ended, as we expected (Chart 23).8 Given the geographical proximity of the Middle East and North Africa to Europe, another refugee deluge is possible. We suspect it would require the collapse of new states, such as Algeria or Egypt, not merely the ongoing crises in Libya and Syria. However, with the Middle East still in flux, a recession on the five-year horizon, and the first anti-EU president in the White House, risks are beginning to stack up against European integration. Chart 23Migrant Crisis Waning The key question for 2017 is the same as it has been since 2010: what will Germany do? If the Europhile turn in German politics is real, then the assumptions that investors have taken for granted may be shifting. A Germany more willing to shoulder the cost of economic rebalancing via higher inflation and debt relief would be a game changer for markets. Pessimists will say that Germans would never accept such costs. But with a 3.9% unemployment rate, an 8.5% of GDP current account surplus, and a budget surplus, Germany is firing at all cylinders. Ultimately, the question for German voters is whether they are willing to bear the costs of regional hegemony. If they are, then Europe's economy and markets are about to enter a multi-year bull market. If they are not, then the centrist victories in 2017 may be the calm before the storm. As BCA's Geopolitical Strategy argued in our aforementioned Special Report on the French election, we recommend going long French industrials versus German industrials, to capitalize on reforms we think are likely after the election (whereas Germany has already reformed). We are also sticking with our long German consumers versus exporters trade, reflecting the robust German economy and persistently dovish ECB. Finally, by contrast with these bullish trades, we maintain our more bearish tactical trade of matching every €1 of euro area equity exposure with 40 cents of VIX term structure, since the latter will spike if and when the various headline political risks cause market flutters. BCA is cyclically overweight euro-area equities relative to the U.S. in currency-hedged terms. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see 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 Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 See footnote 2 above. 4 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 5 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat. 6 Please see Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 7 Please see Geopolitical Strategy Monthly Report, "Austerity Is Kaputt," dated May 8, 2013, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com.

How big a problem are the non-performing loans in Italy and Greece? And what is the solution?